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Study Plan SL/HL B
Plan for Study Schedule (Insert the weekly study schedule here) HL questions are highlighted.
Date
Week
Topic
8/12
B
Introduction-page 5 questions 1-4 will have to catch up for homework!
9/12
B
Markets -page 12 questions 1-10 HL 11-12
12/12
A
Paper 3
13/12
A
Elasticity -page 19 questions 1-9 HL 10-11
14/12
A
Government intervention-page 25 questions 1-5 HL 6
9/1
A
HL Market Power page 41 questions 1-25
10/1
A
Market failure- page 30-31 questions 1-13 HL 14
11/1
A
The level of overall economic activity-page 50 questions 1-4 HL 5
16/1
B
HL Market Power page 41 questions 1-25
17/1
B
Unemployment questions – page 53 questions 1-3
18/1
B
Inflation-page 57 questions 1-4 page 59 question 1
19/1
B
Economic growth- page 61 questions 1-2 Equity page 64 questions 1-3
20/1
B
Debt-page 65 question 1 and Fiscal policy-page 68 questions 1-4
24/1
A
Monetary policy- page 72 questions 1-4
25/1
A
Supply Side -page 76 questions 1-4
30/1
B
HL Market Power page 41 questions 1-25
31/1
B
Trade page questions page 82 2-7, 9 and 11-13 HL 1, 8 & 10
2/2
B
Exchange rates-page 85 questions 1-12 HL 13-14
3/2
B
Balance of Payments-page 87 questions 1-6 HL 7-13
6/2
A
Paper 3
7/2
A
Development-page 92 questions 1-12 HL question 13
8/2
A
Equations and models
Key Economic Concepts
The course is built around 9 key economic concepts. It is good practice to recognise these in your essays (as
appropriate.) There is a great table of explanations for the concepts in your textbook page 8. The concepts are:
Scarcity
Equity
Change
Choice
Economic well being
Interdependence
Efficiency
Sustainability
Intervention
Real World Examples
Paper 1 consists of paired essays, an “A” essay and a “B” essay that can be taken from anywhere in the curriculum.
You have to chose one question and answer the A and B questions. You have 1 hour15 minutes.
“A” essays are worth 10 marks and are usually an explanation accompanying a diagram.
“B” essays always require some sort of evaluation and must use real world examples. Therefore, you must have real
world examples for each of the following:
Microeconomics
Specific or ad valorum indirect tax (sales or sin)
Subsidy
Macroeconomics
A country with high inflation
A country with high levels unemployment
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Price Floor
Price ceiling
Negative externality of production
Positive externality of production
Negative externality of consumption
Positive externality of production
Merit good
Demerit good
Public good
Common access good
An example of command and control
HL Nudge theory
HL An example of asymmetric information.
HL An example of perfect competition (or near.)
HL An example of monopolistic competition
HL An example of oligopoly
HL An example of monopoly
A country with high levels of debt
A country with high levels of inequality
A country with high levels of economic growth
A country with sustainable levels of growth
A country where growth had negative consequences.
A country that used fiscal policy
A country that used monetary policy.
Global Economics
A country with a current account deficit
A country with a current account surplus
A country that is progressing its development
A country that is regressing its development
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Introduction
Blink and Dorton pages 1-43
Factors of production
Land
AKA natural capital
Labour
AKA human capital
Capital
AKA physical capital
Entrepreneurship
All resources in nature that are used to produce goods. The
reward is rent.
Human resource used in producing goods and services. The
reward is wages, salaries, royalties and commissions.
Any tool, machine, method or technology used to produce goods
and services. The reward is interest.
The act of organising the other factors of production to produce
goods and services. This involves risk taking. The reward is profit.
Positive versus normative economics.
A positive statement is a data driven one. For example, “11% of the population is unemployed.” A normative
statement contains opinion. For example, “People are unemployed because they are lazy.” When using data, it is
important to ensure that the right data is being used for the right issue and also be aware that people will use
normative statements on top of positive statements to alter meaning and understanding.
Production Possibility Curves
The model used by economists to illustrate scarcity, choice, opportunity cost and efficiency is the production
possibilities curve. The assumptions of the curve are:
• The economy produces only two goods or services
• Resource and technology levels are fixed.
• On the frontier resources in the economy are fully used.
Above are a straight line and concave production possibility curves. The assumptions are that Italy has a set amount
of resources and technology. In the first diagram it can produce any combination of 9 million units. There is a
constant opportunity cost of one million units if it chooses to change production. Any point on the curve represent
economic efficiency.
The second diagram illustrates increasing opportunity costs as it becomes increasingly expensive to switch
production from pizzas to robots. Point E shows an inefficient use of resources. Note that a movement from point E
to point C would constitute economic growth. Also, if technology or resources increased and he curve moved out to
F this would be economic growth. F is unattainable without this apart from with international trade.
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Rationing Systems
Economics is the study of how scarce resources are allocated. (Shared out or rationed) There are two basic
categories. Planned economies (command economies) are economies where the government decides what to
produce, how to produce it and for whom to produce it. Production is based upon central planning. This system was
prevalent in the USSR (now Russia) and China in the 1980s but is far less common now. Free market economies are
economies where the goods are rationed according to people’s decision making. The what to produce, how to
produce and for whom to produce are all answered by the free market and the invisible hand. In practice most
economies are mixed economies where there are both free market and command aspects. The table on page 22 of
your textbook gives good insight into the disadvantages of both types of economy.
Economics has many schools
It is important to note that economists come in many different types and there is a long history of changing opinions
and understandings. Economics as we know it has moved from mercantilism to classical to neoclassical, to Marxist,
to Keynesian to Monetarism to Behavioural. There are also many other branches. You will not be examined on this,
but it is important to know that there are many, sometimes conflicting opinions that arise from the same data.
Questions on introduction
1. Name the factors of production and the rewards.
2. What are the assumptions of a production possibilities curve?
3. What is the difference between a straight line and a curved pp curve?
4. Correctly draw a pp curve
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Markets.
Blink and Dorton pages 44-91 (excluding 67-79)
Scarcity: the condition of having unlimited wants/desires and limited resources
Market: a place or situation where buyers and sellers meet to exchange.
Opportunity cost: the cost of any decision measured in terms of the value of the next best alternative foregone
Demand
Demand: the willingness and ability of the consumer to purchase goods or service at a range of prices.
The law of demand: as the price decreases, the quantity demanded increases and vice versa, ceteris paribus.
The market demand gives the total quantity demanded by all consumers. The individual demand is the demand of
one individual or firm. The demand curve represents the relationship between the price and the quantity demanded
of a product. A change in the price of a good causes a movement along the demand curve. For instance, as price falls
from P to P1 the demand moves down the demand curve, which increase the quantity demanded from Q to Q1.
The non-price determinants of demand
A change in the non-price determinants shift the demand curve because the quantity demanded at the price has
changed.
Substitutes: Goods that can be used in place of one another as they satisfy the same needs. If the price of a
substitute rises, demand for the good will increase. If the price of coffee falls, many people will shift from drinking
tea to drinking coffee and the demand curve for tea shifts to the left.
Complements: Goods which tend to be used jointly. If the price of a complement rises, demand will decrease.
If the price of petrol rises people are motivated to use fewer cars, and the demand for cars shifts to the left.
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Tastes and preferences: more people may want the product or service (a product becomes 'fashionable') and
demand shifts out. This includes population changes and advertising.
Real income: when income rises, more people can afford to buy cars and the demand curve for cars shifts to the
right for normal goods and a decrease in demand for inferior goods. SCIT = (substitutes, complements, income and
tastes and preference)
HL Demand and alternatives to rational choice theory.
There are two reasons for the law of demand.
The income effect which means that when the price of a product falls consumers have an increase in “real income,”
(an increase in purchasing power.) A lower price means more can be purchased. The substitution effect which
means at lower prices consumers will get the same amount of satisfaction for fewer dollars so are likely to increase
consumption whilst at higher prices they may look for a substitute as they will be getting less satisfaction per dollar.
The development of behavioural economics and particularly the work of Richard Thaler has provided an alternative
to rational choice theory. The table below is taken for you textbook (page 54)
Econs (Rational choice theory)
Are rational
Have perfect information.
Are extremely intelligent and are able to perform
complex calculations quickly.
Seek to maximise their own utility.
Make decisions in their own best interest.
Have consistent preferences over time.
Have no self-control problems.
Are unbiased.
Humans (Real world)
Have bounded rationality.
Have incomplete information.
Are not as intelligent as econs.
Have limited ability to carry out complex calculations.
Are social beings and make decisions in a social
context.
Change their tastes over time.
Have bounded self-control.
Behavioural economists argue that humans possess a “dual system model.” This means that they possess an
automatic system and a reflective system.
Automatic
Decisions are:
Uncontrolled
Based on gut instinct.
Intuitive
Reflective
Decisions are:
Calculating
Controlled
Deliberate
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Effortless.
Logical
Impulsive
Unemotional
Immediate.
low
Fast
The belief that humans are always reflective (as neo-classical economists claim) is clearly not true. The following
biases impact decision making
Cognitive Biases
Availability bias
Anchoring bias:
Framing bias:
Social conformity/ Herd
behaviour:
Status quo/inertia bias:
Loss aversion bias:
Hyperbolic discounting:
Recent information and examples tend to shape people’s decision making.
Consumer behaviour is currently being impacted on by covid.
When our perception of the value of a good is anchored on a certain price. If the
price falls, we are likely to consume much more. Often salespeople will offer a
very high initial price to anchor its value then reduce dramatically.
An item that is 90% fat free contains 10% fat! Depending on how this composition
is framed (positively or negatively) will impact consumer choices.
There is a bandwagon effect where products are purchased because everyone
else is purchasing it. People want to fit in.
People often follow a pattern of sticking with something that they know rather
than researching alternatives.
People feel loses more than they feel gains. This helps explain inertia bias and
also strategies such as the offer having a limited time.
People tend to prefer short term rewards over long term rewards.
Choice architecture is a theory that the choices we make are influenced by the way the choices are presented to us.
The example of lots of chocolate etc being located at the check out in a supermarket is an example! . Default
choices (such as Google on most computers) are choices that are made for us unless we deliberately change them.
Human beings will tend to stick to this default mode. In the textbook the example of organ donation is used. An opt
in system where potential donors have to agree to become donors in case of an accident is more likely to be less
successful than an opt out system where all accident victims’ organs are donated unless they have previously opted
out. Mandated choices are choices that have to be made (by law.)
Nudge theory
Thaler argued that consumers can be nudged to make better choices. Examples of this are all around us from antismoking messages on a billboard. We see many messages like this. They are usually linked to the cognitive biases.
Supply
Supply: the total amount of goods and services that producers are willing and able to purchase at a range of prices.
The law of supply: as the price of a product rises, the quantity supplied of the product will usually increase, ceteris
paribus. The market supply gives the total quantity supplied by all individual producers. The supply curve represents
the relationship between the price and the quantity supplied of a product, ceteris paribus.
The change in the price of a good causes a movement along the supply curve. For instance, as price increases from P
to P1 the supply moves up the supply curve, which increases the quantity supplies from Q to Q1.
Non-price determinants of supply
• Factors of production: changes in costs of factors of production (COP), including land, labour, capital and
entrepreneurship (human capital or intellectual capital). If these costs increase, then supply shifts to the left.
If the government suddenly increased the minimum wage, then this could greatly increase the costs of
labour to a shoe making factory, this would cause a shift in supply to the left.
• Government: Indirect taxes increase COP and subsidies decrease COP. Increased regulation increases COP.
Decreased regulation decreases COP.
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•
Environment: Positive environmental conditions decrease costs of production. Negative environmental
conditions increase COP.
• Price of related products: if producer could produce another product with higher profitability, due to limited
resources, the quantity supplied of the original product would decrease.
• Number of firms in the market: more firms producing shifts supply to the right as more is being supplied at
each price. Market signals like price signals cause this.
• Transportation and infrastructure: if these improve then supply shifts outwards because the firm’s average
costs are lowered.
• Technology: If technology improves then supply shifts to the left. As the firm can become more efficient
with the same amount of costs so increase output.
FERGNIT. (Factors of production, environment, related goods, Government, number of firms, infrastructure, and
technology)
Market equilibrium and changes in equilibrium
Market equilibrium: where the quantity supplied equals the quantity demanded.
Excess supply: more is being supplied than demanded at P1, in order to eliminate the surplus, producer must lower
the price.
Excess demand: more is being demanded than supplied at P2, in order to eliminate the surplus, consumers bid up
the price.
When there is a change in determinants of demand/supply other than the price of the product, it would lead to a
shift of a curve.
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When demand shifts to D1, Qe is the quantity supplied, but Q2 is the quantity demanded, there is excess demand.
The price will rise until P1, where the new equilibrium quantity, is both demanded and supplied.
The role of the price mechanism
The price mechanism moves the market into equilibrium, so that the scarce resources are reallocated.
• Opportunity cost: is the next best alternative forgone. When a choice is made, there is an opportunity cost.
• Rationing function: Prices serve to ration scarce resources when demand in a market outstrips supply.
• Signalling function: prices rise and fall to reflect surpluses and scarcities, which shows where resources are
required.
If prices of bikes are rising because of high demand from consumers, this is a signal to suppliers to increase quantity
supplied to meet the higher demand. This is because consumers will bid up the price until the market clears to
equilibrium. (At Pe there is excess demand)
If there is excess supply in the market (at Pe) the price mechanism will help to eliminate a surplus of a good by
discounting the price till the market clears. An increase in market supply causes a fall in the relative prices of laptops
and prompts an increase in demand.
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Transmission of preferences: through their choices consumers send information to producers about the changing
nature of needs and wants. Higher prices act as an incentive to raise output because the supplier stands to make a
better profit. When demand is weaker in a recession then supply contracts as producers cut back on output. In this
way markets address the questions what to produce, how to and for whom to produce it.
Market efficiency
• Consumer surplus: the extra satisfaction a consumer gains from paying a price less than they were prepared
to pay.
• Producer surplus: the excess of actual earnings that a producer makes from a given quantity of output, over
and above the amount the producer would be prepared to accept for that output.
When a market is allocatively efficient, the social (community) surplus is maximised, this is made up of the
consumer and producer surplus. This means that the marginal social benefit = the marginal social cost.
Allocative efficiency is the combination of goods and services that society wants, when CS and PS are maximised and
you can’t make anyone better off without making someone else worse off, MSB=MSC
Definitions
Term
Demand
Definition
Schedule
Curve
Market Demand
Substitute
Complement
Normal good
Inferior good
Supply
Market Supply
Market
Equilibrium
Consumer
surplus
Consumer
surplus
Allocative
efficiency
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1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
What is the difference between demand and quantity demanded?
What is the difference between supply and quantity supplied?
Why do demand curves slope downwards to the right?
Why do supply curves slope upward to the left?
What are the non-price determinants of demand?
What are the non-price determinants of supply?
Why do markets clear to equilibrium? Illustrate on a graph.
Explain with a diagram how the price mechanism addresses the three questions of resource allocation, what
to produce, how to produce and for whom to produce?
Draw a market (use a real world example) at equilibrium and the illustrate an increase in demand. Explain
how the market clear to the new equilibrium.
Draw a market (use a real world example) at equilibrium and the illustrate an increase in demand. Explain
how the market clear to the new equilibrium
Hl-What are the biases that effect human economic behaviour (use examples)?
HL-What is nudge theory? Use examples.
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Elasticity
PED Blink and Dorton pages 67-79
PES Blink and Dorton pages 92-107
Price Elasticity of demand
Price elasticity of demand (PED): the measure of the responsiveness of the quantity demanded of a good to a change
in its price, along a demand curve. Mathematically the value is negative, as the demand curve slopes downwards,
but we treat it as a positive value
PED= (Δ% Qd) / (Δ%P)
This shows price elastic demand: PED>1
This means that a small percentage change in price causes a large percentage change in quantity demanded. This is
usual for luxury goods with many substitutes, such as Ferraris, Gucci bags and superyachts or goods whose purchase
can be deferred.
