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1-Economics
1 Economics
1.1 Microeconomics and Macroeconomics
Economics can be broadly divided into two branches:
 Microeconomics
 Macroeconomics
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ECONOMICS is the study of how society provides for itself by making the most efficient use of
scarce resources so that both private and social welfare may be improved.
 Economics provides a framework for studying how individuals, households, firms,
governments and global organizations behave and take a wide range of decisions.
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MICROECONOMICS refers to the body of economic principles and concepts that explains the
behaviour of individuals and firms in different situations. The issues covered in microeconomics
can include scarcity and opportunity costs, pricing of goods and services, utility, budget line and
indifference curves, costs, revenues and profits of firms.
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MACROECONOMICS refers to the economic issues that relate to the whole economy. These
issues can include economic growth, unemployment, inflation, national income, and living
standards.
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Many economic issues and problems cannot be satisfactorily classified as micro or macro and
encompass both branches of economics. For example, an increase in taxation on petrol may
reduce the demand for petrol. There is both an effect on income of individuals (micro) and the
revenues of government (macro).
1.2 Normative and Positive statements
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Economists cannot always be certain that what they say is completely accurate or how the
advice they provide will affect an economy.
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POSITIVE STATEMENT is based on empirical or actual evidence.
 Statements about economics that can be proven to be true or false.
 These can be supported or refuted by evidence.
 For example, following is a positive statement: ‘the inflation rate in 2009 was 2.5%.’
 Statements about the future can also be positive statements. For example, ‘The service
sector will grow by 30% in size over the next five years.’
o Statement is capable of being proved or disproved even though economists may
have to wait for five years to know whether it was actually true or false.
NORMATIVE STATEMENTS involve value judgments and are ones that are subjective about
what should happen.
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These statements cannot be supported or refuted.
They are opinions about how economies and markets should work.
For example, the following statements are normative:
o ‘The government should cut fuel tax to reduce the rate of inflation.’
o ‘Public sector workers should reduce their demands for higher wages.’
These are often drawn from the economist’s personal views, political beliefs and ethics.
Normative statements tend to contain words like ‘should’ and ‘ought’. Although
sometimes positive statements also contain these words.
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1.3 Production and Consumption
PRODUCTION is the process of creating goods and services in an economy. Goods and services
have the capacity to satisfy wants.
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CONSUMPTION is the process by which consumers satisfy their wants.
 Some goods, such as sweets, are quickly used up.
 Consumer durables, such as refrigerators and mobile phones, satisfy wants over a
longer period.
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1.4 The time dimension
SHORT RUN is a time period when a firm can only change some and not all factor inputs. At
least one of the factors of production is fixed.
LONG RUN is the time period when all factors of production are variable. Firm may improve the
quantity and quality of its capital by building a new factory to increase its output. This leads to
greater efficiency in the long run.
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VERY LONG RUN is a time period when all key inputs into production are variable. These key
inputs can include technology, government regulations, and social considerations.
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2 Basic economic problem
The FUNDAMETAL ECONOMIC PROBLEM is scarce resources relative to unlimited wants. All
economies face the problem of scarcity.
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2.1 Limited resources
RESOURCES are inputs available for the production of goods and services. There are four types
of FACTORS OF PRODUCTION, i.e. the resources that are combined to produce goods and
services. These include land, labour, capital and enterprise.
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(i) Land
LAND includes the surface of the earth and all natural resources such as lakes, rivers, forests,
mineral deposits and the climate. Some of the major issues with respect to land include:
 The reward for owning land is the income and rent that is generated.
 Land is scarce and it cannot be increased in quantity.
 Natural resources can be both renewable and non-renewable. RENEWABLE RESOURCES
such as forest and fish can be replaced by natural process whereas NON-RENEWABLE
RESOURCES such as mineral deposits, oil and gas cannot be replaced once consumed.
o There is a concern at the rate at which these resources are being depleted.
Higher levels of consumption today means that we enjoy high levels of living
standards today but this will leave fewer resources for future generations with
the concern that the high living standards may not be sustainable in the long run.
o Another concern resulting from the rate of consumption is that it is leading to
higher levels of pollution that may lead to poor living standards in the future.
 Quantity of land can increase due to discovery of mineral reserves, or improvement of
water-logged and eroded land. It can decrease due to depletion of resources, waterlogging and erosion.
 Quality of land can be increased through use of better technology, use of pesticides and
fertilizer, and training of farmers. This will lead to increase in productivity of land.
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(ii) Labour
LABOUR includes all mental and physical effort of humans to produce goods and services. Some
of the issues related to labour are listed below:
 Wages and salaries are paid to labour.
 Labour can be both skilled and unskilled. Skilled labour is more productive but demands
higher wages, whereas unskilled labour is cheaper but less productive.
 Quantity of labour increases because of increase in population size, net immigration,
increased woman participation in the labour force, and higher retirement age.
 Quality of labour can increase through training and education, better leadership style
that motivates the employees, and use of machinery. These steps lead to increase in
productivity of labour.
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Another important issue in recent years that has emerged is that of female participation
in labour force. Most of the nations are evidencing an increase in female labour force
participation. This leads to an overall increase in supply of labour in the market.
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(iii) Capital
CAPITAL includes all man-made aides to production such as robots, machines, software and
spades. Capital goods increase the productivity of and quality of production from land and
labour. Issues with respect to capital include:
 The reward for capital is the rate of return and interest that is earned.
 Capital goods improve the productivity levels in the economy.
 Working or circulating capital is stocks of raw materials, semi-manufactured and
finished goods which are waiting to be sold.
 Fixed capital is the stock of factories, offices, plant and machinery. It is used to
transform working capital into finished products.
 There is a threat that a rapid change in technology may make existing capital obsolete.
 Developing economies do not have enough resources to invest in capital. They then
have to import capital from developed economies.
 Quantity of capital increases when net investment is positive (gross investment is
greater than capital consumption) and through imports.
 Quality of capital can be improved through investment in R&D to improve the state of
technology.
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(iv) Enterprise (Entrepreneurship)
ENTERPRISE performs two functions in an economy: (i) entrepreneurs organize other three
factors of production to produce goods and services; and (ii) entrepreneurs take risk associated
with investment and production. Enterprise involves following issues:
 Profits belong to entrepreneurs.
 Firms can be large or small. Smaller firms have fewer resources and are usually run by
single individuals (sole proprietorship). Larger firms have more resources, engage
specialist managers, use division of labour, and sell shares to shareholders (public
limited companies).
 Quantity of enterprise can be increased through training and education of workers, and
through investor-friendly government policies.
 Quality of enterprise improves through use of training and education, and experience.
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Contribution of enterprise to the economy
Market is performing an increasing role in almost all economies. This has provided
opportunities for the development of an enterprise culture whereby people who are prepared
to take risks may achieve substantial business success. For example, Mian Nishat (Pakistan),
Rata Tata (India), and Richard Branson (UK) have built up large business empires. Enterprise
brings following benefits to the economy:
 Enterprise starts new firms and increase investment in the economy.
 It creates new jobs hence lowering unemployment in the economy.
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Enterprise leads to innovation as a lot of new and hi-tech products are introduced by
new small firms.
Successful firms can become large multinationals.
Profitable firms will give more taxes to the government that can be used to build
infrastructure and improve economic efficiency.
New firms provide competition to existing firms that leads to more choice for
consumers, lower prices and better quality products due to competition.
New firms can also lead to rise in exports and lower imports leading to improvement in
balance of payments.
New firms improve social cohesion by allowing poor or middle class individuals to earn
higher rewards by investing in successful businesses.
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Use of factors of production in different sectors in the economy
All factors of production are required to produce goods and services, however, their relative
importance and use depend on the sector and the production methods.
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ECONOMIC STRUCTURE refers to the way in which an economy is organized in terms of sectors.
The following sectors are recognized:
1. Primary sector: PRIMARY SECTOR consists of agriculture, fishing and activities such as
mining and oil extraction. It requires more land and labour. However, in recent years, there
is an increase in use of capital such as tractors and tube wells.
2. Secondary sector: SECONDARY SECTOR consists of a range of manufacturing activities such
as food processing, textiles, clothing, iron and steel production. It also consists of
construction. It requires more capital where machines are used to produce more goods and
services. Again within it, labour-intensive production techniques use relatively more labour
and capital-intensive production techniques (such as flow production) require relatively
more capital.
3. Tertiary sector: TERTIARY SECTOR consists of services such as retailing, transports, logistics,
banking, insurance and education. It again needs all four factors of production but is usually
more labour-enterprise. It also requires a lot of enterprise.
4. Quaternary sector: QUATERNARY SECTOR is a term used to denote the knowledge-based
part of the economy, especially the provision of information. Typical examples include
scientific research and product development, and computing. It uses a lot of technology and
also requires skilled labour.
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The economic structure changes with the level of development of an economy. In developing
countries, the largest contribution to GDP comes from primary sector which is also the largest
employer. In developed countries, the tertiary sector tends to be the largest employer and also
contributes more toward the GDP.
Factor endowment
FACTOR ENDOWMENT refers to the availability of factors of production in an economy. For
instance, Saudia has abundant oil reserves; Pakistan has good climate and land suitable for
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agriculture; Japan has a lot of capital; etc. Whereas all factors of production will be available to
all economies, however, economies will differ in terms of the abundance or shortage of factors.
For instance, poor and developing economies have abundant labour while facing shortage of
capital; developed economies have abundant capital and face labour shortages. Saudia is rich in
oil; Pakistan has good climate and land for agriculture; China has a lot of skilled and cheap
labour etc. This leads to following issues:
 Abundant factor is cheaper and the short factor is more expensive. Therefore we find
that labour in developing economies (where it is abundant) is cheaper than labour in
developed economies (where it is short). On the other hand capital is cheaper in
developed countries than in developing countries.
 Economies tend to specialize in those products that use more of their abundant
resources. Therefore, developing economies are expected to specialize in labourintensive techniques, and developed economies are expected to specialize in capitalintensive techniques.
2.2 Unlimited wants
Consumer desires can be divided into needs and wants.
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(i) Needs
NEEDS are those desires that must be satisfied for an individual to live. It can include both
physical needs (such as food, shelter and clothing) and psychological needs (such as the need to
be loved and cared). Needs are limited.
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(ii) Wants
WANTS are desires that are less essential but can improve the quality of life. They can include
cars, holidays, cinema, TV and like that.
 Wants are unlimited and are continuously expanding and changing. If one want is
satisfied, a new want will emerge.
 Individuals desire better food, luxurious housing, better working conditions, etc. Firms
want more profits and expansion of business. Society may want improved
infrastructure, low inflation, high economic growth, and better living standards.
 Wants can evolve with our age, our experiences, our environment and social circle, and
through our observation. Every individual has a scale of preference that determines his
needs and wants. This scale of preference depends on an individual’s culture, his
upbringing, and his life experiences.
 Wants are also sometimes called luxuries. A luxury for one individual may be considered
a need for another.
 Some wants expand as we grow up, marry and raise a family.
2.3 Scarcity and Choice
SCARCITY is the fundamental economic problem of having seemingly unlimited wants in a
world of limited resources so that all wants cannot be satisfied. Economy and the decision
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makers hence have to make a choice. CHOICE underpins the concept that resources are scarce
so choices have to be made by consumers, firms and government. Society has to make
following choices:
 What should be produced?
 How it should be produced?
 For whom it should be produced?
Whenever a decision maker faces shortage and makes a choice it gives rise to opportunity cost.
2.4 Opportunity cost
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OPPORTUNITY COST is defined as the benefit foregone on the next best alternative.
Opportunity cost only arises on scarce resources such as land, machines, building and labour.
Abundant resources such as sunlight and sea water do not lead to a problem of scarcity and
have no opportunity costs. All decision makers in the economy will have to face opportunity
costs. Some of the examples are given below.
 Consumers have limited income and cannot purchase all the goods that they want. If a
consumer decides to buy a TV, then, that consumer is foregoing the benefits that he
could have received if he had purchased another good such as a washing machine.
o Similarly, if consumer decides to spend his income, his opportunity cost will be
the interest lost on savings.
 Firms have limited income and finance and cannot produce all products that are
demanded. If the firm decided to produce product A, then, the profit they could have
earned from producing product B is the opportunity cost of producing A.
 Governments have limited tax revenues and cannot spend on all activities required in an
economy. If they spend money on defence, then, they are foregoing the benefits they
could have received from investing in health and education.
o Similarly, if government decides to increase its expenditure by taxing the
population, the opportunity cost will be fall in consumption and in savings
resulting from lower disposable income.
 Workers have limited time available to them but find many job opportunities. When a
worker decides to work in a certain occupation, then, the salary lost from working in
another occupation is his opportunity cost.
o Similarly, when workers decide to spend more time on work, the opportunity
cost is the time they could have spent on leisure activities.
 Others such as charities and international organizations face similar problems.
 Opportunity cost is even present between the choice of present and future. If a society
decides to spend on capital goods, the opportunity cost is fewer consumer goods that
reduce short term living standards.
Opportunity cost thus represents the true cost of taking a decision and economists include the
opportunity cost in cost of taking a decision. NOTE: Scarcity can be shown as the area outside
PPC. Opportunity cost can be explained using PPC and a movement on the curve.
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2.5 Economic goods and Free goods
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ECONOMIC GOODS are those goods which have a cost in terms of the real resources used.
These goods are scarce and give rise to opportunity cost.
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FREE GOODS are those goods that do not require any factor of production to be produced.
 There is no price for free goods.
 There are very few examples of free goods, including air, wild berries etc.
 As the population of planet has increased, the number of free goods has decreased.
 Free goods have no opportunity cost.
2.6 Economic questions
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The problem of scarcity leads to choice that means an economy has to decide: i) what to
produce?; ii) how to produce it?; and iii) from whom to produce?
(i) What to produce?
Since an economy cannot produce all the goods and services that it wants because of scarce
resource, it will have to decide what should be produced. The economy generally would like to
produce those goods and services that maximize satisfaction and economic welfare.
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Free markets make this decision based on price mechanism, i.e. the interaction of demand and
supply forces. Prices give signals in the market. A higher price indicates a higher demand and
firms produce those goods and services whereas a lower price leads to lower production of the
good.
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Planned economies take the decision based on social benefits and social costs. The decision is
taken by a central planning authority and tries to maximize social welfare.
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(ii) How to produce?
Resources available to an economy are scarce in relation to unlimited wants. The economy
therefore has to decide how best to use its resources to maximize the outcome. Economies
have many different production methods to choose from. They can use labour-intensive or
capital-intensive techniques. Free markets base the decision using demand and supply forces.
Other things remaining same, an economy will use the production method which uses more of
its abundant resource and less of its scarce resource. In planned economies this decision is also
taken by a central planning authority.
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It must be noted that this question must not be addressed on purely economic terms. We also
need to consider other issues when deciding this question. For instance, use of slavery or forced
labour can increase production in an economy but there is a moral objection to this
arrangement. Use of GM crops can improve agricultural yields but can lead to damage of
ecosystem.
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(iii) For whom to produce?
The question here is that how many of each person’s wants are to be satisfied. There are many
groups in the economy such as rich and poor; young and old; urban and rural and like that and
each group has unique demand so that an economy cannot satisfy all the wants of all the
groups. Decisions have to be taken concerning how many of each person’s wants are to be
satisfied.
 Whether everyone is going to have a more or less equal share of what is produced?
 Whether some will have more than others?
In free markets this decision is taken through the price mechanism where demand and supply
of each group will result in change in prices. Firms produce those goods where prices are higher
and they can make more profits. In planned economies this decision is taken by the central
authority that judges what is best for the economy.
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Some economies deliberately attempt to create a more equal distribution of wealth and
income. This can be done by taxing the rich and paying benefits to the poor. In other
economies, no such attempts to redistribute income and wealth are made. In answering this
question, more aspects of decision making are again important.
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3 Production possibility curve
3.1 Shape of PPC
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PRODUCTION POSSIBLITY CURVE (PPC) shows the maximum combination of goods and
services that an economy is capable of producing by fully and efficiently utilizing its given
resources and the state of technology.
 The production possibility in an economy is limited by the resources available and state
of technological knowledge. However, they may change over time leading to changes in
PPC.
Shape of PPC depends on whether we assume constant opportunity costs or increasing
opportunity costs.
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Constant opportunity costs and Linear PPC
If we assume that opportunity cost remains same,
then the shape of PPC will be linear (downward
sloping). This is not very realistic and assumes
that resources are perfectly mobile for both
goods.
FACTOR MOBILITY refers to ease by which factors
of production can be moved around. If factors can
be easily moved around different industries or
regions, they are called mobile. If it is difficult to move factors around different regions or
industries, they are called immobile.
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Increasing opportunity costs and Concave PPC
Since resources are not perfectly mobile, i.e. resources are specialized in their nature and
cannot be equally efficient in production of all goods, it is more realistic to assume that
opportunity costs rise as resources are shifted from production of one good to another. This
results in a concave shape of PPC that slopes downwards.
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For example, assume that an economy produces
two types of goods – agricultural goods and
manufacturing goods. As the economy moves
from point A to point B, initially only the least
fertile land is reallocated to production of
manufacturing goods. This means that there is
very low loss of agricultural output (low
opportunity cost). As economy produces more
manufacturing goods, it will have to reallocate
more fertile land which will mean that the
decrease in agricultural production will increase leading to an increase in opportunity cost.
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The following table illustrates the production possibilities available to the economy with its
limited resources.
Explanation
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 At point A on the curve, economy produces only agricultural goods (‘om’) and no
manufacturing goods. The opportunity cost is therefore ‘ok’ of manufacturing goods.
 At point B on the curve, economy produces ‘on’ of agricultural goods and ‘og’ of
manufacturing goods. To produce ‘og’ manufacturing goods, the opportunity cost to the
economy is ‘mn’ of agricultural goods that is foregone.
 At point C on the curve, economy produces ‘oo’ of agricultural goods and ‘oh’ of
manufacturing goods. To increase production of manufacturing goods from g to h, the
loss in agricultural output is ‘no’ which is the opportunity cost.
 At point F on the curve, the economy only produces manufacturing goods and the
opportunity cost is ‘om’ of agricultural goods.
The table shows that the opportunity cost keeps on increasing as we move from point A on the
curve to point F.
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3.2 Analysing economic performance using PPC
PPC can show the maximum level of output that an economy can achieve with its existing
resources and the level of technical knowledge.
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Points inside PPC (e.g. point A) are achievable;
but are either inefficient; or there is
unemployment of scarce resources. To overcome
these problems, the economy should move
toward PPC by increasing aggregate demand (AD)
to increase employment; or promoting
competition to create efficiency.
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All points on PPC (e.g. point B) are achievable and
show full employment and productive efficiency of scarce resource. Economic efficiency
means that economy is maximizing its satisfaction with scarce resources, however, all wants
cannot be met because of scarcity of resources. Firms are producing goods at their lowest cost.
Movement on the PPC shows the opportunity cost. PPC is hence called product transformation
curve. This helps an economy take a decision about how to allocate resources, i.e. which
combination of goods and services should be produced.
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PPC shows the boundary between what can and cannot be produced. Hence it is also called
production possibility frontier. All points on or inside PPC are achievable, and all points above
PPC are not achievable.
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Points outside PPC (e.g. point C) show scarcity. These are not achievable with current resources
or state of technology. Economy can achieve points above PPC by increasing quantity or quality
of its factors of production, improving the state of technology, reallocating resources from
consumer goods to capital goods or engaging in free trade.
Shifts in PPC shows economic growth.
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PPC helps policy-makers to realize that resources need to be shifted from one use to another.
This is called reallocation of resources. REALLOCATION OF RESOURCES refers to deliberate
movement of resources from production of one product to another. Economy has to incur
substantial training costs to reallocate resources from production of one product to the
production of another product. Training is required to provide skills to workers that are
required to produce different types of goods and services.
3.3 Shifts in PPC
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Explaining Microeconomic and Macroeconomic concepts on PPC
Microeconomic concepts that can be explained = Scarcity and Opportunity cost
Macroeconomic concepts that can be explained = Unemployment and Economic growth
Shifts in PPC take place due to a change in quantity or quality of factors of production, a change
in the state of technology, and allowing free trade.
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Economic growth
ECONOMIC GROWTH refers to an increase in the productive potential of the economy and is
shown as a shift outwards of the PPC. It takes place due to increase in quantity of factors of
production, improvement in quality of factors of production, an improvement in technology,
and a reallocation of resources toward producing more capital goods.
 Increase in quantity of resources means that economy will be able to produce more
goods and services leading to an outside
shift in PPC.
 Improvement in quality of resources or in
the state of technology improves
productivity of the factors of production.
PRODUCTIVITY measures the ratio of
output to input and can be measured by
labour productivity or capital productivity.
An increase in productivity means that
economy can produce more goods with
the same resources.
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3 – Production possibility curve
If the change in resources or improvement
in technology is likely to affect just one
good, then, PPC will pivot outward as
shown in the figure below. For example an
improvement in agricultural technology
that is not applicable to manufacturing
products leads to a pivot in the curve.
Maximum
amount
of
agricultural
production has increased but the
maximum amount of manufacturing
production remains the same.
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Exact impact on the shift in PPC depends on how the changes are likely to affect the two goods
under consideration.
 If the change in resources or improvement in technology is likely to affect both goods in
PPC, then, PPC will shift outward parallely as shown in the figure above.
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Apart from maximum production level of manufacturing (which does not change), at all
other levels of agricultural production, manufacturing has increased as shown in the
figure. With the same agricultural production A1, manufacturing production increases
from M1 to M2. This happens because increase in agricultural productivity means that
fewer resources will be required in agriculture. These additional resources can be
shifted to production of manufacturing products thus increasing their production.
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An improvement in quality of agricultural production can also lead to increase in
manufacturing production. Agriculture is an input (raw material) for manufacturing. An
improvement in quality of raw material can lead to increase in efficiency of
manufacturing industry leading to an increase in its maximum output.
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Inward shift in PPC
It takes place due to fall in quantity of factors of production, deterioration in quality of factors
of production, and negative net investments.
 Fall in quantity of resources means that
economy will be able to produce fewer
goods and services leading to an inside
shift in PPC.
 Deterioration in quality of resources
reduces productivity of the factors of
production meaning that economy can
produce fewer goods with the same
resources.
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3 – Production possibility curve
If the change in resources affects just one good, then, PPC will pivot inward.
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Exact impact on the shift in PPC depends on how the changes are likely to affect the two goods
under consideration.
 If the change in resources is likely to affect both goods in PPC, then, PPC will shift inward
parallely as shown in the figure above.
Combination of two factors
Each factor has to be considered in isolation and then an overall impact needs to be considered.
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An increase in one resource and a decrease in another resource
Increase in resource shifts PPC outward. Decrease in another resource shifts it inward. Exact
effect cannot be predicted. It depends on the strength of each impact. If the impact of increase
in a resource is greater than the impact of a fall in
resource, PPC will shift outward and vice versa.
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Increase in agricultural productivity and a fall in
manufacturing productivity
Increase in agricultural productivity means that
there is an increase in maximum agricultural
production. A fall in manufacturing productivity
means that there will be a fall in maximum
manufacturing production. The net impact is
shown in the figure.
3.4 Capital goods or consumer goods
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One choice facing an economy is how much to spend on consumer goods and on capital goods.
The impact is elaborated in following points:
 Spending on consumer goods mean that individuals will be able to enjoy a higher
standard of living in the short run. However, this means less investment in capital goods
which may lead to fewer goods consumed
in the future.
 Spending on capital goods increases the
capital stock of the economy that leads to
increase in productive capacity of the
economy. The exact impact on the
economy depends on the size of
investment and capital consumption.
CAPITAL CONSUMPTION is a term used to
describe the amount of capital that is used up
(worn out) during the process of production. This
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3 – Production possibility curve
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is also called depreciation and is assumed to be area ‘oa’ in the figure.
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INVESTMENT is the creation of capital goods in the process of production and can also be
defined as any production that is not for current consumption. GROSS INVESTMENT is the total
quantity of capital goods produced in the economy. NET INVESTMENT is gross investment
minus capital consumption.
𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐺𝑟𝑜𝑠𝑠 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
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If investment is greater than capital consumption (positive net investment), there will be an
increase in capital stock of the economy leading to an outward shift in PPC. Investment in
capital stock will mean that fewer consumer goods are manufactured leading to a decrease in
living standards in SR. However, this leads to outward shift in PPC which means more goods can
be consumed in the future leading to increase in living standards in LR. Therefore, there is
trade-off and the economy has to decide the optimal level of investment.
If investment is equal to capital consumption, it will just maintain the capital stock in the
economy and this is the minimum investment required to maintain productive capacity and
PPC.
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If investment is less than capital consumption (negative net investment), it will mean that the
capital stock in the economy will fall over time. Individuals will be able to enjoy a higher living
standard in the SR but there will be a fall in living standard over time as PPC shifts inward. Less
investment will also mean that quality of an economy’s capital goods remains underdeveloped
and full benefit of technology will not be enjoyed.
3.5 Choices for developing economies (very poor developing economies)
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DEVELOPING COUNTRY is characterized by low standards of living. These countries need to
grow capital stock if they want to grow and improve their living standards. However, these
countries have very few resources that are hardly sufficient to maintain SUBSISTENCE LEVEL OF
CONSUMPTION, i.e. the level of consumption that is needed to keep the population alive.
 Problem of these developing countries is
that almost all of their resources are
devoted to subsistence.
 They are not even able to invest equal to
capital consumption resulting in an
inward shift in PPC in the LR leading to
food shortages in LR.
 If they divert resources to production of
capital equipment, it will reduce
production of consumer goods leading to
problem of survival again but in the SR.
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3 – Production possibility curve
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The figure explains this concept. If gross investment is equal to oa (capital consumption), there
would be problem of subsistence. If gross investment is less than oa, it will be difficult to
sustain current levels of consumption.
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Solution to this problem is that economies can try to attract foreign direct investment, aid or
foreign debt.
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These will enable economies to increase their capital stock without having to divert their own
limited resources away from consumption. However, it can result in following problems:
 Foreign debt will increase indebtedness and this will mean that these economies will
have to pay a higher proportion of their income in debt payments. If foreign debt is
invested in inefficient projects (which commonly happens in less developed countries)
this will mean that there will be an additional burden on the economy.
 Foreign direct investment will add to capital stock and improve economy’s balance of
payment. However, foreign firms will take away profits back to their countries in the
future and may also exploit workers and environment.
 Aid is not so forthcoming and is usually insufficient.
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Developed economies therefore face a major challenge in terms of resource allocation.
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4 – Money
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4 Money
4.1 Characteristics of money
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MONEY is anything that is generally accepted as a means of payment. It includes national
currency such as dollars (US), pounds (UK), euros (EU) and rupees (Pakistan). Apart from notes
and coins, it also includes cheques, credit cards and debit cards. Coins or notes themselves have
little intrinsic value. Their value comes from the fact that sellers have complete confidence in
money and are willing to exchange goods and services in return for money. Money can also be
in the form of a valuable commodity such as gold or platinum.
 NEAR MONEY are non-cash assets that can be quickly turned into cash such as
government securities, foreign currencies, savings accounts, and certificates of deposits.
These assets contribute to the liquidity of the banks by providing a supply of cash if this
is needed to meet liabilities to depositors. LIQUIDITY is the extent to which there is an
adequate supply of assets that can be turned into cash. LIABILITIES are debt obligations.
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It must be noted that money does not need to have an intrinsic value, i.e. coins and money may
have no or little value of themselves. Value of money comes from the confidence of buyers and
sellers on money and its ability to be used for exchange of goods and services. For something to
be characterized as money, it must have following characteristics.
 It must be DURABLE, i.e. it must retain the same shape, form, and substance over an
extended period of time. Durability also includes social and institutional durability.
o It must not easily decompose, deteriorate, degrade, or otherwise change form.
o Durability is critical to money to perform function of medium of exchange and
store of value. People are willing to accept an item in payment for a good if they
have confidence that the item can be traded at a later time for some other good.
An item works as a medium of exchange because it stores value from one
transaction to the next.
o Refined materials such as gold, silver, copper or nickel have historically been
used as money because they are extremely durable.
o Organic products such as lettuce, ice cream or raw meat are not used as money
because they are perishable.
o Social and institutional durability is important for modern economies. Durability
of modern money, e.g. paper currency and bank accounts, depends on the
durability of social institutions such as banks and government. Ability of paper
currency to act as money depends on the institutional stability of the
government.
 It must be DIVISIBLE, i.e. it can be divided into smaller denominations that can be used
in exchange for goods of varying values.
o For an item to function as medium of exchange, it must be divisible so that it can
be used to purchase a wide range of different goods such as cars and bubble
gums.
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o Metals (gold, silver etc.) have been widely used as money because they can be
divided into smaller units.
o Livestock on the other hand has limited use as money as it cannot be easily
divided into such small denominations to buy sweets.
o Paper currency and bank account balances are easily divisible to match the value
of every good and service in the economy. For example, $1 can be converted
into 100 cents.
It must be PORTABLE, i.e. it can be easily moved from location to another location to
complete exchanges. If it is difficult to carry money, then, trade will become difficult.
o Metals can be easily transported and have historically been used as money.
However, paper currency replaced metals because it was lighter and easier to
carry.
o Items that are physically heavy relative to their value in exchange are not easily
portable. These may include things like maple syrup, economics textbook and a
radio.
It CANNOT EASILY BE COPIED.
o An item will lose its function of medium of exchange if it can easily be copied
and is available to everyone. It will lose its value if it is easily copied.
o Government prevents unrestricted duplication of money. Government controls
the total amount of money in circulation. Paper money can only be printed by
the central bank and hence holds its value. Counterfeits threaten this
characteristic but government takes steps such as redesigning paper currency,
adding water marks, microscopic printing, and magnetic strips to make
counterfeiting difficult.
It must be ACCEPTABLE to both buyers and sellers. Unless money is acceptable trade
will not take place and the buyers and sellers will have to resort to barter trade. This will
make trade slower, time consuming and cumbersome.
It must be RECONGNIZABLE, i.e. people can easily see the item.
It must be UNIFORM, i.e. all versions of the same denomination of money must have
same purchasing power. For example, a $1 bill printed in 1998 would still be able to buy
goods worth $1.
It must be SCARCE, i.e. it is in limited quantity. If it is easily available, it will lose its value.
There must be STABILITY IN VALUE of money, i.e. it must retain its value. One of the
most serious defects of modern money is that it may be affected by inflation.
4.2 Functions of money
HA
From economists’ point of view, money has four necessary functions:
 Medium of exchange
 Unit of account
 Store of value
 Standard of deferred payment
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4 – Money
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(i) Medium of exchange
Money is a medium that buyers use for purchases and that sellers are willing to accept in
exchange for purchases. For example, notes can be used to purchase a bottle of Pepsi.
 The essential characteristic for anything to act as a medium of exchange is scarcity.
Money must also be durable and acceptable to sellers. Otherwise, they will have to
resort to barter trade. It should be portable and divisible, otherwise it will be difficult to
carry money or to buy goods of lower denomination.
 This function of money removes the need for double coincidence of wants and
therefore facilitates trade.
 It also separates the transactions in time and place because sellers and buyers of a
commodity are not required to perform the transactions at the same time and place.
 It gives freedom of choice as consumers can buy a bundle of goods and services. It
increases competition and widens the market.
 It facilitates exchange and helps improve economic efficiency by allowing specialization
and division of labour.
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(ii) Unit of account
Money is used as a unit by which prices are established in dollars and cents. This function
applies to both current and projected transactions.
 Money can be used to price goods and services, e.g. a bottle of mineral water. It
eliminates the need of quoting the price of goods in terms of other goods as in barter,
e.g. quoting price of sweets in terms of chocolates.
 Money can be used to put establish exchange rates, e.g. $1.5/£1.
 It is also a means of establishing relationship between various units of a currency, e.g.
$1 is equal to 100 cents.
 This function facilitates accounting. Value of money can be recorded and summed, e.g.
accounting transactions are recorded in monetary values.
 The function is also relevant for future transactions, for instance when money is
borrowed, the lender can add interest payment to tell the borrower how much he will
have to pay in the future.
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(iii) Store of value/wealth
Money can be held or stored for a period of time before it is used. It can be accumulated to
provide a source of wealth.
 To act as a unit of account, the good chosen must be something that is durable and can
be easily stored. Also the holder of asset must have confidence that the asset will retain
its value over time.
 Money as a store of value is used to meet unforeseen emergencies and to pay debts.
 Individuals’ wealth can be stored in a range of assets and not just money. Other assets
in which wealth can be stored can include bonds, houses, land, diamonds, gold and like
that. The benefits of these assets can be that they generate income, and that their value
may rise in terms of money. However, they have drawbacks such as high storage costs,
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depreciation in some of these assets, and illiquidity of some of these assets so that they
cannot easily be converted into money.
Money is one way of storing wealth. For example, coins and notes, bank deposits,
bonds, stocks and other forms of holding money can be used as the basis for storage
over time. Their advantage is security, convenience and liquidity. However, the
drawback is that value of money may fall due to inflation.
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(iv) Standard for deferred payment
Payments to be made in the future can be denominated in money terms in just the same way
as can a payment to be made today. Money is acting as a unit of account here with an added
dimension of time. If money can perform all of the first three functions, it will also act as a
standard of deferred payment. And a failure in above functions can lead to a failure in the
function as a standard of deferred payment.
 Money has simplified both the taking and repayment of loans unlike in barter where the
repayment of loan that was taken in shape of a horse or a commodity was difficult.
 It simplifies credit transactions that allows credit to be introduced in the economy.
Money facilitates borrowing by consumers to buy houses and like that, and by firms to
invest. It helps in selling of shares and debentures that can used to buy capital leading to
shifts in PPC.
 If value of money increases over time (such as in deflation), the creditors gain and
debtors lose. If value of money fall over time (such as in inflation), the borrowers gain
and debtors lose. The uncertainty over fall in rise in value of currency can be overcome
by linking the value of debt to a price index which measure inflation. Such index-linked
contracts help protect the purchasing power of money.
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Inflation and the functions of money
Inflation is the general and sustained increase in price levels over time. Inflation adversely
affects the functions of money. However, the affect depends on the severity of the rate of
inflation.
 Low rates of inflation will not have a major impact on the medium of exchange. It is
only when there is hyperinflation that people start losing confidence in money and may
resort to barter. However, even in hyperinflation such as in Zimbabwe, money was still
used.
 The unit of account is affected by inflation as it become more difficult to compare
values over time. A nominal rise in GDP can be due to a rise in output levels or a rise in
price levels. To find the real change in GDP, we need to make adjustments to nominal
figures.
 Inflation also affects the store of value function. Fall in value of money due to inflation
should discourage savings as these would be devalued. People may try to find
alternative means of storing their wealth such as gold, foreign currency, land and indexlinked financial assets. This is especially true when the real rates of interest (interest less
rate of inflation) becomes negative. However, some studies show that inflation may
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4 – Money
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actually result in a rise in savings as people believed they would need higher real
reserves in the future.
Inflation also affects the standard of deferred payment function. Businesses may be
unwilling to give credit over long periods of time if they fear a decline in value of money.
However, people will be more willing to borrow money as the real value of debt falls
due to inflation.
Inflation may also affect demand for currency. High rates of inflation will make the
currency less acceptable internationally causing a fall in its demand and a fall in its
value.
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Conclusion
It is important that money performs its functions for smooth working of all economies. If any of
the functions breaks down, people will lose confidence in money leading to economic collapse.
Government economic policies therefore try to ensure that functions of money do not break
down. Otherwise it may lead to collapse of the economic system.
4.3 Barter
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In the absence of money, transactions take place by use of barter. BARTER is the direct
exchange of one good or service for another. For instance, a buyer may buy wheat by giving
cows in return.
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Drawbacks of barter
Barter has several drawbacks that are listed below.
 There must be double coincidence of wants. Both buyers and sellers must have the need
for the goods and services that they want to exchange. In the absence of double
coincidence of wants, trade will not take place. Therefore, the goods must be
acceptable to both parties otherwise trade will not take place.
 Goods that are being used in barter may not be portable hence it will be difficult to
carry them resulting in reduction in trade and economic activity.
 Some of the goods (e.g. car) may not be divisible and hence will not be able to buy
goods of lower denomination.
 There is a lack of a common unit of value making trade difficult as it difficult to find what
the market price for exchanging goods is.
 Future payments or contractual payments would be very difficult to make under barter
system.
 Storing goods will be difficult as some goods may not be durable (e.g. ice), and for
others individuals will incur heavy storage costs and their value may also decline over
time.
 Perishable goods will need to be traded quickly otherwise they will lose their value and
rot.
 Barter trade is therefore slow, cumbersome, time consuming and very impractical.
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Barter also forces individuals to become self-sufficient. This means that there is lack of
specialization and hence results in lack of productivity and efficiency.
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Benefits of money
If buyers and sellers have complete confidence in money, then, it will have following benefits.
 It will facilitate trade because there is no need for double coincidence of wants.
 Individuals, firms and nations can specialize in producing certain goods and services
because trade is now easy.
 This leads to improvement in productivity levels, higher output, and lower cost of
production.
 Higher output levels leads to higher employment levels, higher income levels and better
living standards.
 Money also facilitates international trade and the economies get subsequent benefits of
trade.
 Money can be used for making future payments therefore credit can be easily
introduced in the economy that leads to higher demand, higher output and more
employment opportunities.
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Drawbacks of money
However, money has its drawbacks too.
 The major drawback of money is the potential inflation that may result if government
prints too much money. High inflation levels may result in a loss of confidence in money
leading to a failure of the system.
 Another major problem with money is counterfeiting. Government needs to take steps
against counterfeit notes and introduce measures that restrict counterfeiting. In the
absence of such steps, value of money will fall and people will lose confidence in money.
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It can therefore be concluded that introduction of money in a barter economy will facilitate
trade, improve efficiency and increase international trade. This leads to improvement in living
standards as well.
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5 – Specialization and Division of labour
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5 Specialization and Division of Labour
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LABOUR refers to people in the working age who are both willing and able to work. LABOUR
FORCE is defined as the total number of workers who are available for work. Labour force
refers to both employed and unemployed and includes all males and females who can
contribute to production of goods and services (normally aged 16 years and above).
5.1 Specialization
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SPECIALIZATION is the process by which individuals, firms and economies concentrate on
producing those goods and services where they have an advantage over others.
 Specialization allows individuals, firms and nations to become more efficient by
concentrating on a particular activity. This leads to surpluses that are sold to others to
earn money.
 No one is self-sufficient as people, firms and economies concentrate on producing a
limited range of goods and services. It therefore becomes necessary to exchange or
trade goods and services. Money earned from trade is used to buy the goods and
services that they need and which are produced by other people. Money is therefore
essential for specialization and trade to take place.
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Different levels of specialization
 Specialization by occupation where individual people acquire particular skills and
concentrate on these (e.g. teachers and doctors specialize in their occupations). This
allows them to concentrate on jobs for which they are most suited.
 Specialization in the workplace – division of labour
 Specialization by firms where firms and factories may specialize in particular products.
One firm may specialize in one industry, e.g. food, and another firm in another industry,
e.g. automobiles. Within one company, individual factories may produce particular
components which are then assembled at another factory.
 Specialization by region where a particular region in a country specializes in the
production of certain types of goods or services. For example, Sialkot in Pakistan is
famous for its sports industry. Multan in Pakistan concentrates on agricultural
production, especially of mangoes and cotton.
 Specialization by country where countries focus on producing those goods and services
in which they have a comparative advantage. This depends on the factor endowment,
e.g. Saudia Arabia has abundant oil reserves and therefore specialize in oil; Pakistan has
abundant arable land with suitable climate for agriculture and therefore specializes in
agriculture and agri-based industries.
Benefits of specialization
 At an individual level, the benefit is that individual can specialize in one task that
improves his efficiency.
 At a firm level, the benefit is that firms can practice division of labour and can get the
associated benefits as discussed below.
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5 – Specialization and Division of labour
At regional and national level, the benefits of specialization are discussed in
international trade along with the theory of comparative advantage. Regional and
national specialization allows rise in world output and a rise in world living standards.
National specialization also allows trade to take place that results in outward shift in
PPC.
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Risks of specialization
 Specialization means that no one is self-sufficient. Therefore it increase the interdependence of people and nations on each other. This is especially risky for nations if
political conflicts result in reduction in trade and national output giving rise to
unemployment.
 At an individual level, the risk is that the specialist skills of an individual may become
redundant to changing technologies. Individuals therefore need to be flexible and multiskilled and to be able to move between occupations if they want to successfully counter
the rapid pace of technological change.
 At regional and national level, the risk is of over-specialization, where a change in
consumer tastes can mean that the goods and services produced by a region or country
are no longer demanded in the same quantity. This results in a loss of output and GDP, a
rise in unemployment, a fall in living standards, a fall in balance of payments, and a fall
in exchange rate of the country’s currency.
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Specialization depends on following factors
 People’s ability to exchange what they make for what they need using money as a
medium of exchange.
 The extent of the market – If a market is very large then mass production can take place
and division of labour can be introduced. On the other hand, niche markets serve a
small market and do not allow division of labour to take place.
 Need good transport facilities for the distribution of goods – Developments in air and
sea transport have made it possible to distribute goods in an international market.
5.2 Division of labour
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DIVISION OF LABOUR refers to specialization by individuals where production process is
divided into small tasks and one worker is specialized to perform one task only. Adam Smith, in
his famous book ‘The Wealth of Nations’, described how division of labour amongst pin workers
increased their productivity levels manifold.
 Firms break up the production process into a number of smaller tasks.
 The product is made on an assembly line and the product moves rather than the
workers.
 Each worker performs a particular task and the finished article at the end of the
assembly line is the combined effort of many workers.
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5 – Specialization and Division of labour
This leads to more training for workers making them more productive; to less
movement of workers hence saving time; to use of more tools and machines that
improve productivity of workers and like that.
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Benefits of division of labour
 Specialization enables workers to gain skills in a narrow range of tasks thus making
workers more productive.
 Division of labour makes it cost-effective to provide workers with specialist tools that
can be shared by the workers and improve their productivity.
 It enables the greater use of machinery, technology and the use of robotics.
 It reduces the need for labour leading to lower variable costs.
 Time is saved because a worker is not constantly changing tasks, moving around from
place to place and using different machinery and tools.
 Workers can specialize in those tasks to which they are best suited.
 It leads to deskilling (tasks are often simple that need lower skills) and therefore firms
can pay lower wages.
 It allows manufacturer to take advantage of economies of scale.
 Higher productivity leads to lower cost of production that makes a firm’s output more
competitive and firm can also lower prices.
 Without specialization, economies and workers will need to become self-sufficient in
order to survive. This limits their choice and deteriorates standard of living.
 It increases overall productivity in the economy resulting in an outward shift in the PPC.
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Limitations
 Work can become tedious and monotonous leading to boredom, mistakes, industrial
unrest, loss of output and poor quality.
 It requires deskilling that again makes work less interesting leading to demotivation.
 As size of factories become larger, workers become distant from managers leading to
demotivation and less control.
 There is greater unemployment as it is a capital-intensive process.
 Size of market sets limit on division of labour. Firms in small markets may not be able to
specialize and instead produce a variety of goods to satisfy the market.
 Over-specialization can be dangerous if the demand for the product starts to fall. This
will lead to higher unemployment in the area.
 Production processes in division of labour are closely linked with one another. A
breakdown in part of the chain of production can halt the production process. For
instance, 18 Toyota production plants in Japan were brought to a halt for two weeks in
1997 when the factory of the sole supplier of brake parts to Toyota in Japan was
destroyed in a fire.
 Specialization will need exchange which efficiently takes place only in the presence of
money.
 Division of labour leads to standardized products and a lack of variety because each
product has passed through exactly the same process.
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5 – Specialization and Division of labour
There is a greater risk of unemployment if demand for some goods decline. The
unemployed workers will find it difficult to find jobs in other industries due to lack of
skills.
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Conditions for division of labour
Division of labour is most suitable in following conditions:
 Production is in very large quantities (mass production) such as in the case of consumer
durables like cars, televisions etc.
 There is standardization of goods where all products are alike or where parts are made
that can be used in several different products.
 There must be a medium of exchange such as money otherwise specialization will mean
that workers will have surpluses that they cannot sell, such as a baker will have a lot of
bread that he finds difficult to sell.
 There must also be good transport facilities that aid in transportation of goods from one
region to another.
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6 Economic systems (different allocative mechanisms)
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6 – Economic systems
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Basic economic problem
The basic economic problem is that of scarcity which stems from the fact that an economy has
limited resources and unlimited wants. This means that all of the wants cannot be satisfied
which leads to the problem of scarcity.
 Scarcity can also be shown on the production possibility curve (PPC). The boundary of
PPC shows the opportunity cost of producing products. At any one point, an economy
cannot produce more of both goods if it operating on PPC. All of the area above PPC
hence represents scarcity in the economy.
 Scarcity means that the economy has to make choices and the governments have to ask
themselves following questions – what is produced, how they are produced, and for
whom are the goods produced. The answers to these questions depend on what
economic system a government decides to operate.
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ECONOMIC SYSTEM can hence be described as the means or the allocative mechanism by
which its people, businesses and government make choices. Within an economic system there
will be various actors including:
 Individuals – They are consumers and producers. They may own factors of production
that they supply for production purposes.
 Groups – Firms, trade unions, political parties, families and charities.
 Government – Government might range from local authority to a national or
international parliament. It establishes and influences the relationships between groups,
for instance, through the passing of the law.
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Economists have recognized three distinct types of economic systems.
 Market economy
 Command or planned economy
 Mixed economy
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6.1 The market economy (free market economy/capitalism/Laissez-Faire
system)
HA
FREE MARKET is an economic system in which resource allocation decisions are taken by
households and firms through the use of price mechanism with no or minimal interference
from the government.
 In a purely free market economy, there is no government intervention. However, in
reality governments have some intervention to check the operations of the market and
to ensure availability of essential goods and services such as defence.
 This is not a very realistic model and there are very few, if any, examples of market
economy that could be found. The closest economy to a free market will be that of USA
and Hong Kong.
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Characteristics of a market economy
Following are some of the key characteristics of a market economy.
 Ownership: Nearly all of the country's factors of production are owned privately by
individuals or groups of individuals. They then rent them out to the firms so that they
can produce the goods and services. Government has a very limited role such as
upholding property rights of these private individuals through the legal system.
 Objectives: Everyone in this system is motivated by pure self-interest. Consumers
maximize their welfare. Firms maximize profits. Private individuals, who own the factors
of production, aim to maximize rents, wages, interest and profit.
 Free enterprise: There is freedom of choice in both production and consumption. Firms
can sell anything they want and try to respond effectively to consumer demand.
Consumers are allowed to buy anything that is sold by the producers. Workers can take
on any job they want.
 The level of competition: The level of competition is expected to be very high. It is
assumed that nearly every market is a perfectly competitive one, with numerous buyers
and sellers and no barriers to entry or exit. Firms are competing desperately for
customers and the consumers are competing with each other for the goods on offer.
 Allocative mechanism is the price mechanism: MARKET MECHANISM is the process
where decisions on price and quantity are made on the basis of demand and supply
alone. Price mechanism allocates the economy's resources through free interplay of
demand and supply forces. Price acts as a signal and an incentive for producers to act in
the required way so as to maximize their gain, which, in turn, optimizes the allocation of
resources in the whole economy. Higher prices indicate higher demand levels or
shortages and producers shift resources to produce such goods. Lower prices indicate
lower demand levels or excess supply and producers shift resources to other goods.
 Decentralized decision making. There is no single body which allocates resources within
the economy. Allocation of resources is the result of countless decisions by individual
economic agents. This is as advocated by Adam Smith when he referred to an invisible
hand (self-interest) that results in socially desirable allocation of resources.
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Answering the three economic questions
What is produced?
In a free market, consumers, producers and the owners of the factors of production interact
with each other to allocate economy’s scarce resources. Everyone is motivated by pure selfinterest. Consumers are trying to maximize their utility; firms are trying to maximize profits;
and owners of factors of production are trying to maximize their returns.
HA
Price mechanism decides what is produced. There is consumer sovereignty. A firm will only
produce a good if the consumer is willing to buy it. Therefore, it is the consumers who dictate
what should be produced. And the consumer willingness is represented in the form of price
mechanism. Question of morality does not come into play in this system. If consumers want
more coffee, this will shift the demand curve for coffee to the right leading to a rise in prices.
This signals to producers to produce more coffee. This will also affect the factor market. Higher
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demand for coffee results in shortage of coffee workers leading to a rise in their wages. These
higher wages attract more workers from other sectors of the economy into coffee production.
Thus, there is an increase in resources used in the production of that good where demand has
increased.
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How it is produced?
