What is economics

Scarcity refers to a situation where finite resources are available to produce infinite goods and services.

Opportunity cost refers to the next best alternative forgone, a benefit that an individual may have received by taking another course of
action.

Economic problem
 What to produce - individuals are concerned with how to allocate their scarce resources e.g., should firms produce wheat
or oranges?
 How to produce - individuals also decide what combination of resources may be used to produce decided goods and
services e.g., firms may use more labor than capital for production.
 For whom to produce - individuals also need to decide who will receive their output and how much they will receive.

Factors of production
 Land refers to natural resources available within a country e.g., timber, fisheries, farms, minerals etc.
 Labor refers to the physical and mental human skills available to convert raw materials into goods and services.
 Capital refers to financial resources and capital goods such as tools, machinery and technology that are used in the
production of goods and services.
 Enterprise is the willingness of an entrepreneur to bring the other three factors of production together to produce goods
and services in return for profit.

Public sector is a sector of an economy comprised of organization owned and managed by the government with the aim to provide
public services e.g. public healthcare, education, defense etc.

Private sector is a sector of an economy comprised of businesses owned and controlled by private firms with the aim is to maximize
profits e.g., commercial banks, private schools, grocery stores etc.

Sectors of business
 Primary sector is a sector of business activity which deals with the extraction of raw materials e.g., fishing, mining etc.
 Secondary sector is a sector of business activity which deals with the manufacturing of goods, e.g., textiles, electronics,
construction etc.
 Tertiary sector is a sector which deals with providing services directly to consumers e.g., restaurants, banks etc.

Market economy is an economic system in which decision-making related to resource allocation is done by private individuals and firms
e.g. New Zealand, Singapore.

Advantages
▪ Competition leads to efficiency as businesses seek to earn greater profits.
▪ Innovation is encouraged as it provides a competitive edge for firms.
▪ A large variety of goods and services are available, increasing consumer choice.

Disadvantages
 Products that are unprofitable will not be produced e.g., rural hospitals.
 Large firms may dominate certain markets and exploit consumers, e.g., Amazon has done this in the book industry by
dictating unfair terms to publishers.
 Certain individuals may not be able to work as their skills might not be marketable.

Planned economy is a system in which all the factors of production are owned and controlled by the government e.g. North Korea, Cuba.

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Advantages
 Prices are kept under control, and everyone can afford to consume goods and services.
 There is less inequality of wealth in the economy.
 There is a lower level of unemployment.

Disadvantages
 Consumers have limited/no choice.
 Lack of profit motive may lead to firms being inefficient, leading to decline in quality.
 Time and money are wasted in communicating between the government and firms.

Mixed economy is a system in which some public goods are provided by the government while the private sector provides all types of
goods and services companies e.g. Pakistan, UK. However, the government intervenes if resources are allocated inefficiently.

Advantages
 This may lead to economic development as resources are used efficiently.
 There may more inequality in income.
 The government may provide economic utility to the public which may reduce income inequality.

Industrialization refers to when an economy moves from primary production like agricultural to secondary production like
manufacturing goods.

De-industrialization is a process in which an economy moves from secondary sector of business, manufacturing, to tertiary sector
businesses aimed at providing services to customers.

Value added is the process of adding extra features to a product through the production process aimed at increasing its selling price
e.g., changing the packaging of goods.
Value added = selling price – cost of raw material

Production possibility curve PPC is a graphical representation

of the different combinations of two goods or services that
an economy can produce with the efficient usage of available
resources.
 Efficiency any point on the PPC reflects efficiency, meaning all factors of
Production is being utilized optimally. On the graph, points A, B, C and
D all represent efficiency. However, an economy may exist at point E, inside
the PPC, which represents inefficiency, this may be due to the
under-utilization of resources. A point F, outside the PPC, is unattainable
for an economy with its existing resources.
 Scarcity any point on the PPC represents scarcity as the level of production
is limited due to limited resources.
 Trade-offs in the above figure, in order to produce robots, the economy must partially give up the production of pizzas.
Movement down the PPC indicated the economy is trading off pizzas for robots.
 Opportunity cost by increasing its production of robots, there must be a sacrifice of some quantities of the pizzas e.g., if the
economy moves from point A to B, it must give up 800,000 pizzas.

Shifts in PPC the outwards shift of the PPC represents economic growth which may be due to an improvement in the quantity or quality
of available resources or technological advancements. The PPC may also shift inwards due to degradation of the quality or quantity of its
resources e.g., war may affect the resources adversely and the ability of the economy to produce may decrease.
 PPC generally bows outward, due to the principle of increasing marginal opportunity cost which means that opportunity costs
increase as more of a good is produced increases. The PPF can also be linear, representing constant opportunity cost,
meaning both goods use similar resources.

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Demand
Demand it is the willingness and ability of consumers to buy goods and services at given prices, it represents the behavior of buyers
who are concerned with maximizing utility.

Law of demand an increase in price of a good or service will lead to a fall in its quantity demand, ceteris paribus and vice versa. There
are three rationales for this relationship:

Movement along the demand curve extension of the demand is represented by an increase in quantity demanded due to the fall in
price, while contraction of demand curve is represented by a fall in quantity demanded due to a rise in price.

Difference between change in quantity demanded and change in demand quantity demanded changes only when the price of a good
changes, resulting in a movement along a fixed demand curve. However, demand only changes when a non-price determinant changes,
resulting in a shift of the demand curve, either rightwards (increase in demand) or leftwards (decrease in demand).

Non-price determinants of demand

 Income an increase in income of individuals will increase their ability to buy, resulting in increased spending on goods and
services, resulting in a change in demand.
• Inferior good a good whose demand decreases as consumers’ income increases; this results in leftwards shift of
the demand curve (decrease in demand) e.g., an increase in income may lead to a decrease in demand for public
transportation.
• Normal good a good for whose demand increases as consumers’ income increases, resulting in a rightwards
shift of the demand curve (increase in demand) e.g., an increase in income may increase demand for new cars.
 Population an increase in the number of buyers due to increased population will increase demand for goods, as a result the
demand curve shifts to the right.
 Fashion and taste as preferences and tastes change in favour of a good its demand increases and the curve shifts
rightwards e.g., launch of a new iPhone model may lead to increase in its demand.

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 Substitutes, these are goods which can be used in place of each other as they fulfill the same purpose e.g., coke is a
substitute for pepsi, a fall in price of coke will result in a fall in demand for pepsi.
 Complement these are goods which are jointly demanded with other goods e.g., tea and milk, the demand for tea will
increase with a decrease in the price of milk.
 Future price expectations consumer price expectations in the future can influence demand e.g., if property prices are
expected to rise, people may buy property seeking benefit.

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Supply
Supply is the willingness and ability of producers to sell goods and services at a given prices, it represents the behavior of sellers who
aim to maximize profits.

Law of supply an increase in price of a good will result in an increase in its quantity supplied ceteris paribus and vice versa.

Movement along the supply curve and shifts in supply extension of supply refers to an increase in quantity supplied of a good due to
an increase in its price. Contraction of supply refers to the fall in quantity supplied of a good with a fall in its price. A change in quantity
supplied occurs due to a change in price, and results in a movement along the existing supply curve. However, a change in supply results
due to change in a non-price determinant, resulting in a shift of the supply curve. A rightward shift represents an increase in supply,
while a leftward shift represents a decrease.

Non-price determinants of supply

 Cost of production all firms require various factors of production to produce goods or services e.g., rent, wages, utilities
raw material etc. An increase in the cost of production may reduce profit margins. Producers will be less willing to sell goods
resulting in a decrease in supply, represented by a leftward shift of the supply curve.
 Technology innovation in technology may result in increased productivity, lowering the cost of production. This may lead to
increased profits; new firms may enter the market resulting in an increase in supply.
 Prices of related goods
• Joint supply refers to production of two goods that are derived from a single good, e.g., butter and skimmed milk
are both produced from whole milk. An increase in price of butter may lead to an increase in its quantity supplied,
but also an increase in supply of skimmed milk.
• Competitive supply, if goods compete for use of the same resources, producing more of one means producing
less of the other e.g., a farmer may choose to grow wheat or corn. As price of corn increases, the farmer may
allocate more resources to corn production, resulting in a decrease in supply of wheat.

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 Supply shocks are random events such as natural disasters or wars that may adversely affect supply e.g. bad weather may
adversely affect crops, decreasing supply of agricultural products. However, positive supply shocks such as discovery of
fossil fuels may increase the supply of certain goods.
 Subsidies are financial payments made to firms by the government and are considered a decrease in the cost of production.
This increases profit incentives for existing firms to allocate more resources to the production of goods. Additionally, new
firms may also enter the market due to profit incentives, resulting in an increase in supply.
 Indirect taxes are financial charges imposed on production and consumption of goods and services and are considered an
increase in the cost of production. Taxes decrease profit incentive for existing firms as a result some firms may reduce their
output while others may leave the market, resulting in a decrease in supply.
 Number of firms increases in the number of firms producing goods or services in a market will increase supply resulting in
a rightward shift of the supply curve.
 Future price expectations if firms expect their prices to rise in the future, then they may choose to increase production
now, which increases supply.

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Competitive market equilibrium
Market equilibrium occurs at the intersection of the demand and supply curves which represents the market-clearing price and
quantity traded.

Effect of change in demand on equilibrium an increase in demand creates a situation where quantity demanded exceeds quantity
supplied (shortage), producers increase quantity supplied but raise prices while buyers are willing to pay higher prices but buy lesser
quantity. This continues till equilibrium is reached. Similarly, if demand falls, quantity supplied exceeds quantity demanded (surplus),
producers reduce prices to clear stocks and reduce their output while quantity demanded will increase as consumers are willing to buy
more at lower prices. This continues till the market reaches equilibrium.

Effect of change in supply on equilibrium an increase in supply creates a situation where quantity supplied exceeds quantity
demanded, producers reduce prices to clear stocks and reduce their output while quantity demanded will increase as consumers are
willing to buy more at lower prices. This continues till the market reaches equilibrium. However, a decrease in supply means the quantity
demanded exceeds quantity supplied, producers increase quantity supplied and raise prices while buyers are willing to pay higher prices
but buy lesser quantity. This continues till equilibrium is reached.

The price mechanism refers to the means by which the forces of demand and supply determine the allocation of scarce resources by
competing users.
 Resource allocation (signaling and incentive function)
 The rationing function

If there is a shortage in the market, it sends a signal to firms to meet consumer demand. This introduces an incentive for firms to raise
product prices in order to earn more revenue. However, as prices rise consumers ration their resources (money) by buying fewer
quantities of goods.

However, if a surplus occurs in the market, it sends a signal to firms that there is low demand. This incentivizes firms to reduce prices
and output. Furthermore, as prices fall, consumers ration the resources (money) towards buying more quantities of goods.

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Market efficiency occurs if maximum amount of goods is produced with a given level of resources, and if no additional output is
possible without increasing the number of inputs.
 Consumer surplus is the extra benefit consumers receive when they pay a price below what they are willing to pay.
 Producer surplus is the extra benefit producers receive when they receive a price above the one at which they are willing
to sell at.

Consumer or producer surplus = ½ x base x height

Community (total/social) surplus is the sum of consumer and producer surplus at a given market price and output.
Total surplus = consumer surplus + producer surplus

Productive efficiency occurs when a firm is producing at the lowes possible cost. This can be shown by any point on the PPC curve or
where when P = min ATC on a profit maximization graph.

Marginal benefit is the benefit a person receives by consuming an additional unit of a good or service.

Marginal cost is the cost incurred by a manufacturer of producing one additional unit of a good or service.

Allocative efficiency occurs when a firm produces a combination of goods that are most wanted by consumers and this can been
shown on a proft maximization grpah where MSB = MSC.