This shows price inelastic demand: 0<PED<1
This means that a large percentage change in price causes a small percentage change in quantity demanded. This is
usual for necessity goods with few substitutes, like bread, milk and electricity, goods that only cost a small
percentage of our income or goods whose purchase cannot easily be deferred.
This illustrates price unitary elastic demand: PED=1
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This means that a percentage change in price causes a proportionate percentage change in quantity demanded.
This illustrates perfectly price elastic demand: PED=∞
This means that an infinitesimally small percentage change in price causes infinitely large percentage change in
quantity demanded.
This illustrates perfectly price inelastic demand: PED=0
This means that an infinitely large percentage change in price causes infinitesimally small percentage change in
quantity demanded. In order to remember this graph just remember the demand curve is a vertical line like an 'I' so
it must be 'I'nelastic.
Determinants of PED
Income spent: the higher the proportion of income spent of purchasing a product, the higher the product’s PED.
Degree of necessity and how widely defined: if a product has a high degree of necessity and is well defined, then it
will have a low PED, as it is more inelastic. For instance water will have a high PED.
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Number and closeness of substitutes: the great quantity of close substitutes a product has the higher the PED value,
meaning it is more elastic. For instance toothbrushes have high elasticities, as there are lots of brands selling similar
toothbrushes.
Time period considered: when price of a product changes it takes time for consumers to adapt (lag time) and it takes
time to adjust purchasing habits. This means that the more time it takes the higher the PED. The product will be
inelastic in the short term, but elastic in the long term.
TINS.
Calculate PED
The slope of a straight-line demand curve, one with a constant slope, has constantly changing elasticity. It includes
all five elasticity alternatives--perfectly elastic, relatively elastic, unit elastic, relatively inelastic, and perfectly
inelastic. No two points on a straight-line demand curve have the same elasticity because the slope and elasticity are
different concepts. Slope measures the steepness or flatness of a line in terms of the measurement units for price
and quantity. Elasticity measures the relative response of quantity to changes in price.
Calculate the PED, when there is a price increase from P1 to P2.
PED = (Δ% Qd) / (Δ%P)
= (1/3*100) / (3/3*100)
= 33.3333/100
= 0.33
PED = 0.33 = inelastic
Applications of PED
Significance to firms: if PED is inelastic then the firm can increase its revenue by increasing the price per unit,
because demand will remain high. If PED is elastic then the firm can decrease its price to increase revenue because
demand will increase by a more than proportional quantity.
Significance to governments: if the government uses indirect taxes to tax a good with inelastic PED, then they will
gain higher government revenues than a good with elastic PED. This is part of the reason why cigarettes, petrol and
alcohol are so highly taxed.
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Manufactured goods: tend to have a high PED because they are usually not necessities but have many close
substitutes. For instance cotton socks, seeded bread and cell phones.
Primary commodities: tend to have a low PED because they are usually necessity goods with no close substitutes. For
instance wheat, milk, raw cane sugar, and coal.
Income Elasticity of Demand
Income elasticity of demand (YED): the measure of the responsiveness of the quantity demanded of a good to a
change in income. A change in income shifts the demand curve.
Normal good: demand increases for a normal good as income increases, so they have a positive YED. For instance
televisions and mobile phones.
Inferior good: demand decreases for an inferior good as income increases, so they have a negative YED. For instance
own brand food, second hand cars.
Luxury goods: income is elastic as 1<YED, so the percentage change in demand is very significant as income rises.
This is because once needs have been fulfilled, people purchase their wants in a great number. For instance
jewellery, gadgets, expensive holiday homes, caviar, champagne.
Necessity good: income is inelastic as 0<YED<1, so the percentage change in demand is very small as income rises.
For instance basic food, petrol and electricity.
Calculating Income Elasticity
Income goes up by 10% and consumption of used cars goes down 7%
XED = (Δ% d Used cars) / (Δ% Income)
= (-.07) / (.1)
= -.7
XED = -.7 used cars are inferior goods.
Applications of YED
Luxury goods and services tend to be more badly impacted by a recession. Some goods and chains like Walmart
actually benefit from a recession.
Price Elasticity of Supply
Price elasticity of supply (PES): the measure of the responsiveness of the quantity supplied of a good to a change in
its price, along a supply curve
PES= (Δ% Qs) / (Δ%P) (The value will always be positive because the supply curve slops upwards.)
Elastic: PES>1
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This means that a small percentage change in price causes a large percentage change in quantity supplied.
Inelastic: 0<PES<1
This means that a large percentage change in price causes a small percentage change in quantity supplied.
Unitary price elastic supply: PES=1
This means that a percentage change in price causes a proportionate percentage change in quantity supplied.
Determinants of PES
Ability to store stock: if the producers are able to store more stock, then the supply is more elastic because they are
able to respond to price increases with swift supply increases.
Mobility of factors of production: the more mobile the factors of production are the more elastic supply is. This is
because it is easier to move to another production, with lower average costs, when price rises. For instance, a
printing press can easily be switched from printing magazines to printing cards.
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Unused capacity: the more unused capacity the more elastic supply is because not all resources are being used so
output can easily be increased by using these without incurring great costs. For instance the supply of goods and
services is most elastic during a recession, when there is plenty of spare labour and capital resources.
Time period considered: the longer the time period considered the more elastic the supply is as there is greater time
to increase the factors of production, like capital. In any given instant PES is vertical as there will be a fixed amount
available.
Calculate PES
Calculate the PES, when there is a price increase from P1 to P2. ($3 to $6)
PES = (Δ% Qs) / (Δ%P)
= (1/3*100) / (3/3*100)
= 33.3333 / 100
PES = 0.33 = inelastic
The special case of commodity prices.
Primary commodities is a term for raw materials such as cotton, oil and coffee which are internationally traded. The
consumers therefore are not households but manufacturers who use them in production. An instant coffee
manufacturer needs to purchase coffee beans in order to make the product. Demand is therefore quite inelastic
because without the beans they cannot make the coffee. But so too is supply. Primary commodities: tend to have
a low PES because there cannot be a sudden change in how much is produced. This combination of a very steep
demand curve and a very steep supply curve mean that the price of primary commodities tends to be extremely
volatile. There are good years and bad years. Developing countries reliant on the export of one primary commodity
are particularly vulnerable to this price volatility. (See diagram in the textbook on page 106)
Contrast this with manufactured goods which tend to have a high PES because it is easier to change production in
factories or shops. Also, they have relatively elastic PED, PES and YED. These goods tend to be made in more
industrialised and developed countries.
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Definitions
Term
Elasticity
Price elasticity
of demand
Inelastic
Elastic
Unit elastic
Cross elasticity
of demand.
(XED)
Complement
Substitute
Income
elasticity of
demand (YED)
Price elasticity
of supply (PES)
1.
2.
3.
4.
5.
6.
7.
8.
9.
Definition
What is the equation for PED-give a simple worked example?
What are the determinants of price elasticity of demand?
What are the practical applications of PED?
Give a simple worked example of an equation for PED
What are the practical applications of YED?
Give a simple worked example of an equation for YED.
What are the practical applications of PES?
Give a simple worked example of an equation for PES.
Explain the difference between the immediate, the short run and the long run supply curves.
HL-Extension:
10. Why are movie theatres able to charge a high price for popcorn?
11. What is the relationship between total revenue, marginal revenue and unit elasticity? (Show on a pair of
vertical graphs.)
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Government Intervention:
Aim of imposing indirect taxes: the government does such spending in order to raise tax revenues and to internalise
externalities, to achieve the optimum level of output.
A specific tax: a fixed amount of tax that is imposed on a product, which shifts the supply curve vertically upwards
by the amount of tax.
An ad valorem tax: the tax is a percentage of the selling price and so the supply curve will shift by an increasing
amount as the price of the product rises.
When either specific taxes or valorem taxes are imposed, the market will shrink in size (decrease in quantity), thus
possibly lower the level of employment in the market, since firms might employ fewer people. (Curve shifts up
because it increases costs of production.)
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Producer: revenue falls from P1Q1 to P3Q2.
Consumer: price per unit increases from P1 to P2
Tax burden for producers: Q2(P1- P3)
Tax burden for consumers: Q2(P2- P1)
Tax revenue for government: tax burden for consumers + tax burden for producers
Producers and consumers suffer: producers incur greater average costs, meaning that they partially pass this onto
consumers. Tax reduces output: shifting supply to the left means a lower quantity is supplied, this means that the
market size shrinks. Government benefits: taxes increase government revenue. Tax raises prices: tax shifts demand
to the left and raises equilibrium, meaning higher prices
Tax Incidence and Price Elasticity of Demand and Supply (HL)
If a good with inelastic demand is taxed, the tax burden can be more easily passed on to the consumer (PED is less
than PES). This means the tax burden on the consumer (C) is greater than the tax burden on the producer (P). As
shown in this diagram, the producer would like to raise the price to P4, to pass all the tax burden onto consumers.
However, this would cause excess supply, so price falls to a new equilibrium at P2.
If a good with elastic demand is taxed, the tax burden on the consumer (C) is less than the tax burden on the
producer (P). (PED is more+ than PES). In this second scenario, the producer would like to increase the price to P4, to
pass all the tax burden on to consumers. However, this would cause excess supply, so price falls to a new equilibrium
of P2. This is where enough consumers would continue to buy but not all of the tax burden is taken by the producer.
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Subsidies
Subsidy: an amount of money paid by the government to a firm per unit of output. This causes the supply curve to
shift to the right by the amount of subsidy.
Aims of subsidies
To ensure consumers can afford necessary goods: the price of the product will be lowered so that more consumers
are able to buy. For instance, in Malaysia millions is being spent in order to subsidise food and fuel to keep prices
low. Like sugar which is an essential ingredient in Asian cooking. (July 2012).
Protectionism: subsidies are used to help domestic firms become more competitive in the international markets
therefore increasing export revenue. This is in order to address a balance of payment deficit. For example, the USA
subsidises their steel industry, in order to protect it against countries, such as Brazil, where steel can be produced
more cheaply.
To ensure consumers buy merit goods: merit goods are goods or services which are provided for the benefit of
society. They are usually under-consumed and under-supplied, this is a result of information failure about the
private and external benefits the good can have. Therefore, the government subsidises them in order to make more
consumers willing and able to consume. Examples of merit goods are pensions, healthcare, insurance and education.
In Columbia for instance health insurance is subsidised.
Guarantee the supply of products: the government may believe that some industries need to be supported by
lowering their average costs of production. This may be in order to ensure them for future times such as war. Also
this could be to provide employment. For instance the power supply in India is most states is subsidised as the
government believes it is necessary for the economy.
When subsidies are provided, the market will expand in size (increase in quantity), thus possibly raise the level of
employment in the market, since firms might employ more people. (Curve shifts down because costs of production
decrease).
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Producer: revenue increases from P1Q1 to P3Q2.
Consumer: price per unit decreases from P1 to P2
Cost to government: (P3-P) * Q2
The total cost of the subsidy exceeds the benefit of the consumers and producers so there is a loss of welfare, a
deadweight loss.
Subsidies may undermine foreign firms. For instance developed countries may have subsidised farming making their
products cheaper than underdeveloped countries.
Firms may become inefficient as they are not competing against foreign firms.
There is an opportunity cost as the government spending on the subsidy could have been put to other projects.
Administration costs are part of the so called “leaky bucket.”
Maximum prices (Price ceilings)
Maximum prices: the government sets a price below the equilibrium price to prevent producers from raising the
price above it. Prices are set in order to protect consumers from the high prices of merit and/or necessary goods
because these would be underprovided in a free market. For instance, during food shortages the government may
impose a maximum price on the cost of wheat in order to ensure that food prices a low enough for all income levels
to afford. Also in London maximum prices have been used in order to keep the rent lower than the market
equilibrium in attempt to ensure affordable accommodation is available for those on low incomes.
When a maximum price at P max is put in place by the government, below the equilibrium price of Pe, there is an
excess demand of Qs to Qd. This is because at the new price the quantity demanded is Qd, but the quantity supplied
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is Qs. S1 is the supply of rented housing at the maximum price in the long run. It gets more elastic as people will stop
letting houses as they cannot justify the opportunity cost.
The excess demand from maximum price may result in shortages. This could lead to the emergence of a black
market or parallel underground market, where the products are sold at a higher price than the maximum price but
less than the equilibrium price. Non-price rationing systems may emerge and involve long queues or reservations if
working on a first come first serve basis in order to determine which consumers to serve.
Welfare: there is a deadweight loss of BCE. This is because consumer surplus has changed from AEPe to ACBPmax
whilst producer surplus has decreased from 0EPe to 0BPmax, as a result of the maximum price imposed. It is
therefore not allocative efficient as community surplus is not maximised.
Minimum prices (Price floors)
Minimum price: price set above the equilibrium price by the government, which prevents producers from reducing
their prices to below it. Prices are set in order to protect the supply of products that the government believes are
important, such as agricultural products. This may be because their products are subject to large price fluctuations or
there is a lot of foreign trade. Minimum prices also protect workers as they act as a minimum wage, which ensures
that workers earn enough to lead a reasonable existence. Other reasons include for strategic importance and to
prevent rural urban migration.
When a minimum price at Pmin is put in place by the government, above the equilibrium price of Pe, there is an
excess supply of Qs to Qd. This is because at the new price the quantity demanded is Qd, but the quantity supplied is
Qs.
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Minimum prices usually result in a supply surplus. The government may therefore deal with it by increasing demand
through advertising, restricting the number of imports, selling the product cheaply abroad (undermines foreign
farmers) or buying the product up themselves and storing or burning it, which can be very expensive. For instance,
some EU countries do this, and it is referred to as wine lakes and butter-mountains. Other methods to deal with the
surplus affect the supply of a product. These are usually quotas which limit how much a producer is legally allowed
to produce.
Welfare: there is a welfare deadweight loss of BCE. This is because consumer surplus has decreased from AEPe to
ACPmin whilst producer surplus has changed from 0EPe to 0ECPmin, as a result of the minimum price imposed. It is
therefore not allocative efficient as community surplus is not maximised.
Definitions
Term
Indirect tax
Ad valorum tax
Specific tax
Subsidy
Price Ceiling
Price floor
1.
2.
3.
4.
5.
Definition
Draw a specific indirect tax. How do indirect taxes impact markets?
How does elasticity of demand impact tax incidence?
Draw a subsidy. What are the pros and cons of subsidies?
Draw a price ceiling. What are the pros and cons of price ceilings?
Draw a price floor. What are the pros and cons of price floors?
HL Extension
6.
Explain how the price elasticity of demand impacts the incidence of a tax or subsidy?
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Market Failure
Market failure: the failure for the market to successfully achieve allocative efficiency, because there is an over or
under provision of a good. So community surplus is not maximized and the socially desirable level of output is not
achieved.
Marginal private cost (MPC): private supply curve that is based on the firm's costs of production.
Marginal social cost (MSC): MPC+/-external cost.
Marginal private benefit (MPB): private demand curve that is based on the utility or benefits to consumers.
Marginal social benefit (MSB) = MPB+/-external benefit to third party
Negative externalities
Externalities: occur when the production or consumption of a good or service has an effect upon a third party. MSC
does not equal MPC.
Negative externalities of production: occur when the production of a good or service creates external costs that are
damaging to third parties (MSC>MPC). Examples: carbon emissions from factories, factory waste disposal, noise
pollution, fossil fuels. The diagram shows that MSC is less than MPC. So the firm is only paying the private costs a Q.
This means that the socially efficient output where MSB=MSC at quantity Q* is not being achieved. The triangle
shows the welfare loss, as community surplus has decreased.
Negative externalities of consumption: occur when the consumption of a good or service creates the external costs
that is damaging to third parties (MSB<MPB). Examples: smoking, alcohol, cars, loud music, coal fires. In this
diagram we assume that MSC =MPC. However, MPB is greater than MSB, meaning that the product is not being
consumed at the socially desirable level of MSB = MSC and so there is a welfare loss, of the triangle.
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Demerit goods: goods that the government deems are bad and discourage consumption in some way. These are
goods whose consumption creates external costs. E.g. cigarettes, alcohol, drugs.