The firms will select that method of production which reduces their cost of production and
maximizes profits. Competing firms will try to put technical and economic efficiency into
practice. Economic efficiency refers to the least cost of producing goods that are desired by the
consumers. Price mechanism and market forces play an important role in ideal mix of factors of
production. The costs of factors of production will depend on the availability of factors of
production. Abundant resource tends to be cheaper than the scarce resource. In countries
where labour is expensive and capital is cheap such as in developed countries like USA and
Japan, firms use more capital-intensive processes. In countries where capital is expensive and
labour is cheap such as in developing countries like Pakistan and Bangladesh, firms use more
labour-intensive methods.
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For whom is it produced?
Producers must ensure allocative efficiency in deciding ‘for whom to produce’. Consumer’s
‘money votes’ decide what is produced. Those with more money will be able to consume more
of the goods produced. The process is therefore biased in favour of those goods that are
demanded by the rich. Free market system tends to create an unfair distribution of income. The
wealthy consume a disproportionately large share of what is produced.
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Role of government in a free market economy
In a pure free market, government does not directly interfere with market forces. However, in
reality, government may have to intervene and maintain a limited presence. It may have
following roles to play.
 Government provides public goods that are not produced by private sector. These may
include defence, judiciary and the police force.
 Government raises money through taxes to pay for its expenditure.
 Government issues money and maintains its value.
 Government needs to ensure an adequate legal framework for the allocation and
enforcement of property rights. There also needs to be laws about contracts of
purchase and sale. It must be illegal to destroy other people’s property wilfully.
 Government must have powers to break up monopolies, prevent practices that restrict
free trade, and control the activities of trade union.
The government therefore has a strategic role to play in a market economy but it should
intervene as little as possible.
Advantages of a Free market economy
Free market economy offers following benefits.
 Efficiency. There are many incentives in the free market that promotes efficiency.
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Firms try to become more efficient because of higher competition and profit
motive. They try to reduce their costs to remain competitive and to increase
their profits. Firms will continuously look for improving their processes and
reduce waste to make their goods more competitive. This leads to efficiency in
the economy.
 Workers will try to become more efficient and productive as higher productivity
levels will usually be rewarded with higher salaries or bonuses.
Consumer sovereignty. Firms will produce those goods that are demanded by the
customers. It therefore makes consumers more powerful and they influence the
resource allocation decisions if their demand changes.
Choice. There is more competition in the market and firms will produce products that
are demanded by consumers. It therefore leads to a large choice of goods and services
that are produced in a free market. Workers also have more choice in terms of the
occupation in which they intend to work.
Innovation. High levels of competition and profit motive will force firms to become
innovative and introduce new products in the market. Government (with its limited
interference) protects the intellectual property rights of firms through patents. This
gives a further incentive to firms to introduce better quality products and earn more
profits.
Higher economic growth rates. Countries whose economic system has been nearer to
the free market model have grown much faster than those with a command economy.
Other benefits include the following:
 Higher production leading to rise in GDP, greater taxes, higher income levels, and
improved living standards.
 Lower unemployment results from greater economic activity.
 Lower poverty levels are a result of rising incomes and lower unemployment.
 More development can take place due to greater tax revenue generated by the
higher profits that governments can invest in building infrastructure.
 Lower prices can result due to higher competition and more efficiency resulting
in lower cost of production.
No shortages or surpluses: Price mechanism clears the market that results in no
shortages or surpluses.
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Disadvantages of a free market economy
Free market economy is not without its drawbacks. Following are the key drawbacks:
 Underprovision of public and merit goods, and goods with positive externalities.
o Public goods (e.g. defence and street lighting) cannot be provided privately
because of their twin characteristics of non-excludability and non-rivalry. This
leads to the problem of free riding and the private sector cannot produce these
goods. Government must therefore intervene to provide such goods.
o Merit goods, like health and education, tend to be under provided in a free
market because of lack of information.
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Overproduction of demerit goods and goods with negative externalities.
o Demerit goods, like cigarettes, tend to be overproduced in a free market due to
lack of information.
o Free markets ignore externalities and therefore produce more negative
externalities such as pollution.
Private sector monopolies. Free markets can sometime fail to provide sufficient
competition and lead to establishment of private sector monopolies that reduces
output, increases prices, and is less efficient and innovative.
Unequal distribution of income and wealth. Free markets can lead to unequal
distribution of income and wealth where a few individuals end up owning and earning
most of the wealth and income of an economy. This inequality tends to increase over
time as rich keep getting richer and poor keep getting poorer. This can lead to civil
unrest and may eventually lead to political upheavals.
Resource allocation in favour of the rich. Free markets work on the principle of
economic democracy where each dollar has one vote (unlike political democracy which
gives each person one vote). Since rich own more dollars, they also get more votes.
Therefore, an economy produces more of the goods that are demanded by the rich and
less of those goods that are demanded by the poor.
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Conclusion
Many economists consider free markets to be the most efficient system. In the long run,
assuming that there is competition in the market, free market must achieve efficiency that
results in best utilization of the limited factors of production. This should reduce the problem of
scarcity in the economy. However, since scarcity arises from lack of resources, even free
markets cannot overcome the problem. Economists generally consider this to be better than
other systems because of its efficiency. It must be kept in mind though that free markets may
also lead to market failure leading to government action to correct the failure.
6.2 Planned economy (Command economy, Communism, Socialism)
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In a COMMAND OR CENTRALLY PLANNED ECONOMY resource allocation decisions are taken
by the government by keeping in mind all (social) costs and benefits of a decision. The firms are
owned by the state and they do not operate for maximizing profits. Resources are allocated by
the government through a planning process. In a pure planned economy, every item is
allocated through rationing from education and health to clothes and food.
 Planned economies get their inspiration from the works of Karl Marx who criticized free
markets and predicted class conflicts between the wealthy and the poor. He also
criticized use of capital as it led to higher unemployment and reduced earning
opportunities for individuals. He also criticized the system as concentrating production
in the hands of large monopolistic industrial and commercial organizations. His
criticisms are found to be excessive by many economists. However, his prediction of
concentration of production systems has largely proved true.
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In a command economy, central government and other state bodies take responsibility
of the following:
o allocation of resources,
o determination of production targets for all sectors of the economy,
o distribution of income and determination of wages,
o ownership of most productive resources and property, and
o planning the long-term growth of the economy.
However, it is very difficult for all enterprise to be publicly owned. Therefore, there is a
limited opportunity for the private ownership of small businesses such as shops,
restaurants and personal services such as hairdressing and cleaning.
Planned economy is also an extreme of economic systems and is not found in its true
form today. Most of the economies are mixed today. The closest economy to a planned
economy is North Korea.
Democratic countries pursue similar but less extreme principles in the name of
socialism.
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Characteristics of a planned economy
 Ownership: Nearly all of the country's factors of production are owned publicly by the
government (or the state). The only factor over which the government does not have
total control is labour, but they certainly have indirect control over the workers.
 Free enterprise: There is no choice and the central authority directs and decides which
types of goods and services are produced. There is therefore producer sovereignty.
 Objectives: There is no profit motive and the state-owned enterprises work to provide a
benefit to the society. Consumers, workers and the government are all assumed to be
working for the 'common good', i.e. collective social welfare.
 The level of competition: There is very little competition as all the factors of production
are owned by the state. However, there may be a black market that develops as a result
of shortages. And there can be competition amongst the black market firms.
 Allocative mechanism: There is no price mechanism. The authorities set the prices. They
set prices at low levels to make sure that everyone can afford the goods. This however
may led to long queues or creation of a black market. Government will therefore use
some rationing mechanism such as setting quotas and rations for families and
individuals.
 The planning system: Government plans how all the resources should be used. They
decide what is produced and what quantities, how goods are made (how much labour is
used and which method of production is used) and how the goods are divided between
different groups in the economy. Government directly set the output levels and price
levels. Government considers all (social) costs and benefits when taking a decision and
therefore tries to minimize negative externalities such as pollution.
 There is equality of income and wealth. Income is very evenly distributed.
 Considers all (social) costs and benefits. Government considers all costs to the society
before taking a decision. This should lead to a socially optimal decision.
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Answering the three economic questions
What will be produced?
The planners (or the government) decide what will be produced. The problem is that the
planners may find it difficult to know what consumers want. This may lead to over- or underproduction of goods and services.
How will it be produced?
The planners direct the resources into producing 'units'. All firms are state-owned enterprises
and there is no free enterprise. Planners therefore decide the methods of production.
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For whom to produce?
The planner tries to be fair in distributing output of the economy. Wages are determined by the
planners. Prices of the goods are set by the planners. Government is, effectively, determining
how much each consumer can consume.
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Advantages of a command economy
Command economies have several advantages that are explained below.
 Produce public goods, merit goods and goods with positive externalities.
o Public goods have the twin characteristics of non-excludability and non-rivalry.
These are under-produced in a free market. Merit goods such as health and
education are also under-produced in a free market.
o Strong government will make sure that public and merit goods are consumed at
the right levels and are provided by the government.
 Equal distribution of income. Strong government will try to make sure that nobody falls
through the safety net. It will be a fairer economy, even though it is likely to be less
successful overall.
 Control over negative externalities and demerit goods. Government can ban demerit
goods. It can also try to use production methods that are environmentally superior. In
theory, they should have been able to monitor pollution levels closely, given that they
had control of production, but this simply did not happen. Command economies of the
80s had notoriously poor records on the environment.
 No duplication of effort and reduces wasteful expenditure. Since there is no
competition, a planned economy is able to avoid duplication of production. It also saves
on advertisement expenditure which is considered by many as a wasteful expenditure.
 Profits of the public enterprises are available to all citizens in the economy and hence
create more even distribution of income and wealth.
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Disadvantages
Apart from having advantages, planned economies have suffered a lot due to their
disadvantages. These are explained below.
 Inefficiency. Planners are less likely to make the correct decisions across the whole
economy on what is to be produced, how it is to be produced and for whom to produce
for. There are no profit motive hence there is no incentive to innovate and reduce costs.
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Equality in income creates a disincentive to work and hence workers tend to become
less productive. This leads to increase in production costs making local firms less
competitive internationally. It results in reduction in exports and a deterioration of the
balance of payments.
Less choice. The planner will be more concerned with making sure there are enough
essential goods to go around rather than allocating resources efficiently between all
goods. There will be fewer goods available to citizens hence reducing their choice.
Less innovation. There is no incentive for the planner to be innovative. As long as they
produce the essentials the planners will be happy.
Low economic growth rates. Since the Second World War, the command economies
have had the worst record in terms of economic growth.
Red-tapism, bureaucracy and slow decision making. Since all decisions are taken by
central planning authority, it slows down the decision making process and leads to
delays.
Producer sovereignty. State-owned enterprises and the central planning gain more
importance. Consumer demand is at times not considered. This leads to a reduction in
consumer power.
Shortage. Lack of a proper allocative mechanism and low prices lead to shortages in the
market even for the most essential goods. This leads to excessive queuing and
development of a black market for goods and services.
Poor quality. State production can be of poor quality as there is no incentive to innovate
and improve quality.
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Conclusion
Planned economies of Eastern Europe and USSR did not perform very well and fell well short of
the growth exhibited by free market economies of USA and Europe. This was largely due to the
inefficiency of the state-owned enterprises, corruption and red-tapism, and absence of
incentives to become productive. At the same time, Karl Marx’s fears did not materialize and
the free markets did not evidence a class clash as predicted by Marx. This has led to many
economists criticizing planned economies and suggesting a move towards private enterprise.
Eastern European countries and Russia have also made a shift from planned toward free market
economies.
6.3 Mixed economy (A more realistic model)
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MIXED ECONOMY is a more realistic model where market forces and government, i.e. both
private sector and public sector, are involved in resource allocation decisions.
Characteristics
 Ownership. There is presence of public sector and private sector. Some of the assets are
owned by the government and others are privately owned.
 Objectives. Private sector is motivated by self-interest. Firms will try to maximize
profits. Consumers will try to maximize welfare. Factor owners will maximize rent,
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interest and profit. Public sector, on the other hand, is not working for profit and aims
for providing a social benefit.
Free enterprise. Free enterprise exists only in the private sector.
The level of competition. Private sector can be quite competitive. It depends on the
market structure that prevails in the various industries. Governments set up bodies
whose job is to make sure that industries do not become too uncompetitive.
Allocative mechanism.
o Price mechanism operates in the private sector. Its efficiency depends on how
competitive the market structures are.
o The government run activities, like health and education, tend to be provided
free at the point of use, although there are some charges even in these areas.
Low priced goods provided by the government can result in shortages for which
government will have to find a rationing mechanism such as setting quotas.
Role of government. Government has following roles to play.
o Regulate economic activities of the private sector. It needs to ensure that
competition exists and that property laws are upheld.
o Government provides both public goods and merit goods (education and
healthcare). Government can provide them directly or contract them out to
private firms (paid by the government).
o Government may own strategic industries or sectors that have natural
monopolies (e.g. postal service and electricity industries).
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Real world examples
Almost all economies today are mixed economies. However, the extent of the interference of
the government will vary. Some countries, such as USA, have very little government
interference and tend to be close to a free market. Some economies, such as Zimbabwe, have a
very large public sector and tend to be closer to planned economy. Other economies have a
mixture of both private and public sectors. High government interference though comes at a
cost – higher tax burden on the taxpayers.
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Advantages of private sector
 Efficiency. Profit motive and competition will force firms to become more competitive
leading to lower costs and better quality.
 Consumer sovereignty. Private sector firms will try to produce goods that consumers
are willing to buy.
 Choice. Competition in private sector increases choice for consumers.
 Innovation. Competition and profit motive forces firms to innovate.
 Other benefits. Other benefits stem from the points that are listed above and can
include the following:
o Higher production
o Lower unemployment
o Lower poverty levels
o More development
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o Lower prices
o Improved living standards
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Disadvantages of private sector
Despite its benefits, private sector suffers from following drawbacks:
 Underprovision of public and merit goods, and goods with positive externalities.
 Unequal distribution of income.
 Overproduction of demerit goods and goods with negative externalities.
 Private sector monopolies.
 Resource allocation in favour of the rich.
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Advantages of public sector
Government will need to intervene in the market to correct market failure. It therefore
provides following benefits:
 Government provides public goods and merit goods.
 Control over negative externalities and demerit goods. Government also regulates the
amount of negative externalities by imposing taxes, or through taking legal actions.
 Government sector reduces wasteful expenditure.
 Profits of the public enterprises are available to all citizens in the economy and hence
create more even distribution of income and wealth.
 Government also uses progressive taxation and a system of welfare payments to the
poor that reduces the disparity between the rich and the poor.
 Government controls prices of essential goods.
 Government can control working conditions and allow for a national minimum wage.
 Government can focus on long-run growth with investment in capital goods, training
and education, and infrastructure.
 Government tries to promote competition in the economy by breaking up monopolies.
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Disadvantages of public sector
However, public sector entities suffer from following drawbacks:
 Inefficiency caused by the fact that there is no profit motive and decision making is
slow.
 Public sector is less innovative and may even provide poor quality goods.
 Red-tapism, bureaucracy and slow decision making.
 There is producer sovereignty. State-owned enterprises and the central planning may
ignore consumer tastes and wants.
 Goods provided by public sector at low cost or for free may face shortages in the market
leading to development of black economy.
 Public sector may end up having poor quality.
Conclusion
Mixed economy is therefore a mixture of free market and planned economy. In this system,
there are both private sector and public sector. Its advantages and drawbacks are also a
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combination of the two systems. Mixed economy is the most realistic system and is the most
widely used system.
6.4 Which system is best?
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Both free markets and planned economies have their advantages and disadvantages. As
extremes, neither of the systems work, but from the experience of the world economy over the
last few decades, it appears that the free market has won the argument.
It would be misleading, though, to say that the free market is the winner without any
provisions. Free markets with very limited governments would fail in other ways: poor health
and education services, low state benefits and pensions and an unfair distribution of income.
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Hence, all economies in the world are now mixed. But it is not clear how much should the
government intervene in the free market. This is a subjective decision. Some economies such as
US have low government involvement and some like Zimbabwe have high government
involvement. The general consensus however is that economy will work better if there is little
government intervention. Government has a significant role but too much government and too
much interference in free market will lead to disincentives and loss in efficiency and
productivity.
The extent to which the government should intervene is a normative question and a difficult
one at that. To sum up, governments need to get the balance right. All civilized societies ought
to have a minimum safety net of essential services, but if it is too big and costly, the higher
taxes will make the economy less efficient and less attractive to foreign investors.
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As for overcoming the problem of scarcity, the more efficient the economy, the lower will be
the problem of scarcity. Hence, free markets with some government intervention tend to lead
to higher efficiency and better allocation of resources than a planned economy. However, no
economic system is in a position to eliminate the problem of scarcity.
6.5 Transition economies
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TRANSITION ECONOMIES are the formerly planned economies such as countries in Eastern
Europe that are trying to shift to the free market economy.
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What went wrong with the planned economies?
(Characteristics and benefits and drawbacks of planned economies were discussed earlier)
 Central planning was breaking down: People's standard of living was declining and
people had to wait in long queues even to get essential goods and services. One of the
reasons for the mess was that the state owned enterprises began to ignore instructions
from the government. This caused chaos as the output levels were not as planned, and
this had knock on effects for other enterprises that relied on this output.
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Obsolete capital stock: Unsurprisingly, investment from abroad was non-existent. More
importantly, there was little investment from within these economies. The capital stock
was old, obsolete and falling apart.
Poor quality: Inevitably, the quality of the goods produced was low, and yet consumers
still had to queue at the shops to buy them.
Couldn’t even control pollution: One of the supposed advantages of the command
economy was the fact that the planning authorities could keep pollution low through
their control of the production process. Even on this measure these economies were
failing. The old factories with their out-of-date and dirty machinery were creating an
unacceptable level of air and water pollution.
SOEs were inefficient that led to poor quality and higher costs of production.
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All of this created anxiety among people and they wanted the system to change. This led to the
fall of the Berlin Wall in 1989 that started the collapse of the communist regimes throughout
the world.
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Reforms that were needed to move towards free markets
(i) Price liberalization
Government had to remove price controls and allow prices to be determined by the demand
and supply forces. This resulted in inflation as prices jumped in the SR. However, this could
result in lower queues as goods are rationed through price mechanism. There can be gains from
price liberalization if the government allows domestic prices to reflect world prices more
closely.
 Since price liberalization is a difficult decision, some governments decide to delay price
liberalization. Russian government delayed the decision because of the fear of effect of
price rise on real wages of workers. Sensitive prices (such as on food, housing and
shelter) were not fully liberalized.
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(ii) Removal of subsidies
Government has to remove subsidies paid to the state-owned enterprises (SOEs). The
inefficient state-owned sector was able to survive because of the subsidies and subsidies kept
prices low hence keeping out competition. Removal of subsidies will lead to increase in prices.
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(iii) Privatization
A move towards free markets require privatization of state-owned enterprises. Privatization of
small scale SOEs (such as shops, restaurants and bars) created few problems. They were
handed over to their former managers or owners. This created a visible sign of transition to
market economy and was a source of employment generation.
Privatization of large scale SOEs was a problem as the government needed to ensure that firms
responded to market signals and tried to reduce losses and improve profitability; there should
be a process of corporate control ensuring that shareholders play an active role in appointment
and removal of managers to ensure that the managers are working to maximize benefits for the
shareholders; and the government had to select a transparent method of privatizing that didn’t
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result in corruption, increased government revenue from sales and ensured that the
enterprises were handed over to efficient entrepreneurs.
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(iv) Establishing markets for labour etc.
All sorts of markets (commodities and factor markets) were absent in planned economies.
Market economies need markets for both commodities and factors of production to operate
efficiently. Government will need to allow demand and supply to operate freely. This will create
initial problems which eventually get settled as markets mature.
 Labour market was non-existent as workers were told by the government about their
activities. Workers will now need to find jobs according to their skills and become a part
of the market.
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(v) Improve management techniques
There was a need to improve management techniques as existing managers lacked these skills.
Government could either restructure SOEs and provide training; or sell SOEs to foreign
multinationals so that they bring modern management techniques that improve efficiency.
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(vi) Trade liberalization
Government needed to reform trade policies by removing state monopoly on trade; removing
or reducing trade barriers (tariffs, quotas etc.); and allowing currency to be convertible. This
would create competition for local firms leading to efficiency, lower prices and more choice for
consumers.
 Certain governments however decided to protect the local industries from the pressure
of foreign competition. This is because the SOEs are inefficient and may not be able to
compete with foreign firms initially; large increase in imports will lead to large deficits
on the current account. However, this will mean that the reform process will slow down
and the firms that are using imported raw materials will be at a disadvantage. This may
also hurt export from these firms.
 Central European countries have been successful in their efforts of trade liberalization.
They were able to find new export markets in Europe and were able to successfully
overcome drawbacks of trade liberalization.
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(vii) Currency convertibility
Government needed to make their currencies convertible. Government can either use floating
or fixed exchange rate systems to make the currency convertible.
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(viii) Reform of financial sector
Government needed to reform following areas:
 Establishing an autonomous central bank which is free of government intervention so
that it can control money supply and interest rates independently of government; and it
can act as a lender of last resort to the commercial banks.
 Creating banking institutions to collect savings and channel these savings to firms
(especially SOEs) for restructuring them and improving efficiency.
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Setting up a framework to supervise and regulate activities of the financial sector.
Creating money markets in which government can sell bonds to finance budget deficits.
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These reforms are very difficult and are likely to take many years to complete. Experience of
financial sector reforms is mixed. Some examples are given below:
 In Hungary, government refused to bail-out banks which had made poor lending
decisions; sold them to foreign investors; and adopted tough bankruptcy laws to ensure
banks could recover bad loans. As a result of these policies almost 50% of the banks by
1996 were foreign-owned with very little bad debts in the financial sector.
 Czech Republic on the other hand saw that almost 50% of banks loans were
unrecoverable. Policies adopted by the government led to the failure of the financial
sector. Banks remained in state ownership. These banks were encouraged by the
government to finance many of the privatization of SOEs creating a conflict of interest.
Instead of calling in bad loans, Czech banks gave former SOEs more loans and making
the firms highly indebted. The legal framework tended to favour firms in debt rather
than giving power to banks to recover debt. These policies led to high levels of bad
debts and the Czech government was forced to bail out banks for fear of collapse of the
financial sector. It eventually began the process of privatization.
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(ix) Establishing a stock market
Stock market would enable newly formed enterprises to raise finance for growth.
(x) Changing culture
Government will need to change the culture in the economy to make it efficient and effective.
Economy will need to accept failure so that only efficient and successful firms will survive and
inefficient firms (e.g. SOEs) should be allowed to go down and to be replaced by efficient firms.
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(xi) Change in laws
 Government needs taxation reforms as formerly all profits of SOEs went to the
government but now government will need to raise revenue to finance its spending.
Initially, the government will face the problem of a small tax base which over time is
expected to expand as firms become more efficient and employ more people.
 Government will need to change other laws especially property laws. Formerly, all the
assets belonged to the government but with a shift to the market, asset ownership will
shift to private individuals and firms. Government will need to protect their property if it
wants its reforms to become successful.
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Outcome of reforms
All of the transition economies experienced pain during the transition.
 Output fell dramatically,
 inflation rose (hyperinflation in some of the countries),
 BoP deteriorated,
 devaluation of currency took place,
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SOEs were under threat from foreign competitors and some of them were forced to
shut down, and
unemployment levels rose.
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Reasons why the transition process was so difficult.
 One of the key problems was that the old command economies had no labour, capital or
goods markets. Everything had been directed by the state. The creation of these
markets from scratch was very difficult.
 Governments had never had to use fiscal policy and monetary policy in the way that
developed economies understand. They had to set taxes in order to pay for defence, a
legal system and a welfare state for those who were to inevitably suffer during the
transition process, but the newly formed private enterprises were struggling in their
early days, and so often could not afford the taxes, so they just didn't pay. If the
government raised taxes to allow for this, even more businesses left the formal
economy and joined the informal economy.
 Tax base was small and the government faced difficulties in financing its expenditure
with use of money markets. In western economies, the government can sell bonds and
bills to the public through the stock market. In the transition economies, the stock
markets were under developed, so there was only one other way to raise money - print
new notes. Of course, this caused the money supply to grow enormously, which is the
main reason for the hyperinflation experienced by some of the countries.
 Workers were used to working in a state owned enterprise when all production
decisions came from above. The sudden switch to private enterprise was a shock.
 The new entrepreneurs were cautious in their decisions. They did not want to make lots
of goods that might not be purchased by consumers. They were not keen on investing in
new machinery. So not only was the quality and quantity of their output low, but this
had a knock on effect. Businesses that supplied machinery or the materials required for
the production of the good would suffer too. It led to low output levels that led to low
employment which led to less consumer spending power and so an even lower output.
 Transition economies also shifted to protecting property rights. The laws were often
unclear or contradictory. In some countries, businessmen took advantage of the unclear
property laws by signing land and factories over to themselves during
the privatization process. The laws were also muddled for foreign investors. It was
essential to attract foreign money if the economies were to grow again.
HA
Pace of reforms
Countries have used different approaches to achieve the transition.
 Some economists recommend shock therapy, i.e. involving extensive privatization,
adopting strict monetary and fiscal policies to reduce inflation, and allowing the forces
of supply and demand to determine prices and exchange rates.
 Others argue for (and some countries have adopted) a gradual approach to transition
because the pains from transition need to be softened. They argue that the consumers
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6 – Economic systems
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and produces need time to adopt the new system and the government needs public
support to adopt the policies.
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Concluding comment
The overall success of the reforms depended on a lot of factors such as the extent of reforms,
pace of introducing reforms, ability to attract aid to support economic reform process, ability to
attract FDI from USA, EU and Japan, and the extent to which there is political stability and
commitment to persist with reforms.
HA
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AD
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Some of the countries have proved that transition can be a success if the right steps are taken
at the beginning. Probably the two most important fundamentals that must be in place are:
 A robust legal system along with clear rules governing the issue of property rights.
 A reformed and free capital market to attract foreign investment.
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7 – The price system
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7 The price system
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A MARKET refers to a process through which products that are fairly similar are bought and
sold. The essence of market is trade – there is a buyer (prepared to purchase something such as
consumers) and there is a seller (prepared to sell something such as firms
 Markets usually have a physical existence such as stalls and shops where goods are sold.
But a market may not have clearly defined physical presence. With the advent of
technology and improvement in communication systems, we find that online trading
and trading on telephone has increased a lot.
M
Following are some of the examples of markets that we will study in A-Level:
 Housing market – where buying and selling of houses take place;
 Labour market – where individuals’ labour power is bought and sold;
 Stock market – where shares are bought and sold;
 Commodity market – where commodities (wheat, rice etc.) are bought and sold;
 Foreign exchange market – where currencies are bought and sold.
AD
Within each market there can be SUB-MARKETS, i.e. smaller sections of the overall market, e.g.
computer industry can be broken down into various type of computers depending on their
memory, speed, features and whether they are desktops or laptops. We usually try to find
prices for sub-markets by looking at their demand and supply conditions.
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Free market
A MARKET SYSTEM refers to a resource allocation mechanism where resources are allocated
based on price mechanism. PRICE MECHANISM is the means of allocating resources in a market
economy. Prices in a market are determined by pure demand and supply forces without any
government or external intervention.
7.1 Demand – buy side of the market
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DEMAND refers to the quantities of a product that purchasers are willing and able to buy at
various prices per period of time ceteris paribus (key points are explained in Appendix A).
 EFFECTIVE DEMAND – demand is said to be effective when there is both willingness and
ability to buy a product. Economists only take into account effective demand.
 The LAW OF DEMAND states that price and quantity demanded are inversely
proportional to each other, i.e. a lower quantity will be demanded at a higher price
assuming all other factors remain constant. This is because with an increase in price of
good, value for money (as measured in terms of satisfaction derived per dollar spent on
the product) falls. Fall in value for money leads to a decrease in demand for the product.
 DEMAND CURVE is the diagrammatic representation of demand based on its definition
and shows the relationship between the quantity demanded and the price of a product.
The demand curve for goods is usually downward sloping from left to right, i.e.
consumers are willing to buy more with a fall in prices.
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7 – The price system
Quantity demanded
(Qd) per week
200
240
280
320
360
 MARKET DEMAND is the total amount demanded
by the consumers in a market and is derived by
horizontally summing the individual demand curves.
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Price of
Good A ($)
100
80
60
40
20
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The following DEMAND SCHEDULE (statistical data about quantity demanded of a product at
different price levels) is for a hypothetical product. It shows that with a decrease in price of the
product, quantity demanded of the product rises. The corresponding market demand curve
(plot of a market demand schedule on a graph) is shown in the figure below.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑑𝑒𝑚𝑎𝑛𝑑 = ∑ 𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑑𝑒𝑚𝑎𝑛𝑑
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The demand curve clearly shows that there is an inverse
relationship between price and quantity demanded. An increase in price leads to a fall in
quantity demanded and vice versa. (Some of the key points of the demand curve are discussed
in Appendix B.) The equation of a linear demand
curve is:
𝑄𝑑 = 𝑎 − 𝑏(𝑃𝑟𝑖𝑐𝑒)
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Movement along the demand curve
Movement along the demand curve takes place
due to two reasons:
 A change in price of the product itself
(not of complements and substitutes)
o An increase in price leading to a
fall in quantity demanded is called
CONTRACTION IN DEMAND.
o A fall in price leading to an increase in quantity demanded is called EXTENSION
IN DEMAND.
 A shift in the supply curve also leads to a movement along the demand curve.
HA
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Some special cases
1. GIFFEN GOOD is a good for which demand increases as the price increases and vice
versa. It has an upward sloping demand curve which is contrary to the law of demand. A
Giffen good is typically an inferior product that does not have easily available
substitutes. The most commonly cited example of a Giffen good is that of the Irish
potato. During the Irish famine of 19th century, as the price of potatoes rose, poor
consumers had little money left for more nutritious but expensive food items like meat.
The lack of money led them to buy more potatoes and less meat.
2. VEBLEN GOODS are types of material commodities for which demand is proportional to
their high price. These include luxury goods such as expensive jewellery, fashiondesigner handbags and luxury cars which are in demand because of their high prices.
The high prices makes them desirable as status symbols. A decrease in their prices
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7 – The price system
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would reduce with quantity demanded therefore they have an upward sloping demand
curve.
7.2 Supply – sell side of the market
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SUPPLY refers to the quantities of a product that suppliers are willing and able to sell at various
prices per period of time, ceteris paribus (key points are explained in Appendix C).
 The LAW OF SUPPLY states that price and quantity supplied are directly proportional to
each other, i.e. a higher quantity will be supplied at higher prices, all other things
unchanged. This is because higher prices are more likely to increase profits of the firms
and firms are therefore likely to produce and sell more. Another reason for upward
sloping supply curve is that the firms face diminishing returns in the short run, i.e. the
cost per unit of firm increases with an increase in output. Market prices will have to rise
to convince producers to produce at higher price levels.
 SUPPLY CURVE is the diagrammatic representation of the definition of supply and shows
the relationship between the quantity supplied and the price of the product. The supply
curve of goods is usually upward sloping, i.e. firms will be willing to increase their
output with an increase in prices.
AD
The following SUPPLY SCHEDULE is for a hypothetical product. It shows that with an increase in
price of the product, quantity supplied of the product
Price of
Quantity supplied
rises.
Good A ($)
(Qs) per week
 MARKET SUPPLY is an aggregation of supply
100
360
curves
of individual firms such that:
80
320
60
280
𝑀𝑎𝑟𝑘𝑒𝑡 𝑠𝑢𝑝𝑝𝑙𝑦 = ∑ 𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝑠𝑢𝑝𝑝𝑙𝑦
40
240
20
200
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The supply curve clearly shows that there is a direct relationship between price and quantity
supplied. An increase in price leads to an increase in quantity supplied and vice versa. (Some of
the key points of supply curve are discussed in Appendix D.) The equation of a linear supply
curve is:
𝑄𝑠 = 𝑎 + 𝑏(𝑃𝑟𝑖𝑐𝑒)
HA
Movement along the supply curve
Movement along the supply curve takes place
due to two reasons:
 A change in price of the product itself
o An increase in price leading to a
rise in quantity supplied is called
EXTENSION IN SUPPLY.
o A fall in price leading to a fall in
quantity supplied is called
CONTRACTION IN SUPPLY.
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7 – The price system
A shift in the demand curve also leads to a movement along the demand curve.
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
7.3 Market equilibrium
Total consumer expenditure is given as:
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EQUILIBRIUM refers to a situation of balance where at least under present circumstances there
is no tendency for change to occur.
 In a free market system without government
Price of
Qd per Qs per
intervention, equilibrium price is established where quantity
Good A ($) week
week
demanded is equal to quantity supplied. This can be shown
100
200
360
with the help of a table and graph.
80
240
320
 Market equilibrium takes place where quantity
60
280
280
demanded is equal to quantity supplied (look at the table) or
40
320
240
where the demand curve and the supply curve intersect (look
20
360
200
at the figure). Using the above table, equilibrium price is $60
and equilibrium quantity is 280 units. EQUILIBRIUM PRICE is the price where demand
and supply are equal, where the market clears. EQUILIBRIUM QUANTITY is the amount
that is traded at the equilibrium price.
AD
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 = 𝑇𝑜𝑡𝑎𝑙 𝑓𝑖𝑟𝑚 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑃𝑒 × 𝑄𝑒
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Assuming no government intervention, the total consumer expenditure is equal to total firm
revenue. In the above case, total expenditure or
firm revenue is equal to $16,800 (60x280).
 It must be noted that the firm revenue is
not the same as profits. Profit is
calculated after deducting costs from
revenues. Therefore, we need to know
the cost levels first to calculate profits.
 The consumer expenditure or firm
revenue is shown as the shaded region in
the graph.
HA
Reason for reaching an equilibrium
Equilibrium price is sometimes also called MARKET CLEARING PRICE, i.e. price where all
products supplied to the market are bought or cleared from the market.
 Market prices may be different from equilibrium price that lead to either shortages or
surpluses.
 ‘Free market forces’ will move the market price toward equilibrium.
DISEQILIBRIUM takes place if there is an imbalance where change will happen, i.e. where
demand and supply are not equal. Two situations of disequilibrium are explained below.
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7 – The price system
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(i) Disequilibrium of excess supply
If market price is greater than equilibrium price, there is said to be disequilibrium of excess
supply. At a higher price (such as $80), firms will
be willing to supply a higher amount (320 units)
than the demand (240 units) at that price. This
results in excess supply and following
adjustments:
 As supply is greater than demand, firms
will build up stocks. Reaction of suppliers
will be to cut prices and reduce quantity
supplied in the market hence moving
toward the equilibrium.
 As price is cut, consumers will react by
increasing demand for the product therefore moving toward the equilibrium.
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(ii) Disequilibrium of excess demand
If market price is less than equilibrium price, there is said to be disequilibrium of excess
demand. At a lower price (such as $40), consumers will demand a higher amount (320 units)
than what the firms are prepared to supply (240 units) at that price. This results in excess
demand or shortages and following adjustments:
 As demand is greater than supply, there will be shortages in the market.
 Reaction of suppliers will be to increase prices (they see a profit opportunity) and
increase quantity supplied in the market hence moving toward the equilibrium.
 As price is raised, consumers will react by reducing demand for the product (some
consumers leave the market) therefore moving toward the equilibrium.
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Nothing will be able to prevent companies from adjusting in this way, and, provided there is no
change in demand and supply conditions, an equilibrium will eventually be reached. It must be
noted that the adjustment is not an instantaneous process, rather it takes place through
expert decision making or simple trial and error.
HA
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However, this creates an inherent limitation of the process.
 There will be time lags before the adjustment is completed.
 Markets can thus remain in disequilibrium for some period of time. The market will
eventually clear at the point of equilibrium.
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7 – The price system
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Changes in equilibrium
Equilibrium can change because of a change in demand or supply conditions leading to a shift in
either one or both the curves. Some of the examples are described below.
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(i) An increase in demand
Demand can increase due to rise in income for normal goods or a fall in income for inferior
goods; rise in price of substitutes; fall in price of complements; favourable tastes; increase in
advertisements; positive news about the product
and the company and like that. An increase in
demand leads to a rightward shift in the demand
curve leading to a rise in both price and quantity.
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An increase in demand from D1 to D2 leads to
following changes.
 At the initial equilibrium price (P1), there
will now be disequilibrium of excess
demand as consumers will demand more
goods (Q3) at the same price. This leads to
a shortage equal to Q3 – Q1.
 Suppliers react by increasing prices and increasing quantity supplied. Therefore moving
towards the new equilibrium E2. As prices rise, some consumers leave the market
leading to a fall in quantity demanded. Therefore moving towards the new equilibrium.
 Market clears where the new demand (D2) and supply curve intersect. New equilibrium
is hence established at a higher price (P2) and a higher quantity (Q2).
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(ii) A decrease in demand
Demand can fall due to a fall in income for normal goods, a rise in price of complements, a fall
in price of substitutes, unfavourable tastes, poor
advertisement, a poor news item about the
product and like that. A fall in demand leads to a
leftward shift in the demand curve leading to a
fall in price and a fall in quantity traded.
 At the initial equilibrium price (P1), there
will now be disequilibrium of excess
supply as consumers will demand fewer
goods (Q3) at the same price. This leads to
excess supply equal to Q3 – Q1.
 Suppliers react by decreasing prices and
decreasing quantity supplied. Therefore moving towards the new equilibrium E 2. As
prices fall, some consumers enter the market leading to a rise in quantity demanded.
Therefore moving towards the new equilibrium.
 Market clears where the new demand (D2) and supply curve intersect. New equilibrium
is hence established at a lower price (P2) and a lower quantity (Q2).
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7 – The price system
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(iii) An increase in supply
Increase in supply takes place due to lower cost of production due to lower wages, lower price
of raw materials, lower energy and transportation cost, introduction of cost-saving new
technology, removal of indirect tax, provision of subsidy, and also due to entry of new firms in
the market. An increase in supply shifts supply curve to the right from S1 to S2.
 At the initial equilibrium price (P1), there
will now be disequilibrium of excess
supply as suppliers will supply more
goods (Q3) at the same price. This leads to
excess supply equal to Q3 – Q1.
 Suppliers react by decreasing prices and
decreasing quantity supplied. Therefore
moving towards the new equilibrium E2.
As prices fall, some consumers enter the
market leading to a rise in quantity
demanded. Therefore moving towards
the new equilibrium E2.
 Market clears where the new supply (S2) and demand curve intersect. New equilibrium
is hence established at a lower price (P2) and a higher quantity (Q2).
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(iv) A decrease in supply
Decrease in supply takes place due to a rise in cost of production due to rise in price of raw
materials, a rise in wages, imposition of indirect
taxes, removal of subsidy, rise in energy and
transportation costs, and a fall in number of
firms in the industry. A decrease in supply shifts
the supply curve to the left from S1 to S2.
 At the initial equilibrium price (P1), there
will now be disequilibrium of excess
demand as consumers will demand more
goods (Q3) at the same price. This leads to
a shortage equal to Q3 – Q1.
 Suppliers react by increasing prices and
increasing quantity supplied. Therefore moving towards the new equilibrium E2. As
prices rise, some consumers leave the market leading to a fall in quantity demanded.
Therefore moving towards the new equilibrium E2.
 Market clears where the new supply (S2) and demand curve intersect. New equilibrium
is hence established at a higher price (P2) and a lower quantity (Q2).
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7 – The price system
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(v) Changes in both demand and supply curves
The following table summarizes the impact of changes in both demand and supply curves
simultaneously. Please refer to Appendix G for graphs showing the impact of changes in both
the demand and the supply curves.
Impact on
Impact on
Equilibrium Equilibrium
Price
Quantity
Increase
Decrease
Increase
Decrease
Decrease
Increase
Increase
Decrease
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(i) A change in demand
(a) Increase in demand
(b) Decrease in demand
(ii) A change in supply
(a) Increase in supply
(b) Decrease in supply
(iii) A change in both
(a) Increase in demand & decrease in supply
(b) Decrease in demand & increase in supply
(c) Increase in both demand and supply
(d) Decrease in both demand and supply
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Change
Uncertain
Uncertain
Increase
Decrease
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Increase
Decrease
Uncertain
Uncertain
* Uncertain means that the change in price or quantity cannot be predicted. It may increase,
decrease or remain constant depending on the extent of change in demand or supply.
HA
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This can be explained using the following diagrams.
Increase in demand and a decrease in supply
 Prices should rise.
 Effect on equilibrium quantity is not known. It may i) increase, ii) decrease or iii) remain
constant.
Decrease in demand and an increase in supply
 Prices should fall
 Effect on equilibrium quantity is not known. It may (i) increase, (ii) decrease, or (iii)
remain unchanged.
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Increase in demand and an increase in supply
 Quantity should rise.
 Effect on equilibrium price is not known. It may (i) increase, (ii) decrease, or (iii) remain
unchanged.
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Decrease in demand and a decrease in supply
 Quantity should fall.
 Effect on equilibrium price is not known. It may (i) increase, (ii) decrease, or (iii) remain
unchanged.
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7 – The price system
7.4 Shifts in demand curve
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CHANGE IN DEMAND is a shift in the demand curve due to changes in factors other than the
price of the particular product.
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A rightward shift, as shown in the figure, means
that demand curve shifts from D1 to D2.
 At the same price (e.g. P), consumers are
willing to buy more of the same good
(demand increased from Q1 to Q2).
 For the same quantity (e.g. Q), consumers
are now willing to pay a higher price (price
increased from P1 to P2). Hence,
companies can increase their prices.
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Rightward shift in demand curve
Rightward shift in demand curve takes place because of an increase in demand which can be
due to more favourable tastes; fall in price of
complements; rise in price of substitutes; increase
in income for normal goods etc.
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Leftward shift in demand curve
Leftward shift in demand curve takes place
because of a decrease in demand which can be
due to change in tastes of consumers; rise in price
of complements; fall in price of substitutes;
decrease in income for normal goods etc.
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A leftward shift means that demand curve shifts
from D1 to D2.
 At the same price (e.g. P), consumers are willing to buy less of the same good (demand
decreased from Q1 to Q2).
 For the same quantity (e.g. Q), consumers are now willing to pay a lower price (price
decreased from P1 to P2).
HA
Language used in demand curve
Change in price leads to a movement on the line and we say that there is a change in Quantity
demanded. Change in other factors leads to a shift in the curve and we say that there is a
change in demand.
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7 – The price system
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Major influences affecting shift in demand curve
(i) Financial ability to pay for the product
(a) Purchasing power of income after taxation
DISPOSBALE INCOME is the income left after subtracting direct taxes and adding state benefits.
DIRECT TAX is a tax on income of people and firms and cannot be avoided. The impact of
disposable income on demand depends upon whether the good is normal or inferior.
NORMAL GOODS exhibit a positive relationship between income and demand and a negative
relationship between direct taxes and demand. These include cars and designer clothes.
 An increase in demand for normal goods take place due to rise in income or a fall in
direct taxes and vice versa.
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INFERIOR GOODS exhibit a negative relationship between income and demand and a positive
relationship between direct taxes and demand, such as cheap unbranded clothing.
 An increase in demand for inferior goods take place due to fall in income or a rise in
direct taxes and vice versa.
AD
Apart from incomes and direct taxes, other factors that can influence the purchasing power are:
 large increase in unemployment leads to a fall in aggregate income;
 sustained rise in earnings from work leads to an increase in income; and
 inflation leads to a fall in purchasing power of money.
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(b) Availability of loans or credit and the interest rate that must be paid on loans or credit
card balances
Increase in availability of loans or credit and a decrease in interest rates lead to more borrowing
in the economy which in turn increases the demand for the product (rightward shift).
 Interest rates affects consumption. Many people borrow to buy durable goods. A rise in
interest rates would result in higher instalments or repayments for the product resulting
in a fall in demand for the product and vice versa.
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(ii) Attitudes towards the product
Purchase behaviour of individuals reflects their tastes and preferences for different types of
products. A favourable preference leads to a rise in demand. It can result from:
 a good reputation for reliability and service;
 strong brand identification aided by advertisement and promotion;
 fashion appeal, status symbol, or its looks;
 favourable news item;
 individual likes and dislikes;
 peer pressure and like that.
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7 – The price system
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(iii) Price, availability and attractiveness of related products
Economists classify related product into two categories – (i) substitutes; and (ii) complements.
(a) Substitutes
SUBSTITUTES are products that satisfy essentially the same need or want (an alternative good),
e.g Coke and Pepsi, tea and coffee, and air travel and road travel.
 Range of substitutability can be narrow (such as different competing brands – HP and
Dell, Coke and Pepsi, Honda and Toyota) or broad (such as different product groups –
different types of transport including rail, buses and cars; or different types of soft
drinks such as cola drinks and fruit juices).
 An increase in price of substitute makes the product more attractive leading to an
increase in the demand of the product (rightward shift), e.g. if Toyota decided to
increase its prices, value for money for Toyota will fall and Honda (a substitute) will
become more attractive for the customers. Demand for Honda cars, as a result of
Toyota’s decision to increase price of its cars, will increase.
 A decrease in price of substitutes, on the other hand, will make the product less
attractive leading to a fall in its demand (leftward shift).
 An increase in quality, features, advertisement etc. of a substitute will make substitute
more attractive leading to a fall in the demand of your product (leftward shift) and vice
versa.
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(b) Complements
COMPLEMENTS are products that enhance the satisfaction derived from use of another
product (a good consumed with another), e.g. fish and rice, TVs and DVD players, and PCs and
software. In some cases, main product cannot be used without a complement, e.g. razor and
razor blades; and DVDs and DVD players.
 An increase in price of complement will decrease the demand for complements making
your product less attractive. This will lead to a fall in demand for your product (leftward
shift). A fall in price of complement will increase the demand for complement making
your product more attractive. This will lead to an increase in demand for your product
(rightward shift).
 An increase in attractive and availability of complement will make your product more
attractive leading to an increase in demand of your product (rightward shift) and vice
versa.
HA
(iv) Other demand influencing factors – peculiar to each product
Each product will have some factors that are peculiar to that product, e.g. weather may
influence demand for ice cream.
 Expectations of future are important in determining demand for houses and shares. If
house prices and share prices are expected to rise, there will be a major activity in
buying of houses and shares.
 Expected unemployment and interest rates also influence demand. If unemployment or
interest rates are expected to increase, consumer and industrial spending may fall
leading to a decrease in demand for certain products.
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7 – The price system
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Three types of demand
1. COMPOSITE DEMAND occurs when a good is demanded for two or more uses, e.g. land may
be demanded to build shops, to build houses or to build a factory. Another example is of wheat
that can be used to manufacture bio-fuel and also manufacture bread. If demand for bio-fuel
rises, more wheat will go into production of bio-fuel. An increase in demand for wheat in biofuel industry will raise its price and affect the prices of all other products made from wheat
such as bread. That will mean that supply of bread will fall as less wheat is available for
manufacturing bread.
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2. JOINT DEMAND (complements) occurs when two goods are consumed together, e.g. gaming
consoles and games, and razors and razor blades.
 If demand for gaming consoles rise (may be due to higher income levels), it will also
result in rise in demand for games.
 Alternately, if supply of PCs rise (may be due to fall in costs because of superior
production technology) leading to a fall in their price and a rise in their demand, it will
result in a rise in demand for software. This relationship can also be shown through XED.
AD
3. DERIVED DEMAND occurs when demand for one good occurs as a result of demand for
another, e.g. labour is demanded because there is demand for the final product. Another
example is of input such as steel for car manufacturing. If demand for cars rise, demand for
steel will also rise which is the raw material for manufacturing cars.
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4. COMPETITIVE DEMAND refers to demand for products that are close substitutes for one
another, beef and chicken meat. A decrease in supply of beef leads to a rise in price of beef
which makes chicken more attractive leading to a rise in demand and price of chicken meat.
This relationship can also be shown through XED.
7.5 Shifts in supply curve
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CHANGE IN SUPPLY takes place when there is a shift in the supply curve due to a change in
factors other than the price of the particular product.
HA
Rightward shift in supply curve
Increase in supply can take place due to lower
cost of production because of availability of
cheaper raw material, lower wages, increased
productivity due to better production techniques
and improved technology, provision of
government subsidies, a reduction in indirect
taxes, and entry of new firms in the market. An
increase in supply shifts the supply curve to the
right from S1 to S2.
 At the same price (e.g. P), firms are
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willing to sell more of the same good (supply increased from Q1 to Q2).
For the same quantity (e.g. Q), firms are willing to charge a lower price (price decreased
from P1 to P2).
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Leftward shift in supply curve
Fall in supply leads to a leftwards shift in supply
curve from S1 to S2. Supply can fall due to a rise
in cost of production due to higher wage rates
(due to national minimum wage or union
negotiations), higher raw material prices
(because of raw material shortages etc.),
imposition of indirect taxes, some firms leaving
the industry, or removal of subsidies.
 At the same price (e.g. P), firms are
willing to supply less (supply decreases
from Q1 to Q2).