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Elasticity of demand: price elasticity of demand (PED)
Price elasticity of demand measures the change in quantity demanded of a good due to a change in its price.
PED = percentage change in quality demanded
percentage change in price

Example: if the price of an ice cream cone increases from $2 to $2.20 and the amount individuals buy falls from 100 to 80 cones, then
PED can be calculated as:

PED = (80 -100) / 100 x 100

(2.20 – 2) / 2 x 100

PED = -20 = -2
10

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Determinants of PED
 Number of substitute goods with more substitutes have price-elastic demand, if the price of a good rises, consumers may
switch to other substitutes resulting in a relatively large fall in quantity demanded. But a good with fewer substitutes has
inelastic demand, an increase in price will result in a relatively smaller fall in quantity demanded.
 Proportion of income goods that consume a larger portion of buyer's income tend to have elastic demand as the higher
cost will cause buyers to purchase substitute goods. In contrast, demand will tend to be price-inelastic when a good
consumes a small portion of income.
 Luxury or necessity the greater the necessity for a good the more inelastic its demand. However, luxury goods tend to have
elastic demand as buyers will be more responsive to price changes.
 Addictive nature goods that are addictive in nature will have an inelastic demand due to the fact that they are habit-forming
and can become necessities for consumers.
 Time period if people have more time to adjust to price changes, they may be able to make greater adjustments and will be
more responsive to price changes. But with time, they may buy petrol-efficient cars lowering their demand for petrol.

Usefulness of PED the knowledge of PED may help a producer to analyze the impact of changes in price levels on the demand for its
goods and consequently on its revenue. Producers can use this to decide the price of their goods. If the demand of the good is price-
elastic, by lowering its price, producers may earn greater revenue. However, if demand of the good is price-inelastic, by raising its price
producers may earn greater revenue.

Additionally, producers may use the knowledge of PED to decide whether to bear high burden of indirect taxes themselves or pass it on
to consumers in the form of higher prices. In case of elastic demand, producers bear higher tax burden. But in case of inelastic demand,
producers can pass on a higher proportion of tax to consumers.

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Elasticity of demand: income elasticity of demand (YED)
Income elasticity of demand measures the change in quantity demanded of a good due to change in the income of buyers (normal and
inferior goods).
YED = percentage change in quantity demanded
percentage change in income

Example: An increase in income from $800 per month to $1000 per month may lead to increased purchase of clothes from $100 to $140
per month.

The YED sign is positive, showing that it is a normal good, while the value 1.6 means its demand is price-elastic.
 Normal goods if an increase in income of individuals leads to an increase in their consumption, demand shifts to the right
and YED is positive.
 Inferior goods as income rises, the proportion spent on cheaper goods will reduce as now they can afford to buy more
branded/new goods, the demand curve shifts left and YED is negative.
 Luxury goods are goods that have an income elasticity of demand significantly > 1 e.g., an 8% increase in income might lead
to a 10% rise in the demand for new kitchens.

An Engel curve shows the positive or negative relationship between quantity demanded for a product and income. If the Engel curve is
upward sloping, the product is classified as a normal good. If the Engel curve is downward sloping, the product is classified as an inferior
good

Example: Assume the YED for sausages is –0.25 and that consumers incomes have increased by 3%. Calculate the percentage change in
the demand for sausages.

–0.25 = % change in demand for sausages / 3

% change in the demand for sausages = –0.75

This means that percentage change in demand for sausages is 0.75%

Applications of YED
 During a recession, as income levels fall, inferior goods are likely to face higher demand while luxury goods experience a fall
in demand.
 During an economic boom, as income levels rise, inferior goods face lower demand while superior goods (luxury and normal
goods) experience rising demand.
 Necessities tend not to be affected during economic fluctuations.
 With economic growth, income levels rise, primary sector tends to become less important in terms of contributing to national
output and employment.

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 It is important to note that certain primary commodities such as gold, oil and gas can be income elastic helping countries
Saudi Arabia to prosper
 With rising income levels, the secondary and tertiary sectors tend to become more important.

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Elasticity of supply
Price elasticity of supply measures the change in quantity supplied of a specific good due to a change in its price.
PES = percentage change in quantity supplied
percentage change in price

Example: the price of strawberries increases from €3 to €3.50 per kg and quantity supplied increases from 1000 to 1100 tons.

PES for strawberries is +0.59.

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Determinants of PES
 Mobility of factors of production higher the mobility of factors of production, the more elastic the supply e.g., a printing
press which can switch easily between printing magazines and greeting cards.
 Ability to store stocks if raw materials and finished goods can be stored in large quantities then a firm may be able to
respond quickly to a change in demand, meaning that supply is price elastic and vice versa.
 Unused capacity, if there is spare production capacity a firm can increase output without raising costs, and supply will be
elastic in response to a change in demand.
 Time period supply is more price-elastic when producers have more time to redirect resources to increase production in
response to changes in demand.

Example: A product has a PES of +3, calculate how much quantity supplied changes if the price falls from $13 to $11 while output was
originally 5000 units.

Fall in price = [(11 – 13) / 13] x 100 = -15.38%

As PES = +3, this means that the change in quantity supplied is 3 times
-15.3 x 3 = -46.14%

Change in quantity supplied = 5000 – 45.9%

= 2693 units

Applications of PES primary goods usually have a lower PES than manufactured goods. In the case of agricultural goods, it takes more
time for resources to be shifted in and out of agriculture. Farmers need at least a planting season to be able to respond to higher prices.
In the case of other primary products, such as oil, natural gas and minerals, time is needed to make the necessary investments and to
begin production. Because of the costs involved, firms do not respond quickly to price increases and wait for a serious shortage in the
commodity to arise before they increase production. This suggests that over longer periods of time PES of agricultural products are
elastic.

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Role of government in microeconomics
Governments intervention refers to ways in which a government regulates or interferes with activities or decisions made by
individuals or firms through regulations, taxation or subsidies.

Reasons for government intervention in markets

 To earn government revenue (tax revenue, sale of goods and services, privatization, sovereign wealth funds, public sector
funding)
 To support firms (subsidizing, tax concessions, business development loans, research and development funding, financial
bailouts, protecting local businesses from foreign competition)
 To support households on low income

Tax is a financial charge imposed on individuals or firms payable to government, they are divided into two catagories, direct and indirect
tax.

Direct tax is a tax imposed on the income of individuals or profits of firms and paid directly to the government such as income tax,
corporation tax etc.
 Income tax is a tax imposed on income of private individuals by the government.
 Corporation tax is a tax imposed on profits earned by firms by the government.

Indirect tax is a tax imposed on production and consumption of goods and paid partly by consumers and partly by producers e.g. excise
duty (tax on manufactured goods) and value added tax (tax on retail of goods).

Types of indirect taxes

 Specific tax is an indirect tax charged at a fixed amount per unit of the good sold e.g. €5 per packet of cigarettes.
 Ad valorem tax is an indirect tax charged as a percentage of the price a good e.g. 19% of value of good.

Consequences of indirect tax when an indirect tax is imposed, it must be paid to the government by producers who add it to the selling
price. An indirect tax is considered an increase in the marginal cost of production. It reduces profit incentives of firms resulting in a
decrease in supply (upward shift of supply curve).

Classification of taxes
 Progressive tax refers to a tax in which the rate of tax rises with the increase in income e.g. income tax.
 Regressive tax is a tax in which the rate of tax falls as income increases, meaning people with lower income pay
proportionately higher taxes e.g. GST.
 Proportional tax is a flat tax rate applied at all levels of incomes.

Tax incidence measures the consequences of the imposition of a tax on different stakeholders e.g. consumers, producers and
government.
 If PED > PES, the demand for a good is elastic relative to supply, meaning consumers are more responsive to price changes,
therefore, the burden of the tax burden will be borne more by producers.
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  If PED < PES, demand for a good is inelastic relative to supply, meaning consumers are less responsive to price changes,
therefore, the tax burden will be borne more by consumers.
 If PED = PES, producers and consumers will equally share the tax burden.

Subsidy is a financial payment given by the government to producers of goods and services. It lowers the cost of production, increasing
profit margins for firms. New firms may enter the market, and existing firms may increase their output, increasing supply.

Price controls are forms of government intervention whereby legal minimum or maximum price levels are set to benefit producers and
consumers.

Price ceiling is a maximum legal price set by government on goods that are necessities for consumers e.g. house rents, public
transport. As the price is below equilibrium, quantity demand is greater than quantity supplied, creating a shortage in the market.
 Non-price rationing refers to distributing goods among possible consumers. This involves government creating ration
cards where buyers wait in lines, those who come first buy the good. Additionally, coupons are distributed to interested
buyers so they can buy a fixed amount of the good in a given time period.

 Decreased market size occurs due to lower prices resulting from a price ceiling where suppliers are less willing to sell and
reduce output, thus reducing market output.
 Allocative inefficiency occurs as lower price results in a shortage, meaning fewer resources are allocated to production of
the good relative to the social optimum requirement.
 Informal (black) markets occur as buyers look to other sources who can meet their demand due to the shortage.
 Some consumers are better off as they buy the good at the lower price, but others are worse off. Producers are worse off
as they sell a lesser quantity at a lower price, reducing producer surplus.

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Measures to correct the situation price ceilings are a short-term measure to address needs of buyers who the government believes
are paying a higher price than they should.
 Subsidies may be offered to firms lowering their cost of production and encouraging an increase in output increasing in
supply, resulting in a rightward shift of the supply curve. Consequently, prices will fall, and output will increase as seen in the
fig. below.

Price floor is a minimum legal price set by government on goods that it considers are beneficial from the perspective of producers,
e.g., wheat. The price floor leads to a fall in quantity demanded and an increase in quantity supplied, creating a surplus which the
government buys.

Effects of price floor

 Firm inefficiency higher than equilibrium prices can lead to inefficient production, inefficient firms with high costs of
production do not face incentives to cut costs by using more efficient production methods, because the high price offers
them protection against lower-cost competitors and this leads to inefficiency.
 Allocative inefficiency as too many resources are allocated to the production of the good, this results in a larger than
socially optimal quantity produced, leading to allocative inefficiency.
 Informal markets firms may choose to sell their surplus at prices below the legal price which is illegal and will contradict
the purpose of price floors.
 Consumers and producer surplus consumers are worse off as they must now pay a higher price for the good and buy a
lesser quantity, resulting in a loss of consumer surplus. Producers gain as they receive a higher price and produce a larger
quantity, and if the government buys the surplus, producers may receive higher revenues. Also, producers are protected
against low-cost competition and do not face strong incentives to become efficient.
 Government must pay for buying the surplus produced from taxes putting burden on its budget, reducing its funds to spend
on other economic activities.

Measures to correct the situation the government must decide about what to do with the surplus it purchases.
 One option is to store it for future supply, but this gives rise to additional costs for storage.
 Another way is to export the surplus; this often requires granting a subsidy to lower the price of the good and make it
competitive in world markets, since the price floor has increased the price of the good above the market price (foreign
countries would not want to buy it at a high price).
 A third option is to use it as aid sent to developing countries, but it often poses problems for the developing countries
intended to benefit from the aid.

Direct provision occurs when the government directly provides or supplies goods and services deemed to be in the best interest of the
public e.g. public healthcare, postal services, law and order, public broadcasting etc.

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Command and control regulations and legislation refer to the direct rules and laws governing an activity or industry, stating what is
permitted and what is illegal
 Minimum age laws for tobacco, alcohol, high-energy drinks, gamboling
 Environmental laws
 Banning smoking in public areas such as parks
 Laws requiring packaging to carry healthcare warnings

Example: The table below shows two firms in the industry that create 700 and 600 units of pollution. If the government wishes to reduce
pollution by 70%, what are the additional costs of CAC regulation to the industry.

Firm A needs to reduce pollution by 70% to 210 units at a cost of $1000 per unit.

= 210 x $1000 = $210000

Firm B needs to reduce pollution by 70% to 180 units at a cost of $600 per unit

= 180 x $600 = $108000

Total cost to the industry of CAC regulations = $210000 + $108000 = $ 318000

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Market failure: common pool (common access) resources
Market failure is the inefficient allocation of resources in a market owing to over or under-production or consumption of certain goods.

Marginal private benefit (MPB) is the additional benefit enjoyed by individuals and firms from the production or consumption of an
extra unit of good/service.

Marginal social benefit (MSB) is the total gain to society from an extra unit of production or consumption of goods or services.

Marginal private cost (MPC) is the additional expense of production for firms or extra charge paid by consumers for the output or
consumption of an extra unit of good/service.