Policies to reduce negative externalities
Indirect taxes may be imposed by the government to reduce the negative externality of production or consumption,
such as a tax on carbon or cigarettes. This means that the firm’s costs of production effectively increase and MPC, so
the firm will reduce its output, as it becomes less profitable. Therefore, the externality is internalised.
Indirect taxes do not necessarily stop an activity completely as it is dependent on the individual consumers’ and
producers’ reactions to the tax.
The effectiveness of the tax depends on the ability of the government to determine the correct level. If the tax is too
high: too little consumed and produced; if tax is too low: too much is still consumed and produced.
It also depends on the elasticity of demand. If PED is inelastic the increase in price leads to a smaller percentage
decrease in the quantity demanded. So the socially desirable level of output may still not be achieved.
An increase in tax may also cause consumers and producers to use the black market instead, therefore, the
externality will remain.
An increase in government revenue could allow the government to further invest into reducing the negative
externality, such as improving zero carbon alternatives.
Command and control techniques: government legislation to ban activities with negative externalities. For example,
the Indonesian government could ban firms from dumping factory waste in rivers.
Evaluation: this can completely stop an activity, however, it must be monitored effectively with regular checks that
may be expensive. Also, there must be high penalties to deter firms or consumers from breaking the law, this must
be greater than the cost the firm would have from reducing the externality. For instance, in order to decrease the
number of cars used in a town, the local government may increase the price of car parking tickets which would have
to be well monitored to ensure everyone was paying. If they were not then there would be high fines.
Tradable pollution permits (cap and trade): the government sets a limit on the amount of pollution. Each firm is
allocated or buys permits allowing it a certain amount of pollution. Permits can be sold is not used. Evaluation: it is in
the firms’ interest to reduce pollution as they can receive an income from selling permits and with more pollution,
they will incur more costs. If the government gradually reduces the permits available, then pollution will gradually
decease. However, there is difficulty in setting the cap and the effectiveness depends on the permits’ price. If
permits were given away for free, then there would be little incentive to reduce pollution.
Advertising: this along with education can also reduce the negative externality, as it raises the awareness of the
effects on others.
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Positive externalities
Positive externalities of production: occur when the production of a good or service creates external benefits for
third parties (MPC>MSC). Even though these types of externality may seem to be a good thing, especially due to the
name, they are still a market failure as the goods and services with positive externalities are underprovided or
under-consumed compared to the socially optimal level. Examples: industrial training in firms, research into new
technologies.
Positive externalities of consumption: occur when the consumption of a good or service creates external benefits for
third parties (MSB>MPB). Examples: immunisations, education, healthcare.
Merit goods: goods that the government deems are good for us and encourages us to use them in some way. These
are goods whose consumption creates external benefits. E.g. healthcare, education, museums.
Policies to reduce positive externalities
Subsidies may be introduced by the government to reduce the private costs associated with positive externalities
and therefore shift the MPC curve to the right, so that the quantity of output will be closer to the socially desirable
level of output.
Subsidies are very costly for the government so many developing countries cannot afford them. Also there is always
an opportunity cost as the money could be spent differently on other policies and the government may need to
either go into debt in order to fund the subsidies or increase taxes.
Subsidies can encourage inefficiency as producers rely on them rather than more efficiently allocating resources
through the free market.
The effectiveness of the subsidy depends on the ability of the government to determine the correct socially desirable
level of output. As shown in these diagrams.
Positive advertising campaign: these explain the benefits of consuming the good or service to consumers, so the
MPB curve will shift to the right, closer to the MSB curve. Evaluation: advertising can have very high costs and
opportunity costs. Also, the benefits may take many years to materialise and so its short term effects are limited.
The direct provision of a good also helps to decrease the private costs associated with consumption, such as the NHS
healthcare system and state school education.
Legislation (command and control.) of a good also helps to decrease the private costs associated with consumption,
such as secondary school attendance being mandatory or seat belts being compulsory.
Lack of public goods
Public goods: goods and services that are non-rival and non-excludable and therefore not provided in sufficient
quantities by a free market. Examples of public goods: lighthouses, streetlights, public statues, education,
healthcare, sports centres. There is therefore a ‘free rider’ problem which means that it is difficult to prevent people
who do not pay for the good from consuming it. Because it is difficult to charge the free market doesn’t in sufficient
quantities
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Private goods: a good that is rival and excludable
Quasi-public goods are provided by the government but could theoretically be provided by the free market.
Disadvantages from the government providing public goods: the costs are borne by taxpayers who do not necessarily
use the good, there is crowding out of the private sector and there is an opportunity cost. Advantages from the
government providing public goods: there is greater equality as everyone has access and greater efficiency as the
government can use economies of scale and provide gods collectively. Also, it overcomes the free rider problem.
Common access resources and the threat to sustainability
When there is a lack of a pricing mechanism for common access resources, the goods are susceptible to
overexploitation as a result of the producers and consumers actions. Therefore, this is unlikely to be
sustainable. Examples of common access resources: common land, fishing lakes, forests, irrigation system and
pastures. The ‘tragedy of the commons’ exists because it is very difficult and expensive to exclude people from using
these areas.
Sustainability: exists when consumption needs of present generation are met without reducing ability to meet needs
of future generations The pursuit of economic growth results in environmental externality problems such as overexploitation of land, soil erosion, land degradation, and deforestation. For developing countries these problems
compound poverty and low standards of living. (This is one of the key concepts.)
The government may respond to threats of sustainability by imposing taxes, legislation, cap and trade schemes and
using extra revenue from taxes for clean technology. However, government responses to sustainability are limited
by the global nature of the problems and the lack of ownership of common access resources, so effective responses
require international cooperation.
Asymmetric information (HL)
Asymmetric information: when buyers and sellers do not have equal access to information in a transaction.
Sellers have more information: in the second hand car market and at the doctors/dentists there is unequal
information. This is also the case for financial advisers. It could result in a market failure as consumers are less willing
to consume due to a lack of trust, so even sellers who are truthful lose out on sales.
Buyers have more information: when purchasing car or health insurance the buyer may know information about
themselves which, had the seller known, would have adjusted the price. Also in the labour market, regulation
prevents employers from gaining knowledge about the prospective employee that may unfairly impact their opinion,
such as age.
Government responses: the government may use legislation, like building regulations or legal contracts confirming
no information has been withheld. Also, the government could provide information. For instance food is labelled
with nutrition guidance, whilst the income of consumers is usually validated against the tax office. Licences can also
be used. For instance food stores must have licences stating what food can be sold.
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Definitions
Term
Market failure
Private benefit
Private costs
Social benefit
Social costs
Externalities (spill
over effects)
Demerit Good
Tradable permits
Merit goods
Public good
Non-rival
Non excludable
Common access
resources
Asymmetric
information
1.
2.
3.
Definition
List the key reasons that markets fail with bullet points.
Using a graph and explain how goods with negative externalities of production are an example of
market failure.
What are the pros and cons of each of the methods listed below for internalising negative
externalities of production?
Method
Indirect Tax
Pros
Cons
Regulations
Tradable
Permits
Command and
control.
4.
5.
Using a diagram and explain how goods with negative externalities of consumption are an example of
market failure.
What are the pros and cons of each of the methods listed below for internalising negative
externalities of consumption?
Method
Indirect Tax
Pros
Cons
Command and
control
Education and
advertising.
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6.
Using a diagram explain how goods with positive externalities of production are an example of
market failure?
7.
What are the pros and cons of each of the methods listed below for internalising positive
externalities of production?
Method
Subsidy
Pros
Cons
Government
ownership
Government
provision
8.
Using a diagram explain how goods with positive externalities of consumption are examples of
market failure.
9.
What are the pros and cons of each of the methods listed below for internalising negative
externalities of consumption?
Method
Subsidy
Pros
Cons
Compulsion
Education and
advertising.
Command and
cotrol
10.
11.
12.
13.
14.
Use a diagram and explain how the market for tradable permits works.
Explain why the provision of public goods is an example of market failure?
Explain why common access goods are an example of market failure?
How does the government deal with threats to sustainability?
HL-Explain how asymmetric information is an example of market failure?
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Market Power (HL)
Long run versus short run
Long run: period of time in which all factors of production are variable. All planning takes place in the long run.
Short run: period of time in which at least one factor of production is fixed. All production takes place in the short
run.
The length of the short run depends on the time it takes to increase the quantity of the firm’s fixed factors. Fixed
factors: normally capital or land, but could also include a type of highly skilled labour. In order to increase output in
the short run, more units of the variable factors must be applied to the fixed factors, while the firm plans to change
the number of fixed factors.
Production (Product)
Total product (TP): total output that a firm produces, using its fixed and variable factors in a given period of time.
Average product (AP): output that is produced, on average, by each unit of variable factor.
AP= TP/V
Marginal product (MP): extra output produced by using an extra unit of the variable factor. MP=ΔTP/ΔV
Law of diminishing returns:
as extra units of a variable factor are added to a given quantity of fixed factor, the output per unit of the variable
factor will eventually diminish. This happens in the short run. In an example of a cake shop fixed factors include:
• Workspace
• Ovens
• Cooking equipment
It is efficient to add bakers up to a certain point, but because of the fixed factors, after this point adding workers is
less efficient. This means that as units of a variable factor are added to a productive process holding at least one
fixed (the economic short run) output will eventually increase at a decreasing rate. This means production per
variable unit will decrease and costs will rise.
Economic cost
Explicit costs: factors purchased by the firm for the act of production + Implicit costs: factors that could have been
used in the opportunity cost of the choice the firm made.
Short Run Cost Definition
Total Costs (TC)
Average Costs. (AC)
Fixed Costs (FC)
Average Fixed Costs (AFC)
Variable costs (VC)
Average Variable Costs (AVC)
Marginal Costs (MC)
The costs of all implicit and explicit costs incurred in the production of a
good or service.
TC/Output
Costs incurred by the firm independent of levels of production- eg mortgage.
FC/Output
Costs that change with output levels
VC/Output
The cost of producing the next or last unit of a good or service. TC2-TC1
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Long run costs
The long run average cost curve (LRAC) is an envelope curve, is it envelopes an infinite number of short run average
cost curves (SRAC) If the demand increases and the firm wishes to increase quantity produced, then more than one
variable factor can be used in the short run to move along the SRAC curve to produce more. In order to then
decrease the cost per unit, the firm must move into the long run and change all of its factors. So it will move into the
next curve, SRAC2.
Increasing returns to scale: long run unit costs are falling as output increases. A percentage increase in all factors of
production causes a greater percentage increase in output, long run average costs decrease.
Constant returns to scale: long run unit costs are constant as output increases. A percentage increase in all factors of
production causes a directly proportional percentage increase in output, long run average costs are constant.
Decreasing returns to scale: long run unit costs are increasing as output increases. A percentage increase in all
factors of production causes a smaller percentage increase in output, long run average costs are increasing.
Economies of scale: an increase in input leads to a more than proportionate increase in output and LRAC falls. It
happens in the long run and leads to increasing returns to scale.
• Promotional economies: costs of advertising normally do not rise in direct proportion to output, so cost per
unit falls.
• Transport economies: large bulk orders may not charge delivery costs and larger firms can afford their own
cheaper fleet, which does not include other firms’ profit margins.
• Large machines: machinery may be too expensive for small firm, so they must them.
• Bulk buying: larger firms may be able to negotiate discounts with suppliers. The cost of inputs and unit cost
of production is reduced.
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•
•
•
Financial economies: banks usually charge lower rates to larger firms (less risk), insurance is likely to be less
and loans are more easily accepted.
Division of labour: breaks production process down into smaller activities that workers can perform
repeatedly and quickly.
Specialisation: a larger firm is able to have more management specialised to different roles, thus making the
firm more efficient.
Diseconomies of scale: an increase in input leads to a less than proportionate increase in output and LRAC increase.
It happens in the long run and leads to decreasing returns to scale.
Alienation and loss of identity: in very large firms workers and managers may lose a sense of belonging and loyalty,
while feeling insignificant. So they become less productive and unit costs increase.
Control and communication: a larger firm has a greater need for effective communications as the management will
find it harder to control and coordinate the firm, so communication breaks down and unit costs increase.
Revenue
Total Revenue (TR)
Average revenue (AR)
Marginal Revenue (MR)
The revenue derived from the sale of all production in a given time period.
TR/Output
The revenue derived from selling the next or last unit of production. TR2-TR1 or
MR = ∆TR/ ∆Q
When PED is unitary any firm wishing to increase revenue should leave the price unchanged, since revenue is
already maximised.
When PED is elastic, any firm wishing to increase revenue should lower its price, as it will cause a relatively large
increase in quantity demanded.
When PED is inelastic any firm wishing to increase revenue should raise its price, as it will cause a relatively small
decrease in quantity demanded.
Profit
Total profit = Total revenue – Economic cost (explicit and implicit)
Normal profit (zero economic profit): total revenue equals total costs.
Abnormal profit (economic profit): total revenue is greater than total costs.
Loss (negative economic profit): total revenue is less than total costs.
Breakeven price: price where a firm can make normal profit in the long run. So all costs are covered including
opportunity costs (price=ATC). If price does not cover ATC in the long run, the firm will shut down permanently.
The profit maximising level of output: if a firm wishes to maximise its profits, it should produce at the level of output
where MC cuts MR from below. The AC curve must be cut by the MC at the AC’s minimum.
Shut down price: level of price that enables a firm to cover its variable costs in the short run (price = AVC).
If price does not cover AVC then it will shut down in the short run.
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Alternative goals of the firm
Economists assume that the prime motivation of the firm is profit maximisation. Other goals include:
• Corporate and social responsibility: a firm includes ‘public interest’ in its decision making, adopting an ethical
code that accepts responsibility for the impact of activities on areas like workers, consumers, local
communities and the environment. This builds up brand loyalty.
• Growth maximisation: a firm may aim to achieve growth in the short run, to gain a large market share and
dominate the market in the long run.
• Revenue maximisation: a firm may maximise their sales by producing where MR = 0. This is above the profit
maximising level of output.
• Satisficing: the pursuit of multiple goals.
Perfect competition
Assumptions of a perfectly competitive market:
• No barriers to entry or exit: firms are free to join and leave the market, without regulation, patents, and high
fixed costs. Normal profits in the long run.
• Perfect knowledge: producers are aware of market prices, costs in the industry and workings of the market.
Consumers are fully aware of prices, quality and availability of goods/services
• Identical homogeneous products: there is no differentiation in the product, such as branding or marketing
• Many individual buyers: no has any control over the market price
• Perfectly mobile factors of production: land, labour and capital can change in response to market conditions
• Large number of small firms: each firm has an extremely small share of the market share, so cannot affect
the markets’ output, supply curve or price of the industry. So they are price takers.
Examples for a perfectly competitive market include the EU wheat market, the watermelon market and milk. The
long run position of a perfect competitor will always be one of normal profit.
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Monopolistic competition
Assumptions of monopolistic competition:
• Products are differentiated: consumers can recognize differences, like colour, brand, quality etc.
• No barriers to entry or exit: firms are free to join and leave the market, without regulation, patents, and high
fixed costs. Normal profits in the long run.
• Small scale/local advertising: widely used to make product less elastic.
• Collusion is impossible: too many firms to make and maintain an agreement.
• Imperfect knowledge: amongst consumers and producers, though almost perfect.
• Fairly large number of relatively small firms: one firm’s actions has little impact on others - independent.
Examples of a monopolistic competition include nail salons, car mechanics, plumbers and jewellers.
Abnormal profits and losses can only be made in the short run. In the long run the monopolistic competitor will
make normal profits.
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In the short run, a firm produces at profit maximizing (MC = MR), but not productive (MC = AC) nor allocative
(MC=AR) level of output in a monopolistic competitive market. Basically, consumers are paying slightly more for
more choice.
Oligopoly
Assumptions of an oligopolistic market:
• Interdependent: may collude to act as a monopoly and maximize industry profits. Very sensitive to rivals’
prices, products, advertising and locations.
• High barriers to entry or exit: usually large-scale production or strong branding of dominant firms. Also, high
fixed costs, expertise, knowledge and contacts.
• Non price competition: price tends to remain the same in case other firms so not follow
• Products are differentiated: some are less or more than others, e.g. location, quality etc.
