Demand
Market: A platform where buyers and sellers come together to carry out
economic transactions.
Demand: the amount of a good a consumer or group of consumers are willingly
and able to buy.
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As prices increase, demand for a certain good decrease (and vice versa)
Ceteris paribus (assuming everything else remains the same).
Negative relation is due to :
The income effect: when the price of a good falls, then people will experience an increase in their ‘ real income’, which
reflects the amount that their incomes will buy. Thus they will buy more.
Substitution effect: when the price of a product falls, then the product will be relatively more attractive to people than
other goods, as it is cheaper in comparison.
Diminishing marginal returns: If read using the quantity values, we can see that as the quantity demanded increases,
the price that consumers are willing to pay/ unit of good diminishes. This is due to how utility decreases for every
subsequent good consumed.
Total market demand can be found through addition of total demand of all goods within the market
Change in demand vs Change in quantity demanded
● When there is a change in price, there will be a change in demand, as we move along the curve.
● However, if there are change in other factors, the demand curve will shift.
○ Income: when the price of a product falls, then people will have an increase in real income. This will
mean that if a good is normal, the demand for the good will also rise.
○ Substitutes: If products are interchangeable with one another, then a change in the price of one will
lead to a change in the demand for the other product.
○ Complements: Products that are consumed together. Demand is linked between complements.
○ Taste and preferences , population size and change in income distribution all affect demand.
Supply
The quantity of a good or service that producers are willing to offer for sale at a given price during a specific time
period, ceteris paribus.
● As price increases, more of a certain good is supplied by a firm. This is because firms exist to maximise profit
and are thus more willing to give a certain good at a higher cost.
● LIke demand, to find the market supply of a good, one needs to add up all the individual supply for different
supplies of a good.
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Increase/decrease in price can cause a movement across the supply curve, while a non-price factor will cause all
supply to shift. These non-price factors include:
○ Cost of production: If the cost of maintaining the factors of production increases, some firms may no
longer be willing or able to provide as much of a certain good at a certain cost as they gain less of a
profit, thus shifting the supply curve to the left. (Capital, enterprise, land, labour)
○ Productivity: If firms are able to use fewer resources in the production process, it will spend less on
production. For example, effective management, or utilizing machinery/better technology.
○ Expectations: Companies will make decisions about what to supply based on their expectations of
future prices. If a product is perishable, then a company might wait until demand is high before
producing
● Taxes + subsidies: Businesses see taxes as increase in cost of production and subsidies as a decrease in
cost of production, and as such, this will affect the amount of a good a firm will be able to produce.
● Price of related goods: If producers have a choice regarding what to produce, they will usually use their
limited resources to produce more of a good in demand than a good that is not wanted.
Equilibrium
The point where demand=supply. Where the amount of a good that people wish to buy and the amount of a good that
suppliers wish to supply are the same. The market will remain that way until there is an outside disturbance which will
change it.
Self Righting system: When a market acts freely, the price acts as a signal to all market actors, and will always push
the price back to the equilibrium.
(the equilibrium is found to be the intersection of D and S)
Opportunity cost: the next best cost foregone .
Scarcity forces individuals to make a decision about ‘ what to produce’ ,
and choices feature an ‘opportunity cost’ of foregone alternatives that
could have been pursued.
The key to the market’s ability to allocate resources can be found in the
role of prices as signals and prices as incentives.
Price rise
1. As demand increases, there is an upward pressure on price. This is
due to how some individuals aren’t able to buy the good they
want, and are willing to offer more.
2. The increase in price signals to everyone that a shortage has
emerged.
3. Price therefore rises as producers are incentivized to produce
more as they earn greater profits. At the same time this causes
consumers to ration their income.
4. More resources are ultimately distributed to the creation of these goods.
Price fall
1. As demand decreased, there is a downward pressure on price. This is due
to how supplies are unwilling to incur an extra cost.
2. The drop in price acts as a signal to everyone that a surplus has occurred.
3. Firms will therefore ration their resources as they are incurring excess
costs. Lower costs will incentivize consumers to spend more.
4. Less resources are ultimately distributed to the creation of these goods.
Market efficiency
Consumer surplus: the benefit gained by consumers from paying a price that is
lower that which they are prepared to pay
Currently, good A is being sold at the market price. However, there are some
consumers who are willing to pay more for good A. As such, these consumers
gain extra satisfaction from paying for a price that is lower than what they are
willing to pay. It is the difference between what the consumers are willing to pay ,
and what they actually have to pay.
Producer surplus: The benefit gained by the producer from selling a good that is
higher than which they are prepared to supply it at.
Currently, good A is being sold at the market price. However, there are some
suppliers who are willing to provide the good at a lower cost than the market
price. They gain in the fact that they have made a gain in terms of what they
would have accepted for them in the first place .
Essentially, it is the difference between what a supplier is willing to provide a good at , and what they actually have to
provide
Allocative efficiency: When resources are optimally allocated, and when utility
/community surplus is maximised. The market is producing the amount wanted
by society, and maximising utility to all parties.
Total utility/Community surplus: Consumer surplus + Producer surplus
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If we look at the demand/supply curve, and look at it from the point of
view of the quantity, we are able to see that as the quantity of a good increases,
the marginal price consumers are willing to pay for one unit decreases. Thus, it
can be said that the demand line represents the marginal benefit line, which
demonstrates how the more consumers buy a good, the less utility they get out
of it per unit of good.
In addition, we are able to see that when the overall quantity of a good supplied increases, the marginal cost
suppliers are willing/able to supply for one unit of a good increases as well. Thus, the supply curve represents
the marginal cost.
If we move right of the equilibrium point, we find that the marginal social cost of producing certain goods
exceeds the benefits derived from it, and as such, it is inefficient to produce quantities of that amount, as the
utility of producing falls as it increases, incurring a deadweight loss.
If we move left of the equilibrium point, we find that the marginal social benefit exceeds the marginal social cost
of producing. However, we must take into account the total utility gained from selling this certain product. If
we produce at a quantity to the left of Qe, it will result in a loss of potential utility, creating a deadweight loss.
