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Year 12 Economic Notes
Basic Economic Ideas
Economic efficiency means the using of resources in such a way as to maximize the production of goods
and services. Economic efficiency exists when
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No one can be made better off without making someone else worse off.
More output cannot be obtained without increasing the amount of inputs.
Production proceeds at the lowest possible per-unit cost.
There are two requisites in order to achieve economic efficiency. These are
Productive efficiency
It is achieved when production of goods is achieved at the lowest cost possible.
Look at the PPC diagram below. Point X shows Productive inefficiency. This is because the output is not
optimum and there are still resources left unused. Whereas, Point Y shows productive efficiency, as this is
the maximum output which can be achieved through the utilizing all resources.
In long-run equilibrium for perfectly competitive markets, this is where average cost is at the base on the
Average Cost curve. (MC=AC). In the diagram below q is the point of productive efficiency.
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Allocative efficiency
Allocative efficiency is a situation in which the limited resources of a firm are allocated in accordance with
the wishes of consumers. An allocatively efficient economy produces an "optimal mix" of commodities. In
short, the products that are most wanted must be produced.
A competitive market can lead to Allocative efficiency because the firms are forced to produce what the
customers want.
Ceteris
Paribus
Ceteris paribus is a Latin phrase, literally translated as "with other things the same." It is commonly
rendered in English as "all other things being equal."
In economics, theoretical models are build on the basis of ceteris paribus in order to test and illlustrate
various theories.
When using ceteris paribus in economics, assume all other variables except those under immediate
consideration are held constant. For example, it can be predicted that if the price of beef decreases—ceteris
paribus—the quantity of beef demanded by buyers will increase. In this example, the clause is used to
operationally describe everything surrounding the relationship between both the price and the quantity
demanded of an ordinary good.
Normative and Positive Statements
Two kinds of assertions in economics can be subjected to testing. One of it is a statement of fact, such as “It
is raining outside” or “India has an unemployment rate of 9%.” Like hypotheses, such assertions can be
demonstrated to be false. Unlike hypotheses, they can also be shown to be correct. A statement of fact or a
hypothesis is a positive statement. Although people often disagree about positive statements, such
disagreements can ultimately be resolved through investigation.
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There is another category of assertions, however, for which investigation can never resolve differences. A
normative statement is one that makes a value judgment. Such a judgment is the opinion of the speaker; no
one can “prove” that the statement is or is not correct. Here are some examples of normative statements in
economics: “We ought to do more to help the poor.” “People in the United States should save more.”
“Corporate profits are too high.” The statements are based on the values of the person who makes them.
They cannot be proven false.
Because people have different values, normative statements often provoke disagreement. An economist
whose values lead him or her to conclude that we should provide more help for the poor will disagree with
one whose values lead to a conclusion that we should not. Because no test exists for these values, these two
economists will continue to disagree, unless one persuades the other to adopt a different set of values. Many
of the disagreements among economists are based on such differences in values and therefore are unlikely to
be resolved.
Choices Are Made at the Margin
Economists argue that most choices are made “at the margin.” The margin is the current level of an activity
Think of it as the edge from which a choice is to be made. A choice at the margin decision to do a little more
or a little less of something.
Assessing choices at the margin can lead to extremely useful insights. Consider, for example, the problem of
curtailing water consumption when the amount of water available falls short of the amount people now use.
Economists argue that one way to induce people to conserve water is to raise its price. A common response
to this recommendation is that a higher price would have no effect on water consumption, because water is a
necessity. Many people assert that prices do not affect water consumption because people “need” water.
But choices in water consumption, like virtually all choices, are made at the margin. Individuals do not make
choices about whether they should or should not consume water. Rather, they decide whether to consume a
little more or a little less water. Household water consumption in the United States totals about 105 gallons
per person per day. Think of that starting point as the edge from which a choice at the margin in water
consumption is made. Could a higher price cause you to use less water brushing your teeth, take shorter
showers, or water your lawn less? Could a higher price cause people to reduce their use, say, to 104 gallons
per person per day? To103 When we examine the choice to consume water at the margin, the notion that a
higher price would reduce consumption seems much more plausible. Prices affect our consumption of water
because choices in water consumption, like other choices, are made at the margin.
What is an Economic System?
Because of the fact that there is scarcity of resources and unlimited wants, it is always a problem to allocate
resources in an efficient manner. We are constantly facing three basic questions. These are:
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What to produce?
How to produce?
For whom do we produce?
Every community or country must choose and develop its own way of solving these problems. The way a
country decides what to produce, how to produce and for whom to produce is called it Economic System.
The three Economic Systems existing are:
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Market Economic system
Planned Economic System
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Mixed Economic System
Note:
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There are no PURE command economies
There are no PURE market economies
Instead there is a continuum of different characteristics
What happens when countries move from command economy to
market economy?
CHARACTERISTIC
COMMAND ECONOMY
MARKET ECONOMY
From: government ownership
To: private ownership
From: centrally planned
To: by the market
From: "the social good"
To: self interest and profit
From: set by the government
often distorted
From: inefficiency
full employment
low inflation
low standard of living
shortages
more equal distributor
From: corruption=self interest
lack of incentives (the incentive
problem)
distorted prices (the coordination
problem)
inefficiency
From: LESS FOR MORE
(INEFFICIENT)
and a lower standard of living
To: set by the market
change with market
To: economic efficiency
periods of unemployment.
periods of inflation
high standard of living
wide range available
less equal distributor
To: monopoly= inefficiency
inequality
changing prices
instability (UE, IN)
pollution
Ownership of
resources:
Decision making:
Motivation:
Prices and Wages:
Result:
Problems:
OVERALL:
To: MORE FOR LESS
(EFFICIENT)
and a higher standard of
living
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Unlimited Wants
Human beings, in order to survive need a lot of things. Some of these things are very important for our
existence. For example, food, clothing, water, shelter and air. These things can be classified as Needs. Apart
from this there are things which are needed by us but they are not important for our survival and we can live
without them also. For example, going on an expensive holiday, owning a 57 inches Plasma TV. These are
known as Wants. This list is never ending and is continuously increasing.
Limited Resources
On the other hand, we have limited resources to produce these goods and services we want. There are not
enough car factories to provide cars to everybody on earth. Everything on this planet has some limits except
for our Wants.
When unlimited wants meet limited resources, it is known as Scarcity.
Alternative Uses
All the resources we have on this planet can be utilised in a number of way. They have alternative uses. For
example, a piece of land can be used for making a factory, or doing farming or constructing a school and so
on. Therefore, we have to choose what is best for us. If we talk from an economist point of view it means
‘making the optimum use of resource available’.
Opportunity Cost
Though we have alternative uses, we have to select the best way to use these resources. When we choose
best alternative, the next best alternative which is left out is known as the Opportunity cost of making a
choice. In other words, the benefits we lost and could have achieved from the next best alternative.
Examples of Opportunity Cost
A person who invests $10,000 in a stock denies themselves the interest they could have earned by leaving
the $10,000 dollars in a bank account instead. The opportunity cost of the decision to invest in stock is the
value of the interest.
If a city decides to build a hospital on vacant land it owns, the opportunity cost is the value of the benefits
forgone of the next best thing which might have been done with the land and construction funds instead. In
building the hospital, the city has forgone the opportunity to build a sports centre on that land, or a parking
lot.
Economic Problem
The problem then becomes how to determine what is to be produced and how the factors of production (such
as capital and labour) are to be allocated. Economics revolves around methods and possibilities of solving
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the economic problem.
Qualities of Good Money
Following are the qualities of good money:
General acceptance
The essential quality of good money is that it should be acceptable to all, without any hesitation in the
exchange for goods and services.
Portability
It is also an important quality of good money that is should be easily transferable from one place to another
for doing business and making payment. The paper money is easier to carry because it has minimum
possible wait than metallic money.
Storability
Money should be storable and it should not be depreciate with time. If the money used is perishable it will
lose its value in few days. Paper money has this quality of storability.
Divisibility
Good money is that which could be divided into small units without losing any value.
Durability
Money should be durable. It should not lose its value with the passage of time. The gold and silver coins do
not wear out quickly and quality of money remains the same.
Economy
It is important quality of good money that it should be made economically. If there is heavy cost on issuing
more money that is not good money. Good money is that has low cost and more supply. Paper money has
this quality of economy.
What is money?
Money is anything that is generally accepted as payment for goods and services and repayment of debts.
Functions of Money
A medium of exchange
Money overcomes the problem of needing a double coincidence of wants. It can be used to exchange and is
therefore a comparative object, a tertium comparationis ("a third comparative unit").
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A unit of account
Money acts as a measuring unit for value. Thus different commodities can be expressed in terms of money
uniformly. This simplifies the comparison of the value of two products or services.
A store of value
Money can be used to store value. Unlike barter system where the commodities could not be saved over
time, money can be stored as it does not lose value overtime.
A standard of deferred payment
Money can be used to pay over time for commodities. Goods and services can be paid for in instalments
over a period of time e.g hire purchase. This was much more difficult and complicated in the barter system.
Mixed Economy
A mixed economy is an economic system that incorporates aspects of more than one economic system. This
usually means an economy that contains both privately-owned and state-owned enterprises or that combines
elements of capitalism and socialism, or a mix of market economy and planned economy characteristics.
This system overcomes the disadvantages of both the market and planned economic systems.
Features
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Resources are owned both by the government as well as private individuals. i.e. co-existence of both
public sector and private sector.
Market forces prevail but are closely monitored by the government.
Advantages
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Producers and consumer have sovereignty to choose what to produce and what to consume but
production and consumption of harmful goods and services may be stopped by the government.
Social cost of business activities may be reduced by carrying out cost-benefit analysis by the
government.
As compared to Market economy, a mixed economy may have less income inequality due to the
role played by the government.
Monopolies may be existing but under close supervision of the government.
Planned Economy
In a planned economy, the factors of production are owned and managed by the government. Thus
the Government decides what to produce, how much to produce and for whom to produce.
Features:
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All resources are owned and managed by the government.
There is no Consumer or producer sovereignty.
The market forces are not allowed to set the price of the goods and services.
Profit in not the main objective, instead the government aims to provide goods and services to
everybody.
Government decides what to produce, how much to produce and for whom to produce.
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Advantages
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Prices are kept under control and thus everybody can afford to consume goods and services.
There is less inequality of wealth.
There is no duplication as the allocation of resources is centrally planned.
Low level of unemployment as the government aims to provide employment to everybody.
Elimination of waste resulting from competition between firms.
Disadvantages
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Consumers cannot choose and only those goods and services are produced which are decided by the
government.
Lack of profit motive may lead to firms being inefficient.
Lot of time and money is wasted in communicating instructions from the government to the firms.
Examples of Planned economies
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North Korea
Cuba
Turkmenistan
Myanmar
Belarus
Laos
Libya
Iran
Iraq (until 2003)
Market Economic System
The central thought of this system is that it should be the producers and consumers who decide how to
utilise the resources. Thus, the market forces decide what to produce, how much to produce and for whom to
produce.
Features
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All resources are privately owned by people and firms.
Profit is the main motive of all businesses.
There is no government interference in the business activities.
Producers are free to produce what they want, how much they want and for whom they want to
produce.
Consumers are free to choose.
Prices are decided by the Price mechanism i.e. the demand and supply of the good/service.
Advantages
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Free market responds quickly to the people’s wants: Thus, firms will produce what people want
because it is more profitable whereas anything which is not demanded will be taken out of
production.
Wide Variety of goods and services: There will be wide variety of goods and services available in
the market to suit everybody’s taste.
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Efficient use of resources encouraged: Profit being the sole motive, will drive the firms to
produce goods and services at lower cost and more efficiently. This will lead to firms using latest
technology to produce at lower costs.
Disadvantages
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Unemployment: Businesses in the market economy will only employ those factors of production
which will be profitable and thus we may find a lot of unemployment as more machines and less
labour will be used to cut cost.
Certain goods and services may not be provided: There may be certain goods which might not be
provided for by the Market economy. Those which people might want to use but don’t want to pay
may not be available because the firms may not find it profitable to produce. For example, Public
goods, such as, street lighting.
Consumption of harmful goods may be encouraged: Free market economy might find it profitable
to provide goods which are in demand and ignore the fact that they might be harmful for the society.
Ignore Social cost: In the desire to maximise profits businesses might not consider the social effects
of their actions.
Production
Possibility Curve
Production Possibility Curve/Production Possibility
Boundary/Production Possibility Frontier
From the point of view of an Economy, there is an opportunity cost of using its resources. Production
Possibility curve (PPC) shows the maximum combinations of goods and services that can be produced by an
economy in a given time period with its limited resources.
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In the graph, if all the resources are used to produce Schools then there will be no Hospitals. If you move to
the other end then all the resources would be used to produce Hospitals and not Schools will be there in the
economy. Government has to move along this curve and decide the best possible combination of goods to
produce. For example Z, shows the possible combinations of School buildings and Hospitals. Thus, it is
impossible to build more Schools without also building fewer Hospitals.
Resources have to be switched from building more Hosipitals to building more Schools. This is known as
rellocation of resources. Before the rellocation of resources we will have to consider the costs of rellocating
these resources between uses. This costs will include retraining cost of our workforce and the time
consumed in this rellocation.
Any point outside the curve is unattainable unless there is an outward shift of the PPC. This can only be
possible if there is an improvement in the quantity and/or quality of factors of production. This is known
as economic growth. It is a process of increasing the economy’s ability to produce goods and services.
In economics, factors of production (or productive inputs) are the resources employed to produce goods
and services. These can be categorized as
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Land: All natural resources provided by nature such as fields, forests, oil, gas, metals and other
mineral resources. The payment for land use and the received income of a land owner is rent.
Labour: Human effort used in production which also includes technical and marketing expertise.
The payment for someone else's labour and all income received from ones own labour is wages.
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Labour can also be classified as the physical and mental contribution of an employee to the
production of the good(s).
Capital: Human-made goods (or means of production) which are used in the production of other
goods. These include machinery, tools and buildings.
Enterprise: The skill and risk taking ability of the person who brings together all the other factors of
production together to produce goods and services. Usually the owner or founder of a business.
Because of the fact that choice involves opportunity cost, the factors of production have to be used in the
most efficient way. This is achieved through Specialization and Division of Labour. This means every
individual performs a specific task only so that he can give in the best output. There are advantages and
disadvantages related with division of labour.
Advantages
Specialization results in greater efficiency and productivity
Time and resources are saved as the workers become for conversant with the process
Disadvantages
Repeatedly doing the same job can result in boredom for the workers
If a worker cannot complete his or her job on time this may result in a bottleneck for the whole production
process.
The Price Systems
Theory of Demand
We now consider the basic theories of how the market mechanism works. In this chapter we consider the
economics of the law of demand. This is important background to understanding the determination of prices
in competitive markets.
Demand
Demand is defined as the quantity of a good or service that consumers are willing and able to buy at a
given price in a given time period. Each of us has an individual demand for particular goods and services
and the level of demand at each market price reflects the value that consumers place on a product and their
expected satisfaction gained from purchase and consumption.
Market demand
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Market demand is the sum of the individual demand for a product from each consumer in the
market. If more people enter the market and they have the ability to pay for items on sale, then demand at
each price level will rise.
Effective demand and willingness to pay
Demand in economics must be effective which means that only when a consumers' desire to buy a product is
backed up by an ability to pay for it does demand actually have an effect on the market. Consumers must
have sufficient purchasing power to have any effect on the allocation of scarce resources. For example,
what price are you willing to pay to view a world championship boxing event and how much are you
prepared to spend to watch Premiership soccer on a pay-per-view basis? Would you be willing and able to
pay to watch Elton John perform live through a subscription channel?
Auctions of film posters
Classic film posters are fetching thousands of pounds as more and more private collectors vie for a piece of
cinema history. The prices that collectors are prepared to pay for film posters continues to rise, some of the
buyers are hoping for a financial return whereas others are just willing and able to pay for the satisfaction
that comes from owning a small slice of cinema memorabilia.
Latent Demand
Latent demand is probably best described as the potential demand for a product. It exists when there is
willingness to buy among people for a good or service, but where consumers lack the purchasing power to
be able to afford the product. Latent demand is affected by advertising – where the producer is seeking to
influence consumer tastes and preferences.
The concept of derived demand
The demand for a product X might be strongly linked to the demand for a related product Y – giving rise to
the idea of a derived demand.
For example, the demand for steel is strongly linked to the demand for new vehicles and other manufactured
products, so that when an economy goes into a downturn or recession, so we would expect the demand for
steel to decline likewise. The major producer of steel in the UK is Corus. They produce for a wide range of
different industries; from agriculture, aerospace and construction industries to consumer goods producers,
packing and the transport sector. Steel is a cyclical industry which means that the total market demand for
steel is affected by changes in the economic cycle and also by fluctuations in the exchange rate.
The demand for new bricks is derived from the demand for the final output of the construction
industry- when there is a boom in the building industry, so the market demand for bricks will increase
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The Law of Demand
Other factors remaining constant (ceteris paribus) there is an inverse relationship between the price of a
good and demand.
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As prices fall, we see an expansion of demand
If price rises, there will be a contraction of demand.
The ceteris paribus assumption
Understanding ceteris paribus is the key to understanding much of microeconomics. Many factors can be
said to affect demand. Economists assume all factors are held constant (ie do not change) except one – the
price of the product itself. A change in a factor being held constant invalidates the ceteris paribus
assumption
The Demand Curve
A demand curve shows the relationship between the price of an item and the quantity demanded over a
period of time. There are two reasons why more is demanded as price falls:
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The Income Effect: There is an income effect when the price of a good falls because the consumer
can maintain current consumption for less expenditure. Provided that the good is normal, some of
the resulting increase in real income is used by consumers to buy more of this product.
The Substitution Effect: There is also a substitution effect when the price of a good falls because
the product is now relatively cheaper than an alternative item and so some consumers switch their
spending from the good in competitive demand to this product.
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The demand curve is normally drawn in textbooks as a straight line suggesting a linear relationship
between price and demand but in reality, the demand curve will be non-linear! No business has a perfect
idea of what the demand curve for a particular product looks like, they use real-time evidence from markets
to estimate the demand conditions and they accumulated experience of market conditions gives them an
advantage in constructing demand-price relationships.
A change in the price of a good or service causes a movement along the demand curve. A fall in the price of
a good causes an expansion of demand; a rise in price causes a contraction of demand. Many other factors
can affect total demand - when these change, the demand curve can shift. This is explained below.
Shifts in the Demand Curve Caused by Changes in the Conditions of Demand
There are two possibilities: either the demand curve shifts to the right or it shifts to the left.
In the diagram below we see two shifts in the demand curve:
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D1 – D3 would be an example of an outward shift of the demand curve (or an increase in demand).
When this happens, more is demanded at each price.
A movement from D1 – D2 would be termed an inward shift of the demand curve (or decrease in
demand). When this happens, less is demanded at each price.
The conditions of demand
The conditions of demand for a product in a market can be summarised as follows:
D = f (Pn, Pn…Pn-1, Y, T, P, E)
Where:
Pn = Price of the good itself
Pn…Pn-1 = Prices of other goods – e.g. prices of Substitutes and Complements
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Y = Consumer incomes – including both the level and distribution of income
T = Tastes and preferences of consumers
P = The level and age-structure of the population
E = Price expectations of consumers for future time periods
Changing prices of a substitute good
Substitutes are goods in competitive demand and act as replacements for another product.
For example, a rise in the price of Esso petrol should cause a substitution effect away from Esso towards
competing brands. A fall in the monthly rental charges of cable companies or Vodafone mobile phones
might cause a decrease in the demand for British Telecom services. Consumers will tend over time to switch
to the cheaper brand or service provider. When it is easy and cheap to switch, then consumer demand will be
sensitive to price changes.
Much depends on whether consumers have sufficient information about prices for different goods and
services. One might expect that a fall in the charges from one car rental firm such as Budget might affect the
demand for car rentals from Avis Hertz or Easycar. But searching for price information to get the best deal
in the market can be time consuming and always involves an opportunity cost. The development of the
internet has helped to increase price transparency thereby making it easier for consumers to compare
relative prices in markets.
Changing price of a complement
Two complements are said to be in joint demand. Examples include: fish and chips, DVD players and
DVDs, iron ore and steel.
A rise in the price of a complement to Good X should cause a fall in demand for X. For example an increase
in the cost of flights from London Heathrow to New York would cause a decrease in the demand for hotel
rooms in New York and also a fall in the demand for taxi services both in London and New York.
A fall in the price of a complement to Good Y should cause an increase in demand for Good Y. For example
a reduction in the market price of computers should lead to an increase in the demand for printers, scanners
and software applications.
Change in the income of consumers
Most of the things we buy are normal goods. When an individual’s income goes up, their ability to purchase
goods and services increases, and this causes an outward shift in the demand curve. When incomes fall there
will be a decrease in the demand for most goods.
Change in tastes and preferences
Changing tastes and preferences can have a huge effect on demand. Persuasive advertising is designed to
cause a change in tastes and preferences and thereby create an outward shift in demand. A good example of
this is the recent surge in sales of smoothies and other fruit juice drinks.
The market for health fruit and vegetable drinks has grown rapidly in recent years following a change in
consumer preferences. How much are we influenced by the effects of advertising?
Consumer
Surplus
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Consumer Surplus
The individual consumer surplus is the difference between the maximum total price a consumer would be
willing to pay (or reservation price) for the amount he buys and the actual total price.
Example
Suppose you are in Wal-Mart and you see a DVD on the rack. No price is indicated on the package, so you
bring it over to the register to check the price. As you walk to the register, you think to yourself that $20 is
the highest price you would be willing to pay. At the register, you find out that the price is actually $12, so
you buy the DVD. Your consumer surplus in this example is $8: the difference between the $20 you were
willing to pay and the $12 you actually paid.
If someone is willing to pay more than the actual price, their benefit in a transaction is how much they saved
when they didn't pay that price. For example, a person is willing to pay a tremendous amount for water since
he needs it to survive, however since there are competing suppliers of water he is able to purchase it for less
than he is willing to pay. The difference between the two prices is the consumer surplus.
The maximum price a consumer would be willing to pay for a given amount is the sum of the maximum
price he would be willing to pay for the first unit, the maximum additional price he would be willing to pay
for the second unit, etc.
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Typically these prices are decreasing; in that case they are given by the individual demand curve. If these
prices are first increasing and then decreasing there may be a non-zero amount with zero consumer surplus.
The consumer would not buy an amount larger than zero and smaller than this amount because the consumer
surplus would be negative. The maximum additional price a consumer would be willing to pay for each
additional unit may also alternatingly be high and low, e.g. if he wants an even number of units, such as in
the case of tickets he uses in pairs on dates.
The lower values do not show up in the demand curve because they correspond to amounts the consumer
does not buy, regardless of the price. For a given price the consumer buys the amount for which the
consumer surplus is highest.
Definition of Supply
Supply is defined as the quantity of a product that a producer is willing and able to supply onto the market
at a given price in a given time period.
Note: Throughout this study companion, the terms firm, business, producer and seller have the same
meaning.
The basic law of supply is that as the price of a commodity rises, so producers expand their supply onto the
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market. A supply curve shows a relationship between price and quantity a firm is willing and able to sell.
A supply curve is drawn assuming ceteris paribus - ie that all factors influencing supply are being held
constant except price. If the price of the good varies, we move along a supply curve. In the diagram above,
as the price rises from P1 to P2 there is an expansion of supply. If the market price falls from P1 to P3 there
would be a contraction of supply in the market. Businesses are responding to price signals when making
their output decisions.
Explaining the Law of Supply
There are three main reasons why supply curves for most products are drawn as sloping upwards from left to
right giving a positive relationship between the market price and quantity supplied:
1. The profit motive: When the market price rises (for example after an increase in consumer
demand), it becomes more profitable for businesses to increase their output. Higher prices send
signals to firms that they can increase their profits by satisfying demand in the market.
2. Production and costs: When output expands, a firm’s production costs rise, therefore a higher price
is needed to justify the extra output and cover these extra costs of production.
3. New entrants coming into the market: Higher prices may create an incentive for other businesses
to enter the market leading to an increase in supply.
Shifts in the Supply Curve
The supply curve can shift position. If the supply curve shifts to the right (from S1 to S2) this is an increase
in supply; more is provided for sale at each price. If the supply curve moves inwards from S1 to S3, there is
a decrease in supply meaning that less will be supplied at each price.
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Changes in the costs of production
Lower costs of production mean that a business can supply more at each price. For example a magazine
publishing company might see a reduction in the cost of its imported paper and inks. A car manufacturer
might benefit from a stronger exchange rate because the cost of components and new technology bought
from overseas becomes lower. These cost savings can then be passed through the supply chain to
wholesalers and retailers and may result in lower market prices for consumers.
Conversely, if the costs of production increase, for example following a rise in the price of raw materials or
a firm having to pay higher wages to its workers, then businesses cannot supply as much at the same price
and this will cause an inward shift of the supply curve.
A fall in the exchange rate causes an increase in the prices of imported components and raw materials and
will (other factors remaining constant) lead to a decrease in supply in a number of different markets and
industries. For example if the pounds falls by 10% against the Euro, then it becomes more expensive for
British car manufacturers to import their rubber and glass from Western European suppliers, and higher
prices for paints imported from Eastern Europe.
Changes in production technology
Production technologies can change quickly and in industries where technological change is rapid we see
increases in supply and lower prices for the consumer.
Government taxes and subsidies
20
21
Changes in climate
For commodities such as coffee, oranges and wheat, the effect of climatic conditions can exert a great
influence on market supply. Favourable weather will produce a bumper harvest and will increase supply.
Unfavourable weather conditions will lead to a poorer harvest, lower yields and therefore a decrease in
supply.
Changes in climate can therefore have an effect on prices for agricultural goods such as coffee, tea and
cocoa. Because these commodities are often used as ingredients in the production of other products, a
change in the supply of one can affect the supply and price of another product. Higher coffee prices for
example can lead to an increase in the price of coffee-flavoured cakes. And higher banana prices as we see
in the article below, will feed through to increased prices for banana smoothies in shops and cafes.
Cyclone destroys the Australian banana crop and sends prices soaring
Cyclone Larry has devastated Australia's banana industry, destroying fruit worth $300 million and leaving
up to 4,000 people out of work. Australians now face a shortage of bananas and likely price rises after the
cyclone tore through the heart of the nation's biggest growing region. Queensland produces about 95 per
cent of Australia's bananas. The storm ruined 200,000 tonnes of fruit and market supply shortages will be
severe because Australia does not allow banana imports because of the bio-security risks in doing so.
Bananas are grown throughout the year in north Queensland, with the fruit having a growing cycle of around
two months.
Source: Adapted from news reports, April 2006
Change in the prices of a substitute in production
A substitute in production is a product that could have been produced using the same resources. Take the
example of barley. An increase in the price of wheat makes wheat growing more financially attractive. The
profit motive may cause farmers to grow more wheat rather than barley.
The number of producers in the market and their objectives
The number of sellers (businesses) in an industry affects market supply. When new businesses enter a
market, supply increases causing downward pressure on price.
Competitive Supply
Goods and services in competitive supply are alternative products that a business could make with its factor
resources of land, labour and capital. For example a farmer can plant potatoes or maize.
22
AS Markets & Market Systems
Market Equilibrium Price
In this note we bring the forces of supply and demand together to consider the determination of equilibrium
prices.
The Concept of Market Equilibrium
Equilibrium means a state of equality or a state of balance between market demand and supply.
Without a shift in demand and/or supply there will be no change in market price. In the diagram above, the
quantity demanded and supplied at price P1 are equal. At any price above P1, supply exceeds demand and at
a price below P1, demand exceeds supply. In other words, prices where demand and supply are out of
balance are termed points of disequilibrium.
Changes in the conditions of demand or supply will shift the demand or supply curves. This will cause
changes in the equilibrium price and quantity in the market.
Demand and supply schedules can be represented in a table. The example below provides an illustration of
the concept of equilibrium. The weekly demand and supply schedules for T-shirts (in thousands) in a city are
shown in the next table:
23
Price per unit (£)
Demand (000s)
Supply (000s)
New Demand (000s)
New Supply (000s)
8
6
18
10
26
7
8
16
12
24
6
10
14
14
22
5
12
12
16
20
4
14
10
18
18
3
16
8
20
16
2
18
6
22
14
1
20
4
24
12
The equilibrium price is £5 where demand and supply are equal at 12,000 units
If the current market price was £3 – there would be excess demand for 8,000 units
If the current market price was £8 – there would be excess supply of 12,000 units
A change in fashion causes the demand for T-shirts to rise by 4,000 at each price. The next row of
the table shows the higher level of demand. Assuming that the supply schedule remains unchanged,
the new equilibrium price is £6 per tee shirt with an equilibrium quantity of 14,000 units
5. The entry of new producers into the market causes a rise in supply of 8,000 T-shirts at each price.
The new equilibrium price becomes £4 with 18,000 units bought and sold
1.
2.
3.
4.
Changes in Market Demand and Equilibrium Price
The demand curve may shift to the right (increase) for several reasons:
1.
2.
3.
4.
5.
A rise in the price of a substitute or a fall in the price of a complement
An increase in consumers’ income or their wealth
Changing consumer tastes and preferences in favour of the product
A fall in interest rates (i.e. borrowing rates on bank loans or mortgage interest rates)
A general rise in consumer confidence and optimism
The outward shift in the demand curve causes a movement (expansion) along the supply curve and a rise in
the equilibrium price and quantity. Firms in the market will sell more at a higher price and therefore receive
more in total revenue.
The reverse effects will occur when there is an inward shift of demand. A shift in the demand curve does not
cause a shift in the supply curve! Demand and supply factors are assumed to be independent of each other
although some economists claim this assumption is no longer valid!
24
Changes in Market Supply and Equilibrium Price
���� The supply curve may shift outwards if there is
1.
2.
3.
4.
5.
A fall in the costs of production (e.g. a fall in labour or raw material costs)
A government subsidy to producers that reduces their costs for each unit supplied
Favourable climatic conditions causing higher than expected yields for agricultural commodities
A fall in the price of a substitute in production
An improvement in production technology leading to higher productivity and efficiency in the
production process and lower costs for businesses
6. The entry of new suppliers (firms) into the market which leads to an increase in total market supply
available to consumers
The outward shift of the supply curve increases the supply available in the market at each price and with a
given demand curve, there is a fall in the market equilibrium price from P1 to P3 and a rise in the quantity
of output bought and sold from Q1 to Q3. The shift in supply causes an expansion along the demand curve.
Important note for the exams:
A shift in the supply curve does not cause a shift in the demand curve. Instead we move along (up or down)
the demand curve to the new equilibrium position.
A fall in supply might also be caused by the exit of firms from an industry perhaps because they are not
making a sufficiently high rate of return by operating in a particular market.
The equilibrium price and quantity in a market will change when there shifts in both market supply and
demand. Two examples of this are shown in the next diagram:
25
In the left-hand diagram above, we see an inward shift of supply (caused perhaps by rising costs or a
decision by producers to cut back on output at each price level) together with a fall (inward shift) in demand
(perhaps the result of a decline in consumer confidence and incomes). Both factors lead to a fall in quantity
traded, but the rise in costs forces up the market price.
The second example on the right shows a rise in demand from D1 to D3 but a much bigger increase in
supply from S1 to S2. The net result is a fall in equilibrium price (from P1 to P3) and an increase in the
equilibrium quantity traded in the market.
Defining elasticity of demand
Ped measures the responsiveness of demand for a product following a change in its own price.
The formula for calculating the co-efficient of elasticity of demand is:
Percentage change in quantity demanded divided by the percentage change in price
26
Since changes in price and quantity nearly always move in opposite directions, economists usually do not
bother to put in the minus sign. We are concerned with the co-efficient of elasticity of demand.
Understanding values for price elasticity of demand