• A few large firms: high concentration ratio of output in a few firms with high market influence. (Note
concentration ratio)
Examples for oligopoly include oil companies, motor cars, shampoo products, coffee shops and supermarkets
Non collusive oligopoly
Competing firms have no agreement concerning their behaviour and tactics. They have a kinked demand curve
Price increase is elastic and price decrease is inelastic, so any change in price causes TR to fall. Increasing or
decreasing MC has no effect on MR. It only has an effect on the firm’s profitability.
Collusive oligopoly
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Collusive oligopolies act with a monopolist’s power, so the graph is the same. Therefore, abnormal profits occur in
the short run and into the long run.
Monopoly
Assumptions of a monopoly:
• Imperfect knowledge: specialized information and production techniques are unavailable to potential
producers.
• Unique product: no close substitutes.
• One large firm: the firm is the industry so has complete market share.
• High barriers to entry or exit: stop new firms entering, thus allowing abnormal profits in the long run.
Examples for monopoly include Microsoft, train lines and electricity providers.
Sources of monopoly power
Economies of scale: these benefit monopolists as they have large firms, whereas new entrants would face higher
average costs, as they cannot exploit bulk buying, specialisation etc., as much.
Anti-competitive behaviour: monopolists adopt restrictive practices, legal or illegal. For instance they are in a strong
position to start a price war. They would reduce their price to a loss making level which they would be able to sustain
for a longer period of time than the new entrant.
Brand loyalty: consumers refer to the product as the brand, e.g. Hoover vacuum cleaners. Potential entrants believe
that they cannot sufficiently differentiate themselves to generate strong brand loyalty.
Legal barriers: patents, copyrights and trademarks encourage invention in innovative products, as they can cause the
firm to be protected from rivals, so it becomes a monopoly. The government can also grant individual firms to
produce a certain product by nationalising its industry, e.g. postal service, and banning other entrants.
Possible profit situation in a monopoly
Instead of profit maximising (MC=MR) the monopolist revenue maximises (MR=0). This is likely to please consumers
as the price is less with greater output.
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Disadvantages of monopoly:
• Lower competition – poor service/good, dated
• Lack of consumer sovereignty and choice
• High prices, anti-competitive behaviour
• Profits not invested – only employees benefit
• Diseconomies of scale – due to poor management
• Allocative and productive inefficient.
Advantages of monopoly:
• Avoids duplication and wastage of resources
• Benefits from economies of scale – large profits or lower consumer prices.
• Large profits to fund research and development – latest technologies improve efficiency
• Lower competition and advertising calls.
Natural monopoly:
A monopoly that enjoys economies of scale, falling average costs over the entire range of output. Therefore, it can
undercut two or more would be competitors. These are usually networks such as rail, roads or power. These are
characterised by very high set up costs and very low marginal costs. The government often intervenes with MC
pricing, AC pricing AC=AR, allowing multiple users of the network or government provision.
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Definitions
Term
Short Run
Long Run
Diminishing Returns
Average Product
Marginal product
Total product
Explicit Costs
Implicit Costs
Total Fixed Costs
Total Variable Costs
Total Costs
Marginal Costs
SRAC Curve
LRAC Curve
Total Revenue
Average Revenue
Marginal Revenue
Economic Profit
Normal Profit
Profit maximisation
Revenue Maximisation
Growth Maximisation
Satisficing
Corporate Social
Responsibility
Market
Perfect Competition
Supernormal Profit
Subnormal Profit
Normal Profit
Monopoly
Natural Monopoly
Definition
Monopolistic
Competitor
Price competition
Non-price competition
Oligopoly
Concentration Ratio
Game Theory
Open/Formal Collusion
Tacit Collusion
Non-collusive
monopoly
Price discrimination
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1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
Draw a diagram that shows the relationship between SRAC curves and the LRAC curve
List the causes of economies of scale.
List the causes of diseconomies of scale.
What is the difference between increasing returns and economies of scale?
What is the difference between diminishing returns and diseconomies of scale?
Draw a profit maximising perfect competitor in the long run.
What are the assumptions for perfect competition?
Explain why perfect competitors always make a normal profit in the long run.
Explain why AR=AVC is the shutdown price.
Draw a profit maximising monopoly
What are the assumptions for Monopoly?
Describe typical barriers to entry.
Why can Monopolies maintain super normal profits in the long run?
Draw a natural monopoly.
What distinguishes a natural monopoly from a monopoly?
Compare and contrast perfect competition and monopoly.
Explain the pros and cons of government intervention to regulate natural monopolies.
Draw a profit maximising monopolistic competitor in the short run.
What are the assumptions of monopolist competition?
Why do monopolistic competitors always make normal profits in the long run?
Draw a non-collusive oligopoly. (Collusive is just the monopoly diagram.)
What are the assumptions of oligopoly?
Explain how collusive oligopolies work.
Explain the prisoner’s dilemma as it is associated with collusive oligopolies.
What is the point of:
Profit maximisation?
Revenue maximisation?
Market equilibrium?
Production efficiency?
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The level of overall economic activity
In a closed economy with no government the households buy the nation’s output of goods and services and are
owners of all the economy’s factors of production. They supply these factors of production to the firms and receive
payment from them. By hiring these factors of production from the households, the firms make all of the nation’s
output of goods and services.
A country’s income is usually measured using GDP the total value of goods and services produced in an economy in a
given time usually a year. There are three main different methods for calculating GDP: output, income and
expenditure.
Output method: measures the actual value of all goods and services produced in the country.
Income method: measures the value of all incomes earned in the economy.
Expenditure method: measures the value of all spending on goods and services. This includes household spending
(consumption), spending by firms (investment), government spending, and spending on exports minus spending on
imports.
GNI sometimes known as GNP is GDP plus net capital flows from foreign citizens in the country and citizens living
abroad.
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The diagram illustrates the circular flow of income in an open economy with government and financial markets. The
size of the circular flow depends on the size of the injections (STM) and leakages (GIX). When injections rise relative
to withdrawals the economy will expand and when withdrawals rise relative to injections the economy will contract
Business cycle
A. Depression/ Trough:
Consumer confidence: ↓
Business confidence: ↓
Consumption: ↓
Investment: ↓
House and share prices↓
Unemployment: ↑
Inflation: ↓
Balance of Payments: ↑
(less M)
Household debt: ↑
Government budget: ↓
(deficit)
B. Recovery:
Consumer confidence: ↑
Business confidence: ↑
Consumption: ↑
Investment: ↑
House and share prices:
↑
Unemployment: ↓
Inflation: ↑
Balance of Payments: ↓
(more X)
Household debt: ↓
Government budget: ↑
C. Boom/Peak:
Consumer confidence: ↑
Business confidence: ↑
Consumption: ↑
Investment: ↑
House and share prices:
↑
Unemployment: ↓
Inflation: ↑
Balance of Payments: ↓
(more X)
Household debt: ↓
Government budget: ↑
(Surplus)
D. Recession:
Consumer confidence: ↓
Business confidence: ↓
Consumption: ↓
Investment: ↓
House and share prices↓
Unemployment: ↑
Inflation: ↓
Balance of Payments: ↑
(less M)
Household debt: ↑
Government budget: ↓
(deficit)
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Limitations and Exclusions from GDP
GDP as a figure is nominal and therefore cannot be compared from year to year.
Real GDP has been indexed for changes in price level so is comparable.
Real GDP per capita take into account the size of the population.
Limitations
Does not measure well-being. (Does not take into
account quality of life indicators.)
Dos not differentiate between composition of
output. (Counts good and bad spending
identically.)
Does not value sustainability.
Does not account for externalities
Does not account for quality improvements.
Does not value leisure.
Exclusions
Second hand goods.
The underground economy.
Non cash transactions.
Voluntary goods
Does not count non-marketed output.
Many countries are experimenting with figures like green GDP to address these but no agreement has been
reached. What makes GDP and associated definitions valuable is that it is used by everyone.
Variations in Economic Activity
In microeconomics demand only represents the demand for one product or service in a particular market, whereas
aggregate demand in macroeconomics is the amount of national output that will be consumed at any given price
level.
Components of AD: AD = C+I+G+(X-M)
C= Consumption
I= Investment
G= Government spending
X= Exports
M= Imports
Negative slope: AD has a negative slope because the relationship between price level and AD is inversely
proportional, meaning that as the price level increases real AD decreases. This is due to the income, subsitution and
international trade effects.
The price level also represents inflation.
Real GDP also represents economic growth and employment.
Movements along the AD curve are a result of a change in price level.
An increase in price level reduces the purchasing power of a given level of income and so individuals cannot afford to
buy as many goods and services as their real income decreases.
Inflation is likely to result in higher interest rates which will reduce AD as it makes savings more attractive and
borrowing less attractive for both firms and individuals.
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An increase in domestic prices makes a country’s exports less competitive on the world market and imports appear
relatively cheap. This can reduce demand for exports.
Shift of the AD curve: a change in any of the components of AD, not due to a change in price level will shift the AD
curve.
Factors of consumption
• Consumption (C): the total spending by consumers on domestic goods and services. This is the most
important component. AD curve can be shifted by changes in consumption due to factors.
• Changes in disposable income. When the amount of money people have increase spending on all goods and
services except inferior goods, including imports goes up.
• Changes in consumer confidence. When the population feels good about anything spending goes up. A
stable and growing economy, with low inflation and low unemployment will boast consumer confidence and
increase AD.
• Changes in interest rates. When interest rates rise, the reward for saving money increases and loans become
more expensive, so there is less consumption.
• Changes in wealth. When the value of assets rises individuals feel more wealthy, consumer confidence
increases so consumption increases.
• Changes in personal income taxes. Impacts on disposable income.
• Changes in the level of household debt. This is money owned by householders to lenders. If this increases
initially consumption increases as they can consume beyond their disposable income. However,
consumption the decreases when they have to repay their loans with interest.
Factors of investment
• Investment (I): an increase in the spending of firms on capital. Capital is any manmade good used to produce
other goods and services, such as machinery, buildings. Below are the two main types of investment.
• Replacement Investment (Depreciation): firms spend on capital to maintain the productivity of existing
capital.
• Induced Investment: firms spend on capital to increase their output, in response to higher demand in the
economy.
• Government policy (G): governments may offer incentives to increase foreign and domestic investment, such
as reduction in corporation tax rates, or grants towards research and development.
• Rate of interest (R): cost of borrowing and reward for saving. If firms borrow to fund investment then they
will be charged interest. If firms use their retained profits then they sacrifice the interest foregone had they
continued to save the money in the bank.
• Accelerator (A): investment is dependent upon the level of consumption and the income in an economy. If
consumption increases then they will undertake further investment, called induced investment, to produce
the additional output.
• Profits (P): firms with retained profits may increase investment as they have the internal funds available.
• Expectations (E): if businesses have confidence that consumer demand will rise in the future, then they are
likely to increase investment in new capital equipment in preparation to meet the output demanded.
Business confidence is affected by:
Consumer confidence
GDP
Government optimism
Inflation
Technological changes (T): in order to keep up with advances in technology firms will increase investment.
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Exchange rates (E): the price of one currency in terms of another, determined by the demand and supply of the
currency. When the value of the country’s currency falls the volume of investment will increase.
Factors of government spending
• Government current expenditure: day-to-day spending on things such as salaries or civil servants, drugs for
health service etc.
• Government capital expenditure: spending on manmade goods used to produce other goods and services,
i.e. Public Sector Investment, infrastructure.
• Governments spend in order to ensure that adequate amounts of public and merit goods and services are
consumed such as defence, education and health services and to influence the level of economic activity and
distribution of income.
• Fiscal policy: use of government spending (and taxation) to influence the level of aggregate demand
(economic activity). The amount spent depends upon the political and economic priorities.
Factors of net exports
Export: a flow of money in to the country and is an injection in to the circular flow of income. Import: a flow of
money out of the country and is a leakage for the circular flow of income.
Net exports = exports – imports
•
•
•
Change in protectionism: if a country suddenly increases the level of protectionism, for example introduces a
tax or quota in imports, then this will increase that value of ‘X-M’ as the level of imports in to a country falls.
Income of trading partners: if foreign incomes rise then the demand for goods and services produced by a
given country will increase and this will lend a rise in the value of AD as ‘X’ increases.
The exchange rate: if the exchange rate becomes stronger, then exports from that country appear relatively
expensive while imports appear relatively cheap. This can lead to a fall in the value of net exports
particularly if the demand for imports and exports is elastic.
The multiplier effect-HL
An increase in injections (G, I or X) to the circular flow of income leads to a more than proportionate increase in
national income. An increase in government spending on infrastructure, increases employment as a workforce is
needed to fulfil the investment. Therefore, income levels, consumer confidence, consumer spending and,
investment spending by firms would increase.
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The diagram shows how an increase in government spending on an infrastructure project will create new jobs,
which provide workers with income. The workers will spend their income in local stores and as a result the income
level of the store holders will increase. As a result of increased incomes the store owners may increase investment
which may increase the number of jobs available. The multiplier effect will be higher the more of the increase in
income that is spent i.e. the higher the value of MPC. In addition, the less money that is saved, spent on taxes and
imports the bigger the final effect on the national income.
Increase in AD from AD1 to AD2 represents the initial increase in spending. However, increase AD from AD2 to AD1
represents the multiplied increase in national income.
The multiplier can be calculated by two different formulae.
Multiplier = 1 / (sum of the propensity to save + tax + import)
= 1 / (1 - marginal propensity to consume)
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Aggregate supply
Aggregate supply: the amount of national output that will be produced at any price level.
Positive slope: AS has a positive slope because the price level and AS have a direct relationship. The price level
increases real AS increases. Movement along the supply curve: an increase in price will cause an increase in the
price level which leads to an increase in output in the short run, as an increase in prices will make it more profitable
to produce.
Shift in the short run aggregate supply curve: when factors of production change.
• Changes in business taxation
• Changes in the availability of resources
• Changes in wage levels
• Supply-side shocks (war, natural disasters, famine)
• Changes in the price level of crucial imported factors of production (e.g. oil)
Factors leading to a permanent shift of AS:
• Increase our factors of production. E.g. find new oil reserves, have a larger population that can work
• Increase the quality of our factors of production. E.g. education, training, efficiency
• Increase technology. E.g. new harvesting machinery
Alternative views of aggregate supply
Monetarist/new classical model of LRAS: this is a free-market economy view that LRAS is vertical at the level of
potential output (full employment output) because aggregate supply in the long run is independent of the price
level.
Keynesian model of the LRAS: unemployment can exist in an economy in the long-run and therefore at a given time
there can be a large availability of the factors of production (share capacity) in the economy.
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Spare capacity: the resources (land, labour, capital and enterprise) are not fully employed. It is possible to increase
output without expecting an increase in costs and price level will remain constant.
Approaching full employment: as the economy approaches full employment shortages start to occur in the economy.
They have the effect of bringing up the price/cost of the resources.
Full employment: all resources are being used fully and it is not possible to increase output. Any attempt to increase
output will simply result in higher prices.
The Keynesian economists believe that unemployment can exist in the long-run in an economy as the labour market
does not always reach equilibrium resulting in unemployment.
A decrease in demand for goods and services results in a decrease in demand for labour, however, if the wage rate
does not decrease to meet the new equilibrium, unemployment will exist.
The wages are ‘sticky downwards’ because…
• Trade unions prevent wages falling
• A minimum wage exists
• Unemployment benefits prevent workers from accepting a continual cut to their wages.
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A shift in the LRAS is due to the same factors of production that shift the possibility production curve to the right,
including improvements in efficiency, new technology, reductions in unemployment, and institutional change.
Definitions
Term
Gross Domestic Product
Gross national Income
Real
Output method
Income method
Expenditure method
Injections
Leakages
Aggregate Demand
Aggregate Supply
1.
2.
3.
Definition
What is the difference between GDP and GNI
Using diagrams illustrate and explain the key differences between Keynesian and Classical models
Evaluate the pros and cons of GDP as a measure of economic well-being in bullet points.
Pros
4.