 For the same quantity (e.g. Q), firms are now willing to charge a higher price (price
increased from P1 to P2).
AD
Language used in supply curve
Change in price leads to a movement on the line and we say that there is a change in Quantity
supplied. Change in other factors leads to a shift in the curve and we say that there is a change
in supply.
HA
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Major influences affecting shift in supply curve
(i) Costs of supplying a product
Companies make supply decision on the basis of the price that they can get in the market in
relation to the cost of supplying the product. Shift in supply curve takes place because of a
change in cost of production (other than due to law of diminishing returns). Major influences on
supply include cost of raw materials and components; wage rates; worker productivity; energy
costs; transport costs; equipment maintenance costs; technology and like that.
 Leftward shift (decrease in supply) takes place because of increase in cost of production
which can be due to increase in wage rates (union negotiated or because of higher
inflation); decrease in worker productivity (demotivation etc.); increase in prices of raw
materials and components (higher world demand for or shortage of supply of raw
materials); increase in cost of energy, transportation and equipment maintenance; poor
technology leading to productivity losses etc.
 Rightward shift (increase in supply) takes place because of fall in cost of production
which can be due to decrease in wage rates (decrease in union power, unemployment,
production in low wage countries); increase in worker productivity (use of capital
machinery, motivation etc.); fall in prices of raw materials and components (excess
supply of raw materials); decrease in cost of energy, transportation and equipment
maintenance; improvement in state of technology leading to productivity gains etc.
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(ii) Government policy
(a) Government legislation
Government legislation is designed to protect consumers, workers, and community. Some of
the steps that government take may include:
 quality control legislation (aimed at improving quality of finished good – increases cost
of production of the firm);
 pollution control (aimed at controlling emission of harmful gases and other waste
products that pollute the environment – also increases cost of production);
 minimum wages (decrease poverty and remove worker exploitation – increase costs);
 maximum working hours (prevents worker exploitation – reduces productivity hence
increasing costs of production).
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The impact of legislation is that it increases costs of the firms. Imposition of legislation leads to
leftward shift in the supply curve. Removal of legislation leads to rightward shift in the supply
curve.
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(b) Imposition of indirect taxes
INDIRECT TAXES are taxes imposed by the government on consumption and use of goods and
services. Some common examples of indirect taxes are GST and VAT.
 An indirect tax leads to an increase in the cost as the new price of product must reflect
the additional burden of tax. Therefore, an imposition of tax leads to reduction supply
(leftward shift).
 Removal or decrease in indirect tax results in increase in supply (rightward shift).
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(c) Government subsidies
SUBSIDY is defined as a sum of money granted by the government or a public body to assist an
industry or business so that the price of a commodity or service may remain low or competitive.
 Provision of subsidy reduces costs of the firms leading to an increase in supply
(rightward shift).
 Removal of subsidy leads to a leftward shift.
HA
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(iii) The size and the nature of the industry
Firms inside and outside of the industry are likely to react if they find that there are substantial
profits to be made in the industry.
 Firms inside the industry are likely to increase their capacity. Firms outside are likely are
enter in the industry. Ease of entry into the market will depend on the barriers to entry.
If there are no or low barriers to entry, more firms are likely to enter the market if
industry profitability rises. High level of barriers will make it difficult for firms to enter
the market.
 An increase in size of the industry because of either (i) more firms, or (ii) bigger firms
results in a rightward shift in the supply curve.
 A price war in the industry because of intense competition is likely to lead to a rightward
shift in the supply curve. This happens because price wars lead to lower price levels for
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any given level of output. However, price wars may force some of the smaller firms to
exit the market leaving few larger firms in the industry. These larger firms are then likely
to increase prices in the long run leading to a leftward shift in the LR.
Leftward shift can take place because of decrease in size of industry (firms leaving the
market because of losses or price wars); or collusion among firms (which leads to higher
prices charged by the firms).
(iv) Change in price of other products
 If a competitor lowers its price, it could mean that less will be supplied by other firms
who keep their price unchanged.
 If a competitor increases its price, other firms may gain and will be able to supply more.
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(v) Other supply influencing factors
 JOINT SUPPLY takes place when two items are produced together. Increase in the price
of one good will increase the supply of another jointly produced good and therefore a
reduction in the latter’s price. Increase in price of beef will lead to increase in supply of
beef. The increase in slaughter of cows will lead to an increase in supply of leather
hides. Increase in supply of leather hides lead to a fall in their prices.
 Goods and services in COMPETITIVE SUPPLY are alternative products that a business
could make with its factors of production such as diversion of land used in supplying
food to producing bio-fuels. This would result in lower supply of land for food
production resulting in a rise in food prices.
 If a firm decides to increase its profit margin, it will charge a higher price for the same
quantity sold leading to a leftward shift in the supply curve.
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There would always be certain factors unique to each industry that affect the supply curve.
 Weather conditions affect agricultural produce. Favourable weather increase supply
leading to a rightward shift and vice versa.
 Expectations of future prices influences supply in stock market and foreign exchange
market. If price are expected to fall, supply of shares will increase and if prices are
expected to rise, supply of shares falls.
7.6 Functions of price in a market economy
HA
Price performs following functions in a market economy:
 Allocation of resources
 Rationing
 Transmission of preferences
Main actors in the market
Adam Smith in his book ‘The wealth of Nations’ emphasised the power of market to allocate
resources. The ‘invisible hand’ of the market would allocate resources to everyone’s advantage.
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The main actors in the market – consumers, producers, and owners of the factors of production
– try to maximize their benefit that results in allocation of resources.
 Consumer – In free market, there is consumer sovereignty. Consumers are trying to
maximize their utility and have the option to spend their money on a wide array of
goods and services available in the market.
 The Firm – Firms are motivated by higher profits that they can make from producing
goods and services. They are therefore forced to produce goods and services that are
demanded by the customers so that they maximize their sales. They also try to improve
their efficiency and reduce the cost of production.
 Owners of factors of production – Owners are motivated by the desire to maximize
their returns. They will offer there factor of production to the firm that offers the
highest possible return for their services.
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Functions of price
1. Allocation of resources
The price mechanism works automatically through ‘the invisible hand’ as suggested by Adam
Smith. Prices act as a signal to both producers and consumers. A rise in demand results in an
increase in price, signalling to producers that they should produce more of the product. A fall in
demand results in a fall in prices, signalling to producers that they should produce less of the
product. The price mechanism works in such a way that the outcome is a new equilibrium
position with consumer’s demand equal to producers’ supply.
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2. Price as a rationing mechanism
RATIONING is the controlled distribution of scarce resources, goods or services. Economic
system has to decide how to allocate scarce resources among competing uses. There are
different ways of rationing resources, some of which are listed below:
 Price as a rationing mechanism
 Queues
 Black market
 Ration cards etc.
HA
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Price as a rationing mechanism
Price can act as a rationing mechanism with or without intervention on the part of the
government. Goods are not freely available as there are not enough resources to produce
enough goods to satisfy all individuals. It therefore means that goods must be rationed, i.e.
there must be some mechanism for deciding who gets some of the goods and who does not. In
a market system, such rationing is done by price. Consumers can buy a good if they are willing
and able to pay the market price.
There are many ways in which prices can ration resources.
 If a producer has limited capacity or wishes to restrict the supply of the product, then, if
these producers have high price, the market mechanism will automatically result in
rationing. High price limits demand and in turn seeks to ensure that it is in line with the
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quantity that is supplied. For example, exclusive car manufacturers or designer fashion
companies charge very high prices for their products. These high prices reduce demand
and ensure that it is in line with the quantity that is supplied. Only those consumers who
are willing and able to pay the higher price will be able to buy and consume the good.
Others who were previously buying but are no longer willing or able to pay will leave the
market. Price therefore will ration the supply to consumers who are willing and able to
buy the higher price. (Students should use the diagram of a fall in supply to explain the
process.) This is at times considered unfair because it favours the rich who can afford to
pay higher prices for goods that are in short supply.
Government can use prices as a means of rationing. For example, imposing indirect
taxes on products such as tobacco increases their prices and results in lower demand.
HA
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Other rationing mechanisms
 Government can use different bases of rationing such as rationing based on age, height
etc. Whatever rationing mechanism is used, it will still result in some people getting the
good and some not getting the good. This means that all rationing mechanism
discriminate against some people.
 Government can use maximum prices to ensure that discrimination is not done on
pricing which may be considered unfair. However, maximum prices can lead to
shortages of goods. Price will therefore fail to act as a rationing mechanism. There must
then be some other means of rationing the good.
o Rationing by queuing is often used as a means of dividing goods. For instance,
when the government announced low-priced flour in Pakistan, we witnessed
long queues of people waiting to get the cheaper flour. Those who are able to
wait will get the chance of buying the cheaper flour. It is at times perceived as
fairer than rationing by price. However, there is an opportunity cost of time that
people have to stand to buy the product. The total cost to the consumer will be
the maximum price plus the opportunity cost and it is likely to be higher for
most consumers than the equilibrium price.
o Black markets can also develop in response to use of maximum prices. Black
marketers buy the limited stock of good and then they sell that good at higher
prices to those customers who are willing and able to buy at higher prices. The
actual price that customers pay may actually be greater than the equilibrium
price.
 Other non-price rationing mechanisms are ration coupons and favoured customers.
o Ration coupons are given to customers and they can only buy the good (by
paying) by showing the ration coupons.
o Favoured customer means that in the event of shortages, a seller may try to
make sure that the regular customers are able to buy the product.
3. Transmission of preferences
TRANSMISSION OF PREFERENCES refer to the automatic way in which the market allows the
preferences of consumers to be made known to producers.
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Quantities – economists try to represent information in a quantitative way
Product – items that are being traded. This is a very broad term and can include many
thing such as goods and services; and all tradable items such as money and financial
assets (shares).
Purchasers – demand is from the purchasers’ or consumers’ point. These purchasers
may or may not be the final consumers. These may also include intermediaries (such as
producers, distributors, wholesalers and retailers) in the production-consumption chain.
Willingness to buy – gives rise to notional demand, i.e. purchasers want a product
because of its expected satisfaction or utility when it is consumed. NOTIONAL DEMAND
is speculative and not always backed up by the ability to pay. Economists will not
consider demand unless there is both willingness and ability to buy a product.
Ability to buy – consumer has the purchasing power to buy a product.
Various prices – demand for a product is judged at various price levels
Per period of time – demand must be time related, e.g. sales per day, or sales per week,
or sales per month and like that.
CETERIS PARIBUS (other things being equal) – many factors can affect demand for a
product. It can include both price and non-price factors.
o Ceteris paribus assumption is taken to ensure that when investigating a
relationship, other things are held constant.
o This will enable an economist to judge the impact of one variable on another
variable accurately.
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Appendix A – Explanation of key terms in definition of demand
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Price mechanism allows preferences of consumers to be made known to producers. If
consumers do not buy a particular product because it is not liked or it is too expensive, then
this message is transmitted back to producers. Their reaction should be one of improving the
product, reducing its price or both if they wish to stay in business.
Appendix B – Explanation of key points in demand curve
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HA

There is an inverse relationship between price and quantity demanded. Price is the
independent variable and quantity demanded is the dependent variable.
We are assuming a causal relationship, i.e. a change in price leads to a change in
quantity demanded.
The shape of the demand can change according to the product. We have assumed a
linear relationship in the example given in the text. It may not always be the case. It can
be a hyperbola or any other shape depending on the behaviour or reaction of customers
to price changes. For example, a couple of examples of shape of demand curve are given
in the figure below:
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There is a continuous relationship, i.e. we can find out quantity demanded at any price
level.
There is a time-based relationship, i.e. demand is calculated within a prescribed time
period such as in a week, a month, or a year.
We are making a ceteris paribus assumption, i.e. all other variables (other than price
and quantity demanded) remain unchanged.
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Appendix C – Explanation of key terms in definition of supply

Suppliers are the sellers of the product. They are often referred to as “producers” and
can include manufacturers, intermediaries, and service firms.
Willingness and ability to sell – they would only be willing if the price paid by customers
covers their costs. They would have the ability if they have the physical and capital
resources needed for production.
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Appendix D – Explanation of key points in supply curve
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There is a positive or direct relationship between price and quantity supplied. An
increase in price leads to an increase in quantity
supplied and vice versa.
There is a causal relationship, i.e. changes in
price cause changes in quantity supplied.
Extension of supply refers to movement up the
supply curve. Contraction of supply refers to a
movement down the supply curve.
Supply curve can take any shape depending on
the nature of the product. The example in the text is of a linear supply curve. The figure
shows an example of a non-linear supply curve.
There is a continuous relationship, i.e. we can find quantity supplied at any price level.
There is a time-based relationship, i.e. supply is calculated within a prescribed time
period that must correspond to the time period in the demand curve.
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8 Elasticity
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ELASTICISTY is defined as a numerical measure of the responsiveness of one economic variable
(dependent variable) following a change in another influencing variable (independent variable),
ceteris paribus
 Elasticity is trying to quantify the cause and effect relationships and is trying to measure
the magnitude or extent of change in dependent variable following a change in the
independent variable.
 ELASTIC RELATIONSHIP is when the dependent variable is more responsive to a change
in independent variable, i.e. there is a proportionately larger percentage change in
dependent variable following a change in independent variable. The value of elasticity
(ignoring the sign) is greater than one.
 INELASTIC RELATIONSHIP is when the dependent variable is less responsive to a change
in independent variable, i.e. there is a proportionately smaller percentage change in
dependent variable following a change in independent variable. The value of elasticity
(ignoring the sign) is less than one.
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In our course, we will study the following elasticities:
 Price elasticity of demand (PED)
 Income elasticity of demand (YED)
 Cross elasticity of demand (XED)
 Price elasticity of supply (PES)
Note: You can calculate any type of elasticity based on the principles used in calculation of
above elasticities.
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8.1 Price Elasticity of Demand (PED)
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PRICE ELASTICITY OF DEMAND (PED) is a numerical measure of the responsiveness of quantity
demanded of one product following a change in the price of that product alone.
𝑃𝐸𝐷 =
% ∆ 𝑖𝑛 𝑄𝑑 𝑜𝑓 𝑎 𝑝𝑟𝑜𝑑𝑢𝑐𝑡
% ∆ 𝑖𝑛 𝑃 𝑜𝑓 𝑡ℎ𝑎𝑡 𝑝𝑟𝑜𝑑𝑢𝑐𝑡
HA
Analysing sign
PED has a negative sign because P and Qd have an inverse relationship. An increase in price
leads to a fall in quantity demanded and vice versa.
Analysing magnitude
The magnitude of relationship is seen by looking at the absolute value of PED (i.e. ignoring the
negative sign). PED values, ignoring the sign, range from 0 to infinity (∞).
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(i) Elastic demand
Demand is said to be PRICE ELASTIC if there is a larger proportionate change in quantity
demanded following a change in price of the product alone.
 PED of the product is greater than one but less than infinity. For example, if price of a
product increases from $100 to $105 (5% increase), the quantity demanded falls from
1,000 units to 900 units (10% decrease). In this case, PED is –2.0 (= -10% / +5%).
 The line labelled De in the figure shows
demand curve with elastic demand. It is
flatter and shows the upper part of a
linear demand curve.
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(ii) Inelastic demand
Demand is said to be PRICE INELASTIC if there is
a smaller proportionate change in quantity
demanded following a change in price of the
product alone.
 PED of the product is less than one but
greater than zero. For example, if price of a product increases from $100 to $105 (5%
increase), the quantity demanded falls from 1,000 units to 990 units (1% decrease). In
this case, PED is –0.2 (= -1% / +5%).
 The line labelled Di in the figure shows demand curve with inelastic demand. It is
steeper and shows the lower part of a linear demand curve.
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(iii) Perfectly elastic demand
PERFECTLY ELASTIC DEMAND CURVE is infinitely
responsive to price and the demand curve is
horizontal to the x-axis. Consumers will buy all
the goods available in the market at P1.
 There will be no demand if the price
increased slightly to P2.
 PED of perfectly elastic demand curve is
infinite (∞).
 It is not a very realistic case.
HA
(iv) Perfectly inelastic demand
PERFECTLY INELASTIC DEMAND CURVE is not responsive to price and the demand curve is
vertical to x-axis. Consumers are willing and able to buy the same amount of the product
irrespective of price changes.
 PED of inelastic demand curve is zero (0).
 It is not a very realistic case.
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(v)
Unitary elasticity
Demand is said to have UNITARY ELASTICITY if the relative increase in price is exactly matched
by relative fall in quantity demanded and vice
versa.
 For example, if price of a product rises by
5% and the quantity demanded falls by
5%, PED will be –1.0.
 Demand curve with unitary elasticity
takes the shape of a rectangular
hyperbola.
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Business relevance of PED
An understanding of PED is useful to understand
 impact of changing prices on consumer
expenditure (and firm revenue);
 variations in the market (price and quantity); and
 impact on government revenue and cost because of imposition of taxes or provision of
subsidies.
AD
(i)
Impact of changing prices on consumer expenditure (and firm revenue)
PED can help firm set their pricing policy by understanding the impact of price changes on
revenues (remember that profits are different from revenues and we need to subtract costs
from revenues to get profits).
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(a) Elastic demand
A fall in price due to a rise in supply for a product with elastic demand leads to a greater
percentage rise in quantity demanded leading to
a rise in total revenue. Initial revenue is P1Q1.
New revenue after fall in price is P2Q2. The graph
shows the area of fall in revenue and the area of
increase in revenue. Increase in revenue is
greater than fall in revenue resulting in a rise in
total revenue.
HA
We can change the labels to show that total
revenue falls if prices increase in case of elastic
demand.
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(b) Inelastic demand
A rise in price due to a fall in supply of a product with inelastic demand leads to a smaller
percentage fall in quantity demanded resulting in
a rise in total revenue. Initial revenue is P1Q1.
New revenue after increase in price is P2Q2. The
graph shows the area of fall in revenue and the
area of increase in revenue. Increase in revenue is
greater than fall in revenue resulting in a rise in
total revenue.
We can change the labels to show that total
revenue falls if prices decrease in case of inelastic
demand.
Inelastic demand
Decrease
Increase
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We can hence conclude
that businesses trying to
increase revenues (not
profits) should:
 reduce prices in
case of elastic
demand; and
 increase prices in
case of inelastic
demand curve.
Elastic demand
Increase
Decrease
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Price change
Fall in price
Rise in price
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The following table summarizes the impact of price changes on total revenue if the demand
curve is elastic or inelastic.
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(c) Unitary elasticity
In case of unitary elasticity, firm’s revenue will not change
with a change in prices.
HA
(d) Perfectly inelastic demand
In case of perfectly inelastic demand, firm’s revenue will
change in the same proportion as the change in prices.
 If firm increases price by 5%, then revenue will also
increase by 5% as Qd remains constant.
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(e) Perfectly elastic demand
In case of perfectly elastic demand, firm’s demand becomes zero if there is an increase in price.
Revenue will rise in the same proportion as a rise in quantity sold with no change in price.
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(ii)
Variations in the market (price and quantity)
The figure shows two demand curves De (elastic) and Di (inelastic) which are both in equilibrium
initially at the same point (Pe and Qe). There is then a fall in supply from S0 to S1 leading to an
increase in price and fall in quantity traded in both cases. However the extent of change varies
for the two curves.
 In case of elastic demand, producers are constrained in their ability to raise prices as
consumers react aggressively and a lot of them quit using the product. Therefore, in
case of elastic demand, there is a higher variation in quantity traded and a lower
variation in price.
 In case of inelastic demand, producers have considerable scope to raise prices without
having a considerable loss in quantity demanded. This means that in case of inelastic
demand, there is a higher variation in price and lower variation in quantity.
 This is also shown on the diagram where
price increase in case of inelastic demand
(P1i) is greater than price increase of
elastic demand (P1e).
 The figure also shows that quantity
decrease is greater in case of elastic
demand (Q1e) than quantity fall of
inelastic demand (Q1i).
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This conclusion can also be shown for an
increase in supply where there is a larger fall in
prices in case of inelastic demand and a larger increase in quantity for elastic demand.
Following are scenarios where this principle can be applied:
 Subsidies result in a larger fall in prices when demand is inelastic.
 Tariffs lead to a larger fall in imports when demand is elastic.
 Indirect taxes lead to a larger fall in consumption of demerit goods or production of
negative externalities when demand is elastic.
HA
(iii)
Impact of taxes and subsidies
PED concept is useful for government when it is deciding to increase indirect taxes or provide
subsidies.
 Tax revenue increases if indirect taxes are increased on products that are price inelastic
and vice versa.
 Government bears a higher cost if subsidies are provided on products that are price
elastic and vice versa.
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PED and a downward sloping linear demand curve
PED varies at different points on a linear demand curve. This can be understood with the help
of a table. The table shows quantity demanded at Price
Qd
Revenue Impact on
different price levels of a linear demand curve. Total
($)
(units)
($)
revenue
revenue of the products initially increases with a fall
10
100
1,000
Rises
in prices (elastic demand); reaches a maximum point
8
200
1,600
Rises
(PED = 1); and then revenue starts to fall with a fall in
6
300
1,800
Maximum
prices (inelastic demand). This shows that as price fall,
4
400
1,600
Falls
people become less sensitive to change in price.
2
500
1,000
Falls
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Elasticity of demand varies throughout a downward sloping linear demand curve. Demand in
the upper part of the demand curve is elastic.
Demand in the lower part of the demand curve is
inelastic. For a very small price change, PED is
unitary when total revenue is maximum.
 Firm’s revenue will increase if it decrease
price when demand is elastic; it increase
prices when demand is inelastic; and it does
nothing when demand in unitary as the
revenue is maximum at this point.
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Range and attractiveness of substitutes
The greater the number of substitutes, the higher will be the elasticity of the product.
We will expect consumers to switch to a substitute if the price of the product increases.
The more closely substitutable the products are, the higher will be the elasticity of the
product and vice versa. Close substitutes mean that they satisfy a need with same
effectiveness. Competing products (such as Coke and Pepsi) tend to be close substitutes.
if we define the product broadly, i.e. products from different product groupings (i.e.
juices vs. cola drinks) tend to have low elasticities because of the different nature of
products in each category. However, if we define the product narrowly, i.e. products
within the same group of products (such as competing brands of orange juice) tend to
have high elasticities because of availability of very similar substitutes (i.e. the
competing products).
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(i)
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Factors affecting PED
There are many factors that affect PED. One must
be careful that different factors may indicate
different conditions for elasticity. One has to make
a conclusion based on an overall evaluation of the
factors whether PES is elastic or inelastic. Some of
the major factors are discussed below.
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(ii)
Brand image of a product
A strong brand name or a highly differentiated product will have low price elasticity. This is
because consumers will be loyal to the product and will not easily switch to a competing brand
if the price of the product rises. Companies can achieve differentiation through product
improvements, innovation, and effective advertisement.
On the other hand, products that are less differentiated (such as cheaper alternatives) will tend
to have elastic demand.
(iii)
Addictive properties of the product
If a product is habit-forming (i.e. addictive), it will have an inelastic demand. A good example of
this is cigarettes where consumers do not quit smoking easily even if there is a rise in price.
(However, it must be noted that the demand for individual cigarette brand may be elastic.)
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(iv)
Necessity or luxury
Products that are considered necessities (such as salt, sugar and wheat) tend to have inelastic
demand. Whereas products that are considered luxuries tend to have elastic demand.
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(v)
Quality and accessibility of information
Good quality information about the products that is easily available will make the demand
more elastic. Ease of access to information enables consumers to quickly compare prices of
substitutes and competing firms and also compare their quality. A rise in price of one product
will hence result in large switching to other products by consumers. Internet has been able to
increase quality of information which is easily accessible to consumers.
M
(vi)
Relative expense of the product
The larger the proportion of income that the price represent, the larger will be the impact on
consumer’s real income, hence, making the demand for the product more elastic. A student
with limited pocket money will be affected more by a 10% rise in price of dining out (which
costs a large proportion of student’s pocket money) than a 10% rise in price of a ball point pen
(which costs a small proportion of student’s pocket money).
HA
M
(vii) Time
In short run, demand is expected to be inelastic because people may find it difficult to alter
their spending patterns. Over time, people find ways to adapt and adjust. In the LR, therefore,
demand is expected to become more elastic. It can be hence concluded that PED is likely to
increase over time.
(viii) Shift in demand curve
An increase in demand (rightward shift) will make demand more inelastic. At higher levels of
demand people will be less sensitive to price changes. Similarly, a fall in demand will make
demand more elastic as people become more sensitive to price changes.
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8 – Elasticity
8.2 Income elasticity of demand (YED)
% ∆ 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑
% ∆ 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
AL
I
𝑌𝐸𝐷 =
K
INCOME ELASTICITY OF DEMAND (YED) is defined as a numerical measure of the
responsiveness of demand following a change in income alone. It is given as:
M
Analysing sign of YED
Sign that precedes YED tells the nature of relationship between income and demand. A positive
sign indicates a normal good and a negative sign indicates an inferior good.
 NORMAL GOODS are goods where demand is directly proportional to income, so that a
rise in income leads to a rise in demand and vice versa. Examples of normal goods can
include cars, perfumes and branded goods. YED of normal goods is positive.
 INFERIOR GOODS are goods where demand is inversely proportional to income, so that
a rise in income leads to a fall in demand and vice versa. Examples of inferior goods can
include cheap clothing and unbranded goods. YED of inferior goods is negative.
Analysing values of YED
Numerical value of the measure shows the strength of the relationship.
M
AD
(i) Elastic demand
Demand is said to be INCOME ELASTIC if there is a larger proportionate change in demand
following a change in income alone. YED of the product is greater than one but less than
infinity. It is a flatter curve as shown in the figure below. The sign of YED can be positive (for
normal goods) or negative (for inferior goods).
 A good that has positive income elastic demand are called LUXURY GOODS (superior
goods) such as foreign holidays. A rise in income leads to a greater proportional rise in
spending on these products.
M
(ii)
Inelastic demand
Demand is said to be INCOME INELASTIC if there is a smaller proportionate change in demand
following a change in income alone. YED of the product is less than one but greater than zero. It
is a steeper curve as shown in the figure below.
 The sign of YED can be positive (for normal goods) and negative (for inferior goods).
 A good that has positive income inelastic demand are called NECESSITIES such as
cheaper goods. A rise in income leads to a smaller proportional rise in spending on these
products.
HA
(iii)
Perfectly elastic demand
PERFECTLY ELASTIC DEMAND is infinitely responsive to income and is shown as a line that is
horizontal to the x-axis in the figure below. YED of perfectly elastic demand curve is infinite (∞).
(iv)
Perfectly inelastic demand
PERFECTLY INELASTIC DEMAND is not responsive to income. A change in income does not
affect demand of the product. YED of inelastic demand curve is zero (0) and it is shown as a line
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8 – Elasticity
K
vertical to the x-axis in the figure below. These goods are BASIC NECESSITIES such as salt and
sugar.
M
AL
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(v)
Unitary elasticity
Demand is said to have UNITARY ELASTICITY if the relative change in income is exactly matched
by a relative change in demand. YED will be 1.0. A straight line starting from the origin in case of
normal good should have unitary demand.
AD
It must be noted that the impact of numerical value of elasticity will be on the extent of shift. A
change in income leads to a shift in the demand curve. If the demand is elastic, then a change in
income will have a proportionately higher impact on demand and there will be a greater
movement in the demand curve. If the demand is inelastic, then a change in income will have a
proportionately lower impact on demand and there will be a lesser movement in the demand
curve.
HA
M
M
Change in income and firm’s revenue (or consumer expenditure)
Rise in income
An increase in income in case of normal goods leads to a rightward shift in the demand curve as
shown in the figure.
 Initial equilibrium with demand curve D1
and supply curve S0 was at E1. Equilibrium
price was P1 and equilibrium output was
Q1.
 Increase in income leads to a rightward
shift in the demand curve to D2. There is a
greater rise in demand in case of luxury
goods and a lower rise in demand in case
of necessities.
 New equilibrium is established at E2 with a higher price (P2) and a higher output (Q2).
Total revenue also rises from P1Q1 to P2Q2. There is a larger rise in revenue in case of
luxury goods. However, in case of necessities revenue does not change a lot as
demand is not affected a lot due to change in income levels.
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8 – Elasticity
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An increase in income will lead to a leftward shift in demand curve in case of inferior goods as
shown in the figure.
 Initial equilibrium with demand curve D1
and supply curve S0 was at E1. Equilibrium
price was P1 and equilibrium output was
Q1.
 Increase in income leads to a leftward shift
in demand curve to D2. Extent of shift
depends on the value of YED (whether it is
elastic or inelastic).
 New equilibrium is established at E2 with a
lower price (P2) and a lower output (Q2). This results in a lower revenue which falls from
P1Q1 to P2Q2.
M
A rise in income will not have a major impact on the demand of basic necessities so that
revenue from selling such goods does not change a lot.
AD
Fall in income
A decrease in income in case of normal goods will lead to a leftward shift in the demand curve
leading to a lower price and lower output. There will a greater fall in demand and hence output
of luxury goods. Demand for normal necessities will not fall by much.
A decrease in income will lead to a rightward shift in demand curve of inferior goods leading to
a higher price and a higher output.
M
Fall in income will not affect demand of basic necessities a lot therefore not affecting their
revenue.
HA
M
The effect of income on the demand for normal
and inferior goods can be shown with the use of
the following figure.
 D1 shows the demand for normal goods
that increase with an increase in income.
 D2 shows the demand for inferior goods
that decreases with an increase in
income.
D3 shows a good (such as bread) which is normal
at low levels of income but is inferior at higher
levels of income.
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8 – Elasticity
K
Business relevance of YED
Businesses can use knowledge of YED to develop their product, price and promotional
strategies.
M
AL
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For normal goods, businesses may pursue following strategies.
 During boom, income levels rise leading to an increase in demand for normal goods.
Companies can increase their productive capacity; increase output; and increase prices.
Firms can promote normal goods through attractive displays and persuasive advertising.
In an agrarian society such as Pakistan, firms can aggressively promote luxury products
in those months when crops are sold.
 During recession, income levels fall leading to a fall in demand for normal goods.
Companies producing luxury goods will be especially vulnerable during periods of
recession. They can reduce output and may consider introducing cheaper alternatives
with different brand name to attract price-sensitive customers. By introducing new
brands, firms can both attract customers and also protect the brand image of their
superior products.
AD
For inferior goods, businesses may pursue following strategies.
 During boom when income levels are rising, demand for inferior goods will fall.
Companies can pursue different strategies such as reduce prices; reduce output; and try
to move upmarket by launching a better quality product with a good image.
 During recession income levels fall leading to a rise in demand for inferior goods.
Companies can increase productive capacity; increase output; and increase prices.
M
Businesses and governments can use YED to forecast future demand for a range of goods and
services. A rise in income levels will increase demand for normal goods, especially luxuries such
as cars. Firms will need to produce more cars and government will need to build more roads to
accommodate the increased demand.
M
Government can also assess the impact of changes in income tax. A rise in income tax reduces
disposable income leading to a fall in demand for normal goods and rise in demand for inferior
goods.
8.3 Cross elasticity of demand (XED)
HA
CROSS ELASTICITY OF DEMAND (XED) is a numerical measure of the responsiveness of demand
for one product following a change in the price of a related product alone. XED can be
calculated as:
% ∆ 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝐴
𝑋𝐸𝐷 =
% ∆ 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑟𝑒𝑙𝑎𝑡𝑒𝑑 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝐵
Analysing sign of XED
Sign that precedes XED tells the nature of relationship between price of related product and
demand. There can be two types of related products:
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8 – Elasticity
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
SUBSTITUES are products that satisfy essentially the same need, e.g. brands of
competing firms (such as Coke and Pepsi, HP and Dell, Mobilink and Ufone), and
products from different categories (such as tea and coffee). Substitute products have a
positive value for XED.
COMPLEMENTS are products that enhance the utility derived from consuming another
product, e.g. computers and printers, razors and razor-blades, car and fuel etc.
Complements have a negative value for XED.
K

Analysing values of XED
Numerical value of the measure shows the strength of the relationship.
M
(i) Elastic demand
Demand is said to be CROSS ELASTIC if there is a larger proportionate change in demand
following a change in price of a related good alone. XED of the product is greater than one but
less than infinity. It is a flatter curve as shown in the figure below.
 Elastic demand means that the products are either CLOSE SUBSTITITUES (if XED is
positive and elastic) or CLOSE COMPLEMENTS (if XED is negative and elastic).
AD
(ii)
Inelastic demand
Demand is said to be CROSS INELASTIC if there is a smaller proportionate change in demand
following a change in price of a related good alone. XED of the product is less than one but
greater than zero. It is a steeper curve as shown in the figure below.
 Inelastic demand means that the products are either DISTANT SUBSTITUTES (if XED is
positive and inelastic) or DISTANT COMPLEMENTS (if XED is negative and inelastic).
M
(iii)
Perfectly elastic demand
PERFECTLY ELASTIC DEMAND is infinitely responsive to a change in price of a related good and
is shown as a line that is horizontal to the x-axis in the figure below. XED of perfectly elastic
demand curve is infinite (∞).
M
(iv)
Perfectly inelastic demand
PERFECTLY INELASTIC DEMAND is not responsive to a change in price of another good. A
change in the price of another good does not affect demand of the product. These goods are
therefore UNRELATED GOODS such as shoes and ice cream. XED of inelastic demand curve is
zero (0) and it is shown as a line vertical to the x-axis in the figure below.
HA
(v)
Unitary elasticity
Demand is said to have UNITARY ELASTICITY if the relative change in the price of a related good
is exactly matched by a relative change in demand. XED will be 1.0. A straight line starting from
the origin in case of a substitute good should have unitary demand.
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8 – Elasticity
M
It must be noted that the impact of numerical value of elasticity will be on the extent of shift. A
change in price of a related product leads to a shift in the demand curve. If the demand is
elastic, then a change in price of a related product will have a proportionately higher impact on
demand and there will be a greater movement in the demand curve. If the demand is inelastic,
then a change in price of a related product will have a proportionately lower impact on demand
and there will be a lesser movement in the demand curve.
M
AD
Change in price of related goods and firm’s revenue (or consumer expenditure)
Rise in price of substitutes
If price of substitute (B) goes up, then B will become less attractive and people will turn to
product A because of a more favourable price
leading to an increase in demand and rightward
shift in the demand curve of product A. This is
shown in the figure. The result of rightward shift in
demand is that the price of the product will increase
and the quantity traded will also increase resulting
in a rise in total revenue. Initial revenue is P1Q1 and
the new revenue is P2Q2 which is greater than the
initial revenue.
M
Fall in price of substitute
If price of substitute (product B) falls, then B will become more attractive and people will switch
to B leading to a fall in demand for product A and a leftward shift in the demand curve of
product A. This will result in a fall in price and a fall in quantity traded. This results in a fall in
revenue.
HA
The degree of shift in demand curves and the impact on prices and quantity traded depends on
the numerical value of XED.
 Close substitutes will have high value of XED (meaning elastic demand). This is because
of high degree of interdependence between suppliers and there is a real danger of price
wars in the market. Price reduction by one firm will lead to other firms following suit
leading to a price reduction by all firms and start of price wars.
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8 – Elasticity
Distant substitutes will have lower value of XED (inelastic demand) and there will be
less fear of price wars.
K

AL
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Rise in price of complements
If price of a product B, such as razors, goes up, it will reduce its quantity demanded leading to a
fall in demand of product A that is a complement (e.g. razor blades). This fall in demand leads
to a leftward shift in the demand curve of product
A as shown in the figure leading to a fall in price
and a fall in quantity traded resulting in a fall in
total revenue from selling product A. Initial revenue
is P1Q1 and the new revenue is P2Q2 which is lower
than the initial revenue.
AD
M
Fall in price of complement
If price of a product B, such as razors, falls, it will
make B attractive leading to increase in its quantity
demanded. More use of razors will also increase
demand for razor blades (complements of razors).
This increase in demand leads to a rightward shift in demand curve of product A leading to a
rise in price and a rise in quantity traded hence resulting in total revenue from sales of product
A.
M
The degree of shift in demand curves and the impact on prices and quantity traded depends on
the numerical value of XED.
 Close complements will have high value of XED (meaning elastic demand). This is
because the two products are used together very frequently such as DVD players and
DVDs.
 Distant complements will have lower value of XED (inelastic demand) and the demand
for the product will be less sensitive to a change in price of a complements.
HA
M
The effect of price of related goods on demand of
a product can be shown with the use of the
following figure.
 D1 shows the demand for substitutes that
increases with an increase in price of
related goods.
 D2 shows the demand for complement
that decreases with an increase in price of
related goods.
Business relevance of XED
Firms must also realize that their strategy
depends on the actions of their competitors.
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8 – Elasticity
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
K


Rise in price of competitors will increase demand for firm’s products so the firm can
launch more promotional campaigns in order to increase its sales. Firm can also decide
to increase its price.
Fall in price of competitors will reduce the demand for firm’s products.
Company will have to react to different situations according to the impact on its
demand.
Firms therefore do not take their decisions in isolation but they also have to judge the
reaction of their competitors before adopting a strategy.
Firm’s strategy will be more dependent on the strategy of a close substitute than on the
strategy of a distant substitute.
AL
I

M
XED helps firms identify products that are most complementary. This aids firms in
complementary product pricing to ensure that firms are able to maximize their revenues.
 Products with high value of XED will be close complements and products with low value
of XED will be distant complements.
 Firms can charge a lower price for close complements (such as razors) to attract
customers. However, they can charge a higher price for razor blades because of their
high XED. Fall in revenue for firm because of lower price of razors will be compensated
by higher revenue from charging a higher price for razor blades.
AD
Government can also use the concept of XED to see how its policies affect demand of goods
and services.
 Higher indirect taxes on cigarettes can increase demand for nicotine patches and other
substitutes.
 Rise in price of natural gas affects demand for coal used in power generation.
M
XED can hence be very useful for firms in deciding their strategies and can aid them in
maximizing their revenues. However, demand for a product is not affected by price of related
goods only and a firm must keep in mind other factors as well before finalizing a strategy.
8.4 Price elasticity of supply (PES)
M
PRICE ELASTICITY OF SUPPLY (PES) is a numerical measure of the responsiveness of quantity
supplied to a change in price of the product alone. PES can be calculated as:
𝑃𝐸𝑆 =
% ∆ 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
% ∆ 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
HA
Analysing sign of PES
PES is positive because relationship between price and quantity supplies is a direct one as
stated by the law of supply (because of profit motive and the law of diminishing returns). An
increase in price leads to an increase in quantity supplied and vice versa.
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8 – Elasticity
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Analysing magnitude of PES
The numerical value of PES ranges from 0 to ∞ depending upon the elasticity of the product.
AL
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(i) Perfectly inelastic supply
PERFECTLY INELASTIC SUPPLY is not responsive to price. Suppliers are willing and able to supply
the same amount of product irrespective of price
changes. PES of inelastic demand curve is zero (0)
and the supply curve is vertical to x-axis. An example
of perfectly inelastic supply can be parking space in
a mall. If price changes, the owners of the mall will
not be able to the change the parking space.
M
(ii) Perfectly elastic supply
PERFECTLY ELASTIC SUPPLY is infinitely responsive
to change in prices. The supply curve is horizontal to
the x-axis and suppliers will supply all products
available in the market at P1 but there will be no supply if price increased slightly to P2. PES of
perfectly elastic supply curve is infinite (∞). It is not a very realistic case.
M
AD
(iii) Unitary elasticity
Supply is said to have UNITARY ELASTICITY if
percentage change in quantity supplied is equal to
the percentage change in price. For example, if price
of a product rises by 5% and the quantity supplied
also rises by 5%, PES will be +1.0. All linear supply
curves that start from origin have unitary elasticity.
The equation of such supply curve will be:
𝑄𝑠 = 𝑏𝑃
HA
M
(iv) Elastic supply
Supply is said to be PRICE ELASTIC if there is a larger
proportionate change in quantity supplied following a change in price of the product alone. PES
of the product is greater than one. For example, if
price of a product increases from $100 to $105 (5%
increase), the quantity supplied rises from 1,000
units to 1,100 units (10% increase). In this case, PES
is +2.0 (= +10% /+5%).
 The line labelled Se in the figure shows an
elastic supply curve.
(v) Inelastic supply
Supply is said to be PRICE INELASTIC if there is a
smaller proportionate change in quantity supplied
following a change in price of the product alone. PES
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8 – Elasticity
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of the product is less than one. For example, if price of a product increases from $100 to $105
(5% increase), the quantity supplied rises from 1,000 units to 1,010 units (1% increase). In this
case, PES is +0.2 (= +1% /+5%).
 The line labelled Si in the figure shows supply curve with inelastic demand.
AL
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Business relevance of PES
PES can explain the speed and ease with which businesses can respond to market conditions.
 In case of a rise in demand, businesses with elastic supply can respond more quickly
than businesses with inelastic supply. Firms with elastic supply can easily hire more
workers and use their spare capacity.
M
PES is relevant in agricultural markets in explaining the difficulty in increasing crops or switching
to more lucrative ones when price rises. Farmers are constrained by climatic and soil
conditions, and availability of land. Pakistan’s cotton growers cannot easily switch to growing
coffee.
AD
In case of a shift in the supply curve (imposition of tax, provision of subsidies etc.), the impact
is as follows:
 Inelastic supply is inflexible and does not shift a lot (a perfectly inelastic supply curve
does not shift at all). Increase in supply (provision of subsidy) and a decrease in supply
(imposition of indirect tax) is not going to affect both prices and quantity a lot. In case
of perfectly inelastic supply curve, there is no shift in the supply curve and hence no
change in either price or quantity traded.
 Elastic supply is flexible and shifts in response to a change in tax or subsidy. There is
going to be a greater change in both prices and quantity due to imposition of tax or
provision of subsidy.
M
Factors influencing PES
The key factor that influences elasticity of supply is flexibility of supply, i.e. if firms and
industries are more flexible in the way they behave, then supply tends to be more elastic and
vice versa. The main influences on elasticity of supply are discussed below.
HA
M
(i) Ease with which firms can accumulate or reduce stocks of goods
Stocks allow companies to meet variations in demand through output changes rather than price
changes.
 Firms that can easily stock goods will have higher PES (elastic supply). Goods that can be
easily stored include durable goods, non-perishable goods, goods that use good
packaging that increases their shelf life, and goods where there is no fear of
obsolescence such as goods in industries that are not facing rapid technological change
or goods that are not fashion items.
 Firms that find it difficult to stock goods will have lower PES (inelastic supply). Goods
that cannot be easily stored include perishable items (food), fashion items (clothing),
and hi-tech goods (technology) etc.
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8 – Elasticity
Services cannot be stored.
K
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M
AL
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(ii) Ease with which firms can increase production
Firms, in SR, may be constrained by many factors.
 Firms and industries with spare capacity will have higher PES (elastic supply) as they will
be able to increase supply of goods easily if there is an increase in demand. Supply will
be inelastic if industry is operating at full capacity as it will not be able to expand output
in SR as demand rises.
 Shortages of critical factor inputs (such as skilled workers, components and fuel) will
lead to inelastic supply as firms will not be able to increase output quickly because of
shortage of inputs and vice versa.
 Unemployment in the economy can influence elasticity of supply. At full employment
levels, supply tends to be inelastic as firms will not be able to change their output in SR
due to shortage of workers. If the economy is operating below full employment levels,
supply tends to be elastic as firms can easily hire workers to expand output.
AD
(iii) Length of the production process
The longer that it takes to produce a good or service, the lower will be the PES (inelastic supply)
because firms will not be able to react quickly to changes in demand and vice versa. Agricultural
products take considerable time to grow and supply tends to be inelastic in the short-run. In
manufacturing sector, production process is usually shorter and it takes less time to change
output making supply elastic. However, even in manufacturing where production takes a longer
period such as in construction or in making luxury yachts, supply tends to be inelastic.
M
(iv) Ability to import inputs
If a country is able to import inputs (raw material and capital) easily and cheaply, supply will be
elastic and vice versa.
HA
M
(v) Over time
In very short-run (momentary period) supply is perfectly elastic and is restricted to the
quantities actually available in the market. In short-run, supply can be changes but is inelastic
and is constrained by the availability of resources, availability of capacity and also due to long
production runs in some sectors such as agriculture. Supply tends to become elastic in the longrun as companies can increase their productive capacity by investing in more capital
equipment, more firms can enter or leave an industry, workers can be trained in skills, new
suppliers of raw material can be identified and like that.
8.5 Limitations of using elasticities
In practice, it is very difficult to calculate elasticities leading to following problems:
 Calculating elasticity values from historical data can be difficult and may even be
misleading.
o One problem is of ceteris paribus assumption. When calculating elasticity values
using historical data we have to assume that changes have only been caused by
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8 – Elasticity
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one variable, e.g. in case of PED, changes in demand are only caused by changes
in price of that product. However, non-price factors can also influence demand
of the product. It is hence difficult to separate out all other influences and just
measure the impact of price changes alone on quantity demanded. This problem
is referred to as identification problem. This problem can be overcome partially
through use of market research.
It is difficult to collect data from other sources such as market testing or surveys.
o Data collection can be costly and time consuming and the results collected may
not be valid and reliable because of sampling and other errors.
Another problem is of rapidly changing markets. If markets are rapidly changing, then,
elasticity results will also change. This will make past data less relevant for making
predictions about the future.
HA
M
M
AD
M
Possible solutions to overcome difficulties in calculating elasticities are listed below.
 Firms can carry out market research using sophisticated simulation techniques to isolate
the impact of relevant variables only (such as price in case of PED).
 Firms must use historical data with caution.
 Firms can make rough guesstimates of elasticity values using the experience of the
management.
 Firms can even decide to work with incomplete data.
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9 – Consumer surplus and Producer surplus
K
9 Consumer surplus & Producer surplus
9.1 Consumer surplus
AD
M
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CONSUMER SURPLUS is the difference between the value a consumer places on units
consumed and the payment needed to actually
purchase that product. It shows the welfare that a
consumer derives from the purchase of a product.
 The demand curve shows the value that
consumers place on the product.
Consumer surplus arises because some
consumers are willing to pay a higher price
than the market price.
 For instance, if a consumer is willing to pay
price P2 (e.g. $10) while the equilibrium
price is P1 (e.g. $3), then the consumer surplus for that particular consumer is equal to
P2 – P1 ($7). As the quantity sold increases, consumers are willing to pay less. The
consumer surplus therefore keeps on falling. The last consumer is just willing to pay a
price equal to equilibrium price and his surplus is hence equal to zero.
 Total consumer surplus is therefore the area below the demand curve and above the
equilibrium price and is given by the area ABP1.
M
The amount of consumer surplus will depend on whether the demand is elastic or inelastic.
 When the demand for a good or service is perfectly elastic, consumer surplus is zero
because the price that people pay matches precisely the price they are willing to pay.
 When demand is perfectly inelastic, consumer surplus is infinite. Demand is totally
invariant to a price change and remains the same.
HA
M
The majority of demand curves are downward
sloping. When demand is inelastic, there is a
greater potential consumer surplus because there
are some buyers willing to pay a high price to
continue consuming the product.
 The figure shows De as elastic demand
curve and Di as inelastic demand curve.
Market equilibrium is at price P1.
 In case of inelastic demand curve,
consumer surplus is the area ABP1. Whereas in case of elastic demand curve, consumer
surplus is the area CBP1. Inelastic demand curve clearly has a larger consumer surplus.
A fall in supply leading to a rise in price will lead to a fall in consumer surplus. Consumer
surplus falls from AE1P1 to AE2P2. Fall in consumer surplus is equal to P1E1E2P2. The impact will
depend on whether the demand is elastic or inelastic. Fall in supply will have a greater impact
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9 – Consumer surplus and Producer surplus
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on prices in case of inelastic demand. Therefore, there will be a greater proportional change in
consumer surplus in case of inelastic demand.
M
An increase in supply leads to fall in prices and increase in quantity traded. This leads to an
increase in consumer surplus. Consumer surplus rises from AE1P1 to AE2P2.
M
AD
An increase in demand shows that consumers are prepared to pay a higher price for the same
quantity bought. This leads to an increase in their consumer surplus. Consumer surplus rises
from AE1P1 to BE2P2.
A fall in demand shows that consumers are prepared to pay a lower price for the same quantity
bought. This leads to a fall in consumer surplus from AE1P1 to BE2P2.
M
9.2 Producer surplus
HA
PRODUCER SURPLUS shows the difference
between the price a producer is willing to accept
and what is actually paid. It shows the producer
welfare.
 Producer surplus is the area below the
equilibrium price and above the supply
curve.
 If a producer is willing to charge a price P3
(e.g. $1) and receives a higher price P1 (e.g. $3), then the producer surplus is equal to P 1
– P3 ($2).
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9 – Consumer surplus and Producer surplus
In the figure, this is the area ABP1.