Marginal social cost (MSC) is the total expense to society from an extra unit of production or consumption of a good/service

Positive externalities of consumption are the gains enjoyed by a third party due to consumption of goods e.g. vaccines, healthy food,
education etc.
 Market failure can be graphed through a marginal analysis.
 The market equilibrium exists at the intersection of MSC and MPB,
whereby price is P1, and quantity is Q1
 The MSB curve is towards the right of the MPB curve, meaning the
 benefit to society exceeds the benefit to individual consumers
 As people are unaware of the benefits of consumption, the good
is under-consumed causing market failure
 The potential welfare gain is shown by the shaded area in
 the diagram below

Positive externalities of production are the gains enjoyed by a third party due to the production of goods e.g. national defense,
streetlights, public parks, lighthouses etc.
 Market failure can be graphed through a marginal analysis.
 The market equilibrium exists at the intersection of MPC and MSB,
whereby price is P1, and quantity is Q1
 The MSC curve is towards the right of MPC, meaning the social
cost is less than the private cost which means the good is underproduced,
 The potential welfare gain is shown by the shaded area in the diagram
below

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Negative externalities of production are the expenses incurred by a third party due to the production of goods e.g. air pollution
caused by factories.
 Market failure can be graphed through a marginal analysis
 The market equilibrium exists at the intersection of MPC
and MSB, whereby price is P1, and quantity is Q1
 The MSC curve is towards the left of the MPC curve,
meaning the social cost exceeds the private cost
 The good is over-produced casing market failure
 The deadweight loss is shown by the shaded area

Negative externalities of consumption are the expenses incurred by a third party due to the consumption of goods e.g. obesity due to
junk food and passive smoking.
 Market failure can be graphed through a marginal analysis
 The market equilibrium exists at the intersection of MSC and MPB,
whereby price is P1, and quantity is Q1
 The MSB curve is towards the left of the MPB curve, meaning the
social benefit is less than the private benefit
 The good is under-consumed casing market failure
 The deadweight loss is shown by the shaded area

Common access resources (CARs) are those resources that are non-excludable but rivalrous in consumption and create a situation
of tragedy of the commons resulting in negative externalities and unsustainable production
 Tragedy of the commons refers to the degradation, depletion or destruction of a common pool resource caused by the
problem of rivalry and overuse. The term was coined by Garrett Hardin
 Examples include overfishing, air pollution due to over-congested roads, deforestation, soil erosion, destruction of natural
habitat and climate change

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Unsustainable production and negative production externality (overfishing)
 Over-fishing depletes fish from the sea without allowing them
to replenish
 A marginal analysis can be used to visualize externality
 The market equilibrium exists at the intersection of MPC
and MSB, whereby price is P1, and quantity is Q1
 The marginal social cost exceeds the private cost, meaning
the good is over-produced causing market failure

Unsustainable production and negative consumption externality (pollution)

 Using petrol (fossil fuel) in cars creates environmental pollution
 A marginal analysis can help visualize the externality
 The equilibrium exists at the intersection of MSC and MPB,
whereby price is P6, and market quantity is Q6
 Private benefit exceeds the social benefit, meaning the good is being
over-consumed causing market failure

Possible solutions
 Pigouvian taxes are indirect taxes used by the government in response to negative externalities and common pool
resources
 Carbon taxes are taxes on greenhouse gas emissions or carbon content of fossil fuels in order to reduce pollution from
particular industries
 Legislation and regulation refer to stipulation of laws and their subsequent monitoring to tackle imperfect information in
markets
 Awareness creation educating the public about costs of consuming demerit goods and the benefits of consuming merits
goods is an approach to correcting market failure
 Subsidies are financial payments from the government to domestic firms to lower their production costs to help them
compete. Subsides increase output and lower market prices of goods and services
 Government provision direct provision of goods and services is also a government response to market failure e.g. public
transportation and libraries, museums, parks and healthcare services

International agreements are bilateral or multilateral agreements between governments to respond to the growing problems of
negative externalities of production and consumption
 Most international agreements are legally binding
 According to the IEA (international environmental agency) more than 3000 environmental agreements have been registered
e.g. hazardous substances, freshwater resources etc.

Collective self-governance refers to voluntary communal actions to tackle the problems of negative externalities and exploitation of
common pool resources. Environmental sustainability is possible if people work together to create democratically agreed and adaptable
rules for the exploitation of common resources.

Tradable permits cap and trade schemes are government-regulated emission trading schemes using a market-based approach to
reduce production to a socially efficient level by setting limit on total amount of emissions in an industry.
 Firms are issued permits such as the right to pollute up to 100 units of carbon dioxide per month
 Permits are freely traded (based on the price mechanism) enabling more efficient firms to sell their excess permits
 EU’s emission trading scheme is one of the world’s largest cap and trade schemes covering 11000 factories and power
station across all EU members

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Supply of permits is perfectly inelastic as it is controlled by the government. An increase in demand (D1 to D2) leads to an increase in
price from P1 to P2 while the quantity remains unchanged (Q1). Over time, the government can reduce supply (S1 to S2). The price of
permits rises to P3, and the market quantity falls to Q2. Firms may be forced to consider using (greener) production techniques.

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Market failure: public goods
Classification of goods
 Merit goods are demmed soically desirable for soceity e.g., healthcare and vacinations.
 Demerit goods are considered socially less desirable for consumption e.g. sugary drinks, fast food etc.
 Public goods are collective consumption goods that have two key features of being ono-rivalrous and non-excludable e.g.
flood control systems, law and order, lighthouses, national defense, open-source software such as YouTube, streetlights.

The free-rider effect occurs when people have access to (or benefit from) a good or service without having to pay for it. As a result,
the good or service will be underprovided or not provided at all in a free market.
 Free-riding leads to under provision and or under consumption of a public good, therefore, it is highly inefficient e.g. national
defense is enjoyed by people who may not pay taxes
 Overconsumption and over exploitation of public goods can often lead to the tragedy of the commons e.g. public beaches
being destroyed by the growing number of tourists
 Free riders do not consider the external costs of their activities such as litter and plastic waste left in public parks causing
damage to the environment

Possible solutions
Direct provision occurs when the government directly provides the public goods e.g. law and order, national defense, emergency
services, government statistics etc.
 The government may choose to use contracting out to the private sector, where it pays a specialized third-party firm with
expertise to provide the public good, e.g. highway maintenance services, waste disposal, public fireworks etc.
 The imperfections of the market economy in the provision, or the lack of public goods, needs to be weighed against the
imperfections of government intervention

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Measuring economic activity and illustrating its variations
Macroeconomics focuses on the allocations of a nation’s scarce resources with a focus on the following objectives:
 Economic growth (steady rise in national income)
 Low unemployment
 Low and stable inflation rate
 Sustainable level of government debt
 Balance of payment equilibrium
 Equality in income distribution

National income is used to measure the level of economic activity in a nation. It refers to money value of all goods and services
produced in a country for one year. Gross domestic product (GDP) is the most common measure of national income.
 The output approach measures the actual value of all final goods and services produced in an economy in one year. Only the
final output is included in calculation of the national output to prevent double counting e.g. manufactured products used in the
production process. This method is also referred to as national output
 The income approach calculates the value of all factor incomes earned in the economy over one year, i.e. rent (land), wages
(labor), interest (capital) and profit (enterprise). This method is also referred to as national income
 The expenditure approach measures the total value of all spending on newly produced goods and services in an economy in
one year. This approach accounts for consumption expenditure, investment expenditure, government spending and net export
expenditure. This method is also referred to as national expenditure
GDP = C + I + G + (X - M)

Circular flow of income an economy is divided into two sectors households and firms. The households provide resources namely land,
labour, capital and enterprise to firms who in return pay wages, rent, interest and profit. Firms produce goods and services which are
consumed by household, and these households spend money on purchasing goods and services produced by the firms. The flow of goods
and services through these markets is balanced by counter-flows of payments. Households make payments for things they buy in
product markets, while firms make factor payments, wages, interest payments, rents, royalties in exchange for resources they buy.
 Government sector households pay taxes to the government, which is spent on building roads, transfer payments,
defense etc. In this model taxes are considered leakages while government spending is considered an injection into the
economy.
 Foreign sector it is a portion of economy that includes exports and imports, exports bring in revenue which
considered an injection in the economy, but imports result in leakages as money leaves the economy.
 Financial sector consists of financial institutions engaged in borrowing and lending with firms. Financial institutions
help individuals and firms invest money for interest payments or borrow money to invest in capital goods. Financial
institutions perform the function of mobilizing savings for investment; savings are considered leakages and
investments are considered injections in the economy.

Nominal gross domestic product is the value of all final output of goods and services produced in an economy in a year
 Nominal GDP measures national output using current year prices
 These values are not adjusted for inflation
 Irrespective of the method used, all three approaches give the same numerical value (statistical adjustments)

Consumption = $150bn, investment expenditure = $60bn, government spending = $55bn, export earnings = $31bn, import expenditure =
$28bn and net income earned abroad = $ 8bn. Calculate nominal GDP from given information

Nominal GDP = C + I + G + (X - M)
GDP = 150 + 60 + 55 + (31 - 28)
GDP = $268bn

Nominal gross national income is the value of a nation’s final output of goods and services plus net factor income earned from abroad
Nominal GNI = nominal GDP + net factor income from abroad

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Real gross domestic product and real GNI account for fluctuations in prices allowing for better comparisons of economic activity
 Comparing nominal values is less meaningful
 Real GDP and real GNI are adjusted for inflation using the GPD (price) deflator
 The deflator is used to convert nominal values to constant prices

Real GDP/GNI per capita means expressing the real GDP/GNI of a nation in terms of its population size to determine the value of
national income per person
Real GDP/capita = real GDP / population size

Real GNI/capita = real GNI / population size

A nation’s population is 23.59 million and GDP is $590bn, calculate its GDP/capita
GDP/capita = $590bn / 23.59mil = $25010

Purchasing power parity refers to the exchange rate that enables residents to purchase a common basket of goods and services in
different countries
 Comparisons of GDP are difficult as calculations are done in local currencies
 PPP is the exchange rate needed people to buy the same quantity of goods and services in different countries using the same
amount of money
 Economists can ascertain whether the currency is over or undervalued

Example: If $1 equals Dong (VND) 23000, then if a cup of coffee cost $5 in USA, then the cup should cost VND 115,000 in Vietnam. But if
the coffee costs VND 90000, then this equals only $3.91. This means the Dong is undervalued $1 should equal VND 18000.

Example: Calculate the real GDP in 2019

Real GDP = (nominal GDP / GDP deflator) x 100

Real GDP2019 = (230.3/107.8) x 100 = $213.5 bn

The average annual salary in 2020 is $24000
Calculate the average real income for the average worker

Real income = (nominal income/GDP deflator) x 100

Real income2020 = (24000/109.8) x 100 = $21857.9

A business cycle is a model that describes the fluctuations in the level of economic activity of a nation over time, thus creating a long-
term trend of economic growth
 Growth (boom)
 Peak
 Recession
 Trough (slump)

Peak
 Economic activity is at its highest
 Low unemployment
 Business and consumer confidence are high
 High levels of income level
 Price levels are high

Trough
 Lowest point of a recession (depression)
 Negative growth
 High levels of cyclical unemployment
 Business and consumer confidence are low
 Business closures
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Recovery
 GDP starts to rise
 Employment is generated
 Improved business and consumer confidence
 Rising investment and spending

Recession
 GDP falls (negative growth for 2 quarters)
 Rising unemployment
 Falling business and consumer confidence

Appropriateness of using GDP/GNI statistics to measure economic well-being

Benefits
 Use of GDP/GNI stats enables economists make comparisons of well-being over time
 Comparisons can be made between nations
 Indicate material standard of living

Limitations
 GDP/GNI figures do not show distribution of income
 Does not reveal differences in tax rates
 Cost of living is not considered
 Do not account for the externalities generated by production of goods

Green GDP adjusts a nation’s GDP to take account of the value of environmental degradation associated with economic growth
Green GDP = nominal GDP – environmental production costs

Alternative measures of well-being

The OECD better life index (BLI) is an alternative to national income as measure of well-being, based on a set of 11 criteria defined by
the OECD (organization of economic cooperation and development) to be essential in terms of material living conditions and quality of life
 Housing, income, jobs, community, education, environment, governance, health, life satisfaction, safety and work-life balance
 BLI does not rank these measures
 It is subjective but enables policymaking process to be more informed

The happiness index (HI) is an alternative to national income as measure of well-being, by considering how information technology,
governance, and social norms influence communities and the level of well-being
 Business and economic, citizen engagement, communication and technology, diversity, education and families, emotional well-
being, environment and energy, food and shelter, government and policies, law and order, health, religion and ethics,
transportation, and work
 Survey samples from representative countries
 HI ranks well-being (0 - 10) (least happy to most happy)
 Difficult to make historic comparisons

The happy planet index (HPI) is a measure of sustainable human well-being i.e. how individuals and countries are able to achieve long,
happy and sustainable lives
 Well-being (0 – 10)
 Life expectancy (average life)
 Inequality of outcomes (percentage of how long people live and how happy they are)
 Ecological footprint (expressed as global hectares GHA per person)

HPI = (well-being x life expectancy x inequality) / ecological footprint

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Variations in economic activity: aggregate demand and aggregate supply
Aggregate demand is the total amount of goods and services demanded within an economy over a period of time at a given price levels.