The total utility gained is at it’s greatest when it’s at the equilibrium point.
Deadweight loss: the loss of potential utility/welfare.
Price elasticity of demand: The responsiveness of the quantity demanded to changes in the price of a good or service.
The value is always negative because of the negative correlation between the changes in price and the quantity
demanded.
%𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄
%𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄 𝒄𝒄𝒄𝒄𝒄
After calculating the elasticity of demand, the final elasticity should then be changed to a positive value.
If PED is 1, that good is unit elastic. That means that when there is a percentage change in price, there will be an equal
percentage change in quantity demanded.
0<PED<1: Inelastic demand. Percentage change in price greater than percentage change in quantity.
1<PED : Elastic demand. Percentage change in price greater than percentage change in quantity.
PED=0: Any change in price is met with no change in quantity demanded. Horizontal demand curve.
PED= Infinity. Any change in price leads to an infinite change in quantity demanded. If price increases by 1%, no one will
consume it, while if price decreases by 1%, every single consumer will want to consume it. Vertical demand curve.
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Substitutes: Consumers will be more responsive to a change in the price of a good if there are a large number
of substitutes, vice versa if there are little.
Proportion of income: Demand for goods that make up a large proportion of consumer’s income will tend to be
more elastic, since they will lose/gain a lot if the price of a good decreases/increases. This is in comparison to a
good that cost very little.
Luxury/necessity: goods which are necessities will have less elastic demand because of how consumers are not
able to do without it. Addictive goods will also be considered necessities, thus, meaning they less elastic
demand.
Time to respond: if the time given for consumers to respond is little, there will be little change as consumers will
not have enough time to respond or identify substitutes.
Type of good: primary commodities are usually more inelastic, and manufactured goods are elastic. (check notes
up ahead)
Across a curve, the PED is not constant. At higher prices,
the PED is more responsive, while at lower prices, the
PED is less responsive.
This is because when prices are high and
quantities are low, the percentage change in Q is
relatively large, while the percentage change in p is
relatively small.
Applications:
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Producers can use this to find the point where they can maximise revenue. A firm producing at an inelastic range
of the demand curve can always benefit by reducing its output and increasing its price since consumers will be
not very responsive to the change in price, and thus total revenue will increase, as the decrease in consumers
will not be proportional to the rise in price.
- Vice versa for a firm producing at the elastic range of the demand curve, which can decrease the cost of it’s
good in order to increase its total revenue. Thus firms can use the PED to know how to maximise total
revenue.
This phenomenon is due to the fact that at lower prices, the goods represent a lesser amount of the consumer’s
income, because the good has lost its luxury status .
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PED is also important as taxed goods are usually inelastic, in order to allow the government to tax inelastic
goods and earn adequate revenue from it, otherwise if they tax an elastic good, then they might cause demand
to decrease by a large amount, and will cause an industry to go bankrupt, reaping little tax revenue.
Cross price elasticity of demand
Measures the responsiveness of a particular good to a change in the price of a related good. Depends on the closeness
of the relationship between two goods.
Percentage change in quantity of good A/ Percentage change in price of good B .
A positive XED indicates two goods are substitutes of each other. As the price of good B decreases, the quantity
demanded for good A will decrease. An elastic positive XED means that the two goods can be said to be strong
substitutes of each other.
However, a negative XED indicates two goods are complements. As the price of good B decreases, the percentage
demanded for good A will increase as well because good B has become cheaper. An elastic negative XED indicates that
the two are goods are strong complements of each other.
0<XED<1= Cross price inelastic
1<XED= cross price elastic.
0=XED happens to goods which are completely unrelated.
Applications:
- If the substitutes are produced by a single business, the degree of XED needs to be considered. For example, if
the value of XED is high between sprite and coke, then the company will not decrease the price of one of the
goods because it will came at the expense of another.
- Substitutes produced by rival businesses: Predict the amount of profit they make if their rivals drop their price,
and to see whether or not it will benefit if they do so.
- Businesses producing complementary goods will often collaborate in order to take advantage of sales, and to
help reap extra benefits. It can also be used to predict the effect of taxation on one of the goods.
Income elasticity of demand
YED= Percentage change in quantity demanded/percentage change in income
- If there is a direct relationship between income and demand, then the YED coefficient will be positive, meaning
that a good is normal, and as income rises, demand for the good rises as well.
- However, if YED is negative, this will mean that a good is inferior, and as income rises, demand for the good will
fall.
- The same roles for unit/elastic/inelastic applies for the YED values.
- A income inelastic good is one that is a necessity, while one that is income elastic is a luxury. ( what is a luxury
and what is a necessity depends on the country)
Applications of the YED:
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Understanding YED helps businesses and government to analyse the effects of changing income. For example, if
a business produces a normal good, they will scale back production if they know a recession is coming on. This
will allow firms to produce in an expanding market. The higher the YED, the greater the expansion.
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Governments can also recognize the effects of varying income elasticities of demand for different goods. A
government’s decision to increase or decrease income tax will affect disposable income and will therefore
directly affect the demand for goods and services in a nation. A government must therefore consider these
factors to make an informed choice.
○ Governments can also use YED to predict the effect of economic growth on the sectors within an
economy. Typically, agricultural sectors will shrink while manufactured sector will grow. This will
therefore allow the government to see which industries may need support.
Price elasticity of supply
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A measure of how much the supply of a product changes when there is a change in the price of the product.
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄𝒄𝒄𝒄𝒄 𝒄𝒄 𝒄𝒄𝒄𝒄𝒄
The same meanings for elastic/inelastic/unit elastic is the same as XED.
Determinants of PES
● How much costs rise as output is increased. If total costs rise significantly, then producers will not have a great
incentive to increase supply. As such, PES depends on:
○ The existence of unused capacity: if a firm has significant resources which it has not properly used, then
it will be able to increase output easily. While on the other hand, if a firm is producing at full capacity it
will not be able to produce more.
○ The mobility of factors of production: If a firm has factors of production which can be utilized to
produce different goods, then PES will be relatively elastic.