Cons
Construct a Neo Classical and Keynesian AD/AS diagram
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Macro-economic objectives: Unemployment
Unemployment: when a person is actively searching for a job, which they are able and willing to do, but cannot find
one. Unemployment rate: the proportion of unemployed in the labour force
=number of unemployed/labour force x 100
Labour force: the total number of people that are able to work, therefore including both the unemployed and the
employed. The natural rate of unemployment is in a arbitrary range around 3.5%-5%. This is considered to be full
employment.
Difficulties in measuring unemployment:
• Hidden unemployment: the stated unemployment rate may be overstated because some individuals conceal
their true employment status as they fear the loss of transfer payments, like benefits, or are employed in
illegal industries.
• Discouraged workers: these are people that would like to work and have previously been seeking
employment, but have since stopped because they could not find a job.
• Underemployment: individuals that are employed but they are unsatisfied as the work is inadequate. This
may be because the only work they could find was part time, when they wanted full time, or they are highly
skilled but have a low paid job.
• Average ignoring disparities: the unemployment rate is only an average so does not account for disparities in
age, gender, ethnicity and region. For instance, youth unemployment tends to be higher as well as the
unemployment rate amongst ethnic minority groups.
Consequences of unemployment
Economics consequences:
• Loss of GDP: the distance between actual and potential output grows as fewer goods and services are being
produced due to fewer workers.
• Loss of household income: inevitably the loss of a job will mean lower income for the individual and
therefore a lower standard of living. In order to prevent more job losses, employers may cut the pay of those
still employed which again leads to a loss of household income.
• Loss of tax revenue: with lower real incomes, households will pay the lower rates of direct tax and private
spending will decrease, so tax revenue from indirect taxes also decreases.
• Increased cost of unemployment benefits: government spending will increase as more people will be in need
of transfer payments, like benefits, in order to maintain an adequate standard of living.
• Large income disparities: certain groups of people are more geographically mobile than others and therefore
more likely to find work whilst others may remain unemployed for a long time. Also individual industries
tend to fair an economic downturn differently. For instance, owners of discount stores and bankruptcy
lawyers may do better than holiday companies and furniture stores during a recession.
Social consequences:
• Increased crime rates: prolonged unemployment may lead individuals to go to extreme ends, like theft, in
order to maintain a reasonable standard of living. In addition, frustration with the policies may lead to
greater violence and riots. Some people also resort to alcohol and drug abuse due to a loss of self-esteem.
• Increased stress levels: even those that are still employed are likely to suffer from greater stress because
they constantly fear losing their own job. This can result in a higher instance of mental health issues.
• Increased indebtedness: with lower household incomes, families are likely to be less able to make their
mortgage repayment and therefore their debt will increase.
• Homelessness: the government's policies to redistribute wealth may not be adequate under the pressure of
high unemployment, leading those that are unable to support themselves to be left homeless.
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•
Family breakdowns: the increase in stress from unemployment tends to cause greater friction within families
and therefore more separations.
Types and causes of unemployment
Frictional unemployment: this occurs when people move between jobs and are in a transitory state on
unemployment as they seek a new job. It is regarded as a natural and inevitable form of unemployment as even in a
vibrant and growing economy some people will be changing their job. It can exist at full employment.
Structural unemployment: this is a more permanent form of unemployment as it is when certain sectors or
industries of the economy experience job losses. It is caused by changes in the demand for particular labour skills,
changes in the geographical location of industries, and labour market rigidities. For instance, the miners in 1980s
Britain suffered severe job losses in particular. It can exist at full employment
Seasonal unemployment: this is when people are unemployed at certain times of the year, often due to weather
conditions. For instance, ski instructors are only employed in the winter months, whereas lifeguards may be in more
demand in the summer months.
Cyclical unemployment: this is also referred to as demand deficient unemployment as it is a result of a lack of
aggregate demand for goods and services. It occurs economic growth is low. This is a particularly dangerous form of
unemployment as it can result in a perpetual cycle of unemployment. For example, as individuals lose their jobs,
their real income decreases and so they usually reduce their consumption. This means that firms receive lower
revenues and profits, so they have to cut jobs and decrease their investment. Therefore, the unemployment rate
increases further as aggregate demand moves from AD to AD1.
Government policies to deal with unemployment
Frictional unemployment:
• Improving information for job seekers as imperfect information worsens frictional unemployment because
people are unaware of job opportunities.
• Lowering unemployment benefits can incentivise people so they become more willing to find a job.
However, this reduction in benefits can result in people becoming more vulnerable if they cannot find work
and social dissatisfaction which may lead to unrest.
Seasonal unemployment:
• Improving the skills of individuals in order to increase their occupational mobility. For example, a ski
instructor may go on a lifeguarding course so that he can more easily change jobs. This training results in
higher costs for firms which they may not be willing to pay for and so firms may reduce the number of
workers that they hire.
Structural unemployment:
• A broader range of training programmes and university courses could be introduced to allow individuals to
retrain in areas that are experiencing strong economic growth. However, this has an opportunity cost as it
would mean that the government may have to increase taxes or run into a budget deficit.
• Investing or encouraging investment in an affected area.
Cyclical unemployment:
• Expansionary fiscal and monetary policy is used in order to increase aggregate demand and therefore job
opportunities.
• Expansionary fiscal policy: the government reduces taxes and/or increases government spending to
stimulate growth.
• Expansionary monetary policy: the central bank reduces the base rate to decrease the banks' interest rates
and/or increase the money supply.
• Market or interventionist supply side policies
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Definitions
Term
Unemployment
Definition
Underemployment
Cyclical Unemployment
Structural Unemployment
Frictional Unemployment
1.
2.
Why is unemployment difficult to measure?
What are the economic and social consequences of unemployment?
Economic
3.
Social
List appropriate strategies to address the following types of unemployment.
Frictional Unemployment
Cyclical Unemployment
Structural Unemployment
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Macroeconomic Objectives: A Low and stable rate of inflation
Inflation: an increase in the average price level of goods and services in a nation over time.
Disinflation: a decrease in the rate of inflation
Deflation: decrease in the average price level of goods and services over time.
Consumer price index (CPI): this measures inflation and deflation by calculating the change in the price of a basket of
goods and services consumed by the average household. It is therefore a type of weighted price index.
Weighted price index (HL): weights are attached to each category of good or service, these are then multiplied to the
price index of each item of spending for a given year.
The price index a year: the sum of (price x weight) / sum of the weights
Problems with CPI:
• Different income earners may experience a different rate of inflation when their pattern of consumption is
not accurately reflected by the CPI.
• The weights of particular products are fixed so the inflation rate may be overestimated.
• Substitution bias: if the price of a product in the sampled basket of goods increases, then consumers may
begin to purchase a cheaper alternative. Therefore, the CPI would be overestimated as it would still be
based on the original product.
• New product bias: new products are not immediately taken into account in the CPI calculations, which may
make the inflation rate less accurate especially if these new products become suddenly very popular.
• New retail outlet bias: new retail outlets may also not be sufficiently sampled.
• Quality bias: improved quality of goods and services may not be considered in the construction of CPI.
Core inflation: economists measure a core/underlying rate of inflation to eliminate the effect of sudden swings in the
prices of food and oil, for example.
Producer price index (PPI): measures changes in the prices of factors of production may be useful in predicting future
inflation.
Causes of inflation
Demand pull inflation: this tends to happen when the economy is reaching full employment. An increase in any
components of AD which then cause AD to increase will in turn raise the average price level, and therefore cause
demand pull inflation.
• Exchange rate depreciation: this increases the price of imports and reduces foreign prices of exports. If
consumers buy fewer imports, while foreigner by more exports, AD will rise, as the value of (X-M) increases.
• Reduced direct or indirect taxation: consumers will have more real disposable income causing demand to
rise. A reduction in indirect taxes will mean that a given amount of income will now buy a greater real
volume of goods and services. Both factors can take aggregate demand and real GDP higher and beyond
potential GDP.
• Rapid growth in money supply: perhaps due to increased bank lending and low interest rates. Consumers
and firms are more able to borrow money and therefore spend more on goods and services causing AD to
rise.
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•
•
Confidence: an increase in the value of assets, such as higher house prices, may cause people to gain
confidence (wealth effect) and therefore increase consumption.
Economic growth in trading nations: this may give a boost to exports and so increase AD.
Keynesian diagram showing demand-pull inflation
Classical diagram showing demand-pull inflation
Cost-push inflation: when there is a general rise in costs of production. A primary determinant of the SRAS curve is
the productivity of a nation’s resources and the costs of production, therefore an increase in the costs of production
will shift the SRAS to the left.
• Increase in oil/electricity prices: oil/electricity is used in many processes, so this would increase many firms
costs of production and lead to higher prices.
• Increase in the minimum wage: trade unions in some countries have the power to bargain for increases in
the national minimum wage. An increase in this, or its implementation, raises costs of production and
reduces production, so unemployment rises.
• Currency depreciation: if the value of the currency falls then the relative price of imports increases. These
imports may be raw materials or semi-finished products used in the production process that will increase the
costs of production to firms. If the imports are finished products then this will directly increase the price
level. With higher priced imports domestic firms also have less incentive to reduce costs and they face less
competition which can lead to higher prices.
• Natural factors/war: natural disasters can destroy a nation’s infrastructure and reduce their productive
capacity. This will increase a firms’ costs of production and reduce national output. Poor weather can
destroy crops or reduce the yields and this can lead to higher prices of foodstuffs.
• Higher taxes: corporate taxes will increase firms’ costs of production and may result in an increase in prices.
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•
The current inflation we are experiencing comes from supply chain issues where vital capital is not being
delivered to firms on time forcing up costs of production. This compounds as it works its way through the
economy.
Diagram showing cost-push inflation
Consequences of inflation
The severity of the consequences of inflation depends on whether or not it has been anticipated.
• Anticipated inflation: when people can accurately predict the inflation rate, they can take steps to protect
themselves from its consequences. For instance, trade unions may negotiate with employers for increases in
money wages so as to protect the real wages of union members. Households may also switch savings into
deposit accounts that offer a higher nominal rate of interest. People can therefore protect the real value of
their financial assets. Firms may also adjust their prices or buy more raw materials in advance, to avoid
higher costs of production and protect their profit margins.
• Unanticipated inflation: prediction about inflation become very difficult to make when the rate of inflation is
particularly volatile. Unanticipated inflation is when economists make errors in their inflation forecasts. This
means that the effects of inflation are exacerbated as people cannot adequately prepare for it.
• Money illusion: this is when money, such as in the form of wages, appears to increase in value. However, in
reality this is merely due to inflation. Therefore, although the nominal value is increasing, the real value is
not.
• Savers: inflation leads to a rise in the general price level so that money loses its value. When inflation is high,
people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if
nominal interest rates are lower than inflation - leading to negative real interest rates.
• Wage demands: inflation can get out of control because price increases leads to higher wage demands as
people try to maintain their real living standards. Businesses then increase prices to maintain profits and
higher prices then put further pressure on wages. This process is known as a 'wage price spiral'. Rising
inflation leads to a build-up of inflationary expectations that can worsen the trade-off between
unemployment and inflation.
• Redistribution of income: inflation tends to hurt those employees in jobs with poor bargaining power in the
labour market - for example people in low paid jobs with little or no trade union protection may see the real
value of their pay fall. Inflation can also favour borrowers at the expense of savers as inflation erodes the
real value of existing debts. And, the rate of interest on loans may not cover the rate of inflation. When the
real rate of interest is negative, savers lose out at the expense of borrowers.
• Investment: budgeting becomes very difficult because of the uncertainty created by rising inflation of both
prices and costs - and this may reduce planned capital investment spending. Lower investment then has a
detrimental effect on the economy's long run growth potential.
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•
•
•
•
Balance of payments: inflation is a possible cause of higher unemployment in the medium term if one
country experiences a much higher rate of inflation than another, leading to a loss of international
competitiveness and a subsequent worsening of their trade performance. If inflation in the UK is persistently
above our major trading partners, British exporters may struggle to maintain their share in overseas markets
and import penetration into the UK domestic market will grow. Both trends could lead to a worsening
balance of payments.
Unemployment: as firms' costs of production rise production becomes less profitable and firms reduce their
output as a consequence and therefore less labour is required to produce lower levels of output.
Menu costs: costs associated with firms having to change price lists, reprogram computers, change vending
machines etc to deal with the higher prices.
Shoe leather costs: during times of rising inflation consumers find it difficult to know what price to pay for
certain goods and services and therefore spend much more time 'shopping around' to check whether the
prices they have been quoted are appropriate.
Consequences of Deflation
• Deflation can be as negative as inflation. It is generally associated with recession and an economy operating
below the full employment level. The following are the consequences:
• Redistribution in favour of those on fixed incomes.
• Favours creditors over debtors. Debt including government debt will get more expensive.
• Causes uncertainty.
• And worse can lead to a self-perpetuating deflationary spiral. The expectation the prices will go down
causes purchases to be delayed meaning process do go down.
• Increase in firms failing.
Definitions
Term
Inflation
Definition
Deflation
Disinflation
Demand Pull Inflation
Cost Push Inflation
Core inflation
Consumer price index
Producer Price Index.
1.
2.
3.
4.
What is the difference between inflation, disinflation and deflation?
What is the difference between cost push and demand pull inflation?
How is inflation measured?
What are the consequences of inflation and deflation?
Consequences of inflation.
Consequences of Deflation
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Relationship between inflation and unemployment (HL)
In 1958, Alban Philips found that there was a trade-off between the inflation rate and the unemployment rate of an
economy. He suggested that falling unemployment might cause rising inflation and a fall in inflation might only be
possible by allowing unemployment to rise. Therefore, if a government wanted to reduce unemployment, it could
increase aggregate demand but, although this might temporarily increase employment, it could also have
inflationary implications in labour and the product markets.
Reasons for trade off:
• The labour market: as unemployment falls, labour shortages may occur where skilled labour is in short
supply. This puts pressure on wages and prices to rise.
• Other factor markets: cost push inflation can also come from rising demand for commodities such as oil,
copper and processed manufactured goods such as steel, concrete and glass.
• Product markets: rising demand allow suppliers to lift prices to increase profit margins.
The risk of rising prices is greatest when demand is out stripping supply capacity. As a result of supply shocks, such as
natural disasters or wars, the SRAS curve may decrease. As shown in the diagram this means that the inflation rate
(average price level) would increase but real GDP would decrease, therefore increasing unemployment. This means
that the economy is experiencing stagflation - inflation accompanied by stagnant growth, unemployment or
recession. This in turn causes the Philips curve to move upwards and to the right as inflation and unemployment has
increased.
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Classical economists accept that the short run Philips curve existed - but that in the long run, the Philips curve
should be drawn vertical and, as a result, there would be no trade-off between unemployment and inflation. The
classicalists highlighted that each short run Philips curve was drawn on the assumption of a given expected rate of
inflation. So if there were an increase in inflation caused by monetary expansion and this had the effect of driving
inflation expectations higher, then this would cause an upward shift in the short run Philips curve. The classical view
is that attempts to boost AD to achieve faster growth and lower unemployment have only a temporary effect on
jobs. Friedman argued that a government could not permanently drive unemployment down below the natural rate the result would be higher inflation which in turn would cost jobs and hit growth but with inflation expectations also
increased.
1.
HL Explain the difference between the short run and long run Philips Curve using a diagram.
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Macroeconomic Objectives: Economic Growth
Economic growth: increase in real GDP through time.
Economic growth is depicted on a production possibilities curve (PPC) by an outward shift as the economy’s actual
output increases.
A point within the PCC, like A, moves closer to the PPC, like B, due to various factors including a decline in
unemployment and an increase in productive efficiency. This means that the actual output increasing closer to the
potential output as existing resources are being used more fully. On the AD/AS diagram this actual growth is
illustrated by an increase in AD.
When the quality and quantity of factors of production increases the volume of output increases and the economy
experiences an increase in its potential output. Therefore, the PPC increases from PPC1 to PPC2. On the AD/AS
diagram this potential growth is illustrated by an increase in LRAS.
Improved labour productivity is necessary to achieve economic growth in the long run, as it implies greater output
per worker. In order to create greater productivity investment in natural, physical and human capital is required.
Improvements in institutional framework are also needed.
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Consequences of economic growth:
• Living standards: if economic growth is greater than population growth, then it may result in higher real
incomes and therefore improved living standards.