If Ped = 0 then demand is said to be perfectly inelastic. This means that demand does not change at
all when the price changes – the demand curve will be vertical
If Ped is between 0 and 1 (i.e. the percentage change in demand from A to B is smaller than the
percentage change in price), then demand is inelastic. Producers know that the change in demand
will be proportionately smaller than the percentage change in price
If Ped = 1 (i.e. the percentage change in demand is exactly the same as the percentage change in
price), then demand is said to unit elastic. A 15% rise in price would lead to a 15% contraction in
demand leaving total spending by the same at each price level.
If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is
elastic. For example a 20% increase in the price of a good might lead to a 30% drop in demand. The
price elasticity of demand for this price change is –1.5
What Determines Price Elasticity of Demand?
Demand for rail services
At peak times, the demand for rail transport becomes inelastic – and higher prices are charged by rail
companies who can then achieve higher revenues and profits





The number of close substitutes for a good / uniqueness of the product – the more close
substitutes in the market, the more elastic is the demand for a product because consumers can more
easily switch their demand if the price of one product changes relative to others in the market. The
huge range of package holiday tours and destinations make this a highly competitive market in terms
of pricing – many holiday makers are price sensitive
The cost of switching between different products – there may be significant transactions costs
involved in switching between different goods and services. In this case, demand tends to be
relatively inelastic. For example, mobile phone service providers may include penalty clauses in
contracts or insist on 12-month contracts being taken out
The degree of necessity or whether the good is a luxury – goods and services deemed by
consumers to be necessities tend to have an inelastic demand whereas luxuries will tend to have a
more elastic demand because consumers can make do without luxuries when their budgets are
stretched. I.e. in an economic recession we can cut back on discretionary items of spending
The % of a consumer’s income allocated to spending on the good – goods and services that take
up a high proportion of a household’s income will tend to have a more elastic demand than products
where large price changes makes little or no difference to someone’s ability to purchase the product.
The time period allowed following a price change – demand tends to be more price elastic, the
longer that we allow consumers to respond to a price change by varying their purchasing decisions.
27