● Time period considered. In the immediate time period, producers are not really able to increase their supply,
especially if it is a natural resource such as tomatoes or potatoes. However, in the long run, firms may be able
to increase the quantity of all of the factors, and as such, it would be much more elastic in this case.
● Ability to store stock: if the firm is able to store high levels of this particular good, then they will be able to react
to price increases. (higher PES)
Commodities
● PED for natural resources (commodities) are relatively low. This is because producers of a certain good are the
ones who purchase natural resources, and they usually have very few choices in this regard. THey have a set
amount of resources to produce, and so wouldn’t overspend either, and will not buy extra even if prices
decrease. They are also necessities, with little to no substitutes.
● PES for commodities tend to be more inelastic as it is very hard for producers to quickly reallocate resources as
it takes time to grow these goods.
Manufactured goods:
● PES for manufactured goods tend to be more elastic as it is easier to increase supply.
● Manufactured goods for consumers tend to have a more elastic PED as there are many substitutes available to
them.
Government intervention
In order to solve some problems within the economy, the government can implement various policies in order to curb
them. These policies can:
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Increase government revenue
reduce consumption of a certain good that are harmful for the individual. Taxing these goods will reduce
consumption. Improve the allocation of resources.
Taxation:
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Direct: A tax imposed on individuals or
businesses.
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Indirect: A tax imposed upon expenditure.
Raises the firm’s costs and shifts the supply curve for
the product upward.
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Percentage (ad valorem) tax: Where the tax is a
percentage of the selling price, and so the supply curve
will shift in an unproportionate manner.
specific tax: A specific or fixed amount of tax that is imposed upon a product, thus shifting the supply
curve vertically upwards by the amount of the tax.
Effects of taxes:
● Consumers suffer: Consumers pays a higher price and receive less of the product
● Government benefit: taxes collected will increase government revenue, and thus be spent on infrastructure.
○ Can be used to correct a market failure.
- Convenient to pay, easy to pay at the time of purchase.
● Less workers hired in the process. (harmful to industries). Producers incur extra costs, produce less, and are
less likely to make a large profit.
○ Regressive. Will affect poor more than it will affect the rich, and thus, incur inequality
Market period: the period right after the change in price takes place.
When a tax is introduced, the consumer and the producer burdens some of it. Here, the tax is one that is P1 to X, with
the producer and consumer burdening half of it.
Subsidies
A subsidy is a payment made by the government to a firm for the purpose of increasing the production of a good.
Governments may do this to :
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increase the consumption of a good by lowering the price, as it is lower, increasing demand. (positive
externality)
Supporting a certain industry, especially one which is struggling . Will help guarantee supply for products that
the government believes is necessary. Such as basic food or a power source, or an industry which hires a large
number of people.
Give greater incentive to produce goods which leave a positive externality, and reduce market failure:
subsidies to the solar industry are intended to promote the growth of solar power.
Affect the balance of payment deficit by lowering the price of domestic products.
Impact of subsidy
Here, the government has introduced a subsidy of AB. This means that for
each unit of output the firm is willing and able to produce, it receives a lower
rice than the original by the amount of the subsidy.
Equilibrium quantity produced and consumed increases from Q* to
Q(ab)
Equilibrium price falls for consumers
Price received by producers increases from p* to P.
Entire shaded area represents the cost of the subsidy.
Overallocation of resources, as the MC (s1) is to the left of the current
supply curve.
Consequences for stakeholders
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Consumers: Consumers are affected by the fall in the price, increasing quantity purchased and the standard of
living.
Producers: receive a higher price, and produce a larger quantity. Receive a larger revenue. (Pp*Qab).
- Allows competitiveness overseas.
Government: pays the subsidy, which is a burden on it’s budget, resulting in an opportunity cost.
- Firms may become complacent, and uncompetitive, meaning that it will be a drain on resources
within the economy.
May only work in the long term, and susceptible to corruption.
More workers hired in the process, aiding with production
Price controls
Price floors
Minimum prices set by the government for a certain commodity and service that it believes that is being sold at a price
that is too low. Used to protect suppliers who need more funds for the production of their good.
Examples include:
● Agricultural price support
● Minimum wage
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Therefore, a surplus will exist if the price floor is above the equilibrium
price.
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The price floor will mean that resources are being used which could be
devoted to other things.
Consequences (minimum wage):
Unemployment, and excess supply (resources wastage) . Misallocation
leading to a welfare loss
Illegal workers and black markets existing below the minimum level.
Goods may become uncompetitive overseas.
Affect standard of living on those who rely on the good.
Helps farmers/those on a minimum wage.
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To counteract this, the government may spend money to buy up the surplus. This results in :
- An opportunity cost
- Allows for a reserve of food/resources that can used in a time of emergency/ can be used to provide
welfare/donations.
Firms: firms are worse off, as they face higher cost of production due to higher labour costs.
Workers: some workers gain by having access to a higher salary, but some lose their job.
Consumers: consumers are negatively affected, because the increase in labour costs leads to decrease in supply of
products, causing higher product prices and lower quantities.
It could be argued that minimum wage may mean that firms respond without firing workers, but by cutting back on their
non-monetary payment. Labour productivity may also increased due to an increased incentive.
Price ceiling:
Maximum price set by the government for a certain commodity and service that it believes is necessary. Used to
protect consumers.
A shortage exists here, as there will be many who want the good who are now
unable to obtain it.
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Non-Price Rationing might take place in order to distribute resources.
Use of government created ration cards, or the use of favouritism, for sellers
selling goods to preferred customers.
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Allocative efficiency does not occur, as marginal benefit no longer is
equal to marginal cost, and the market size is a lot smaller, meaning less benefit,
and what is demanded is not being provided. Utility is minimized.
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Black markets: These also arise, some consumers are willing to pay
more, informally or formally for a good. Underground markets are inequitable,
and frustrate the efforts sought by the price ceiling.
Welfare loss: loss in surplus for both consumers and producers)/Allocative inefficiency
Consequences:
- Consumers: consumers who are able to buy the good at the lower price are better off, and helps prevent
consumer exploitation/negative effects during inflation.