• Unemployment: when the economy expands, unemployment tends to fall as more employees are required
to expand production. However, jobless growth can occur if inappropriate technologies that do not rely on
labour are utilised.
• Inflation: if the growth in demand exceeds the growth of the productive capacity then higher incomes may
cause the economy to overheat. Demand pull inflation may result from economic growth if it causes AD to
increase too quickly. Also cost push inflation may be created if the growth puts pressure on input prices.
However, non-inflationary growth is possible if the LRAS increases at least as fast as AD.
• Distribution of income: economic growth tends to reduce government spending and increase government
revenue as fewer people require transfer payments and more people pay higher rates of tax due to
increases in real wages. The government is then able to fund redistribution programmes with the additional
revenue. However, if the government were not to do this then the benefits would likely be unbalanced, with
certain regions or areas profiting more than others.
• Balance of payments: if growth is export driven then the trade deficit will decrease and a trade surplus may
result. However, if it is due to domestic demand, then households may spend more on imports and
therefore the trade deficit may widen.
• Sustainability: economic growth may threaten sustainability as industries create many externalities, such as
air, water and sound pollution. Firms may not take account of the future and therefore exhaust resources.
Definitions
Term
Economic Growth
Definition
Living standards
Sustainability
Balance of payments
1.
2.
Illustrate economic growth on a PP curve, and two AD/AS curves illustrating increases in AD and AS.
List the positive and negative aspects of economic growth.
Positive aspects of growth
Negative aspects of growth.
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Macroeconomic Objectives: Equity in the distribution of income
Equitable: fair, not necessarily equal. Due to the unequal ownership of factors of production, the market system may
not result in an equitable distribution of income.
Measuring income inequality:
Inequality ratios: the ratio of disposable income of the top 10% (decile) over the bottom 10% of the population.
Lorenz curve: a curve showing the proportion of national income earned by a given percentage of the
population. (Normally divided into quintiles)
Gini coefficient: the ratio of the area between the Lorenz curve and the diagonal over the area of the half square.
= (area A)/(area A + B)
0=total equality 1=total inequality so therefore the larger the Gini co-efficient, i.e., the closer to one the less income
equality.
Poverty:
Absolute poverty: the minimum income necessary to satisfy basic physics needs. (Less than $2 per day.)
Relative poverty: the extent to which a household's income falls below the national average.
Those with low incomes have low human capital as they cannot afford the opportunity cost of schooling and health.
However, they also do not have the funds to invest in physical capital and often deplete the natural capital in order
to survive. This results in low productivity which in turn creates a poverty trap. Therefore, living standards remain
low and individuals continue to be unable to access health care and education.
Taxation to redistribute income:
Direct taxes: taxes whose burden cannot be shifted onto someone else. This is because they are on income, profits
or wealth. For example, income tax. Direct can be used in order to redistribute income.
Indirect taxes: taxes whose burden can be shifted onto someone else. This is because they are on goods and
expenditures. For example, sales tax.
Marginal tax rate (MTR): the extra tax paid due to an extra $ earned. MTR= ΔT/ΔY
Average tax rate (ATR): the ratio of tax collected over the tax base, which is the amount taxable such as income.
ATR=T/Y
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Progressive tax: the higher income individuals pay proportionately more as the marginal tax rate is greater than the
average tax rate. In most societies income taxes are progressive in order to redistribute income. This is an automatic
stabiliser.
Proportional tax: the higher income earners pay proportionately the same as low income individuals as the marginal
tax rate is equal to the average tax rate.
Regressive tax: the higher income earners pay proportionately less as the marginal tax rate is less than the average
tax rate. For example, sales tax.
Governments undertake expenditures to provide directly, or to subsidize, a variety of socially desirable goods and
services, thereby making them available to those on low incomes. For example, health care services, education, and
infrastructure that includes sanitation and clean water supplies. Transfer payments: payments by the government
for which no goods or services are exchanges. For example, old age pensions, unemployment benefits and child
allowances. This is another automatic stabiliser.
Relationship between equity and efficiency
• Government intervention can put greater pressure on taxpayers and disincentivise workers. In order to avoid
this, governments aim to keep taxes equitable so that they are based on the taxpayer's ability to pay and to
make taxes convenient to pay by taking into account the timings and methods. Also the cost of collecting tax
should be small in comparison to the tax yield, otherwise it is no longer economical.
• Fiscal policy: the use of government spending and taxation to influence the level of aggregate demand.
• Sources of government revenue: primarily from taxes (direct and indirect), as well as from the sale of goods
and services, profits from state owned enterprises, sale of state owned enterprises and rent from
government owned buildings and land.
• Current spending: day-to-day expenditure on wages, books for schools, drugs for the health sector.
• Capital spending: adding to the capital stock of the economy, e.g. road network.
• Transfer payments: benefits paid for which no goods and services are received in return, such as
unemployment benefits and pensions.
• Budget surplus: if government revenues exceed total expenditures.
• Budget deficit: if total expenditures exceed government revenue.
• Balanced budget: if total expenditures and government revenue are equal.
• National debt: the sum of all past debt/borrowing and interest on the debt.
• A budget deficit increases the national debt and surplus reduces it.
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Definitions
Term
Equity
Definition
Equality
Lorenz Curve
Absolute Poverty
Relative Poverty
Direct Tax
Indirect Tax
Progressive Tax
Regressive tax
Proportional Tax
1.
For each of the following strategies to improve equity list the pros and cons.
Strategy
Progressive taxes
Transfer payments
Provision of Public
Goods
Provision of quasipublic goods
2.
3.
Pro
Con
Construct a sketch Lorenz curve illustrating a country that has effectively introduced a system of
transfer payments and progressive taxes. Show before and after.
What impact will this have on the Gini coefficient?
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Macroeconomic Objectives: Sustainable levels of debt.
It is inevitable that governments will get in debt. There is no real definition of what a sustainable level of debt is-this
depends upon the capacity to repay it without too much impact upon the economy. There is a general agreement
that borrowing falls into two categories. Bad borrowing is borrowing for items that are unlikely to generate income
and help pay for themselves or are necessary pieces of infrastructure that assist economic growth and thus impact
positively on the tax take. So borrowing for infrastructure might be considered goo borrowing. For example if the
government borrows money to build a hydro-electric dam then theoretically the proceeds from the dam can be use
to pay back the debt. This needs to be tempered with the understanding that corruption can cause this not to work
and also that often government investments are not wise investment decisions. The classic real-world example is
NZ’s borrowing for the so called Think Big projects. These were all energy projects designed to shield NZ rom rising
oil prices. When oil prices fell however many of the projects were uncompetitive and theoretically good borrowing
turned into bad borrowing.
Borrowing for consumption or politicians’ private benefit is bad borrowing as it does not give a return. A number of
countries such as the USA and NZ have borrowed money to subsidise workers made unemployed by the Covid
pandemic. This money does not generate money however the argument could be made that such borrowing stops
the economy from falling into a deeper recession.
Unsustainable borrowing occurs when the ratio of debt to GDP grows too high. There are now many countries who
have a debt to GDP ratio of over 100% . These countries will be perceived as being more at risk and interest charges
will rise as they struggle to get loans to roll over their debt. This will increase repayments meaning more money
gathered in tax today is spent on paying back debt and less is available for today’s government spending. In extreme
cases a country can default on its loans which is economically disastrous.
1.
Explain what a sustainable level of debt is?
Demand management: Fiscal Policy
Fiscal policy refers to changes in government spending or taxation designed to impact aggregate demand. Therefore
it can be either expansionary or contractionary.
Discretionary fiscal changes: deliberate changes in direct and indirect taxation and government spending, e.g. fiscal
stimulus which would involve spending on infrastructure.
Expansionary fiscal policy
Expansionary/Reflationary fiscal policy: increase in government spending and/or reduction in taxation. AD will
initially increase and the effect will increase further due to the multiplier effect.
• A decrease in income tax: more consumption induces more investment. As C and I are components of AD,
AD increases.
• A decrease in corporate tax: increases the proportion of retained profits, increasing investment AD and AS.
• A decrease in indirect tax like sales tax (VAT): increases the purchasing power of consumers and real
income, so AD increases.
• Increase in government spending on investment: increases AD due to the multiplier effect. Investment
provides jobs which increases income and consumption. Profits of firms increase and investment, as well as
capital and current spending. The economy reflates as the price level increases from P to P1.
Unemployment would decrease if more labour is needed to produce extra output, as the economy grows.
The balance of payments deteriorates as imports increase.
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Contractionary fiscal policy
Contractionary/Deflationary fiscal policy: decrease in government spending and increase in taxation to reduce
inflation. AD decreases.
• Income tax: increases
• Corporation tax: increases
• Sales tax: increases
• Government spending: decreases
The economy deflates as the price level decreases from P to P1. Unemployment would increase if less labour is
needed to produce less output, as the economy shrinks.
Automatic stabilisers
Automatic fiscal changes/stabilisers: changes in taxation and government spending arising automatically as the
economy moves through different phases of the business cycle.
• Progressive Tax revenues: as economy expands tax revenue increase, taking more money out of the circular
flow of income and spending and slowing down the recovery. Similarly, when incomes go down the tax take
goes down and stops a recession becoming too deep.
• Transfer payments: a growing economy means that the government does not have to spend as much on
means-tested welfare, such as income support and unemployment benefits. In a recession spending on
these benefits will increase.
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Evaluation of fiscal policy
Time lags (Fiscal drag):
• Recognition lag: takes time to realise GDP is falling too much or increasing too much.
• Administrative lag: takes time to implement appropriate responses.
• Impact lag: takes time for the changes in fiscal policy to work.
Government spending and tax cuts: government spending increase has a greater impact on AD than tax cuts by the
same amount. This is because individuals can decide how to spend extra income from tax cuts, which may be
savings, to pay other indirect taxes or to buy imports. Therefore, increasing withdrawals from the circular flow of
income and make the value of the multiplier lower.
Direct crowding out: the effect on private expenditure and investment which decreases, as a result of increased
government spending. For instance, new libraries means less books are bought from shops; new state school means
less consumption of private schools.
Indirect crowding out: increase in government spending, so budget deficit and borrowing increases. Therefore, the
demand for money increases/loans and interest rates rise, as banks sell bonds. Consumption and investment
decrease.
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Crowding out depends on the government spending, so it is unlikely to make the fiscal policy completely ineffective.
But large budget deficits need financing from taxation. Neo classical economists believe that increases in taxation
drags down business investment, labour market incentives and productivity growth.
Political influences: politicians may not act in the best interests of the economy as a whole, instead to get votes in
the run up to the election.
Definitions
Term
Fiscal policy
Definition
Expansionary fiscal policy
Contractionary fiscal policy.
1.
2.
3.
4.
5.
Explain expansionary fiscal policy with a diagram.
Explain contractionary fiscal policy with a diagram.
What are the automatic stabilisers and how do they work?
Explain what crowding out is?
What are the pros and cons of expansionary fiscal policy G>t?
Pros
Cons
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Demand management: Monetary Policy
Monetary policy: the use of interest rates and the money supply to influence AD.
The central bank usually controls the money supply, such as the UK’s Bank of England/US Federal Reserve/Bank
Indonesia. They are independent from the government, so they are less prone to political pressure from the
government.
The central bank sets the base/discount rate, which in turn influences the interest rate charged by financial
institutions. For instance, BCA will have an interest rate from mortgages above the base rate, but if the base rate,
which they are charged, increases then they will also increase the interest that they charge.
The interest rate: the reward for saving and the cost of borrowing money, which is the price of money. This is
charged on mortgages, loans to businesses and credit cards. It depends on the risk involved for the lender, as well as
the base rate.
The demand for money is due to the desire to buy goods and services and to hold it as assets. The total demand for
money is inversely related to the rate of interest.
The supply of money is not dependent on interest rates as it is determined by the central bank.
The central bank determines the level of supply in attempt to change interest rates.
The role of monetary policy
The central bank uses the following in order to adjust the money supply:
• The base rate of interest
• The reserve requirement
• The purchase of government bonds (quantitative easing)
The base rate: the rate of interest the central bank charges on loans to the commercial banks. The central bank is the
lender of last resort, so loans to commercial banks when they cannot meet demands for consumers’ funds. If the
base rate decreases, commercial banks lower their interest rates, so loans are less expensive and with more loans
the money supply increases and interest rates across the whole economy falls.
Reserve requirement: the central bank may control the amount of money that the commercial banks have to keep
on deposit to meet the needs of their customers, for example 20% of the customer’s savings. A decrease in the
reserve requirement allows commercial banks to lend more of the money they receive as deposits, which increases
money supply and interest rates.
Sale and purchase of government bonds: a bond is an I.O.U. issued by the government in return and so represents a
loan to the government. It guarantees the holder the repayment of the money, on a given date, with fixed annual
interest. The price of bonds depends on the demand and supply on the day – they are traded on the stock exchange.
The government may issue a large number of these to the commercial banks to reduce the money supply and
interest rates. This is known as quantitative easing or tightening.
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Expansionary/Reflationary/Loose monetary policy
This is designed to increase aggregate demand in the economy by increasing the money supply and reducing interest
rates. Lower interest rates will increase consumption and investment which are components of AD.
To increase money supply and decrease the interest rate, the government will:
• Lower the base rate
• Decrease the reserve requirement
• Buy bonds from banks, giving the commercial banks more money to lend.
A decrease in interest rates will:
• Decrease savings, as there is a lower reward
• Increase consumption, as there is less incentive to save and real income increase as mortgages and loan
repayments become less expensive
• Increase investment, as borrowing to fund it is less expensive.
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Contractionary/Deflationary/Tight monetary policy
This is designed to decrease aggregate demand in the economy by decrease the money supply and increasing
interest rates. Higher interest rates will decrease consumption and investment which are components of AD.
To decrease money supply and increase the interest rate, the government will:
• Increase the base rate
• Increase the reserve requirement
• Sell bonds to banks, so banks have less to lend
An increase in interest rates will:
• Increase savings, as there is a higher reward
• Decrease consumption, as there is more incentive to save and real income decreases as mortgages and loan
repayments become more expensive
• Decrease investment, as borrowing to fund it is more expensive.
Inflation targeting: the central banks of certain countries, rather than focusing on the maintenance of both full
employment and a low rate of inflation, are guided in their monetary policy by the objective to achieve an explicit or
implicit inflation rate target.
Evaluation of monetary policy
Argument against:
• Time lags: monetary policy can be implemented fairly quickly compared to fiscal policy, however, the impact
on the economy can take several months to come into effect.
• Business and consumer confidence: if confidence is low even low rates of interest will not encourage them
to borrow to finance investment and consumption, as they may believe that in the future they will not be
able repay the loans.
• Very low interest rates: when interest rates are very low, or close to zero, it is not possible to reduce the
interest rates further, so other policies are needed (e.g. quantitative easing).
• Conflicting goals: a deflationary monetary policy designed to reduce inflation can lead to slower economic
growth and demand deficit unemployment.
• Unresponsive to change in interest rates: the demand for funds might be unresponsive if it is interest
inelastic, meaning that a change in interest will have relatively little impact on the AD.
Arguments for:
• Speed: monetary policy can be enforced far more quickly than fiscal policy. For instance, in the UK the
Monetary Policy Committee meets once a month to make decisions about the interest rate, whereas, fiscal
policy may not be able to be changed until the annual budget.
• No politics: most central banks are independent from the government, so political desires about ensuring
votes will not impact on the monetary policy.
• No crowding out: it does not borrow large sums of money which reduces the amount of private sector
borrowing and so interest rates will not increase due to this, when they are intended to fall.
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Definitions
Term
Monetary policy
Definition
Expansionary monetary policy
Contractionary monetary policy.
Wholesale interest rates
Retail interest rates
1.
2.
3.
Explain expansionary monetary policy with a diagram.
Explain contractionary monetary policy with a diagram.
What are the pros and cons of expansionary monetary policy?
Pros
4.
Cons
Briefly explain how the government uses wholesale interest rates to impact AD?
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Supply Side Management
Supply side policies: these aim at positively affecting the production side of an economy by improving the
institutional framework and the capacity to produce (that is, by changing the quantity and/or quality of factors of
production). Therefore, the LRAS shifts to the right, achieving growth in potential output.