In the short run, the demand may be inelastic, because it takes time for consumers both to notice
and then to respond to price fluctuations
Whether the good is subject to habitual consumption – when this occurs, the consumer becomes
much less sensitive to the price of the good in question. Examples such as cigarettes and alcohol and
other drugs come into this category
Peak and off-peak demand - demand tends to be price inelastic at peak times – a feature that
suppliers can take advantage of when setting higher prices. Demand is more elastic at off-peak times,
leading to lower prices for consumers. Consider for example the charges made by car rental firms
during the course of a week, or the cheaper deals available at hotels at weekends and away from the
high-season. Train fares are also higher on Fridays (a peak day for travelling between cities) and also
at peak times during the day
The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for
petrol or meat, demand is often fairly inelastic. But specific brands of petrol or beef are likely to be
more elastic following a price change
Wi-fi prices and price elasticity of demand
From airports to hotels to conference centres. From inter-city rail services to sports stadiums and libraries,
more and more people are demanding wireless internet connections for personal and business use. But
demand is being constrained by the limited availability of services and, in places, high user charges.
However the price of connecting to the internet through wi-fi services is set to fall as competition in the
sector heats up. Nearly 90 per cent of laptops now come with wi-fi connections as standard and many public
areas are being equipped with hotspots, but users often complain about the high price of accessing the
internet. At present airports and hotels can charge high prices because in many cases a wi-fi service provider
has exclusivity on the area. However the supply of wi-fi services is more competitive on the high street and
prices are falling rapidly as restaurants and coffee shops are using low-priced wi-fi access as a means of
attracting customers. The more wi-fi providers there are in the market-place, the higher is the price elasticity
of demand for wi-fi connections.
Wireless usage is growing across the UK with sales of 3G cards growing by 475%; these are mostly through
business channels. In the consumer market, sales of Wi-Fi routers for the home have grown by 77% many
broadband providers are now providing free wireless routers with each new broadband subscription.
Note: WiFi stands for Wireless Fidelity
Source: The Cloud and GFK UK Technology Barometer, 2006
Demand curves with different price elasticity of demand
28
Elasticity of demand and total revenue for a producer
The relationship between price elasticity of demand and a firm’s total revenue is a very important one. The
diagrams below show demand curves with different price elasticity and the effect of a change in the market
price.
29
When demand is inelastic – a rise in price leads to a rise in total revenue – for example a 20% rise in price
might cause demand to contract by only 5% (Ped = -0.25)
When demand is elastic – a fall in price leads to a rise in total revenue - for example a 10% fall in price
might cause demand to expand by only 25% (Ped = +2.5)
The table below gives a simple example of the relationships between market prices; quantity demanded and
total revenue for a supplier. As price falls, the total revenue initially increases, in our example the maximum
revenue occurs at a price of £12 per unit when 520 units are sold giving total revenue of £6240.
Price
£ per unit
20
18
16
14
12
10
8
6
Quantity
Units
200
280
360
440
520
600
680
760
Total Revenue
£s
4000
5040
5760
6160
6240
6000
5440
4560
Marginal Revenue
£s
13
9
5
1
-3
-7
-11
Consider the price elasticity of demand of a price change from £20 per unit to £18 per unit. The % change in
demand is 40% following a 10% change in price – giving an elasticity of demand of -4 (i.e. highly elastic).
In this situation when demand is price elastic, a fall in price leads to higher total consumer spending /
producer revenue
Consider a price change further down the estimated demand curve – from £10 per unit to £8 per unit. The %
change in demand = 13.3% following a 20% fall in price – giving a co-efficient of elasticity of – 0.665 (i.e.
inelastic). A fall in price when demand is price inelastic leads to a reduction in total revenue.
Change in the market
Ped is inelastic and a firm raises its price.
Ped is elastic and a firm lowers its price.
Ped is elastic and a firm raises price.
Ped is -1.5 and the firm raises price by 4%
Ped is -0.4 and the firm raises price by 30%
Ped is -0.2 and the firm lowers price by 20%
Ped is -4.0 and the firm lowers price by 15%
What happens to total revenue?
Total revenue increases
Total revenue increases
Total revenue decreases
Total revenue decreases
Total revenue increases
Total revenue decreases
Total revenue increases
Elasticity of demand and indirect taxation
Many products are subject to indirect taxation imposed by the government. Good examples include the
excise duty on cigarettes (cigarette taxes in the UK are among the highest in Europe) alcohol and fuels. Here
we consider the effects of indirect taxes on a producers costs and the importance of price elasticity of
demand in determining the effects of a tax on market price and quantity.
30
A tax increases the costs of a business causing an inward shift in the supply curve. The vertical distance
between the pre-tax and the post-tax supply curve shows the tax per unit. With an indirect tax, the supplier
may be able to pass on some or all of this tax onto the consumer through a higher price. This is known as
shifting the burden of the tax and the ability of businesses to do this depends on the price elasticity of
demand and supply.
Consider the two charts above. In the left hand diagram, the demand curve is drawn as price elastic. The
producer must absorb the majority of the tax itself (i.e. accept a lower profit margin on each unit sold).
When demand is elastic, the effect of a tax is still to raise the price – but we see a bigger fall in equilibrium
quantity. Output has fallen from Q to Q1 due to a contraction in demand. In the right hand diagram, demand
is drawn as price inelastic (i.e. Ped <1 over most of the range of this demand curve) and therefore the
producer is able to pass on most of the tax to the consumer through a higher price without losing too much
in the way of sales. The price rises from P1 to P2 – but a large rise in price leads only to a small contraction
in demand from Q1 to Q2.
The usefulness of price elasticity for producers
Firms can use price elasticity of demand (PED) estimates to predict:
The effect of a change in price on the total revenue & expenditure on a product.
The likely price volatility in a market following unexpected changes in supply – this is important for
commodity producers who may suffer big price movements from time to time.
The effect of a change in a government indirect tax on price and quantity demanded and also whether the
business is able to pass on some or all of the tax onto the consumer.
Information on the price elasticity of demand can be used by a business as part of a policy of price
discrimination (also known as yield management). This is where a monopoly supplier decides to charge
different prices for the same product to different segments of the market e.g. peak and off peak rail travel or
yield management by many of our domestic and international airlines.
31
Habitual spending on cigarettes remains high but sales are falling
Sales of cigarettes are falling by the impact of higher taxes mean that smokers must spend more to finance
their habits according to new research from the market analyst Mintel. Total sales of individual sticks for the
UK in 2006 are forecast to be 68 billion, eleven billion lower than in 2001. Over a quarter of cigarettes are
brought into the UK either duty free or through the black market. Total consumer spending on duty-paid
cigarettes is likely to exceed £13 billion, 13% higher than in 2001. In the past, increases in the real value of
duty (taxation) on cigarettes has had had little effect on demand from smokers because demand has been
inelastic. But there are signs that a tipping point may have been reached. Sales of nicotine replacement
therapies such as patches, lozenges and gums have boomed by nearly 50% over the past five years to around
£97 million. But for every £1 spent on nicotine replacement, over £130 is spent on cigarette sticks.
Nearly half of smokers tried to kick the habit last year. According to the Mintel research, smokers under the
age of 34 are the most likely to stop smoking, with people aged 65 and over the least likely to try quitting. A
ban on smoking in public places comes into force in England, Northern Ireland and Wales in the spring of
2007, the same ban became law in Scotland in March 2006.
Sources: Adapted from Mintel Research, the Guardian and the Press Association
32
Income Elasticity of Demand
How sensitive is the demand for a product to a change in the real incomes of consumers? We use income
elasticity of demand to measure this. The results are important since the values of income elasticity tell us
something about the nature of a product and how it is perceived by consumers. It also affects the extent to
which changes in economic growth affect the level and pattern of demand for goods and services.
Definition of income elasticity of demand
Income elasticity of demand measures the relationship between a change in quantity demanded for good X
and a change in real income.
The formula for calculating income elasticity: % change in demand divided by the % change in income
Normal Goods
Normal goods have a positive income elasticity of demand so as consumers’ income rises, so more is
demanded at each price level i.e. there is an outward shift of the demand curve


Normal necessities have an income elasticity of demand of between 0 and +1 for example, if income
increases by 10% and the demand for fresh fruit increases by 4% then the income elasticity is +0.4.
Demand is rising less than proportionately to income.
Luxuries have an income elasticity of demand > +1 i.e. the demand rises more than proportionate to
a change in income – for example a 8% increase in income might lead to a 16% rise in the demand
for restaurant meals. The income elasticity of demand in this example is +2.0. Demand is highly
sensitive to (increases or decreases in) income.
Inferior Goods
Inferior goods have a negative income elasticity of demand. Demand falls as income rises. Typically
inferior goods or services tend to be products where there are superior goods available if the consumer has
the money to be able to buy it. Examples include the demand for cigarettes, low-priced own label foods in
supermarkets and the demand for council-owned properties.
The income elasticity of demand is usually strongly positive for
Fine wines and spirits, high quality chocolates (e.g. Lindt) and luxury holidays overseas.
33
Consumer durables - audio visual equipment, 3G mobile phones and designer kitchens.
Sports and leisure facilities (including gym membership and sports clubs).
In contrast, income elasticity of demand is lower for
Staple food products such as bread, vegetables and frozen foods.
Mass transport (bus and rail).
Beer and takeaway pizza!
Income elasticity of demand is negative (inferior) for cigarettes and urban bus services.
Product ranges: However the income elasticity of demand varies within a product range. For example the
Yed for own-label foods in supermarkets is probably less for the high-value “finest” food ranges that most
major supermarkets now offer. You would also expect income elasticity of demand to vary across the vast
range of vehicles for sale in the car industry and also in the holiday industry.
Long-term changes: There is a general downward trend in the income elasticity of demand for many
products, particularly foodstuffs. One reason for this is that as a society becomes richer, there are changes in
consumer perceptions about different goods and services together with changes in consumer tastes and
preferences. What might have been considered a luxury good several years ago might now be regarded as a
necessity (with a lower income elasticity of demand).
Consider the market for foreign travel. A few decades ago, long-distance foreign travel was regarded as a
luxury. Now as real price levels have come down and incomes have grown, so millions of consumers are
able to fly overseas on short and longer breaks. For many an annual holiday overseas has become a necessity
and not a discretionary item of spending!
Estimates for income elasticity of demand
How high is the income elasticity for fine wines?
Income elasticity for baked beans? Likely to be low
but positive as beans are a staple food
Income elasticity for cigarettes? According to some
What of the income elasticity of demand for private
34
estimates, cigarettes are inferior goods
Product
All Foods
Fruit juices
Tea
Instant coffee
Margarine
Share of budget
(% of household income)
15.1
0.19
0.19
0.17
0.03
executive air travel?
Price elasticity of
demand (Ped)
n/a
-0.55
-0.37
-0.45
n/a
Income elasticity of
demand (Yed)
0.2
0.45
-0.02
0.16
-0.37
Source: DEFRA www.defra.gov.uk
The income elasticity of demand for most types of food is pretty low – occasionally negative (e.g. for
margarine) and likewise the own price elasticity of demand for most foodstuffs is also inelastic. In other
words, the demand for these products among consumers is not sensitive to changes in the product’s price or
changes in consumer income.
How do businesses make use of estimates of income elasticity of demand?
Knowledge of income elasticity of demand for different products helps firms predict the effect of a business
cycle on sales. All countries experience a business cycle where actual GDP moves up and down in a regular
pattern causing booms and slowdowns or perhaps a recession. The business cycle means incomes rise and
fall.
Luxury products with high income elasticity see greater sales volatility over the business cycle than
necessities where demand from consumers is less sensitive to changes in the economic cycle
The UK economy has enjoyed a period of economic growth over the last twelve years. So average real
incomes have increased, but because of differences in income elasticity of demand, consumer demand for
products will have varied greatly over this period.
Income elasticity and the pattern of consumer demand
Over time we expect to see our real incomes rise. And as we become better off, we can afford to increase
our spending on different goods and services. Clearly what is happening to the relative prices of these
products will play a key role in shaping our consumption decisions. But the income elasticity of demand will
also affect the pattern of demand over time. For normal luxury goods, whose income elasticity of demand
exceeds +1, as incomes rise, the proportion of a consumer’s income spent on that product will go up. For
normal necessities (income elasticity of demand is positive but less than 1) and for inferior goods (where
the income elasticity of demand is negative) – then as income rises, the share or proportion of their budget
on these products will fall
35
Definition of price elasticity of supply
Price elasticity of supply measures the relationship between change in quantity supplied and a change in
price.
If supply is elastic, producers can increase output without a rise in cost or a time delay
If supply is inelastic, firms find it hard to change production in a given time period.
The formula for price elasticity of supply is:
Percentage change in quantity supplied divided by the percentage change in price




When Pes > 1, then supply is price elastic
When Pes < 1, then supply is price inelastic
When Pes = 0, supply is perfectly inelastic
When Pes = infinity, supply is perfectly elastic following a change in demand
Factors that Affect Price Elasticity of Supply
(1) Spare production capacity
If there is plenty of spare capacity then a business should be able to increase its output without a rise in
costs and therefore supply will be elastic in response to a change in demand. The supply of goods and
services is often most elastic in a recession, when there is plenty of spare labour and capital resources
available to step up output as the economy recovers.
(2) Stocks of finished products and components
If stocks of raw materials and finished products are at a high level then a firm is able to respond to a change
in demand quickly by supplying these stocks onto the market - supply will be elastic. Conversely when
stocks are low, dwindling supplies force prices higher and unless stocks can be replenished, supply will be
inelastic in response to a change in demand.
36
(3) The ease and cost of factor substitution
If both capital and labour resources are occupationally mobile then the elasticity of supply for a product is
higher than if capital and labour cannot easily and quickly be switched
(4) Time period involved in the production process
Supply is more price elastic the longer the time period that a firm is allowed to adjust its production levels.
In some agricultural markets for example, the momentary supply is fixed and is determined mainly by
planting decisions made months before, and also climatic conditions, which affect the overall production
yield.
Supply curves with different price elasticity of supply
The non-linear supply curve
A non linear supply curve has a changing price elasticity of supply throughout its length. This is illustrated
in the diagram below.
37
Useful applications of price elasticity of demand and supply
Elasticity of demand and supply is tested in virtually every area of the AS economics syllabus. The key is to
understand the various factors that determine the responsiveness of consumers and producers to changes in
price. The elasticity will affect the ways in which price and output will change in a market. And elasticity is
also significant in determining some of the effects of changes in government policy when the state chooses
to intervene in the price mechanism.
Some relevant issues that directly use elasticity of demand and supply include:




Taxation: The effects of indirect taxes and subsidies on the level of demand and output in a market
e.g. the effectiveness of the congestion charge in reducing road congestion; or the impact of higher
duties on cigarettes on the demand for tobacco and associated externality effects
Changes in the exchange rate: The impact of changes in the exchange rate on the demand for
exports and imports
Exploiting monopoly power in a market: The extent to which a firm or firms with monopoly
power can raise prices in markets to extract consumer surplus and turn it into extra profit (producer
surplus)
Government intervention in the market: The effects of the government introducing a minimum
price (price floor) or maximum price (price ceiling) into a market
Elasticity of demand and supply also affects the operation of the price mechanism as a means of rationing
scarce goods and services among competing uses and in determining how producers respond to the
incentive of a higher market price.
38
AS Markets & Market Systems
Cross Price Elasticity of Demand
Very often, a change in the price of one product leads to a change in the demand for another, economists call
this the cross-price effect and this is the focus of this chapter.
Cross price elasticity (CPed) measures the responsiveness of demand for good X following a change in the
price of good Y (a related good). We are mainly concerned here with the effect that changes in relative
prices within a market have on the pattern of demand.
With cross price elasticity we make an important distinction between substitute products and
complementary goods and services
Substitutes: With substitute goods such as brands of cereal or washing powder, an increase in the price of
one good will lead to an increase in demand for the rival product. Cross price elasticity for two substitutes
will be positive. For example, in recent years, the prices of new cars have been either falling or relatively
flat. Data on price indices for new cars and second hand cars is shown in the chart below. As the price of
new cars relative to people’s incomes has declined, this should increase the market demand for new cars and
(ceteris paribus) reduce the demand for second hand cars. We can see that there has been a very marked fall
in the prices of second hand cars.
Complements: With goods that are in complementary demand, such as the demand for DVD players and
DVD videos, when there is a fall in the price of DVD players we expect to see more DVD players bought,
leading to an expansion in market demand for DVD videos. The cross price elasticity of demand for two
complements is negative
The stronger the relationship between two products, the higher is the co-efficient of cross-price
elasticity of demand. For example with two close substitutes, the cross-price elasticity will be strongly
39
positive. Likewise when there is a strong complementary relationship between two products, the crossprice elasticity will be highly negative. Unrelated products have a zero cross elasticity.
Complementary goods - the UK IT market
The value of the UK IT market was estimated to be worth £3.9 billion in the first six months of 2006. It
provides a good example of complementary products since a rise in the demand for one product such as a
new personal computer will frequently be associated with an increase in demand for related goods and
services. The IT market is usually split into seven sectors and their estimated value measured by the level of
total sales revenue in the first half of 2006 is shown below
Personal Computers (desktops and laptops) (£1,443m)
Printing devices (£303m)
Monitors (£343m)
Consumables such as ink cartridges (£813m)
Hard disk drives (£130m)
Communication devices (£122m)
Computer software (£239m)
Source: GFK report on Consumer Spending Trends, July 2006
How can businesses make use of the concept of cross price elasticity of demand?
Pricing strategies for substitutes: If a competitor cuts the price of a rival product, firms use estimates of
cross-price elasticity to predict the effect on the quantity demanded and total revenue of their own product.
For example, two or more airlines competing with each other on a given route will have to consider how one
airline might react to its competitor’s price change. Will many consumers switch? Will they have the
capacity to meet an expected rise in demand? Will the other firm match a price rise? Will it follow a price
fall?
Consider for example the cross-price effect that has occurred with the rapid expansion of low-cost airlines
in the European airline industry. This has been a major challenge to the existing and well-established
national air carriers, many of whom have made adjustments to their business model and pricing strategies to
cope with the increased competition.
Pricing strategies for complementary goods: For example, popcorn, soft drinks and cinema tickets have a
high negative value for cross elasticity– they are strong complements. Popcorn has a high mark up i.e. pop
corn costs pennies to make but sells for more than a pound. If firms have a reliable estimate for Cped they
can estimate the effect, say, of a two-for-one cinema ticket offer on the demand for popcorn. The additional
profit from extra popcorn sales may more than compensate for the lower cost of entry into the cinema.
Advertising and marketing: In highly competitive markets where brand names carry substantial value,
many businesses spend huge amounts of money every year on persuasive advertising and marketing. There
are many aims behind this, including attempting to shift out the demand curve for a product (or product
range) and also build consumer loyalty to a brand. When consumers become habitual purchasers of a
product, the cross price elasticity of demand against rival products will decrease. This reduces the size of
the substitution effect following a price change and makes demand less sensitive to price. The result is that
firms may be able to charge a higher price, increase their total revenue and turn consumer surplus into
higher profit.
40
Government Intervention in the Price system
Market Failure
41
When markets do not provide us with the best outcome in terms of efficiency and fairness, then we say that
there exists market failure. This brief chapter introduces us to some of the main causes of market failure; we
will explore them in more detail in succeeding chapters.
What is market failure?
Market failure occurs whenever freely-functioning markets operating without government intervention, fail
to deliver an efficient allocation of resources and the result is a loss of economic and social welfare.
Market failure exists when the competitive outcome of markets is not satisfactory from the point of view of
society. This is usually because the benefits that the free-market confers on individuals or businesses
carrying out an activity diverge from the benefits to society as a whole.
One useful distinction is between complete market failure when the market simply does not exist to supply
products at all (i.e. we see “missing markets”), and partial market failure, when the market does actually
function but it produces the wrong quantity of a good or service at the wrong price.
Markets can fail for lots of reasons and the main causes of market failure are summarized below:
1. Negative externalities (e.g. the effects of environmental pollution) causing the social cost of
production to exceed the private cost
2. Positive externalities (e.g. the provision of education and health care) causing the social benefit of
consumption to exceed the private benefit
3. Imperfect information means merit goods are under-produced while demerit goods are overproduced or over-consumed
4. The private sector in a free-markets cannot profitably supply to consumers pure public goods and
quasi-public goods that are needed to meet people’s needs and wants
5. Market dominance by monopolies can lead to under-production and higher prices than would exist
under conditions of competition
6. Factor immobility causes unemployment hence productive inefficiency
7. Equity (fairness) issues. Markets can generate an ‘unacceptable’ distribution of income and
consequent social exclusion which the government may choose to change
42
Market failure and economic efficiency
When markets function well we experience an efficient and fair (equitable) allocation of resources
Market failure results in