AD = C + G + I + (X - M)

The AD curve is downward sloping for three reasons:

 Wealth effect a rise in the price level will reduce the amount of goods and services that people’s wealth can buy, purchasing
power of savings held in form of bank accounts and other financial assets will fall.
 Interest rate effect a rise in the price level will increase demand for money to pay for the higher prices, increasing interest
rates. A higher interest rate may reduce consumption and investment.
 Net export effect higher price levels in an economy lead to foreigners buying fewer exports while locals desire more foreign
goods, reducing net exports.

Shifts in aggregate demand

 Consumption is the spending by households on goods and services. A rise in consumer confidence, a cut in income tax, an
increase in wealth, a rise in money supply, an increase in population, a fall in interest rates, a reduction in household
indebtedness may increase household consumption leading to an increase in aggregate demand.
 Investment is the spending by firms to purchase capital goods that will be used to produce more goods and services. A rise
in business confidence, a cut in corporation tax, and advances in technology, a decrease in interest rates may lead to an
increase in investment by firms in capital goods leading to an increase in aggregate demand.
 Government spending includes spending on goods and services by local, state and central governments. A desire to
stimulate the economy through deliberate efforts to influence aggregate demand or win political support, a reduction in
government indebtedness leading to an increase in aggregate demand.
 Net exports are the difference between exports and imports. A fall in the exchange rate, a rise in the quality of domestically
produced products, an increase in incomes abroad, restrictions on imports will cause an increase in net exports, increasing
aggregate demand.

Short run and long-run in macroeconomics the short-run is a period of time whereby prices of resources are inflexible, especially
labor wages. The long run is a period of time whereby prices of all resources are flexible and change with changes in the average price
level.

Short run aggregate supply SRAS shows the relationship between the price level and the quantity of real output (real GDP) produced
by firms when resource prices (especially wages) do not change.

Shifts in short run aggregate supply

Cost of production are the expenses that firms face in the production of goods and services
 Labor costs a relatively small change in wage costs (e.g. increase in minimum wage rate) will have a large impact on cost
of production of firms. This will lead to a decrease in SRAS
 Raw material costs an increase raw material, or component costs (e.g. crude oil or timber prices rising) will raise
production costs for firms, decreasing SRAS
 Exchange rate an appreciation of the exchange rate means the domestic currency can buy more imports at a lower price. If
an economy relies on imported raw materials, they may experience a fall in production costs for domestic firms. However, a
depreciation will cause higher production costs for firms as imported raw material becomes expensive
 Interest rates firms with existing loans will have fewer funds for interest payments if interest rates rise, which can reduce
the level of aggregate supply and vice versa
 Bureaucracy and administration strict procedures and policies mean that firms have to comply with rigorous bureaucratic
matter e.g. stringent health and safety laws. This may lower aggregate supply
 Indirect taxes raise cost of production, lowering profit margins and reducing SRAS.

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The short run macroeconomic equilibrium exists at the intersection of the short run aggregate supply and aggregate demand. It
determines the general price level and real GDP in the economy
 Recessionary gap occurs when an economy is producing below its potential meaning the SRAS curve intersects the AD
curve below the LRAS curve. This means that firms require less labor, and therefore, unemployment is greater than the
natural rate of unemployment.
 Inflationary gap occurs when an economy is producing beyond its potential, meaning the SRAS curve intersects the AD
curve above the LRAS curve. To produce more output, firms’ labor needs increase, and unemployment falls to become less
than the natural rate of unemployment.
 Full employment level occurs when an economy is producing at its full potential meaning the SRAS curve intersects the AD
curve on the LRAS curve. Therefore, unemployment is equal to the natural rate of unemployment and there is no
recessionary or inflationary gap.

The long run equilibrium exists at the intersection of aggregate demand and LRAS curves. Any increase in aggregate demand beyond
the full employment level of GDP will lead to inflationary pressure A fall in aggregate demand will lead to a decline in price levels in the
economy.

Keynesian view of aggregate supply

 Phase 1: aggregate supply is perfectly elastic as there is spare capacity in the economy. An increase in aggregate demand
has no direct impact on price levels
 Phase 2: aggregate supply is relatively price elastic as there is pressure on scare resources. An increase in aggregate
demand has will incentivize firms to raise price levels
 Phase 3: aggregate supply is perfectly inelastic as there is no spare capacity. An increase in aggregate demand leads to
inflationary pressure

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The macroeconomic equilibrium in Keynesian model is determined by the point where the AD curve intersects the Keynesian AS curve.
This can occur at any level of real GDP.

There are three equilibrium states of the economy. Fig. a shows the AD curve intersecting the AS curve in its horizontal section,
determining Ye which is less than Yp, indicating a recessionary gap. Aggregate demand is too weak to induce firms to produce at Yp. In
fig. b, the economy is producing at Ye, which is greater than Yp, and is experiencing an inflationary gap. There is strong aggregate
demand, unemployment has fallen below its natural rate, and as the economy approaches its maximum capacity, the price level has
increased. Fig. c shows the case where the economy has achieved full employment equilibrium, or potential output, at Yp.

Shifts of the long run aggregate supply

 Changes in the quantity and/or quality of factors of production
 Improvement in technology
 Increases in efficiency
 Changes institutions

Example: Calculate the equilibrium level of national output in the economy

At price index 128: AD = [20 + 4 + 5 + (6 – 10)] = $25bn

At price index 124: AD = [22 + 6 + 7 + (7 – 9)] = $33bn
At price index 120: AD = [24 + 8 + 9 + (8 – 8)] = $41bn
At price index 116: AD = [26 + 10 + 11 + (9 – 7)] = $49bn

Therefore, equilibrium level of national output is $41bn

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Macroeconomic objectives – economic growth
Economic growth refers to a sustained increase in a nation’s real GDP over time
 It is expressed as the annual percentage change in real national output
 Economic growth is an increase in real GDP for 2 consecutive quarters
 Recession (negative economic growth) is a fall in real GDP for 2 consecutive quarters

Reason for economic growth

 Factor endowments refer to the quality and quantity of resources of a nation e.g. Saudi Arabia is well endowed in oil supply
while France has arable land
 Size and skill of the labor force impacts economic growth e.g. China huge labor force and Germany’s skilled labor force
 Investment expenditure in capital and human resources is vital for long-term growth as it boosts the nation’s productive
capacity. This can also encourage foreign direct investment
 Discovery of raw materials such as gas reserves will increase a nation’s productive capacity, helping to increase its
production potential
 Labor productivity is determined by many factors e.g. qualification, experience, training and motivation. Higher productivity
leads to greater economic growth
 Mobility of labor refers to the extent to which workers are willing and able to change jobs (occupational mobility) and move
to different locations for work (geographical mobility)

Short-term growth
 Actual output refers to the current, rather than the potential, level of real GDP in an economy (any point in the PPC)
 Actual growth occurs in the short term when an economy operates below its full-employment level of national income but
moves towards its potential level of GDP by using resource more efficiently

Real GDP growth rate = real GDP (new) – real GDP (old) x 100
real GDP (old)

Nominal GDP growth rate = nominal GDP (new) – nominal GDP (old) x100
nominal GDP (old)

Example: Real GDP of U.K in 2019 was £175 billion, while in 2020 it grew to £180 billion. Calculate economic growth

Real GDP growth rate = 180 – 175 x 100 = 2.8%

175
China has a nominal GDP of $13608 bn with a population of 1400mil people. Calculate the nominal GDP per capita

Nominal GDP/capita = $13608 bn = $9334.28

1400mil

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Long-term growth
Potential output is associated with an increase in the quantity and/or quality of factors of production in the long run
Land, labor, capital, enterprise and technology. Using the PPC model, long run growth is demonstrated by an outward shift of the PPC
curve.

Consequences of economic growth

 Reduction or elimination of poverty owing to higher income per person as new jobs are created
 Increased tax revenue enables the government to fund public and merit goods
 Increased consumer spending leads to higher revenues for firms which may be reinvested into buying capital stock,
improving the production potential
 With rising income, the amount spent on demerit goods tends to increase
 There is a risk of inflation if the economy continues to grow owing to excessive aggregate demand in the country
 Higher rates of growth can cause negative externalities that damage the environment e.g. air pollution, road congestion, land
erosion
 It may cause other forms of market failure e.g. depletion of natural resources such as deforestation and overfishing
 Resource depletion by the current generation is not always sustainable thereby threatening intergenerational equities
 Economic growth often creates greater disparities in income distribution and wealth
 Growth also leads to greater tax revenue enabling the government to redistribute income and wealth in the economy

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Macroeconomic objectives – low unemployment
Unemployment occurs when people of working age are both willing and able to work but are unable to find work.

Unemployment rate = number of unemployed x 100

labor force

Example: suppose there is a population of 35.5 million people, of whom 17.3 million are in the labor force, 1.5 million work part time
though they would rather work full time, 0.5 million are discouraged workers, and 1.4 million are looking for work but cannot find any.

UR = 1.4 × 100 = 8.1% (this means 8 out of every 100 people in the labor force are unemployed)
17.3

Measuring the number of unemployed workers

 The labor force refers to people of working age who are in employment, self-employment and the unemployed. The UN’s
international labor organization states 15 as the minimum age to enter the labor force with no upper limit but many countries
use a range between 15 and 65 years.
 The claimant count is a measure of people who are unemployed, actively seeking work and claiming unemployment benefits

Labor force participation is a ratio of the number of people in the labor force to the total working-age population of a nation

Labor force participation rate = labor force x 100

working-age population

Calculate the total number of unemployed people

7.9 = number of unemployed × 100

30
number of unemployed = 30 x 0.079 = 2.37 million

Difficulties in measuring unemployment

 Underemployment exists when people are inadequately employed e.g. part-time workers, skilled individuals working low-
paying jobs
 Hidden (disguised) unemployment refers to those who are technically unemployed, but are not included in the official
measurement of unemployment e.g. discouraged or underemployed workers
 Voluntary unemployed people are economically inactive and choose not to pursue full-time work e.g. elderly people, parents
who choose not to work in order to take care of their kids, people who have retired early
 Regional disparities, different regions have face different unemployment rates e.g. in 2019, unemployment in the UA was
3.6%, but Alaska recorded 6.1% unemployment
 Gender disparities females tend to experience higher average rates of unemployment than males e.g. gender inequalities in
unemployment rates are exceptionally high in the Middle East and North Africa

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Cause of unemployment
Frictional unemployment exists when people are temporarily unemployed while in between jobs or seeking to enter the job market for
the first time. Some people may take time off to look after their family or take a sabbatical
 Improve information symmetry between employers and job seekers
 Reduce unemployment benefits

Seasonal unemployment is caused regular and periodic changes in the derived demand for labor at different times of the year e.g. Ski
instructors are less in demand during summers
 Improve information symmetry between employers and job seekers
 Reduce unemployment benefits

Structural unemployment arises when labor skills mismatch with the jobs available in a specific industry e.g. changes in technology
 It exists when the demand for labor is less than the supply of labor
 The UK has suffered from structural unemployment in motor manufacturing and steel owing to geographical relocation of
these industries
 Changing market trends means that new jobs are created but workers may lack the skills needed for such jobs

Structural unemployment can be addressed by:

 Improve training and education programs
 Facilitate mobility of labor force to encourage relocation as demands
for labor change in regional areas

Cyclical (demand-deficient) unemployment is unemployment caused by

lack of aggregate demand in the economy e.g. the Covid-19 pandemic
 It is the most severe cause of unemployment and is caused by a fall
in one or more components of aggregate demand
 A decline in business cycle
 Derived demand for labor falls at output falls and workers are made redundant

Cyclical unemployment can be addressed by the government through the use of:
 Expansionary fiscal policy which includes lowering taxes and increasing
government spending
 Expansionary monetary policy which includes lowering interest rates to
spur consumption and investment in the economy
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The natural rate of unemployment NRU is the sum of structural, frictional and seasonal unemployment in a nation
NRU = structural UE + frictional UE + seasonal UE

 Reforms in welfare benefit system to create incentive for people to work e.g. limiting the duration of time an individual can
receive unemployment benefits
 Reforms to trade unions by reducing their collective bargaining power e.g. labor unions pressurize governments to raise
minimum wage rates
 Reduction in personal taxes can help improve incentives to work e.g. lower marginal tax rates
 Reducing barriers to labor mobility so that people can find jobs in different industries or areas

Consequences of unemployment
 A loss of real GDP as fewer people work, the amount of output produced is less than the level the economy is capable of
producing, meaning an economy finds itself somewhere inside its production possibility curve.
 Loss of income for unemployed workers, people who are unemployed do not have an income, they are likely to be worse
off financially.
 Loss of tax revenue since unemployed people do not pay income taxes, reducing tax revenue for the government.
 Unemployment benefits the greater the unemployment, the larger the unemployment benefits that must be paid, and the
less tax revenue left over to pay for important government-provided goods and services such as public goods and merit
goods.
 Unequal distribution of income unemployed people becomes poorer while employed people are able to maintain their
income levels, leading to disparity in the levels of income in the country.