Market based policy: aims to allow markets to work more freely with minimal government intervention.
Interventionist policy: government provides capital goods and services where it is believed that the market has
failed to provide them.
Interventionist supply side policies
Interventionist policy: this affects both AS and AD, as it involves government spending – a component of AD. Whilst
it also increases productivity, total output and so AS.
Investment in human capital: investment in education and training will raise the levels of human capital and have a
short-term impact on aggregate demand, but more importantly will increase LRAS. This is because a more skilled
workforce will improve their productivity and increase total output.
Training: the government may provide specific training centres or give subsidies to firms to help them train their
workforce. Also, it helps to retrain workers who have lost their jobs and need to adapt their skills in order to renter
the labour market.
Education: as a merit good education is under provided and under consumed in a free market, so the government
intervenes to supply free or subsidised education and regularly make changes to the curriculum and methods of
delivery. Education provides skills and productivity to the workforce, therefore increasing total output.
Healthcare: in some countries the public health is poor, so there are many absentees from school or work.
Therefore, the government may intervene to provide free or subsidised healthcare.
Investment in new technology: the government can actively encourage research and development by firms by
offering tax incentives, such as not paying corporation tax when doing research and development. They can also act
as sponsors for research and development programmes.
Investment in infrastructure: large scale building projects increase the output of the economy as it becomes cheaper
and easier to produce and transport finished products. Also it will make the labour more geographically mobile.
Industrial policies: governments can have agencies that support and develop a specific industry.
Protection of infant industries: a government may use tariffs to protect small new firm that do not yet profit from
economies of scale, therefore, giving it an opportunity to expand to compete on the world market.
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Financial incentives and advice for small firms: governments may provide financial incentives, like subsidised loans,
reduced corporation tax rates, and direct subsidies. They may also provide advice on business start-up for firms and
provide support in writing business plans etc.
Evaluation of interventionist policies
Budget constraints: the majority of these policies require large amounts of government spending and
implementation of these policies may be limited by the government’s budget and their ability to borrow money. This
spending also involves an opportunity cost in terms of what money could have been spent on instead.
Time lags: the demand side effects of many of these policies might be felt quite quickly, however, the supply side
effects may take many years to have an impact. In the meantime there will be an increase in AD. It can even lead to
wage price spirals.
Market based supply side policies
Policies to increase competition: greater competition results in greater efficiency, so a largest amount of output can
be produced with the same amount of resources. Competition may also result in better quality, more innovative
products and lower prices.
Privatisation: the sale of state owned industries to the private sector, as privately owned firms can be more efficient
since they are more motivated to make profit. So fewer resources are needed to produce the same amount output,
as productivity increases, and the average costs of production fall.
Trade liberalisation: this involves reducing barriers to international trade such as removing tariffs (tax on imports)
and quotas. This encourages specialisation and trade and increases the number of goods and services available to
consumers.
Anti-monopoly regulation: monopoly power gives producers the power to restrict output and force up prices. Antimonopoly laws (anti-trust laws) seek to prevent domestic monopolies in the market. With increased competition
there will be greater choice for consumers and usually lower prices.
Deregulation: reducing the number and severity of the regulation on a business. This involves laws on a number of
firms that are allowed to compete, health and safety laws, environmental laws etc. This reduces the costs of
production for firms as they no longer have to spend time and money to comply with so many rules.
Labour market reforms: designed to make the markets more responsive to supply and demand so that the level of
employment will increase and productivity will rise.
Reducing trade union power: a trade union is a group of workers who act together to further their own interests
with regards to wages and working conditions. They often result in wages above the equilibrium wage and lower
levels of productivity. Policies designed to reduce their power should result in higher levels of employment, higher
productivity and an easier process to make workers redundant. So workers will more between employers more
easily.
Reducing unemployment benefits: this encourages more people to accept jobs, especially even low paid jobs.
Reducing the national minimum wage: this reduces the costs of labour so firms are able to hire more workers and
produce more output.
Incentive related reforms:
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Reducing corporate taxes: (tax on firms’ profits) this gives firms more funds for investment. This could also be used
for research and development which then improves technology advancement.
Reducing income tax: may provide an incentive for workers to work harder and for longer hours as they get to keep
a higher proportion of their income and so increase productivity. However, many individuals do not have the
opportunity to alter their hours, as they are contracted to work a certain amount. This increase real wages and the
number of workers.
Evaluation of market-based policies
Increased inequality: these reforms may cause the low income earners and the unemployed to find their incomes
falling relative to that of other members of society. The incentive based policy of cutting the income tax which is
progressive in nature will also result in more inequality.
Effects on tax revenue of cutting tax rates: the Laffer curve shows that a cut to tax rates could lead to an increase or
decrease in tax revenue.
Increasing the tax rate could increase tax revenue from R to R2 or decrease it to R1.
Increased negative externalities: as a result of reduced regulation with regards to the environment and policies to
increase competition this might result in an increase in the negative externalities of production.
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Evaluation of supply side policy
Supply side policies aim to increase the productive potential of the economy and shift the LRAS to the right.
However, from the Keynesian perspective there is insufficient AD, an increase in AS will not result in an increase in
real output and economic growth.
1.
2.
Explain what is meant by the term interventionist supply side policies?
What are the pros and cons of interventionist supply side policies?
Pros of interventionist supply side policies
3.
4.
Cons of interventionist supply side policies
Explain what is meant by the term market-based supply side policies?
What are the pros and cons of market-based supply side policies?
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International Trade (Pages 354-390)
The advantages of trade
• Lower prices.
• Greater choice.
• Access to different resources, goods and services.
• Economies of scale
• Increased competition
• More efficient allocation of resources
• Source of foreign exchange.
HL Comparative Advantage
Comparative advantage is when one country can produce a good or service at a lower opportunity cost than
another. This concept is illustrated on the table. (To calculate the opportunity cost make the good you are
calculating for the denominator.)
Country
Litres of Palm Oil
Indonesia
New Zealand
6
2
Opportunity cost of
one litre of palm oil.
8/6 = 1.34
½ = 0.5
Kilos of Bananas
8
1
Opportunity cost of
one kilo of bananas
6/8 = 0.75
2/1 = 2
In this (made up) example Indonesia has an absolute advantage in both palm oil and bananas. However, NZ has a
comparative advantage in palm oil. Indonesia should specialise in bananas and import palm oil from NZ as they can
purchase at a lower opportunity cost. Note that the theory does not take into account issues such as quality or
transport costs. Consumers in each country do not have perfect knowledge of the other market, that trade is free
and factors of production are constant. This is unlikely in the real world.
Free trade and reason for protectionism
Free trade occurs when there are no barriers to trade. There are many reasons for imposing barriers to free trade.
These include:
• Protecting domestic employment.
• Protecting against low-cost labour overseas.
• Protecting an infant (sunrise industry.)
• To avoid the risks of over-specialisation.
• Strategic reasons.
• To prevent dumping.
• To maintain high quality standards.
• To raise government revenue.
• To correct a current account deficit.
• To be a tool in diplomacy.
Reasons against protectionism
• It raises the price of imports.
• It reduces choice.
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•
•
•
•
It reduces competition.
It leads to an inefficient use of resources.
It can lead to retaliation and trade wars.
It can hinder economic growth and employment.
Types of protectionism
Tariff
A tariff is a tax on imported goods.
Price
Sd
WP + Tariff
World Price
Dd
Q1
Q3
Q4
Q2
Quantity
On the diagram above:
With free trade the amount of imports will be Q1-Q2
The amount produced domestically will be 0-Q1
The value of imports will be (Q1-Q2) x World Price
Once the tariff is imposed the price rises to WP + tariff.
Imports reduce to Q3-Q4
Government revenue is the shaded area.
(Note in HL you may be asked to calculate these areas if numbers are given.)
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International Trade Subsidies
Price
Sd
Sd + Subsidy
World price
PW
Q1
Q3
Q2
Quantity
The subsidy means that the price will stay at PW. Imports will be reduced from Q1-Q2 to Q3-Q2. The subsidy is the
amount of the double headed arrow, and the cost of the subsidy is shaded. This means that the government bears
the cost. Subsidies are an effective means of protectionism, but they carry the normal costs namely the cost to the
government, the opportunity cost, the leaky bucket and the loss of efficiency because of reduced competition.
Import Quotas
The import quota is the horizontal difference between the two supply curves. Before the quota the price is the price
at world supply. Afterwards it goes up to P2. The quota reduces imports from Q1-Q4 to Q2-Q3.
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Administrative Barriers
Administrative barriers include:
• Red tape
• Health and safety and environmental standards
• Embargos
Red tape and health and safety and environmental standards increase the costs for the exporter thus moving the
world price up. An embargo is a complete ban often used for political purposes such as what is being done on some
Russian products currently.
Economic Integration
Economic integration is where countries coordinate and link their economic policies.
Preferential Trading Area.
Where a group of countries give each other better market access than they do to the rest of the world.
Free Trade Area
Where a group of countries have no protectionism amongst themselves but are free to trade with other countries
under whatever conditions they choose.
Customs Union
This is a free trade area that adopts common protectionism against those countries outside the union.
Common Market
This is a customs union that has common policy on product regulation and the free movement of goods, services,
capital and labour within the union.
Economic and Monetary Union
This is a common market with a single currency and a common central bank.
HL What are the advantages and disadvantages of a membership of a monetary union.
Pros:
• Exchange rate fluctuations disappear amongst members.
• The currency is more powerful.
• Business confidence tends to improve.
• Transaction costs between members are eliminated.
• Price differences become more obvious leading to gradual equalisation.
Cons:
• Countries lose control over their monetary policy as this is decided by the central bank.
• There is a lack of coordination with fiscal policy.
• Individual countries lose control over their exchange rates.
• It is costly to set up.
Full Economic Integration
Countries would have no control over their economic policy. As yet there are no real-life examples
What are the advantages of being in a trading block?
• Access to a bigger market.
• Increased competition and efficiency.
• Greater possible investment stimulus.
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•
•
•
If the block has freedom of movement of labour, it creates greater employment opportunities.
Possible improvements in international relations and political stability.
More power in trade negotiations due to increased size.
HL Trade Creation and Trade Diversion
Trade creation occurs in a customs union. When a member joins the customs union tariffs are removed from their
products. If they can make a product cheaper than existing members then the whole union moves from high cost to
lower cost production of the good, essentially creating trade. The new member will also have access to cheaper
goods and services from other members of the union creating trade.
Trade diversion is the opposite and is a negative consequence of greater economici country. It is essentially a
transfer from low cost production to high cost production. If a country previously sourced a cheap supply of a raw
material before it joins a customs union, after it joins it has to pay the more expensive cost from within the union.
The WTO
The World Trade Organisation sets the rules for international trade and resolves disputes between member
countries. Since it came into existence in 1947 average world tariffs have fallen from around 40% to 4%.
Its aims are:
• Non-discrimination.
• More open trade.
• Predictability and transparency.
• Encouraging fair competition.
• Supporting developing countries.
• Environmental protection.
Its functions are:
• Administer WTO trade agreements.
• Provide a forum for trade negotiations.
• Dispute resolution
• Monitoring trade policies
• Providing technical assistance and training for developing countries.
The current round of talks, the Doha round have been ongoing since 2001 and have not been resolved. Issues
around agricultural subsidies in the EU and the USA and the desire of larger developing countries for developed
countries to remove their tariffs. As yet no compromise has been reached. The WTO is not currently meeting its
aims because:
• Unequal power between member countries.
• Trade rules impact negatively on developing countries.
• The growing number of trade deals negotiated outside the WTO.
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Questions
1
What are the advantages of international trade?
2
HL Comparative Advantage
The table below illustrates two hypothetical countries, Wennington and Seandonia who both produce butter and
cheese.
Wennington
Butter (million kilos)
Cheese (million kilos)
500
0
400
50
300
100
200
150
100
200
0
250
Seandonia
Butter (million kilos)
Cheese (million kilos)
600
0
500
200
400
400
300
600
200
800
100
1000
0
1200
Calculate the opportunity cost of producing butter and cheese:
Country
Opportunity cost of one kilo of
butter
Wennington
Seandonia.
Opportunity cost of one kilo of
cheese
In Wennington:
In Seandonia:
Assuming a 1:1 rate of exchange between the two countries (i.e. 1 kilo of butter for 1 kilo of cheese)
Show the original position on the PPC if Wennington is consuming 100 million kilos of cheese and 200 million kilos of
cheese.
Illustrate on the diagram and explain what will happen in Wennington specialises in butter production, consumes
200 million kilos and exports the rest to Seandonia on a 1:1 ratio.
3
HL Explain the limitations of comparative choice theory.
4
List reasons in favour of protectionism
5
List arguments against protectionism
6
Draw and explain
• A tariff
• An international trade subsidy.
• A quota
7
Explain how non-tariff barriers and embargos work.
8
Describe the 6 types of economic integration.
9
HL What are the advantages and disadvantages of a membership of a monetary union.
10
What are the advantages of being n a trading block.
11
HL What is the difference between trade creation and trade diversion?
12
What are the aims and functions of the WTO?
13
Why is the Doha round not reaching a compromise?
14
What factors limit the WTOs effectiveness?
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Exchange Rates
An exchange rate is the value of one currency in terms of another. The market, known as the FOREX market includes
the currency trading of governments, central banks, private banks, MNCs and other financial institutions and
regularly tops US$1.5 trillion per day. There are many different types of exchange rate systems. We focus on fixed,
floating and managed systems.
The market operates on the basic premise that the supply curve for a currency is controlled by the country as they
supply their currency to the market to buy foreign currency to buy foreign goods and services, visit foreign countries
as tourists or deposit money in another country’s financial system. The demand is driven by foreigners who demand
the countries currency to buy their goods and services with, visit their country or deposit money in their financial
system.
Fixed:
Under a fixed regime the value of the currency is set in term of another (or a commodity like gold) by the
government or reserve bank. If a decision is made to increase the currency’s value, it is called a revaluation and if
the decision is made to reduce its value it is called a devaluation.
Assume a country with a fixed exchange rate stars importing more. They will supply more of their currency to buy
foreign currency to buy the imports. This is an increase in supply. To maintain the value at the fixed exchange rate
must sell foreign reserves which will increase the demand for its currency. If the country sees extra tourists this will
increase the demand for the currency. To maintain the fixed rate the country must purchase foreign reserves by
supplying more of its dollars.
Floating:
The floating exchange rate is a simpler concept. If demand for the currency goes up the value of the currency goes
up against the others, this is known as an appreciation. If the supply increases the value of the currency falls, this is
known as a depreciation.
Managed:
Under a managed system the currency is allowed to float in a certain acceptable range but the central bank will
intervene by buying and selling currency if it goes outside this range. Note that many countries that purport to have
a floating rate in fact will often manage their currency. This is also known as a dirty float.
Calculating exchange rates (mainly used in paper 2 and 3)
If US$1 = NZ$1.40 then NZ$1 = 1/1.4 = 0.7143 (round to 4 places)
If the good was selling for US$80 it would cost 80 x $NZ1.4 = Nz$112
If the US currency depreciated to 1.3 then the good would cost 80 x $NZ1.3 = 104
You can note from this example that a depreciating currency makes your exports cheaper and will therefore increase
the quantity demanded of your exports. It will however make your imports more expensive
Advantages of high exchange rates:
• Anti inflationary as it reduces the costs of imported raw materials and capital.
• More imports can be bought.
• It forces domestic producers to improve their efficiency.
Disadvantages of high exchange rates:
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• Damages export industries.
• Damages domestic industries.
• Negative impact on the current account.
Advantages of low exchange rates:
• Exports more attractive.
• Greater employment in export industries
• Greater demand for locally produced goods increasing domestic employment.
• Positive impact on the current account.
Disadvantages of high exchange rates:
• Damages import industries.
• Can be inflationary.
Government Intervention
The government can influence the value of its currency either by buying and selling foreign reserves (currencies) or
by changing domestic interest rates. They might do this to:
• Increase employment.
• Reduce inflation.
• Maintain a fixed rate.
• Manage the currency to an acceptable level.
• Maintain a level of stability.