Productive inefficiency: Businesses are not maximising output from given factor inputs. This is a
problem because the lost output from inefficient production could have been used to satisfy more
wants and needs. Costs are higher and productivity is lower than it might have been.
Allocative inefficiency: Resources are misallocated and the economy is producing goods and
services that are not wanted or not valued by consumers. This is a problem because resources might
be put to a better use making products that we value more highly. Allocative efficiency is the most
relevant concept that you can use at AS level to analyse and evaluate market failure.
What are externalities?
Externalities are third party effects arising from production and consumption of goods and services for
which no appropriate compensation is paid. Externalities cause market failure if the price mechanism
does not take account of the social costs and benefits of production and consumption.
Many types of economic activity give rise to the creation of externalities. And these externalities can
be positive and negative.
Externalities can and do result in the market mechanism producing the wrong quantity of goods and services
so that there is a loss of social welfare
Externalities occur outside of the market i.e. they affect economic agents not directly involved in the
production and/or consumption of a particular good or service. They are also known as spin-over or spillover effects.
43
Externalities and the importance of property rights
External costs and benefits are around us every day – the key point is that the market may fail to take them
into account when pricing goods and services. Often this is because of the absence of clearly defined
property rights – for example, who owns the air we breathe, or the natural resources available for
extraction from seas and oceans around the world?
A question of property rights
I paint a picture on the side of your house – who owns the picture?
Property rights confer legal control or ownership of a good. For markets to operate efficiently, property
rights must be clearly defined and protected – perhaps through government legislation and regulation. If an
asset is un-owned no one has an economic incentive to protect it from abuse.
This can lead to what is known as the Tragedy of the Commons i.e. the over use of common land, fish
stocks etc which leads to long term permanent damage to the stock of natural resources.
Negative Externalities
Negative externalities occur when production and/or consumption impose external costs on third parties
outside of the market for which no appropriate compensation is paid. Some examples are given below, many
of them are environmental.
1.
2.
3.
4.
5.
6.
7.
8.
9.
Smokers ignore the unintended but harmful impact of toxic ‘passive smoking’ on non-smokers
Acid rain from power stations in the UK can damage the forests of Norway
Air pollution from road use and traffic congestion
The social costs of drug and alcohol abuse
External costs of scraping the seabed for supplies of gravel
External costs of travelling by taxi
The environment damage caused by the intensive use of fertilisers in agriculture
The external costs of cleaning up from litter and the dropping of chewing gum
The external costs of the miles that food travels from producer to the final consumer
US pollution may damage UK health
Pollution created by consumers and producers in one country can often cause external costs in other
countries. The classic example of this is the effects of the nuclear fall-out from the Chernobyl disaster in
1986. Recent news reports have claimed that polluted air from America could be damaging the health of
people in Britain. A study from the Intercontinental Transport of Ozone and Precursors programme has
found that airborne chemicals from 8,000km away are being dumped in the UK and Western Europe and
may be to blame for a rise in lung disease. They claim that "It is highly likely that air leaving the States
contains a cocktail of nitrogen oxides and hydrocarbons, which are emitted from vehicle exhausts and power
stations."
Adapted from news reports, June 2004
Private Costs and Social Costs
The existence of production and consumption externalities creates a divergence between private and social
costs of production and also the private and social benefits of consumption.
Social Cost
=
Social Benefit =
Private Cost + External Cost
Private Benefit + External Benefit
44
When negative production externalities exist, social costs exceed private cost. This leads to the private
optimum level of output being greater than the social optimum level of production. The individual consumer
or producer does not take the effects of externalities into their calculations.
External costs from production
Production externalities are generated and received in production - examples include noise pollution and
atmospheric pollution from factories and the long-term environmental damage caused by depletion of our
stock of natural resources
External costs from consumption
Consumption externalities are generated and received in consumption - examples include pollution from
cars and motorbikes and externalities created by smoking and alcohol abuse and also the noise pollution
created by loud music being played in built-up areas.
Negative consumption externalities lead to a situation where the social benefit of consumption is less than
the private benefit. Positive consumption externalities lead to a situation where the social benefit of
consumption is greater than the private benefit. In both cases externalities can lead to market failure.
Positive Externalities
There are many occasions when the production and/or consumption of a good or a service creates external
benefits which boost social welfare. In this note we consider the idea of positive externalities and the market
failure that can result if the market under-consumes or under-provides these sorts of products.
Examples of positive externalities






Social benefits from providing milk to young schoolchildren
External benefits from vaccination / immunisation programmes
Social benefits from restoration and use of historic buildings
External benefits from improved training and education
External benefits from development of renewable energy sources
External benefits from other new production technologies
Positive externalities and market failure
45
Where positive externalities exist, the good or service may be under consumed or under provided since the
free market may fail to value them correctly or take them into account when pricing the product. In the
diagram above, the normal market equilibrium is at P1 and Q1 – but if there are external benefits, the Q1 is
an output below the level that maximises social welfare.
There is a case for some form of government intervention in the market designed to increase consumption
towards output level Q2 so as to increase economic welfare.
Bird flu vaccine being prepared
The economics of vaccination
46
What good is a vaccination? Obviously there are benefits for the person receiving the vaccine, they are
less susceptible to disease and children in particular are more likely to attend school and earn more income
over their lifetime. A new study on the economic effects of vaccinations from the World Bank finds that
well designed and comprehensive vaccination programmes have a positive effect on savings and wealth and
encourage families to have fewer children which lead to less demographic pressures on scarce resources.
More subtly, it can be good for an entire population since, if enough of its members are vaccinated, even
those who are not will receive a measure of protection. That is because, with only a few susceptible
individuals, the transmission of the infection cannot be maintained and the disease spread.
In the case of many vaccines, there are non-medical benefits, too, in the form of costs avoided and the
generation of income that would otherwise have been lost. These goods are economic. The dispassionate
economic case for vaccination, therefore, looks at least as strong as the compassionate medical one.
Spending on vaccination programmes appears to be a sound social investment for the future.
Source: Adapted from the Economist, October 2005
Vocational training – externalities and market failure
There is growing evidence that skilled workforces have positive impacts on high-level economic aims, such
as raising productivity and enhancing a country's GDP growth.
At the same time, there is evidence of a major skills deficiency in the UK, which is reflected in the low
numbers of people holding intermediate level vocational qualifications, compared to Germany and other
European Union countries. There is further evidence that there are three forms of market failure that
continue to cause this skills gap:
1. Externalities leading to under-investment in training by employers. Firms are concerned that once
trained, an employee will leave the firm before the firm has recouped its investment. Unless training pays
off very quickly, firms are therefore reluctant to provide training to their workers. This is an example of the
free-rider problem - where one firm can take advantage of the money invested in training by another firm.
Fewer than four in ten employers in the UK provide some off-the-job training each year.
2. Imperfect information leading to employees (workers) being unable to judge the quality of their training
or appreciate the benefits to themselves. This reduces their willingness for example to accept lower wages
during the training period or to receive any training at all.
3. Credit market imperfections. Training is a costly business, but individuals expect to obtain higher
wages from training in the long-term (i.e. their wages are likely to be higher in jobs that require a greater
degree of training and specific skills). Some individuals may wish to borrow money to fund training in the
expectation that they will be able to pay back the loan through higher future wages. However, low-paid
employees in particular are likely to be "credit constrained" and unable to obtain loans to pay for training.
These market failures mean that the level of training provided by the market is likely to be inefficiently low
from society’s point of view. Well-designed government intervention may help to bridge the gap
How can government intervention help to resolve the “training gap?”
The aims of government intervention might be to




Move towards a socially optimal level of training
Achieve higher productivity among those who take training programmes
Build the economy’s human capital
Increase the proportion of the employed workforce that has a recognised vocational training
qualification
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Options for government intervention





Increased funding for education and training programmes within the public sector
State funded and operated vocational training e.g. modern apprenticeships and expansion of
vocational exams
Tax credits for businesses that invest in vocational training programmes
Regulation
The Industrial Training Levy (2002)
Government Intervention & Externalities
How can we take into account some of the third party effects that arise? Is there anything that the
government can do? To many economists interested in environmental problems and who believe that that
the government can successfully intervene in the price mechanism, the key is to internalise some or all of
the external costs and benefits to ensure that the businesses and consumers who create the externalities
include them when making decisions.
Taxes
One common approach to adjust for externalities is to tax those who create negative externalities. This is
sometimes known as “making the polluter pay”. Introducing a tax increases the private cost of
consumption or production and ought to reduce demand and output for the good that is creating the
externality. According to the Department of the Environment, “Taxes send a signal to polluters that our
environment is valuable and is worth protecting.”
Some economists argue that the revenue from pollution taxes should be ring-fenced and allocated to projects
that protect or enhance our environment. For example, the money raised from a congestion charge on
vehicles entering busy urban roads, might be allocated towards improving mass transport services; or the
revenue from higher taxes on cigarettes might be used to fund better health care programmes. Usually in the
UK, revenue from environmental taxation simply goes into the general pot of taxation which is then used to
finance all types of government spending.
Examples of Environmental Taxes
1. The Landfill Tax - this tax aims to encourage producers to produce less waste and to recover more
value from waste, for example through recycling or composting and to use more environmentally
friendly methods of waste disposal. The tax applies to active and inert waste, disposed of at a
licensed landfill site.
2. The Congestion Charge: -this is a very high profile environmental charge introduced in February
2003 by the Mayor of London Ken Livingstone. It is designed to cut traffic congestion in innerLondon by charging motorists £5 per day to enter the central charging zone – for more information
go to the Transport for London web site
3. Plastic Bag Tax: In Ireland a pioneering new 15 cent levy on plastic shopping bags was launched in
2002. The tax is designed to encourage people to use reusable bags and has stimulated an increase in
the availability of biodegradable bags. Payable in all sales outlets 15 cents are charged for each bag
issued and itemized separately on receipts. Proceeds from the tax go to the Environment Fund and
are used to fund various waste management and other environmental initiatives.
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Would a tax on aviation fuel be an effective and appropriate way to reduce carbon emissions from the
airline industry?
Problems with Taxes to Curb Pollution
Many economists argue that pollution taxes can create further problems which lead to government failure
and little sustainable improvement in environmental conditions. The main problems are as thought to be as
follows:
(1) Assigning the right level of taxation:
There are problems in setting tax so that private cost will exactly equate with the social cost. The
government cannot accurately value the private benefits and cost of firms let alone put a monetary value on
externalities such as the cost to natural habitat, the long-term effects if resource depletion and the value of
human life
(2) Imperfect information:
Without accurate information setting the tax at the correct level is impossible. In reality, therefore, all that
governments and regulatory agencies can hope to achieve is a movement towards the optimum level of
output.
(3) Consumer welfare effects
1. Taxes reduce output and raise prices, and this might have an adverse effect on consumer welfare.
Producers may be able to pass on the tax to the consumers if the demand for the good is inelastic
and, as result, the tax may only have a small effect in reducing demand
2. Taxes on some de-merit goods (for example cigarettes) may have a regressive effect on lowerincome consumers and leader to a widening of inequalities in the distribution of income.
(4) Employment and investment consequences:
If pollution taxes are raised in one country, producers may shift production to countries with lower taxes.
This will not reduce global pollution, and may create problems such as structural unemployment and a loss
of international competitiveness. Similarly higher taxation might lead to a decline in profits and a fall in the
volume of investment projects that in the long term might have beneficial spill-over effects in reducing the
energy intensity of an industry or might lead to innovation which enhance the environment.
49
Dumped rubbish on the streets of the UK – the landfill tax is widely regarded as having encouraged flytipping
Command and Control Techniques – Regulation
Instead of trying to change market prices and therefore affect the behaviour of consumers and producers, the
government may choose to intervene directly in a market through the use of regulations and laws.
For example, the Health and Safety at Work Act covers all public and private sector businesses. Local
Councils can take action against noisy, unruly neighbours and can pass by-laws preventing the public
consumption of alcohol. Cigarette smoking can be banned in public places – such as the ban on smoking in
workplaces and bars and restaurants introduced in Ireland in 2004. The British government is currently
consulting about a ban on smoking in public places from 2006. However the government has also introduced
a more liberal licensing law for the sale of alcohol, although this has met fierce resistance from come critics.
The European Union has also introduced a wide range of directives on how consumer durables such as cars,
batteries, fridges freezers and other products should be disposed of. The onus is now on producers to provide
facilities for consumers to bring back their unwanted products – but the costs of disposal eventually get past
onto consumers.
Can the market mechanism find the right incentives for consumers to recycle – or is there a need for
government intervention and regulation to make us recycle more of what we consume?
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Carbon Emissions Trading – Marketable Pollution Permits
Some countries have moved toward market-based incentives to achieve pollution reduction. This new
approach involves the creation of a limited volume of pollution rights, distributed among firms that
pollute, and allows them to be traded in a secondary market. The intent is to encourage lowest-cost pollution
reduction measures to be utilized, in exchange for revenues from selling surplus pollution rights. Companies
that are efficient at cutting pollution will have spare permits that they can then sell to other businesses. As
long as the total bank (or stock) of permits is reduced year by year by the government or an agency, cuts in
total pollution can be achieved most efficiently.
Quite simply, limiting emissions makes polluting a scarce resource, and scarcity brings economic value.
Emissions’ trading is a central feature of the Kyoto Protocol and the European Carbon Emissions Trading
Scheme started in full in January 2005.
Is carbon trading the best market-based solution to the threats from global warming?
In short, carbon trading is designed to reduce the cost of achieving sustainable cuts in greenhouse gas
emissions and secondly to extend the principle of property rights as a means of meeting environmental
objectives.
Subsidising positive externalities
An alternative to taxing activities that create negative externalities is to subsidise activities that lead to
positive externalities. This reduces the costs of production for suppliers and encourages a higher output. For
example the Government may subsidise state health care; public transport or investment in new technology
for schools and colleges to help spread knowledge and understanding. There is also a case for subsidies to
encourage higher levels of training as a means to raise labour productivity and improve our international
competitiveness.
Public and Private Goods
Public goods provide an example of market failure resulting from missing markets. To understand this it is
helpful first to discuss what is meant by a private good or service.
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Private Goods
A private good or service has three main characteristics:
1. Excludability: Consumers of private goods can be excluded from consuming the product by the
seller if they are not willing or able to pay for it. For example a ticket to the theatre or a meal in a
restaurant is clearly a private good. Another example is the increasing use of “pay-per-view” as a
means of extracting payment from people wanting to watch exclusive coverage of sporting events on
television or the payment required to travel on a toll-road or toll-bridge. Another example of a
private good is the use of subscription-based services on the internet. Some newspapers provide the
bulk of their news stories on the internet as a “quasi public good” such as The Guardian
www.guardian.co.uk. Others are developing an alternative business model where users can only
access premium services through password-protected parts of a web site that require payment from
consumers – examples include The Economist www.economist.com and the Financial Times
www.ft.com. Excludability gives the service provider (the seller) the chance to make a profit from
producing and selling the product. As we shall see, with public goods, such excludability does not
exist. When goods are excludable, the owners can exercise property rights.
2. Rivalry: With a private good, one person's consumption of a product reduces the amount left for
others to consume and benefit from - because scarce resources are used up in producing and
supplying the good or service. If you order and then enjoy a pizza from Pizza Hut, that pizza is no
longer available to someone else. Likewise driving your car on a road uses up road space that is no
longer available at that time to another motorist. The greater the volume of traffic on the roads, the
higher the likelihood of traffic congestion which has the effect of reducing the average speed and
increasing the average journey time for each road user.
3. Rejectability: Private goods and services can be rejected - if you don't like the soup on the college or
school menu, you can use your money to buy something else! You can choose not to travel on Virgin
Rail on a journey to the North West and go instead by coach, or you can choose not to buy a season
ticket for your local soccer club and instead use the money to finance a subscription to a local health
club. All private goods and services can be rejected by the final consumer should their tastes and
preferences change.
Private and Public Goods – a question of exclusion
Le Shuttle is a private good – the service is excludable, rival in consumption and rejectable. But not all
providers of public goods make a profit. EuroTunnel is facing large losses and even bigger debts!
Characteristics of Public Goods
As one might expect, the characteristics of pure public goods are the opposite of private goods:
52


Non-excludability: The benefits derived from the provision of pure public goods cannot be
confined to only those who have actually paid for it. In this sense, non-payers can enjoy the benefits
of consumption at no financial cost to themselves – this is known as the “free-rider” problem and it
means that people have a temptation to consume without paying!
Non-rival consumption: Consumption of a public good by one person does not reduce the
availability of a good to everyone else – therefore we all consume the same amount of public goods
even though our tastes and preferences for these goods (and therefore our valuation of the benefit we
derive from them) might differ
Examples of Public Goods
There are relatively few examples of pure public goods. Examples of public goods include flood control
systems, some of the broadcasting services provided by the BBC, public water supplies, street lighting
for roads and motorways, lighthouse protection for ships and also national defence services.
Policing – a public good?
To what extent is our current system of policing an example of a public good? Some (but not all) aspects of
policing might qualify as public goods. The general protection that the police services provide in deterring
crime and investigating criminal acts serves as a public good. But resources used up in providing specific
police services mean that fewer resources are available elsewhere. For example the use of police at sporting
events or demonstrations and protests means that police resources have to be diverted from other policing
duties. The police services must make important decisions about how best to allocate their manpower in
order to provide the most effective policing service for the whole community.
Private protection services (including private security guards, privately bought security systems and
detectives) are private goods because the service is excludable, rejectable and rival in consumption and
people and businesses are often prepared to pay a high price for exclusive services. A good recent example
of this has been the use of private security firms in post-war Iraq where up to 15,000 workers are said to
have been working for private businesses protecting installations, coalition buildings and convoy protection.
Public goods and market failure
Pure public goods are not normally provided at all by the private sector because they would be unable to
supply them for a profit. Thus the free market may fail totally to provide important pure public goods and
under-provide quasi public goods (see below).
It is therefore up to the Government to decide what output of public goods is appropriate for society. To do
this, it must estimate the social benefit from the consumption of public goods. Putting a monetary value on
the benefit derived from street lighting and defence systems is problematic. The electoral system provides an
opportunity to see the public choices of voters but elections are rarely won and lost purely on the grounds of
government spending plans and the turnout at elections continues to fall.
Cost Benefit Analysis
Cost benefit analysis seeks to mitigate the problem of negative and positive externalities by attempting to
quantify the opportunity cost to society of the various possible outcomes or sources of action.
The cost benefit approach differs from private sector methods of appraisal in two main respects. These are:

It seeks to include all of the costs and benefits not just the private ones
53

It of ten has to impute shadow prices on costs and benefits where no market price is available. An
example would be how to value the loss of agricultural land. Other examples might be how to value
the benefit of cleaner air or being able to live in less noisy environment.
There are four main stages to cost –benefit analysis

Stage 1 Identification of all relevant costs and benefits

Stage 2 Putting a monetary value on all relevant costs and benefits.