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Total producer surplus depends on whether the
supply is elastic or inelastic. Inelastic supply will
have a higher producer surplus.
 Si is the inelastic supply curve and Se is an
elastic supply curve.
 In case of inelastic supply curve, the
producer surplus is the area OBP1. In case
of elastic supply curve, the consumer
surplus is the area ABP1. The area is larger in case of inelastic supply.
K
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AD
M
A rise in demand means that suppliers can sell more quantities of goods at higher prices
leading to increase in producer surplus from AE1P1 to AE2P2. Rise in producer surplus is equal to
P1E1E2P2.
A fall in demand means that suppliers can sell fewer quantities of goods at lower prices leading
to a fall in producer surplus from AE1P1 to AE2P2. Loss in producer surplus is equal to P1E1E2P2.
HA
M
M
A rise in supply increases the producer surplus from P1E1A to P2E2B. A fall in supply reduces the
producer surplus from P1E1A to P2E2B.
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10 Taxes – Direct and Indirect
TAXES are charges that are imposed by governments on people and businesses.
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10 – Taxes
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AD
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Purposes of taxation
 To collect tax revenue for the government – Government collects taxes to finance its
spending such as on public goods, merit goods, administration, welfare benefits and
subsidies. Developed countries depend mainly on direct taxes while developing
countries depend mainly on indirect taxes.
 To reduce inequalities in the distribution of income – Government tries to reduce
income inequality to create social cohesion and avoid any unrest in the society.
Government can reduce income inequality in four ways:
o Progressive tax system where a higher percentage of tax is charged from those
who are earning higher income.
o Tax exemption for the poor.
o Higher indirect taxes on luxuries such as cars that are usually bought by the rich.
o Negative income tax where if a household earns less than the minimum level of
income, the government gives a subsidy so that they have a subsistence level of
income.
 To combat inflation – Government can charge higher direct taxes that reduces
disposable income and aggregate demand hence controlling demand pull inflation.
o Imposition of indirect taxes, on the other, raise prices and increases inflation.
 To correct an adverse balance of payments – Government can impose a tariff on
imported goods that raises their prices and reduce their demand.
 To check consumption of goods that are considered undesirable – Government can
impose indirect taxes on consumption of goods that have negative externalities or are
considered demerit goods such as cigarettes.
 To protect local/infant industries – Government can protect infant industries by giving
them tax holidays or tax exemptions or by putting tariffs on imports hence reducing
demand for imported goods and increasing demand for local goods.
 To reallocate resources – Heavy taxes on certain goods can discourage consumption
and its production whereas lowering taxes on certain goods or industries can encourage
their expansion.
HA
Rates of tax
AVERAGE RATE OF TAX is defined as the average percentage of total income that is paid in
taxes. All forms of taxation are included in the calculation.

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑡𝑎𝑥 =
𝑇𝑎𝑥 𝑝𝑎𝑖𝑑⁄
𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 × 100
It is more equitable for the poorest income groups to have a low average tax rate;
higher earners should in contrast should have higher average tax rate.
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10 – Taxes
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𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑡𝑎𝑥 = ∆𝑇𝑎𝑥⁄∆𝐼𝑛𝑐𝑜𝑚𝑒 × 100
K
MARGINAL RATE OF TAX is the proportion of an increase in income that is paid in taxes to the
government.
In a progressive tax system, the marginal rate of tax will be greater than the average
rate of tax resulting in a more equal distribution of income.
AD
M
Relationship between taxation and income
 PROGRESSIVE TAX is a tax that takes a higher percentage from those with higher
incomes. Income tax in most countries is usually progressive.
o The average rate of tax will be lower than the marginal rate. It results in a more
equal distribution of income.
o A high marginal tax rate is however a disincentive to work and may result in a fall
in aggregate supply.
 REGRESSIVE TAX is a tax that takes a greater percentage from those on lower incomes.
Indirect taxes are regressive in nature.
o The average and the marginal rates of tax fall with a rise in income. It results in
inequality of distribution of income with poor bearing a larger burden of tax.
 PROPORTIONAL TAX is a tax whereby as income rises, the proportion of income paid in
tax remains the same. The tax rate is therefore constant.
o The average and marginal rates of tax are equal and constant.
NOTE: As income rises, people pay more in absolute terms but what is more relevant in this
classification is the percentage of income paid in tax.
M
M
Governments need to achieve the right balance between direct and indirect taxes.
 A trend in many countries has been to collect increasing revenues from indirect taxes
since they can usually be collected quickly, are less liable to evasion and corruption, and
do not interfere with the work incentive problems. This is a usual practice in developing
countries.
10.1 Canon of taxation
HA
CANONS OF TAXATION are the criteria for a ‘good’ tax set by the famous economist Adam
Smith in his book The Wealth of Nations. The canons are listed below:
1. Equitable – Those who can afford to pay more should pay more. Equity can be achieved
through progressive tax system, tax exemption for the poor, and negative income tax.
2. Economic – The revenue should be greater than the costs of collection. This partly
explains why people with low income and those in rural areas are not taxed as the cost
of collecting would be greater than the revenue earned.
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3. Transparent – Taxpayers should know exactly what they are paying. They must be
certain of the payment (should not fluctuate), the period of payment (usually within a
year), and the method of payment (in instalments, or in person, on online).
4. Convenient – It should be easy to pay. The taxpayers must be least inconvenienced in
filling the returns and in making payments.
M
These principles are necessary but insufficient to make an ideal tax system. Other features are
listed below that make the system better.
 A tax must not discourage effort and initiative.
 It must be flexible and can adjust itself to different economic conditions.
 There should be variety of taxes used such as a good mixture of direct and indirect
taxes.
 Double taxation should be avoided.
 Tax avoidance and evasion should be made difficult such as by imposing heavy
penalties on those who do not pay taxes.
 It must be consistent with government policy.
10.2 Direct taxes
M
M
AD
DIRECT TAX is one that taxes the income of people and firms and cannot be avoided such as
income tax for individuals, sole proprietors, and partnerships; corporation tax on the profits of
businesses; property tax on assets like houses, land and buildings; inheritance tax for inherited
property; road tax on vehicles based on engine capacity; and national insurance contributions
paid by employers and employees.
 These are called direct because they are paid directly to the government by the
taxpayers.
 There burden cannot be shifted to the third party. The impact of tax (who pays the first)
and the incidence of tax (who ultimately pays the tax) will coincide. For instance,
taxpayer cannot evade the personal income tax by passing the burden to someone else.
 Direct taxes are based on income and wealth. The more one earns, the more one pays
the tax.
 Direct taxes are usually progressive in nature. The marginal tax rate rises with a rise in
incomes.
 Direct taxes are compulsory in nature. They are totally unavoidable and tax evasion in
an offence in the eyes of the law.
HA
Advantages
 It can be raised or lowered by the government in response to the needs of the state.
 It is convenient and certain.
 The incidence of tax can be calculated.
 It can reduce income inequality.
 It is a build-in stabilizer, i.e. it helps reduce economic fluctuations. During inflation,
higher income taxes are paid and during recession, lower income taxes are paid.
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10 – Taxes
It is a major source of revenue especially for developed economies.
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Disadvantages
 Payments of large sums at one time is inconvenient.
 It reduces personal savings.
 There is large administrative costs to collect taxes, check and keep records for tax
reports.
 High rates of marginal tax can be a disincentive to work hence reducing aggregate
supply.
 Tax evasion is possible especially if tax rates are high, policing mechanism is weak and
penalties are low.
 Form filling of tax returns can be time-consuming and complicated task.
M
NOTE: On a demand and supply diagram, direct taxes affect demand curve. A rise in direct taxes
reduces disposable income leading to a fall in demand for normal goods and a rise in demand
for inferior goods and vice versa.
10.3 Indirect taxes
M
M
AD
INDIRECT TAX is a tax levied on goods and services. It can include customs duties which are
imposed on imported goods, excise duties which are taxes on locally produced goods, sales tax
which is a tax on the value of sales, entertainment tax which is on entertainment such as on
cinema, and value-added tax which is on various stages of production.
 The tax burden can be shifted to the third party. The impact and the incidence are not
identical. The producer usually will bear the impact of the tax but ultimately the burden
will be borne by the consumer in the form of higher prices. However, the extent to
which the burden is borne by the consumer or the producer depends on the elasticities
of demand and supply.
 Indirect taxes are based on expenditure and consumption. The more one spends, the
more tax one has to pay.
 All indirect taxes are regressive in nature. The burden of indirect tax is heavier on the
poor rather than on the rich.
 Indirect taxes can be avoided, i.e. if one avoids consuming a good, then the tax on that
good can be avoided.
HA
Impact of imposition of indirect taxes on supply curve
Imposition of indirect taxes result in a rise in cost of production resulting in a leftward shift in
the supply curve. The impact on supply curve depends on whether it is a specific tax or an ad
valorem tax.
 SPECIFIC TAX is an indirect tax that is fixed per unit charged and leads to a parallel shift
leftwards in the supply curve. Excise duty is an example of such type of tax.
 AD VALOREM TAX is a tax that is charged as a given percentage of the price. The higher
the value of the product, the higher will be the tax charge. In case of an ad valorem tax,
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10 – Taxes
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the amount of tax will increase with an increase in price of the product leading to a nonparallel leftward shift in the supply curve.
AD
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Impact of imposition of indirect taxes on prices and quantity traded
Imposition of indirect taxes lead to a leftward shift in the supply curve from S1 to S2. Initial
equilibrium is at point E1 where firms charge a
price P1 and the quantity traded is Q1. Shift in
supply from S1 to S2 leads to a new equilibrium at
E2 where market price has increased to P2 and
quantity traded has fallen to Q2. Tax per unit
charged is the vertical distance between the
supply curves at the new quantity traded (Q2).
Therefore, tax per unit is equal to the distance
E2X or P2P3.
M
Impact on government
Government gains revenue. Total revenue of the government is equal to tax per unit multiplied
by the quantity traded and is equal to the area P2E2XP3. Government revenue will be greater if
demand is inelastic.
HA
M
Incidence of tax
INCIDENCE OF TAX is the extent to which the tax burden is borne by the producer or the
consumer or both.
 Increase in price (P1 to P2) is less than the tax charged per unit (P2P3). This means that
the incidence of tax is unlikely to fall totally on consumers and is most likely to be
shared by both producers and consumers. The extent of tax burden that falls on the
consumers or the producers depends on the elasticities of demand and supply. In the
figure, tax burden that falls on the consumers is P 2EeYP1 whereas producers pay P1YXP3
in taxes.
Impact on consumers
Consumers are likely to lose due to a rise in prices and a fall in quantity. There is a greater
impact on consumers of a rise in price if demand is inelastic and supply is elastic. Initial
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consumer surplus was AE1P1. New consumer surplus after imposition of tax is AE2P2. Loss in
consumer surplus is equal to P1E1E2P2.
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AD
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All of tax will be paid by consumers if demand curve is perfectly inelastic or supply curve is
perfectly elastic as shown in the figure.
 In case of perfectly inelastic demand curve, the increase in price (P1 to P2) is equal to the
amount of indirect tax charged per unit (E2E1), therefore, whole of the tax is paid by the
consumers.
 In case of perfectly elastic supply curve, the price increase (P1 to P2) is again equal to the
tax charged (E2E1), therefore, the complete burden of tax falls on the consumers.
HA
Impact on producers
Producers are likely to lose due to fall in quantity and a reduction in price that they are
getting. Producers will bear a larger burden if demand is elastic and supply is inelastic. Initial
producer surplus was BE1P1. New producer surplus after imposition of tax is BXP3. Loss in
producer surplus is equal to P1E1XP3. Producer revenue will fall. Initial producer revenue was
P1Q1 and new producer revenue is P3Q2.
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10 – Taxes
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All of tax will be paid by producers if demand curve is perfectly elastic or supply curve is
perfectly inelastic as shown in the figure.
 In case of perfectly elastic demand curve, there is no change in price as the supply curve
shifts to the left. This means that the whole of the tax burden is borne by the producers.
 In case of perfectly inelastic supply curve, firms will not be able to change their output in
the short run at least. This means that imposition of tax does not affect the supply curve
and hence there is no change in market equilibrium. Since, price of the product does not
change, the whole incidence of tax falls on the producer.
M
Impact on society
Society will lose due to reduction in consumer and producer surplus being greater than the
government revenue. DEADWEIGHT LOSS (loss in welfare to the society) is equal to E2E1X.
HA
Drawbacks
 It raises prices leading to cost-push inflation (greater price increase when demand is
inelastic and supply is elastic). Higher prices may lead to a fall in exports (when
combined elasticities of demand and supply are greater than one).
 Reduces consumer and producer surplus. Use of indirect taxes also results in
deadweight loss, i.e. loss of economic welfare.
 Lower production of good leading to fall in GDP and a rise in unemployment (greater
impact when both demand and supply are elastic)
 Indirect taxes are regressive and their use put more burden on the poor.
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10 – Taxes
Market mechanism is not allowed to operate freely due to government intervention.
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10.4 Removal of indirect taxes
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Benefits of indirect tax
 It checks consumption and production of negative externalities and demerit goods
(useful when both demand and supply are elastic).
 Government collects tax revenue that can be spent on building infrastructure such as
spending on health and education (useful when demand is inelastic)
 Indirect taxes are difficult to evade and must be paid.
 It stabilizes the economy automatically, i.e. if demand is to high leading to inflation,
indirect taxes will also increases leading to a fall in demand.
 In this way, government can tax those who are not paying income tax.
 It can help in reducing imports and improving balance of payments. Lower imports also
protect infant industries. There will be a greater fall in imports if demand is elastic.
 They are relatively easy to collect.
 It does not discourage work.
M
M
AD
In the figure, the initial equilibrium is at P1 and Q1. Removal of tax leads to increase in supply
from S1 to S2 leading to a new equilibrium at a
lower price P2 and a higher quantity traded Q2.
 Amount of tax reduction is the vertical
distance between the supply curves and is
equal to E1X or P1P3.
 Reduction in price from P1 to P2 is less than
the reduction in indirect tax (P1P3). This
means that the impact of tax reduction is
partially passed on to the consumer and is
partially enjoyed by the producer. The
exact impact depends on the elasticities of demand and supply. In case of inelastic
demand or elastic supply there is a larger price decrease meaning that more of the
benefit is passed to the consumers. In case of elastic demand or inelastic supply there
will be a lower decrease in price meaning that producers will gain more.
HA
Impact on government
Government will lose tax revenue equal to P1E1XP3. There would be a greater loss if demand is
inelastic.
Impact on consumers
Consumers are likely to gain due to a fall in prices and a rise in quantity (greater gain if
demand is inelastic and supply is elastic). Initial consumer surplus was AE1P1. New consumer
surplus after removal of tax is AE2P2. Gain in consumer surplus is equal to P1E1E2P2.
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Impact on society
Society will gain due to a rise in welfare equal to E1E2X.
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Impact on producers
Producers are likely to gain due to rise in quantity and a rise in price that they are getting
(producers gain more if demand is elastic and supply is inelastic). Producer revenue will rise.
Initial revenue was P3Q1. New revenue is P2Q2.
M
Analysis of removing indirect taxes
Removal of indirect taxes leads to following benefits:
 Reduces prices hence controlling inflation (more useful when demand is inelastic and
supply is elastic). Lower prices may lead to a rise in exports (when combined elasticities
of demand and supply are greater than one).
 Increase consumer surplus
 Higher production of good leading to rise in GDP and a fall in unemployment
 Burden on poor is reduced as indirect taxes are regressive.
 It will allow market mechanism to work without government intervention.
AD
However, the society may lose due to:
 Rise in consumption of negative externalities or demerit goods (greater impact when
demand and supply are elastic)
 Fall in government tax revenue (greater fall when demand is inelastic)
10.5 Government’s tax collection and elasticity
HA
M
M
Government tax collection is also affected by PED. Increasing indirect taxes on products with
inelastic demand will increase government revenue.
Resulting increase in price does not have a major
impact on quantity demanded as shown in the figure.
Initial market price without government intervention
is P1. An initial tax shifts the supply curve to S2 with a
new price P2. Government is able to earn revenue
equal to P2P4XE2. Further increase in tax reduces
supply to S3 with a new price P3 and the government
revenue is P3P5YE3. The new government revenue is
greater than previous revenue.
 Increasing indirect taxes on products with elastic demand leads to lower government
revenue. Resulting increase in price results in a major decrease in quantity demanded.
In this case, the government may consider reducing taxes.
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11 – Subsidy
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11 Subsidy
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SUBSIDY is a government grant given by government to encourage the production or
consumption of a particular good or service. There are several reasons for giving subsidies:
 They may be given to lower price of essential goods such as housing or bread.
 They may be given to firms that employ disadvantaged workers such as the long term
unemployed or people with disabilities.
 Subsidies may be given to raise income especially of farmers.
 They may also be given to firms to make domestic firms more competitive
internationally and to increase exports.
 It may be given to increase production of merit goods and goods with positive
externalities.
 Government may provide subsidies to increase aggregate demand so that there is
growth in the economy resulting in lower unemployment.
 They may be given to firm on purchase of capital goods so that there is a rise in
investment.
 Governments may give subsidies to MNCs to attract FDI.
11.1 Impact of subsidy on prices and quantity traded
M
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AD
Provision of subsidy reduces the cost of producer and shifts the supply curve to the right. Initial
equilibrium with demand (D0) and supply (S1) is
at point E1. At this point firms charge a price P1
and the quantity traded is Q1.
 Provision of subsidy increases supply from
S1 to S2 leading to a new equilibrium at E2
where market price has fallen to P2 and
quantity traded has risen to Q2.
 Subsidy per unit is the vertical distance
between the supply curves at the new
quantity traded (Q2) and is equal to E2X or
P 2P 3.
Impact on government: It increases government expenditure that is equal to subsidy per unit
multiplied by the quantity traded and is equal to the area P2E2XP3.
HA
Impact on consumers: Consumers gain due to reduction in price and increase in quantity. Initial
consumer surplus was AE1P1. New consumer surplus is AE2P2. Increase in consumer surplus is
equal to P1E1E2P2.
 Gain for consumers is equal to the P1YE2P2 which is equal to the reduction in price times
the quantity traded.
 Decrease in price (P1 to P2) is less than the subsidy provided per unit (P2P3). This means
that some of the benefit of subsidy is taken by the firms and is not transferred to the
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consumers. Consumers will benefit more if there is a greater fall in price which happens
in demand is inelastic and supply is elastic.
M
AD
M
Impact on firms: Firms gain due to rise in quantity and provision of subsidies.
 Firm revenue increases because of provision of subsidy. Initial firm revenue was P1Q1.
New firm revenue is equal to P3Q2.
 Producers gain more when demand is elastic and supply is inelastic.
HA
M
Evaluation of providing subsidies
Providing subsidies will bring following benefits:
 Lower prices of essential goods (this is only useful if demand for the good is inelastic
and supply elastic).
 Higher exports due to lower prices (more useful if demand and supply are elastic)
 Increases consumer surplus
 Higher production of good resulting in lower unemployment (this is more useful when
demand and supply are elastic)
 Society may also benefit if the subsidy is provided on merit goods and positive
externalities (this is more useful when demand and supply are elastic).
However, it will have following limitations:
 taxpayers will have to pay higher taxes to pay for the subsidy
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there is an opportunity cost as the government could have spent the same amount on
other activities such as provision of health services
It will not allow market mechanism to work unhindered.
It will make producers complacent and they will not have the incentive to innovate and
become more productive.
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11.2 Subsidies and perfectly elastic and inelastic demand
M
The largest fall in prices will occur when either demand is highly inelastic or supply is highly
elastic. If demand is very elastic or supply very
inelastic, there will be very little, if any change, in
price following the granting of a subsidy. This is
because producers will not pass on the subsidy to
consumers. They will absorb the subsidy, which will
allow them to increase their profits. The impact is
shown in the following figures.
AD
Provision of subsidy when the demand is perfectly
elastic leads to increase in supply and quantity
traded but there is no impact on prices. All of the
subsidy is enjoyed by firms as higher profits.
M
In case of perfectly inelastic supply, a provision of
subsidy will have no impact on supply as producers
are unable to increase supply. This means there is
no change in either quantity traded or price.
Therefore, all of the benefits of subsidy are taken by
the firms.
11.3 Removal of subsidies
HA
M
Removal of subsidies will lead to an increase in price and reduction in quantity traded as shown
in the figure.
 Initial equilibrium is at P1 and Q1.
 Removal of subsidy leads to fall in supply
from S1 to S2.
 The new equilibrium is established at a
higher price P2 and a lower quantity traded
Q2.
 Amount of subsidy reduction is the vertical
distance between the supply curves and is
equal to XE1 or P3P1.
 Impact on consumers: Consumers lose due to increase in price and decrease in
quantity.
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o Initial consumer surplus was AE1P1. New consumer surplus is AE2P2. Fall in
consumer surplus is equal to P1E1E2P2.
o Increase in price (P1 to P2) is less than the reduction in subsidy (P3P1). This
means that consumers do not suffer by the full amount of the removal of
subsidy. Some of the loss of subsidy removal is borne by the firms. There would
be a greater rise in price if demand is inelastic and supply is elastic.
Impact on firms: Producer lose because of loss in subsidy and decrease in quantity.
o Firm revenue falls because of removal of subsidy.
o Initial firm revenue was P3Q1. New firm revenue is equal to P2Q2.
Impact on government: Government expenditure decreases because of removal of
subsidy. Fall in government expenditure is equal to the area P1E1XP3.
AD
M
Evaluation of removing subsidies
Removing subsidies will bring following drawbacks:
 Higher prices of essential goods (greater damage when demand for the good is inelastic
and supply elastic).
 Lower exports due to higher prices (more damaging if demand is elastic)
 Reduction in consumer surplus
 Lower production of good resulting in higher unemployment (more damaging when
demand and supply are elastic)
 Society loses due to lower consumption of merit goods and positive externalities (more
damaging when demand and supply are elastic).
HA
M
M
However, it will have following benefits:
 taxpayers will have to pay less taxes
 It will allow market mechanism to work without government intervention.
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12 – Merit and Demerit goods
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12 Market failure – Information failure, Merit goods and Demerit goods
M
Common forms of market failure
Common forms of market failure include:
 externalities (both positive and negative);
 merit goods and demerit goods;
 public goods;
 lack of competition and existence of monopoly;
 factor immobility; and
 inequality in distribution of income and wealth.
AL
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MARKET FAILURE occurs when markets lead to inefficient allocation of resources. Market
failure can lead to either overproduction of products (such as in negative externalities and
demerit goods) or underproduction of products (such as in positive externalities and merit
goods) or complete failure to produce at all (such as in public goods).
 In such cases, the government may intervene to correct the market failure.
M
AD
Costs and benefits of a decisions
1) Costs (shown on the supply curve)
 Private costs of a decision are the costs involved in an action that accrues to the
decision makers alone. For a tannery, this can include cost of electricity, raw hides,
chemicals, and labour. Private businesses base their decisions on private costs only.
 External costs are the costs that are borne by third parties (rest of the society) because
of the decision taken by a decision maker (producer or consumer). For a tannery, this
can include the waste that they dump and the gases emitted during the manufacturing
process. These costs affect the rest of the society and are not considered by decision
makers when taking a decision.
 Social costs of an action are the total costs of a decision accruing to all individuals
whether the decision maker or the third parties. Social costs include both private costs
and external costs.
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𝑆𝑜𝑐𝑖𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 = 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝑐𝑜𝑠𝑡𝑠 + 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝑐𝑜𝑠𝑡𝑠
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2) Benefits (shown on the demand curve)
 Private benefits of a decision are the benefits that accrue to the decision makers alone.
For example, the private benefit of getting inoculated against a disease is that the
individual getting inoculated will not catch the disease. Decision makers base their
decisions on private benefits only.
 External benefits are the benefits received by third parties (rest of the society) because
of the decision taken by a decision maker (producer or consumer). External benefit of
inoculation is that the individual getting inoculated will not become a career of disease
and other people are not likely to catch disease from this person. These benefits affect
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the rest of the society and are not considered by decision makers when taking a
decision.
Social benefits of an action are the total benefits of a decision accruing to all individuals
whether the decision maker or the third parties. Social benefits include both private
benefits and external benefits.
𝑆𝑜𝑐𝑖𝑎𝑙 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 = 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 + 𝐸𝑥𝑡𝑒𝑟𝑛𝑎𝑙 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
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Decision making at the margin
Decisions are made on margins, i.e. equilibrium takes place where marginal costs equal
marginal benefits.
 MARGINAL COST of production is the extra cost of producing an extra unit of output.
Marginal cost rises with an increase in production because adding a variable factor (e.g.
labour) to a fixed factor (e.g. capital) leads
to inefficiency as less and less capital is
available to workers. This results in
inefficiency and a rise in marginal costs.
The marginal cost curve is the supply
curve of a firm in a competitive market.
 MARGINAL BENEFIT is the benefit
received from consuming an extra unit of
output. Marginal benefit of consuming a
product falls as consumption increases
because continuously consuming an extra
unit of a product gives a lower satisfaction to the consumer. The marginal benefit curve
is the demand curve for consumers.
 Equilibrium takes place where the MC=MB.
o At all output levels below this point, MB is greater than MC and total net benefit
rises if more output is produced.
o At all output levels above this points, MC is lower than MB and total net benefit
rises if less output is produced.
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1) Decision makers (producers or consumers)
Firms are trying to maximize their profits while consumers are trying to maximize their utility
(satisfaction). Decision makers (producers or consumers) only consider private benefits and
private costs. They will produce or consume the quantity where marginal private cost is equal
to marginal private benefit.
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐶𝑜𝑠𝑡 (𝑀𝑃𝐶) = 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝐵𝑒𝑛𝑒𝑓𝑖𝑡 (𝑀𝑃𝐵)
2) Socially optimal decision
Society includes both decision makers (producers and consumers) and the third parties. Society
therefore bears and must consider social costs and benefits (i.e. private and external costs and
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benefits). Socially optimal production takes place where marginal social cost is equal to
marginal social benefit.
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐶𝑜𝑠𝑡 (𝑀𝑆𝐶) = 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑆𝑜𝑐𝑖𝑎𝑙 𝐵𝑒𝑛𝑒𝑓𝑖𝑡 (𝑀𝑆𝐵)
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12.1 Information failure
In an efficient market, both buyers and sellers have good knowledge of the product.
Sometimes, though, information is imperfect. Consumer who purchases a washing machine
after may be 8 years, is unlikely to have very good information about the product and hence
can make the wrong choice.
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Another problem can be ASYMMETRIC INFORMATION when either the buyer or seller has
more information than the other party. This can give rise to moral hazards and adverse
selection
 MORAL HAZARDS is tendency for people who are insured or otherwise protected to
take greater risks. It can take place when one person (e.g. doctor in the next example) is
better informed than those seeking advice. An incorrect advice can lead to misallocation
of resources and a market failure. For example, when a patient goes to a doctor, he/she
is not certain about the ailment and wants the doctor’s advice on the ailment. The
patient lacks appropriate information and goes to the doctor to get the appropriate
information.
o The system works satisfactorily as long as the doctor does not inadvertently or
deliberately gives the patient the wrong information. The patient has no way of
the accuracy of information that is being provided.
o If the information is wrong, the patient will make an undesirable choice about
possible treatment leading to misallocation of resources and hence market
failure.
 ADVERSE SELECTION results from the fact that information may be withheld or be
inaccurate. For example, it can be a case where information failure results in someone
who is unsuitable obtaining insurance. A person requiring insurance may provide
incorrect information or withhold some information. The insurer will not be able to
judge the risk of insurance correctly and the cost of insurance will be too low. A
treatment for the undisclosed problem will be paid by rising premiums for healthy
people. High premiums may decrease demand of insurance by healthy individuals and
high costs may force the insurer to leave the market. This leads to misallocation of
resources and market failure.
Information failure can also lead to the problem of merit goods and demerit goods.
12.2 Merit goods and positive consumption externalities
MERIT GOODS are defined as products that are better for a person than the person consuming
the good realizes, e.g. education and healthcare. A person taking education doesn’t fully realize
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the benefits of education, otherwise he would spend more time studying. This leads to lower
demand for education.
 Merit goods also have positive externality associated with them. For example, an
individual student is generally not motivated to study hard in order to benefit others
later in life, although everyone associated with them will benefit from their education in
some way. Beneficiaries include future employers and all those who consume the
products supplied such as their employer, their family, and friends. The better job they
obtain, the more tax they will pay, and the greater the benefit to those who receive
welfare benefits and transfers. Since the decision maker ignores the external benefits of
consuming merit goods, therefore he consumes less of merit goods leading to underconsumption and under-production of these goods leading to lower output and lower
prices.
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Positive externality from consumption arises when marginal social benefits are greater than
marginal private benefits. The figure below shows the decision making process.
 Decision maker only considers private benefits and hence operates at lower demand
curve D1. Total benefits to the society (social benefits) are higher and therefore, the
demand curve considering social benefits is to the right, D2. We are assuming no
externalities from production (MSC =
MPC) and the supply curve is S0.
 Equilibrium for decision makers is at E1
where D1 and S0 intersect. The producer
hence produces a lower quantity Q1 and
charges a lower price P1. This happens
because there is less demand for the
product.
 Socially optimal production takes place
where MSC = MSB, i.e. E2 where D2 is
equal to S0. Socially desirable production
is Q2 (higher) and at this quantity price is higher at P2.
 The vertical distance between the two demand curves at the optimal production level is
equal to marginal external benefit.
 Market has failed as it is allocating too few resources in producing the good, i.e.
production is less than socially desirable output leading to problem of underproduction
equal to Q2 – Q1.
 At the production level Q1, there is welfare loss to the society equal to the shaded
triangle called the welfare loss triangle or deadweight loss triangle.
Government intervention
Government can intervene to correct the market failure resulting from the presence of merit
goods. It can take following steps.
 Provide information – There is the issue of parentalism where the government is seen
as knowing better than the consumer. PARENTALISM is a situation where society knows
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Subsidies – Government can provide
subsidies to producers equalling the
marginal external benefits (S=MEB). This
will reduce cost of good and shift the
supply curve to the right leading to an
increase in quantity traded and a
reduction in price hence overcoming the
problem of underproduction.
o Advantages:
 It allows market mechanism to allocate resources.
 Subsidies lead to lower prices and therefore controls inflation.
 It also leads to higher output leading to lower unemployment and more
exports.
o Problems of this method include the following:
 Difficult in placing a monetary value to external benefits – It leads to the
problems of deciding on optimal amount of subsidy provided. A higher
estimation of external benefits leads to higher subsidies and much higher
production. An underestimation of external benefits would mean lower
subsidies and underproduction will remain.
 It will increase government expenditure as subsidies have to be paid out.
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best and as some right to make a value judgement. Government can provide more
information to the public through advertisement campaigns that educate people on the
merits of using such goods. With better information, the demand for merit goods is
likely to increase. A very good example of this can be the extensive advertisement
campaign carried out by the government
of Pakistan to encourage parents to send
their students to schools. The message
has focused on the need for getting
education including the future prospects.
o Advantages
 Parents will be able to
realize the benefits of
sending children to school
therefore raising demand
overcoming
underconsumption.
 It allows market mechanism to operate.
o Drawbacks
 It is expensive and will increase government expenditure. Government
will have to raise taxes to finance the costs which would increase the
burden on taxpayers.
 There is an opportunity cost as this money could have been spent on
other areas such as building roads.
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Government will have to raise taxes to provide subsidies. This leads to a
greater burden on the taxpayers.
 There is an opportunity cost of this decision as the same funds could have
been employed in another use such as building schools and hospitals or
in subsidizing another industry.
o It is more effective when demand and supply is elastic so that there is a greater
change in output.
Direct provision – Government can also directly provide some of the merit goods such
as health and education. For example, in Pakistan government provides state education
and health, e.g. Nishtar Hospital in Multan that provides free check-up for patients.
Punjab government provides free schooling to poor plus provides them free text books
and also gives a stipend to poor students to compensate their families for loss in income
when their child doesn’t work and instead goes to a school.
o Advantages of this method are as follows:
 Increases supply of merit goods leading to lower prices and more output.
 Government can provide the goods at low cost or even for free. This
would increase the demand and consumers will be encouraged to
consume merit goods.
 Lower prices will be affordable for the poor who otherwise would not be
able to afford health and education.
o Problems of this method include the following:
 Increases government expenditure that is paid for by raising taxes leading
to a burden on the taxpayers.
 Government-operated firms tend to lack incentives to innovate or
become efficient. This leads to inefficiencies leading to higher costs.
State-owned firms also do not innovate and are unlikely to provide a lot
of choice to consumers (e.g. government healthcare institutions are
unlikely to provide beauty treatments).
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Regulation – Government may force consumers to purchase a merit goods, e.g.
government may make education compulsory, leading to a rise in its demand.
o Advantages
 These steps would increase demand leading to an increase in output.
 Government expenditure would be lower in case of regulation (making it
compulsory to take education).
o However, there are following problem with using regulation:
 It is often difficult for government to fix the right level of regulation to
ensure efficiency. Regulation might be too lax or too tight.
 It does not allow market mechanism to operate.
 Government will incur administrative costs in enforcing the law.
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12.3 Demerit goods and negative consumption externalities
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DEMERIT GOODS are defined as those products that are worse for the individual consumer
than the consumer realizes, e.g. smoking cigarettes. When a person makes a decision to smoke
a cigarette, he or she is not in possession of full information concerning the harmful effects of
smoking. If he or she were in possession of full information, then they would likely to either quit
or reduce smoking leading to lower demand for the product.
 Demerit goods also have negative externality associated with them. Smoking can
damage health of passive smokers too but a decision maker ignores this external cost
and only considers his private costs and benefits. .
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Negative externality from consumption arises when marginal social benefit is less than
marginal private benefit. When people use their cars, other people suffer from their exhaust
fumes, the added congestion, the noise etc. These
negative externalities make the marginal social
benefit (MSB) of using cars less than the marginal
private benefit (MPB) of the motorist. The figure
shows the decision making process.
 D1 is based on marginal private benefit. D2
is based on marginal social benefit and is
to the left due to negative externalities. It
is assumed that there are no externalities
from production (MSC = MPC).
 Equilibrium for decision makers is at E1
where D1 and S0 intersect. The consumers hence consume a higher quantity Q1 and pay
a higher price P1 because they are associating a greater benefit to the product ignoring
external costs.
 Socially optimal production takes place where MSC = MSB, i.e. E2 where D2 is equal to S0.
Socially desirable production is Q2 (lower).
 The vertical distance between the two demand curves is equal to marginal external cost.
 Market has failed as it is allocating too many resources in producing the good, i.e.
production is more than socially desirable output leading to problem of overproduction
equal to Q1 – Q2.
 At the production level Q1, there is welfare loss to the society equal to the shaded
triangle called the welfare loss triangle or deadweight loss triangle.
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Government intervention
Government can intervene to correct the market failure resulting from the presence of demerit
goods. It can take following steps.
 Provide information – There is the issue of parentalism where the government is seen
as knowing better than the consumer. PARENTALISM is a situation where society knows
best and as some right to make a value judgement. Government can provide more
information to the public through advertisement campaigns that educate people on the
harmful effects of demerit goods. With better information, the demand for demerit
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Indirect taxes – Government can charge an indirect tax equal to the marginal external
cost (T=MEC). This will increase the cost of goods and shift the supply curve leftward.
This internalizes the externality by bringing it back into the framework of market
mechanism and is hence favoured by
economists. This will lead to a reduction
in quantity traded and an increase in price
hence overcoming the problem of
overproduction.
o Advantages of this method are
listed below:
 It allows the market
mechanism to allocate
resources.
 Government collects revenue.
 It is difficult to evade.
o Problems of using indirect taxes include:
 Difficulty in setting the optimal tax which must be equal to MEC. It is
difficult to place a monetary value to external costs. A higher estimation
of external costs leads to higher taxes and lower production. An
underestimation of external costs would mean lower taxes and negative
externalities will remain.
 It is inflationary and leads to cost-push inflation.
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goods is likely to decrease. A very good example of this can be the extensive
advertisement campaign carried out by the government of Pakistan to discourage
smoking. Government has also made it necessary for cigarette companies to give
warning messages on cigarette packs (such
as ‘smoking kill’; and showing a mouth
with cancer on the cover).
o Advantages
 Consumers will realize the
negative impact of these
goods therefore lowering
demand and overcoming
over-consumption.
 It allows market mechanism
to operate.
o Drawbacks
 It is expensive and will increase government expenditure. Government
will have to raise taxes to finance the costs which would increase the
burden on taxpayers.
 There is an opportunity cost as this money could have been spent on
other areas such as building roads.
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Regulation – Government can restrict production or sale of demerit goods.
Government can set minimum age at which a person can buy a product (e.g. alcohol,
cigarettes and lottery ticket – Government of Pakistan has enacted a law that restricts
sale of cigarettes to children below 18) thereby reducing demand for the product.
Government can set distribution controls such as regulating sale of certain drugs
through prescription of doctor only.
o Advantage – These steps would reduce demand leading to a fall in production.
o However, there are following problem with using regulation:
 It is often difficult for government to fix the right level of regulation to
ensure efficiency. Regulation might be too lax or too tight.
 It does not allow market mechanism to operate.
 Government will incur administrative costs in enforcing the law.
 There is some parentalism as government thinks it knows what is better
for the consumer. It, therefore, reduces choice (especially if a produce is
banned or an age groups is restricted to use it).
 Black markets can emerge for products that are banned and there can
even be smuggling of goods.
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It reduces output and increases unemployment. It can even lead to a
reduction in exports.
 It is regressive and poor bear the majority of the tax burden.
o It is effective when demand and supply are elastic so that there is a greater fall
in quantity.
12.4 Merit goods, demerit goods and value judgments
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Merit and demerit goods give rise to value judgments, i.e. that society is able to say to
consumers that they do not fully realize what is good or bad for them and society may actually
decide what is good and what is bad. In effect, we are allowing paternalism to be a part of
economics. We are, therefore, moving away from value-free positive Economics.
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13 Market failure – Public goods
13.1 Public goods
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PUBLIC GOODS are those goods that possess the combined characteristics of non-excludability
and non-rivalry and for which it is usually difficult to charge a direct price. Typical examples of
public goods include national defence, street lights and lighthouses. Consumption of these
goods is on a collective rather than an individual basis.
 NON-EXCLUDABILITY is a characteristic of public goods whereby it is impossible to stop
all from benefiting from the consumption of public good, i.e. once the good has been
provided, it is impossible to stop other consumers from benefiting from the good. For
example, once national defence is provided, it is provided to all the citizens and no one
can be left out of its benefits.
 NON-RIVALRY is a characteristic of public goods where as more people consume a given
good, the benefit to those already consuming is not diminished. For example, a rise in
population will still provide defence facilities to the existing population.
 Another characteristic of public goods is NON-REJECTABILITY, i.e. once the good is
provided, everyone automatically has to consume the good or service. For example,
everyone is protected when national defence is provided.
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Free riding
FREE RIDER is someone who does not pay to use a public good. It is possible for them to do this
as they cannot be stopped from using public goods (non-excludable) and the benefit for them
does not fall as other people use it (non-rivalry). Free market may fail to produce public goods
at all because of the problem of FREE RIDING.
 People may wish for the provision of such goods, but the demand may never be
registered in the market. People may wait for others to provide the public good and
they may use it for free.
 Since private sector cannot charge price for public goods, they often do not provide
these goods. This leads to underproduction of pubic goods. Existence of public goods
means that scarce resources are not used in the most desirable way. People may wish
for the provision of such goods as they give utility but the demand may never get
registered in the market, hence leading to market failure.
 Government therefore has to intervene and may be provide public goods directly to the
public free of cost.
13.2 Quasi-public goods
QUASI-PUBLIC GOODS are goods that have some but not all the characteristics of public goods.
These are public in nature, but do not exhibit fully the features of non-excludability and nonrivalry. For instance, the road network is available to all but it could be made excludable via a
system of electronic road pricing. There is also non-rivalry in consumption but only up to an
extent. Once the road becomes congested there is rivalry in consumption.
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13.3 Private goods
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PRIVATE GOODS are those bought and consumed by individuals for their own benefits and
possess the twin characteristics of excludability and rivalry.
 EXCLUDABILITY means that it is possible to exclude some people from using a private
good. This is normally done through charging a price. If the price is not acceptable, then
that good will not be consumed. Once a private good has been purchased by one person
it cannot be consumed by others.
 RIVALRY means that consumption by one person reduces the availability for others. For
instance, when we purchase food, clothes or textbooks then this means that fewer of
these goods are available for purchase by others.
 Private goods can also be REJECTED if price is too high or quality is not what is expected.
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Private sector can provide private goods as firms are able to charge a price for these goods.
Merit goods are mostly private goods where underproduction is due to information failure.
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NOTE: Charging price for the produce is not an essential feature of a private good. It is one way
of excluding the product. However, if a good is provided for free such as public sector
education, it does not become a public good.
13.4 Applying the characteristics on some products
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Lighthouse – Public good
o It is non-excludable because once built it will be provided to all ships sailing
within a certain distance of the lighthouse.
o It is non-rival because if one ship gets the benefit of the light emitting from the
lighthouse, the benefit does not reduce for other ships.
National defence – Public good
o It is non-excludable because once provided, it is available to all.
o It is non-rival because increase in population does not reduce the protection
available to current citizens.
o It is also non-rejectable because once provided, everyone is automatically
protected.
Streetlight – Public good
o It is non-excludable as it is impossible to stop someone from seeing the light
from a streetlamp.
o It is non-rival as the benefit does not diminish if one person walks past a
streetlamp.
School – Private good
o It is excludable because schools can charge a price for the service.
o It is rival because there are only a limited number of people who can fit in the
building.
Radio program – quasi-public good
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o It is non-excludable as anyone with a radio can listen to the program.
o It is non-rival because if one person listens to the program, it does not diminish
the benefit to the others.
o These programs are sometimes paid by the government and sometimes can be
provided by the private sector firms that earn revenue through advertising.
o Improvement in technology can also exclude people for instance by scrambling
TV and radio signals, these programs will only be available to those consumers
who pay for decoding boxes.
Public park – quasi-public good
o It is usually non-excludable as public parks are free to enter. However, it is
possible to exclude people by admission systems (only families are allowed and
not males alone) and by charging for entry in some parks.
o It is usually non-rival, however, overcrowded parks can reduce the enjoyment of
people if more people entered the parks.
Light bulb – private good
o It is excludable as a price is charges when it is sold.
o It is rival when use within one person’s home as it prevents others from
benefiting.
Sandy beach – quasi-public good
o It is usually non-excludable and is available to all those who wish to use it.
However, it is possible to exclude people through a number of ways.
o It is non-rival up to a point. As the beach becomes crowded and space gets
limited, enjoyment may reduce thus making it rival.
13.5 Who provides public goods and private goods? (private sector or public
sector)
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Public goods
 Public goods face the problem of free riding due to which private sector cannot provide
public goods as it is not possible to charge for these goods.
 This leads to the problem that these goods may not be provided at all.
 Therefore, government must either provide them directly or subsidize private sector
fully to produce these goods.
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Private goods
 Private sector can provide private goods because they can charge a price for the goods
and therefore earn profits.
 Private goods should ideally be left to private sector to provide because private sector
is more efficient, incurs less costs and therefore can charge lower prices, can produce
better quality product, gives choice to customers due to competition, innovates and
introduces both improved and new products, etc.
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However, private sector may under-produce private goods if they are merit goods or
they have positive externalities. The price they charge for these goods may also be out
of the reach of poor (e.g. health and education).
In such cases, government should intervene and either directly produce the goods or
provide subsidies to the private sector.
o The benefits of government intervention is that it will reduce prices for essential
goods such as health and education which will be affordable to the poor
(government may even provide these goods for free); and it will increase output
of merit goods hence overcoming problem of under-production.
o However, direct provision by the government is rife with problems such as
lower efficiency and higher cost of production leading to higher prices unless
subsidized; poor quality of goods; no or less innovation; no choice due to no
competition; slow decision making, etc.
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14 – Maximum price, Minimum price, etc.
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14 Maximum prices, Minimum prices, and Price stabilization scheme
14.1 Maximum prices – Operation
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MAXIMUM PRICE (PRICE CEILING) is a price fixed by the government so that the market price
must not exceed the price. EFFECTIVE MAXIMUM PRICE is when government sets the
maximum price below the normal equilibrium price in a free market. If maximum price is set
above the equilibrium, it will not be effective and market will keep operating at going prices
and output. Government usually sets maximum prices for goods and services that are
considered to be essential such as staple foodstuff such as bread, rice and cooking oil, rents in
certain types of housing, services provided by utilities, such as gas and electricity companies,
and transport fares.
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Operation of Maximum price
Operation of maximum prices can be described using the example of rented accommodation.
Free market price (without government intervention) is P1 at which Q1 is bought and sold.
Government may consider P1 to be too high for
the poorest in society who may not be able to
afford accommodation at this price resulting in
homelessness. Government intervenes and fixes
the price below equilibrium at PM.
 In short run, this may alleviate the
problem as landlords continue to offer Q1
of housing while the poor enjoy it at a
lower price.
 In the long run however, demand at PM
will rise to Qd as consumers will demand
more housing at lower prices. Landlords will reduce supply, for instance by selling off
their properties for owner occupation, not buying new properties to rent out, or living in
their properties instead of renting them out. New supply will be Qs. This will create
excess demand equal to Qs to Qd. Market may react in a number of ways:
o Shortages may result in queues or waiting lists. It becomes a matter of luck
whether one is able to get rented accommodation. The effective price for
consumers who are able to get the accommodation will be P M plus opportunity
cost.
o State may devise systems to allocate rented accommodation on the basis of
greatest need.
o Black market may develop resulting in higher prices (may be even more than
initial equilibrium).
Economic theory therefore predicts that maximum prices may benefit some consumers who
are able to get goods at controlled prices, but will disadvantage those who are prepared to pay
more but are unable to obtain good because of shortages.
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Initial consumer surplus was the area AEP1. With lower price and lower quantity (Qs),
the new consumer surplus is the area ABCPM.
Initial producer surplus was the area NEP1. New producer surplus falls to NCPM.
Area BEC is the deadweight loss, i.e. loss in welfare to the society.
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Government intervention
Government can overcome the problem of shortages by taking following measures:
 Government can offer subsidies to firms to encourage production of these goods. This
shifts supply to the right resulting in lower
prices. The benefits of the scheme are
that it lower prices of essential goods, it
increases
output
and
creates
employment, and it allows market system
to operate. The drawbacks involve a rise
in government expenditure, rising burden
on taxpayers, and an opportunity cost.
This method is only effective in reducing
prices if demand is inelastic and supply is
elastic.
 Government can directly produce and supply goods to overcome problem of supply
shortages. This shifts supply to the right resulting in lower prices. This method also
increases government expenditure and involves and opportunity cost. The state-owned
enterprises tend to be inefficient and state may have to bear huge losses on directly
providing goods.
 Government can release previously stored inventory of such goods that increases
supply and eliminate shortages. This is only possible where goods can be stored. But
such schemes will incur huge government expenditure on storing and managing
inventory that also raises tax burden and results in an opportunity cost.
14.2 Minimum price
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MINIMUM PRICE (PRICE FLOOR) is a price that is fixed by the government so that the market
price must not go below this price. EFFECTIVE MINIMUM PRICE is when government sets the
price above the normal equilibrium price in a free market. If minimum price is set below the
equilibrium, it will not be effective and will not affect market price and output.
HA
To reduce demand for demerit goods and imports
Government sets minimum prices for certain types of goods such as demerit goods such as
tobacco products and alcohol, and certain types of imported goods where domestically
produced close substitutes are available.
Free market price (without government intervention) is P1 at which Q1 is bought and sold. At a
minimum price of PM, producers are willing to supply more than what is demanded by
consumers. As price cannot fall, quantity supplied is fixed at Qd. This result in a lower quantity
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traded (Qd) compared to quantity at equilibrium (Q1). But the use of minimum price has
following drawbacks:
 It promotes less-efficient local producers
who have little incentive to become
efficient as they are protected through
minimum price from foreign competitors.
 There is a danger that an informal sector
will develop especially for sought-after
products like imported cigarettes.
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To overcome worker exploitation
Government can intervene in the labour market
by setting national minimum wage. This results in a rise in supply of workers and a lower
demand for workers. This results in unemployment. However, some workers who remain
employed will gain from this legislation.
AD
To product producer income
Government also sets minimum price to help producers increase their income. This is at times
use in agriculture (Pakistan’s government has set a minimum price of Rs. 1,200 per maund for
wheat in 2012). This ensures that farmers will grow enough crop that will satisfy the local
needs.
M
Operation of minimum prices can be described using example of wheat market. Free market
price (without government intervention) is P1 at which Q1 is bought and sold. Government may
consider P1 to be too low for the farmers and sets a minimum price of P M. Higher price means
that farmers grow more wheat (Qs) whereas the demand falls to Qd. This results in excess
supply of Qd to Qs.