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Macroeconomic objectives – low and stable rate of inflation
Inflation is the sustained rise in the general price level of goods and services in an economy over time

hyperinflation refers to extraordinary high and uncontrollable rate of inflation that causes serious macroeconomic problems

The consumer price index is a weighted index of average consumer prices of goods and services over time
 A base year with an index value of (100), is used as a starting period when calculating a price index such as CPI
 Basket price of goods and services refers to selection of goods and services that represent the average household’s
expenditure
 Statistical weights each item of expenditure in the list of goods and services is assigned a different weight to represent
different patterns of spending overtime

Assume 2017 is the base year with basket price $20

CPI = basket price current year x 100

basket price base year
CPI2020 = (22/20) x 100 = 110
• prices in 2020 are 10% higher than 2017
CPI2021 = (24.5/20) x 100 = 122.5
• prices in 2021 are 22.5% higher than 2017 (on average)

Example: Calculate the inflation rate if consumer price index changes from 123 in 2018 to 129.5 in 2019
IR = (129.15 – 123) x 100 = 5%
123

Example: Calculate the consumer price index if there is 3% inflation during the year if the price index was previously at 130
CPI = 130 x 1.03 = 133.9

The limitations of the cpi in measuring inflation

 CPI considers the expenditure of the average household, but students or pensioners may have different spending habits,
therefore, CPI could have minimal relevance for atypical households
 CPI does not reflect regional or international disparities e.g. prices tend to rise faster in business districts as compared to
rural areas
 High income earners are less sensitive to price changes as compared to low-income earners e.g. individuals without a care
may not be affected by a rise in petrol prices
 CPI ignores the changes in quality of goods and services over time

Causes of inflation
 Demand pull inflation is caused by increases in aggregate demand, in turn brought about by changes in any of the
determinants of aggregate demand.
 Cost push inflation is caused by increases in costs of production or supply-side shocks.

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Consequences of inflation
 Rising price level mean exports become more expensive to foreign buyers, reducing the country’s international
competitiveness.
 People cannot predict future changes in purchasing power, causing uncertainty among economic decision- makers.
 As prices rise and incomes remain constant, real incomes fall, decreasing purchasing power of individuals.
 If interest rates do not rise in line with inflation, borrowers will gain and lenders will lose, because borrowers will pay back
less in real terms and lenders will receive less.
 Menu costs are costs incurred by firms when they have to print new menus (in restaurants), catalogues, advertisements,
price labels, etc. due to changes in prices.
 Inflation can make it difficult to assess what is happening to relative prices, known as inflationary noise.

Deflation is the persistent fall in the average price levels in an economy over time and is caused by a fall in aggregate demand or an
increase in short run aggregate supply.

Disinflation occurs when there is a fall in the rate of inflation i.e. prices are still rising, but at slower pace.

Consequences of deflation
 With falling price levels, individuals on fixed incomes, holders of cash, savers and lenders all gain as the real value of their
income or holdings increases. But borrowers lose as they must pay out sums that have an increasing real value.
 Deflation creates uncertainty for firms, which are unable to forecast their costs and revenue.
 A deflationary spiral involves a process where deflation sets into motion a series of events that worsen the deflation.
Deflation discourages spending by consumers, because they postpone making purchases as they expect that prices will
continue to fall.
 It results in an increase in the real value of debt.

Imported inflation is common for countries which are dependent on imported goods, an increase in prices of imported goods will lead
to a rise in general price levels in the economy. In this case exchange rate plays a vital role. If the currency of a country depreciates it
will lead to inflation as imports will become costlier.

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Macroeconomic objectives - potential conflicts between macroeconomic objectives
Low unemployment and low inflation
 When the economy grows rapidly people are in employment, but it is likely that inflationary pressure will occurs
 Low unemployment means people have extra money to spend as the economy reaches full employment. This is likely to
increase aggregate demand and therefore cause demand-pull inflation
 Moreover, low unemployment may also cause cost-push inflation as full employment makes it harder to attract skilled labor,
putting upward pressures on wage rates

High economic growth and low inflation

 Economic growth is usually associated with an increase in the level of aggregate demand. The risk associated with inflation
becomes higher as the economy approaches full employment level of national output
 If aggregate demand rises faster than aggregate supply, demand-pull inflation occurs as price levels of goods and services
rise.
 Cost-push inflation can also occur because of high economic growth, as full employment level of output makes it difficult for
firms to attract skilled labor owing to labor market rigidities, leading to wage inflation and ultimately higher price levels in
the economy

High economic growth and environmental sustainability

 Economic growth is also associated with issues regarding environmental sustainability.
 As the economy grows, increased levels of production and consumption can create negative externalities that cause
environmental problems e.g. pollution, land erosion and loss of the ecosystem
 This can damage the well-being of individuals and societies long-run standard of living
 However, environmentally sustainable methods of production e.g. use green technology and renewable energy sources may
benefit the well-being of current and future generations

High economic growth and equality in income distribution

 Rapid economic growth creates greater disparities in income and wealth distribution within the economy as everyone may
not experience the same benefits
 Higher income groups tend to save a greater proportion of the increased income while low-income groups tend to spend
more on meeting basic needs
 The world’s richest had a combined wealth of $743 billion in 2019, an increase of 74% in just two years. By contrast, during
the same period, the US economy grew by 7.5% while the EU grew by 6.4%
 In 2020, the combined wealth of the top 10 richest people exceeded the nominal GDP of Singapore, Turkey, South Africa,
Switzerland

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Economics of inequality and poverty
Inequality in income is an extreme concentration of wealth or income in the hands of a small percentage of a population.

Factors leading to difference in wealth between nations

 Economic factors high levels of debt are a key reason why countries have different levels of wealth e.g. Yemen have a debt
to GDP ratio of over 100%
 National resources some nations are endowed with natural resources such as agricultural land conducive for production of
cash crops which can be traded to gain income, enabling them to enjoy a higher net wealth per capita
 Environmental factors some nations like Bangladesh often face problems like floods which may decrease their resource
productivity, thereby making them less prosperous
 Physical factors some nations have a challenging landscape e.g. dry climate may not be conducive for agriculture
production, limiting economic prosperity
 Political factors the degree of political instability caused by war or corruption is highly likely to limit a nation’s level of
domestic economic activity and international trade, compromising per capita wealth
 Social factors a low level of education, population density and low female participation in the labor force can limit the
nation’s wealth accumulation

Measuring economic inequality - Lorenz curve and gini coefficient

The lorenz curve is a representation of the income distribution in a country, based on the income or wealth accounted for by each
quintile of the population.
 Further the Lorenz curve, the more unequal is the distribution of income

Gini coefficient is a tool that measures the income or wealth inequality

Gini coefficient = area of A

area of A + B
 If gini coefficient = 0 (complete equality)
 If gini coefficient = 1 (total inequality)

Poverty is the condition of an individual, household, community or nation being extremely poor i.e. not being able to meet their basic
needs
 Absolute poverty exists when people are deprived of basic human needs for survival e.g. malnutrition, lack of clean water,
inadequate shelter.
 Relative poverty is a measure of wealth inequality, describing an individual or group's wealth relative to another individual
or group

Measuring poverty - single indicators of poverty

International poverty line (IPL) is the minimum threshold level of income that a person must ear to have access to in order to meet
the basic needs necessary for human survival
 According to the UN, more than 700 million people (10% of world population) live in absolute poverty i.e. $1.9 or less per day
 IPL does not consider access to sanitation, water and electricity
 The national poverty line is the level of income below which a person in the country cannot meet their basic needs

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Minimum income standards (MIS) measure the lowest amount of income needed for what members of the public in a country think is
acceptable to be able to live in an appropriate way
 Within a country, adjustments are made to MIS for those living in large cities (higher living costs) and rural areas
 In UK, employers must pay £10.75 per hour for those working in London and £9.30 an hour for those living outside London

The Multidimensional poverty index (MPI) is a composite measure of poverty that identifies numerous deficiencies of individual, and
households based on three indicators, health, education, standard of living
 Weights are assigned to different categories e.g. nutrition 1/6

Causes of inequality and poverty

 Inequality of opportunity means that some individuals and societies have less or no access to employment and consumption
opportunities so are deprived of economic prosperity
 Different levels of resource ownership the lack and/or poor management of resources will reduce a nation’s potential net
exports, resulting in greater levels of economic inequalities and poverty
 Different levels of human capital the insufficient provision of education and training leads to mass poverty in a country
 Unequal status and power marginalized people are exploited and deprived of basic social and economic opportunities,
which can widen income and wealth inequalities
 Discrimination, gender and racial discrimination often brings conflict which creates an environment less conducive for
economic growth and development
 Government tax and benefit policies a major role of taxation is to promote income equality by redistributing income to
low-income groups. This can significantly reduce the gap between the rich and poor
 Globalization and technological changes both globalization and technological changes help a nation to improve local
production and improve export competitiveness, creating more wealth per capita. However, use of capita-intensive
production methods may also lead to job losses

Impacts of income and wealth inequality

 Higher income inequality brings the possibility of higher income for those who work hard and an lead to a higher saving ratio
and improved standards of living
 Greater inequalities create social tension
 This could lead to greater spending by the government of transfer payments
 Equality in society correlates to the ability of people to live harmoniously while inequality may lead to political and social
unrest

The role of taxation in reducing poverty, income and wealth inequality

Direct taxes
 A personal income tax is a financial charge levied on the income of individuals
 A corporate tax is a direct tax imposed on the annual profits of private sector firms
 A wealth tax is a direct tax based on the market value of assets owned by an individual, household or firm

Indirect tax
 A specific tax is an indirect tax imposed on per unit of a good or services produced or consumed
 An ad valorem tax is an indirect tax imposed as a percentage on the sales of good or services

A proportional (flat) tax charges the same percentage rate of tax irrespective of the taxpayer’s level of income, wealth or profit
 Example include capital gains tax (levied on assets sold), GST (goods and services tax) and VAT (value added tax)
 Denmark has a 25% GST whereas GST in Pakistan is 17%
 VAT in India and Japan is 5%
 All income groups pay the same tax rate

A progressive tax charges a higher percentage tax as an individual’s income rises

 The tax threshold refers to the amount of income that workers can earn per year before they become liable for tax
 Taxable income is the amount of income that an individual of firm is liable to pay tax on, after taxable allowances have been
accounted for
 It is an effective way of reducing inequalities by redistributing income and wealth from the rich to the poor
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A regressive tax applies a uniform tax rate to all taxpayers, thereby taking a larger proportion of income from low-income earners as
compared to high-income earners
 Example include airport tax in Pakistan (international passengers) is Rs. 6200

Further policies to reduce poverty, income and wealth inequality

 A transfer payment is a sum of money from the government to another party for which no goods or services are being paid
e.g. unemployment benefits, disability allowance, subsidies for domestic producers, student loans, pensions, housing
allowance
 A universal basic income (UBI) refers to the guaranteed minimum level of income that a government guarantees to each
individual in a country e.g. during a recession, the government can use UBI to ensure a minimum income level to maintain
people’s standard of living
 A minimum wage rate is the lowest rate of pay that firms must pay to their workers as stipulated by the government
 Policies to reduce discrimination, anti-discrimination legislation helps a nation to tackle inequalities educating about
standards expected in society, establishing deterrents for those who violate these standards

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Demand management – (demand-side policies) monetary policy
Functions of money
▪ Medium of exchange a medium used to buy goods for purchases, both buyers and sellers are willing to accept it.
▪ Unit of account prices are quoted in terms of common monetary units e.g., in USA dollars are used, while in Pakistan rupees.
▪ Standard for deferred payment some household bills are paid monthly, others may be paid annually. Payments can be
made in the future once terms have been agreed between the parties involved.
▪ Store of wealth, money can be held for a period of time, usually with a bank, before it is used, meaning it is a measure of
value over time.