Stage 3 Forecasting future costs and benefits

Stage 4 Decision-making-The interpretation of the results from CBA. If the current and future
social benefits outweigh the current and future costs then the project is worthwhile as it provides an
overall net benefit to the community.
Merit Goods
Merit goods create a divergence between the private and social costs and benefits of production and
consumption leading to the risk of market failure.
Risk of under-consumption:
Merit goods are those goods and services that the government feels that people will under-consume, and
which ought to be subsidised or perhaps provided free at the point of use so that consumption does not
depend primarily on the ability to pay for the good or service.
Who provides merit goods?
It is important to realise that it is not simply the government (or public sector) that supplies merit goods.
Both the state and private sector provide merit goods & services. We have an independent education system
and people can buy private health care insurance.
Externality issues:
Consumption of merit goods is believed to generate positive externalities- where the social benefit from
consumption exceeds the private benefit.
Merit goods – museums and libraries
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What are the external benefits that might flow from more people having access to our major museums and
other heritage sites?
Merit goods can be defined in terms of their externality effects and also in terms of informational problems
facing the consumer
A merit good is a product that society values and judges that everyone should have regardless of whether an
individual wants them. In this sense, the government (or state) is acting paternally in providing merit goods
and services. They believe that individuals may not act in their own best interest in part because of
imperfect information about the benefits that can be derived. Good examples of merit goods include health
services, education, work training programmes, public libraries, Citizen's Advice Bureaux and inoculations
for children and students.
Notice here that we are talking about the sorts of goods and services that society judges to be in our best
welfare. Judgements involve subjective opinions – and we cannot escape from making some valued
judgements when we are analysing and discussing merit goods.



Do you believe that most National Health Services and dental services should be made available free
at the point of need?
Should the state continue to provide free and compulsory education up to the age of 16?
Should people be forced to make compulsory savings for their retirement?
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Education as a merit good
Exclusive schooling
Education is provided by the state and the private sector – but if it was left only to be fee-paying sector,
education would be heavily under-consumed
The argument concerning imperfect information is an important one. Parents with relatively poor
educational qualifications may be unaware of the full longer-term benefits that their children might derive
from a proper education. Because the knowledge of these private benefits is an ongoing learning process,
children themselves will tend to underestimate the long term gains from a proper education.
Education is a long-term investment decision. The private costs must be paid now but the private benefits
(including higher earnings potential over one’s working life) take time to emerge.
Education should provide a number of external benefits that might not be taken into account by the free
market. These include rising incomes and productivity for current and future generations; an increase in
the occupational mobility of the labour force which should help to reduce unemployment and therefore
reduce welfare spending.
Increased spending on education should also provide a stimulus for higher-level research which can add to
the long run trend rate of growth. Other external benefits might include the encouragement of a more
enlightened and cultured society, less prone to political instabilities and one which manages to achieve a
greater degree of social cohesion. Providing that the education system provides a sufficiently good education
across all regions and sections of society, increased education and training spending should also open up a
higher level of equality of opportunity. The reality is of course that there are very deep and wide variations
in educational performance and opportunities across the country.
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Demerit Goods
Basically, de-merit goods are the opposite of merit goods. They can cause market failure too!
Externalities and information failure with de-merit goods. De-merit goods are thought to be ‘bad’ for
you. Examples include the costs arising from consumption of alcohol, cigarettes and drugs together with the
social effects of addiction to gambling. The consumption of de-merit goods can lead to negative
externalities.
The government seeks to reduce consumption of de-merit goods. Consumers may be unaware of the
negative externalities that these goods create – they have imperfect information about long-term damage to
their own health.
The government may decide to intervene in the market for de-merit goods and impose taxes on producers
and / or consumers. Higher taxes cause prices to rise and should lead to a fall in demand. But many
economists argue that taxation is an ineffective and inequitable way of curbing the consumption of drugs
and gambling particularly for those affected by addiction.
Banning consumption through regulation may reduce demand, but risks creating secondary (illegal) or
underground markets in the product.
Government Intervention in the Market
In a free market economic system, scarce resources are allocated through the price mechanism where the
preferences and spending decisions of consumers and the supply decisions of businesses come together to
determine equilibrium prices. The free market works through price signals. When demand is high, the
potential profit from supplying to a market rises, leading to an expansion in supply (output) to meet rising
demand from consumers. Day to day, the free market mechanism remains a tremendously powerful device
for determining how resources are allocated among competing ends.
Intervention in the market
The government may choose to intervene in the price mechanism largely on the grounds of wanting to
change the allocation of resources and achieve what they perceive to be an improvement in economic and
social welfare. All governments of every political persuasion intervene in the economy to influence the
allocation of scarce resources among competing uses
What are the main reasons for government intervention?
The main reasons for policy intervention are:
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


To correct for market failure
To achieve a more equitable distribution of income and wealth
To improve the performance of the economy
Options for government intervention in markets
There are many ways in which intervention can take place – some examples are given below
Government Legislation and Regulation
Parliament can pass laws that for example prohibit the sale of cigarettes to children, or ban smoking in the
workplace. The laws of competition policy act against examples of price-fixing cartels or other forms of
anti-competitive behaviour by firms within markets. Employment laws may offer some legal protection for
workers by setting maximum working hours or by providing a price-floor in the labour market through the
setting of a minimum wage.
The economy operates with a huge and growing amount of regulation. The government appointed regulators
who can impose price controls in most of the main utilities such as telecommunications, electricity, gas and
rail transport. Free market economists criticise the scale of regulation in the economy arguing that it creates
an unnecessary burden of costs for businesses – with a huge amount of “red tape” damaging the
competitiveness of businesses.
Regulation may be used to introduce fresh competition into a market – for example breaking up the
existing monopoly power of a service provider. A good example of this is the attempt to introduce more
competition for British Telecom. This is known as market liberalisation.
Direct State Provision of Goods and Services
Because of privatization, the state-owned sector of the economy is much smaller than it was twenty years
ago. The main state-owned businesses in the UK are the Royal Mail and Network Rail.
State funding can also be used to provide merit goods and services and public goods directly to the
population e.g. the government pays private sector firms to carry out operations for NHS patients to reduce
waiting lists or it pays private businesses to operate prisons and maintain our road network.
Fiscal Policy Intervention
Fiscal policy can be used to alter the level of demand for different products and also the pattern of demand
within the economy.
(a) Indirect taxes can be used to raise the price of de-merit goods and products with negative externalities
designed to increase the opportunity cost of consumption and thereby reduce consumer demand towards a
socially optimal level
(b) Subsidies to consumers will lower the price of merit goods. They are designed to boost consumption and
output of products with positive externalities – remember that a subsidy causes an increase in market supply
and leads to a lower equilibrium price
(c) Tax relief: The government may offer financial assistance such as tax credits for business investment in
research and development. Or a reduction in corporation tax (a tax on company profits) designed to
promote new capital investment and extra employment
(d) Changes to taxation and welfare payments can be used to influence the overall distribution of income
and wealth – for example higher direct tax rates on rich households or an increase in the value of welfare
benefits for the poor to make the tax and benefit system more progressive
Intervention designed to close the information gap
58
Often market failure results from consumers suffering from a lack of information about the costs and
benefits of the products available in the market place. Government action can have a role in improving
information to help consumers and producers value the ‘true’ cost and/or benefit of a good or service.
Examples might include:




Compulsory labelling on cigarette packages with health warnings to reduce smoking
Improved nutritional information on foods to counter the risks of growing obesity
Anti speeding television advertising to reduce road accidents and advertising campaigns to raise
awareness of the risks of drink-driving
Advertising health screening programmes / information campaigns on the dangers of addiction
These programmes are really designed to change the “perceived” costs and benefits of consumption for the
consumer. They don’t have any direct effect on market prices, but they seek to influence “demand” and
therefore output and consumption in the long run. Of course it is difficult to identify accurately the effects of
any single government information campaign, be it the campaign to raise awareness on the Aids issue or to
encourage people to give up smoking. Increasingly adverts are becoming more hard-hitting in a bid to have
an effect on consumers.
The effects of government intervention
One important point to bear in mind is that the effects of different forms of government intervention in
markets are never neutral – financial support given by the government to one set of producers rather than
another will always create “winners and losers”. Taxing one product more than another will similarly have
different effects on different groups of consumers.
The law of unintended consequences
Government intervention does not always work in the way in which it was intended or the way in which
economic theory predicts it should. Part of the fascination of studying Economics is that the “law of
unintended consequences” often comes into play – events can affect a particular policy, and consumers and
businesses rarely behave precisely in the way in which the government might want! We will consider this in
more detail when we consider government failure.
Judging the effects of intervention – a useful check list
To help your evaluation of government intervention – it may be helpful to consider these questions:
Efficiency of a policy: i.e. does a particular intervention lead to a better use of scarce resources among
competing ends? E.g. does it improve allocative, productive and dynamic efficiency? For example - would
introducing indirect taxes on high fat foods be an efficient way of reducing some of the external costs linked
to the growing problem of obesity?
Effectiveness of a policy: i.e. which government policy is most likely to meet a specific economic or social
objective? For example which policies are likely to be most effective in reducing road congestion? Which
policies are more effective in preventing firms from exploiting their monopoly power and damaging
consumer welfare? Evaluation can also consider which policies are likely to have an impact in the short term
when a quick response from consumers and producers is desired. And which policies will be most costeffective in the longer term?
Equity effects of intervention: i.e. is a policy thought of as fair or does one group in society gain more than
another? For example it is equitable for the government to offer educational maintenance allowances
59
(payments) for 16-18 year olds in low income households to stay on in education after GCSEs? Would it
be equitable for the government to increase the top rate of income tax to 50 per cent in a bid to make the
distribution of income more equal?
Sustainability of a policy: i.e. does a policy reduce the ability of future generations to engage in economic
activity? Inter-generational equity is an important issue in many current policy topics for example decisions
on which sources of energy we rely on in future years.
International Trade
One feature of nearly every aspect of economic life is that individuals, businesses and countries engage in
specialization. Specialization is when we concentrate on a particular product or task. Surplus products can
then be exchanged and traded with the potential for gains in welfare for all parties.
The potential benefits from specialization
By concentrating on what people and businesses do best rather than relying on self sufficiency:
Higher output: Total output of goods and services is raised and quality can be improved. A higher output at
lower costs means more wants and needs might be satisfied with a given amount of scarce resources.
Variety; Consumers have improved access to a greater variety of higher quality products i.e. they have more
and better choice both from their own economy and from the production of other countries
A bigger market: specialisation and international trade increase the size of the market offering
opportunities for economies of scale (a fall in long run costs per unit of output)
Competition and lower prices: Increased competition for domestic producers acts as an incentive to
minimise costs and innovate to remain competitive. Competition helps to keep prices down and maintains
low inflation
60
The division of labour
Specialisation occurs in nearly every business – from manufacturing to restaurants
The division of labour is a particular type of specialisation where the production of a good is broken up into
many separate tasks each performed by one person or by a small group of people. The division of labour
raises output per person, thereby reducing costs per unit because lower skilled workers are easily trained and
quickly become proficient through constant repetition of a task – ‘practice makes perfect’ – or “learning by
doing”. Low unit costs allow firms to remain competitive in the markets in which they operate. Traditionally
the division of labour and high level of specialisation in manufacturing industries is associated with the
concept of scientific management or Taylorism.
Limitations of division of labour
There are limits and downsides to the breaking down of production into many small tasks. Perhaps the
greatest downside is that the division of labour may eventually reduce efficiency and increase unit costs
because unrewarding, repetitive work lowers worker motivation and productivity. Workers begin to take less
pride in their work and quality suffers, the result may be a problem of diseconomies of scale.
The division of labour also runs the risk that if one machine breaks down then the entire factory stops. Some
workers receive a narrow training and may not be able to find alternative jobs if they find themselves out of
work (they may suffer structural unemployment). Another disadvantage is that mass-produced standardized
goods tend to lack variety.
The concept of comparative advantage
First introduced by David Ricardo in 1817, comparative advantage exists when a country has a ‘margin of
superiority’ in the production of a good or service i.e. where the marginal cost of production is lower.
Countries will usually specialise in and then export products, which use intensively the factors inputs, which
they are most abundantly endowed. If each country specializes in those goods and services where they have
an advantage, then total output can be increased leading to an improvement in allocative efficiency and
economic welfare. Put another way, trade allows each country to specialise in the production of those
products that it can produce most efficiently (i.e. those where it has a comparative advantage).
This is true even if one nation has an absolute advantage over another country. So for example the
Canadian economy which is rich in low cost land is able to exploit this by specializing in agricultural
61
production. The dynamic Asian economies including China have focused their resources in exporting
low-cost manufactured goods which take advantage of much lower unit labour costs.
In highly developed countries, the comparative advantage is shifting towards specializing in producing and
exporting high-value and high-technology manufactured goods and high-knowledge services.
Production advantage, the PPF and specialisation
Two countries are producing two products (X and Y). With a given amount of resources,
Country A
Country B
Output of X
180
200
Output of Y
90
150
In this example, country B has an absolute advantage in both products. Absolute advantage occurs when a
country or region can create more of a product with the same factor inputs.
But although country A has an absolute disadvantage, in fact it has a comparative advantage in the
production of good X. It is 9/10ths as efficient at producing good X but it is only 3/5ths as efficient at
producing good Y.
Comparative advantage exists when a country has lower opportunity cost, ie, it gives up less of one product
to obtain more of another product. Economists argue countries benefit if they specialise in a product in
which they have a comparative advantage and trade.
In our example above, for country A, every extra unit of good Y produced involves an opportunity cost of 2
unit of good X. Whereas for country B, an additional unit of good Y involves a sacrifice of only 4.3 units of
good X.
There are gains to be had from country A specializing in the supply of good X and country B allocating
more of their resources into the production of good Y.
Another worked example of comparative advantage
62
In this second example, we will work through an example of comparative advantage and also show some
of the possible benefits that might flow from specialisation and trade between two countries.
Consider two countries producing two products – digital cameras and vacuum cleaners. With the same factor
resources evenly allocated by each country to the production of both goods, the production possibilities are
as shown in the table below.
Pre-specialisation
UK
United States
Total
Digital Cameras
600
2400
3000
Vacuum Cleaners
600
1000
1600
Working out the comparative advantage
To identify which country should specialise in a particular product we need to analyse the internal
opportunity costs for each country. For example, were the UK to shift more resources into higher output of
vacuum cleaners, the opportunity cost of each vacuum cleaner is one digital television. For the United States
the same decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative
advantage in vacuum cleaners.
If the UK chose to reallocate resources to digital cameras the opportunity cost of one extra camera is still
one vacuum cleaner. But for the United States the opportunity cost is only 5/12ths of a vacuum cleaner.
Thus the United States has a comparative advantage in producing digital cameras because its opportunity
cost is lowest.
Output after Specialization
UK
United States
Total
o
o
o
Digital Cameras
0 (-600)
3360 (+960)
3000
3360
Vacuum Cleaners
1200 (+600)
600 (-400)
1600
1800
The UK specializes totally in producing vacuum cleaners – doubling its output to 1200
The United States partly specializes in digital cameras increasing output by 960 having given up 400
units of vacuum cleaners
As a result of specialisation according to the principle of comparative advantage, output of both
products has increased - representing a gain in economic welfare.
For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange of
one product for another.
There are gains from trade between the two countries. If the two countries trade at a rate of exchange of 2
digital cameras for one vacuum cleaner, the post-trade position will be as follows:
o
o
The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras
The USA exports 840 digital cameras and imports 420 vacuum cleaners
Post trade output / consumption
UK
United States
Total
Digital Cameras
840
2520
3360
Vacuum Cleaners
780
1020
1800
63
Compared with the pre-specialisation output levels, consumers in both countries now have an increased
supply of both goods to choose from.
We have seen in this chapter how specialisation and trade based on the idea of comparative advantage can
lead to an improvement in economic welfare.
The simple principles explained above are based on the following assumptions