 With low demand, farmers will not be able to sell their excess stock and would thereof
carry stock with them. This will force them to sell the excess stock at lower prices until
the market is cleared. The price that farmers eventually get may even be less than the
initial equilibrium price P1.
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Government intervention
Government can take following actions to ensure
that minimum price is maintained.
 Government can buy up all excess stock.
This shifts the demand curve to the right
leading to higher prices (equal to
minimum price). Government can then
export this wheat at lower prices, or it can
destroy the excess stock. This process will
however cost government a lot of money as the price paid for buying stock is less than
the price at which wheat is sold.
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Government can alternatively restrict production by forcing farmers to leave part of
their land uncultivated. This results in leftward shift in the supply curve (lower supply)
leading to higher prices (equal to minimum price). Reducing output to achieve higher
prices is how OPEC operates.
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Drawbacks
 Price of goods (at times essential goods such as wheat) will rise hurting the consumers.
 Taxpayers will have to pay if the government decides to buy the excess stock. The total
government expense to buy the excess stock is equal to the area BQdQsC.
14.3 Price stabilization policies
AD
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PRICE STABILIZATION POLICIES (such as BUFFER STOCK SCHEME) are intended to stabilize
prices of products and hence stabilize incomes of producers. This is frequently used in
agriculture where supply and hence price of agricultural commodities vary greatly according to
crop yield.
 A bumper crop will increase supply but depress prices. Bumper crop may be disastrous
for farmers who will have to sell more to stabilize their income.
 Crop failure on the other hand will reduce supply but prices will rise. Only those farmers
who have crops to sell with benefit from higher prices. Farmers whose crops have been
mostly or completely destroyed will receive little or no income.
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1. Buffer stock scheme
Government can use buffer stock scheme to even out price fluctuations for producers. It
combines elements of maximum and minimum pricing. Government sets an intervention price.
 If the free market price is equal to the intervention price (supply curve at S1), then the
government does not need to intervene in the market.
 If the free market price is below the
intervention price (supply curve is S2),
then the government buys up enough
supply to bring prices to the minimum
price.
 If the free market price is above the
intervention price (supply curve at S3),
then government needs to sell stocks that
it has accumulated. This increases the
supply of the commodity leading to fall in
prices to the intervention price level.
 In effect, buffer stock shifts the demand curve for the product to the right when free
market prices are below the intervention price, and shift the supply curve to the right
when free market forces are above the intervention price.
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Drawbacks
 Considerable amount of capital is needed to set up buffer stock schemes.
 There are high costs of administration and storage of the produce purchased.
 Pressure to set up these schemes often comes from producers who have a vested
interest in setting the interventionist price above the average market price to increase
their revenues.
Conclusion
Successful buffer stock schemes are those which correctly guess the average price and resist
attempts by producers to set the intervention price above it.
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2. Guaranteed price scheme
In this the government guarantees a price, e.g. P1
to the farmers. Farmers therefore produce Q1.
The market clearing price for this quantity is P2
where the demand is equal to this supply level.
 Government pays a subsidy equal to P1P2
per unit to farmers. Total subsidy is the
subsidy per unit multiplied by quantity
sold (Q1) and is equal to area P1abP2.
 Government will not have to buy and
store the crop. This saves administration
and warehousing costs for the government.
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15 Government intervention
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Government aims to i) overcome market failure; and ii) achieve fair or equitable distribution of
resources in the economy. Governments intervene in the markets if the market fails to
allocate resources efficiently (e.g. externalities, merit and demerit goods, public goods and
monopoly) or equitably (e.g. unfair distribution of income and wealth). However, government
intervention can lead to further distortions in the market and most economists favour minimal
government intervention only to the extent that is required.
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Forms of government intervention
Government intervention in the market can take various forms:
 Regulation
 Financial intervention (taxes or subsidies)
 State production
 Transfer payments
15.1 Regulation
AD
REGULATION refers to use of legal and other methods by which governments seek to control
production and consumption.
HA
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Regulations to overcome overproduction (demerit goods and negative externalities)
 Government can lay down maximum pollution levels or might even ban pollution
creating activities. This limits the supply of output. However, this is inflationary and can
also cause unemployment.
 Government can also limit production to
the socially optimal level (Q2 in the
graph) to control over-production. At this
point MSC is equal to MSB and this is the
optimal production level. Limiting
production will mean that supply curve
becomes vertical at Q2. This also results in
inflation and a rise in unemployment.
 Government can set minimum age at
which a person can buy a product (e.g.
alcohol, cigarettes and lottery ticket). This
reduces demand for the product. This can result in emergence of black market.
 Government can set distribution controls such as regulating sale of certain drugs
through prescription of doctor only). This again results in a fall in the demand. This can
also result in emergence of black market.
 Other methods were discussed earlier.
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Regulations to overcome underproduction (merit goods and pubic goods)
 Government may force consumers to purchase a merit good, e.g. motorists are forced
in some countries to buy car insurance by
law. Therefore, demand curve for car
insurance will become perfectly inelastic
at point OB. Price of motor insurance will
however be higher than it would have
been if there had been no regulation.
Advantage of this method is that it does
not need taxpayers’ money. However,
they impose heavy costs on the poor in
society who are forced to buy a good.
Some citizens may even evade the law as
the cost is very high.
 Other methods of overcoming were discussed earlier.
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AD
Other reasons for regulation
 To overcome worker exploitation – Government can set national minimum wage, fix
maximum working hours, and require certain standards for working conditions from
firms. This would increase costs of firm that can result in cost-push inflation and a rise in
unemployment.
 To overcome consumer exploitation – Government can enact hygiene laws and quality
controls. This again results in higher costs and lower supply. Government can also
protect consumers from being exploited by setting maximum prices.
 To protect farmer’s income – Government can protect farmer’s income by setting
minimum prices, buying up excess stock, and using price stabilization techniques.
 Other regulations can include controls on shop opening and closing hours, control over
age at which people are required to attend school, payment of social insurance
contributions, rent controls etc.
M
Some regulations such as quality controls, environmental controls, hygiene laws (such as setting
standards for production of food), minimum wage legislation, and maximum hours of work per
week raise cost of production resulting in leftward shift in supply curve. These result in higher
prices and lower quantity traded resulting in cost-push inflation and a rise in unemployment.
HA
Some regulation such as distribution controls (regulate sale of certain drugs through
prescription of doctor only), and setting minimum age at which a person buy a product (e.g.
alcohol, cigarettes and lottery tickets) can result in lower demand for the product.
Through regulation, government tries to overcome market failure (ban or reduce negative
externalities and demerit goods) and achieve equitable distribution of resources (reduced
prices and better quality).
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15 – Government intervention
15.2 Financial intervention
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Government can use financial intervention such as taxes and subsidies to influence production,
prices of commodities, and income and distribution of wealth in an economy.
 Indirect taxes are imposed on demerit goods to reduce their consumption and
production.
 Subsidies are paid for various reasons including reducing price of essential goods such
as food, increase production of merit goods and also of public goods. These may be
partial subsidies, e.g. in the case of public transport (Metro Bus Project in Lahore), or it
can be a full subsidy, e.g. in the case of free eye tests for children in full-time education.
 Taxes such as vehicle excise duty are paid every six months in UK and are used to deter
ownership of a vehicle. Taxes such as tax on petrol are designed to deter use of vehicles
by making its use more expensive.
 Another form of financial intervention is to provide finance needed to produce a good
or service. Government is not producing the product. It is just providing finance.
Government could finance education by providing funds to privately held and operated
schools, colleges and universities. Government can provide healthcare for free but drugs
used can be privately produced.
15.3 Direct provision (state production)
AD
Government can take over production of a good or service, either in whole or in part. Stateowned industries are often referred to as nationalized industries. Industries such as electricity
and railways are entirely owned and managed by the state in Pakistan. Government also
provides merit goods such as schools, hospitals and public transport.
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Benefits of SOEs
 SOEs operate for the interest of the society and takes into account social costs and
benefits when taking decisions.
 SOEs can keep operating loss making units if the benefit to the society is considered to
be higher.
 SOEs are not trying to exploit consumers by charging higher prices.
 SOEs do not operate for profits only. Rather they aim for social objectives.
 Profits of SOEs are available to all citizens hence the whole economy can benefit from
their profits.
 State can provide public goods and merit goods which may be underproduced by the
private sector. The justification is on the grounds of equity. .It is argued that everyone
should have access to a certain level of health care and education regardless of income.
 SoEs charge a lower price for essential commodities that result in improved welfare for
the poor.
 Direct provision is one way of reducing inequality in the society if the service if provided
free of cost to the low-income citizens. These are financed through the tax system.
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Drawbacks of SOEs
 SOEs have no profit motive hence it leads to inefficiency, poor quality, higher cost of
production and higher prices.
 SOEs are slow to respond to market changes.
 Decision making in SOEs is slow leading to poor service quality.
 SOEs suffer from bureaucracy and red-tapism.
 Government has to heavily subsidize inefficient SOEs that increases burden on the
taxpayers.
 Many countries have seen rampant corruption in SOEs.
15.4 Income and other transfers
M
The trend in many countries is toward privatization as SOEs have proved to be huge burdens on
national exchequer. Privatization brings in revenues for government and promotes efficiency
and competition in the economy. Many goods and services (especially merit goods) are
provided by both private sector and public sector. Two of the best examples are education and
healthcare which in many countries are provided by private sector as well as public sector.
AD
Free market forces may lead to uneven distribution of wealth which may be considered
undesirable for following reasons:
 Absolute poverty refers to the number of people living below the poverty line. It may
exist in society with many people who are homeless and underfed.
 Relative poverty looks at the gap between rich and the poor. Government may consider
gap between rich and poor to be too wide which can lead to social unrest.
M
Government policies to redistribute income and wealth
Redistribution of income and wealth is done to remove inequity from the operation of free
markets. Government can use various measures to remove inequity.
HA
M
INCOME TRANSFERS can be used by governments as a means of redistributing income from
one group in society to another group. Income transfers are therefore justified on the grounds
of achieving fairness of equity in an economy. Government can use many policies to
redistribute income. These can include the following:
 Government can provide monetary benefits (e.g. unemployment benefits, old age
pensions, child benefits, and food coupons) to those requiring financial support. These
benefits can be means-tested, i.e. only available to those in need (e.g. unemployment
benefits or Benazir Income Support Programme) or they can be universal, i.e. available
to everyone who qualifies for a certain criteria (e.g. old age pensions and child benefits).
 Government can directly provide goods and services at free of cost. This would be
equivalent to a universal benefit but will benefit the low-income groups more. It can
provide housing to elderly or provide goods and services such as education and health
which give citizens equality of opportunity in society.
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15 – Government intervention
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Government can use progressive taxes (where proportion of income paid in tax rises
with income) to reduce income disparities.
Government can use legislation such as minimum wages to improve incomes of poor.
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The extent to which transfer payments can be paid is heavily dependent on the amount of tax
collected and the tax base. Pakistan has a growing elderly population but has a low tax base.
Pension and social security coverage is therefore limited to the formal sector and therefore
covers only a small percentage of the population.
M
Intervention in the economy may lead to higher economic welfare for some, but it may also
lead to lower economic welfare for others. Some members of the society have to pay higher
taxes to finance additional government expenditure. Higher taxes reduce incentive to work
resulting in lower aggregate supply. Similarly high unemployment benefits reduce incentive to
work.
AD
Free market economists argue that costs of government intervention are very high and
outweigh the benefits of redistribution of income.
 They argue that economic growth will increase if taxation is low, if government
regulation of the economic activities is minimal and if state production of goods and
services is kept to the barest minimum.
 They argue that poor will benefit from increased economic growth. Higher incomes
from growth will eventually trickle down to the less fortunate.
15.5 Effectiveness of government policy
M
Governments intervene in the free markets because markets fail in many instances to achieve
efficiency or equity. However government intervention itself may lead to creating inefficiencies
because of the following problems:
 Problems of information
 Problems of incentives
 Problems of distribution
HA
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(i) Problems of information
Government collects information to develop its policies. The problem arises when government
collects incorrect information which may lead to policies that increase inefficiency. Some of the
examples of such inaccuracies are given below.
 Lack of information about true value of an externality
It is often difficult to give an accurate monetary value to the effect of an externality such
as pollution. Overestimation of environmental costs will lead to a higher level of indirect
tax imposed on the product leading to underproduction of the good.
 Lack of information about the level of demand for a product
Government needs to have a very accurate demand forecast if it were to provide the
good directly to consumers. An inaccurate demand forecast will lead to wrong
production levels creating inefficiency in the economy.
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(ii) Problems of incentives
Government policies may create inefficiencies because of creation of undesirable incentives in
the market. Some of the examples of undesirable incentives are given below.
 Impact of income tax on incentive to work
Higher marginal rates of taxation1 create disincentive for people to work harder and
gain more income leading to reduced efficiency in the economy. Similarly an indirect tax
leads to deadweight loss in the economy creating loss in welfare.
 Political motives
Politicians may design policies to remain in power than to improve economic efficiency.
They may avoid an unpopular tax on a product with negative externality because of fear
of losing voters.
 Conflicting motives of public sector enterprises
Public sector enterprises do not have a profit motive. What else may drive them to
achieve efficiency? This lack of clear motive leads to inefficiency in public sector entities.
AD
(iii) Problems of distribution
Whereas government intervention takes place on the ground of reducing inequity in income
and wealth of the rich and the poor, the actual effect of government policy may end up in an
increase in inequity. For example, imposition of any tax may have distributional effects. Tax on
energy use may be aimed at reducing harmful emissions of greenhouse gases. However this has
different effect on different groups of people. If the tax is on the use of domestic fuel, the older
members of the society may feel greatest effect because they use proportionately more
domestic fuel for heating. This may lead to inequity in society.
M
It can therefore be concluded that government intervention may be necessitated by the failure
of markets, however, it at times leads to furthering inefficiencies in the market rather than
removing them.
15.6 Privatization
HA
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PRIVATIZATION refers to the sale of publicly owned businesses, assets or services to the private
sector; and it also includes deregulation and contracting out of former public sector activities.
Privatization nowadays is considered a broader term and includes a lot of activities such as:
 Direct sale of government owned and operated activities to the private sector – The sale
of assets can be in the form of offering shares to the public (PIA); management and
worker buyout (ABPL); direct sale to new owners (MCB); and partial sale with
government retaining some shares in the business.
 Deregulation – DEREGULATION involves removal or reduction of government
regulation. This moves the economy towards a free market system. One of the common
forms of deregulation is the removal of barriers of entry in the form of a legal monopoly
1
Marginal rate of taxation is the percentage of the last dollar of income that is paid in taxes. Marginal rate of tax is
greater than average rate of tax in a progressive tax system.
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where government allows private sector to set up firms in competition to state owned
monopolies. This ends up in many cases in creation of contestable markets.
Franchising – FRANCHISING gives a new private sector owner the right to operate a
particular service or activity for a given length of time (PSO pumps). It can be either an
exclusive franchise or the government may allow some competition.
Contracting out of services – OUTSOURCING refers to procuring some services from an
outside supplier that were previously carried in-house. Government can contract out
some services that it was previously carrying out itself. It is usually non-core activities
that the government will outsource and it may sometimes allow private sector firms to
compete directly with public sector firms for a particular contract.
M
Rationale for privatization
Privatization of state-owned industries may be both economically and politically motivated.
Some of the reasons for privatization are listed below.
 Commitment to reduce government involvement in the economy – Some political
parties are committed to a free market economy. When they come into office, they
deliberately make an effort to return to free markets and one of the major steps in
achieving this objective is to privatize state-owned enterprises.
Deliberate policy to widen share ownership amongst the population and the employees
of privatized companies – Share ownership allows population in general to reap the
benefits of economic activity as the profits of enterprises are more evenly divided. It is
seen as a way to enhance motivation and improve labour relations in a company. As
workers become shareholders in the business they can appreciate the risks taken by
entrepreneurs and understand the undesirability of wage increases in many instances.

Lower costs (more efficiency) – Public sector monopolies are complacent and are
bureaucratic and hence have no incentive to reduce costs. Private sector firms when
trying to increase profits introduce new production techniques that lead to lower costs
and increase productive efficiency.

Innovation – State organizations have little incentive to innovate. Private sector firms try
to innovate and differentiate to increase their profits. This leads to dynamic efficiency.
M
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Benefits for consumers – Privatization results in lower prices, wider choice, better
quality, reduction in x-inefficiency as competition forces firms to reduce their costs, and
consumer sovereignty as consumers become more important after privatization.
HA
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Sale of nationalized industries generates substantial income for the government that
can be used to reduce its public sector borrowing requirement, to operate with annual
budget surpluses in some years as the subsidies to inefficient, loss-making public sector
enterprises is not needed, and to help cope with deficits in trading account of balance of
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Belief that privatized companies are more efficient – This is because they are able to
raise capital easily, they lower prices by cutting out waste, and they are economically
more efficient as the management is free to take decisions that are in the best interest
of the firm and the workers are highly motivated.
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payments by having a large capital account surplus (if assets sold to foreign firms e.g. in
case of PTCL).
Case against privatization
Privatization may also have its drawbacks. Some of these are listed below.
 Creates private sector monopoly – Firms will continue some of the practices of the
monopoly which does not lead to efficiency increase as expected (e.g. KB and IB in
Multan).
If there are natural monopolies, they are best left to the public sector – NATURAL
MONOPOLIES will require only one firm to efficiently produce a product. Competition
will be wasteful, inefficient and not in the best interest of customers. Therefore, some
argue that natural monopolies (such as electricity generation) may be best left to the
public sector.

Income from sale of assets is only ‘one off’ and it cannot be seen as a permanent source
for income by countries.

Negative externalities – Privatization leads to negative externalities such as job losses
after privatization. In Pakistan, we have seen that new management of privatized
organizations asked a lot of their employees to leave because of redundancy. Therefore,
privatization may lead to increase in unemployment.

Private firms have to be regulated – Once privatized, firms still need to be regulated to
ensure that there is fair competition in the market and that the firms are not resorting
to monopolistic practices. Government will have to set up regulators (e.g. PEMRA, PTA
etc.) and this will mean extra costs for the government.
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AD
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Pakistan experience
1970s saw a wave of nationalization under the leadership of Zulfiqar Ali Bhutto. However by the
time he left office, there was a general discontent with the inefficiency and corruption in the
state-owned enterprises. Therefore, 1980s and 1990s saw a massive tilt toward the market
system with deregulation and subsequent privatization of many industries. Even Bhutto’s
Pakistan People’s Party shifted its policy towards privatization of state-owned enterprises.
Some of the major examples of privatization included Muslim Commercial Bank, United Bank
Limited, Habib Bank Limited, PTCL, Pak-Arab Fertilizer and like that. There is a general
perception that these organizations have done better since their privatization. Service levels
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have improved and prices have decreased. All the major political parties in Pakistan are now in
favour of privatization and operation of free market economy.
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Conclusion
Privatization brings both benefits and drawbacks. Therefore, each case of privatization should
be taken up separately and a privatization decision should only be taken after a thorough
examination of both pros and cons. The trend in recent years in many economies including the
former central planned economies has been toward privatization of state-owned enterprises.
15.7 Nationalization
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NATIONALIZATION is when governments take over a private sector business and transfer it to
the public sector. It was used a policy tool by the PPP regime in the 1970s under the leadership
of PM Zulfiqar Ali Bhutto where banks, airlines, mining, insurance, fertilizers and other
industries were taken over by the government.
AD
Following points are raised as a case for nationalization.
 Public sector should provide merit goods and public goods.
 Public sector should provide strategic goods such as railways, water supplies, electricity
generation and like that.
 Public sector should own natural monopolies.
 Public sector reduces competition and therefore avoids duplication that result from
competition.
 Profits belong to the government and can be used for public welfare activities.
 Employees feel a sense of ownership and work hard.
 Nationalized industries can keep providing loss-making services for social reasons.
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However, nationalization has been criticized on many grounds. The primary reasons being the
drawbacks of public sector and that it misses on the benefits of privatization. Nationalization in
Pakistan has been unsuccessful.
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16 Aggregate demand and Aggregate supply
16.1 Aggregate demand
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AGGREGATE DEMAND (AD) is the total spending on an economy’s products in a given time
period at different values of the general price level.
AD
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Components of Aggregate Demand
There are four sectors in the economy, i.e. households, firms, government and international
trade. These different sectors spend on goods and services produced in an economy.
 Consumption is the spending by households who buy household goods and services to
satisfy their needs and wants. The level of consumption in an economy is affected by
income levels, wealth, taxes, interest rates and like that.
 Investment is the spending by firms on buying fixed assets or building inventory. It is
used to produce other goods and services.
 Government spending is the spending done by government for day to day running of
the government affairs, and for building infrastructure such as roads, schools, hospitals
and like that.
 Net exports is the spending on local goods by foreigners. Some of the goods produced
in the economy are sold to the foreigners and hence exports are added into the
aggregate demand. Some of the local spending is on foreign produced goods and
services and hence imports are subtracted from aggregate demand.
𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)
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Aggregate demand curve
The AD curve slopes downwards from left to right. A rise in price levels will cause a contraction
in aggregate demand and a fall in price levels will
cause an extension in aggregate demand. AD is
downward sloping due to following reasons:
 The wealth effect: A rise in price levels
reduce the purchasing power of financial
assets and savings that reduce the amount
of goods and service that people’s wealth
can buy.
 The interest rate effect: A rise in price
levels increase demand for money to pay
the higher prices that result in higher
interest rates that result in reduction in consumption and investment.
 The international effect: A rise in price levels reduce the demand for net exports as
exports become less price competitive and imports become more price competitive.
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Shifts in aggregate demand
AD curve shifts because of a change in non-price
factors.
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* Note that the x-axis label is real GDP. This is equal to real income, real expenditure and real
output in the economy.
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AD
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Rightward shift
AD rises due to rise in either consumption,
investment, government spending or net exports
(rise in exports and a fall in imports).
 Consumption may rise due to rise in
income levels, fall in unemployment, rise
in wealth (both financial and physical
wealth), fall in income taxes and fall in
indirect taxes, availability of wide range of goods and services, easy availability of
capital, and optimism about the future.
 Investment may rise due to a fall in interest rates, introduction of new technology,
reduction in cost of capital, reduction in corporate taxes, provision of grants and
subsidies, higher firm profits, improvement in infrastructure, political stability,
improvement in law and order, rise in demand for consumer goods, and optimism about
the future.
 Government spending may rise due to a rise in demand for public goods and merit
goods, elections where government wants to get more votes by spending more, rise in
population, rise in taxes, and a change in government policy.
 Net exports may rise due to lower inflation locally, higher productivity, improvement in
quality, better marketing by local firms, depreciation of currency, better trade relations
with other countries, and imposition of tariffs on imports.
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Leftward shift
AD may fall due to a fall in either consumption, investment, government spending, or net
exports.
16.2 Aggregate supply
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AGGREGATE SUPPLY (AS) is the total output (real GDP) that producers in an economy are
willing and able to supply at a given price level in a given time period.
 AS can be divided into short-run aggregate supply and long-run aggregate supply.
Short-run Aggregate Supply (SRAS)
SRAS is the total output of an economy that will be supplied when there has not been enough
time for the prices of factors of production to change. SRAS slopes up from left to right
meaning that producers are willing and able to supply more goods and services as prices rise.
This happens due to following reasons.
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The profit effect: A rise in price levels when the costs of factors of production do not
change result in higher profits and firms are willing to supply more.
The cost effect: As output rise, average
costs also rise in the SR (cost of materials
and the wage rates do not change).
Average costs may rise due to overtime
payments to workers and due to costs of
recruiting more workers. To cover any
extra costs that may be involved in
producing a higher output, producers will
require higher prices.
The misinterpretation effect: Producers
may confuse changes in the price level
with changes in relative prices. They may think that a rise in the price they receive for
their products indicate that their own product is becoming more popular. As a result
they may be encouraged to produce more.
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Shifts in SRAS
Shifts in SRAS take place due to the following:
 Rightward shift occurs due to a fall in unit
costs such as increase in productivity
levels in the economy, lower cost of raw
materials, lower wage rates, lower power
of trade unions, lower electricity costs,
provision of subsidies, a reduction in
indirect taxes and corporate taxes, and
like that. Factors that increase LRAS also
increase SRAS.
 Leftward shift occurs due to higher
payments to factors of production such as an increase in wage rates not matched by an
increase in productivity levels, increase in cost of raw materials, shortages of factors of
production, increase in cost of electricity, an increase in indirect taxes and corporate
taxes, and like that.
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Long-run Aggregate Supply (LRAS)
LRAS is the total output of a country supplied in the period when prices of factors of production
have fully adjusted to changes in aggregate demand and price levels.
 There are two different approaches to LRAS – Monetarist and Keynesian approach.
(i) New Classical Economists’ LRAS curve
NEW CLASSICAL ECONOMISTS are economists who think that the LRAS curve is vertical and
that the economy move towards full employment without government intervention. New
classical economists (Monetarists) believe that, in the long-run, economy will operate at the full
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capacity (full employment level or on the PPC).
The LRAS is therefore vertical to the x-axis at the
full capacity level.
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(ii) Keynesian LRAS
KEYNESIANS are the followers of the economist
John Maynard Keynes who maintain that
government intervention is needed to achieve
full employment. Keynesian LRAS behaves
differently in three stages.
 LRAS curve is perfectly elastic at low
levels of output (from 0 – Q1) and output can be raised without increasing price levels.
This happens because of very high levels of unemployment of factors of production (in a
recession). Factors of production can easily be increased without any increase in their
costs. Since costs are same, firms would be willing to increase their supply at the same
price level. There are many reasons why
wages are sticky downwards.
o There might be national minimum
wage which sets a floor for wages.
o High unemployment might persist
in one area of the country when
there is full employment in
another area because of labour
immobility.
o Firms may not want to lower
wages
because
this
could
demotivate staff and lead to lower productivity.
 LRAS curve is upward sloping over a range of output (from Q1 to Q2). National output is
getting closer to the full employment level (economy is coming out of recession). Firms
therefore start to experience shortages of resources. They bid up wages, rent and
interest to attract more factors of production to increase their supply. As the costs start
to increase, firms will increase AS if there is an increase in price levels.
 LRAS curve becomes perfectly inelastic when the economy is working at full capacity (at
Q2 and on PPC). This indicates the maximum output that can be achieved with existing
resources and their productivity levels.
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Shits in LRAS curve
Shifts in vertical part of the LRAS curve takes place due to change in the quantity or quality of
resources.
 Quantity of resource increase due to following reasons:
o Net immigration of people of working age increases the size of the labour force.
o An increase in the retirement age will increase the size of the labour force.
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o More women entering the labour force will increase the size of the labour force.
Woman participation in the work force varies a lot from country to country and
depends a lot on the country’s culture.
o Net investment (when gross investment exceeds capital consumption) increase
capital stock.
o Discovery of new resources (for instance new oil fields or coal reserves as in
Pakistan) can increase a country’s productive potential.
o Land reclamation can increase the quantity of land. Dubai is an example where
land has been reclaimed from sea on which it has built houses, hotels, and
theme parks.
Quality of resources (productivity) increase due to following reasons:
PRODUCTIVITY is a ratio of output to input such as labour productivity that is measured
by dividing total output with the number of hours worked.
o Improved education and training will increase the skills of workers and increase
labour productivity.
o Advances in technology will reduce costs of production and increase productive
capacity.
16.3 Interaction of AD and AS
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MACROECONOMIC EQUILIBRIUM is the output
and price level achieved where AD equals AS.
 If price levels are below P, then, AD will
be greater than AS leading to excess
demand. Excess demand will push prices
back to equilibrium.
 If price levels are above P, then, AS will
be greater than AD. Some goods and
services are not sol. Suppliers will have to
cut price levels to sell the excess stock
leading the economy back to equilibrium.
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Changes in equilibrium
An increase in AD is likely to increase output levels and raise price levels in the short-run. An
increase in AS is likely to increase output levels and lower prices.
Impact in the Long run (preferable to use Keynesian model unless specifically asked)
The long run impact depends on whether we look from the new classical economists’
perspective or from the Keynesian perspective.
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AD
(i) Increase in AD – New Classical Economists
According to Monetarists, an increase in AD due
to expansionary fiscal or monetary policy
(increase in government spending, reduction in
taxes, increase in money supply and a fall in
interest rates) will lead to rise in inflation rates
without having an impact on output levels in the
long run. This is because the economy operates
at full capacity in the LR and an increase in AD
will have no impact on output levels. However, higher demand levels will force prices up.
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(ii) Increase in AD – Keynesian LRAS
Impact of rise in AD on price levels and output levels depends on the stage of the LRAS.
 If AD increases when LRAS is perfectly
elastic (from AD1 to AD2), then, there is
no change in price levels (remains P1) but
the output levels will increase (from Q1 to
Q2).
 If AD increases when LRAS is upward
sloping (from AD2 to AD3), then, both
price levels and output levels will rise
(from P1 to P2 and from Q2 to Q3).
 If AD increases when LRAS is perfectly
inelastic (from AD3 to AD4), then, there is
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no change in output levels (remains Q3) as the economy is operating at full capacity.
Increase in AD therefore only leads to increase in price levels (P2 to P3).
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Supply side policies are very popular with the monetarists. An increase in AS will reduce
price levels and increase output levels (or national income).
Supply side policies, according to Keynesians, will only be beneficial if the economy is
operating close to full capacity. Supply side policies will shift the LRAS in the vertical part
leading to increase in output levels and a fall in price levels. However, according to
Keynesians, there will be no impact on the economy of supply side policies if the
economy is operating in the elastic part of the supply curve (recession). According to
them, economy can only come out of recession by adopting demand side policies.
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(iii) Increase in AS
Increase in AS takes place because of supply side policies. Increase in AS leads to an increase in
output levels while controlling the inflation levels. This is generally recommended by many
economists as the long run policy that should be adopted by the government for long run
success of the economy and to make local firms more competitive internationally.
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IMPORTANT TIP: Changes in some variables, including investment, net immigration and
government spending on education may shift both the aggregate demand curve and the
aggregate supply curve.
 Reduction in interest rates: A reduction in interest rates will increase AD as there will be
a rise in both consumption and investment. A rise in investment will lead to an increase
in LRAS.
 An increase in government spending on education and healthcare: Government
spending is part of AD and a rise in government spending on education and healthcare
will increase AD. This investment will also increase the productivity level of workers
resulting in an increase in LRAS.
 Advances in information technology: This will increase investment and therefore
increase AD. Better technology also results in improvement in productivity levels
resulting in an increase in LRAS.
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AD
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Net emigration: Net emigration will mean a fall in population in the economy resulting
in a fall in AD. If emigration is of people in the working age, then it will result in a fall in
the size of the labour force resulting in a decrease in LRAS. Net immigration will have an
opposite impact.
A cut in income tax: It will raise disposable income and consumers and firms will spend
more resulting in a rise in AD. Higher levels of investment will result in an increase in
capital stock and increase LRAS.
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17 Macroeconomic policy measures
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The main government macroeconomic policy aims are:
 full employment
 low and stable inflation
 balance of payments equilibrium
 steady and sustained economic growth
 avoidance of exchange rate fluctuations
 sustainable economic development.
At any one time, a government may prioritise one objection depending on the severity of the
problem. A government may use different policy measures to achieve its macroeconomic
objectives. These policies include demand side policies (fiscal, monetary and exchange rate
policies) and supply side policies.
17.1 Fiscal policy
FISCAL POLICY deals with decisions about spending, taxes and borrowing of the government.
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The budget position
BUDGET is an annual statement in which the government outlines plans for its spending and tax
revenue. It is presented as a finance bill in Pakistan in June every year in the national assembly
for approval. It presents the spending and tax plans of the government for the next year.
 Main source of revenue for the government are taxes. These can be direct or indirect
taxes, corporate tax, wealth tax and like that.
 The main areas of public spending can be defence, education, roads, and health.
 Government is said to have a balanced budget if revenues are equal to expenditure. This
rarely happens although most of the governments may set this as a long term aim.
 In most years, there are budget deficits when spending exceeds revenues. Government
will have to increase its borrowing (PSBR – Public Sector Borrowing Requirement) to
finance budget deficit.
 Budget surplus (again rare) is said to happen when revenues exceed expenditures. This
allows the government to pay back some of its debt.
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Analysing budget deficit
A government may welcome budget deficit in the SR to spur economic activity.
 CYCLICAL BUDGET DEFICIT is a budget deficit caused by changes in economic activity.
This occurs due to automatic stabilisers. For instance, during recession, government
spending will increase and tax revenue will fall. It is not much of a concern as it moves
towards balance as economic activity increases.
 STRUCTURAL BUDGET DEFICIT is a budget deficit caused by an imbalance between
government spending and taxation. This arises when a government has committed too
much to spending relative to its tax revenue. In this case, the deficit will not disappear
when GDP increases.
 In practice, a budget deficit may contain both cyclical and structural elements.
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Objectives of fiscal policy
Fiscal policy as an instrument of policy is used to achieve three main policy goals or objectives.
 To improve macroeconomic performance by having lower unemployment, lower
inflation, higher economic growth and better BoP. It does this by influencing demand
side of the economy.
 To achieve a more desirable distribution of income and wealth by taxing the rich and
providing benefits to the poor.
 To correct market failure at the microeconomic level by providing public and merit
goods, taxing consumption of demerit goods and negative externalities, providing
subsidies on production of positive externalities, improving mobility of labour and
increasing competition in product markets.
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Fiscal policy and Aggregate demand (and expenditure)
Government’s fiscal policy can have a direct impact on the aggregate expenditure and hence
the level of income and employment in the economy.
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Reflationary/Expansionary fiscal policy
An expansionary fiscal policy refers to fiscal policy that is used to increase aggregate demand. It
involves lowering of tax rates and an increase in government spending. Lower tax rates have an
impact on both consumption and investment. Consumer will find that with lower tax rates their
disposable income has increased. This will encourage them to spend more. For firms, lower tax
rates will have multiple effects. First, it will increase their product’s demand as consumers
spend more. Second, firms will have higher retained profits that lead to higher investment.
Third, lower taxes will increase return from prospective projects that lead to increase in
investment. Higher government spending will usually increase demand in those sectors where
the government decides to invest, for instance in education, construction and defence.
 Benefit – Higher growth, lower unemployment and improvement in living standards.
o Expansionary fiscal policy leads to an increase in aggregate expenditure.
o If the economy was in recession, this policy should lead to an increase in output,
income and employment hence leading to an improvement in living standards.
o However, if the economy was already operating close to the full employment
level, then, this can lead to a rise in inflation. Monetarists would argue that this
will not have any impact on unemployment in the LR and only result in inflation.
 Drawbacks
o Monetarists argue that expansionary policy will not impact unemployment in LR.
It will only cause a rise in inflation rates.
o Increase in aggregate demand can lead to an increase in imports and
deterioration in the balance of payments.
o Higher aggregate demand also leads to environmental damage as more natural
resources are used.
o Rise is demand also usually leads to a change in income distribution where rich
tend to become richer.
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o It can lead to crowding out effect. Higher government spending has to finance
with borrowing. This leads to an increase in interest rates which leads to a fall in
investment.
Keynesians generally prefer and recommend that to overcome recession, government
should increase government spending. The resulting increase in aggregate expenditure
and its multiplier effect should take the economy out of recession. They believe that
lower tax rates will have a slower impact as firms and consumers are slow to react to
this initiative.
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Deflationary or contractionary fiscal policy
A deflationary or contractionary fiscal policy refers to fiscal policy that is used to reduce
aggregate demand. It involves increasing taxes and lowering government spending. Higher
tax rates reduce disposable income and lead to a fall in aggregate demand. It also lowers
retained profits of firms and therefore reduces investment in the economy. Lower
government spending again lowers demand especially in those sectors where government
has decided to decrease spending.
 Benefit – Controls inflation and improves BoP
o Contractionary fiscal policy therefore leads to a fall in aggregate expenditure and
the impact again depends on the value of the multiplier, and the inflationary and
deflationary gap.
o This policy is useful in periods of high inflation when a fall in aggregate
expenditure leads to a fall in output and hence a fall in the inflationary pressure.
o It can also be used to improve balance of payments where lower aggregate
demand leads to lower imports and firms are forced to sell their products abroad
leading to higher exports. This is referred to as expenditure dampening measure.
 Drawbacks – It can lead to a fall in GDP and a rise in unemployment.
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Fiscal policy and macroeconomic objectives
It can be seen from the above discussion that there are a lot of trade-offs and fiscal policy has
different impact on different objectives.
 Expansionary fiscal policy leads to a fall in unemployment and a rise in GDP (growth).
However, it is inflationary and it can lead to balance of payment problems.
 Contractionary fiscal policy may lower inflationary pressure and improve BoP but it
leads to higher unemployment and lower GDP.
 Government can also try to use fiscal policy to influence distribution of income by taxing
the rich and providing benefits to the poor.
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Based on the above discussion, it is very difficult to say whether a uniform fiscal policy will be
successful in all countries. Countries should rather change the policy according to the problems
that they are facing.
 Countries that are in recession or have continuous high level to unemployment will like
to use expansionary policy. But they need to keep in mind that it can lead to rise in
inflation and may have negative impact on BoP.
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17 – Macroeconomic policy measures
Countries that are facing high levels of inflation or consistent deficits in BoP will like to
use contractionary policy but at the expense of lower growth and high unemployment.
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We can also conclude that fiscal policy needs to be used in conjunction with other policies if the
government wants to achieve lower inflation and unemployment, higher growth and a current
account equilibrium.
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Discretionary (Active) fiscal policy
DISCRETIONARY FISCAL POLICY is the deliberate change in government spending and taxation.
Government can do this by altering tax rates or changing level of government spending to
influence economy activity by influencing aggregate demand.
 During recession, government would like to raise aggregate demand by using
expansionary fiscal policy.
 During boom, government would like to use contractionary policy to reduce aggregate
demand.
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Automatic (built-in) stabilisers
AUTOMATIC STABLISERS are changes in
government spending and taxation that occur to
reduce fluctuations in aggregate demand without
any alternation in government policy. These
stimulate aggregate demand when an economy is
going into recession or which reduce aggregate
demand in an expansionary mechanism. This
mechanism reduces the impact of changes in the
economy on national income
 Government
spending
such
as
unemployment benefits and taxation are
both automatic stabilizers.
 During recession, government automatically increases its spending on unemployment
benefits as number of unemployed increase. The fall in aggregate demand is therefore
less than what it would otherwise have been. Tax revenues from corporate tax, income
tax and indirect tax falls as profits, income, and expenditure fall. The revenue tends to
fall at a faster rate than a fall in income as lower incomes have lower tax rates. With
government collecting less tax, disposable incomes are higher than they would
otherwise be and therefore consumption can be at a higher level than would be the
case without automatic stabilizers.
 During boom, government spending falls due to less unemployment. Tax revenues
increase at a faster rate than the increase in income. Therefore, aggregate demand will
be lower than it would otherwise be with these automatic stabilizers therefore limiting
the inflationary pressure in the economy.
 The figure above shows how tax revenue and government spending change
automatically as GDP changes. Initially, the economy is operating below full
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employment at Y with a significant gap between government spending and taxation. As
GDP rises, government spending on benefits fall while tax revenue rises with more
people in employment and so receiving more income.
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Fiscal policy and Aggregate Supply
Apart from affecting aggregate demand, fiscal policy can also be used to affect aggregate supply
by changing incentives facing firms and individuals (discussed in supply-side policies).
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Limitations of fiscal policy to manipulate aggregate demand
 Conflicting policy objectives: It can manipulate one variable such as lower
unemployment but then may harm other such as higher inflation or deteriorating BoP.
 Time lags: Some fiscal policy measures take less time to have an impact on the economy
and others take a longer time. Changing income tax rates, social security payments and
public sector wages will all act quickly to change demand. Long term capital projects
such as road building or hospital building take a longer time to have an impact on the
economy.
o This problem may actually lead to unforeseen problems. For instance, a time lag
may mean that extra spending in the economy may take place when the
economy is already in boom leading to overheating and high inflation.
 Inadequacy of economic data: Government’s statistics may have many inaccuracies. In
addition to that, an effective fiscal policy will need a good understanding of the value of
the multiplier. Over- or under-estimating this leads to policy errors.
 Fiscal and monetary policy: Fiscal and monetary policies are linked with each other and
this at times limits the effectiveness of fiscal policy. If government increases its spending
to increase aggregate demand, it will have to finance this spending through extra
borrowing from financial institutions. This raises interest rates and leads to a fall in
aggregate demand. Therefore ability of fiscal policy to act alone is in question.
o However, fiscal policy may be a good measure when an economy is in deep
recession. This is because economy is in a liquidity trap and interest rates cannot
fall further. Government spending therefore creates extra demand without
increasing interest rates.
 National debt: Continuous deficits can build up national debt that will make it difficult
for governments to finance extra expenditures. This will limit the ability of governments
to use fiscal policy.
 Undesirable side effects: Government action to reduce aggregate demand by increasing
taxes creates a disincentive for workers to work and firms to invest. This leads to a fall in
aggregate supply.
 Political decision: Sometimes it is difficult to use fiscal policy because it is politically
unpopular. For instance, a government may resist spending cuts and tax increases if
they may be politically unpopular.
The overall conclusion then is that governments do use fiscal policy to achieve certain
macroeconomic objectives. However, there are both limitations in use of this measure as well
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NOTE: Fiscal policy can be explained using AD and LRAS graph.
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as trade-offs as described above. Governments therefore try to use fiscal policy along with
other policy measures to achieve multiple objectives.
17.2 Monetary policy
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MONETARY POLICY is the use of interest rate, direct control of the money supply and the
exchange rate to influence aggregate demand.
 Monetary policy measures are usually implemented by the central bank of the country.
In recent years, changes in money supply has been a main policy measure used to
control inflation and to influence economic activity.
 A central bank may also target money supply in the economy as changes in the money
supply can influence aggregate demand.
 Exchange rate measures include government decisions on what type of exchange rate
system to operate, and at what rate to se the exchange rate.
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Monetary policy and Aggregate demand (and expenditure)
Monetary policy can have a direct impact on the aggregate expenditure and hence the level of
income and employment in the economy.
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Interest rates
Rate of interest is the price of money. The higher the rate of interest, the lower will be the level
of aggregate demand (AD) and vice versa. Interest rate affects AD in following ways.
 Consumer durables: Lower interest rates encourage consumers to borrow and spend on
consumer durables hence increasing their demand.
 Housing market: Lower interest rates reduce mortgage payments leading to a rise in
demand in the housing market.
 Wealth effect: Lower interest rates cause a rise in demand for shares and houses leading
to a rise in their prices. Higher prices mean that wealth of individuals has risen which
encourages them to increase consumption expenditure.
 Exchange rate: Fall in interest rates leads to a fall in value of domestic currency which in
turn leads to cheaper exports and dearer imports. Export demand therefore rises and
import demand reduces. This leads to a rise in AD.
 Savings: Lower interest rates discourage savings leading to a rise in consumption.
 Investment: Lower interest rates make new projects more attractive. This leads to an
increase in investment in those projects (refer to MEC).
Money supply
Increase in money supply leads to a fall in interest rates and a rise in AD and vice versa. There
are a number of ways in which government can control money supply and hence interest rates
in the economy.
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Open market operations: By buying and selling government securities, the central bank
can influence money supply. When central bank sells government securities, there is a
fall in money supply; and when central bank buys government securities, there is a rise
in money supply.
Statutory liquidity reserve: Central banks can force commercial banks to hold certain
assets as a percentage of their total assets. The higher the amount of liquidity reserve,
the lower is the amount of credit creation and therefore lower is the money supply.
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Quantitative easing
QUANTITATIVE EASING is an unconventional monetary policy in which a central bank prints
more money in order to buy financial assets, particularly government bonds. This lower interest
rate and increases money supply. A lower interest rate may encourage consumers and firms to
spend more leading to a rise in consumption and investment and therefore a rise in aggregate
demand.
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Forward guidance
FORWARD GUIDANCE is a tool used by a central bank to exercise its power in monetary policy
in order to influence, with their own forecasts, market expectations of future levels of interest
rates. It consists of telling the public not only what the central bank intends to do, but also
about the conditions that will cause it to stay the course and about the conditions that would
cause it to change its approach.
 By doing this, it attempts to influence the financial decisions of households, businesses
and investors by letting them know that to expect from interest rates. This is an attempt
to prevent surprises that might disrupt the market.
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Exchange rate
EXCHANGE RATE POLICY refers to the government’s decision of selecting a method of
determining the exchange rate of a country’s currency. Government can influence the exchange
rate of its currency by changing interest rates and by buying and selling its own currency.
 Raising value of currency (appreciation)
o It can be achieved by increasing interest rates or by buying its currency in the
foreign exchange market.
o Appreciation puts downward pressure on inflation but is harmful for BoP as
exports become expensive and imports become cheaper. Lower exports and
higher imports also reduce GDP and increase unemployment.
 Reducing value of currency (depreciation)
o It can be achieved by reducing interest rates or by selling its currency in the
foreign exchange market.
o Depreciation leads to improvement in BoP which results in higher GDP and lower
unemployment. However, depreciation of currency can lead to inflationary
pressures in the economy.
 Exchange rate system – The exchange rate systems are discussed in the next topic.
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Policy objectives
Deflationary or contractionary monetary policy
Government can increase interest rates, lower money supply and increase the value of foreign
exchange rate to reduce aggregate demand.
 Lower aggregate demand controls inflation as price levels fall.
 However, this leads to a fall in equilibrium output and hence a rise in unemployment.
Appreciation of currency can also lead to deterioration in the current account in the LR
(reverse J curve).
 According to Keynesians, the impact of interest rates depends on how close the
economy is to the full employment level. The closer the economy is to the full
employment level, the lower is the impact on output and unemployment and the more
is the impact on inflation.
 Higher interest rates will also discourage investment that will lead to reduction in
economic growth.
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Expansionary/Reflationary monetary policy
Government can lower interest rates, increase money supply and resort to devaluation of
currency to increase aggregate demand. This encourages growth and helps the economy in
coming out of recession.
 Increase in aggregate demand leads to a rise in output and fall in unemployment.
Monetarists, however, believe that this effect is only SR and in the LR the economy
comes back to natural rate of unemployment. Depreciation of currency can lead to
improvement in the current account deficit in the LR when demand for imports and
exports become elastic (J curve).
 Higher demand levels however lead to increase in price levels. Exact impact on prices
depends on how close the economy is operating to the full employment level. If the
economy is in deep recession, then, rise in AD is likely to increase employment without
impacting price levels.
 BoP is likely to fall in the SR due to depreciation as the demand for imports and exports
is elastic in the SR (J curve).
 Lower interest rates encourage investment that is likely to lead to higher growth and
increase in AS.
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Trade-offs
The use of monetary policy can have trade-offs between objectives.
 Rise in interest rates may reduce inflation in the SR but results in increase in
unemployment and reduction in growth. It may also lead to deterioration of BoP as
currency devalues due to higher investment. Fall in interest rate has the opposite
impact – lower unemployment, higher growth, and an improvement in BoP but at the
cost of higher price levels.
 Higher interest rates benefit the savers at the expense of the borrowers and vice versa.
 Monetary policy may at times also conflict with other policy measures. For instance, the
central bank may be tightening the monetary policy when the government is using
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expansionary fiscal policy. The policies need to be adopted such that there is
consistency in the policies.
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Limitations
Central banks face a number of problems when using monetary policy as an instrument to
achieve the objectives.
 Time lags: There are significant time lags between change in interest rates and its
impact on the economy.
 Uncertainty: Increase in interest rates may hit poor more than the rich as poor are more
likely to be net borrowers.
o Similarly, in recession, lowering interest rates may not persuade them to spend
more if they are worried about job prospects and future markets.
o Increasing mobility of financial capital makes it difficult for a country to operate
interest rates significantly different from its competitors. A very low level of
interest rates will lead to outflow of hot money leading to BoP problems.
 Different measures of money supply: There are many different measures of money
supply and it is difficult for the central bank to control money supply. There is evidence
that money supply can change its character if a central banks attempts to control it.
AD
The overall conclusion then is that use of monetary policy has certain benefits but also certain
limitations. It may be useful in controlling inflation or reducing unemployment but not both.
Hence, government has to make trade-offs at least in the SR. There are also certain limitations
that reduce the effectiveness of monetary policy. Governments therefore try to use monetary
policy along with other policy measures to achieve multiple objectives.
17.3 Supply side policies
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SUPPLY SIDE POLICIES refer to government policies designed to increase the productive
potential of the economy and push the long run aggregate supply curve to the right.
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Supply side policies and macroeconomic objectives
Supply side policies lead to a rightward shift in the LR aggregate supply curve. It can thus
achieve following macroeconomic objectives.