Monetary policy is the use of interest rates and the money supply to influence the level of aggregate demand and economic activity in
the country

The central bank is monetary authority responsible for a nation’s financial system and implementing monetary policy, including
regulation of commercial banks and the nation’s money supply. The central bank is the executor of monetary policy, government’s bank,
issuer of legal tender, lender of last resorts and credit control

A commercial bank also called high street bank earns profit by accepting lending to customers.

Interest rates are the cost of borrowing and the profit of lending money

The money supply is the amount of money in circulation within an economy at a particular point in time e.g. banknotes, coins, loans,
bank deposits and central bank reserves

Real versus nominal interest rates

 The nominal interest rate is the actual interest rate that is agreed between a bank and consumer i.e. the rate borrowers
pay on their loans and savers receive on their cash deposits
 The real interest rate accounts for the impact of inflation
Real interest rate = nominal interest rate – inflation
 Negative interest rates occur when the inflation rate is greater than the nominal interest rate, meaning any return on
savings is completely diminished

Example: A person who saves $10000 in bank account for a year receives a nominal interest rate of 2.5%. The annual inflation rate is
2%. Calculate the nominal and real return on the person’s savings

Returns at nominal interest rate = $10000 x 2.5% = $250

Real interest rate = 2.5% - 2% = 0.5%
Returns at real interest rate = $10000 x 0.5% = $50

Expansionary (loose) monetary policy aims to boost economic activity by expanding the money supply. This is achieved by lowering
interest rates to stimulate aggregate demand, thereby closing a deflationary gap
 Increase in money supply due to a lower base rate will lower interest rates offered by commercial banks
 Consumption may increase as households save less and spend more, or lower debt payments or increased borrowing to fund
consumption
 Investment in capital goods may rise as firms may seek to borrow more owing to lower cost of borrowing or lower existing
debt payments
 Foreigners may invest less in local banks leading to a currency depreciation, raising exports and reducing imports, leading to
an increase in net exports
 Aggregate demand will increase

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Advantages
 Changes can be incremental and easily reversible
 Short time lag
 Monetary policy may be free from political influences
 Can be used to manipulate the value of a currency

Disadvantages
 Limited scope of reducing interest rates when close to zero (liquidity trap)
 Lower consumer and business confidence during recession
 It cannot target specific sectors of the economy

Contractionary (tight) monetary policy aims to reduce economic activity by limiting the money supply. This is achieved by raising
interest rates to lower aggregate demand, thereby reducing an inflationary gap
 A fall in money supply due to a high base rate which will raise interest rates
 Consumption may fall as households save more and spend less, or higher debt payments or decreased borrowing to fund
consumption
 Investment in capital goods may fall as firms may borrow less owing to higher borrowing cost or greater existing debt
payments
 Foreigners may invest more in local banks leading to a currency appreciation, reducing exports and raising imports, leading
to a fall in net exports
 Aggregate demand will fall

Advantages
 Changes can be incremental and can help target inflation rate
 Short time lag as compared to other policies
 Monetary policy may be free from political influences

Disadvantages
 High consumer confidence during inflation may limit the impact of the policy
 Cannot tackle supply-side inflation
 I cannot target specific sectors of the economy

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Demand side management – fiscal policy
Fiscal policy is the use of taxation and government expenditure policies to influence the level of economic activity and macroeconomic
objectives
 Sources of revenue
 Government expenditures

Types of government revenue

 Direct and indirect taxation
 The sale of government assets
 The sale of goods and services by government-owned enterprises
 Borrowing from financial institutions or selling bonds

Types of government expenditure

 Current (consumption) expenditures refer to government spending on goods and services consumed in the current year
e.g. wages, healthcare, education, grants and subsidies, interest repayments on loans
 Capital expenditures refer to long-term items of government spending that boost the economy’s productive capacity. It is
also known as fixed capital formation e.g. infrastructure, airports, state schools, public libraries, highways
 Transfer payments are sums of money from the government to another party for which no goods or services are being paid
e.g. unemployment benefits, disability allowance, student loans, pensions, housing allowance

Budget is a record of a country’s tax revenues and expenditures over time.

 Balanced budget exists when tax revenues equal government expenditures.
 Balanced surplus exists when tax revenues exceed government expenditures.
 Balanced deficit exists when government expenditures exceed tax revenues. The accumulation of deficits leads to public
(government) debt.

Expansionary fiscal policy is the use of increased government spending and/or reduced taxes in order to stimulate economic activity
 Increase in government spending and/or cutting taxes
 Lower taxes lead to greater disposable income for households and firms, raising consumption and investment spending in the
economy
 Increased government spending directly injects money into the circular flow of income
 As consumption, investment and government spending are components of aggregate demand, AD increases reducing a
deflationary gap

Advantages
 Helps to target specific sectors of the economy
 Government spending is effective in deep recession
 Automatic stabilizers help counter fluctuations in the business cycle

Disadvantages
 Political pressures may lead to delays
 Time lags (recognition, administrative and impact lag)
 Maintaining a sustainable level debt may be an issue as borrowing is needed
 Crowding out occurs when increased government borrowing causes interest rates to rise, reducing private sector
investment
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  Inability to address supply-side issues

Contractionary fiscal policy is the use of reduced government spending and/or increased taxes in order to reduce economic activity
 Reduction in government spending and/or tax hikes
 Greater taxes lower disposable income for households and firms, lowering consumption and investment spending in the
economy
 Reduced government spending is a leakage of money from the circular flow of income
 Aggregate demand falls reducing an inflationary gap

Advantages
 Helps to target specific sectors of the economy
 Raising taxes is unpopular for the government
 Automatic stabilizers help counter fluctuations in the business cycle

Disadvantages
 Political pressures may lead to delays
 Time lags (recognition, administrative and impact lag)
 Inability to address supply-side issues

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Supply-side policies
Supply-side policies are long term government strategies used to increase the potential productive capacity of the economy by
increasing the quality and/or quantity of factors of production
 Market-based supply-side policies
 Interventionist supply-side policies

Market based supply-side policies focus on increasing market competition and incentives to work to increase aggregate supply,
thereby improving productivity
 Privatization is the selling of state-owned businesses to the private sector. This leads to increased efficiency as profit-
seeking private firms look to improve operations to compete for customer satisfaction. This leads to the use of improved
production techniques coupled with skilled labor leading to increased productivity, lowering the cost of production. This puts
downward pressure on market prices, firms raise output, increasing the real GDP of the economy.
 Deregulation involves eliminating or reducing government regulation on private sector firms such as lowering license fee,
reducing bureaucratic hurdles etc. This reduces barriers to entry in a market, increasing competition, and putting pressure
on firms to become cost-efficient. This leads to a fall in prices and increased output for the economy.
 Anti-monopoly regulations anti-trust laws restrict mergers that may result in monopoly power or breaking up large firms
that are engaged in monopolistic practices, into smaller units that will behave more competitively. This puts downward
pressure on prices, forcing firms to strive for efficiency, lower costs and improved quality, leading to increased economic
output.
 Minimum wage rate reducing or eliminating minimum wage rate may reduce unemployment as firms will be able to hire
more workers at lower wages. Firms will experience a fall in unit costs, increasing their profit margins, leading to increased
production. This may lead to increased investment in the economy and economic growth.
 Unemployment benefits if the government reduces expenditure on unemployment benefits, unemployed workers will be
forced to work, increasing the production level of firms and reducing government expenditures.
 Trade union power trade unions attempt to keep wages above the market wage level. If the power of trade unions is limited,
wages will be more responsive to the forces of supply and demand. This may lead to increased employment at lower wages,
raising output.
 Trade liberalization seeks to remove trade barriers such as tariffs and quotas to allow the free flow of goods and services
across borders. This increases pressure on local firms to compete along with allowing local firms to export goods to foreign
markets.
 Personal income tax cuts, reducing income tax for low-income people can create an incentive to work harder or seek
better employment opportunities. This reduces unemployment and increases productivity
 Cuts in business tax and capital gains tax act as incentives for firms to invest more in capital goods, increasing the
productive capacity of the economy over time

Advantages of market-based supply-side policies

 Improved allocation of resources
 There is no burden on government budget
 Can counter the impacts of cost-push inflation

Disadvantages of market-based supply-side policies

 Supply-side policies need time to reap desired results
 Such polices may not improve equity in income distribution
 Economic output may rise but at the cost of environmental degradation

Interventionist supply-side policies are deliberate attempts by a government to influence aggregate supply and productive capacity of
the economy
 Education and training supply-side policies can increase human capital by increasing government spending on education
and vocational training. This helps raise the skills, mobility and productivity of the labor force
 Improving quality and access of healthcare helps improve the quality of life of the workforce, reducing costs related to
illness and loss of time
 Research and development are the process of business activities to improve, introduce and innovate products and
processes. This helps improve productivity an lowers production cost of firms in the economy
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  Provision of infrastructure such as organizational structures, roads, power, communication networks, transportation and
electricity help firms produce goods and services in a more cost-effective way, leading to increased productivity
 Industrial policies are aimed at encouraging the development and growth of the manufacturing sector of the economy to
promote growth and employment e.g. tax allowances, lower interest rates and tax breaks

Advantages of interventionist supply-side policies

 Direct support can be provided to key sectors of the economy
 The supply of merit goods can be supported
 Can put downward pressure on price levels in the economy

Disadvantages of interventionist supply-side policies

 Such polices may not improve equity in income distribution
 Huge costs may be incurred in the implementation of such policies
 Such policies need significant time to reap necessary results

Demand-side effects of supply-side policies

 Tax cuts on personal income tax and business profits (supply-side measures) help to increase household consumption of
goods and services and investment by firms in capital goods, meaning an increase in aggregate demand
 An increase in expenditure on education, healthcare and training is part of government spending, a component of aggregate
demand
 Spending on R&D, infrastructure and industrial policies have a demand-side effect

supply-side effects of demand-side policies

 Increased spending by the government on education, healthcare and vocational training, in the long run, will increase
aggregate supply (LRAS)
 Government spending on R&D, infrastructure and industrial policies have a demand-side effect that will improve the
productive capacity of the economy and increase LRAS
 Business tax cuts help to increase investment by firms in capital goods, but in the long run, will increase LRAS

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Benefits of international trade
International trade is the exchange of goods and services between nations, involving exports of goods and services to foreign buyers
and import of goods and services by domestic buyers

Benefits of international trade

 Increased competition
 Lower prices
 Greater choice
 Acquisition of resources
 More foreign exchange earnings
 Economies of scale
 More efficient allocation of resources
 More efficient production

Free trade is the free flow of goods and services across national borders without government restrictions.