- However some customers will be unhappy as they will not have access to the goods.
- Producers: producers are worse off, because the price ceiling means they sell a smaller quantity of the good.
- Helps maintain competitiveness in overseas market.
- Government: no gains or losses, as no budget is used. However, they may lose political popularity, and have
to deal with black markets.
Examples include:
● Rent control, in order to allow housing to be available to those with a low income.
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Rice bread and other staple food, which is necessary for people with lower income.
Market failure
Any situation where the allocation of resources is not efficient.
a situation where the quantity of demanded by consumer equates to the quantity supplied by producers. This is called
allocative inefficiency, and it involves the over-allocation or the under-allocation of resources.
Pareto optimality: THe point where no one can be made better off without making someone else worse.
Externalities: when someone outside of a transaction (a third party) enjoys the benefit or costs.
Marginal social benefit (MSB) : The benefit individuals and society as a whole receive from the consumption of one
more unit of a certain good.
Marginal social cost (MSC) : The cost individuals and society as a whole pay for the consumption of one more unit of a
certain good.
The MPB and MPB refers to the benefits and costs to individuals involved within the transactions. If these differ from
marginal private benefit and marginal private cost, then there are externalities.
If MSC= MSB, there are no externalities, because ultimately, society as a whole do not receive extra or pay for anything
more. This is called the social optimum.
Negative production externalities (negative change in supply): The cost third parties suffer from the production of a
certain good or service (producer). For example, a coal produces a significant amount of air pollution which could take a
toll on the health of others.
Because the consumption of coal produces extra costs to society, the marginal
social costs is higher up, reflecting the full cost of production which takes into
account the entirety of society.
This is not a shift in the supply curve, but rather a “true” reflection of the supply
curve. Therefore to cover every single cost to society , the cost of the good should
be higher. Therefore, we can conclude that production is higher and price is
lower than it should be in , and that total marginal social costs are greater than
total marginal social benefit. Because p* Q* represents the optimum
production, anything from that represents the deadweight loss and is a
negative externality, as the marginal cost to society of producing more than
Q* is one that is greater than the marginal benefit of doing so.
Potential solutions:
Taxes : By taxing a good, the MPC, will shift to the left. This will mean that more of the negative effects to society are
covered by an increase in price. This tax covers a portion of the externality cost, meaning that the total loss to society
is not as large. In addition to this, increasing a price will also decrease production (e.g Carbon tax)
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Internalizes externalities: costs are now paid by consumers/producers. Allows firms who would have not
previously paid a high cost to face the damage they are producing, cutting down on output.
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Gives incentive for firms to further cut down their use of polluting technologies, and innovate into cleaner
energy as this will mean they pay less.
Provides firms with flexibility: Some industries will find it difficult to reduce pollution levels dramatically. Tax
will give them flexibility, and prevents them from losing large quantities of revenue. This will mean that they will
ot become uncompetitive and potentially leave the nation.
Hard to put a value on the effect of pollution and to quantify . It is also difficult to identify which firms are
polluting and to what extent the firms are causing the pollution.
Firms may simply ignore the tax and continue polluting due to low price elasticity of demand.
Cost of measuring the pollution
Cap and trade schemes:
The government sets a national target for emission reduction, and encourage firms to meet the targets by creating
permits for polluting. Firms can sell its permits to other firms in order to earn more revenue, resulting in a continued
incentive to reduce pollution. The maximum level of pollution will also remain the same within a nation.
- Limits overall level of pollution within nation : definite decrease in pollution within a nation. There will be a
definite decrease regardless of price elasticity of demand.
- Allows flexibility for firms: firms who can’t reduce pollution can obtain permits from firms who can reduce
pollution. This will prevent businesses from being badly hurt.
● Difficult to set value: if the maximum level is set too high, it will not have the desired effect of cutting pollution
levels. If it set too low, the permits become costly, causing economic hardship.
● Cost of measuring pollution levels
Legislation and regulation: Laws and regulations may be enacted which will decrease the spillover costs. Thus, this
will move the MSC closer to the MPC in an effort to reduce the production of negative externalities. However, a
government may also implemented measures to charge firms more heavily,, shifting MPC closer to MSC. ideally they
will want MSC=MPC.
● Simple and implemented easily. The technical difficulties in enforcing a tax, and deciding the cost of a tax
make it more practical to involve regulations.
● Forces firms to comply.
● Do not allow externality to be internalized, creating no market incentive to further reduce their level of
pollution upon the legislated amount. Unable to make distinctions between firms that have higher costs of
pollution and lower costs of pollution.
● Economic hardship for firms who cannot immediately comply with the regulation. Might severely reduce
competitiveness/revenues earned.
● Hard to set up and police the regulations which would have been put up. Black markets may arise.
Negative consumption externalities: (negative change in demand)
External costs can occur on the consumption, where a person’s use of a product
affect other adversely. The benefit of a certain good that is enjoyed by a consumer is
greater than society’s benefit. This is because that although the consumer may enjoy
consumption, others will have to pay some of the costs of consumption, meaning MSB
is less. (Cigarettes. )
If the market were able to incorporate all the associated costs with the consumption
of this good, it would demand fewer of the item, and also value them less. The
welfare loss is that of the MSB and the MSC.Anything produced past Q has a
MSC>MSB, resulting in a welfare loss. THIs is the amount of output that is
overproduced relative to the social optimum.
Difference in BC is known as the ‘external cost’
- Demerit goods: goods that are considered to be undesirable for consumers, but which are overproduced by the
market.
Potential solutions:
Legislation: Government can ban the consumption of goods with high spillover costs to society. (E.G: ban on harmful
drugs). Shifts MPB towards the MSB, reduces the size of the externality
● (given above)
Taxation: In order to internalize the externality, governments may tax the good. A tax would increase the MPC, and
shift it to the left, thus reducing consumption, and bringing the point of production
closer to the optimum level of production at Q2. leads to greater allocative
efficiency, as it reduces the welfare loss.
● Internalizes externality. Creates incentive for consumers to change
their consumption, as they are directly facing the cost.