• Improve a current account deficit.
HL What are the advantages and disadvantages of fixed and floating exchange rates?
Fixed:
The advantages are:
• A fixed rate reduces uncertainty for businesses about costs and prices.
• It ensures sensible government action on inflation.
• It should reduce currency speculation.
The disadvantages are:
• Actions to maintain the rate may impact the domestic economy negatively. (e.g. the government raises
interest rates to maintain the value of a falling currency but this causes a rise in unemployment.)
• The country must maintain high levels of foreign reserves.
• Setting the best level is difficult.
Floating:
The advantages are:
• Interest rates can be used to address domestic issues.
• It should alleviate current account deficit. (note Marshall Lerner)
• It reduces the need to keep sizeable foreign reserves.
The disadvantages are:
• They create uncertainty.
• They encourage speculation
• It can exacerbate inflation.
Questions
1
What is an exchange rate?
2
What factors influence the demand for a currency?
3
What factors influence the supply of a currency?
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4
What is a fixed exchange rate?
5
What is a floating exchange rate?
6
What is a managed exchange rate?
7
Distinguish between a devaluation and a depreciation of the currency.
8
Distinguish between a revaluation and an appreciation of the currency.
9
If one Singapore dollar equals .6 US dollars, then:
• Calculate the value of the US dollar in Singapore dollars.
• How much will a S$90 cost in $US?
• What happens t the cost of the item if it Singapore dollar appreciates to US$.65?
10
What are the advantages and disadvantages of high exchange rates?
11
What are the advantages and disadvantages of low exchange rates?
12
How and why might a government intervene in the FOREX market?
13
HL What are the advantages and disadvantages of floating exchange rates?
14
HL What are the advantages and disadvantages of fixed exchange rates?
Balance of Payments
The balance of payments is the record of value of all the transactions between the residents of one country and the
residents of all other countries in the world. Any transaction that leads to money coming into the country has a
positive value and any transaction that sees money leaving is given a negative value. There are a few international
variations for the components, the one given here follows the IBDP curriculum. The balance of payments is given as
the following equation:
Current Account + (Capital + Financial Account + net errors and omissions) = 0
(Net errors and omissions will be used to make the account balance.)
Current Account
Is the measure of the flow of funds from trade in goods and services plus other income flows.
The current account is made up of the following balances:
The balance of trade
The balance of services.
Net Investment income (Income from investments in other countries)
Net current transfer income. (Foreign aid, grants and repatriated wages)
(Current Account = BoT + BoS + NITI + NIII)
The capital account.
A relatively small account made up of two components.
Capital transfers (money gained or lost through migrants moving assets, debt forgiveness etc)
Non produced, non-financial assets (land purchases, rights to natural resources, patents, franchises etc.)
The Financial Account
Direct investment
Portfolio investment
Reserve assets.
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HL The relationship between the current account and the exchange rate.
Even though a current account deficit can be caused by both supply and demand factors we illustrate it as an
increase in supply of the currency. This signifies that the end result of a current account deficit is that more of a
currency is supplied than is demanded. Similarly, a surplus is depicted as an increase in demand signifying that the
demand for the currency is greater than the supply and causing an appreciation.
HL Consequences of a current account deficit
• Foreign reserves may become depleted.
• If the deficit is being funded through foreign investment foreigners may take control of many profitable
businesses and this could be harmful if they are strategic assets such as banks and utilities.
• If it is financed from lending then the debt will have to be repaid.
• High levels of debt may result in a dropping of the country’s credit rating
• If the reserve bank lowers interest rates to lower the exchange rate this can cause domestic inflation.
• Allowing the currency to depreciate may cause domestic inflation but may also help the deficit to correct.
• A current account deficit reduces AD so therefore price level, output and employment.
HL Causes and consequences of a current account surplus.
Causes
• Countries may have a long term competitive advantage in producing products such as South Korea and
electronics.
• Countries may have a relatively high MPS
• The main export is inelastic (like oil) and the price goes up.
• The country may be like Singapore and have developed high levels of productivity and research and
development.
• Short run cyclical causes such as a global upturn or increased global demand for the main export(s)
Consequences
• More foreign reserves can be purchased.
• AD will shift to the right; this could be positive or could be inflationary.
• The currency will appreciate which could normalise the current account.
• It may lead to a reduction in local consumption and investment.
• It means trading partners are in deficit which may lead to retaliation.
Expenditure switching policies.(to eliminate a current account deficit.)
Policies designed by the government to get consumers to move away from imports and towards domestically
produced goods and services. The government could attempt to depreciate or devalue the currency or even use
protectionist policies. The government may even promote locally made products.
Expenditure reducing policies.(to eliminate a current account deficit.)
The government can use contractionary fiscal and monetary policy which will reduce expenditure including
expenditure on imports. This can be very unpopular, and the success depends on the PED of imports.
Policies to reduce current account deficits are generally unpopular and difficult to achieve.
HL Marchall Lerner and the J Curve.
When there is a current account deficit in a floating exchange rate regime the expectation is that once the currency
depreciates the economy will head towards surplus because imports will become more expensive causing a decrease
in quantity demanded while exports will become cheaper causing and increase in quantity demanded. Whilst this is
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true it does not happen instantaneously. Rather it will only happen when the Marshall-Lerner condition has been
reached. This states that PED exports + PED imports > 1. This takes time as we know that elasticity increase over
time. (Pre orders, contracts, shipping time etc.) This can be depicted as a J curve
Questions
1
2
3
4
5
6
7
8
9
10
11
12
13
What is the balance of payments?
What are the components of the current account?
What are the components of the capital account?
What are the components of the financial account?
What figure is used to balance the balance of payments?
What is the relationship between a positive financial account and the investment income figure in the
current account?
HL What is the relationship between the current account and the exchange rate?
HL What are the consequences of a current account deficit?
HL What are the causes of a current account surplus?
HL What are the consequences of a current account surplus?
HL What are expenditure switching policies?
HL What are expenditure reducing policies?
Hl A country with a current account deficit and a floating exchange rate notices that after the currency
depreciates the deficit initially gets worse until it appreciates.
Economic Development
Economic growth and economic development.
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Economic growth refers to increases in output and income over time and is usually measured in terms of GDP or GNI
per capita. Economic development is a more nebulous concept that refers to increased standards of living for a
population as a whole. This is a broad term and has to be measured in multi-dimensional ways. Essentially
economic development combines increased GDP per capita with increased standards of living, reductions in poverty,
increased access to goods and services to satisfy basic needs (food, shelter, health, education sanitation etc.)
increased employment opportunities, decreased unemployment and reduced inequality. Linked to the concept of
economic development is the concept of human development which has three core values:
• Life sustenance.
• Self-esteem.
• Freedom.
Sources of Growth
The causes of economic growth are the same world-wide but some sources are of particular importance to lesser
developed economies.
• Increasing the level of physical capital. Labour productivity (The ratio of the output per unit of labour input.)
tends to be low because of a lack of capital (remember my analogy about cutting the grass.) Increases in the
capital stock will increase the productivity of labour if there is capital deepening but not if there is capital
widening.
• Increasing human capital. Because of poor health and low levels of education in developing countries
economic growth can be increased by making larger sections of the population able to work in a wider range
of activity.
• Development and Use of Appropriate Technology. As previously stated increasing the stock of capital helps
improve productivity. Often however technology appropriate for a developed economy is not appropriate
for a developing one. (Issues such as maintenance requirements, spare parts etc. must be considered.)
• Institutional changes. This refers to the way that business is done and encompasses issues like corruption,
the legal system, taxation, banking and transparency.
Growth based on commodities.
Often countries that are resource rich struggle with economic growth and development. This is because they are
overly dependent on that commodity (such as Venezuela at the moment) and don’t develop the broad-based
economy that other resource poor countries do. Often these countries experience conflict over the control of the
resource as in the case of Nigeria and its oil or suffer from poor fiscal management.
Economic Growth does not always mean economic development.
A country can grow economically without developing. GDP per capita can go up but the average person may not
have a better quality of life. There is a theory called the “Trickle Down Theory,” which states that if you make the
country wealthier some of that wealth will trickle down to those most in need. This theory has been largely
discredited. If the merit goods that help bring about improved quality of life are not present e.g., no extra spending
on health education, women’s rights and environmental protection then trickle down is unlikely to happen.
Inequality in such a circumstance will increase. If an economy does not grow it can still develop if resources are
transferred towards more merit goods, but this is not sustainable in the long run. To successfully develop the
economy should ideally combine increased GDP per capita to spend on increasing access to merit goods.
What is sustainable development?
A key conceptual understanding is that endless economic growth, based on the consumption of finite resources,
cannot continue indefinitely. The concept of sustainable development is that it is development that meets the
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needs of the present without compromising the ability of future generations to meet their own needs. It has in
recent years with the advent of events such as huma made global warming to ignore the negative impact of
unsustainable economic growth. Key sustainability issues facing us include:
• Access to safe water.
• The spread of tropical diseases.
• Increased droughts.
• Decreased food production particularly in the tropics and near tropics
• Rising sea levels and the emergence of climate refugees.
What are the sustainable development goals (SDGs)?
The SDGs were promulgated at the UN conference on sustainable development in Rio de Janeiro in 2012 replacing
the Millenium Development Goals. Up until the covid pandemic (see research question) the SDGs were said to be
responsible for:
• Moving a billion people out of extreme poverty.
• Halving child mortality.
• Halving the rate of children out of school.
• Reducing HIV/Aids by 40%
Each goal is broad but supported by detail as to what the world will look like in 2030.
HL The relationship between poverty and sustainability.
To meet their needs poor people tend to be more reliant upon the environment and this can cause sustainability
issues such as pollution, depletion of common access goods, pressure on wildlife and deforestation. Lack of access
to land makes agriculture difficult and makes it difficult to borrow money to develop. Slash and burn techniques
make the land less productive and erosion prone. Poor people are also more prone to environmental catastrophes
such as floods
Common characteristics of developing countries:
• Low standards of living
• Low levels of productivity
• High population rates and dependency burden.
• High and rising rates of unemployment and under employment.
• Dependence of agricultural and primary production.
• Imperfect markets and limited information.
• Dominance, dependence and vulnerability in international relationships.
Diversity amongst developing countries:
• Different resource endowments.
• Different historical backgrounds.
• Different geographic and demographic factors.
• Different ethnic and religious backgrounds.
• Different industry structures.
• Different per capita incomes.
• Different political structures.
Measuring Economic Development
Because the concept of development is nebulous and the causes are so different it is not possible to use a single
indicator to measure development. Composite indicators give a far more accurate picture. A measure that includes
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health, education and income is more accurate than one that just measures income. The HDI consists of four single
indicators of wellbeing which consist of, GNI per capita, average years of schooling, life expectancy at birth, Mean
years of schooling for those over 25 and expected years of schooling for those entering school.
A score of below ).555 is an indicator of low huma development whilst a score over ).800 indicates very high human
development. There are many other measures of development like the inequality adjusted HDI, the Happy Planet
Index, and the multi-dimensional poverty index. The term ppp used when discussing GNI per capita refers to
purchasing power parity.
Factors that hinder economic development.
• Poverty traps.
• Rising inequality
• Lack of access to infrastructure.
• Low levels of human capital.
• Over dependence on the primary sector.
• Lack of access to international markets.
• Informal economies.
• Capital flight.
• High indebtedness.
• Geographical factors.
• Political/social factors.
• Gender inequality
• Lack of good governance and corruption.
Strategies that promote economic development.
• Import substitution
• Export promotion.
• Economic integration.
• Diversification.
• Market based supply side policies. (Trade liberalisation, privatisation, deregulation)
• Foreign direct investment
• Social enterprise promotion.
• Institutional change. (Banking system, microfinance, phone banking, women’s empowerment, reducing
corruption.
• Securing property rights.
• Interventionist supply side strategies. (Infrastructure, human capital)
• Redistributive fiscal policies.
• Transfer payments.
• Minimum wages.
• Merit goods.
• Foreign aid
Foreign Aid
Foreign aid is defined as the transfer of funds or goods and services to a developing country with the main objective
of improving economic, social or political conditions. Generally, it is given by other countries, bilaterally from one
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country to another, multilaterally from various UN agencies or from a non-government organisation (NGO). To fill
the characteristics of aid they must be both concessional and non-commercial. Concessional means that the terms
are better than might be available privately- either the interest rate is lower or it is a grant that does not need to be
re-paid. Non concessional means that it must not involve buying selling or generally making a profit. Humanitarian
aid is aid given to a country to cope with some type of disaster such as an earthquake or an outbreak of Ebola. It is
generally short term. Development aid is more medium and long term and is given to address development needs.
Official development assistance helps fulfil SDG 17 which calls for global partnerships to promote sustainable
development. Developed countries should contribute 0.7% of GNI to fulfil these objectives. The aid may not be
military to fulfil the criteria.
There are some concerns about aid.
• A prominent one is that the benefits from aid projects do not reach the intended target because of
corruption.
• Aid can be given for political rather than development needs.
• Aid may be given to countries with similar political views.
• Aid can be tied forcing the recipient to buy goods and services off the donor.
• Food provision can hurt local farmers who cannot compete with free food.
• There is an element of creating a culture of dependency.
• Aid often targets urban areas over rural ones.
• Aid sometimes requires the country to adopt certain economic policies such as deregulation and trade
liberalisation.
Non-governmental organisations.
There is a wide variety of NGOs which are responsible for a large range of development programmes around the
world. They are diverse in their origins and aims. Some are religious, some backed by governments and others by
professions. NGOs tend to have operational activities where they plan and implement targeted projects and they
often advocate for public policy decisions to help development. They have a significant positive impact but are:
• Limited by the size of their incomes.
• Often NGOs fail to coordinate with each other causing duplication and waste.
• Thy may have religious or political bias.
• They are unaccountable
• A lot of their incomes often go into things other than aid such as advertising.
World Bank
The World Bank is made up of the International Bank for Reconstruction and Development (IBRD) and the
International Development Agency. Its role is to supply financial support and technical assistance with a view to
reducing poverty and supporting development. Formed after World War 2 the IBRD now makes loans to middle
income developing countries which it finances through World bank bond sales. The IDA which was founded in 1960
focusses on the poorest countries and provides zero to low interest loans to support development n the world’s
poorest countries.
The International Monetary Fund.
The IMF was first proposed at Bretton Woods in 1944 as an organisation of 189 countries to:
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• Promote international monetary cooperation.
• Facilitating the expansion and balanced growth of international trade.
• Promoting exchange rate stability.
• Assisting the establishment of a multilateral system of payments
• Making conditional assistance available for members suffering balance of payments difficulties.
The IMF can give loans to member countries and is financed form quotas from member countries. The IMF works to
support Heavily Indebted Poor Countries 9HIPC) and also now has a branch known as the Catastrophe Containment
and relief Trust to work to support poor countries hit by natural disasters.
These institutions are essential in providing support and assistance but they are dominated by the United States and
their solutions often focus upon a Western view of what the best pathway for development is. Criticism is that this
support is conditional upon:
• Trade liberalisation.
• Encouraging the export of primary commodities.
• Floating (and therefore depreciating) the currency.
• Liberalising capital flows.
• Encouraging FDI.
• Privatisation of nationalised industries.
• Elimination of subsidies and price controls.
• Austerity measures.
Questions
1
2
3
4
5
6
7
8
9
10
11
12
13
Distinguish between growth and development.
What are the causes and pros and cons of growth.
Why are composite indicators used to measure economic development?
What are common attributes of developing countries?
Sketch the poverty trap.
What are some factors that hinder economic development? (Choose five and explain)
What are strategies that promote economic development. (State the pros and cons of 5)
What is foreign aid?
Explain some concerns about foreign aid?
What is the role of the IMF?
What are the conditions for IMF support?
What is the role of the world bank?
HL What is the relationship between poverty and sustainability?
Resources
Blink and Dorton, 2020, Economics Course Companion Oxford University Press, United Kingdom.
McBride, 2011, Workbook for the New IB Economics Croecko Publications, Oman.
Tragakes 2012 Economics for the IB Diploma. Cambridge University Press, Dubai
https://ibstudy.wixsite.com/ibeconomics/economics-notes
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