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Types of trade protection
Trade protection is the use of barriers to trade to safeguard an economy from excessive international trade and foreign competition

Tariffs are a specific tax on imported goods and services. They can be issued by the government unilaterally or as a requirement of a
trading bloc
 All other forms of protection are called non-tariff barriers

Effects of tariffs on different stakeholders

 Consumers will lose surplus
 Reduced consumer choice
 Consumers will pay higher prices
 Domestic producers will benefit from increased producer surplus
in the short run due lack of competition
 Increased producer revenue
 Retaliation from foreign government
 Foreign producers will lose revenue and will need to compete
on quality
 The government will receive tax revenue
 The government may succeed in protecting jobs in the industry
 The government may be burdened by the cost of enforcing the tariff
 The government may face action from the WTO e.g. fines

Subsidies are a form of financial assistance given to local firms to help them compete against foreign rivals by lowering the cost of
production of domestic suppliers

Effects on different stakeholders

 Consumer buy more domestic goods
 Consumers surplus remains unchanged
 The quality of domestic goods may be lower than foreign goods
 Increased producer revenue which may cause them to expand
their product range.
 Foreign producers will lose revenue and may seek other markets
 The government faces a negative impact on its budget
 Taxpayers are worse off as there is an opportunity cost of using
this money for the subsidy

Quotas are quantitative limits on the import of goods in a country

Effects on different stakeholders

 Reduced consumer choice
 Consumers will pay higher prices
 Consumers will lose surplus
 Domestic producers will benefit from increased producer surplus
 Foreign producers will lose revenue and may seek other markets
to sell their goods
 The government may receive some revenue from the sale of import
quota
 The government may succeed in protecting jobs in the industry
 The government may be burdened by the cost of enforcing the quota

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Administrative barriers are the application of bureaucratic standards and regulations imposed on foreign firms in order to protect
domestic firms and consumers
 Embargos are a form administrative barrier that involves the use of bans on trade with a certain country, often due to
political and/or economic disputes
 Exchange controls are a form of administrative barrier that involve restrictions on the quantity of foreign exchange that can
be bought or sold by domestic residents

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Arguments for and against trade control
Trade protection is the use of barriers to international trade e.g. tariffs, to safeguard an economy from excessive trade competition
from foreign firms

Arguments in favor of trade protection

 Protection of infant (sunrise) industries are usually new unestablished industries that have the potential to achieve a
comparative advantage but are too underdeveloped to compete with foreign firms
 Some governments insist that it is in the national interest of for some essential industries to remain self-sufficient in case
of major crises e.g. global conflicts
 Health and safety a government may have concerns about the safety of particular goods entering an economy e.g. food and
medicines
 Environmental standards as environmental protection become more of a priority for governments, some domestic firms
relocate their production facilities aboard to avoid stricter controls and fines and then import their goods back into their
country
 Dumping is the sale of goods and services by foreign firms at a price lower that the cost of production
 Unfair competition some governments use business regulations to favor domestic firms e.g. a lower corporate tax which
gives them an unfair advantage when exporting to other countries
 Generating government revenue, governments in need of additional revenue may regard tariffs as an opportunity to gain
revenue
 Protection of jobs when domestic consumers buy imports, they reduced the derived demand for labor in local markets
 Dumping is the sale of goods and services by foreign firms at a price lower that the cost of production
 Unfair competition some governments use business regulations to favor domestic firms e.g. a lower corporate tax which
gives them an unfair advantage when exporting to other countries
 Generating government revenue, governments in need of additional revenue may regard tariffs as an opportunity to gain
revenue
 Protection of jobs when domestic consumers buy imports, they reduced the derived demand for labor in local markets
 An ELDCs have access to low levels of physical and human capital which means they tend to produce primary commodities,
e.g. rice. Trade protection is used to avoid over-specialization
 Balance of payments correction the imbalance of the BOP is a result of a currency that is not freely floating. If a currency
is overvalued, then its quantity supplied exceeds its quantity demanded, meaning debits exceed credits, leading to a BOP
deficit

Arguments against trade protection

 Misallocation of resources trade protection distorts market forces and comparative advantages, leading to less efficient
production and loss in community surplus
 Retaliation refers to the actions taken by a country in response to trade restrictions being imposed on it by other countries
 Increased costs if a country relies on the importation of raw materials, protectionist measures such as tariffs may
increase the production costs for domestic firms
 Higher prices protectionist policies result in increased market price of goods either due to higher input costs
 Domestic firms lack incentive to become more efficient x-inefficiencies refer to the lack of incentive of local producers
to control production costs owing to decreased foreign competition
 Reduced export competitiveness occurs when domestic firms lack the ability to export products successfully to foreign
markets owing to their inefficiencies
 Less choice trade protection can lead to foreign firms existing from the local market, leaving consumers with less choice

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Economic integration
Economic integration is the process of countries becoming more interdependent and economically unified by reducing trade barriers

A preferential trade agreement (PTA) is a trade agreement between two or more countries, giving special terms and conditions of
trade to member countries
 A bilateral trade agreement is a preferential trade agreement between two countries, usually by mutual agreement to
reduce or remove trade barriers
 A regional trade agreement is a reciprocal trade agreement between two or more countries, usually belonging to the same
geographical area
 A multilateral trade agreement is a legally binding preferential trade agreement between more than two countries and/or
trading blocs, under the guidelines of the WTO

A trading bloc is a group of countries that agree to economic integration and freer trade by reducing trading restrictions
 An free trade area (FTA) is a trading bloc between member countries that agree to trade freely with each other but can
impose separate trade restrictions with non-member countries e.g. SAFTA
 Custom union consists of member countries in a trading bloc that engage in free trade but impose a common external tariff
when trading with non-member countries e.g. EU
 Common market is the most integrated trading bloc, consisting of a custom union that allows the free movement of factors
of production between members e.g. EEA

Advanatges
 Access to larger markets
 Greater employment opportunities
 Greater political stability and cooperation

Disadvanatges
 Loss of sovereignty
 Challenges to multilateral trade negotiations

A monetary union refers to the monetary system in a common market that requires the convergence of monetary policy that is
governed by a common central bank
 The European central bank (ECB)
 A single currency

The World Trade Organization (WTO) is an international organization dealing with trading rules among member countries. Its main aim
is to increase trade by promoting free trade (lowering trade barriers) and improving the flow of trade
 Trade negotiations
 Implementation and monitoring
 Dispute settlement
 Building trade capacity
 Outreach

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Exchange rates
Exchange rates refer to the value of one currency expressed in terms of another currency
 Foreign consumers demand a local currency while domestic consumers supply a local currency e.g. US citizens demand
euros but supply dollars
 Foreign investors demand a local currency while local investors supply a local currency
 Foreign governments demand a local currency while local governments supply a local currency

A floating exchange rate is where the value of a currency is determined by the demand and supply of the currency in a foreign
exchange market

An appreciation is an increase in the value of a country’s currency in terms of anther currency in a floating exchange rate system
 Imports became cheaper for domestic consumers
 Increased imports may hurt domestic production
 Exports have become expensive for foreign consumers and may fall

A depreciation is a decrease in the value of a country’s currency in terms of another currency in a floating exchange rate system
 Expansion of domestic export industry as exports became cheaper
 Imports become expensive for domestic consumers which may lead to imported inflation if the domestic economy relies on
imported raw materials

Example: The exchange rate for the British pound and the US dollar is £1= $1.35. Calculate the price for consumers in Britain buying US
cars priced $35500

£1= $1.35
$1= (1 / 1.35) = £0.74
For British consumers buying a car worth $35500 = 0.74 x 35500 = £26270

Example: If the exchange rate for the US dollar to British pound is $1 = £0.64, calculate the price paid in pounds sterling by a British
tourist spending $65 on a theme park ticket in Florida

$1 = £0.64
For British tourist buying a ticket worth $65 will cost = 0.64 x 65 = £41.626270

Example: If the US dollar depreciates against the pound sterling to $1 = £0.60, calculate the new amount paid in pounds sterling that the
British tourist would have to pay

$1 = £0.60
For British tourist buying a ticket worth $65 will cost = 0.60 x 65 = £39

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Changes in demand and supply for a currency
 Tastes and preferences (foreign demand for exports and domestic demand for imports) if the demand for US exports
increases in Pakistan, Pakistanis will demand more US dollars, leading to an appreciation of the US dollar relative to the
Pakistani Rupee
 Interest rates (relative) if the European central bank lowers interest rates, ceteris Paribas, fewer foreigners will seek to
invest in European financial assets, reducing the demand for the euro, leading to depreciation of the euro
 Price levels (relative inflation) if price levels rise in the UK relative to China, Chinese consumers will seek to buy fewer UK
exports, depreciating the UK pound against the Chinese Renminbi
 Speculation if Pakistanis buy US dollars in anticipation that its value will rise against the Rupee, Pakistanis must supply
rupees to buy dollars, thereby depreciating the rupee relative to the dollar
 Income (relative growth rates) with economic growth in Malaysia, national income levels rise, thereby Malaysians may buy
more imported goods from other countries, leading to a depreciation of the Malaysian Ringgit
 Inwards/outward foreign direct investment and portfolio investment inwards investment coming into Hong Kong either
FDI or portfolio investment will increase demand for the Hong Kong dollar, causing an appreciation

Consequences of changes in exchange rate

 A currency depreciation will generally raise import price and reduce exports prices, leading to an increase in exports
relative to imports. This will increase net exports, causing an increase in aggregate demand, leading to an increase in price
levels and vice versa. Depreciation can also cause cost push inflation if the domestic firms are reliant on imported raw
material
 Appreciation of the currency will lead to an increase in export prices and exports may fall if their demand is price elastic,
this will lower net exports, causing a fall in aggregate demand
 Appreciation may lead to a significant fall in demand for exports, this may cause a fall in demand for labor
 An appreciation will lower export revenue and increase import expenditure, assuming that PEDx + PEDm > 1, causing a current
account deficit and vice versa.

Advantages of free float

 Domestic policy freedom
 Self-adjustment and balance of payment
 Flexible response to external shocks

Disadvantages of free float

 Uncertainty for investors
 Risk of imported inflation
 Volatility

A fixed exchange rate exists when the central bank buys and sells foreign currencies to ensure the value of its currency stays at a
single, predetermined rate
 Devaluation occurs when the price of currency operating in a fixed exchange
rate system is officially and deliberately lowered
 Revaluation occurs when the price of currency operating in a fixed exchange
rate system is officially and deliberately raised

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A managed float is a system where the government periodically intervenes in the
forex market to influence the exchange rate when deemed necessary to maintain
certainty and confidence in the economy
 A crawling peg is a form of fixed exchange rate system in which a
currency is permitted to fluctuate within predetermined bands of exchange
rates
 Intervention takes the form of buying and selling of currencies by the
central bank using foreign reserves
 Central banks may change interest rates to impact exchange rates
 The government may set exchange controls, limiting the amount of
currency that can be exchanged
An overvalued currency occurs when the value of a currency is above its market equilibrium value in the long run
 Imports become cheaper while exports become expensive, putting downward pressure on the inflation rate
 May lead to lower revenues in export-related industries
 Overvalued currencies can also be a negative impact on a nation’s balance of payments

An undervalued currency occurs when the value of a currency is below its market equilibrium value in the long run
 Imports become expensive while exports become cheaper, leading to economic growth and employment in export industries
 Local consumers may switch to buying domestic goods owing to higher import prices
 For countries relying on imported raw materials, this can put upward pressure on price levels in the country

Advantages of fixed exchange rate

 It ensures certainty and inspires confidence among trading countries
 It eliminates speculative buying and selling of currencies by investors
 It helps the government maintain a stable rate of inflation

Disadvantages of fixed exchange rate

 Fixed exchange rate systems require intervention, e.g. use of interest rates or buying or selling of currencies which may
conflict with other macroeconomic objectives
 Buying and selling of currencies causes depletion of foreign exchange reserves
 It does not automatically correct a BOP disequilibrium

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Balance of payments
The balance of payments is a financial record of nation’s transactions with the rest of the world, usually one year
 Credits items are payments received from consumers, firms or governments of another country
 Debit items are payments made to consumers, firms and governments located in other countries

Components of the balance of payments

The current account is a record of all the trade (goods and services) flows, income flows and current transfers between two countries
 Balance of trade in goods records all export and imports of physical goods such as rice, coffee, oil etc. between one
country and the rest of the world.
 Balance of trade in services records all export and imports of services such as insurance, banking, tourism etc. between
one country and the rest of the world. These are sometimes referred to as invisibles. The balance of trade is the difference
between a nation’s total export earnings and import expenditures
 Income transfers records income receipts earned from foreign investments minus the income payments paid to foreign
investors e.g. profits, wages, rent etc.
 Current transfers are the inflows and outflows of money that are not made in exchange for trade e.g. foreign aid,
government grants, loan, donations etc.