 Higher supply leads to increase in output levels leading to growth in the economy.
 Higher AS leads to a fall in price levels. Supply side policies when used along with
expansionary fiscal and monetary policies can increase the growth rate in the economy
while controlling inflation.
 Supply side policies can also be useful in reducing unemployment, especially reducing
the natural rate of unemployment through training and educating the workforce and
like that.
 Effective supply side policies improve competitiveness of local products hence leading
to an increase in exports and fall in imports. This improves the current account of BoP.
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Supply side policies
There are two broad approaches to supply side policies.
 Supply side economists believe that free market promotes economic efficiency and the
government’s role should be to use market-oriented policies to remove barriers in the
working of free markets.
 Interventionist economists believe that free markets may fail to maximize economic
efficiency and the government should use interventionist policies to correct market
failure.
Within these two broad approaches there are several policies that can improve the aggregate
supply in the economy.
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Labour market policies
The following policies are all designed to improve the quality and quantity of labour. Higher
quantity of labour will increase productive potential of the economy shifting PPC and LRAS cure
outward. Increased quality will improve the productivity of labour leading to rise in AS.
 Legislation against trade unions: Reduction in trade union power makes labour markets
more flexible and efficient leading to an increase in AS.
 Education and training: Government spending on education and training improves
workers’ human capital leading to increase in their productivity levels and an increase in
AS. It should also be noted that improved training, especially for those who lose their
job in an old industry, will improve the occupational mobility of workers in the
economy.
 Income tax rates: Very high marginal rate of tax acts as a disincentive to work. Lower
tax rates are therefore likely to motivate workers to work more leading to a rise in LRAS.
 Unemployment benefits: Higher unemployment benefits act as a disincentive to work.
Lowering unemployment benefits encourage workers to work leading to an increase in
LRAS.
 Minimum wages: Minimum wages prevent some workers who would be prepared to
work for lower pay from getting jobs. This lowers AS. Free market economists argue for
abolition of minimum wages.
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Product market supply side policies
All of the policies in the product market are designed to increase competition, and so efficiency.
If the productivity of an industry improves, then it will be able to produce more with a given
amount of resources, shifting the LRAS curve to the right.
 Privatization: Privatization breaks up state monopolies to create competition. This
promotes efficiency that leads to rightward shift in the LRAS.
 Deregulation: Reducing government rules and laws to control industry will increase its
efficiency and productivity leading to an increase in LRAS.
 Free trade: Promoting free trade allows countries to specialize and increase its
productivity leading to rightward shift in LRAS.
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Help for businesses: Government can encourage businesses with grants, lower tax rates
etc. to encourage them to invest and increase AS.
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Capital market policies
Increasing the capital stock such as factories, offices and roads will increase AS.
 Profitability: Government can take steps to increase profitability of firms. This will
encourage higher investment in the country. One measure that the government can
take is to reduce corporate tax rates which will increase firms’ profitability.
 Increasing sources of capital available to firms: Government can encourage private
sector to provide financial capital to small businesses by giving tax incentives to
individuals putting up share capital for a business.
 Cutting corporation tax: Lower corporate tax will encourage investment as firms will
have more profits and also more funds to invest. This increases both AD and AS.
AD
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Interventionist approaches
 Firms may not be able to provide education and training to their workers. In this case, it
should be the government’s duty to provide workers with necessary education and
training.
 If there is insufficient investment in the economy, then, state should set up state-owned
enterprises or subsidize investment by private industry.
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Limitations
Supply side policies have become very popular however they also have certain limitation.
 Cutting income tax may encourage some people to work fewer hours if they are content
with their earnings.
 Lowering welfare benefits will not succeed in reducing unemployment if there are no
jobs available.
 Privatization may not increase efficiency if privatized industries act as a monopoly and
do not take into account external costs and benefits.
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Supply-side policies tend to be long-term and uncertain in their measurable outcome as they
require structural changes to be made to increase aggregate supply in the economy. They
therefore have little relevance from the point of view of short-term economic management.
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18 Foreign exchange rates
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EXCHANGE RATE is the price of one currency in terms of another currency, e.g. $1.5/£1.
 It shows bilateral rates, i.e. price of one country’s currency of that of another country.
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Impact of exchange rate on price and demand for exports and imports
A change in exchange rate will have an impact on the price of both exports and imports and
their demand.
 Depreciation of currency leads to a fall in price of exports in terms of foreign currency
and a rise in price of imports in terms of domestic currency. This leads to a rise in AD as
demand for exports rise and demand for imports fall. Its impact on current account is
uncertain and depends on the elasticities of demand.
 Appreciation of currency leads to a rise in price of exports in terms of foreign currency
and a fall in price of imports in terms of domestic currency. This leads to a fall in AD as
demand for exports fall and demand for imports rise. The impact on current account is
uncertain and depends on the elasticities of demand.
AD
Trade weighted exchange rate
TRADE WEIGHTED EXCHAGE RATE is the price of one currency against a basket of currencies.
 Nominal exchange rate of a currency may be appreciating against one currency but may
be depreciating against another currency. Trade weighted index is an attempt to
measure the general change in a country’s foreign exchange rate. This is known as
multilateral exchange rate, i.e. involving currencies of more than 2 countries.
 Weights are assigned according to the relative importance in trading terms.
 The base year has an index of 100.
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An example
 Let us assume that UK is trading with two countries – USA and China. Let us assume that
trade with USA is 80% and trade with China is 20%. These percentages will become the
weights for each country respectively.
 Let us assume that UK£ appreciated 30% against US$ and depreciated 20% against
Chinese Yuan.
 Trade weighted index for pound therefore will be
[(0.8 x +30) + (0.2 x -20)] x 100 = 120
o That means that pound appreciated on average by 20% against currencies of its
trading partners.
 Trade weighted exchange rate shows a better picture of movements in exchange rate of
country’s currency than nominal exchange rates.
Real effective exchange rate (REER)
REAL EFFECTIVE EXCHANGE RATE is a currency’s value in terms of its real purchasing power.
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It takes into account both price changes and exchange rate changes to assess changes in
the competitiveness of a country’s products in global market.
REER may rise as a result of appreciation or an increase in the country’s relative
inflation rate. This reduces a country’s international competitiveness.
However, international competitiveness depends on many other factors such as:
o Quality of goods and services
o Quality of factors of production that affect their productivity and hence cost of
production.
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18.1 Floating exchange rate system
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Exchange rate system
EXCHANGE RATE SYSTEM is a system by which the external value of domestic currency (i.e.
exchange rate) is determined. There are three main exchange rate systems:
 Floating exchange rate system where exchange rate is determined by the market forces
of demand and supply.
 Fixed exchange rate system where exchange rate is set by the central bank using foreign
reserves.
 Managed float (or dirty float) where exchange rate is determined by both the market
forces and the intervention of the central bank.
AD
FLOATING EXCHANGE RATE is an exchange rate that is determined by the market forces of
demand and supply.
FOREIGN EXCHANGE MARKET is the market where buying and selling of foreign exchange takes
place. It consists of many players such as importers, exporters, speculators, investors, banks,
brokers etc.
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Demand for domestic currency
Demand of domestic currency is determined by both the endogenous factor (exchange rate)
and also by exogenous factors.
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Affect of endogenous factor (exchange rate) on demand – downward sloping demand curve
Demand curve is downward sloping.
 When price of domestic currency (£) is high (appreciation of currency), the local goods
become more expensive for foreign buyers leading to a reduction in demand for
exports. Lower exports lead to lower demand for domestic currency. This is called
extension in demand.
 When price of domestic currency (£) is low (depreciation of currency), the local goods
become cheaper for foreign buyers leading to a rise in demand for exports. Higher
exports lead to higher demand for domestic currency. This is called contraction in
demand.
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Exogenous factors
A change in exogenous factors lead to a shift in the demand curve. Foreigners demand for
domestic currency rises due to following reasons:
 Rise in exports: This can be due to lower inflation than competitors, better quality of
local goods, more marketing by local firms therefore increasing their demand and brand
loyalty, and a rise in GDP of countries than import our goods hence leading to rise in
demand for exports.
 Rise in inward investment flows: Foreign firms are likely to invest in our country when
there are good domestic investment prospects, when tax rates are lower than in other
countries, when government offers grants and subsidies to attract FDI, when better
infrastructure is available domestically, when labour and raw material is easily available
at lower rates, and when there is political and economic stability.
 Rise in inward savings: Inward savings (hot money) depends on interest rates. HOT
MONEY FLOWS refer to flows of money moved around the world to take advantage of
changes in interest rates and exchange rates. A rise in domestic interest rates (so that it
is higher than in other countries) attracts foreigners to save in our countries leading to a
rise in inflows and a rise in demand for domestic currency.
 When speculators think that domestic currency will rise, they buy domestic currency
leading to a rise in its demand.
 Other reasons for rise in demand for domestic currency: Inflows into the country in the
form of foreign remittance, loans, etc.
Supply of domestic currency
Supply of domestic currency is determined by both the endogenous factor (exchange rate) and
also by exogenous factors.
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Affect of endogenous factor (exchange rate) on supply – upward sloping supply curve
Supply curve is upward sloping.
 When price of domestic currency is high (appreciation of currency), foreign goods
become cheaper in local markets leading to increase in demand for imports. Higher
imports lead to higher supply for domestic currency. This is called extension in supply.
 When price of domestic currency is low, foreign goods become more expensive leading
to a fall in demand of imports. Lower imports lead to lower supply of domestic currency.
This is called contraction in supply.
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Exogenous factors
A change in exogenous factors lead to a shift in the supply curve. Local people supply more of
their currency in foreign exchange market (rise in supply) when:
 Rise in imports: This can be due to higher local inflation than competitors, poor quality
of local goods, more marketing by foreign firms therefore increasing their demand and
brand loyalty, and a rise in local GDP and income levels hence leading to rise in demand
for imports.
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Rise in outward investment flows: Local firms are likely to invest in foreign countries
when there are better investment prospects in foreign countries, when domestic tax
rates are higher than in other countries, when foreign governments offer grants and
subsidies to attract investment, when local infrastructure is poor, when labour and raw
material is easily available in foreign countries at lower rates, and when there is political
and economic instability domestically.
Rise in outward savings: Outward savings (hot money) depends on interest rates. A fall
in domestic interest rates (so that it is lower than in other countries) force domestic
savers to save their wealth in foreign banks leading to a rise in outflows and a rise in
supply of domestic currency.
When speculators think that domestic currency will fall, they sell domestic currency
leading to a rise in its supply.
Other reasons for rise in supply of domestic currency: Outflows from the country in the
form of outward remittance, repayment of loans, etc.
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Equilibrium
Equilibrium takes place where the demand and
supply of currency become equal. As shown in the
figure, the equilibrium price is P1 and equilibrium
quantity is Q1.
 If exchange rate is at P2, then, £ is overvalued
resulting in excess supply of £. Market forces
will force value of £ toward equilibrium.
 If exchange rate is at P3, then, £ is
undervalued resulting in excess demand of £.
Market forces will force value of £ toward
equilibrium.
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Causes of changes in equilibrium exchange rate
Change in supply or demand of currency causes a change in exchange rate.
 Appreciation results from a rise in demand or a fall in supply of currency.
 Depreciation results from a fall in demand or a rise in supply of currency.
HA
Advantages and drawbacks of floating exchange rate system
Advantages
 Government has no exchange rate targets as in a managed or a fixed exchange rate
system. It can therefore focus on pursuing other macroeconomic objectives.
 There is an automatic adjustment mechanism to correct BoP disequilibria – both
deficits and surpluses.
o BoP deficits mean that there are net outward flows (inward flows are less than
outflows). This puts pressure on the currency which depreciates leading to
reduction in price of exports and increase in price of imports. Demand for
exports, subsequently, rises whereas demand for imports fall. Assuming elastic
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demand, import bill will reduce and export revenue will rise leading to
improvement in current account of the BoP.
o BoP surpluses mean that there are net inward flows of currency. This creates
demand for domestic currency leading to appreciation of domestic currency
which subsequently increases price
of exports and reduces price of
imports. This leads to higher
demand for imports and lower
demand for exports. Assuming
elastic demand, import bill will rise
and export revenue will fall leading
to reduction in surpluses.
Government does not have to hold a large
foreign exchange reserve as it requires if it
uses fixed exchange rate system. Foreign reserves are used to help maintain a currency's
position within a fixed exchange rate. If a currency is freely floating, then there is no
need to use reserves to affect its value.
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Disadvantages
 Floating exchange rate system leads to exchange rate fluctuations. Fluctuations in
exchange rate add to uncertainty of outcome of international transactions, especially if
international transactions use deferred payments. This discourages trade.
o If exchange rate is unstable, exporters will be uncertain about the prices of
goods that they sell. This discourages them to export goods. A depreciation is
favourable for the exporters as it reduces prices in foreign currency while
maintaining their profit margins. An appreciation is unfavourable as it increases
prices in foreign currency or reduces their profit margins.
o Importers are uncertain about the prices of imported goods and price of raw
materials that they import. A depreciation of currency will increase the price of
raw materials in local currency hence reducing their profit margins. An
appreciation of currency will reduce the price of raw materials in local currency
hence increasing their profit margins.
o Firms can use hedging techniques to reduce risk but even these techniques have
costs.
o Uncertainty reduces investment in the economy.
 Floating exchange rate can be inflationary especially if there is a tendency for exchange
rate to depreciate. Depreciation causes a rise in aggregate demand (demand-pull
inflation) and a rise in price of imports (cost-push inflation).
 Floating exchange rates can lead to speculation if speculators think that the exchange
rate is at the wrong level. If speculators believe that the currency is overvalued and is
expected to depreciate, then they start selling the currency. This actually leads to a fall
in price of currency. If they believe that the currency is undervalued and is expected to
appreciate, they start buying the currency which actually results in a rise in price of the
currency.
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Floating exchange rate system has many benefits but then there are drawbacks too. To
overcome the drawbacks, governments may intervene in the market to manage exchange rates
to provide stability and favourable environment for growth in trade.
18.2 Depreciation in exchange rate
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DEPRECIATION is a decrease in the international price of a currency caused by market forces
(as in a floating exchange rate system). DEVALUATION is a decision by the government to lower
the international price of the currency (as in a fixed exchange rate system). For example, if
exchange rate moves from $1.5/£1 to $1.3/£1 (pound has become cheaper). It can result from
either a fall in demand for currency or increase in supply of currency. This results in a surplus of
domestic currency at the current exchange rate hence putting pressure on the exchange rate to
fall.
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Causes of depreciation
 Fall in relative interest rates: Savings (hot money) depends on interest rates.
o A fall in domestic interest rates so that it is lower than in other countries reduces
inflows of hot money as foreigners start putting their savings in other countries
therefore reducing demand for the domestic currency.
o Domestic savers are also attracted to save their wealth in foreign banks leading
to a rise in outflows and a rise in supply of domestic currency.
 Higher inflation rates: Exchange rate is also affected by relative inflation rates. A higher
domestic inflation rate compared to trading partners will make exports expensive and
imports cheaper. This leads to a fall in demand for exports hence leading to a fall in
demand of the domestic currency. It also increases demand for imports leading to a rise
in supply of domestic currency.
 Poor domestic investment prospects: If a country offers poor investment prospects,
then foreign investment coming into the country will fall resulting in fall in demand of
the currency. At the same time, local investors will prefer to take their investments to
foreign countries leading to a rise in supply of the currency.
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Poorer quality of locally manufactured goods: If there is a perception that locally
manufactured goods are of poorer quality, this will reduce the demand for exports and
hence reduce demand for the domestic currency. At the same time, it will increase
demand for imports hence leading to a rise in supply of domestic currency.
Domestic economic growth leading to a rise in income levels will result in higher
demand for imports, especially of branded goods, tourism and services. This leads to a
rise in supply of domestic currency. ‘
Recession in trading partners leading to a fall in their income levels results in lower
demand for exports of domestic products. This results in fall in demand of the domestic
currency.
Use of protectionist measures by other countries such as use of tariffs and quotas lead
to a fall in local exports resulting in a fall in demand of domestic currency.
When speculators think that price of domestic currency will fall, they sell domestic
currency leading to a rise in its supply. This will also reduce the demand for domestic
currency as speculators stop buying the currency.
Higher tax rates: Higher domestic tax rates will discourage inward investment leading to
a fall in demand of the domestic currency. Local investors will also prefer to invest in
foreign countries leading to a rise in outflow of investment and a rise in supply of
domestic currency.
Political and economic instability discourages foreign firm from investing in a country
leading to a fall in demand of currency. It also persuades local investors to invest in
foreign countries leading to a rise in supply of the currency.
Terrorist activities such as in Pakistan also drives investors (both local and foreign) away
from the country leading to a fall in demand and a rise in supply of the domestic
currency.
Other reasons for rise in supply of domestic currency: Outflows from the country in the
form of outward remittance, repayment of loans, etc.
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Evaluating depreciation of currency
 Impact on prices: Depreciation results in a fall in price of exports in foreign currency and
a rise in price of imports in local currency
leading to worsening in terms of trade.
This means that a country will have to sell
more of its output to buy the same level
of imports.
 Impact on aggregate demand: Cheaper
exports result in a rise in demand for
exports. Dearer imports result in a fall in
demand for imports. This increases
aggregate demand.
 Unemployment and income levels: With a
rise in aggregate demand, unemployment falls resulting in a rise in income levels.
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Living standards: Living standards of people rise because of lower unemployment and
higher wages. However, higher inflation rates and lower imports leading to less choice
for consumers may lower living standards.
Inflationary impact: Depreciation is inflationary leading to both demand-pull and costpush inflation.
o It leads to lower price of exports generating higher export demand. This leads to
increase in aggregate demand and demand-pull inflation.
o It leads to increase in price of imported raw material. This causes an increase in
cost of production of local producers leading to cost-push inflation.
o Depreciation leads to increase in price of imported products. As a consequence of
this, local suppliers will also increase their prices leading to inflation.
o Higher inflation levels leads to higher wage demand by workers in the economy.
This makes local output less competitive internationally.
Impact on BoP: Impact on BoP depends on elasticities of demand as explained by the
Marshall-Lerner condition. The condition states that depreciation will lead to
improvement in BoP if the combined demand for imports and exports is greater than
one. The J-curve explains that in the short-run, current account deteriorates as the
demand for imports and exports is inelastic. However, in the long run, current account
improves as the demand for imports and exports become elastic.
Fall in investment: Large depreciation of currency may scare the foreign investors as the
value of their investment in a country falls.
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There are other criticisms of depreciation. Depreciation’s ability to improve BoP is
questionable due to its impact on inflation. Devaluation leads to higher inflation which reduces
the competitiveness of local industry.
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The overall impact of depreciation depends on elasticities of demand and the severity of the
macroeconomic problems.
 It will be useful during economic recession as it may help to reduce unemployment
without increasing price levels. It may cause inflation during boom.
 Its impact on BoP will depend on elasticities of demand where current account is likely
to deteriorate in the short run when demand in inelastic and is likely to improve in the
long run when demand becomes elastic.
 Depreciation may help a country gain competitive advantage as exports become
cheaper and imports become expensive.
HA
Government may need to intervene to correct continuing depreciation because of its impact on
high levels of inflation in the economy.
Gainers and Losers
Gainers
 Exporters will gain as the price of exports reduces in international markets making their
products more competitive leading to an increase in the demand of their products.
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Local producers who were competing with imports will gain because imports become
dearer and the local producers can increase their prices and their sales.
Economy as a whole may gain because of the improvement in the BoP and fall in
unemployment.
Workers may gain due to rise in aggregate demand and reduction in unemployment.
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Losers
 Importers will lose as the demand for imports will reduce due to their higher price.
 Consumers will lose because of higher prices in the market and less choice because of
fewer imports.
 Local producers who were using imported raw material will lose as the raw material
becomes more expensive leading to increase in cost of production.
AD
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Marshall-Lerner condition
MARSHALL-LERNER CONDITION states that “a fall or devaluation of the exchange rate will
improve a balance of payments deficit when the combined price elasticities of demand for
exports and imports are greater than one.”
 If demand for exports and imports is price-elastic, then, a fall in exchange rate leads to
increase in export revenue and a reduction
in import expenditure. This leads to
improvement in the balance of payments.
HA
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This can be shown with the use of elasticity
diagrams as well. The following diagram shows
demand for imports and impact on import
expenditure due to devaluation of currency.
 Devaluation of currency leads to increase
in price of imports in domestic currency. If
the demand for imports is elastic, then, a
rise in price leads to fall in import spending
as shown in the figure. This leads to
improvement in BoP by reducing the
currency account deficit.
 If the demand for imports is inelastic, then,
a rise in price leads to rise in import
spending as shown in the figure. This leads
to deterioration in BoP by increasing the
currency account deficit.
Therefore, it is shown that devaluation of currency
will only lead to improvement in BoP if the demand is elastic.
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J-curve effect
J CURVE EFFECT refers to a fall in the exchange rate causing an increase in a current account
deficit before it reduces it due to the time it takes for demand to respond. It explains the
impact on balance of payments for a single change (devaluation) in exchange rate of a currency.
 This happens because in SR, demand for exports and imports tend to be inelastic. Fall
in exchange rate therefore leads to a fall in price of exports and rise in price of imports.
Inelastic demand means that export revenue will fall and import expenditure will
increase leading to deterioration of BoP.
 In SR, demand is inelastic because of following reasons:
o Many countries need to import raw materials, supplies and components for
producing their exports.
o In SR, firms have fixed contracts that can’t be changed.
o In SR, there is no alternative
domestic supplier that can enhance
production to replace imports.
 In LR, demand for exports and imports
become elastic. Fall in export prices lead
to a rise in export revenue, and a rise in
import prices lead to a fall in import
expenditure. This leads to an improvement
in the current account of the BoP. In the
LR, demand tends to become elastic
because of the following reasons:
o Contracts can be revised in the LR.
o Domestic producers can increase capacity and supply in the LR.
 The impact is shown on the graph where BoP deteriorates in the SR but improves in the
LR.
18.3 Appreciation in exchange rate
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APPRECIATION is an increase in the international price of a currency caused by market forces
(as in a floating exchange rate system). REVALUATION is a decision by the government to raise
the international price of its currency (as in a fixed exchange rate system). For example, if
exchange rate moves from $1.5/£1 to $1.7/£1, it means that £ has appreciated. It can result
from either a rise in demand for £ or fall in supply of £. This results in a shortage of domestic
currency at the current exchange rate hence putting pressure on the exchange rate to rise.
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Causes of appreciation
 Rise in relative interest rates: Savings (hot money) depends on interest rates.
o A rise in domestic interest rates so that it is higher than in other countries
increases inflows of hot money as foreigners start putting their savings in the
country’s banks therefore increasing demand for the domestic currency.
o Domestic savers also reduce their outward investments and put their savings in
local banks leading to a fall in supply of domestic currency.
 Lower inflation rates: Exchange rate is also affected by relative inflation rates. A lower
domestic inflation rate compared to trading partners will make exports cheaper and
imports dearer. This leads to a rise in demand for exports hence leading to a rise in
demand of the domestic currency. It also reduces demand for imports leading to a fall in
supply of domestic currency.
 Better domestic investment prospects: If a country offers better investment prospects,
then foreign investment coming into the country will rise resulting in rise in demand of
the currency. At the same time, local investors will prefer to keep their investments in
the country and reduce their outward investments leading to a fall in supply of the
currency. This also happens when government gives grants and subsidies to attract FDI.
 Superior quality of locally manufactured goods: If there is a perception that locally
manufactured goods are of superior quality, this will increase the demand for exports
and hence increase demand for the domestic currency. At the same time, it will reduce
demand for imports hence leading to a fall in supply of domestic currency.
 Recession in domestic economy leading to a fall in income levels will result in lower
demand for imports, especially of branded goods, tourism and services. This leads to a
fall in supply of domestic currency. ‘
 Growth in the economy of trading partners leads to a rise in their income levels that
results in rise in demand for exports of domestic products. This results in rise in demand
of the domestic currency.
 Use of protectionist measures by a countries such as use of tariffs and quotas lead to a
fall in imports resulting in a fall in supply of domestic currency.
 When speculators think that price of domestic currency will rise, they start buying
domestic currency leading to a rise in its demand. This will also reduce the supply of
domestic currency as speculators stop selling the currency.
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Lower tax rates: Lower domestic tax rates will encourage inward investment leading to
a rise in demand of the currency. Local investors will also prefer to invest locally leading
to a fall in outflow of investment and a fall in supply of domestic currency.
Political and economic stability encourages foreign firms to invest in a country leading
to a rise in demand of currency. It also persuades local investors to invest locally leading
to a fall in supply of the currency.
Other reasons for rise in demand of domestic currency: Inflows into the country in the
form of inward remittance, rise in loans, etc. Remittances is one of the major source of
foreign exchange and also of currency’s demand in many countries such as Pakistan.
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Evaluating appreciation of currency
 Impact on prices: Depreciation results in a rise in price of exports in foreign currency
and a fall in price of imports in local currency leading to improvement in terms of trade.
This means that a country will have to sell fewer local goods to buy the same level of
imports.
 Impact on aggregate demand: Expensive exports result in a fall in demand for exports.
Cheaper imports result in a rise in demand for imports. This reduces aggregate demand.
 Unemployment and income levels: With a fall in aggregate demand, unemployment
rises resulting in a fall in income levels. This would be a major concern if an economy is
already operating in a recession.
 Living standards: Living standards of people fall because of higher unemployment and
lower wages. However, lower inflation rates and more imports leading to more choice
for consumers may improve living standards.
 Inflationary impact: Appreciation controls both demand-pull and cost-push inflation.
This is especially useful if an economy is operating at or close of full employment level.
o It leads to higher price of exports resulting in lower exports. This leads to fall in
aggregate demand and lower pressure of demand-pull inflation.
o It leads to fall in price of imported raw material. This causes a reduction in cost
of production of local producers leading to control over cost-push inflation.
o Depreciation leads to fall in price of imported products. As a consequence of this,
local suppliers will also reduce their prices leading to lower inflation.
o Lower inflation levels lead to lower wage demand by workers in the economy.
This makes local output more competitive internationally.
 Impact on BoP: Impact on BoP depends on elasticities of demand where inelastic
demand will improve current account of BoP and elastic demand worsens it. The
reverse J-curve explains that in the short-run, current account improves as the demand
for imports and exports is inelastic. However, in the long run, current account
deteriorates as the demand for imports and exports become elastic.
The overall impact of appreciation depends on elasticities of demand and the severity of the
macroeconomic problems.
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It will be useful during boom as it may help to reduce inflationary pressure without
affecting employment levels a lot. However, it may cause unemployment during
recession.
Its impact on BoP will depend on elasticities of demand where current account is likely
to improve in the short run when demand in inelastic and is likely to deteriorate in the
long run when demand becomes elastic.
Appreciation may make a country’s goods less competitive as exports become
expensive and imports become cheaper.
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Government may need to intervene to correct continuing appreciation because of its impact on
aggregate demand, unemployment and current account.
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Gainers and Losers
Gainers
 Importers will gain as the demand for imports will rise due to fall in their prices.
 Consumers will gain because of lower prices in the market and more choice because of
greater imports.
 Local producers who were using imported raw material will gain as the raw material
becomes cheaper leading to fall in cost of production.
M
AD
Losers
 Exporters will lose as the price of exports rises in international markets making their
products less competitive leading to a fall in the demand of their products.
 Local producers who were competing with imports will lose because imports become
cheaper and the local producers will have to reduce their prices.
 Economy as a whole may lose because of the deterioration in the BoP and a rise in
unemployment.
 Workers may lose due to fall in aggregate demand and a rise in unemployment.
HA
M
Impact of elasticities on current account position
Appreciation of the exchange rate will improve a balance of payments if the demand for
imports and exports is inelastic.
 If demand for exports and imports is
price-inelastic, then, a rise in exchange
rate leads to increase in export revenue
and a reduction in import expenditure.
This leads to improvement in the balance
of payments.
This can be shown with the use of elasticity
diagrams as well. The following diagram shows
demand for imports and impact on import
expenditure due to appreciation of currency.
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Appreciation of currency leads to fall in price of imports in domestic currency. If the
demand for imports is elastic, then, a rise in price leads to rise in import spending as
shown in the figure. This leads to
deterioration in BoP.
If the demand for imports is inelastic,
then, a fall in import prices lead to fall in
import spending as shown in the figure.
This leads to improvement in BoP.
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Therefore, it is shown that appreciation of
currency will only lead to improvement in BoP if
the demand is inelastic.
HA
M
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AD
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Reverse J-curve effect
It shows the impact of one time revaluation on country’s currency. It shows that in some
countries, rise in exchange rate will improve BoP (short run) before deteriorating it (long run).
 This happens because in SR, demand for
exports and imports tend to be inelastic.
Rise in exchange rate therefore leads to a
rise in price of exports and fall in price of
imports. Inelastic demand means that
export revenue will rise and import
expenditure will fall leading to
improvement of BoP.
 In SR, demand is inelastic because of
following reasons:
o Many countries need to import
raw materials, supplies and components for producing their exports.
o In SR, firms have fixed contracts that can’t be changed.
o In SR, there is no alternative domestic supplier that can enhance production to
replace imports.
 In LR, demand for exports and imports become elastic. Rise in export prices lead to a
fall in export revenue, and a fall in import prices lead to a rise in import expenditure.
This leads to a deterioration in the current account of the BoP. In the LR, demand tends
to become elastic because of the following reasons:
o Contracts can be revised in the LR.
o Domestic producers can increase capacity and supply in the LR.
The impact is shown on the graph where BoP improves in the SR but deteriorates in the LR.
18.4 Fixed exchange rate system
FIXED EXCHANGE RATE is an exchange rate set by the government and maintained by the
central bank. For example, the value of the UAE’s dirham may be fixed at 1 dirham = US$0.25.
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Its central bank will maintain the rate by intervening in the foreign exchange market and/or
changing the rate of interest.
 If there is a downward pressure on the exchange rate may be due to rise in supply of
currency from S1 to S2, and the central bank wants to increase the value to bring it to
the fixed rate (0.25), it may increase the
rate of interest to attract hot money
flows, or it can buy domestic currency
(sell foreign currency from its reserves)
equal to Q2 – Q1. This increases demand
to D2 and hence maintain the exchange
rate at the fixed value.
 If, on the other hand, there is an upward
pressure on the exchange rate may be
due to rise in demand of the currency
from D1 to D2, and the central bank wants
to reduce the value to bring it back to the fixed rate, it may reduce the rate of interest
that results in outflows of savings, or it can sell domestic currency (buy foreign
currency). This increases supply of the currency and hence maintain exchange rate at
the fixed value.
HA
M
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AD
Benefits and drawbacks of fixed exchange rate system
Advantages of fixed exchange rates
 There is more certainty in exchange rates that lowers the risk of international trade as
exporters and importers know the exact price at which they would be selling their goods
or buying raw materials. It encourages international trade and investment.
 It minimizes speculation as speculators expect that government will intervene to
correct any upward and downward pressure on the exchange rate.
 It prevents use of beggar-thy-neighbour policies where trading partners resort to
competitive devaluation. Competitive devaluation results in lower trade, lower
efficiency and lower aggregate demand. This may start or prolong a recession.
 Fixed exchange rates control inflation as there is no devaluation of currency. It also
imposes discipline on a government to keep inflation low so that a loss of international
price competitiveness do not put downward pressure on the exchange rate.
 It forces local firms to seek other ways to become more efficient and more competitive
internationally. Depreciation in exchange rate is an easy way of improving firms’
efficiency as it reduces prices of exports. However, it happens at the expense of inflation
in the economy. A fixed exchange rate will force firms to find other means of improving
their efficiency, for instance, by reducing waste and improving management techniques.
Problems of fixed exchange rates
 Central banks need to hold large quantities of foreign exchange reserves because they
have to intervene in the market to correct the exchange rate. This may reduce the
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foreign exchange reserves of a country if there is a continuous downward pressure on
the exchange rate.
A long-term disequilibrium can lead to speculative pressure especially when speculators
see that the central bank does not have sufficient reserves and would not be able to
intervene in the market to correct downward pressures. .
Government may sacrifice other policy objectives in order to maintain a fixed exchange
rate. A rise in interest rates to attract hot money will improve the exchange rate but it
will reduce aggregate demand and increase unemployment.
There is no automatic adjustment mechanism to correct BoP disequilibrium.
M
Evaluation
It is easier for a central bank to maintain a fixed exchange rate if that rate is set close to the
long-run equilibrium value of the currency. This is because it will only have to offset short-run
fluctuations that are likely to be small. If the exchange rate is overvalued, the central bank may
be in danger of running out of reserves trying to keep the exchange rate at the fixed level.
M
M
AD
What steps can government take to influence exchange rate?
 Buying and selling of currencies (explained earlier)
 Changing interest rates (explained earlier)
 Using deflationary/contractionary policies that reduce income levels. It works in two
ways.
o It reduce the level of consumer spending leading to a fall in imports. This results
in a fall in supply of the currency.
o It reduces the rate of inflation making local goods more competitive
internationally. It results in a rise in exports leading to a rise in demand of the
currency, and a fall in imports leading to a fall in supply of the currency.
o The overall result is a rise in price of the currency.
 Using protectionist measures that reduce demand for imports or increase demand for
exports. Reduction in imports due to use of tariffs and quotas will reduce supply of
currency. Rise in demand for exports due to giving export subsidies result in a rise in
demand of currency. The combined effect is a rise in price of currency.
 Supply side policies: This is where the government attempts to increase the long-term
competitiveness of local goods by encouraging reductions in the cost of production
and/or improvements in the quality of UK goods.
18.5 Managed float/Dirty float
HA
MANAGED FLOAT is a system where the exchange rate is influenced by state intervention. It
combines features of a floating exchange rate system and a fixed exchange rate system.
 Government allows exchange rate to be determined by market forces within a given
band which has upper and lower limits. There is a par value (OP1 in the figure) around
which government sets an upper and a lower limit.
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Free market operates within the band and government intervenes if the exchange rate
goes beyond the band.
Initial equilibrium is at par value given D1
and S1.
If there is higher demand for £ may be
due to higher exports, the demand curve
will shift to the left (D2) leading to a rise
in exchange rate beyond the upper limit.
To bring the exchange rate back into the
range, the government must buy foreign
exchange to create extra supply of £ (S2).
This brings the exchange rate back to par
value at D2 and S2.
If there is an increase in supply of £ due to higher imports, then the supply curve will
shift to the left (S3) leading to fall in exchange rate below the lower limit. Government
will have to sell foreign currency from its foreign reserves in the market to create
demand for £ (D3). This brings the exchange rate back to the par value at D3 and S3.
This means that the government must have access to large quantity of foreign exchange
reserves. Continuing depreciation and frequent government intervention (selling of
foreign currency) will lead to rapid fall in foreign exchange reserves. Government will
have to borrow more to stabilize its reserves. Further depreciation will force
government to accept floating exchange rate system where because of automatic
adjustment mechanism, government will not need to carry a lot of foreign exchange
reserves.
M
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M
Dirty floating has similar benefits and drawbacks to the floating and the fixed exchange rate
system.
18.6 Purchasing Power Parity (PPP)
M
Purchasing power parity states that the price of a basket of goods should be same after
conversion to a common currency in all countries. PPP is assuming no transportation costs and
no trade barriers. This statement has important implications for exchange rate determination.
HA
PPP and exchange rates
If the above statement is true, then, the following conclusions can be drawn.
1. Exchange rate between the two countries must be equal to:
𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 ($/£) =
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝐴 ($)
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝐵 (£)
For example, if price of a basket of goods is US$150 in US and is UK£100 in UK, then, the
exchange rate must be $1.5/£1.0.
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2. It follows from the above that if the exchange rate is not as according to PPP, then, it
must either be overvalued or undervalued.
o If in the above example, the exchange rate were $2.0/£1.0, then price of basket
in UK after conversion into US$ would be $200. It is more expensive in the UK,
and the £ is overvalued by roughly 33.33% ([200-150]/150) and should fall.
o If in the above example, the exchange rate were $1.0/£1.0, then price of basket
in UK after conversion into US$ would be $100. It is cheaper in the UK, and the £
is undervalued by roughly 33.33% ([100-150]/150) and should rise.
10%
20%
$110
Both countries have same price and are
therefore equally competitive internationally
Higher inflation in country B
$120
Price in both countries has increased but
there is a higher increase in country B making
its products less competitive.
Country B has higher inflation that results in its products getting less competitive. We
are assuming that all other factors are constant. It will result in the following:
o Lower exports from country B.
o Higher imports of country B.
o Results in depreciation of the currency.
HA
M
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Price of the
basket in
country B
$100
AD
Price in
year 1
Inflation in
year 2
Price in
year 2
Price of a
basket of goods
in country A
$100
M
PPP, inflation, and exchange rate
PPP implies that the currency of a country which has higher (lower) inflation rate should
depreciate (appreciate). This can be explained using the following table.
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19 Inflation
AD
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INFLATION refers to a general and sustained increase in price levels in an economy. It is
measured by the rate of inflation such as Retail Price Index (RPI) and Consumer Price Index
(CPI). Governments usually set a priority to control inflation because of its importance and its
impact on other macroeconomic objectives.
 Increase in prices is only inflationary if it is sustained over a period of time.
 Impact of rate of inflation on price levels, index, cost of living and purchasing power
o If the rate of inflation is POSITIVE, then price levels, index and cost of living are
rising and the purchasing power is falling. This is the case if the rate is positive
and rising (such as from 3% to 5%) or if the rate is positive and falling (such as 6%
to 3%).
o If the rate of inflation is NEGATIVE, then price levels, index and cost of living are
falling and the purchasing power is rising. This is the case if the rate is negative
and falling (such as from –3% to –5%) or if the rate is negative and rising (such as
–6% to –3%).
 The rate of inflation is just an average figure. A rate of inflation of 6% DOES NOT MEAN
that prices of all goods and services rose by 6%. It is possible that prices of some goods
and services rose by a greater percentages, prices of some goods and services rose by a
smaller percentage, and prices of some goods and services may have actually fallen.
 Is inflation good or bad? Low, steady (non-accelerating) and anticipated inflation rates
are considered desirable in the economy. High, accelerating and unanticipated inflation
is considered undesirable. Deflation is also usually considered undesirable.
M
M
Degrees of inflation
Creeping inflation
CREEPING INFLATION (also called MILD INFLATION) is a low rate of inflation when prices rise
3% or less in a year. Many economists consider this to be beneficial for the economy because it
sets expectations that prices will continue to rise. This sparks increased demand as consumers
decide to buy now before prices rise in the future. This mild inflation therefore drives economic
expansion as firms produce more goods and services.
HA
Walking inflation
WALKING INFLATION is a higher level of inflation between 3-10%. It is harmful to the economy
because it heats up economic growth too fast. People start buying more than they need that
drives demand even further. Supplies usually do not keep pace with rise in demand of the
goods and services.
Galloping inflation
GALLOPING INFLATION is when inflation rises to 10% or greater. Money loses value so fast that
business and employee incomes can’t keep up with costs and prices. Foreign investment dries
up. The economy becomes unstable and galloping inflation must be prevented.
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Hyperinflation
HYPERINFLATION is an exceptionally high rate of inflation, which may result in people losing
confidence in the currency. This is often taken to be an inflation rate that exceeds 50% but it
can go much higher. Inflation in Zimbabwe in 2008 reached anywhere between 200 million
percent and 89 sextrillion (1 followed by 21 zeros) percent. It occurs when inflation gets out of
control and sometimes result in people resorting to barter. Such high levels of inflation usually
occur due to imprudent expansion of money supply by the government. If there is
hyperinflation in the economy, the currency usually has to be replaced by a new currency unit.
Deflation
DEFLATION refers to a general and sustained fall in price levels in the economy. The rate of
inflation is NEGATIVE (e.g. –3%). Deflation results in a fall in prices, index and cost of living. It
results in a rise in purchasing power of the currency.
M
Disinflation
DISINFLATION is a fall in the inflation rate such as from 6% to 3%. It is a type of inflation and is
not same as deflation. It results in a rise in prices although at a slower rate. The purchasing
power of currency falls.
AD
Reflation
REFLATION is an increase in price levels with an increasing rate such as from –2% to +3%.
Stagflation
STAGFLATION exists when inflation co-exists with unemployment. The economic growth is
stagnant and there is unemployment. However, price levels are still rising. This seems
contradictory and pose a challenge to policy makers to tackle both the problems
simultaneously.
M
19.1 Measuring Inflation
INFLATION RATE is the change in average prices in an economy over a given period of time. It is
measured as a percentage change in consumer price index or retail price index.
M
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑑𝑒𝑥
× 100
𝑂𝑙𝑑 𝑖𝑛𝑑𝑒𝑥
HA
Different measures of inflation
(a) Retail price index (RPI) – It includes house prices and mortgage interest payments. Thus
changes in interest affect RPI. If interest rates are cut, it will reduce mortgage payments
resulting in a fall in RPI.
(b) Consumer price index (CPI) – CONSUMER PRICE INDEX is an index that shows the average
change in the prices of a representative basked of products purchased by households. It
excludes costs of home (such as house prices and interest payments) out of the basket. It is
not affected by a change in interest rates on mortgages. CPI tends to be a little lower than
RPI expect when mortgage interest rates fall.
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Constructing a price index
There are following stages to construct a price index.
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(c) Underlying rate of inflation (RPIX) – It makes an adjustment in RPI by excluding mortgage
interest payments. It is closer to CPI but is not exactly the same.
(d) Core inflation (RPIY) – It is same as the RPIX, but excludes indirect taxes. A cut in indirect
taxes (such as VAT) will reduce RPI but will not affect RPIY. Some economist argue that rises
in indirect taxes cause the price of a large proportion of the goods and services that people
buy to increase. They argue that it is therefore not very sensible to use RPIY.
M
(i) Selecting a base year
Government statisticians try to select a base year that should be a relatively standard year in
which there were no dramatic changes. It is given an index value of 100.
 Problem: Base year may get very old and may not be a good representation of spending
patterns in future years.
 Solution: Government statisticians will then need to change the base year so that the
new base year can be more representative.
M
AD
(ii) Construct a basket of goods
Government statisticians need to construct a basket of goods that must consist of items that
are representative of general consumption pattern.
 Government officials carry out surveys to understand how people spend their incomes.
A sample of the population’s households are asked to keep a record of what they buy.
 The products purchased are placed into categories such as food and clothing.
 Problem: The spending pattern of households may change over time and new product
categories may be introduced in the market.
 Solution: Statisticians will need to overview the basket of goods regularly and will need
to update and change the basket if they find that the spending patterns have changed.
Some items may be removed while some new items may be added in the basket.
M
(iii) Attaching weights to different categories
WEIGHTS are given to each item in the basket of goods in accordance with the proportion of
expenditure on that item. For example, the following table shows a hypothetical basket of
goods, expenditure on each item, and the weight of each item.
HA
Item
Expenditure
Food
100
Entertainment
60
Travelling
40
Total
200
Weight
50%
30%
20%
100%
Weight of each item is calculated by the
following formula:
𝑊𝑒𝑖𝑔ℎ𝑡 (%) =
𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑜𝑛 𝑡ℎ𝑒 𝑖𝑡𝑒𝑚
𝑇𝑜𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
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Assigning weights is essential because every item has different importance in terms of
the expenditure made on each item. In the above table, food is more important than
travelling as more money is spent on food.
Government again carry out surveys to collect information about expenditure on
different items and then assigns weights to each item according to the proportion of
income spent on each item.
Problem: Spending patterns may change over time. Expenditure on different items will
therefore change and so would their weights.
Solution: Government will have to keep updating the weights to ensure the weights
reflect the correct importance of each item.
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(iv) Finding out price changes
Government statisticians need to track prices of commodities included in the basket of goods.
 Government officials find out information about prices each month by surveying shops,
post offices, power companies, train companies and a range of other outlets.
 Surveys can be cumbersome and may include a sampling bias. However, this is
necessary to find out movement in prices and to calculate index.
AD
(v) Weighted price index
Weighted price index is then calculated by multiplying weights by price changes. The total will
give a change in the consumer price index.
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑝𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 = ∑ 𝑊𝑖 × 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥𝑖
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = ∑ 𝑊𝑖 × 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒𝑖
Weight
Price
index
Food
Housing
Transport
Entertainment
40%
10%
25%
25%
100%
110
95
100
108
Weighted
price
index
44.0
9.5
25.0
27.0
105.5
HA
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M
M
Item
New index is 105.5 and this shows that the prices in general have increased by 5.5%
over the base year.
Using the above method, a cost of living index can also be calculated. Cost of living index is a
theoretical price index that measures relative cost of living over time or regions. It can be
calculated using the following formula:
165
𝑛
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑙𝑖𝑣𝑖𝑛𝑔 𝑖𝑛𝑑𝑒𝑥, 𝑦𝑒𝑎𝑟 1 = ∑
1=𝑖
𝑊𝑖1 𝑃𝑖1
× 100
𝑊𝑖0 𝑃𝑖0
where
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AL
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w = weight of item in family expenditure
p = price of item
n = total number of items in the index
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19 – Inflation
If the index is greater than 100 in year 1, then the cost of living has increased compared
to the base year.
If the index is less than 100 in year 1, then the cost of living has fallen.
HA
M
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AD
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Accuracy (limitations) of price indices
 The price index is not fully representative. It represents the expenditure of the
‘average’ household such as pensioners. It may be inaccurate for the ‘non-typical’
household. For instance, single people have different spending patterns from
households that include children, young from old, male from female, rich from poor and
minority groups. These groups have different ‘weighting’ for goods and services that
does not coincide with that assigned for the retail price index.
 Index cannot indicate changes in the quality of goods and services. For instance, cars
may increase in price because their specifications improve rather than due to
inflationary price rise. It therefore may over-estimate inflation.
 Household spending pattern changes over time. For instance, spending on food has
decreased over the last couple of decades. Weights of items in the index have to change
over time as the spending patterns change.
 Base year may not be representative of the basket of goods that are being used in
current years. Government statisticians will have to change the base.
 Price index is slow to respond to the emergence of new products and services. For
instance, Tablet PCs may be included in the basket many years after its release.
 An inflation rate of 4% only indicates that prices ‘on average’ have increased by 4%. It
does not mean that prices of all goods and services have increased. It may be possible
that prices of some products have decreased and prices of some products have
increased by more than 4%.
 The date collected is subject to sampling error. The sample selected may not be truly
representative of the population. These errors can be reduced by using a much larger
sample but that will add to costs of carrying out surveys.
 It is difficult to compare these rates between countries due to base year differences,
differences in the basket of goods, and differences in weights.
 It is also difficult to compare inflation rates over time due to introduction of new
products in the basket of goods, change in weights, and change in quality of goods and
services.
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Money and real data
MONEY OR NOMINAL DATA represents values calculated at current prices, i.e. prices that were
prevailing at the time of calculating the data.
 Changes in nominal data can be due to changes in prices or changes in output levels.
 Using nominal data can therefore be misleading as it will not show the change in actual
level of activity.
REAL DATA represents values calculated at constant prices, i.e. prices prevailing in the base
year. Real data is therefore calculated by making an adjustment of inflation from the nominal
data. The adjustment can be made by using the following equation:
𝑅𝑒𝑎𝑙 𝑑𝑎𝑡𝑎 = 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑑𝑎𝑡𝑎 ×
It is better to use real data if a change in level of activity is to be found. Changes in real
data only reflect changes in output levels.
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𝐼𝑛𝑑𝑒𝑥 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
𝐼𝑛𝑑𝑒𝑥 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟
M
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Use of rate of inflation
 It is seen as a measure of success of government’s economic policies. Rising inflation
rates adversely affect the purchasing power of people and reduce their living standards.
Government need to take steps to control the rate of inflation.
 It is used during wage negotiations where trade union can use the inflation data to
demand for wage rise greater than the rate of inflation. Inflation reduces the purchasing
power of workers and it is considered a reasonable demand by the union to protect
their real income to increase wage equal to inflation rate.
 It affects the distribution of income. Some groups such as firms, farmers and
shareholders will gain from a rise in price levels. Other groups especially those who are
on fixed income (such as pensioners, workers and bondholders) will lose from a rise in
price levels as their real income falls.
 There is arbitrary redistribution of income from savers to borrowers. During a period of
rising prices, savers lose as the real value of debt is falling. They can therefore demand a
higher interest to cover the loss in the real value of debt.
19.2 Causes of inflation
HA
Economists generally discuss three main causes of inflation – Demand-pull inflation, Cost-push
inflation and Money inflation.
(i) Demand-pull inflation
DEMAND-PULL INFLATION refers to inflation caused by increases in aggregate demand that are
not matched by an equivalent increase in aggregate supply.
 AD can increase because of following reasons:
o It can increase because of a fall in unemployment and an increase in income
levels.