● Produces government revenue which can be spent on advertising
campaigns.
● Inelastic demand of cigarettes tend to mean that taxes do not
manage to reduce quantity demanded by a lot, and so a heavy tax
will need to be applied, will not be politically favorable.
● Some people may consider cigarettes, necessities, unable to forego them, and thus simply lower their
standard of living.
● May lead to black markets/strengthening of crime
Advertising and persuasion: Governments can persuade consumers to change their behavior. This can be done through
advertising the negative effects of the consumption of the good. This will result in a shift in the MPB, as consumers will
find the good less desirable than before. The price decreases, as does quantity consumed, with less influence than a
specific tax.
● Simpler, and less difficult to assess extent of damage.
● Less resentment towards the government/does not affect living standard/state of businesses.
● Cost of government advertising campaigns, meaning there are less funds available for use elsewhere.
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May not have much effect, as some teenagers still continue to smoke despite knowing the dangers.
Positive externalities of production (Positive movement of supply)
External benefits created by producers. For example, when a firm provides high quality training. When these employees
leave they will be able to benefit other firms. As such, the MPC is greater than the MSC. In addition, these also include
research and development.
In all of these situations, a producer is producing a good that benefits
others beyond its consumers.
The MSC, which is the true cost to society, is lower at every point than the
private cost being experienced by the firm. This suggests, that total utility
will be maximised to society as a whole if the good is produced at point
Q1, and at the current state, the market is inefficiently allocating
resources. society would enjoy the extra benefit of production. This can
be seen through the pink triangle, which is the potential welfare gain.
Potential solutions:
● Subsidies: The government can actively encourage extra production
through providing a small payment to a firm. This will shift the MPC,
downward, lowering the price, allowing for more consumers to enjoy the
production, and resulting in an equilibrium price that will be closer to the optimal point.
●
Direct government provision: Governments often engage in research and development for new technology,
(medicine). The government can also directly provide training for workers, thus resulting in the MPC shifting
downwards as more goods are being produced for every cost.
Positive externalities of consumption (positive movement of demand)
: External benefits created by consumers. For example, additional years of
education can create strong spillover effects to the rest of society. As such,
we can say that the social benefits of a certain good exceeds the private
benefit.
Left alone, the market will produce Q. However the optimum point is at Q1. If
society’s true value for the good was included, the price would be higher than
it is. As such, it demonstrates that society would gain considerably by
providing more of this good as by producing at this new price, they will have
reached a point where they would have maximised utility. The amount of
potential welfare gain is the pink triangle, and it illustrates the loss of social
benefit due to this underproduction.
Merit goods: goods that are held to be desirable for consumers, but which are underprovided by the market. May be
underprovided due to consumer ignorance, positive externalities and low levels of income and poverty.
Potential solutions:
●
●
●
Subsidies: Governments could provide money to the firm, and thus it will shift the MSC downwards, thus making
the new price closer to the socially efficient level of the good.
○ However, there might be problems related to the cost of such a move. Some developing nations will not
have the money necessary. Difficulty in analysing size of externality .
○ Susceptible to political pressure, as different groups will compete to receive benefits.
Use of positive advertising, which will shift the MPB curve to the right and thus closer to the MSB.
○ High cost to advertising for something which may not necessarily work. (e.g: in cases within developed
countries where people simply lack the resources to put their children through schooling)
○ In addition to this , the effect may only be effective in the long run, and the benefits will be minimal in
the short run.
Direct government provision: (public health) Increases MPC/MSC/Supply, shifting it outward.
○ Involve the use of government funds. Choices must be made on which goods to provide
○ Difficulty in analysing size of externality
○ Susceptible to political pressure, as different groups will compete to receive benefits.
Public goods:
Public good: goods which are non rivalrous and non excludable in nature. E.G: National defence
Non-Rivalrous: Consumption of good does not prevent others from enjoying it
Non-Excludable: Producer cannot prevent particular individuals from enjoying
The fact that these goods are non-excludable means that no-profit maximising firm will be able to benefit form
producing a good they cannot sell at some price. This failure to produce this good results in a market failure as no
resources are allocated to produce this good.
Free rider problem: When people can enjoy the use of a good without paying for it. (non-excludability)
Solutions
- Direct provision of the good: The government will have to directly finance the production of the goods the
private market will be unable to produce.
Common access resources
Natural resources over which there is no established private ownership, but can be used up. (Non-excludable but
rivalrous) (E.g: Fishing grounds, forests and pastures. )
The nature and the inability to charge for them may encourage overuse/over-consumption, which will eventually lead to
depletion of the resources. For example, it is in the interest of fishermen to take as many fish as they want, as every
extra fish will add marginal utility for the individual. Hence, people continue to fish as the benefits to the individual
outweigh the external cost to the whole group.
Sustainability: Fulfilling the needs of those in the present without reducing the ability to meet the needs of
future generations.
Solutions:
-
-
Clean technologies: Use of renewable resources such as solar power , wind power etc. can be used to help
encourage sustainable development. Government can encourage this through subsidising research into this
technology, or provide a subsidy to a firm if they utilize clean technology.
Cap and trade, regulation and taxation (mentioned above)
A problem facing the enforcement of these sort of regulations is the lack of cooperation, as laws may be different from
place to place.
Macroeconomics
Economic activity:
Households: Consumers
-
Owners of land, labour, capital and entrepreneurship. Firms repay them through wages, rent and interests.
Firms
-
Buys factors of production and uses them to produce goods and service. Households repay them through
household expenditure (consumer spending)
The circular flow of income shows that in any given time period:
the value of output produced in an economy= total income needed to produce that output= expenditure made on
purchasing output
Leakages and injections
Imports and exports
- Some of the money or factor of productions will be spent/given to foreign firms, thus meaning that the
money/F.O.P will leave the domestic economy into a foreign economy.
- However, the opposite effect will happen, with exports, bringing back revenue from foreign individuals to
domestic firms.
Savings and investments
-
Some consumers save their money rather than spend it. This is considered a leakage as it is money that is not
spent to buy goods and services.