No transport costs are charged
Two country, two product assumption being realistic (which is a long way from reality)
Production costs are constant
There are no restrictions on free trade between those countries which possess absolute and
comparative advantage
Types of protection
Tariffs
A tariff is a tax on imports. It can be either specific, that is so much per item or it can be ad valorem, which
is a percentage of the price.
Quotas
Quotas are restrictions on the maximum quantity of imports. Their effect is to reduce the supply of imports
on the domestic market. This will lead to a higher equilibrium price than would occur in a free market
Exchange controls
One way of preventing excessive spending on imports is to set legal limits on the dealings in foreign
currency that a country’s citizens can make. If importers are limited in their access to foreign currency, they
cannot pay for imports to the full extent of the foreign demand that exists.
Export subsidies
Sometimes a government can give subsidies to domestic firms to aid their exports. This makes their products
more competitive in foreign markets. Foreign consumers will enjoy an increase in their economic welfare as
the price falls. Those employed in those industries subsidized might also benefit as the demand for their
product increase. However, those who lose are the tax payers who have to pay for the subsidies.
Arguments for protectionism
Protectionists believe that there is a legitimate need for government restrictions on free trade in order to
protect their country’s economy and its people’s standard of living.
The "Comparative Advantage" argument has lost its legitimacy
The Comparative Advantage argument is used by most economists as a basis for their support of free trade
policies. Opponents of these policies argue that the Comparative Advantage argument has lost its legitimacy
in a globally integrated world—in which capital is free to move internationally. Herman Daly, a leading
64
voice in the discipline of ecological economics, emphasizes that although Ricardo's theory of comparative
advantage is one of the most elegant theories in economics, its application to the present day is illogical:
"Free capital mobility totally undercuts Ricardo's comparative advantage argument for free trade in goods,
because that argument is explicitly and essentially premised on capital (and other factors) being immobile
between nations. Under the new global economy, capital tends simply to flow to wherever costs are
lowest—that is, to pursue absolute advantage." [10]
Protectionists would point to the building of plants and shifting of production to Mexico by American
companies such as GE, GM, and even Hershey Chocolate as proof of this argument.
The Comparative Advantage argument is also premised on full employment. According to the Wikipedia
entry on Comparative Advantage, “if one or other of the economies has less than full employment of factors
of production, then this excess capacity must usually be used up before the comparative advantage reasoning
can be applied”. Protectionists believe that it is therefore erroneous to base trade policy on the principle of
Comparative Advantage in those countries that suffer from significant unemployment or underemployment.
[edit] Domestic tax policies can favor foreign goods
Protectionists believe that allowing foreign goods to enter domestic markets without being subject to tariffs
or other forms of taxation, leads to a situation where domestic goods are at a disadvantage, a kind of reverse
protectionism. By ruling out revenue tariffs on foreign products, governments must rely solely on domestic
taxation to provide its revenue, which falls disproportionately on domestic manufacturing. As Paul Craig
Roberts notes: "[Foreign discrimination of US products] is reinforced by the US tax system, which imposes
no appreciable tax burden on foreign goods and services sold in the US but imposes a heavy tax burden on
US producers of goods and services regardless of whether they are sold within the US or exported to other
countries."[11]
Protectionists argue that this reverse protectionism is most clearly seen and most detrimental to those
countries (such as the US) that do not participate in the Value Added Tax (VAT) system. This is a system
which generates revenues from taxation on the sale of goods and services, whether foreign or domestic.
Protectionists argue that a country that does not participate is at a distinct disadvantage when trading with a
country that does. That the final selling price of a product from a non-participating country sold in a country
with a VAT tax must bear not only the tax burden of the country of origin, but also a portion of the tax
burden of the country where it is being sold. Conversely, the selling price of a product made in a
participating country and sold in a country that does not participate, bears no part of the tax burden of the
country in which it is sold (as do the domestic products it is competing with). Moreover, the participating
country rebates VAT taxes collected in the manufacture of a product if that product is sold in a nonparticipating country. This allows exporters of goods from participating countries to reduce the price of
products sold in non-participating countries.
Protectionists believe that governments should address this inequity, if not by adopting a VAT tax, then by
at least imposing compensating taxes (tariffs) on imports.
[edit] Infant industry argument
Main article: Infant industry argument
Protectionists believe that infant industries must be protected in order to allow them to grow to a point where
they can fairly compete with the larger mature industries established in foreign countries. They believe that
without this protection, infant industries will die before they reach a size and age where economies of scale,
industrial infrastructure, and skill in manufacturing have progressed sufficiently allow the industry to
compete in the global market.[citation needed]
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[edit] Unrestricted trade undercuts domestic policies for social good
Most industrialized governments have long held that laissez-faire capitalism creates social evils that harm its
citizens. To protect those citizens, these governments have enacted laws that restrict what companies can
and can not do in pursuit of profit. Examples are laws regarding:








child labor
environmental protection
competition (antitrust)
occupational safety and health
equal opportunity
collective bargaining
minimum wage
intellectual property
Protectionists argue that these laws place an economic burden on domestic companies bound by them that
put those companies at a disadvantage when they compete, both domestically and abroad, with goods and
services produced by companies unfettered by such restrictions. They argue that governments have a
responsibility to protect their corporations as well as their citizens when putting its companies at a
competitive disadvantage by enacting laws for social good. Otherwise, they believe that these laws end up
destroying domestic companies and ultimately hurting the citizens these laws were designed to protect.
[edit] Arguments against protectionism
Protectionism is frequently criticized[by whom?] as harming the people it is meant to help. Most mainstream
economists instead support free trade.[1][4] Economic theory, under the principle of comparative advantage,
shows that the gains from free trade outweigh any losses as free trade creates more jobs than it destroys
because it allows countries to specialize in the production of goods and services in which they have a
comparative advantage.[12] Protectionism results in deadweight loss; this loss to overall welfare gives no-one
any benefit, unlike in a free market, where there is no such total loss. According to economist Stephen P.
Magee, the benefits of free trade outweigh the losses by as much as 100 to 1.[13]
Most economists, including Nobel prize winners Milton Friedman and Paul Krugman, believe that free trade
helps workers in developing countries, even though they are not subject to the stringent health and labour
standards of developed countries. This is because "the growth of manufacturing — and of the myriad other
jobs that the new export sector creates — has a ripple effect throughout the economy" that creates
competition among producers, lifting wages and living conditions.[14] Economists[who?] have suggested that
those who support protectionism ostensibly to further the interests of workers in least developed countries
are in fact being disingenuous, seeking only to protect jobs in developed countries.[15] Additionally, workers
in the least developed countries only accept jobs if they are the best on offer, as all mutually consensual
exchanges must be of benefit to both sides, else they wouldn't be entered into freely. That they accept lowpaying jobs from companies in developed countries shows that their other employment prospects are worse.
A letter reprinted in the May 2010 edition of Econ Journal Watch identifies a similar sentiment against
protectionism from sixteen British economists at the beginning of the 20th century.[16]
Alan Greenspan, former chair of the American Federal Reserve, has criticized protectionist proposals as
leading "to an atrophy of our competitive ability. ... If the protectionist route is followed, newer, more
efficient industries will have less scope to expand, and overall output and economic welfare will suffer."[17]
Protectionism has also been accused of being one of the major causes of war. Proponents of this theory point
to the constant warfare in the 17th and 18th centuries among European countries whose governments were
predominantly mercantilist and protectionist, the American Revolution, which came about primarily due to
British tariffs and taxes, as well as the protective policies preceding both World War I and World War II.
According to Frederic Bastiat, "When goods cannot cross borders, armies will."
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Free trade promotes equal access to domestic resources (human, natural, capital, etc.) for domestic
participants and foreign participants alike. Some thinkers[who?] extend that under free trade, citizens of
participating countries deserve equal access to resources and social welfare (labor laws, education, etc.).
Visa entrance policies tend to discourage free reallocation between many countries, and encourage it with
others. High freedom and mobility has been shown to lead to far greater development than aid programs in
many cases, for example eastern European countries in the European Union. In other words visa entrance
requirements are a form of local protectionism.
Balance of Payments
The balance of payments provides us with important information about whether or not a country is “paying
its way” in the international economy.
What is the Balance of Payments?
The balance of payments (BOP) records all of the many financial transactions that are made between
consumers, businesses and the government in the UK with people across the rest of the World. The BOP
figures tell us about how much is being spent by British consumers and firms on imported goods and
services, and how successful UK firms have been in exporting to other countries and markets. It is an
important measure of the relative performance of the UK in the global economy. At AS level we focus only
on one part of the balance of payments accounts. This section is known as the current account. We will go
through the make-up of this account in a later section.
Why is the export sector of the economy vital for the UK?



Aggregate demand and the multiplier: An increasing share of Britain’s national output is exported
overseas as the nation becomes ever more integrated into the global economy. Export earnings are
an injection of AD into the circular flow. If British companies can successfully sell more goods and
services overseas, the rise in exports boosts national income and should have a positive multiplier
effect on the national income, output and employment.
Manufacturing industry: Export sales are particularly important for manufacturing industry where
exports are a high % of total production. Thousands of jobs depend directly on the performance of
the export sector and even more are affected in supply industries. Select this link for more articles on
British manufacturing industry
Regional economic health: The relative success of failure of export industries is important for
certain regions of the UK. When export sales dip (for example as a result of a global downturn or the
67
impact of the strong exchange rate), output, employment and living standards come under threat
and threaten to widen the existing north-south divide.
Trade in goods includes items such as:
Manufactured goods
Semi-finished goods and components
Energy products
Raw Materials
Consumer goods
(i) Durable goods e.g. DVD recorder and new
cars
(ii) Non-durable goods e.g. foods and beverages
Capital goods (e.g. new plant and equipment)
Trade in services includes:
Banking, insurance and consultancy services
Other financial services including foreign
exchange and derivatives trading
Tourism industry
Transport and shipping
Education and health services
Services associated with research and
development
Cultural arts
Trade in goods
Trade in goods includes exports and imports of oil and other energy products, manufactured goods,
foodstuffs, raw materials and components. Until recently this was known as visible trade – i.e. exporting and
importing of tangible products. Since 1986 the net balance of trade in goods for the UK has been in deficit.
And as the following chart shows, the trade deficit in goods has increased enormously in the last few years.
In 2005 there was a record trade deficit of £66 billion, over three times the deficit seen in 1998.
Trade in services
Overseas trade in services includes the exporting and importing of intangible products – for example,
Banking and Finance, Insurance, Shipping, Air Travel, Tourism and Consultancy. Britain has a strong trade
base in services with over thirty per cent of total export earnings come from services.
68
The balance of trade in services has been positive for many years. In 1999 the UK became the second largest
exporters of services in the world and in 2004 the UK achieved its highest ever annual trade surplus in
services although there was a smaller surplus in 2005 partly because of higher insurance payouts arising
from the effects of Hurricane Katrina in the United States. Strong surpluses are especially common in
financial and business services and hi-tech knowledge services.
But the UK runs a deficit in international travel and transportation in part because of the growth of demand
for overseas holidays as living standards have improved. Once again, rising incomes have caused a large rise
in the demand for overseas leisure and business travel and the sustained strength of the exchange rate against
most European currencies and the rapid expansion of low cost airlines offering short haul overseas breaks
has also played its part.
Britain has a comparative advantage in selling financial services to the rest of the world. London is one of
the three main financial centres in the world and has the largest share of trading in many international
financial markets. Many overseas banks have established themselves in London’s money and capital
markets. And numerous British financial businesses have world class status in their areas of expertise. Our
UK based commercial banks, fund managers, securities dealers, futures and options traders, insurance
companies and money market brokerage businesses are part of a complex network of financial and business
services that represent a huge asset for the UK balance of payments accounts.
Measuring the current account
The current account balance comprises the balance of trade in goods and services plus net investment
incomes from overseas assets. Net investment income arises from interest payments, profits and dividends
from external assets located outside the UK. We also add in the net balance of private transfers between
countries and government transfers (e.g. UK government payments to help fund the various spending
programmes of the European Union).
The net investment income flow for the UK is positive – a reflection of the heavy investment overseas in
recent years by British businesses and individuals. The transfer balance is negative – one reason is that the
British government is a net contributor to the EU budget.
69
The current account of the balance of payments
The current account balance is essentially a reflection of whether the British economy is paying its way with
other countries. The annual balance is volatile from year to year, because each of the four component parts is
subject to wide fluctuations.
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Balance of trade
in goods
£ billion
-13.7
-12.3
-21.8
-29.1
-33.0
-41.2
-47.7
-48.6
-60.9
-67.3
Balance of trade
in services
£ billion
11.2
14.1
14.7
13.6
13.6
14.4
16.8
19.2
25.9
17.9
Net Investment
Income
£ billion
0.6
3.3
12.3
1.3
4.5
11.7
23.4
24.6
26.6
29.9
Current transfers Current account
balance
£ billion
£ billion
-4.8
-6.7
-5.9
-0.8
-8.4
-3.2
-7.5
-21.7
-10.0
-24.8
-6.8
-21.9
-9.1
-16.5
-10.1
-14.9
-10.9
-19.3
-12.2
-26.6
Source: Office of National Statistics
What are the main questions that concern economists regarding these figures?



Causation: Why does the UK now run such large trade deficits in goods?
Consequences: Does it really matter if the British economy is running persistent current account
deficits?
Correction: Which demand and supply-side economic policies are likely to be most effective in
improving our trade balances in the years ahead?
The underlying causes of the UK trade deficit
It is useful to group the explanations for the record trade deficit in goods into short-term, medium-term and
long-term factors. Some relate to the demand-side of the economy, others to supply-side economic
influences
Short-term factors




Strong consumer demand: Real household spending has grown more quickly than the supply-side
of the economy can deliver, leading to a very high level of demand for imported goods and services
High income elasticity of demand for imports: Evidence suggests that UK consumers have a high
income elasticity of demand for overseas-produced goods – demand for imports grows quickly when
consumer demand is robust. Nicholas Fawcett and Michael Kitson in a recent article in the Guardian
estimated that the income elasticity is around +2.3 suggesting that a 2% increase in real incomes
boosts demand for imports by 4.6%. Because the overseas demand for UK exports rarely keeps pace
with the surging demand for imported products, so the trade deficit widens when the economy enjoys
a period of consumption-led growth.
The strong exchange rate has helped to reduce the UK price of imports causing an expenditureswitching effect away from domestically produced output.
The weakness of the global economy and in particular the slow growth in the Euro Zone has
damaged UK export growth. Nearly 60% of UK manufactured goods exports and over 50% of our
exports of services are to fellow members of the European Union.
Medium-term factors
70


UK trade balances have been affected by shifts in comparative advantage in the international
economy – for example the rapid growth of China as a source of exports of household goods and
other countries in South-east Asia who have a cost advantage in exporting manufactured products
The availability of imports from other countries at a relatively lower price inevitably causes a
substitution effect from British consumers.
Longer-term factors



Much of our trade deficit is due to structural rather than cyclical factors
Our trade performance has been hindered by supply-side deficiencies which impact on the price and
non-price competitiveness of British products in global markets - non-price competitiveness factors
such as design and product quality are now more important for trade than merely price alone.
o A relatively low rate of capital investment compared to other countries
o The persistence of a productivity gap with our major competitors – measured by
differences in GDP per person employed or per hour worked – this is linked to low
investment and also to the existence of a skills-gap between UK workers and employees in
many other countries
o A relatively weak performance in terms of product innovation – linked to a low rate of
business sector spending on research and development
The UK manufacturing sector has been in long-term decline for more than twenty years. This is
known as a process of deindustrialisation. Although we still have some world class manufacturing
companies, the size of our manufacturing sector is not large enough both to meet consumer demand
in the UK and also to export sufficient volumes of products to pay for a growing demand for imports
What does a current account deficit mean?
Running a sizeable deficit on the current account basically means that the UK economy is not paying its way
in the global economy. There is a net outflow of demand and income from the circular flow of income and
spending. The current account does not have to balance because the balance of payments also includes the
capital account. The capital account tracks capital flows in and out of the UK. This includes portfolio capital
flows (e.g. share transactions and the buying and selling of Government debt) and direct capital flows
arising from foreign investment.
The Effects of Changes in the Balance of Payments on the UK Economy
Consider the effects of a slowdown in exports and a faster growth in imports of goods and services caused
by a rise in the value of sterling against other currencies that leads to a worsening of the balance of
payments. This has further effects on the economy as a whole:




Reductions in demand in the circular flow: There will be a net fall in AD because more money is
leaving the circular flow of income (through imports) than is coming in from exports. An inward
shift of AD would lead to a contraction along the SRAS curve.
Lost jobs: There will be a loss of employment if exporting industries require less labour and if UK
businesses lose market share and output to cheaper imports from overseas.
Dip in business confidence and investment: A fall in business confidence and a decline in capital
investment spending by UK exporting firms whose order books are less full and whose profits take a
hit from a fall in demand from overseas.
Reductions in inflationary pressure: Lower inflation because imports coming into the UK are
cheaper and a fall in AD takes the economy further away from full capacity. Reduced inflationary
pressure might then persuade the Bank of England to reduce interest rates to provide a boost to
macroeconomic activity.
The exchange rate and the balance of payments
71
Changes in the exchange rate can have a big effect on the balance of payments although these effects are
subject to uncertain time lags. When sterling is strong then UK exporters found it harder to sell their
products overseas and it is cheaper for UK consumers to buy imported goods and services because the
pound buys more foreign currency than it did before.
The Balance of Payments and the Standard of Living
A common misconception is that balance of payments deficits are always bad for the economy. This is not
necessarily true. In the short term if a country is importing a high volume of goods and services this is a
boost to living standards because it allows consumers to buy more consumer durables. However, in the long
term if the trade deficit is a symptom of a weak economy and a lack of competitiveness then living standards
may decline.
An increase of welfare has been recognized as a main objective of economic integration. The increase of
trade between member states of economic unions is meant to lead to the increase of the GDP of its members,
and hence, to better welfare - a goal of any state around the world. This is one of the reasons for the global
scale development of economic integration, a phenomenon now realized in continental (ASEAN, the North
American Free Trade Agreement (NAFTA), SACN, European Union (EU), Eurasian Economic Community
(EurAsEC) and proposed for intercontinental (Comprehensive Economic Partnership for East Asia
(CEPEA), Transatlantic Free Trade Area (TAFTA)) economic blocks.
The other objective for the states pursuing economic integration is to stay/become regionally and globally
competitive, as the goods in the states outside economic blocks become more expensive (i.e., less
competitive). This is the other reason making global economic integration inevitable.
[edit] Stages
Stages of economic integration around the World:
(each country colored according to the most advanced agreement that it participates into.)
Economic and Monetary Union (CSME/EC$, EU/€)
Economic union (CSME, EU)
Customs and monetary union (CEMAC/franc, UEMOA/franc)
Common market (EEA, EFTA)
Customs union (CAN, CUBKR, EAC, EUCU, MERCOSUR, SACU)
Multilateral Free Trade Area (AFTA, CEFTA, COMESA, GAFTA, GCC, NAFTA, SAFTA, SICA, TPP)
72
Free trade around the World:
Multilateral free trade agreements or more advanced agreements
Bilateral free trade agreements or more advanced agreements
No free trade agreements, but World Trade Organization members
The degree of economic integration can be categorized into six stages:
1.
2.
3.
4.
5.
Preferential trading area
Free trade area, Monetary union
Customs union, Common market
Economic union, Customs and monetary union
Economic and monetary union,
o Fiscal union
6. Complete economic integration
These differ in the degree of unification of economic policies, with the highest one being the political union
of the states.
A "free trade area" (FTA) is formed when at least two states partially or fully abolish custom tariffs on
their inner border. To exclude regional exploitation of zero tariffs within the FTA there is a rule of
certificate of origin for the goods originating from the territory of a member state of an FTA.
A "customs union" introduces unified tariffs on the exterior borders of the union (CET, common external
tariffs). A "monetary union" introduces a shared currency. A "common market" add to a FTA the free
movement of services, capital and labor.
An "economic union" combines customs union with a common market. A "fiscal union" introduces a shared
fiscal and budgetary policy. In order to be successful the more advanced integration steps are typically
accompanied by unification of economic policies (tax, social welfare benefits, etc.), reductions in the rest of
the trade barriers, introduction of supranational bodies, and gradual moves towards the final stage, a
"political union".
Stages of Economic integration
activities inside the trade bloc
Trade pact
type
eliminating barriers for
exchange of
Shared policies
common barriers in external
relations
goods
Nongoods services capital labour monetary fiscal Tariff
tariff
Preferential
trade
agreement
TIFA
BIT,
TIFA
services capital labour
73
Free trade
agreement
Common
market
Monetary
union
Fiscal union
Customs
union
Customs and
monetary
union
Economic
union
Economic and
monetary
union
Complete
economic
integration
[partial] — [substantial] — [none or not applicable]
The Terms of trade
In the simplified case of two countries and two commodities, terms of trade is defined as the ratio of the
total export revenue] a country receives for its export commodity to the total import revenue it pays for its
import commodity. In this case the imports of one country are the exports of the other country. For example,
if a country exports 50 dollars worth of product in exchange for 100 dollars worth of imported product, that
country's terms of trade are 50/100 = 0.5. The terms of trade for the other country must be the reciprocal
(100/50 = 2). When this number is falling, the country is said to have "deteriorating terms of trade". If
multiplied by 100, these calculations can be expressed as a percentage (50% and 200% respectively). If a
country's terms of trade fall from say 100% to 70% (from 1.0 to 0.7), it has experienced a 30% deterioration
in its terms of trade. When doing longitudinal (time series) calculations, it is common to set a value for the
base year to make interpretation of the results easier.
In basic Microeconomics, the terms of trade are usually set in the interval between the opportunity costs for
the production of a given good of two countries.
Terms of trade is the ratio of a country's export price index to its import price index, multiplied by 100
74
Measurement in the Macro-economy
The labour force in an economy is defined as the total number of workers who are available for work.
The labour force participation rate refers to the percentage of the total population of working age who are
actually classified as being part of the labour force.
A lower participation rate in a developed economy usually indicates that an economy has a high
participation rate in higher education and a relatively large number of people opting for early retirement
From a general perspective certain demographic trends contribute to the size of the labour force in most dev
eloping economies. These are as follows:



Birth Rates exceed death rates. Consequently the total population and hence the labour force in
these countries is increasing
Dependency ratios in most developing countries are high as a consequence of high birth rates and
an increasing life expectancy. Consequently there is an increasing number of economically inactive
people relative to those who constitute the labour force.
Migration from rural areas to towns and cities has caused increased urbanisation. This has made it
very difficult for these economies to provide enough jobs to meet the needs and aspirations of its
labour force.
Labour Productivity
Labour productivity refers to the quantity of goods and services that a worker is able to produce in a
particular period of time.
Variations in living standards between economies can often be explained in terms of variations in the
productivity of labour
Labour is not a uniform resource, hence there are variations in the productivity of labour depending on
the education, training, experience and skills of the workforce in an economy.
75
Employment and Unemployment
Labour force = Total number of workers in employment + Total number of workers who are
unemployed.
The measurement of unemployment is very important for the macro-economy. For example if there is
unemployment in an economy Output will be below its potential level
Unemployment and the production possibility frontier
The economic and social costs of unemployment
High unemployment is widely recognised to create substantial costs for individuals and for the economy as a
whole. Some of these costs are difficult to measure, especially the longer-term social costs of a high level of
unemployment. Some of the costs are summarised below:
1. Loss of income: Unemployment normally results in a loss of income. The majority of the
unemployed experience a decline in their living standards and are worse off out of work
2. Loss of national output: Unemployment involves a loss of potential national output (i.e. GDP
operating below potential) and represents an inefficient use of scarce resources. If some people
choose to leave the labour market permanently because they have lost the motivation to search for
work, this can have a negative effect on long run aggregate supply (LRAS) and thereby damage the
economy’s growth potential
3. Fiscal costs: The government loses out because of a fall in tax revenues and higher spending on
welfare payments for families with people out of work. The result can be an increase in the budget
deficit which then increases the risk that the government will have to raise taxation or scale back
plans for public spending on public and merit goods
4. Social costs: Rising unemployment is linked to social deprivation. There is a relationship with
crime, and social dislocation (increased divorce rates, worsening health and lower life expectancy).
76
Areas of high unemployment see falling real incomes and a worsening in inequalities of income
and wealth
Government policies to reduce unemployment
Some countries are more successful than others in reducing the scale of unemployment. In the long term,
effective policies are required for both the demand and the supply side of the economy so that enough new
jobs are created and that people possess the skills and incentives to take those jobs.
In general the most effective policies are those that:
1. Stimulate an improvement in the human capital of the workforce – so that more of the
unemployed have the skills to take up the available jobs. Policies normally concentrate on improving
the occupational mobility of labour. The pattern of employment in any modern economy is always
changing, so people need to have sufficient flexibility to adapt to structural changes in industries
over the years
2. Improve incentives for people to search and then accept paid work – this may require reforms of
the tax and benefits system for example a reduction in the starting rate of income tax (an incentive
for people in lower paid jobs). Or perhaps a change in welfare benefits such that people who find
work do not experience a sharp withdrawal of benefits because they are now earning more. The
reality is that simply cutting welfare benefits across the board makes little difference to the
unemployment figures – because of the complex nature of most unemployment. But targeted
measures to improve incentives, including the linking of welfare benefits to participation in work
experience programmes which is part of the New Deal programme or lower tax rates for people on
low incomes might have an impact.
3. Employment subsidies: Government subsidies for those firms that take on the long-term
unemployed will create an incentive for businesses to increase the size of their workforce.
Employment subsidies may also be available for overseas firms locating in the UK as part of the
government’s regional policy. Labour’s New Deal programme works by offering subsidised jobs and
training to the long-term unemployed. It differs from previous job creation schemes, in that people
who refuse to comply can have their benefits stopped. According to the government's own figures,
more than 40% of the jobs gained through the New Deal are short-term.
4. Achieve a sustained period of economic growth – this requires that aggregate demand is
sufficiently high for businesses to be looking to expand their workforce. The Keynesian theory of
unemployment emphasises the argument that if monetary and fiscal policy does not keep demand at
a high enough level, then the economy is less likely to be able to sustain a high rate of employment.
However, not every increase in aggregate demand and production has to be met by employing more
labour. Each year we expect to see a rise in labour productivity (more output per worker employed).
And, businesses may decide to increase production by making greater use of capital inputs such as
extra units of machinery. A growing economy creates jobs for people entering the labour market for
the first time. And, it provides employment opportunities for people unemployed and looking for
work.
Policies used in the UK to reduce unemployment
Demand side policies
Supply-side policies
Employment subsidies for employers who take on Welfare reforms – including lower starting rates of
the long-term unemployed (New Deal)
income tax and the introduction of tax credits
Financial assistance for inward investment from Policies to promote entrepreneurship and the
overseas
growth of small-medium size enterprises
Monetary policy – low interest rates has allowed Increased spending on education and attempts to
aggregate demand to grow despite a global
increase private sector spending on training
economic slowdown. Fiscal policy is also boosting
77
AD as the budget deficit increases
Evaluation points on unemployment policies
1. There are always cyclical fluctuations in employment. If growth can be sustained and monetary
and fiscal policy can avoid a large negative output gap then it should be possible to create a steady
flow of new jobs
2. Demand and supply-side policies need to work in tandem for unemployment to fall in the long term.
Simply boosting demand if the root cause of unemployment is structural is an ineffective way of
tackling the problem. If demand is stimulated too much, the main risk becomes one of rising inflation
(i.e. the trade-off between these two objectives may worsen)
3. Full-employment does not mean zero unemployment! There will always be some frictional
unemployment – it may be useful to have a small surplus pool of labour available
4. There are still large regional differences in unemployment levels and pockets of deep-rooted longterm unemployment in many areas, which causes significant economic and external costs
Using Index Numbers
Index numbers are a useful way of expressing pieces of information and collections of data. This brief
chapter shows you how to express data in index number format and some examples of data which is
commonly presented as an index number
Converting data in index number format: Measuring the level of real national output
When we are measuring the level of national income we often make use of index numbers to track what is
happening to real GDP. In the table below we see the value of consumer spending and also real GDP
expressed in £ billion. I have chosen 1995 as the base year for our index of spending and output. So the data
for consumer spending and real GDP has an index value of 100.0 in 1995.
To calculate the index number for consumer spending in 1996 we use the following formula
Index (1996) = (consumer spending (1996) / base year consumer spending) x 100
1995 (Base)
1996
1997
1998
1999
2000
Consumer
spending
£ billion
512.6
531.9
551.1
572.3
598.8
625.1
Index of consumer
spending
1995 = 100
100.0
103.8
107.5
111.6
116.8
121.9
Real GDP
Index of real GDP
£ billion
857.5
880.9
908.7
938.1
966.6
1005.5
1995 = 100
100.0
102.7
106.0
109.4
112.7
117.3
78
2001
2002
2003
2004
644.9
667.4
684.8
710.2
125.8
130.2
133.6
138.5
1027.9
1048.5
1074.9
1108.9
119.9
122.3
125.3
129.3
One of the advantages of index numbers is that it allows us to compare and contrast more easily different
sets of economic data. Consider the information in the table above. Using 1995 as our base year for the
index, we can see that consumer spending has grown more quickly than real national income over the period
1995-2003.
Of course the two sets of data are closely linked because consumption accounts for more than 60% of GDP.
But the data indicates that consumer demand has been a key factor behind the continuing growth of the
economy, indeed consumption as a share of GDP has grown from 60% in 1995 to nearly 65% in 2003 – a
record level. Can this consumer boom continue? Much of it has been financed by high rates of borrowing
linked to low interest rates and the recent UK housing boom.
Calculating a price index
We will now see how information on prices can be used to create a weighted price index for the economy –
this is the sort of data which is then used to calculate the rate of inflation
Category
Food
Alcohol & Tobacco
Clothing
Transport
Housing
Leisure Services
Household Goods
Other Items
Price Index
106
110
97
103
106
112
95
105
Weighting
18
6
12
15
22
9
7
11
100
Price x Weight
1908
660
1164
1545
2332
1008
665
1155
10437
A weighted price index calculates changes in the average level of prices in the economy. In the
hypothetical data shown in the table above we have split consumer spending into eight categories and given
each a “weighting” based on the share of total consumer spending given over to each category. So for
example, housing and food costs are assumed in our example to take up 40% of total consumer spending.
These two items will have a heavy influence on the overall price index.
The price index for each category shows what has happened to the price level since a base year value. To
generate a weighted price index we multiply the price index for each category by its weight and then sum
these. We then divide by the sum of the weights (100) to find an overall price index (104.37) or 104.4
rounded to one decimal place.
Here is some real world data on a selected of price indices for goods and services in the UK.
All items Health Transport Communication Tobacco Clothing New Cars Second Hand Cars
1996
100.0 100.0
100.0
100.0 100.0 100.0
100.0
100.0
2000
105.6 111.6
112.7
89.3 141.2
82.2
99.8
91.2
79
2003
109.8 124.2
116.9
84.5
158.8
66.8
95.7
85.1
Over the period 1996-2003 there has been a 10% rise in the general price level. But this hides major changes
in average prices for different products. The average cost of purchasing tobacco products has jumped by
nearly sixty per cent whereas the prices of clothing, second hand cars and communication have been falling.
Macro-economic problems
Inflation
What causes rising prices in an economy? And what tools are available to keep inflation under control?
This chapter focuses on the causes of inflation and some of the consequences.
What is inflation?
Inflation is best defined as a sustained increase in the general price level leading to a fall in the
purchasing power or value of money. The greatest falls in the value of money came during the mid-late
1970s and again in the late 1980s when there was acceleration in the rate of inflation in the UK. In contrast,
80
the last fifteen years have seen much lower rates of inflation – and as a result, money has held value
better. The next chart shows the UK consumer price index since 1970.
The value of money refers to the amount of goods and services £1 can buy and is inversely proportionate to
the rate of inflation. Inflation reduces the value of money. When prices are increasing, then the value of
money falls.
The rate of inflation is measured by the annual percentage change in the level of consumer prices. The
British Government has set an inflation target of 2% using the consumer price index (CPI). It is the job of
the Bank of England to set interest rates so that AD is controlled and the inflation target is reached. Since the
Bank of England was made independent, inflation has stayed comfortably within target range. Indeed Britain
has one of the lowest rates of inflation inside the EU.
81
There has been a fall in average inflation rates in most of the world’s developed countries including the UK
over the last fifteen years. Indeed lower inflation seems to have become a global phenomenon. Japan has
experienced negative inflation (i.e. price deflation) over recent years (although in 2006, this period of price
deflation came to an end) and the German economy has also come close to experiencing deflation with
inflation of less than one per cent.
Deflation
Price deflation is when the rate of inflation becomes negative. I.e. the general price level is falling and the
value of money is increasing. Some countries have experienced deflation in recent years – good examples
include Japan and China. In Japan, the root cause of deflation was slow economic growth and a high level of
spare capacity in many industries that was driving prices lower. In China, economic growth has been rapid
– but the huge amount of capital investment and rising productivity has led to economies of scale being
exploited and a fall in production costs.
There has been some price deflation in the UK economy – not for the whole economy – but for items such
as clothing (where many prices of clothing on the high street have been driven lower by cheaper imports);
audio-visual equipment, computers and many other household goods. The effects of technological change in
increasing supply are important when explaining deflation in some UK markets. Rapid advances in
technology help to explain for example the sharp fall in the prices of state of art digital cameras and
televisions, which has made the digital age accessible to millions of consumers.
82
Hyperinflation
A 500 billions bill with most zeros in the economy history. The product of hyperinflation in Yugoslavia 1993
Hyperinflation is extremely rare. Recent examples include Yugoslavia Argentina , Brazil , Georgia and
Turkey (where inflation reached 70% in 1999). The classic example of hyperinflation was of course the
rampant inflation in Weimar Germany between 1921 and 1923 . When hyperinflation occurs, the value of
money becomes worthless and people lose all confidence in money both as a store of value and also as a
medium of exchange. The current hyperinflation in Zimbabwe is a good example of the havoc that can be
caused when price inflation spirals out of control.
Often drastic action is required to stabilize an economy suffering from high and volatile inflation – and this
leads to political and social instability. The International Monetary Fund is often brought into the process of
implementing economic reforms to reduce inflation and achieve greater financial stability.
The main causes of inflation
83
Inflation can come from several sources: Some come direct from the domestic economy, for example the
decisions of the major utility companies providing electricity or gas or water on their prices for the year
ahead, or the pricing strategies of the leading food retailers based on the strength of demand and competitive
pressure in their markets. A rise in government VAT would also be a cause of increased domestic inflation
because it increases a firm’s production costs.
Inflation can also come from external sources, for example an unexpected rise in the price of crude oil or
other imported commodities, foodstuffs and beverages. Fluctuations in the exchange rate can also affect
inflation – for example a fall in the value of sterling might cause higher import prices – which feeds through
directly into the consumer price index.
We make a simple distinction between demand pull and cost push inflation.
Demand-pull inflation
Demand-pull inflation is likely when there is full employment of resources and aggregate demand is
increasing at a time when SRAS is inelastic. This is shown in the next diagram:
In the diagram above we see a large outward shift in AD. This takes the equilibrium level of national output
beyond full-capacity national income (Yfc) creating a positive output gap. This would then put upward
pressure on wage and raw material costs – leading the SRAS curve to shift inward and causing real output
and incomes to contract back towards Yfc (the long run equilibrium for the economy) but now with a higher
general price level (i.e. there has been some inflation).
The main causes of demand-pull inflation
Demand pull inflation is largely the result of the level of AD being allowed to grow too fast compared to
what the supply-side capacity can meet. The result is excess demand for goods and services and pressure
on businesses to raise prices in order to increase their profit margins.
Possible causes of demand-pull inflation include:
84
1. A depreciation of the exchange rate which increases the price of imports and reduces the foreign
price of UK exports. If consumers buy fewer imports, while exports grow, AD in will rise – and
there may be a multiplier effect on the level of demand and output
2. Higher demand from a fiscal stimulus e.g. via a reduction in direct or indirect taxation or higher
government spending. If direct taxes are reduced, consumers will have more disposable income
causing demand to rise. Higher government spending and increased government borrowing feeds
through directly into extra demand in the circular flow
3. Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand – for
example in raising demand for loans or in causing a sharp rise in house price inflation
4. Faster economic growth in other countries – providing a boost to UK exports overseas. Export
sales provide an extra flow of income and spending into the UK circular flow – so what is happening
to the economic cycles of other countries definitely affects the UK
Cost-push inflation
Cost-push inflation occurs when firms respond to rising costs, by increasing prices to protect their profit
margins. There are many reasons why costs might rise:
1. Component costs: e.g. an increase in the prices of raw materials and other components used in the
production processes of different industries. This might be because of a rise in world commodity
prices such as oil, copper and agricultural products used in food processing
2. Rising labour costs - caused by wage increases, which are greater than improvements in
productivity. Wage costs often rise when unemployment is low (skilled workers become scarce and
this can drive pay levels higher) and also when people expect higher inflation so they bid for higher
pay claims in order to protect their real incomes. Expectations of inflation are important in shaping
what actually happens to inflation!
3. Higher indirect taxes imposed by the government – for example a rise in the specific duty on
alcohol and cigarettes, an increase in fuel duties or a rise in the standard rate of Value Added Tax.
Depending on the price elasticity of demand and supply for their products, suppliers may choose to
pass on the burden of the tax onto consumers
Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. The fall
in SRAS causes a contraction of national output together with a rise in the level of prices.
85
Which government policies are most effective in reducing inflation?
Most governments now give a high priority to keeping control of inflation. It has become one of the
dominant objectives of macroeconomic policy.
Inflation can be reduced by policies that (i) slow down the growth of AD or (ii) boost the rate of growth of
aggregate supply (AS). The main anti-inflation controls available to a government are:
1. Fiscal Policy: If the government believes that AD is too high, it may reduce its own spending on
public and merit goods or welfare payments. Or it can choose to raise direct taxes, leading to a
reduction in disposable income. Normally when the government wants to “tighten fiscal policy” to
control inflation, it will seek to cut spending or raise tax revenues so that government borrowing (the
budget deficit) is reduced. This helps to take money out of the circular flow of income and spending
2. Monetary Policy:A tightening of monetary policy involves higher interest rates to reduce
consumer and investment spending. Monetary policy is now in the hand of the Bank of England –it
decides on interest rates each month.
3. Supply side economic policies: Supply side policies include those that seek to increase
productivity, competition and innovation – all of which can maintain lower prices.
The most appropriate way to control inflation in the short term is for the British government and the Bank of
England to keep control of aggregate demand to a level consistent with our productive capacity. The
consensus among economists is that AD is probably better controlled through the use of monetary policy
rather than an over-reliance on using fiscal policy as an instrument of demand-management. But in the long
run, it is the growth of a country’s supply-side productive potential that gives an economy the flexibility to
grow without suffering from acceleration in cost and price inflation.
Why has inflation remained low in the UK over recent years?
86
The last twelve years has been a period of very low and stable inflation. No one factor explains this – but
among them we can highlight the following:
1. Low wage inflation from the labour market: Wages have been growing at a fairly modest rate in
recent years despite a large fall in unemployment. This has been helped by a fall in expectations of
inflation
2. Low global inflation and deflation in some countries: There has been a clear fall in the average
rate of consumer prices inflation among leading economies, and this decline in global inflation has
filtered through to the UK. World inflation has stayed low despite the recent increases in the prices
of many of the world’s globally traded commodities.
3. The effectiveness of monetary policy in the UK: The success of the Bank of England through
monetary policy in keeping aggregate demand under control through interest rate changes
4. Increased competition: Many markets have become more contestable in the last decade and this
extra competition has placed a discipline on businesses to control their costs, reduce profit margins
and seek improvements in efficiency. Many UK businesses face severe pressure from foreign
competition as the process of globalisation continues
5. The strength of the exchange rate: The recent strength of the pound has lowered the cost of
imported products and also squeezes demand for UK exporters
6. Information technology effects: The rapid expansion of information and communication
technology has helped to reduce costs and has made prices more transparent for consumers – ecommerce has contributed to falling prices in many markets
In short, low inflation is the result of a combination of demand and supply-side factors.
87
Balance of Payment problems
The underlying causes of the UK trade deficit
It is useful to group the explanations for the record trade deficit in goods into short-term, medium-term and
long-term factors. Some relate to the demand-side of the economy, others to supply-side economic
influences
Short-term factors