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o Net exports may rise due to an improvement in quality of local goods, use of
trade barriers by the government leading to a fall in imports, boom in the world
economy leading to a rise in exports, and also due to depreciation of currency
that make exports cheaper and imports more expensive.
o Consumer spending may increase due to lower interest rates, availability of easy
credit (e.g. credit cards), or higher consumer confidence.
o Firms may increase their spending because of lower interest rates, higher
consumer demand or optimism about the future.
o Government can increase its spending substantially or cut tax rates.
o Government can affect AD through use of reflationary policies can lead to
inflation in the economy. REFLATION refers to a fiscal or monetary policy
designed to expand a country’s output and can include reducing taxes, increasing
government spending, increasing money supply and lowering interest rates.
Government can also affect AD by imposing trade barriers, giving subsidies to
exporters, and reducing the value
of currency in the foreign
exchange market.
The extent to which rise in AD affects
price level depends on the state of the
economy. It will not affect prices levels a
lot if economy is operating at very high
levels of unemployment (usually during
recession such as a rise from AD1 to AD2).
It will have the greatest impact when
economy is operating at full employment
(such as a rise in aggregate demand from AD3 to AD4), then, an increase in AD leads to
increase in price levels only.
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(ii) Cost-push inflation
COST-PUSH INFLATION results because of increasing cost of production which is passed on to
consumers in the form of higher prices.
 Increase in cost of production leads to leftwards shift in the AS curve. This leads to a
reduction in output levels and an increase
in price levels.
HA
Costs can increase because of following factors.
 Higher oil prices usually have an impact
on the whole economy. Oil supply is
controlled by OPEC. Restricting oil supply
leads to increase in price of oil. In recent
years, demand for oil has increased
because of higher energy demands of
emerging economies such as China, India
and Brazil. Higher demand has led to increase in price of oil.
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Increase in raw material prices either domestically or internationally. This happens
either because of increase in demand for raw material or a shortage of raw material (for
instance due to poor weather conditions in the major supplier of an agricultural good).
Increase in wages more than the rise in productivity can also lead to cost push inflation.
Wage increase can take place due to government’s national minimum wage or
increased activity of trade union. Higher wages can cause a wage-price spiral. Higher
wages cause a rise in prices. Then workers seek higher wages to restore their real value
and so on.
Increase in prices of imports can also fuel cost-push inflation. An increase in price of
finished imported goods will directly lead to an increase in prices as local suppliers will
also increase their prices. An increase in the price of imported raw material will also fuel
inflation as the cost of production of local suppliers who are using imported raw
material will rise. They will try to shift the burden of increase in costs to the consumers
as higher prices. Price of imports may increase because of higher world demand for
imported goods leading to an increase in their price, lower supply of imported goods,
substantial fall (depreciation) in exchange rate leading to increase in price of imported
goods in local currency, and imposition of tariff on imported goods.
Increase in indirect taxes will also shift the supply curve to the left leading to a rise in
price levels.
If firms decide to increase their profit margins, it will shift the AS to the left leading to a
rise in price levels.
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Government actions can affect cost-push inflation. Some of the government actions can lead
to a rise in price levels. These actions may include increase in indirect taxes, depreciating the
currency, imposing trade barriers, and using national minimum wage.
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(iii) Money inflation (Quantity Theory of Money)
MONETARISTS are economists who consider that inflation is caused by an excessive growth in
the money supply. This happens if rate of growth of money supply is greater than increase in
the level of output in the economy. This forces up prices. This can be explained through Fisher
equation.
𝑀𝑉 = 𝑃𝑇
HA
where
M = Money supply
V = Velocity of money or number of times money changes hand
P = Price levels
T = Output or transactions in the economy (also real GDP)
 MV is effectively equal to the money spent in the economy and equals GDP. PT is the
value of everything on which income is spent and must also be equal to GDP.
 It is assumed that in the short run, V and T remain constant. Therefore, a change in
money supply only affects price levels. Prices rise by the same proportion as change in
money supply.
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This shows that reckless printing of money by central bank can cause havoc to price
levels in the economy.
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(iv) Other causes
Wars, political upheavals and civil unrest also result in high levels of inflation in the economy.
Such events usually lead to panic in the economy and people lose confidence in money supply.
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Inflationary spiral
INFLATIONARY SPIRAL refers to a self-sustaining upward trend in general price levels due to
interaction of demand-pull and cost-push
inflation. It is also known as wage price spiral.
 Rise in AD leads to a rise in price levels.
 High cost of living prompts demands for
higher wages which push production costs
up forcing firms to increase prices.
 Higher wages lead to a rise in AD. Plus a
rise in prices lead to further demands for
higher wages and so on.
HA
M
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AD
Policies to overcome demand-pull inflation
If inflation is caused by higher AD, then,
government may use deflationary or contractionary fiscal or monetary policies to control
inflation.
 Government may use deflationary fiscal policies to reduce AD. For instance,
government can decide to increase tax rates, reduce the threshold at which people start
paying taxes, and widen the tax base. Government may cut its own spending. This is
especially useful in countries, such as Pakistan, where only a relatively small proportion
of the population pay income tax.
o However, raising income tax may lead to high wage claims as workers try to
maintain their disposable income. These higher wages lead to a rise in cost of
production and generate cost-push inflation. Similarly, if workers are optimistic
about the future, then they may reduce savings rather than consumption as their
disposable income falls. They may also create disincentive effects especially
discouraging some workers to work leading to a fall in AS and hence rise in
prices.
 Government can also use deflationary monetary policy to reduce AD. Many central
banks are given target rates of inflation and are asked to use interest rates to control
inflation. If inflation is rising above the target rate, the central bank can increase interest
rates to reduce AD.
o Rise in interest rates will increase cost of borrowing leading to fall in spending on
durable goods such as cars and houses, and also a fall in investments.
o Rise in interest rates result in higher savings as the return on savings have
increased.
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o It will attract hot money which may increase the external value of floating
exchange rate. This is likely to put downward pressure on domestic prices as
domestic firms will face increased competitive pressure at home and abroad and
lower costs of imported raw material.
o However, rise in interest rates may not discourage consumption as it is
dependent on many other factors. If they are optimistic about the future, then a
rise in interest rates may not discourage consumption. It will also have an
adverse impact on investments as it will raise the cost of borrowing. If
investment falls below capital consumption, the capital stock will decline leading
to a fall in PPC. The resulting decrease in AS can push up prices.
Monetarists argue that the only wat to reduce inflationary pressure is to lower the
growth of the money supply. If increases in the money supply do not exceed increase in
output, they suggest there will be no upward movement of the price level.
LR solution of controlling inflation is to use supply side policies. Government can take
steps to make the labour market more
competitive by reducing trade union
power or by cutting unemployment
benefits. Government can also take steps
to improve productivity of labour force by
providing training and education and by
encouraging use of capital goods.
Government can also try to increase
competition by privatizing state-owned
industries, and encouraging small firms to
set up. Additional supply in the market will
lower the price levels in the economy.
o However, supply side policies are also useful in the long-run. However, in the
short-run they may also have adverse effects on inflation. For instance, spending
on education and cuts in income tax may increase aggregate demand before
they increase aggregate supply.
M
There are constraints on the use of fiscal and monetary policies. Countries that are members
of an economic union will be forced to operate the same interest rate. It is also the case if there
is a fixed exchange rate system and raising interest rate may put upward pressure on the
exchange rate. High rates of taxes will discourage work and investment.
HA
Policies to correct cost-push inflation
 Government may instruct the central bank to raise exchange rate to control cost-push
inflation. It will reduce cost of raw materials and capital. It is also likely to put pressure
on domestic firms to find ways to cut their costs.
o However, a rise in exchange rate may not reduce inflation, if foreign producers
decide to keep the price of their exports unchanged in the country’s currency.
Local firms also may not respond to competitive pressures to reduce their costs
and prices.
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Government may use supply side policies to correct cost-push inflation. Increase
spending on training can increase labour productivity that reduce labour costs. Lower
corporation tax may encourage firms to invest in efficient capital equipment hence
reducing their unit costs.
o However, increased training will increase productivity but a more skilled
workforce will also demand higher wages resulting in a rise in cost of production.
o Similarly, lower corporation tax may not lead to a rise in investment if firms are
pessimistic about the future.
Government may give subsidies to firms to reduce prices. Subsidies may also encourage
investment in the economy.
o However, government subsidies may increase AD but may not increase AS if
firms do not respond positively by using them to increase efficiency.
Government may try to curb trade union power so that their disruptive activities are
reduced that improve firms’ efficiency.
Government may also try to use forward guidance so that it is able to check inflation
expectations. Lower inflation expectations will limit demands for wage rise.
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19.3 Evaluating inflation
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AD
Effect of inflation depends on the rate of inflation, whether it is accelerating or stable rate of
inflation, whether inflation rate is anticipated or unanticipated, and the relative inflation rates
between countries.
 Low, stable and anticipated rates of inflation are generally desired in an economy.
Government, however, tries to avoid hyperinflation, accelerating or unanticipated
inflation. Government also tries to avoid deflation.
HA
M
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Drawbacks of hyperinflation, accelerating inflation and unanticipated inflation
Drawbacks of high/hyper rates of inflation
 High rates of inflation lead to a loss in purchasing power resulting in a fall in AD. Lower
consumption leads to loss in output levels, increase in unemployment and a fall in living
standards. There will be a higher loss for people who are on fixed income especially if
the increase in their income is less than inflation rates.
 Very high rates of inflation will lead to a loss of confidence in money which may
eventually lead to economy going back to barter that would lead to inefficiency, loss in
output levels, rise in unemployment, and less international trade. People may stop
putting their savings in banks that will mean less money will be available to commercial
banks for lending. This may also reduce credit in the market again leading to a fall in
business activity.
 Very high rates of inflation are one of the major causes of political instability and causes
changes in governments in many countries.
 High rates of inflation lead to shoe leather costs. SHOE LEATHER COSTS are the costs of
moving money around in search of the higher return. People or companies that keep
money which earns no interest will find that the purchasing power is falling. They will
therefore try to search for highest rate of interest and may incur costs in doing so.
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o This can also be applied to firms and consumers who spend more time searching
for lowest prices.
High rates of inflation also lead to inflationary noise. INFLATIONARY NOISE is the
confusion over relative prices caused by inflation. This is also called money illusion.
o Rise in price of a good may not mean it has become more expensive than other
goods. Instead if the rise in price is less than the inflation rate, then, good has
actually become relatively cheaper.
o This makes it difficult to assess the markets signals and may confuse both
consumers and producers leading to misallocation of resources. Producers may
increase output because of increase in prices but increase in price may be due to
inflation and not because of higher demand.
Inflation can increase costs of firms due to rise in wages and rise in costs of raw
material, hence, reducing production and increasing unemployment in the economy.
If producers expect prices to rise further, they may hoard their stock creating artificial
scarcity of commodities in the market.
High rates of inflation may also lead to menu costs. MENU COSTS are the costs to firms
of having to change prices due to inflation. These costs include changing prices on
catalogues, price tags, bar codes and advertisements. This involves staff time and cost
and it regular price changes may also be unpopular with customers.
Higher levels of inflation compared to other countries will mean that country’s exports
become relatively more expensive and imports become relatively cheaper. This leads to
fall in demand for exports and an increase in demand for imports. Assuming that the
demand for exports and imports is elastic, this will lead to deterioration in the balance
of payments.
o Lower exports and higher imports lead to lower local output.
o Lower local output leads to rise in unemployment.
o Lower exports may also lead to depreciation of currency which may spark
another round of inflationary pressure.
High levels of inflation cause uncertainty which may discourage financial and capital
investment in the country.
Periods of high inflation cause redistribution of income and wealth.
o During periods of rising prices, debtors gain and creditors (including savers)
lose. Inflation reduces the real value of money. Real value of savings of net
savers will fall. Real value of debts will also fall, though this is a benefit for the
borrowers. This is especially a problem when interest rates do not rise and
match the inflation rates. Savers are hence paid a negative real interest rate. It
penalizes thrift, which is a bad thing for the economy because, over the long
term, the amount of investment in an economy is closely related to the amount
of saving.
o Salaried workers such as clerks, and teachers and recipients of fixed income
such as pensioners, bondholders and those on unemployment benefits lose
during times of inflation as their salaries are slow to adjust when prices are
rising.
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o Wage earners may gain or lose depending upon the speed with which their
wages adjust to rising prices. If the unions are strong, they may get their wages
linked to the cost of living index hence protecting their real wage.
o Shareholders gain during times of inflation as business activity and profits are
expanding during inflationary periods. As profits rise, dividends on equities also
increase.
Inflation may generate further inflation as consumers, workers and firms will come to
expect prices to rise. As a result, they may act in a way that will cause inflation. For
example, workers may press for higher wages, firms may raise prices to cover expected
higher costs, and consumers may see to purchase products now before their prices rise
further.
There may be fiscal drag. FISCAL DRAG refers to the fact that the income and people
and firms is pushed into higher tax brackets as a result of inflation. This is also referred
to as bracket creep.
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AD
Drawbacks of accelerating inflation
ACCELERATING INFLATION refers to an inflation rate that is rising over time, e.g. it increases
from 5% to 8% and 15% in years 1, 2 and 3 respectively.
 This results in an inflationary spiral.
o Workers expecting high inflation will press for higher wages leading to increase
in unit cost.
o Firms expecting high inflation will increase prices to cover expected higher costs.
o Consumers expecting high inflation will seek to purchase now before prices rise
further. This will lead to increase in demand now but a fall in demand later.
 Accelerating inflation causes uncertainty. This may discourage investment.
 It will lead to increase in administrative costs as firm will need to employ more staff
devoted to estimating future inflation to make appropriate strategy.
 It also increases menu costs and shoe leather costs.
 It also leads to redistribution of income from savers to borrowers.
HA
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Drawbacks of unanticipated inflation
UNANTICIPATED INFLATION occurs when inflation was either not expected or is higher than
had been expected. Households, firms and government have to estimate the expected rate of
inflation and plan accordingly. If their estimates are inaccurate, their plans will be frustrated.
 Economic agents can take steps to mitigate the effects of inflation.
 It leads to uncertainty about future inflation and can result in fall in investment and
consumption.
 It can lead to arbitrary redistribution of income. Borrowers tend to gain and lenders
lose because nominal interest will be less than inflation leading to a fall in real interest.
 Income may get transferred from old to young. Elderly tend to be net savers and lose
purchasing power due to inflation. Young tend to be net borrowers and gain as the
value of debt fall in real terms.
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o This also happens as state pensions tend to rise in line with inflation only but
wages for young usually rise faster.
AD
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Benefits of low, stable and anticipated inflation
Advantages of low and stable rates of inflation
 It may stimulate output if price rise is caused by increase in AD. Firms feel optimistic
about the future leading to higher investment.
 Firms will benefit if price rise is greater than increase in its costs. This will lead to
increase in firm profits.
 This may stimulate consumption. This happens because real interest may be low or
negative because nominal interests do not tend to rise in line with inflation. This means
that the debt burden will be falling.
 It may help firms to reduce costs. Firms may not increase wages or increase them by
less than inflation. As the increase in wages is less than increase in prices, firms will
become more profitable.
o However, their ability to do so will depend on the bargaining power of the
employees. If employees have low bargaining power, firms will be more
successful in increasing their profits.
 Lower inflation levels compared to other countries will make country’s products more
competitive with exports becoming cheaper and imports become dearer. This leads to
rise in demand for exports and fall in demand for imports. Assuming that demand for
exports and imports is elastic, this will lead to improvement in the balance of payments.
o Higher exports and lower imports lead to higher local output.
o Higher local output leads to fall in unemployment.
o Higher exports may also lead to appreciation of currency.
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Benefits of stable inflation
STABLE INFLATION refers to an inflation rate that remains same for a period of time, e.g. a 5%
inflation on average for the last three years.
 Stable inflation means that it is easy to predict future inflation. This enables firms to
plan their investments and should lead to rise in investment.
 Firms, employees and government can take measures to protect from harmful effects
of inflation. For instance, government can use indexed pensions (pensions that change
with a change in inflation) to protect real income of the pensioners.
HA
Benefits of anticipated inflation
ANTICIPATED INFLATION occurs when the rise in general price levels is the one, or close to one,
expected.
 Firms, workers, consumers and government can take measures to avoid harmful
effects.
o One way to mitigating the harmful effects is through indexation. This is where
economic variables like wages or taxes are increased in line with inflation. For
instance, a union might negotiate a wage agreement with an employer for
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annual increases of 2% plus the rate of inflation. However, indexation increases
costs based on historical results. If a government wants to reduce the rates of
inflation, indexation will be a much hurdle in its efforts.
o Firms can increase prices to reflect expected inflation. This will maintain their
profits margins but can result in an inflationary spiral.
o Nominal interest can be changed to achieve the desirable real interest. An
inflation premium is added to real interest that ensures that the real value of the
savings will be protected. Higher nominal interest may, however, discourage
investments.
o Consumers can compare inflation rates and prices of goods and services and
make the optimal purchase decision.
o Government can adjust tax thresholds, and use index-linked pensions and
benefits to secure real income of pensioners and civil servants.
Some of the costs such as shoe-leather and menu costs will remain.
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AD
Evaluation
The effects of inflation depend on the following:
 Causes of inflation: Demand-pull inflation is likely to be less harmful than cost-push
inflation. This is because demand-pull inflation is associated with rising output levels and
low unemployment. Cost-push inflation, on the other hand, is associated with falling
output.
 Rate of inflation: High rate of inflation causes more damage than a low rate especially if
the high rate develops into hyperinflation.
 Accelerating rate of inflation and also a fluctuating rate of inflation will cause
uncertainty and may discourage firms from undertaking investment.
 Unanticipated inflation leads to uncertainty and therefore discourages consumption
and investment.
 Comparative inflation rates: A lower inflation rate than trading partners will actually
increase exports and reduce imports leading to improvements in BoP, rise in output
levels, and fall in unemployment.
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19.4 Evaluating deflation
DEFLATION refers to general and sustained decrease in price levels. Fall in price levels lead to a
fall in RPI. This is usually associated with a recessionary environment. Governments generally
try to avoid deflation because its harmful effects outweigh its benefits.
HA
Benefits of deflation
 Lower price levels may result due to increase in AS. The figure shows that an increase in
AS leads to:
o Lower price levels
o Higher output levels
o Higher employment levels
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Lower price levels may increase international competitiveness of country’s goods
leading to higher exports and lower
imports. This may lead to improvement in
BoP, higher output levels leading to more
employment opportunities, and a rise in
the value of the currency.
It leads to increase in purchasing power
of consumers who can afford to buy more
goods and services. This may lead to
increase in their living standards. People
on fixed incomes are likely to gain more
because of fall in price levels.
Deflation will mean that the real value of debt will increase which will give benefit to the
savers who will be able to get higher real returns on their savings.
Workers will not demand higher wages and so the company can control its costs.
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Drawbacks of deflation
 Deflation is usually recessionary and therefore governments try to avoid this.
o It may be caused by fall in AD
which means that firms will
reduce
investment
in
the
economy. The figure shows that a
fall in AD (recession) results in
lower prices and lower output
levels.
o Lower output levels mean that
economy is operating inside PPC
leading to higher unemployment
in the economy, lower income
levels, lower tax revenue for the government, higher government expenditure in
the form of unemployment benefits and lower living standards.
 Firms will lose if price of their goods fall while they are not able to reduce their costs.
This will result in lower profits and lower investment.
 This may deter consumption due to following:
o Consumers expecting further reduction in price levels may delay their purchases.
o Consumers may become pessimistic as unemployment levels are increasing and
wage levels may be falling. They may, in turn, increase their savings and reduce
consumption.
o Real interest rates will be high that will lead to reduction in borrowing.
Consumers will have to bear a higher debt burden in real terms.
 Real value of debt will rise that will lead to lower borrowing by firms and consumers.
This results in lower investment and lower consumption.
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Firms may experience lower profit margins if the fall in prices is greater than fall in costs.
Firms may find it difficult to reduce wage levels as much as a fall in prices due to union
pressure or government’s minimum wage legislation. Lower profits will deter
investment, lead to higher unemployment as some firms may leave the market, and
lower price of shares in the stock market leading to lower wealth of investors.
Falling asset prices such as lower prices in the housing market and shares will lead to
lower wealth leading to further decline in AD and a rise in precautionary savings.
Deflation can lead to confusion in price signals in the market as lower prices of goods
and services may not necessarily indicate lower demand for goods.
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Evaluating deflation
Deflation is not necessarily bad.
 If falling prices are caused by higher productivity leading to higher aggregate supply,
then it can result in robust growth.
 If the falling prices are simply the result of improving technology or better managerial
practices, that is fine.
 On the other hand, if deflation reflects a slump in demand and excess capacity, it can be
dangerous triggering a downward spiral of demand and prices.
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Malign deflation occurs when prices fall because of a structural lack of demand which creates
huge excess capacity in an economic system. If there is a slump in demand, companies go out of
business and sack people, and hence demand falls again.
 Government can use reflationary policies to overcome the impact of deflation.
Government can use monetary and fiscal policies to overcome deflation. Government
can cut interest rates, increase money supply, reduce tax rates and increase government
spending to increase AD and hence overcome deflation.
 The impact of such measures may be limited due to following reasons:
o If consumer confidence is low, then, consumers and firms may not readily
respond to government policies and may still want to save more.
o If asset prices are falling, consumers and firms will still prefer not to consume or
invest and hold more cash.
o Lower taxes may also lead to lower government revenue and hurt government
spending.
 Keynesians suggest that governments should therefore use higher government spending
to overcome the problem of low AD in the SR. Government can increase its spending by
borrowing more. This can provide the required stimulus in the economy to overcome
deflation.
Policies to correct deflation
Government is only worried about controlling malign deflation. Government can use
reflationary fiscal and monetary policies to increase AD. Government may cut tax rates,
increase government spending, reduce interest rates and increase money supply. According to
Keynesians a rise in government spending may be more effective than other measures.
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This is because consumption and investment are affected by other variables too. If firms
and households are pessimistic in recessions, then a fall in tax rates and a reduction in
interest rates may not affect their spending a lot.
When interest rates are low, it may not be possible to reduce them much further and
any cuts have little impact on AD.
Rise in money supply will make more funds available to commercial banks to lend. The
banks, however, may be reluctant to lend in recession due to risk of defaults.
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20 Balance of Payments
20.1 Construction of the Balance of Payments
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BALANCE OF PAYMENTS (BoP) is a record of a country’s economic transactions with the rest of
the world over a year.
 There is an internationally agreed method of its presentation recommended by IMF. It
permits economists to make international comparisons. Balance of payments statistics
must be arranged within a coherent structure to facilitate their utilization and
adaptation for multiple purposes—policy formulation, analytical studies, projections,
bilateral comparisons of particular components or total transactions, regional and global
aggregations, etc.
 BoP accounts are simply a record of flow of money between residents of one country
and non-residents. Every credit entry is matched by a debit entry. For example, export
of goods by a UK resident is recorded as a credit entry in accounts. (Imports recorded as
a debit entry.)
o But we also need to record how foreign residents paid for the exports. If foreign
resident has a bank account in UK which is used to pay exporter, then, it is
shown in accounts as a debit entry. There is a decrease in UK liabilities abroad
(foreign residents have less of a claim on a UK based account). (In case of
imports, there will be credit entry meaning that UK liabilities have increased.)
o BoP therefore must always balance as the amounts of debit are equal to the
amounts of credit.
 BoP consists of i) Current account; ii) Capital Account; iii) Financial Account (including
international investment position); and iv) Errors and Omissions.
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1) Current Account
The CURRENT ACCOUNT is a part of balance of payments and it is a record of the trade in
goods, trade in services, investment income and current transfers.
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(a) Trade in goods (visible trade)
TRADE IN GOODS covers items that can be touched, weighed or counted as they are traded,
e.g. imports of cars (debit item in the current account of UK) or export of cashmere sweaters
(credit item). This is also sometimes called visible trade.
HA
BALANCE OF TRADE (also called the visible balance, the merchandise balance and the trade in
goods balance) is the difference between visible exports and imports. If exports are greater
than imports, then, there is a TRADE SURPLUS. If imports are greater than exports, then, there
is a TRADE DEFICIT.
(b) Trade in services (invisible trade)
TRADE IN SERVICES covers exports and imports of services. For example, if a UK resident
purchases an airline ticket from a foreign airline, this is an import of service and is a debit item.
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If a Merchant Bank in UK raises a loan for foreign firm, the fee charged by the bank is an export
of service and is recorded as a credit item. Services can include transportation, travel,
communication services, insurance services, financial services, etc.
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INVISIBLE TRADE BALANCE is the difference between exports and imports of services. A surplus
means that exports are greater than imports and a deficit means that the imports are greater
than exports.
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(c) Income
INCOME ACCOUNT consists of income in the form of profits, interest and dividends earned on
direct investment abroad and foreign earnings on investment in the country. The income can
come from investment in physical or financial assets abroad. It can include interest and
dividend received (inward) or paid (outward).
 Dividend paid on foreign shares held by UK residents is a credit entry and dividends paid
to foreign residents on UK shares is a debit entry.
 Interest received by UK residents on foreign deposits is a credit entry and interest paid
to foreign holders of deposits in UK financial institutions is a debit entry.
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(d) Current transfers
CURRENT TRANSFERS cover payments made and receipts received for which there is no
corresponding exchange of an actual good or service. These can include the following:
 Government transfers such as payments to and receipts from international
organizations and foreign aid.
 Transfers by private individuals are also included in this part of the current account.
One such transfer is workers’ remittances. This transfer of money from people working
in a foreign country back to their relatives at home forms a large credit item in some
countries such as Pakistan.
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CURRENT ACCOUNT BALANCE refers to the difference in inflows and outflows in the current
account (including trade in goods, services, incomes and current transfers). CURRENT
ACCOUNT SURPLUS refers to the fact that total inflows in current account are greater than
total outflows in current account. CURRENT ACCOUNT DEFICIT refers to the fact that total
outflows in current account are greater than total inflows in current account.
 A persistent deficit in current account is of a grave concern for economies.
INVISIBLES in current account include trade in service, income transfers, and current transfers.
HA
2) Capital Account
CAPITAL ACCOUNT is a part of the balance of payments and it is a record of capital transfers
and the acquisition and disposal of non-produced, non-financial assets. Capital transfers
include transfer of funds of migrants, and debt forgiveness; and Acquisition or disposal of nonproduced, non-financial assets include such things as intangibles including patents and
goodwill. It is usually a small part of the balance of payments.
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3) Financial Account
FINANCIAL ACCOUNT is a part of the balance of payments and it is a record of the transfer of
financial assets between the country and the rest of the world. It includes the following:
 DIRECT INVESTMENT involves building of a factory in another country and the takeover
of an existing firm in another country (debit items) or the setting up of a new plant or
the takeover of a firm in the country by a foreign firm (credit items).
 PORTFOLIO INVESTMENT includes the purchase and sale of government bonds and
shares that do not involve legal control of a firm.
 Other investments covers shorter-term movements of financial investment including
bank loans and inter-government loans.
o Income on direct, portfolio, and other investments is recorded in the current
account.
 Reserve assets are made up of government’s holdings of gold, foreign exchange
reserves, Special Drawing Rights and changes in the country’s reserve position in the
IMF. Reserves are kept to settle international debts and to influence the value of the
exchange rate.
o A deficit elsewhere in the BoP can be supported by drawing on reserves which is
a credit in the reserves.
o Addition to reserves are shown as debit items, while reductions in the reserves
are shown as credit items.
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CAPITAL AND FINANCIAL ACCOUNT SURPLUS refers to the fact that total inflows in capital and
financial account are greater than total outflows in capital and financial account. CAPITAL AND
FINANCIAL ACCOUNT DEFICIT refers to the fact that total outflows in capital and financial
account are greater than total inflows in capital and financial account.
 Capital account surplus can be used to overcome the deficits in current account.
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4) Errors and Omissions
NET ERRORS AND OMISSIONS is a figure included to ensure the balance of payments balances.
 The final balance of BoP must be zero. This happens because the amount of debits and
credits must be equal.
 However, it is very difficult to collect all of the data required for the balance of
payments in a totally accurate fashion. Therefore, the balance of payment may not
balance because of errors or omissions. The fourth heading therefore ensures that after
taking account of all headings, the BoP actually balance and the eventual balance is
zero.
Conclusion
 Developing economies generally have a deficit in their trade in goods and services. There
are however exceptions. Malaysia and Singapore have substantial export earnings from
manufactured goods and financial services.
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o These deficits can be financed through income from abroad (remittance in case
of Pakistan), foreign investments, foreign reserves held by central banks and
loans from IMF and other agencies.
o Current account deficits are not a major problem if they are financed by income
or investment from abroad.
o It is a major problem if it results in reduction in reserves or increase in foreign
loans.
Developed economies show a lot of variations.
o USA has a massive deficit on trade in goods and services.
o Germany and Japan have substantial surplus on trade in goods and services.
o Japan has very high levels of net income from investments abroad as its multinationals have widespread interests across the world.
Looking at BoP over time is more relevant than looking at just one year. This helps in
analysis of medium term and long term trends. This also helps the government to use
appropriate policies to overcome BoP problems.
A persistent deficit on the current account is a cause of concern. Although a short run
current account deficit can be overcome by a surplus in the capital account.
20.2 Equilibrium and disequilibrium in BoP
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Persistent deficits on BoP lead to fall in foreign exchange reserve. Very low reserves are
alarming and country may be forced to borrow from IMF to finance BoP deficits.
On an international scale, deficits and surpluses must balance. Surplus of one country is
offset by deficit or deficits of someone else.
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Equilibrium in BoP
EQUILIBRIUM in BoP refers to a situation where manageable deficits are cancelled out by
modest surpluses over a period of time. Hence, there is no tendency for the exchange rate to
change. Following are some situation of equilibrium.
 Current account deficit is offset by a financial account surplus, e.g. imports are greater
than exports BUT are offset by an inflow of FDI.
 Current account surplus is offset by a financial account deficit, e.g. exports are greater
than imports BUT are offset by outflow of FDI.
HA
Disequilibrium of BoP
DISEQUILIBRIUM of BoP occurs when, over a particular period of time, a country is recording
persistent deficits or surpluses in its BoP.
 There is a tendency for the exchange rate to be undervalued or overvalued on the
foreign exchange market.
 This is a more serious problem if there are persistent deficits leading to a fall in foreign
exchange reserves and an increase in foreign debt. Developing countries can especially
find that high level of foreign debt would be a strain on their income and growth. High
levels of foreign debt will lead to high levels of debt servicing that can lead to chronic
deficit on BoP as substantial portion of export earnings are spent on debt repayment.
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Situations of net deficits
 Deficits in both current account and the capital account.
 Marginal surplus in current account BUT a large deficit on financial account.
 Large deficit in current account and a marginal surplus in financial account.
Situations of net surpluses
 Surpluses in both current account and the capital account.
 Marginal deficit in current account BUT a large surplus on financial account.
 Large surplus in current account and a marginal deficit in financial account.
Causes of Current Account Deficit
Some of the reasons are discussed below.
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As already discussed, a persistent deficit is a larger concern for the economy as it will lead to a
fall in the foreign reserves and a depreciation in the exchange rate of the currency.
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(1) High propensity to import goods
BoP depends on the amount of goods imported into a country which depends on the
MARGINAL PROPENSITY TO IMPORT (mpm), i.e. the percentage of additional income in the
economy that is spent on imports. A higher mpm means more imports and a larger deficit in
BoP and vice versa. Higher imports result from many factors.
 People may perceive that local goods are not the best and the imported goods are
better. In this case, they will import more of things such as cars, clothing etc.
 There may be limited domestic production in developing economies. They therefore rely
on imported goods for meeting consumer demand.
 Developing economies usually have unfavourable terms of trade because of their
reliance on export of primary goods. The developing countries, therefore, have to spend
a higher amount on importing the goods they want and get lower revenue from their
exports.
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Government can use different policies to overcome this problem.
 Expenditure-switching policies
 Expenditure-dampening policies
 Depreciation of currency.
 Supply side policies
 Developing economies can try to develop a manufacturing base to reduce their reliance
on export of primary goods.
(2) Expansion in macro economy
Expansion in macro-economy (high GDP) may result in a rise in current account deficit.
 Firms increase their output and buy imported raw materials and capital goods.
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Exports may decline as firms find it more profitable to sell locally than in foreign
markets.
With rising consumer incomes, there is likely to be higher spending on luxurious
imported goods leading to a deficit in current account.
However, this is a short term problem. In the long-run, an expansion in the economy
should lead to increase in exports and attract foreign investment leading to an
improvement in BoP.
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(3) World aggregate demand
If countries that buy goods of the local country experience recessions or slowdowns in
economic growth, their import expenditure may fall or rise more slowly. It is not usually
considered to be a major problem as it is relatively short-term and is likely to be self-correcting.
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A current account deficit that arises from either changes in the economic cycle of the domestic
economy or the economies of trading partners is sometimes called a cyclical deficit and is not
considered to be a major problem as it is self-correcting.
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(4) Change in exchange rates
Rise in exchange rate will increase imports and reduce exports and vice versa (explained in the
next section on exchange rates). Solution to this problem is to devalue the currency.
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(5) Change in price of goods and services in different countries
Higher prices of locally produced goods will deteriorate the BoP and vice versa. Reason for
higher cost of production can be less efficiency of local factor or higher inflation rates in the
economy. Following can be solutions to overcome this problem:
 Improved productivity of factors of production (e.g. through training and education) will
reduce costs of locally produced goods making them more competitive and leading to
increase in exports and reduction in imports (improvement in BoP).
 Controlling inflation rates will make local goods more competitive leading to higher
exports and lower imports (improvement in BoP).
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(6) Quality of goods produced
Poor quality of locally produced goods will reduce their demand leading to deterioration in BoP.
HA
A current account deficit that lasts over the long run is more of a concern. This is because it
indicates that domestic firms are not internationally competitive and that the country may have
to borrow to finance the surplus spending. These include an overvalued exchange rate, a
relatively high inflation rate, low labour and capital productivity. A structural deficit is a
concern as it will not be self-correcting.
Causes of a financial account deficit
 Outflow of capital due to lack of confidence in the economic environment. Lack of
confidence in an economy will mean that investors will be less willing to invest in the
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economy. There will be capital flight from the economy as foreign investors may sell
their shares and may also sell their assets. This will reduce tax revenue and increase
unemployment and may result in the country moving into a recession. Lack of
confidence in the economy can result from political instability; economic instability (high
inflation, lower growth in GDP etc.); exchange rate instability; lower investment
opportunities; poor future prospects etc. It can rest Following steps can improve
confidence in the economy:
o Political stability
o Controlled inflation and interest rates
o Consistent taxation policies
o Stable exchange rates
o Expansionary fiscal (lower taxes and higher government spending) and monetary
policy (lower interest rates and higher money supply) lead to increase in GDP
growth.
o Giving incentives to firms to attract foreign direct investment. These incentives
can include lower taxes, provision of subsidies, infrastructure facilities etc.
Another reason for financial account deficit can be lower local interest rates compared
to other countries. It can also be the case if savers expect that other currencies may
rise in value. This will result in an outflow of hot money. This may not be a major
problem as it will give rise to an inflow of profits, interest and dividends in the future
years.
20.3 Evaluating BoP Disequilibrium
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(i) BoP deficit
BoP DEFICIT refers to the fact that outflows of currency from the country are greater than
inflow of currency in the country. It can be due to a large current account or a large capital
account deficit.
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Drawbacks
 Persistent deficits will mean that foreign exchange reserves will be falling. Country will
find it difficult to pay for imports in the future and may have to borrow from
international organizations.
 Persistent trade deficits will mean that there are higher imports and lower exports. This
can lead to lower production in the economy leading to higher unemployment and
lower income levels. This may lead to lower living standards.
 Persistent deficits in BoP will lead to lower business confidence. Foreign and local
investors will be reluctant to invest in the economy leading to lower growth, and low
investment.
 Deficits lead to depreciation of currency that can lead to inflationary pressures in the
economy and may result in reduced international competitiveness over time. Higher
price of imports will also lead to a fall in living standards.
 Government may resort to expenditure switching or expenditure dampening policies.
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o Expenditure switching policies may lead to lower living standards as government
limits import of luxury items.
o Expenditure dampening policies may lead to reduction in disposable income,
lower aggregate demand and may lead to higher unemployment in the
economy.
o This may also alienate the economy from international trade. Other countries
may also retaliate and put barriers on country’s exports leading to lower exports.
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Benefits
 Higher imports can improve living standards as country imports more luxury items such
as expensive cars, digital TVs etc.
 Imports of capital goods can actually lead to long term growth as the productive
potential in the economy increases and the PPC shifts outward. SR deficits may
therefore lead to LR surpluses as the economy expands, produces more and increases
exports.
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Evaluation
The effects of a deficit on an economy depends on the size, cause and the duration of the
deficit.
 It is therefore argued that SR deficits in trade or BoP are not a major concern. But
persistent LR trade deficits are a major area of concern and government will need to
intervene and correct the problem.
 Small, manageable deficits are not a major concern if they can be offset by surpluses in
subsequent years. Large deficits are a major source of concern especially if that leads to
fall in reserves or increase in borrowing.
 Persistent trade deficits that may be due to inefficiency and lack of competitive
advantage is a major source of concern. Trade deficits can be financed by following
sources:
o Current account deficits in the short run may be financed by capital account
surpluses. However, capital inflows are relatively unstable and difficult to
predict. Secondly, in developing economies, capital markets are underdeveloped
and may not be able to attract sufficient capital investment to overcome trade
imbalances.
o Trade deficits (higher import of goods) can also be financed by expanding service
sector. However, given that service sector is smaller than the manufacturing
sector, it is an unreliable form of overcoming the trade deficits in the LR.
o In developing countries, such as Pakistan, worker remittances from abroad are a
major source to overcome trade deficits. However, these remittances can vary
and will also depend a lot on the confidence that individuals have on the
strength of the local economy.
o Government therefore will have to intervene to correct LR BoP deficits. Some of
the policies are discussed in the next section. A developing country’s country can
consider expanding the industrial base to reduce its focus on exports of
agricultural goods.
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o SR deficits can be financed by large foreign exchange reserves but persistent
deficits will force governments to borrow more. Governments can also try to
correct these using different measures explained below.
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(ii) BoP surplus
BoP SURPLUS refers to the fact that inflow of currency from a country is greater than outflow
of currency into the country. This can be caused by large current account surplus or a large
capital account surplus.
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Benefits
 Persistent surpluses will mean that foreign exchange reserves will increase. Country can
use the additional reserves to import capital goods or pay its foreign currency liabilities.
 Trade surplus means that there is higher production in the economy leading to lower
unemployment, increase in income levels and improvement in living standards.
 BoP surpluses lead to higher business confidence leading to increase in investment in
the economy.
 Surpluses lead to appreciation of currency that can reduce inflationary pressures in the
economy. Lower import prices also lead to improvement in living standards.
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Drawbacks
 Appreciation of currency will increase the price of exports making them less competitive
internationally.
 Lower imports can reduce living standards.
 Lower imports of capital goods may limit economic growth.
 High trade surpluses mean low local consumption.
 Surpluses can be invested in foreign markets leading to large capital account deficits
(e.g. Japanese firms invest a lot of money in foreign markets).
 Trade surplus of one country is a deficit of another. Large deficits of other countries may
lead to those countries resorting to protectionist measures leading to trade wars.
 There are possible inflationary consequences. Surpluses due to rising demand for
exports (and therefore rise in AD) can cause demand-pull inflation if the economy is at,
or near, full employment.
HA
Surpluses are generally preferred over deficits as they lead to improvement in foreign exchange
reserves and create employment. However, a possible retaliation from trading partners can be
threat to international trade and the government may intervene to correct LR high surpluses
too.
20.4 Policies to correct BoP disequilibria
An economy will be particularly concerned if there is a persistent deficit in the balance of
payments. This results in falling foreign exchange reserves, depreciation, inflation, lack of
confidence in the economy, higher foreign debt level and so on. The government must
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therefore take steps to stem the continuing deficit. The government can take following steps to
overcome the problems.
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(1) Expenditure switching policies
EXPENDITURE SWITCHING POLICIES are policy measures designed to encourage people to
switch from buying foreign-produced products to buying domestically produced products.
 These policies are designed to encourage domestic households and firms to purchase
more domestically produced goods and services. This results in a fall in imports.
 Similarly, these policies encourage foreign households and firms to buy more exports
from the domestic economy.
 These policies therefore do not aim to reduce the aggregate expenditure but to redirect
or switch it to home-produced goods.
 Fall in import expenditure results in a fall in supply of the domestic currency and a rise
in export revenue results in a rise in demand for the domestic currency. The overall
impact is a rise in the price of the domestic currency.
 Government can use i) protectionist measures; and ii) devaluation of currency.
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Protectionist measures
Government can use protectionist measures to restrict imports or promote exports. It can take
following steps:
 Tariffs will raise price of imported goods therefore reducing their demand locally. This
measure is going to be more effective when demand for imports is elastic resulting in a
greater fall in quantity demanded for imports as a result of higher prices.
 Quotas will restrict the volume of goods that are imported into a country. This measure
would be effective even if demand for imports is inelastic as it will limit the quantity of
goods that are imported into a country.
 Embargoes will completely ban a product from entering a market. This can be done to
restrict import of harmful goods or to protect local industry or to improve BoP.
 Other measures can include voluntary export restraints and trying to run a ‘buy-local’
campaign.
 Government can also take steps to promote exports:
o It can give subsidies to exporters to make goods cheaper and increase their
demand.
o Helping local firms to market their product internationally. This can be done
through different agencies such as the Trade Development Authority in Pakistan.
HA
The impact of these policies will be to reduce import expenditure (reduce supply of domestic
currency in foreign exchange market), increase export earnings (increase demand of domestic
currency in foreign exchange market), and lead to appreciation of currency.
But government can face following problems in using these policies:
 They interfere with market forces and country does not get the benefits of specialization
and trade fully.
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Government’s ability to use these measures is limited by membership of WTO and other
free trade agreements.
Other countries may retaliate and put barriers on the country’s exports leading to lower
export revenues.
Subsidies to exporters is expensive, raises tax burden on taxpayers, and has an
opportunity cost.
Local goods may be of poorer quality leading to fall in living standards of consumers
who either have to buy expensive imports or poor-quality local goods.
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Devaluation of currency
DEVALUATION means that the government will lower the value of its exchange rate. This can
be used in a pegged exchange rate system. It is used when an economy is facing persistent
deficits.
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Devaluation will have following impact on the economy:
 Increase in price of imports leading to lower demand for imports, and a fall in price of
exports leading to increase in demand for exports.
 Impact on BoP will depend on the elasticity of demand and supply.
 According to Marshall-Lerner effect, BoP will improve if demand for import and export is
elastic.
 J-curve suggests that BoP will deteriorate in the SR when demand is inelastic and will
improve in the LR when demand becomes elastic.
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However, devaluation has its own problems:
 Devaluation can lead to inflation in the economy making exports less competitive.
 Frequent devaluation will mean lower benefits from having a pegged exchange rate
system.
 Trading partners can also devalue their currency. This competitive devaluation is not in
the interest of any country.
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(2) Expenditure dampening policies
EXPENDITURE DAMPENING (REDUCING) POLICIES are policy measures designed to reduce
imports and increase exports by reducing demand.
 It will result in fall in domestic spending leading to a fall in imports. The domestic
producers will try to find export markets as their local sales fall due to fall in AD.
HA
Government can use contractionary fiscal or monetary policy to reduce expenditure.
 Contractionary fiscal policy involves raising taxes and reducing government
expenditure. Higher taxes will reduce disposable income leading to lower expenditure.
Lower government spending reduces incomes and reduces expenditure.
 Contractionary monetary policy involves raising interest rates and reducing money
supply. Lower money supply leads to lower aggregate expenditure.
o Higher interest rates will have two impacts.
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(i) It will reduce the demand for loans for consumption and investment leading
to a lower aggregate expenditure.
(ii) Higher interest rates will attract hot money that will lead to appreciation of
currency.
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Higher mpm means that the fall in aggregate expenditure will have a higher impact on
import spending and the taxes may not have to be raised so much to achieve the
desired results.
Lower mpm will mean that the government will bring a large tax increase to get the
desired impact on import reduction.
AD
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∆ 𝑖𝑛 𝑖𝑚𝑝𝑜𝑟𝑡 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔
∆ 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
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𝑚𝑝𝑚 =
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Impact of lower spending in the economy will be reduction in imports depending on the
marginal propensity to import (mpm); and higher exports. Exports rise because a lower demand
in domestic market forces local producers to find new markets and export their products to
foreign markets.
 The impact of these policies will however depend on the marginal propensity to import
(mpm). MARGINAL PROPENSITY TO IMPORT measures the change in import spending
to a change in disposable income and is calculated by the following formula:
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Contractionary policies have following problems
 These policies are deflationary and may lead to a reduction in local output, higher
unemployment, lower income and so on.
 Contractionary fiscal policies are unlikely to be long term solutions as once the
measures are taken back, aggregate expenditure will rise leading to a rise in imports and
hence a fall in the current account.
 These measures may also be politically unpopular (e.g. higher taxes and lower
government spending) and the government may not use these measures.
 Rising interest rates may attracting hot money into the country. This leads to
appreciation of currency that will deteriorate BoP in the LR.
 These policies have time lags and take some time to show results.
 Government will not be able to control monetary policy if it is part of a common
currency.
HA
(3) Revaluation of currency
Revaluation means that the government will raise the value of its exchange rate in a pegged
exchange rate system. This can be done if there are persistent surpluses in the BoP. These are
however used less frequently as surpluses do not pose a major threat to the governments most
of the time.
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(4) Interest rate policy
Government’s interest rate policy can also impact the BoP.
 Higher interest rates in the economy will make local investments more attractive as they
are giving a higher return. This will attract hot money leading to an improvement in the
capital account.
 Lower interest rates will have an opposite impact.
 Problem is that this is a short run impact. In the LR, interest payments made on these
investments will lead to a deterioration of current account. Secondly, higher interest
rates will make borrowing more expensive leading to reduction in aggregate demand
and a reduction in investment in capital goods. This can lead to lower output levels,
higher unemployment and a fall in domestic productivity levels.
 Another problem is that with increasing mobility of financial expenditure, it can be
difficult for a country to operate an interest rate that is significantly different from rival
countries.
(5) Supply side policies
Supply side policies refer to the actions taken by the government to improve quantity and
quality of the factors of production.
AD
Measures can include providing training and education to work force to improve its
productivity; investing in R&D to improve the technology to make both capital and labour more
productive; using better fertilizers and pesticides to improve the output of farms etc.

Benefits of these measures include improvement in international competitiveness of the
economy without intervention in free trade. The economy therefore enjoys benefits of
specialization and trade while at the same time improving its BoP.
Problem of using these measures is that the impact of these measures comes in the long
run. These also have an opportunity cost in terms to lower consumption in the short
run.
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These measures lead to improvement in quality of the product of firms. Firms can hence charge
a premium on their exports. These measures also lead to improved productivity and a reduction
in the unit cost of production. Lower unit costs enable firms to lower their prices in
international market making local firms more competitive.
HA
(6) Floating exchange rate system
Floating exchange rate system allows exchange rate of a currency to be determined purely by
market demand and supply factors without the intervention of the government. A government
that is using pegged exchange rate system can convert to a floating exchange rate system to
achieve long run equilibrium in the BoP. Floating exchange rate system has an automatic
adjustment mechanism that adjusts disequilibria in the BoP.
 BoP deficits lead to depreciation of currency leading to cheaper exports and more
expensive imports. This should lead to improvement in BoP in the long run.
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20 – Balance of payments
BoP surpluses lead to appreciation of currency leading to more expensive exports and
cheaper imports. This should lead to a reduction in surplus in the long run.
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However, floating exchange rate systems lead to uncertainty and speculation and therefore can
hurt investment in the country.
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Conclusion
It can therefore be concluded that the government will try to use a mix of the above measures
to improve its BoP. However, the longer run solution will be to invest in improving the quality
and quantity of factors of production. Another long run solution that can be used by economies
that are operating pegged exchange rate system is the use of floating exchange rate system.
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21 – International trade
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21 International trade
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International trade involves buying and selling of goods across countries. It differs from internal
trade because of restrictions imposed by the government; difficulties in communication due to
long distances and different languages and cultures; higher costs of transportation and
communication; different currencies involved in trade that require exchange of currencies and
associated exchange rate risk; different tastes in different markets and so on.
 It leads to interdependence of economies. For example, a crisis in USA will affect trade
in China, India and Mexico.
 International trade also links developed and developing countries. Developed countries
provide range of consumer goods, capital goods, and financial services. Developing
economies in general provide raw materials, agricultural goods and some manufactured
goods. Trade is beneficial for both as they complement each other.