However, money which is saved is also available for investing, with firms using this money to purchase capital,
or individuals using it to purchase housing, injecting it back into the flow.
Taxes and spending
- Government's first draw tax money from the population, acting as leakage of income from the government.
- The money should then eventually re-enter the model as governments spend on salaries and infrastructure
within the economy.
Leakage>Injection
- Fewer goods are purchased, firms cut back on their output/buy fewer factors of production, unemployment
increases, and household income is decreased.
injection>Leakage
- Size of the circular flow increases. Consumers demand more goods and service, firms begin to produce more,
demanding more factors of production, unemployment decreases and household income increases.
GDP/GNP
Gross domestic product: The market value of all final goods and services produced in a country over a time period. (This
means that it includes foreign firms producing in a domestic firm)
As the circular flow of income implies expenditure=income=output, the GDP can be measured in the following three
ways:
Expenditure method.
Method counts the total spending on final goods and services within a given year.
- Final refers to goods and services that are ready for final use, and be contrasted with intermediate goods and
services.
GDP= consumption (all purchases by households) + Investment (Spending by firms on capital goods/ spending on new
construction) + Government spending + net export (exports- Imports)
Income approach:
If all spending on goods and services within a market must be income to firms and individuals receiving payment, it is
possible to arrive at an accurate GDP by counting the income received by individuals within a certain year. It measures
the returns for the factors of production, which means wages, interest, rent, payment as well as business taxes (as it
represents production) and fixed capital consumption
Output approach:
Government measures the value added at every level of production, thus using it to see how much the goods and
services produced within a country is worth. Only value added is counted to avoid double counting.
GNI : total income received by the residents of the country/value of all final goods and services produced by the factors of
production supplied by the country’s residents.
- Measure the flow of income based on actual ownership of productions. This means that it will
include domestic firms production abroad, and not include foreign firms producing domestically.
GNI= GDP + net property income from abroad
Real GDP : nominal GDP adjusted to remove the influence of changes in price.
Nominal GDP: GDP at current price levels.
Per capita GDP: reflects productivity of a certain country. GDP per population. Is useful as a measure of standard of
living, as it provides an indication of how much of total output can be attributed to one person.
GDP is useful for:
1. Political power. Governments can utilise this information to convince voters or to sway opinions.
2. Evaluation of economic performance, and economic productivity
3. Policy adjustments: with this information, governments can know what sort of policy would benefit the
economy, and what would not.
Evaluating GDP
Inability to measure ‘true’ GDP:
● GDP/GNI do not include non-marketed output: Some goods and services is not sold in the market and does not
generate any income. (Unpaid output is not counted. Volunteer work, which are desirable, is not quantified. )/
No information regarding parallel/underground markets.
● Does not take into account improvement in quality: Technological chances which can benefit consumers are
not shown at all on the GDP/GNI.
● Under reporting the loss of natural resources: These may decrease society’s well being in the long run.
● Do not take into account different price levels within economies, making it difficult to compare two countries.
Why measures of the value of output cannot accurately measure standards of living
● Negative social behaviors and transactions are added to the GDP. (Composition of the output is a mystery). No
distinctions about how much they actually contribute to the standard of living.
● Cannot reflect achievement in levels of education, health and life expectancy: These contribute massively to an
improved quality of life, which can be brought on by technological improvements.
● No information about income distribution: High GDP may be simply in the hands of a few.
Green GDP: Seeks to estimate a country’s aggregate output while also factoring in any output losses created by
environmental harm. However it is difficult as this harm is hard to quantify.
Business Cycle:
Decrease in GDP: A decrease in GDP value
Decrease in growth: a slowing down of growth
- Fluctuations in the growth of real output, consisting of periods
of expansion/contraction are called business cycles.
The trend line shows how in the long term , economy is growing.
This is because of an increase in population and an improvement in
technology.
Potential output: represents the output when the economy is
producing at full employment (unemployment: NRU)
Aggregate demand:
Total demand/output for a particular nation’s goods and services at a range of price levels at a particular period of time.
. (THe same as the GDP)
●
Consumption: Measures all spending by domestic households on goods and services during a particular period
of time.
● Investment: Measures the total spending by firms on capital equipment as well as labour. The level of
investment in a nation is a function of the national output.
● Government spending (G): Government spending on goods and services. (transfer paying such as state pensions
and job seekers allowance are not included, as they are not a payment to a factor of production for any output
produced, these simply increase consumption, NOT FACTORS OF PRODUCTION. .)
● Net export (X-M): The total income earned from the sale of exports to foreigners minus the total amount spent
by a nation’s households on goods and services from other countries. Trade deficit and trade surplus can be
seen through this.
As AD increases,there is an injection into the flow of income, thus resulting in a rise
The slope moves downwards because:
1.
The wealth effect: (wealth refers to the value of assets that people
own). If the price levels increase, the real value of wealth falls. People feel worse
off and cut spending.
2.
The interest rate effect: In response to a rise in the price levels, this
causes an increase in the demand for money, thus raising the interest rate,
causing less to be spent as firms and households find these higher interest rates
unattractive. Thus resulting in a fall in quantity demanded etc
3.
The net export effect: As the price level in a particular country falls,
more goods will be demanded from foreign nations, thus increasing quantity
demanded.
A shift in Aggregate demand will arise when one of components of Aggregate demand changes.
Consumption:
.- Level of national income: As people have more money, or income, they spend more on goods/services. This will be
affected by personal income taxes.
interest rates: decreasing interest rates will mean more spending
- Consumer confidence: Optimism consumers have about the economy. If they feel safe, and believe their incomes to
increase, they will spend more.
- Wealth: an increase in the value of assets makes people feel well-off, prompting them to spend more.
- Household indebtedness: if indebtedness is high, they are under pressure to make monthly payments,
Investment:
- Interest rates: If interest rates rise, firms will be less willing to consume
- Business confidence: How confident firms are about their future sales. They will spend more.
- Technology: When new technology arises, firms will spend more on new technology.
- Degree of business tax: A high business tax means firms will have less incentive to spend on consuming goods.