A current account surplus occurs when the sum of money flowing into a country’s current account exceeds the money flowing out

A current account deficit occurs when the sum of money flowing out of a country’s current account exceeds the money flowing in

The capital account records the difference between forms of capital inflows and outflows of a country, namely capital transfers and
transactions in non-produced, non-financial assets
 Capital transfers are the different forms of capital inflows and outflows of a country e.g. debt forgiveness, assets bought
into an economy by immigrants or those leaving with emigrants, capital grants for building infrastructure
 Transactions in non-produced, non-financial assets are the legal property rights to natural resources e.g. land rights,
intellectual rights (trademarks, copyrights, patents) which are likely to produce an income stream for the country

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The financial account records transactions related to the change in ownership of assets i.e. cross-border investments
 Foreign direct investment refers to spending by multinational companies in an economy e.g. setting up production and
distribution facilities or expanding their operations by buying machinery, buildings and other fixed assets
 Portfolio investment refers to the stock of investment assets, which can include shares, government bonds and securities
 Reserve assets are stocks of foreign currencies and liquid assets e.g. gold reserves held by the central bank used to
balance international payments
 Official borrowing refers to government borrowing from institutions out their country e.g. IMF and world bank

Current account = capital account + financial account

Based on the above three tables
BOP = -80 + 65 + +15 = 0

Or (current account = capital account + financial account + errors and omissions)

Example: Calculate the value of the balance of trade

BOT = – $18.3bn + $21.8bn = 3.5bn

Calculate the value of the current account

Current account balance = – $18.3bn + $21.8bn + $6.7bn – $5.6bn = $4.6bn

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Sustainable development
Sustainable development is economic development that meets the needs of the present generations without compromising the ability
of future generations to meet their own needs
 Non-renewable natural resources are not naturally replenished once they have been used e.g. fossil fuels, minerals and
ground water
 Renewable resources are naturally replenished if they are sustainably e.g. timber, food crops, animal husbandry and
renewable energy sources

Social sustainability refers to the ability of an economy to develop social processes and structures that enable its current population
to live optimally and to support the ability of future populations to do the same
 Society should offer equal opportunity for all community member
 Society should ensure that basic needs of its members are met to aid a better standard of living through good healthcare,
stable employment, social housing and education
 All members of society should be able to have a voice and raise their concerns to facilitate better functioning of government
 Society should promote diversity, to bind the community for improved well-being

Economic sustainability refers to the optimal use of scarce resources in such a way to ensure future generations are not
disadvantaged in favor of today’s generation
 Economic sustainability attracts domestic and foreign investment as they see this as an opportunity to increase long-term
economic prosperity
 Local communities can function more efficiently as well as innovatively
 Firms can enjoy lower production costs owing to reduction in environmental costs
 Economic suitability helps households to maintain a stable level of income

Environmental sustainability refers to the responsible use of the planet’s natural resources so that future generations are not
compromised on their use of these natural resources
 Encouraging the use of renewable energy resources e.g. wind, solar or biomass, reducing the reliance on non-renewable
resources
 Global warming and climate change have caused a gradual increase in the overall temperature of the planet
 Environmental sustainability helps our ecosystem to be healthy and productive to meet the needs of future generations
 Environmental sustainability laws that protect common access resources from being over exploited

Sustainable development goals (SDGs) of the united nations development programme consist of 17 international development targets
aimed at achieving peace and prosperity for all UN member countries by 2030

The millennium development goals (MDGs) of the united nations committed members to combat poverty, hunger, disease, illiteracy,
environmental degradation and discrimination against women. The MDGs were scheduled to be achieved by 2015

Sustainable development goals

 End poverty in all forms
 End hunger and improved nutrition
 Ensure healthy lives and promote well-being
 Ensure inclusive and quality education
 Achieve gender equality
 Ensure sustainable management of water/sanitation
 Ensure access to affordable, sustainable energy
 Sustainably use oceans and marine resources
 Strengthen the means of implementation of sustainable development
 Promote sustainable economic growth
 Build resilient infrastructure, promote industrialization and innovation
 Reduce inequality within and among nations
 Make cities safe, resilient and sustainable
 Ensure sustainable consumption and production patterns
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 Take urgent actions to tackle climate change
 Protect and restore sustainable use of ecosystems
 Provide justice and build effective institutions

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Measuring development
Single indicators of economic development
 GDP/GNI per capita means expressing the real GDP/GNI of a nation in terms of its population size to determine the value of
national income per person. Purchasing power parity refers to the exchange rate that enables residents to purchase a
common basket of goods and services in different countries
 Health indicators are indicators of measuring economic development by using health-related determinants of the quality of
life e.g. life expectancy, under-five mortality rate, and expenditure on healthcare as percentage of GDP
 Education indicators are indicators that use education-related determinants of the quality of life e.g. literacy rates and the
mean years of schooling

Composite indicators of economic development

The human development index HDI is a measure of economic development comprising real income, life expectancy and educational
attainment
 Healthcare measure life expectancy at birth. The greater the healthcare in a nation, the greater the social and economic
well-being tends to be for its citizens
 Education indicates the mean years of schooling and expected years of schooling in a country
 Income levels measure national income of a country i.e. real GNI per capita at PPP

The value of HDI ranges between 0 and 1. The greater the value, the greater the human development e.g. Norway has an HDI of 0.953
while Pakistan has an HDI value of 0.557
 However, HDI ignores factors such as gender inequality, income distribution, environmental issues and sustainable
development

Gender inequality index (GII) measures development by calculating gender disparities through three dimensions i.e. reproductive
health, empowerment and labor market participation

The inequality human development index IHDI is a measure of the average level of human development by accounting for inequalities
in societies
 The difference between HDI and IHDI is the social and economic cost of inequality
 IHDI value is likely to be below the HDI value as inequalities rise

The happy planet index (HPI) is a measure of sustainable human well-being i.e. how individuals and countries are able to achieve long,
happy and sustainable lives. HPI measure well-being ranging from (0 – 10)

HPI = (well-being x life expectancy x inequality) / ecological footprint

Benefits of the approaches to measuring economic development

 These measures can be used for comparisons between countries
 Such indictors can be used to measure changes in development within a country over time

Limitations of the approaches to measuring economic development

 Measuring economic well-being is a complex process that changes over time
 Some indicators only portray a particular strength of a country but not necessarily the full picture
 Most indicators use qualitative factors
 Political and social conflicts, corruption, and external shocks make it challenging to access data

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Barriers to growth and/or economic development
The poverty trap is a vicious cycle of poverty and deprivation causing even greater poverty, from one generation to the next

The savings ratio is the amount of savings expressed as a proportion of total disposable income in an economy

Low income

No basic
Low saving
education

Low Low
productivity investment

Economic barriers to economic growth and development

 Rising economic income and wealth inequality can hinder development
 Low levels of human capital including poor access to healthcare and education
 Lack of access to international markets owing to trade protection and tough global competition is detrimental for ELDCs
 Capital flight is the withdrawal of money, assets or resources from a country owing to economic and political uncertainties.
This can hinder economic growth and development
 Lack of access to infrastructure and appropriate technology e.g. telecommunication and public utilities
 Dependence on primary sector production e.g. mineral extraction can hinder development as these resources are
exhaustible, so cannot be sustained in the long run
 Economic growth and development can be hindered by the geographic location of a country e.g. access to sea routes
 Tropical climates are susceptible to diseases, e.g. malaria which may cause deaths and reduce labor productivity
 High levels of debt can slow down economic growth and development
 Activities in the informal economy are not recorded, leading to lower tax collections

Political and social barriers

 Unequal political power and status means that millions of women, migrants and ethnic minorities may be excluded from
progress on human development, limiting their contribution in economic activity
 Lack of good governance, including corruption, may make a country unattractive for investors, encourage informal sector
activities and may increase transaction costs
 Gender inequality limits the quantity and quality of labor resources in the production process e.g. in some countries women
are not allowed to work with men, vote or drive
 Weak institutional framework may include poor legal systems, unfriendly corporate laws, poor taxation structures, inability
of the banking system to provide micro-credit, and inability to protect property rights. This can limit economic growth and
development

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Economic growth and/or development strategies
Trade strategies
 Import substitution is an inward-looking strategy that encourages domestic production and the purchase of domestic
output through protectionist policies e.g. tariffs. This may help increase domestic employment and lessen the impact of
fluctuations in import prices
 Export promotion is an outward-looking trade strategy that focuses on greater international trade. This helps domestic
firms gain access to larger markets, and allows for the transfer of skills and technology
 Economic integration creates economic benefits for trading partners e.g. lower prices, greater consumer choice and
improved political relations along with easier access to international markets
 Diversification is a strategy that involves countries broadening their supply of goods and services in export markets. This
helps overcome overspecialization in ELDCs and reduce their vulnerability to fluctuations in prices of primary sector output

Social enterprise
A social enterprise is an organization that focuses on meeting specific social objectives e.g. Oxfam which strives to end injustices that
cause poverty around the world
 Their services typically align with environmental needs of community
 Can help create awareness about issues
 Social enterprises get government support
 They encourage voluntary work

Market-based and interventionist policies

 Trade liberalization encourages free trade which lowers costs of conducting international trade
 Privatization improves competition leading markets efficiencies and lower prices
 Deregulation limits the level of government intervention by lowering barriers to entry, allowing for quicker decision making
 Tax policies are used to redistribute income and wealth to support low-income households
 Transfer payments are another way of to facilitate greater economic growth and development by providing financial
assistance through pensions, unemployment benefits and child allowances
 Minimum wage policies can be enforced by the government to help wage earners receive a higher amount deemed to
provide people with income sufficient to maintain an acceptable living standard

Provision of merit goods

 Growth and development strategies also include provision of merit goods such as education and health programmes to
improve the human capital in the nation
 Government spending on infrastructure such as transportation and telecommunication networks helps to encourage inward
FDI
 Green and clean energy sources enable a nation to provide affordable and reliable energy in the long run, which facilitates
economic sustainability and development
 Investment in transport such as railways, roads, shipping and aviation which help lower business costs and allow for timely
delivery of goods
 Access to clean water and sanitation help communities to live a healthy life, reducing infectious diseases that can harm
labor productivity

Inward foreign direct investment

 As multinational companies (MNCs) operate at a large scale, they tend to enjoy economies of scale, which can benefit
consumer in the form of lower prices
 MNCs are keen to expand into ELDCs that are well-endowed in natural resources that can be exploited for production
 Access to fast-growing economies e.g. Bangladesh present enormous opportunities to MNCs to generate sales revenue
 ELDCs offer financial incentives e.g. tax rebates or cheaper rents to MNCs to incentivize them to relocate operations
 Inward FDI generates national income, which can help domestic growth and development
 FDI allows for the transfer of knowledge and technology, helping to improve productivity of domestic firms
 Inward FDI helps generate employment opportunities in the domestic country

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Foreign aid is financial assistance from donor nations to ELDCs for the purpose of development. Aid is given on concessional and non-
commercial terms
 Humanitarian aid is foreign aid used to help countries to achieve development objectives and improve standard of living.
This may include grants, concession loans, project aid and conditional aid
 Economic aid is to ELDCs with the interest to build better economic ties e.g. tied aid, which requires the recipient country to
spend the aid on buying products from the donor country
 Political aid is given to promote specific political objectives e.g. the UK provides aid to its former colonies seeking to
maintain an influence. The US provides aid to support capitalism in ELDCs
 Foreign aid can be used to increase production and productivity
 May help to eradicate extreme poverty
 As a form of injection into the circular flow of income, it may help reduce inequalities and unemployment
 It creates economic dependence on donors
 Aid in the form of loans incurs interest payments
 It may be insufficient to help ELDCs achieve economic development

Debt relief (debt forgiveness) is the partial or total remission of foreign debt, especially owed by low-income countries and ELDCs
 Debt rescheduling means renegotiating the length of time to repay the existing loans of highly indebted nations
 Internal debt is money borrowed by a country from domestic lenders e.g. commercial banks
 External foreign debt is money borrowed by a nation from foreign lenders e.g. foreign commercial banks, IMF, world bank,
foreign governments

Official development assistance ODA is foreign aid from donor governments, rather than NGOs for development purposes
 ODA can be provided bilaterally or channeled through a multilateral development agency e.g. United Nations

Multilateral development assistance MDA is financial support delivered through international institutions such as world bank and IMF
 The world bank is an international financial institution that lends money to ELDCs for economic development projects
 The IMF is an international multilateral financial institution that’s aims to promote global monetary cooperation and facilitate
economic growth and development

Institutional change
 Improved access to banking, including microfinance and mobile banking
 Microfinance (micro-credit) refers to small sums of borrowed funds by individuals in ELDCs for self-employment purposes
so they can generate income
 Mobile banking is a service provided by financial institutions that allows customers to conduct financial transactions
remotely using a mobile device e.g. smartphone
 Property rights are the entitlement to both tangible and intangible assets owned by an individual, organization or
government e.g. land rights and intellectual property rights
 Land rights refer to the ability of individuals to obtain, use and hold land at their will
 Increasing women empowerment helps to end social and cultural discrimination against females, which can have a positive
impact on their self-esteem and mental well-being.
 Reducing corruption creates incentives for investors, which can lead to greater capital formation and economic
development

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