Strong consumer demand: Real household spending has grown more quickly than the supply-side
of the economy can deliver, leading to a very high level of demand for imported goods and services
High income elasticity of demand for imports: Evidence suggests that UK consumers have a high
income elasticity of demand for overseas-produced goods – demand for imports grows quickly when
consumer demand is robust. Nicholas Fawcett and Michael Kitson in a recent article in the Guardian
estimated that the income elasticity is around +2.3 suggesting that a 2% increase in real incomes
boosts demand for imports by 4.6%. Because the overseas demand for UK exports rarely keeps pace
with the surging demand for imported products, so the trade deficit widens when the economy enjoys
a period of consumption-led growth.
The strong exchange rate has helped to reduce the UK price of imports causing an expenditureswitching effect away from domestically produced output.
The weakness of the global economy and in particular the slow growth in the Euro Zone has
damaged UK export growth. Nearly 60% of UK manufactured goods exports and over 50% of our
exports of services are to fellow members of the European Union.
Medium-term factors
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UK trade balances have been affected by shifts in comparative advantage in the international
economy – for example the rapid growth of China as a source of exports of household goods and
other countries in South-east Asia who have a cost advantage in exporting manufactured products
The availability of imports from other countries at a relatively lower price inevitably causes a
substitution effect from British consumers.
Longer-term factors
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Much of our trade deficit is due to structural rather than cyclical factors
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Our trade performance has been hindered by supply-side deficiencies which impact on the price
and non-price competitiveness of British products in global markets - non-price competitiveness
factors such as design and product quality are now more important for trade than merely price alone.
o A relatively low rate of capital investment compared to other countries
o The persistence of a productivity gap with our major competitors – measured by
differences in GDP per person employed or per hour worked – this is linked to low
investment and also to the existence of a skills-gap between UK workers and employees in
many other countries
o A relatively weak performance in terms of product innovation – linked to a low rate of
business sector spending on research and development
The UK manufacturing sector has been in long-term decline for more than twenty years. This is
known as a process of deindustrialisation. Although we still have some world class manufacturing
companies, the size of our manufacturing sector is not large enough both to meet consumer demand
in the UK and also to export sufficient volumes of products to pay for a growing demand for imports
What does a current account deficit mean?
Running a sizeable deficit on the current account basically means that the UK economy is not paying its way
in the global economy. There is a net outflow of demand and income from the circular flow of income and
spending. The current account does not have to balance because the balance of payments also includes the
capital account. The capital account tracks capital flows in and out of the UK. This includes portfolio capital
flows (e.g. share transactions and the buying and selling of Government debt) and direct capital flows
arising from foreign investment.
The Effects of Changes in the Balance of Payments on the UK Economy
Consider the effects of a slowdown in exports and a faster growth in imports of goods and services caused
by a rise in the value of sterling against other currencies that leads to a worsening of the balance of
payments. This has further effects on the economy as a whole:
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Reductions in demand in the circular flow: There will be a net fall in AD because more money is
leaving the circular flow of income (through imports) than is coming in from exports. An inward
shift of AD would lead to a contraction along the SRAS curve.
Lost jobs: There will be a loss of employment if exporting industries require less labour and if UK
businesses lose market share and output to cheaper imports from overseas.
Dip in business confidence and investment: A fall in business confidence and a decline in capital
investment spending by UK exporting firms whose order books are less full and whose profits take a
hit from a fall in demand from overseas.
Reductions in inflationary pressure: Lower inflation because imports coming into the UK are
cheaper and a fall in AD takes the economy further away from full capacity. Reduced inflationary
pressure might then persuade the Bank of England to reduce interest rates to provide a boost to
macroeconomic activity.
The exchange rate and the balance of payments
Changes in the exchange rate can have a big effect on the balance of payments although these effects are
subject to uncertain time lags. When sterling is strong then UK exporters found it harder to sell their
products overseas and it is cheaper for UK consumers to buy imported goods and services because the
pound buys more foreign currency than it did before.
The Balance of Payments and the Standard of Living
A common misconception is that balance of payments deficits are always bad for the economy. This is not
necessarily true. In the short term if a country is importing a high volume of goods and services this is a
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boost to living standards because it allows consumers to buy more consumer durables. However, in the
long term if the trade deficit is a symptom of a weak economy and a lack of competitiveness then living
standards may decline.
Exchange Rates
Exchange Rates
This chapter looks at the currency markets where the value of one currency against another is determined
on a daily basis
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The exchange rate measures the external value of sterling in terms of how much of another
currency it can buy. For example - how many dollars or Euros you can buy with £5000.
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The daily value of the currency is determined in the foreign exchange markets (FOREX) where
billions of $s of currencies are traded every hour.
The global currency markets are open 24 hours a day allowing businesses, banks, individuals to trade
in the currencies that they need.
Recent trends in the exchange rate
The UK operates with a floating exchange rate system where the forces of market demand and supply for a
currency determine the daily value of one currency against another. If, for example, overseas investors want
to buy into sterling to take advantage of higher interest rates on offer in UK bank accounts, they will swap
their own currencies for pounds. This causes an increase in the demand for sterling in the foreign exchange
markets, and in the absence of other offsetting factors, this will force sterling higher against other currencies.
How does a change in the exchange rate influence the economy?
Changes in the exchange rate can have a powerful effect on the macro-economy affecting variables such as
the demand for exports and imports; real GDP growth, inflation and unemployment – but as with most
variables in economics, there are time lags involved.
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The scale of any change in the exchange rate.
Whether the change in the currency is short term or long term.
How businesses and consumers respond to exchange rate fluctuations – the concept of price
elasticity of demand is important here.
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Advantages of an appreciation in the currency
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Cheaper imports for consumers: A high pound leads to lower import prices – this boosts the real
living standards of consumers at least in the short run – for example an increase in the real
purchasing power of UK residents when travelling overseas or the chance to buy cheaper computers
or motor vehicles from the United States or Europe.
Lower costs for producers: When the sterling exchange rate is high, it is cheaper to import raw
materials, component parts and capital inputs such as plant and equipment – this is good news for
businesses that rely on imported components or who are wishing to increase their investment of new
technology from overseas countries. A fall in import prices has the effect of causing an outward shift
in the short run aggregate supply curve. And if a country can now import more productive
technology, the LRAS curve may shift out.
Lower inflation: A strong exchange rate helps to control the rate inflation because domestic
suppliers now face stiffer international competition from cheaper imports and will look to cut their
costs and prices accordingly in order not to suffer from a loss of international competitiveness.
Cheaper prices of imported foodstuffs and beverages will also have a negative effect on the rate of
consumer price inflation.
If inflation is lower, then interest rates will be lower than if the exchange rate was weaker – and
cheaper money will eventually stimulate higher consumer spending and capital spending in the
circular flow
Disadvantages of an appreciation
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Increase in the trade deficit: The lower price of imports leads to consumers increasing their
demand and this can cause a large trade deficit. Exporters lose price competitiveness because they
will find it more expensive to sell in foreign markets and face losing market share – this can damage
profits and employment in some sectors and industries.
Slower economic growth: If exports fall, this causes a reduction in aggregate demand and reduces
the short-term rate economic growth as measured by the % change in real GDP. Some regions of the
economy are affected by this more than others. In the North east for example, manufacturing
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industry accounts for over 28% of regional GDP whereas the percentage for the UK as a whole is
just 19%.
If exports fall, then so will business confidence and capital investment – because investment is
partly dependent on the strength of demand
Showing the effects of currency movements using AD-AS analysis
Changes in the exchange rate have quite a powerful effect on the economy but we tend to assume ceteris
paribus – all other factors held constant – which of course is highly unlikely to be the case
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Counter-balancing use of fiscal and monetary policy: For example the government can alter fiscal
policy to manage the level of AD and the Bank of England has the flexibility to change interest rates
(e.g. lower interest rates if they felt that a high exchange rate was damaging export sectors and
causing much lower inflation)
Low elasticity of demand: In the short term, the effects of exchange rates on export and import
demand tends to be low because of low price elasticity of demand
Business response to the challenge of a high exchange rate: Businesses can and do adapt to a high
exchange rate. There are several ways in which industries can adjust to the competitive pressures that
a strong pound imposes. Some of the options include:
Cutting their export prices when selling in overseas markets and therefore accepting lower profit
margins to maintain competitiveness and market share
Out-sourcing components from overseas to keep production costs down
Seeking productivity / efficiency gains to keep unit labour costs under control or perhaps trying to
negotiate a reduction in pay levels
Investing extra resources in new product lines where demand is price inelastic and less sensitive
to exchange rate fluctuations. This involves producing products with a higher income elasticity of
demand, where non-price factors such as product quality, design and effective marketing are as
important in securing orders as the actual price
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Policies to correct balance of payments disequilibria
Solution to correct balance of payment disequilibrium lies in earning more foreign exchange through
additional exports or reducing imports. Quantitative changes in exports and imports require policy changes.
Such policy measures are in the form of monetary, fiscal and non-monetary measures.
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Image Credits © SteveFiji.
Monetary Measures for Correcting the Balance of Payments ↓
The monetary methods for correcting disequilibrium in the balance of payment are as follows :-
1. Deflation
Deflation means falling prices. Deflation has been used as a measure to correct deficit disequilibrium. A
country faces deficit when its imports exceeds exports.
Deflation is brought through monetary measures like bank rate policy, open market operations, etc or
through fiscal measures like higher taxation, reduction in public expenditure, etc. Deflation would make our
items cheaper in foreign market resulting a rise in our exports. At the same time the demands for imports fall
due to higher taxation and reduced income. This would build a favourable atmosphere in the balance of
payment position. However Deflation can be successful when the exchange rate remains fixed.
2. Exchange Depreciation
Exchange depreciation means decline in the rate of exchange of domestic currency in terms of foreign
currency. This device implies that a country has adopted a flexible exchange rate policy.
Suppose the rate of exchange between Indian rupee and US dollar is $1 = Rs. 40. If India experiences an
adverse balance of payments with regard to U.S.A, the Indian demand for US dollar will rise. The price of
dollar in terms of rupee will rise. Hence, dollar will appreciate in external value and rupee will depreciate in
external value. The new rate of exchange may be say $1 = Rs. 50. This means 25% exchange depreciation of
the Indian currency.
Exchange depreciation will stimulate exports and reduce imports because exports will become cheaper and
imports costlier. Hence, a favourable balance of payments would emerge to pay off the deficit.
Limitations of Exchange Depreciation :1. Exchange depreciation will be successful only if there is no retaliatory exchange depreciation by
other countries.
2. It is not suitable to a country desiring a fixed exchange rate system.
3. Exchange depreciation raises the prices of imports and reduces the prices of exports. So the terms of
trade will become unfavourable for the country adopting it.
4. It increases uncertainty & risks involved in foreign trade.
5. It may result in hyper-inflation causing further deficit in balance of payments.
3. Devaluation
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Devaluation refers to deliberate attempt made by monetary authorities to bring down the value of home
currency against foreign currency. While depreciation is a spontaneous fall due to interactions of market
forces, devaluation is official act enforced by the monetary authority. Generally the international monetary
fund advocates the policy of devaluation as a corrective measure of disequilibrium for the countries facing
adverse balance of payment position. When India's balance of payment worsened in 1991, IMF suggested
devaluation. Accordingly, the value of Indian currency has been reduced by 18 to 20% in terms of various
currencies. The 1991 devaluation brought the desired effect. The very next year the import declined while
exports picked up.
When devaluation is effected, the value of home currency goes down against foreign currency, Let us
suppose the exchange rate remains $1 = Rs. 10 before devaluation. Let us suppose, devaluation takes place
which reduces the value of home currency and now the exchange rate becomes $1 = Rs. 20. After such a
change our goods becomes cheap in foreign market. This is because, after devaluation, dollar is exchanged
for more Indian currencies which push up the demand for exports. At the same time, imports become
costlier as Indians have to pay more currencies to obtain one dollar. Thus demand for imports is reduced.
Generally devaluation is resorted to where there is serious adverse balance of payment problem.
Limitations of Devaluation :1. Devaluation is successful only when other country does not retaliate the same. If
both the countries go for the same, the effect is nil.
2. Devaluation is successful only when the demand for exports and imports is elastic.
In case it is inelastic, it may turn the situation worse.
3. Devaluation, though helps correcting disequilibrium, is considered to be a weakness for the country.
4. Devaluation may bring inflation in the following conditions :i. Devaluation brings the imports down, When imports are reduced, the domestic supply of
such goods must be increased to the same extent. If not, scarcity of such goods unleash
inflationary trends.
ii. A growing country like India is capital thirsty. Due to non availability of capital goods in
India, we have no option but to continue imports at higher costs. This will force the industries
depending upon capital goods to push up their prices.
iii. When demand for our export rises, more and more goods produced in a country would go for
exports and thus creating shortage of such goods at the domestic level. This results in rising
prices and inflation.
iv.
Devaluation may not be effective if the deficit arises due to cyclical or structural changes.
4. Exchange Control
It is an extreme step taken by the monetary authority to enjoy complete control over the exchange dealings.
Under such a measure, the central bank directs all exporters to surrender their foreign exchange to the
central authority. Thus it leads to concentration of exchange reserves in the hands of central authority. At the
same time, the supply of foreign exchange is restricted only for essential goods. It can only help controlling
situation from turning worse. In short it is only a temporary measure and not permanent remedy.
Non-Monetary Measures for Correcting the BoP ↓
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A deficit country along with Monetary measures may adopt the following non-monetary measures too
which will either restrict imports or promote exports.
1. Tariffs
Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices of imports would
increase to the extent of tariff. The increased prices will reduced the demand for imported goods and at the
same time induce domestic producers to produce more of import substitutes. Non-essential imports can be
drastically reduced by imposing a very high rate of tariff.
Drawbacks of Tariffs :1. Tariffs bring equilibrium by reducing the volume of trade.
2. Tariffs obstruct the expansion of world trade and prosperity.
3. Tariffs need not necessarily reduce imports. Hence the effects of tariff on the balance of payment
position are uncertain.
4. Tariffs seek to establish equilibrium without removing the root causes of disequilibrium.
5. A new or a higher tariff may aggravate the disequilibrium in the balance of payments of a country
already having a surplus.
6. Tariffs to be successful require an efficient & honest administration which unfortunately is difficult
to have in most of the countries. Corruption among the administrative staff will render tariffs
ineffective.
2. Quotas
Under the quota system, the government may fix and permit the maximum quantity or value of a commodity
to be imported during a given period. By restricting imports through the quota system, the deficit is reduced
and the balance of payments position is improved.
Types of Quotas :1.
2.
3.
4.
5.
the tariff or custom quota,
the unilateral quota,
the bilateral quota,
the mixing quota, and
import licensing.
Merits of Quotas :1.
2.
3.
4.
Quotas are more effective than tariffs as they are certain.
They are easy to implement.
They are more effective even when demand is inelastic, as no imports are possible above the quotas.
More flexible than tariffs as they are subject to administrative decision. Tariffs on the other hand are
subject to legislative sanction.
Demerits of Quotas :-
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1. They are not long-run solution as they do not tackle the real cause for disequilibrium.
2. Under the WTO quotas are discouraged.
3. Implements of quotas is open invitation to corruption.
3. Export Promotion
The government can adopt export promotion measures to correct disequilibrium in the balance of payments.
This includes substitutes, tax concessions to exporters, marketing facilities, credit and incentives to
exporters, etc.
The government may also help to promote export through exhibition, trade fairs; conducting marketing
research & by providing the required administrative and diplomatic help to tap the potential markets.
4. Import Substitution
A country may resort to import substitution to reduce the volume of imports and make it self-reliant. Fiscal
and monetary measures may be adopted to encourage industries producing import substitutes. Industries
which produce import substitutes require special attention in the form of various concessions, which include
tax concession, technical assistance, subsidies, providing scarce inputs, etc.
Non-monetary methods are more effective than monetary methods and are normally applicable in correcting
an adverse balance of payments.
Drawbacks of Import Substitution:1. Such industries may lose the spirit of competitiveness.
2. Domestic industries enjoying various incentives will develop vested interests and ask for such
concessions all the time.
3. Deliberate promotion of import substitute industries go against the principle of comparative
advantage.