- Corporate indebtedness:
Government spending
- Depends on the government’s fiscal policies, (the use of taxes and spending to stimulate or contract the level of
AD), and the government’s political/economic priorities
Net export:
- Incomes abroad: If a major trading partner’s incomes fall, then exports will also fall for that country.
- Exchange rates: lower exchange rate will mean people are more willing and able to consume the good
- Protectionism: If a country has a very protectionist approach, such as trade barriers, then most likely, there will
be less exports.
Aggregate supply:
Total amount of goods and services that all the firms in all the industries in a country will produce at every price level
in a given period of time.
Short run: All input prices are fixed (all costs of production are fixed)
Long run: Factors of production are all flexible
As price level increase, firms profitability will increase, due to the
unchanging costs of production.
Shifting in supply curve:
A rightward shift means that for any particular price level, firms
produces a larger quantity of real GDP.
1. Cost of production (change in input prices): Cost of production
will increase, thus meaning producers are less willing and able to
provide goods. If costs increase while at the same price, firms are
unable to produce as much. wages/non-labour cost of productions.
2. Indirect taxes/subsidies: Taxes will move to the left, subsidies will move it to right.
3. Supply shock: A change which suddenly disrupts the supply of a good. Unfavorable weather or war will result in
supply curve shifting left.
Equilibrium in the short run
Equilibrium level of output occurs when aggregate demand intersects aggregate supply. The output of an economy can
either be in a deflationary, inflationary or full employment depending on it’s location from the point of output where
there is full employment.
- Recessionary gap: where real GDP is less than potential GDP
- Inflationary gap: where real GDP is greater than potential GDP
These three phases correspond to the positions of the business cycle.
-Shifts in either AD or AS will change the level of output, and thus, affect the economy.
- When Aggregate supply shifts inwards, it will lead to a situation where output decreases (real GDP) and prices rise.
This is known as stagflation, and is a term coined in the 1970s to describe the oil price increase by OPEC.
- Aggregate demand will affect the output of the economy, and the general price level experienced.
Long run aggregate supply
Here we assume there is maximum/full employment, as this is in the long run where all markets must be clear. Neomonetarists believe that in the long run, an economy will always produce at the level of potential output because wages
and cost of production will be flexible, and mean that firm’s profits will remain the same. (SAME AS THE EDGE OF THE
PPC, MAXIMUM PRODUCTIVE CAPACITY OF THE ECONOMY)
-
-
As the definition of long run incorporates a chance in price, wages will change constantly to match output price.
As price level rises or falls, firms’ profits remain the same, so they no longer have any incentive to
increase/decrease output.
As AD shifts outwards , when firms profits increase, firms therefore increase quantity of output produced by
moving upwards along the SRAS curve.
- In order to produce this, firms have to hire more workers/capital. This increases scarcity, and results in
the rise of wages/rent etc. This results in the shift of the SRAS curve inwards, and the firm is back at the
original point.
-
As AD falls from AD2 to AD3, initially, we will see a decrease in output as Aggregate demand shrinks. Firms
therefore cut back on labour and wages/payments for other factors of production.
- Due to unemployment, and a decrease in the wages of workers , the supply curve thus shifts outwards
as it becomes easier for firms to hire and workers become willing to accept lower wages. This returns
output to the maximum amount.
This is based on the assumption of wage and price flexibility in the long run. Ultimately only price level is affected.
Keynesian model
The monetarist model depends on wage flexibility, which Keynes argued
against. He described the concept of downward wage rigidity which arises
from :
Labour contracts fix wage rates for certain periods of time
Minimum wage legislation
Worker and labour unions resist wage cuts.
Because of this, firms will avoid lowering prices because that would reduce
their profits. The inability for wages to change means supply does not shift,
This inflexibility in both wages and price is represented by the horizontal
section of the the AS curve. This implies the economy can be stuck in a
deflationary gap for quite a while.
. As AD falls from AD to AD1, there is a small decrease in price levels, as
their cost of production cannot be lowered, but instead, they lay off
employers and reduce output.
-
On the other hand, when demand rises from AD1 to AD1, the price levels do not increase by a large amount, as
there is a large extent of spare capacity for the firm. Firms can easily produce more without affecting their
production costs, thus meaning that they do not really need to raise prices.
After this, there is an inflexible part of this curve. This demonstrates how an increase in output produced will lead to a
large increase in price level. A bottleneck appears, and there is no longer spare capacity. Wages and prices within the
economy rises, and firms will have to increase price in order to maintain their profit margins.
-
The completely vertical point of the curve comes when all labour and resources are used. Real GDP cannot
increase because firms are using the maximum amount of labour, and can only pass on the excess demand as an
added cost.
Equilibrium output occurs at any point there is an intersection between LRAS and LRAD.
Keynesians model the short run analysis, when costs are unable to change, and aggregate demand is too low to buy
enough output to reach the potential output. This increase in AD may not be inflationary.
Shifts in aggregate supply (Keynesian) :
An increase in potential output signifies economic growth over the long term, while a decrease signifies negative
growth.
1. Increase in quantities of factors of production: if the quantity of a factor of production increases, the LRAS and
Keynesian curve increases. The economy is now able to produce more real GDP.
2. Improvement in the quality of factors: Improvements in resource quantity shifts the LRAS and AS curves to the
right. (greater level of health, education etc.)
3. Improvement in technology: an improvement in technology of production means that the factors of
productions can be used more efficiently, and more output can be produced with the given resources available
in the economy (fertilizer) .
4. Institutional changes: Altering the degree of public/private ownership, the degree of government regulation,
competition, bureaucracy etc. can affect the way /efficiency of resources used within an economy.
Long term growth: increases in output brought on by a rise in potential output (LRAS)
Short run growth: increases in AD or SRAS which bring about rise in output
Unemployment
An unemployed person is someone who is of working age who is actively looking for a job but who isn’t employed.