 Receipts from international tourism is also a part of international trade and is a major
source of revenue for some countries such as Caribbean, and East Africa. It is important
for their economic development, and is a major source of foreign exchange earnings.
 Some countries however promote the concept of buy-local, i.e. promote sales of homeproduced goods. This is done to reduce outflow of foreign currency. This however limits
trade to essential items only and limits the export potential of the country.
 International trade permits specialization. Countries can specialize in products and
commodities that they can produce more efficiently (in which they have a comparative
advantage).
 International trade affects the balance of payments. Receipts from exports of goods and
services increase foreign reserves of an economy and are useful in making payments for
imports. Imports are required as some products cannot be produced (such as oil in
Pakistan) and some products cannot be produced as efficiently (such as textile
machinery in Pakistan).
o Some countries such as Germany and China have high export surpluses while
others such as UK, US and Pakistan face a deficit. Deficit of one country is a
surplus of another country therefore the world trade flows will eventually
balance. A country may have a deficit with one country but a surplus with
another country.
 Comparative and absolute advantage depends on the factor endowment. Countries
have an advantage in those industries where factors of production are readily available.
o Economies having naturally occurring resources such as oil and copper can trade
them on world market.
o Climate and soil of a country can make it more efficient in production and trade
of food products or a good destination for international tourists. Pakistan has
good climatic conditions and suitable soil for agriculture production. It therefore
excels in agro-based industries.
o Countries having highly skilled workforce or cheaper labour (e.g. China) can
competitively produce products employing labour-intensive techniques such as
clothing.
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21 – International trade
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o Countries such as Japan and USA where capital is cheaper are more efficient in
producing high-tech products using capital intensive production techniques.
o Comparative advantage of countries may change as some countries acquire new
technologies, train their workforce, use better management practices, and
discover new natural resources. These will improve a country’s efficiency and
improve its comparative advantage.
21.1 Principles of International Trade
Trade will take place when countries have either an absolute or a comparative advantage in
production of a good. For examples, Pakistan has a clear-cut advantage (absolute advantage)
over Saudi Arabia in production of cotton which Saudia has an advantage in production of oil.
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Assumptions (both theory of absolute advantage and theory of comparative advantage)
 There are just 2 countries involved in trade.
 There are only 2 products produced.
 Both countries have different productivity levels, i.e. they are able to produce varying
quantities of each product.
 Production costs are constant.
 Opportunity costs are constant, therefore, PPC is linear.
 Resources can be shifted from one use to another.
 There are no transportation costs.
 There is no restriction on free trade.
 There are no negative externalities from production of goods.
 Factors of production are perfectly mobile.
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Theory of Absolute advantage
A country has an ABSOLUTE ADVANTAGE over another country when it is better off at making
a good than another country so that it uses fewer resources to make the same amount of good.
Or we can say that, for a given amount of resources, it can produce more of the good than its
competitor.
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The theory of absolute advantage states that countries should specialize in those products in
which they have an absolute advantage and then trade with their partners. This will:
 increase each country’s productivity,
 increase world output, and
 increase living standard of each country by shifting the PPC outward.
HA
We can use the following example to illustrate the points made. In the example, we are
assuming that each country has the same resources and that the resources are distributed
evenly in the production of each good.
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21 – International trade
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Looking at the table, we have a situation where
Pakistan has an absolute advantage in the
production of cloth and Saudia has an absolute
advantage in the production of oil.
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Pre-specialization situation
Assume that two countries, Pakistan and Saudia, with similar amounts of resources both
produce only two goods, cloth and oil. The table gives
Cloth (units) Oil (units)
the production possibilities for a given year assuming
150
300
that they each split their resources evenly between the Saudia
Pakistan
200
200
production of cloth and oil.
Total
350
500
This information can be illustrated on PPC.
 Pakistan could produce 400 units of cloth if it concentrated all of its resources on
production of cloth.
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It makes sense for each country to specialize and
produce the good that it is best at, i.e. Pakistan
should specialize and produce cloth and Saudia
should specialize and produce oil.
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Situation after specialization
If each country specializes in the good in which they have an absolute advantage, then, the
production is shown in the table below.
Cloth (units) Oil (units)
Total production of both goods has now risen because Saudia
0
600
each country is concentrating on production of the
Pakistan
400
0
good in which it has an absolute advantage. Both
Total
400
600
countries will however only benefit if the exchange
rate is between the respective opportunity costs of each country. Opportunity costs are
shown in the table below.
Oil (units)
150
200
350
300
200
500
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Cloth (units)
Opp. cost
(one unit of cloth)
2.0 Oil
1.0 Oil
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Saudia
Pakistan
Total
Opp. cost
(one unit of oil)
0.5 Cloth
1.0 Cloth
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Pakistan (without trade) could produce one extra unit of cloth at the cost of one unit of
oil. Pakistan will, therefore, only trade if it receives more than one unit of oil by giving
one unit of cloth (1 cloth = more than one oil). If the exchange rate is below this,
Pakistan will not trade and will not specialize.
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21 – International trade
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Saudia can produce one extra unit of cloth by giving up production of 2 units of oil. It
will therefore want to buy one unit of cloth by giving up less than 2 units of oil (1 cloth =
less than 2 units of oil). If the exchange rate is above this, Saudia will not trade.
The exchange rate should thus be between one and two oil in return for one cloth
(1cloth = between one and two units of oil).
We can also state the exchange rate in terms of oil in which case it will be one unit of oil
should sell for between 0.5 and 1.0 units of cloth (1 oil = 0.5 and 1.0 units of cloth).
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Situation after specialization and trade
Specialization and trade will bring following benefits:
 Both countries will benefit as their PPCs will pivot outward and the consumers will be
able to consume more units of goods than before. This will improve the living standards
of both the countries (note: this will only happen if exchange rates are between the
respective opportunity costs). One possible result of specialization and trade is given in
the table assuming that exchange rate is 1.5 units of oil for 1 unit of cloth.
Cloth (units) Oil (units)
Saudia
200
300
Pakistan
200
300
Total
400
600
World output will increase leading to overall increase in world GDP. Both countries are
gaining as they can consume more units of goods.
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We can therefore conclude that specialization and trade will benefit both countries if countries
specialize in those goods in which they have an absolute advantage. If a country has an
absolute advantage in producing both goods, even then trade will result in benefits to
individual country and the world. This is explained by the theory of comparative advantage.
Limitations
Explained below after discussion on theory of comparative advantage.
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Theory of Comparative advantage
A country has a COMPARATIVE ADVANTAGE over another country when it has a lower
opportunity cost than another country.
HA
Theory of comparative advantage states that countries should specialize in those products in
which they have a comparative advantage, even if one country may have an absolute
advantage in production of both goods. They should trade with their partners. This will:
 increase each country’s productivity,
 increase world output, and
 increase living standard of each country by shifting the PPC outward.
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21 – International trade
K
We can use the following example to illustrate the points made. In the example, we are
assuming that each country has the same resources and that the resources are distributed
evenly in the production of each good.
It can be seen from the table that Pakistan has
an absolute advantage in production of both
cloth and oil (it can make more of both goods by
using same resources).
This can be illustrated on a PPC.
Oil (units)
100
200
300
Pakistan could produce 400 units of cloth if
it concentrated all of its resources on
production of cloth.
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Saudia
Pakistan
Total
Cloth (units)
150
200
350
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Pre-specialization situation
Assume that two countries, Pakistan and Saudia, with similar amounts of resources both
produce only two goods, cloth and oil. The table below gives the production possibilities for a
given year assuming that they each split their resources evenly between the production of cloth
and oil. We are assuming that both countries can only produce two products, cloth and oil.
Pakistan has an absolute advantage in production of
both goods but the comparative advantage differs.
This can be shown by calculating the opportunity
costs of each country.
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100
200
300
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150
200
350
Opp. cost
(one unit of oil)
1.5 Cloth
1.0 Cloth
Opp. cost
(one unit of cloth)
0.67 Oil
1.0 Oil
In case of oil, 1 unit of oil costs 1.5 units of cloth in Saudia and 1 unit of oil costs 1.0
units of cloth in Pakistan. Pakistan has a comparative advantage in oil at it has a lower
opportunity cost.
In case of cloth, 1 unit of cloth costs 0.67 oil in Saudia and 1 unit of cloth costs 1.0 oil in
Pakistan. Saudia has a comparative advantage in cloth as it has a lower opportunity cost.
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Oil (units)
M
Saudia
Pakistan
Total
Cloth (units)
The theory of comparative advantage states that each country should specialize in the product
in which it has a comparative advantage. In the above example, Pakistan should specialize in
production of oil and Saudia should specialize in production of cloth. This will improve world
output and increase the living standard in each country.
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21 – International trade
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Situation after specialization
If each country specializes in the good in which they have a comparative advantage, then, the
production is shown in the table below.
Cloth (units) Oil (units)
Total world output has increased from 650 units to 700
Saudia
300
0
units. However, production of cloth has fallen. But it
Pakistan
0
400
must be seen that oil used more resources, therefore, a
Total
300
400
higher production of oil means that the total efficiency
has increased. However, a slightly different combination of goods produced will lead to
increase in world output although there won’t be 100% specialization in that case. It can be
shown in the table below.
 The world output is now 700 units.
Cloth (units) Oil (units)
 Output of both products has increased.
Saudia
300
0
 However, this is not optimal as the previous Pakistan
70
330
table shows the more optimal output based on Total
370
330
complete specialization.
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AD
Both countries will however only benefit if the exchange rate is between the respective
opportunity costs of each country.
 Pakistan (without trade) could produce one extra unit of oil at the cost of one unit of
cloth. Pakistan will, therefore, only trade if it receives more than one unit of cloth by
giving one unit of oil (1 oil = more than one cloth). If the exchange rate is below this,
Pakistan will not trade and will not specialize.
 Saudia can produce one extra unit of oil by giving up production of 1.5 units of cloth. It
will therefore want to buy one unit of oil by giving up less than 1.5 units of cloth (1 oil =
less than 1.5 units of cloth). If the exchange rate is above this, Saudia will not trade.
 The exchange rate should thus be between 1 and 1.5 units of cloth in return for one unit
of oil (1 oil = between one and 1.5 units of cloth).
 We can also state the exchange rate in terms of cloth in which case it will be one unit of
cloth should sell for between 0.67 and 1.0 units of oil (1 cloth = 0.67 and 1.0 units of oil).
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Situation after specialization and trade
Specialization and trade will bring following benefits:
 Both countries will benefit as their PPCs will pivot outward and the consumers will be
able to consume more units of goods than before. This will improve the living standards
of both the countries (note: this will only happen if exchange rates are between the
respective opportunity costs).
 World output will increase leading to overall increase in world GDP.
We can therefore conclude that specialization and trade will benefit both countries if countries
specialize in those goods in which they have a comparative advantage.
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Limitations
Explained below.
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No trade scenario – Equal opportunity costs
If opportunity costs of producing two goods are same for two countries, then, trade will not be
mutually beneficial and therefore no trade will take place. This will mean that the PPCs of two
countries will be parallel to each other.
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Limitation of the Theory of Absolute Advantage and of the Theory of Comparative Advantage
The theories make a lot of assumptions that may not be very realistic. This limits the ability of
these theories to explain the pattern of international trade in many countries. The limitations of
the two theories are described below.
 Theory assumes that the PPC is linear. However, the assumption is not very realistic as
the opportunity cost tends to increase as we divert resources from production of a
good. This is because the least productive resources are shifted (low opportunity cost)
initially and more productive resources (high opportunity cost) are shifted later.
 It is assumed that factors of production are perfectly mobile and that the resources can
easily shift from production of one product to another. However, in practice, factors are
seldom perfectly mobile. This is because different occupations require different skills
that every worker does not possess.
 The exchange rate operating for international transactions must be between domestic
opportunity cost ratios. If it is not like that, then, trade will not be mutually beneficial
and countries may resort to producing both goods locally. Trade has greatest potential
when the difference between opportunity costs is widest.
 The assumption of no transportation costs is unrealistic. In practice, movement of goods
will require transportation costs to be incurred. However, there can still be gain from
international trade if production benefit is greater than the transportation costs.
 The theory assumes two-countries and two-products. This assumption is also unrealistic.
There are many trading partners in a global economy. Countries may specialize in many
goods rather than just one.
 Theory assumes that production costs are constant. This is also unrealistic.
Specialization should lead to economies of scale and a reduction in production costs.
However, if specialization goes too far, a country may experience diseconomies of scale.
 The theory assumes that traded goods are homogeneous. Some goods such as steel,
copper or wheat are similar. However, most of the products such as cars and like that
are different in quality.
 It is assumed that there is no restriction on free trade between countries possessing
absolute and comparative advantage. This is unrealistic as governments may resort to
protectionist policies because of many factors. This would mean that a country that
does not enjoy comparative advantage in production of a good may still keep producing
that good due to government support.
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Conclusion
 Theories make some unrealistic assumptions. However, they show clear gains from
international trade.
 These theories can be extended to any number of countries and any number of
products. Multilateral free trade (trade between many countries) is therefore beneficial
for well-being of the world economy. It leads to specialization, efficiency and minimum
waste of scarce resources.
 Restrictions on trade will reduce gain from free trade and is not in the interest of
economic efficiency.
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Trading possibility curve
TRADING POSSIBILITY CURVE is a diagram showing the effects of a country specialising and
trading. For example, a country may be able to
produce a maximum of 50 million units of
clothing or 100 million units of food. The
opportunity cost is 1 unit of clothing to 2 units of
food. If it specialises in clothing and imports
three units of food for every unit of clothing it
exports, this will enable the country to increase
the total quantity of products the country can
consume.
 If the country had initially produced 40
million units of clothing, then it could
produce a maximum of 20 million units of food.
 If it engages in international trade and specialize in clothing, it can produce a total of 50
million units of clothing and export 10 million units of it.
 At the exchange rate of 1 cloth to 3 food, it can now imports 30 million units of food,
hence, enabling it to buy more of food.
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Advantages of trade
 There is an increase in world output. Resources are allocated more efficiently based on
comparative advantage. It results in higher income levels and creates employment.
 There are gains for individual country as a result of specialization and trade.
 There is an increase in consumer choice resulting in higher living standards. They can
buy commodities that cannot be produced locally (e.g. iphone in Pakistan) and those
goods that are too expensive to be produced locally.
 Imports provide additional competition for domestic producers leading to increased
efficiency in local firms and reduced prices.
 Local firms can learn management practices from MNCs.
 Exports enlarge the market for products of developing economies which benefits the
producers, provides more employment and generate foreign exchange for the country.
 Firms can get access to capital goods that can be imported. This will increase the
productivity levels locally.
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Developing countries can exploit their advantage of cheaper labour to gain comparative
advantage in production of many manufacturing goods.
It promotes cultural exchanges that improves relationships between trading partners.
It also brings sharing of new knowledge and information and helps in transfer of
technical know-how.
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Disadvantages of trade
 There can be over-specialization as a country specializes in a limited number of
commodities. This leads to dependence on other countries for the rest of the products
that can be difficult to manage in times of conflict. Economy can also become more
vulnerable to external influences such as price fluctuations.
 If developing countries focus on trade of primary goods, this can lead to lower terms of
trade where they will need to sell more goods to buy same amount of imports; and
depletion of resources if they export raw materials such as minerals and oil.
 Countries may refuse to trade with one another due to political differences, such as the
United States and Iran.
 Higher competition from MNCs can mean that some of the local firms may go out of the
market resulting in lower GDP and higher unemployment.
 High levels of imports can result in deterioration of BoP and outflow of foreign
exchange.
21.2 Types of protection and their effects
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PROTECTIONISM involves protecting domestic producers from foreign competition.
PROTECTIONIST POLICIES are the policies adopted by the government that distorts market
forces in order to give a competitive advantage to the domestic industry of an economy.
Protectionist policies are a form of expenditure switching policies that aim to switch
expenditure, both domestic and foreign, to output of goods and services of the domestic
economy.
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Methods of protection
(i)
Tariffs
TARIFF is a tax on imports. It can be either i) Specific tax – It is a fixed tax charged per unit of
import, e.g. $5 per unit; or ii) Ad valorem tax – It
is a tax charged as a percentage of the value of
the import, e.g. 5% of the import value.
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The impact of a tariff can be illustrated by the
help of a figure.
 Domestic demand and supply (in the
absence of international trade) is given by
D – Domestic and S – Domestic.
Equilibrium without international trade is
at price P and quantity Q. If government
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21 – International trade
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allows international trade, consumers will benefit from specialization.
Country will be able to import goods at a much lower price, P 1.
At the lower price P1, the domestic supply will only be Q1 and the supply curve therefore
will be ABF. The domestic demand will be Q2 and domestic supply will be Q1 only.
The differential between the local demand and the local supply, i.e. Q2 – Q1 is satisfied
by imports. Therefore, the amount of imports in the country will be M1 that is equal to
Q2 – Q1.
Imposition of tariff will increase the price of imported goods from P1 to P2. Local
producers will now be willing to supply a higher quantity, i.e. Q3 and the new supply
curve will therefore be AMN.
At the higher price P2, the domestic demand will be Q4 and domestic supply will be Q2
only. The differential between the local demand and the local supply, i.e. Q 4 – Q3 is
satisfied by imports. Therefore, the amount of imports in the country will be M 2 that is
equal to Q4 – Q3.
With imposition of tariffs, imports will therefore reduce.
Government will gain revenue equal to the product of tariff charged (P 2 – P1) and the
amount of imports (Q4 – Q3). This is the area MNCE.
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* Note: If tariff is so high that the price of imports after tariff exceeds local price (P), then, no
imports will take place. This is called a PROHIBITIVE TARIFF.
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Gainers
 Local producers will gain because they will be able to (i) increase their output, and (ii)
receive higher price in local market.
o Producer surplus before tariff was the area ABP1.
o Producer surplus after tariff will be the area AMP2 showing an increase in the
producer surplus.
 Government – because it receives revenue. Government will get more revenue if
demand for imports is price inelastic.
 Economy can gain if there is lower imports. There will be a greater fall in imports if
demand for imports is price elastic.
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Losers
 Consumers – as they have to pay a higher price.
o Consumer surplus initially was the area P1FX.
o Consumer surplus after tariff will be the area P2NX showing a fall in the
consumer surplus.
 Importers – as higher price of imported goods make them less competitive with local
producers leading to a reduction in demand for imported goods.
 Price of imported raw material will also increase making firms that were using imported
raw material less competitive.
 There is a loss to the society.
o Area NEF is the net loss due to decrease in quantity consumed.
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21 – International trade
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o Area BCM is the loss due to inefficiency. Extra production is being done at an
extra cost.
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(ii)
Quotas
QUOTA is a physical limit on the number of units of the product that can be imported into a
country, e.g. the government may limit the import of cars to 50,000 only.
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The impact of quotas can be described using the figure.
 Domestic demand and supply (in the absence of international trade) is given by D –
Domestic and S – Domestic. Equilibrium without international trade is at price P and
quantity Q. If government allows
international trade, consumers will
benefit from specialization.
 Country will be able to import goods at a
much lower price, P1.
 At the lower price P1, the domestic supply
will only be Q1 and the supply curve
therefore will be ABF. The domestic
demand will be Q2 and domestic supply
will be Q1 only.
 The differential between the local
demand and the local supply, i.e. Q2 – Q1
is satisfied by imports. Therefore, the amount of imports in the country will be M 1 that is
equal to Q2 – Q1.
 If the government restricts imports by imposing a quota (equal to MN or Q4 – Q3), the
following will happen:
o Import will decline from M1 to M2 which is equal to Q4 – Q3.
o Price will increase (to P2) because of lower imports.
o Local demand will reduce to Q4.
o Local producers will increase output from Q1 to Q3.
 It prevents domestic consumers from benefiting from all advantages of international
trade.
 There is a welfare loss to the society.
 The government receives no revenue from quota.
HA
Gainers
 Local producers will gain because they will be able to (i) increase their output, and (ii)
receive higher price in local market.
o Producer surplus before tariff was the area ABP1.
o Producer surplus after tariff will be the area AMP2 showing an increase in the
producer surplus.
 Some of the importers who are still able to import and sell. They will receive a higher
price for their product. They receive additional revenue equal to the area MNCE.
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21 – International trade
Economy can gain if there is a fall in imports. Quotas are effective even if the demand
for imports is price inelastic as quotas will limit the amount of goods that can be
imported.
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Losers
 Consumers – as they have to pay a higher price.
o Consumer surplus initially was the area P1FX.
o Consumer surplus after tariff will be the area P2NX showing a fall in the
consumer surplus.
 Some of the importers who are not able to import at all.
 Government is not able to collect any revenue. However, in some cases government
sells licenses to foreign firms. This may raise revenue for the government.
 There is a loss to the society.
o Area NEF is the net loss due to decrease in quantity consumed.
o Area BCM is the loss due to inefficiency. Extra production is being done at an
extra cost.
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(iii)
Anti-dumping duties
ANTI-DUMPING DUTIES are tariffs imposed on imported products that are found to be sold at a
price below their cost of production. Dumping is seen as unfair and harms the local producers.
Anti-dumping duties make the competition fairer and protect local firms against unfair
competition.
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(iv)
Administrative policies
Countries can use bureaucratic controls to limit or delay imports in the market. For instance
countries often impose certain safety standards that are unnecessary, but put off foreign
imports.
 There are many examples of countries that will only allow certain goods to be imported
through a certain port or checkpoint.
 There have also been examples of countries that take weeks to process the
administration involved in admitting an import.
 A country can use health and safety regulations to limit imports. These standards raise
the costs of imports and therefore limit their demand.
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(v)
Exchange controls
EXCHANGE CONTROLS involve setting a legal limit on dealings in foreign currency that a
country’s citizens can make.
 It prevents excessive spending on imports as importers are limited in their access to
foreign currency.
 It results in lower imports.
 Consumers will suffer as there will be (i) less choice, and (ii) higher prices in the market.
 All member states of EU abandoned exchange controls in 1993.
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(vi)
Embargoes
A TRADE EMBARGO is a law or policy of a country to prohibit import or export of goods. Trade
embargoes can be motivated by political, economic, moral or environmental reasons. An
example of embargo is the complete ban on import of alcohol in Pakistan.
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(vii) Export subsidies
Subsidy is a grant paid by the government to a firm producing a certain good. Export subsidies
are paid to exporters to make their products more competitive in the international market. It
has the following impact on the market.
 It increases supply of country’s exports in the world market.
 It reduces the price of good below that determined in a free market.
 Gainers
o Foreign consumers enjoy an increase in economic welfare as price of goods fall.
o People employed in domestic market may also benefit with higher wages, more
employment and more job security.
 Losers
o Tax payers however lose as subsidy is paid out from higher taxes.
o Domestic consumers may lose as firms divert resources to producing exported
goods.
o Shortage of supply of goods in local market may fuel inflation.
o Foreign firms lose out as their goods may not remain competitive.
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(viii) Voluntary export restraints
VOLUNTARY EXPORT RESTRAINTS (VER) are limits set by a country on its exports. The limits are
usually set after an agreement between the two countries involved in trade. There may be
several reasons for setting export restraints. They may include the following.
 There is a shortage of product in the country and therefore the country either bans
exports or limits exports to the amount of any excesses produced.
 Exporting country may put a limit because of a fear that other countries may put
restrictions on its exports.
 The exporting country may also do this to increase the price of the product by creating
shortages.
(ix)
Buy-local campaigns
Government can run campaigns that encourage consumers to buy locally produced goods.
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(x)
Keeping the exchange rate below its market value
A lower exchange rate will reduce the price of exports and increase the price of imports hence
giving local producers a competitive advantage.
 Impact of this on the current account will depend on the Marshall-Lerner condition and
the J-curve shows the impact in the short-term and the long-term.
 A major drawback of doing this is that it will start competitive devaluation where trading
partners may also lower their exchange rates.
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Conclusion
Protectionist policies distort international market forces to achieve narrow national interests.
The behaviour is generally considered uncompetitive.
 It gives local firms competitive advantage over foreign industries leading to an increase
in exports and a fall in imports.
 These practices are however discouraged by terms of international trading agreements
such as WTO.
 Protectionist policies ignore the benefits set down by theory of comparative advantage.
 Protectionist policies lead to lower short term gains such as promoting local producers
and gaining government revenue at the cost of above benefits.
 There is a fear that protectionist policies will be reciprocated by other countries leading
to a fall in exports.
 Governments are keenly looking at alternative strategies to promote exports such as
using supply side policies to make their firms more competitive and increase exports.
Arguments in favour of protectionism and their assessment
There are many reasons why some people justify the use of protectionist measures. Some of
these are analysed below.
Problems
o Many industries start claiming infant industry status and ask for import controls.
They lobby politicians to protect their industry.
o Once an industry is given a protection, it is often difficult for the government to
remove the protection as special interest groups start lobbying the politicians
against removal of import controls. This can therefore promote inefficiency
rather than allowing firms to become competitive.
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(1) Infant industry argument
INFANT INDUSTRY is an industry in an economy which is at an early state of its life but has the
potential to gain comparative advantage.
 The problem for infant industry is that it has a low market share that does not enable it
to get economies of scale. Their workers are inexperienced; and there is a lack of
communication networks, reliable suppliers, and specialist research and development.
Infant industry will, therefore, not be able to compete with large MNCs. Large
established MNCs can drive new firms out of the market by lowering their prices.
 Economic justification – Protectionism will protect infant industry from foreign
competition and allow to grow locally. This would allow them to gain economies of scale
and become competitive internationally. Once comparative advantage is achieved,
government can remove import controls.
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(2) To protect declining industries
SUNSET INDUSTRIES are those which have lost their comparative advantage and their sales are
falling. This may result in a rise in unemployment.
 If the industry is granted protection and that protection is gradually removed, large
sudden unemployment may be avoided. Some of the workers that eventually lose jobs
may retire and some may find jobs in other industries.
 However, this can lead to inefficiency and the industry may resist reduction in the
protection it receives. This can also make ancillary industries inefficient. For example, if
government gives protection to an inefficient steel industry, it may disadvantage local
automobile manufacturers who otherwise had a comparative advantage. They will have
to buy the more expensive domestic steel leading to inefficiency in automobile industry.
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(3) Prevent dumping
DUMPING is the process of selling goods in an overseas market at a price below the cost of
production. This is a form of price discrimination where consumers in the home market will pay
a higher price to overcome the losses made in foreign markets.
 Purpose of dumping is to destroy competition in the overseas market and once some
firms have left the market, the firm practicing dumping can raise prices and enjoy
superior returns.
 Firm is able to achieve dumping by receiving export subsidies; ensuring consumer in
home market pay a high price to cover total costs; and accepting losses in the short run
if firm is able to destroy competition in the hope of making higher profits in the future.
 Economic justification – Anti-dumping duties can be justified if dumping leads to anticompetitive behaviour, and prevents emergence of comparative advantage.
 Problem
o Local firms losing out to cheap imports often claim dumping whereas in reality
low prices may be due to superior efficiency.
o It is difficult to prove dumping practices. Therefore, government needs to
carefully investigate before using import controls.
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(4) Retaliation against unfair trade practices
Country can retaliate against countries which impose restrictions on your exports. It can reduce
trade but in the long-run, it can be useful if it pressurizes the other country to remove barriers.
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(5) Safeguard employment in home country
The argument that is given is that imports lead to lower local production and higher
unemployment. Therefore, to protect local employment, the government needs to protect local
industries by using protectionist measures.
 It will be more useful when import penetration ratio is high as it will result in a large fall
in imports and a greater rise in local production. IMPORT PENETRATION RATIO refers to
the proportion of domestic sales of a product which is taken up by imports.
 Justification – There is no economic justification for this reason. There is only
justification on social grounds to protect jobs.
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Economic argument
o To maximize economic welfare, labour should be swiftly reallocated to its best
use. This can be done by improving its occupational and geographical mobility.
o Cheaper imports should benefit the consumers (lower price and more choice)
and increases the economic welfare.
o If economy specializes and grows in more efficient industries, it will actually
create additional employment in the economy.
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(6) Correct balance of payment disequilibria
Balance of payment disequilibrium is exaggerated usually by a continuing deficit in the current
account. It is argued that expenditure switching policies (e.g. protectionist policies) will reduce
imports and improve exports leading to an improvement in the balance of payments.
 Drawbacks of using Expenditure Switching Policies – It can lead to retaliation by other
countries leading to a loss in exports. It would not be possible to use this policy if the
country is a part on a trade agreement.
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(7) Reduce reliance on imports
 Developing countries can try to develop a manufacturing base and reduce its reliance on
primary goods. Primary goods are reliant on weather conditions and a poor weather can
result in high unemployment and low growth. Primary goods have another problem, i.e.
these are income inelastic and therefore there is little growth potential in this sector.
 Countries can try to develop its own base for foodstuff to reduce its reliance on other
countries. For instance, Pakistan in the 1950s established sugar industry to reduce its
reliance on imports for this staple food.
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(8) Prevent exploitation of labour in developing economies and to take account of
externalities
Some people justify protectionist policies on moral grounds claiming that imported goods are
cheap because labour and environment is exploited. Labour is paid very low wages and the
MNCs operating in developing economies do not take measures to protect the environment.
This leads to lower cost of production. They argue that imports should be prevented to stop or
reduce the exploitation of workers and the environment in the developing countries.
 Similarly, firms producing in developed countries pay a higher wage and are hence
unable to compete with firms in developing economies. To protect the higher wages
paid in developed economies; government should restrict imports of cheaper goods.
 Analysis
o There is no economic justification since cheap labour is a reflection of a country’s
factor endowment. Presence of large supply of unskilled labour in developing
economies leads to lower wages and lower priced products.
o Theory of comparative advantage suggests that the country should specialize in
producing products in which it has a comparative advantage (least opportunity
cost). In developing countries, that will be to produce products using labourintensive techniques.
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o There is even no moral justification for this argument. Import controls will
reduce import from developing economies leading to lower production, higher
unemployment and even lower wages in those countries.
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Other reasons for using protectionist measures are listed below:
 A country may decide not to trade with certain countries due to political disagreements
such as low trade between India and Pakistan.
 A country can exploit its monopoly power by reducing exports and therefore supply in
the world market. This will push up prices for the good. A good example are the
practices of OPEC that limits supply of oil to increase oil prices.
 A country can prevent imports of harmful goods such as Pakistan limits import of pork;
and has also banned YouTube.
 A country may decide to protect rural communities that are under threat from large
MNCs by limiting imports.
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Limitations of protectionism
 It is inflationary as prices of imported goods will increase.
 It restricts the choice of goods available to consumers.
 There can be retaliation from other countries resulting in lower exports for the country.
 Imports will protect local firms from foreign competition. It may, therefore, reduce
firms’ incentives to reduce costs and it may also result in protection of inefficient
industry.
 It will increase administrative costs for the government to ensure implementation of its
policies. It can also lead to increase in bribes paid to custom’s officials.
 Countries will not gain from specialization and other benefits of trade.
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Conclusion
 Arguments given in favour of protectionist policies seldom have economic justifications.
The only cases where there is a genuine reason for import controls are the dumping
argument and the infant industry argument.
 There has been tremendous growth in international trade over the last two decades
with growth in international trade outstripping the growth in GDP.
 Economies are getting increasingly interdependent on each other and the developing
countries can get a lot of benefits of globalization through trade.
 It can therefore be concluded that protectionism is not in the best interest of a country
even a developing country. However, in case of dumping practices and presence of
infant industries, import controls can be justified.
21.3 Economic integration
ECONOMIC INTEGRATION refers to the deliberate ways in which national economies agree to
merge their economic affairs into a single economic organization through eliminating
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protectionist measures among the member countries and promoting cooperation. It results in
economies becoming closely linked to each other.
 Much of the world trade takes place within these trade blocs.
 Following are some examples of economic integration.
o European Union (EU) is an economic and political union of 27 member states
located in Europe.
o North American Free Trade Agreement (NAFTA) includes USA, Canada and
Mexico.
o Free Trade Area of the Americas (FTAA) includes various members in Canada and
South America plus the NAFTA members.
o Asian-Pacific Economic Cooperation (APEC) principally includes Australia, NZL,
China, Hong Kong, Japan, Taiwan, South Korea and NAFTA countries.
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Main types of Economic Integration
(1) Preferential trade agreement
PREFERENTIAL TRADE AGREEMENT is a trading bloc that gives preferential access to certain
products from the participating countries. This is done by reducing tariffs but not by abolishing
them completely. One of the examples is South Asian Free Trade Area among the SAARC
countries.
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(2) Free Trade Area
FREE TRADE AREA involves systematic removal of trade restriction between member countries,
e.g. NAFTA, FTAA, APEC.
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General characteristics
 Removal of tariff or quotas on internal trade.
o Trade restriction may be withdrawn on just a selected range of commodity
types.
o These organizations generally exclude discussion on agriculture which is
considered very sensitive especially for the developed countries.
 Members are free to determine their own external trade policy toward non-members.
o There is a fear that non-member countries can sell their goods into the free
trade area through the country that has the lowest external tariff. Measures are,
therefore, taken to prevent imports from outside area via the country with the
lowest external tariff.
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(3) Customs Union
CUSTOMS UNION refers to an agreement where the member countries agree to remove trade
barriers among themselves and also adopt a common external tariff on trade with non-member
countries.
 Tariff may be on all trade or mainly on imported goods which member states are able to
adequately produce themselves.
 An example is the Customs Union of Belarus, Kazakhstan and Russia.
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(4) Common market
COMMON MARKET refers to a trade agreement where member countries agree to remove
trade barriers and also allow free movement of labour and capital among the member
countries. Common markets impose a common external tariff on imports from non-member
countries. An example of this type of integration is the European community.
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(5) Economic Union
ECONOMIC UNION involves removal of restrictions on trade, common external trade policy and
also removal of restriction on the movement of factors of production (labour and capital)
between members. In addition to this, there is harmonization and centralization of economic
policies. An example of economic union is the European Union (EU).
 EU has developed various common policies in areas such as agriculture, transport,
regional and social affairs.
 EU is also progressing towards an Economic and Monetary Union (EMU) with following
features:
o A single currency – Euro.
o Centralized economic policies with monetary policy being in the control of the
European Central Bank. European Central Bank hence controls money supply
and interest rates.
 Benefits of a single currency:
o It reduces transaction costs as firms in the member countries do not have to
exchange currency during trade with each other.
o It improves transparency as it is easier to compare prices of products in different
countries as they are quoted in a single currency.
 Drawbacks of a single currency
o It reduces national sovereignty as countries will have to forego monetary policy.
o There is a one-time cost of printing notes and coins.
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Trade creation and Tarde diversion
i) Trade creation
TRADE CREATION occurs where high-cost domestic production is replaced by more efficiently
produced imports from within the trading bloc. This means that following will happen:
 Greater specialization will occur and the less-efficient producers will lose market to
more efficient producers from within the trade bloc.
 This will therefore mean that resources will be more efficiently used.
 A country will be able to import goods at lower prices. This may increase imports but
increase the overall welfare of the economy as shown in the diagram below.
 A country can also gain as it will be able to increase exports and get access to a larger
market. This will allow local firms to benefit from economies of scale hence reducing
their unit costs.
The gains from trade can be shown with the help of a diagram below:
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Local demand with tariff imposed was Q3 with local suppliers selling Q2 and imports
equal to Q3 – Q2.
Removal of tariff will increase demand to
Q4 resulting in an increase in consumer
surplus (P1NFP2).
Local suppliers lose as quantity supplied
falls to Q1 resulting in a loss of producer
surplus equal to P1MBP2.
Government loses revenue equal to
MNCE.
The net welfare gain is equal to areas MBC
and NEF.
Total sales have increased resulting in trade creation equal to Q3 to Q4.
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ii) Trade diversion
TRADE DIVERSION occurs where trade with a low-cost country outside a trading bloc is
influenced by higher-cost products supplied from within. This leads to inefficiency.
 Trade is diverted from a more efficient non-member exporter towards a less efficient
exporter who is a member of the trade bloc. In the absence of the trade bloc, the
importing country applied the same tariff to all nations. It meant that it imported from
the most efficient producer at the lowest price.
o With the establishment of the trade bloc, a less-efficient nation’s producer will
have to pay a lower tariff or no tariff at all. This means that the less efficient
producer will become more competitive offering its product at a cheaper price
due to lower or no import tariff. Consequently, the importing country will
purchase goods from a higher-cost, less-efficient producer. This means that
there will be trade diversion and resources will now be used less efficiently.
o An example of trade diversion is the UK’s import of lamb. Before Britain joined
the EU, most lamb imports came from New Zealand, the cheapest lamb
producer. However, when Britain joined the EU, the common external tariff
made it more expensive to import lamb from New Zealand than from other
countries inside the union, thus France became the majority exporter of lamb to
the UK. Trade was diverted from
New Zealand and created between
France and the UK.
 This can be shown using a graph.
Originally the country buys a product from
the most efficient country and places a
tariff on imports of the product. The price
paid is P, the quantity consumed is Q and
the tax revenue earned is c+e. When the
country joins the trade bloc, trade is
diverted to a member country. The price
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to consumers fall to P1 and the quantity consumed rises to Q1. Consumer surplus
increase by a, b, c, and d. Producer surplus fall by a and the government revenue falls
(loss is c+e). Welfare will be reduced if the areas b and d are smaller than area e.
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Conclusion
Whether the trade bloc that is established leads to greater efficiency or not depends on the
amount of trade creation and trade diversion.
 A greater trade creation will make the bloc economically efficient.
 A greater trade diversion means that bloc will create economic inefficiency.
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Benefits of Economic Integration
 It leads to trade creation that promotes efficiency and therefore better allocation of
resources among member nations.
 It increases production due to specialization based on comparative advantage.
 It increases volume of trade that allows firms to get economies of scale.
 It increases competition within the bloc leading to increased efficiency.
 There is improvement in living standards due to lower prices, better quality and lower
unemployment.
 It shifts PPC out leading to economic growth.
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Problems of Economic Integration
 Geographical distances can create problems in the establishment of a trading bloc.
Nearness to each other is essential for forming an economic union to be successful.
 There is trade diversion leading to world inefficiency.
 There is a fear of loss of national sovereignty in case of an economic union and a single
currency.
 Governments will lose revenue due to removal of tariffs.
21.4 Terms of trade (ToT)
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TERMS OF TRADE measures the rate at which the good of one country exchange for the goods
of another country. This can be represented as a terms of trade index which measures the ratio
of export prices and import prices and can be calculated by the following formula.
𝐼𝑛𝑑𝑒𝑥 𝑜𝑓 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑒𝑥𝑝𝑜𝑟𝑡𝑠
× 100
𝐼𝑛𝑑𝑒𝑥 𝑜𝑓 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑖𝑚𝑝𝑜𝑟𝑡𝑠
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𝑇𝑒𝑟𝑚𝑠 𝑜𝑓 𝑇𝑟𝑎𝑑𝑒 𝑖𝑛𝑑𝑒𝑥 =
Base year will have an index equal to 100. If, for example, 2005 is the base year and the price of
exports have risen since then by 20% and the price of imports have risen by 10%, then,
 Index of price of exports = 120
 Index of price of imports = 110
 ToT index = (120/110) x 100 = 109
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The index is calculated from average prices of many goods which are traded in world market.
The goods are given weights according to their importance.
 For international trade to be mutually beneficial for each country, the terms of trade
must lie within the opportunity cost ratios for both country.
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Favourable (improving) terms of trade
Terms of trade is said to improve if the country receives a relatively higher value for its exports
than it pays on its imports.
 ToT index is greater than 100.
 Country has to sell fewer goods (goods) to buy the same amount of imports.
 Some scenarios of a favourable terms of trade
o Price of exports has increased whereas price of imports is stable.
o Prices of both exports and imports have increased but price of exports has
increased more than price of imports.
o Price of exports is stable while price of imports has decreased.
o Price of exports has fallen but price of imports has fallen by a greater
percentage.
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Unfavourable (deteriorating) terms of trade
Terms of trade is said to deteriorate if the country pays a relatively higher value on its imports
than it receives for its exports.
 ToT index is less than 100.
 Country has to sell more goods (goods) to buy the same amount of imports.
 Some scenarios of an unfavourable terms of trade
o Price of exports has decreased whereas price of imports is stable.
o Prices of both exports and imports have increased but price of imports has
increased more than price of exports.
o Price of exports is stable while price of imports has increased.
o Price of imports has fallen but price of exports has fallen by a greater
percentage.
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Factors influencing Terms of Trade
Terms of trade are influenced by a number of factors. Important among them are given below:
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1. Rate of Exchange:
Changes in the rate of exchange of a country's currency also affect its terms of trade.
 If a country's currency appreciates, its terms of trade will improve because a rise in the
value of the currency causes increase in export prices and decrease in import prices.
 Depreciation on the other hand leads to deterioration in terms of trade as export prices
fall and import prices rise.
2. Relative inflation rates:
Inflation relative to other countries will have an impact on ToT.
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Rise in inflation relative to other countries will increase the price of exports more than
the price of imports leading to an improvement in ToT.
Lower inflation relative to other countries will mean that price of imports will rise more
than the price of exports leading to deterioration of ToT.
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3. Elasticity of Demand:
The elasticity of demand for exports and imports of a country influence its terms of trade.
 If the demand for a country's exports is less elastic than demand for imports, the terms
of trade will tend to be favourable because exports can command higher price than
imports.
 If the demand for imports is less elastic than that for exports, the terms of trade will be
unfavourable.
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4. Nature of Goods:
 If a country is producing and exporting only primary goods, and importing manufactured
goods, the terms of trade will be unfavourable.
 Countries that are producing and exporting manufactured goods and importing primary
goods will have favourable ToT.
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5. Economic Development (higher income levels):
Higher income levels lead to an increase in demand for imports that leads to increase in import
prices and a deterioration in ToT.
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6. Productivity levels:
 Higher productivity levels compared to a country’s trading partners should reduce the
relative price of exports leading to deterioration in ToT.
 Lower productivity levels compared to a country’s trading partners should increase the
relative price of exports leading to an improvement in ToT.
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7. Tariff Policy:
Tariffs and quotas also influence the terms of trade.
 Imposition of tariff will reduce demand for imported goods leading to fall in their prices
and an improvement in the ToT. However, this is at the expense of the exporting
country which may retaliate. Retaliation will lead to higher tariffs on country’s exports
making them less attractive resulting in fall in demand and prices of exports.
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8. Size of Population:
An overpopulated country will have larger demand for imports. As a result, the terms of trade
will tend to be unfavourable.
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9. Size of Country:
A larger country will tend to have less favourable terms of trade as compared to a smaller
country. This is because larger country will tend to gain from economies of scale making its
exports cheaper.
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10. Degree of Competition:
If a country enjoys monopoly power in case of its exports and there are many alternative
sources of supply of its imports, then it will have favourable terms of trade.
Is it desirable to have favourable ToT?
Favourable ToT has both benefits and drawbacks depending on the reasons for improvement in
ToT and the conditions.
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Balance of Payments
The impact of ToT on BoP depends on the price elasticity of demand for exports and imports.
 Favourable ToT will lead to improvement in BoP if the demand is inelastic. Rising export
prices and reducing import prices will increase export revenues and reduce import
expenditure if the demand is inelastic.
o If, however, the demand is elastic, then, a favourable ToT will actually lead to
deterioration in BoP.
 Unfavourable ToT will lead to improvement in BoP if the combined elasticity of demand
for exports and imports is greater than 1 (elastic) as per the Marshall Lerner condition.
 In recent years, the prices of commodity products such as copper and wheat have risen
due to an increase in world demand. Since commodities tend to be price inelastic,
therefore, increase in commodity prices has both improved the ToT and the BoP of
commodity exporting countries.
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Inflation
Favourable ToT can have an impact on the inflation levels in the country.
 Favourable ToT can be due to appreciation of currency. Appreciation of currency makes
imports cheaper and lowers the demand for exports. This results in a fall in inflation
levels locally.
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Unfavourable ToT can also have an impact on inflation levels.
 Unfavourable ToT due to depreciation of currency will make imports more expensive
and lead to increase in demand for exports. Depreciation therefore leads to inflationary
pressures in the economy.
GDP and unemployment
Favourable ToT with rising export prices and cheaper imports would mean that local production
will be falling. This leads to a fall in GDP and an increase in unemployment.
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Unfavourable ToT, on the other hand, with falling export prices and more expensive imports
would mean that local production will be rising as the demand for export rise and the demand
for imports fall. This leads to a rise in GDP and a fall in unemployment.
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International competitiveness
Favourable ToT can have both positive and negative impact on international competitiveness of
a country.
 Favourable ToT resulting from an improvement in quality of goods and services
produced will improve the long term competitive of the local industry.
 However, a rise in prices due to higher inflation in the country or due to lower
productivity will mean that the country’s products will become less competitive
internationally.
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Unfavourable ToT can also have both positive and negative impact on international
competitiveness.
 Unfavourable ToT resulting from deterioration in quality of goods and services produced
will harm the competitiveness of the local industry.
 A fall in prices due to lower inflation in the country or due to higher productivity will
give a competitive advantage to local firms.
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Other impacts
 Improvement in ToT because of a fall in import prices will increase volume of imports.
This leads to more choice to consumers and an increase in their living standards.
 A shift toward manufacturing from primary industries will increase value added for
developing countries, increase employment opportunities and improve BoP.
 Improvement in ToT because of imposition of tariff means that country will:
o lose benefits of international trade,
o may promote inefficient industry, and
o there is a fear that trading partners may retaliate and impose tariffs on country’s
exports.
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It can therefore be concluded that a favourable ToT in good for the current account and BoP if
the demand for exports and imports is inelastic, if it is caused by improvement in the quality of
goods and services produced locally, if it caused by a shift in developing countries toward
manufacturing sector, and that it controls inflation. However, favourable ToT may lead to
worsening of BoP (if elastic demand), loss in local output and a rise in unemployment.
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Unfavourable ToT, on the other hand, will be useful in controlling inflation, improvement of
BoP (if demand is elastic), rise in GDP and a fall in unemployment. However, unfavourable ToT
can lead to a fall in BoP if the demand is inelastic, if it is caused by deterioration in quality of
goods and services produced, and can be inflationary.
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Conclusion
The effect of changes in the terms of trade are influenced by their cause, the income effect, by
the time period under review, and extent of involvement of the economy in world trade.
 Cause: An increase in export prices arising from an increase in demand will have a more
beneficial effect on the BoP position than an increase arising from inflation.
 Time period: Impact depends on elasticity of demand (Marshall-Lerner and J curve)
 Income effect: Higher import prices could mean that foreign countries are earning more
resulting in increase in their demand. This can result in rise in exports of other countries.
 Extent of world trade: ToT will be more important for countries that engage in world
trade on a large scale. Even small changes in ToT can make a large impact on the BoP.
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Trends in ToT
 The PREBISCH-SINGER HYPOTHESIS suggest that the terms of trade tend to move
against primary producing countries. This happens because demand for primary
products are income inelastic and demand for manufactured goods and for services is
income elastic. A rise in world income levels have risen to a greater rise in demand for
manufactured goods and for services hence leading to a rapid rise in their prices
compared to prices of primary products.
 Fuel exporting countries have seen a very favourable terms of trade in recent years due
to high demand for oil and a subsequent rise in its prices. However, in the past few
years, there has been a lot of volatility in the price of fuel making it harder for the
governments to make long term economic plans.
 Many developing countries are heavily dependent on exporting oil. Volatility in
international commodity markets creates serious problems with these countries’ terms
of trade.
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Reasons for deterioration in ToT of developing countries (such as Pakistan)
It has been observed that terms of trade is going against the developing countries like Pakistan.
It is due to the following reasons.
 Export of Primary Goods: Those developing countries that are dependent on export of
primary goods for their export revenues have seen fluctuations in their ToT. If there is
bumper crop any year the price of that good falls as such goods cannot be stored and
they have to be sold even at lower prices. Accordingly the terms of trade goes against
developing countries.
 Low Income and Price Elasticities of Demand: Income and price elasticities of demand
for exports of developing countries are very low. Therefore even at lower prices the
exports of poor countries do not increase.
o People in developed countries spend a major share of their incomes on luxuries.
In this way they have lower income elasticity of demand for primary goods
exported by developing countries.
 Monopoly of developed countries in products imported by developed countries:
Developed countries have monopolies in production of some manufacturing goods such
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as automobiles, aircrafts, machines etc. This gives them the power to charge higher
prices for these goods leading to unfavourable ToT for developing countries.
Increase in Population: With very high population growth rates of developing countries,
they are experiencing massive increase in labour markets leading to lower wage levels.
This results in lower cost of production of products manufactured in developing
economies leading to lower prices of their exports and an unfavourable ToT. Although,
in this case, the unfavourable ToT improves the competiveness of the local industry.
Lack of Trade Unions: Low power of trade union in developing countries makes their
products more competitive because of a lower cost of production. This results in a fall in
price of exports of developing economies resulting in an unfavourable ToT.
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