Unemployment and underemployment means that the economy is wasting scarce resources by not using them fully. (in
underemployment, some resources which were used for training and education are wasted when people are forced to
work at a job that does not make use of their skills)
Unemployment rate can be calculated through:
𝑁𝑁𝑁𝑁𝑁𝑁 𝑁𝑁 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁
× 100
𝑁𝑁𝑁𝑁𝑁𝑁 𝑁𝑁𝑁𝑁𝑁
It can be said to be used to measure the wellbeing of workers in a nation.
Unemployment rate’s limitations (factors which make the unemployment rate an inaccurate measure) :
So called hidden unemployment can exist within an economy, and make it more difficult for economists to measure this
value.
- Hidden Unemployment for individuals who are out of job but have given up the search for work. This
undermines a serious problem, and may mean in the long term, what may appear to be a decrease in
unemployment may just be a discouraged workforce.
- Another form of hidden unemployment refers to those working in the underground economy/informal
sector.
- Underemployment: the label ‘ employed’ does not take into account the number of hours or the level of
income one earns. Part time workers who would like to be full time are considered employed, despite how
they feel they are underemployed, and are barely able to make ends , or are unable to fully fulfill their potential.
- Some people may be overqualified for certain jobs, and their dissatisfaction with their job is not
reflected, nor is the loss of potential output.
- Difficulty in measuring unemployment amongst different social groups: certain regions, genders, ethnic groups
or ages may suffer greater than others.
Consequence of unemployment:
Economic costs
○ Loss of real GDP: since fewer people work than are available to work, the amount of output produced is lower.
The country is producing within it’s ppc curve, and it is not being productive with it’s resources.
○ Loss of income for unemployed people: people who are unemployed do not have an income from work, and
they will be worse off financially, weakening demand further, and meaning they will suffer from a lower
standard of living.
○ Loss of tax revenue and increased cost for unemployment benefits, forcing a budget deficit and resulting in a
opportunity cost
○ Unequal distribution of income: since certain groups may be harder hit than others, the effect of income
inequality and poverty tends to be concentrated amongst groups which are already disadvantaged to begin
with. This may lead to social tensions and unrest.
○ Unemployed people may have difficulty finding work in the future due to the loss of skills, even in economically
favorable times.
Personal costs:
○ Decreased household income/purchasing power. Inability to sustain standard of living
○ Stress/psychological illnesses, and demotivation. May result in the breakdown of family, family
tensions and a lower self esteem.
Social costs:
○ Increased poverty and crime/Homelessness
Types of unemployment
Frictional unemployment: People who are in between jobs or have just entered employment and do not have a job.
Seasonal unemployment: people who are unemployed due to the fact that their job depends on the seasons, and so are
unemployed otherwise .
a. If workers cannot be matched to the firms who demand jobs very quickly, frictional unemployment
would last. Due to incomplete information and logistical errors, it becomes difficult for this to take
place. Can be corrected via improved information flow.
Structural unemployment: When a worker loses his job due to the changing structure of the nation’s economy, the
individual becomes structurally unemployed. For example, when a developing country moves from an agricultural base
to a manufacturing base. ( When oil demand falls in the 1980s, or
the automation of the car industry in the US during Obama’s
administration)
b. Change in demand for particular labour skills: This
can be due to new technology which make a
certain job redundant, or the fact that a certain
industry within the economy might be declining.
Change in consumer tastes may also contribute to
this. This leads to a mismatch between the labour
skills demanded and supplied by workers.
c. Changes in the geographical location of jobs:
When a large firm or industry moves from one
region to another, there is a resulting fall in
demand. This results in a mismatch
Labour rigidities instigating unemployment
Higher than equilibrium wages and employment protection leads to higher cost of production for firms, causing the
supply curve for products to shift inwards, leading to a smaller quantity produced. Unemployment can also arise from
minimum wage legislation.
Structural unemployment is a serious type of unemployment because it tends to be long term. Governments can include
measures to encourage workers to retrain or obtain new skills etc.
Natural rate of unemployment:
Structural, seasonal and frictional employment that is considered ‘natural’ and an unavoidable part of the economy.
Unemployment that exists when the economy is still producing at maximum capacity. Thus a shift in the LRAS is due to a
decrease in these factors.
- Recessionary gap: Natural rate<Unemployment
- Inflationary gap: unemployment<natural rate.
Cyclical unemployment/demand deficient unemployment
Unemployment that arises due to fluctuations in the business cycle. Occurs due to a contraction in private or public
spending, and meaning that firms lay off workers in order to preserve their profit margins and due to the fact they don’t
have a need to produce a high level of output.. In the upturn of the business cycle, the recessionary gap becomes
smaller and cyclic unemployment falls.
● Recalling keynesian theory: As demand for their goods and services fall, firms cannot decrease their costs of
production due to sticky wages, and instead hire less people.
● Demand side policies can be used to control this.
Inflation
Inflation: The persistent increase in the average price level of goods and services in a nation over a minimum of two
quarters.
Deflation: Decrease in the general price level over time.
Disinflation: Decrease in the rate of inflation.
Consumer price index:
measure the change in prices of a basket of goods and services consumed by the average household (cost of living for
the typical household). Price index is calculated by:
𝑁𝑁𝑁𝑁𝑁 𝑁𝑁 𝑁𝑁𝑁𝑁𝑁𝑁 𝑁𝑁 𝑁𝑁𝑁𝑁𝑁 𝑁𝑁 𝑁𝑁𝑁𝑁𝑁𝑁
𝑁𝑁𝑁𝑁𝑁 𝑁𝑁 𝑁𝑁𝑁𝑁𝑁𝑁 𝑁𝑁 𝑁𝑁𝑁𝑁𝑁 𝑁𝑁 𝑁𝑁𝑁𝑁
x100 = CPI (for august)
Shortcomings of the CPI
1. CPI does not reflect the purchases of all households in a nation: not all nation’s households are typically in that
the income of a nation is evenly distributed. Some consumers will purchase different basket of goods, and as
such, the CPI may overstate/understate the consequence of inflation relative to the other goods.
2. Consumers may use coupons/discounts and consumer consumption patterns may change due to fashion or
changes in price of the goods.
3. CPI does not reflect changes in the quality of products produced and consumed: E.G, when TVs evolve
technologically, although CPI is higher, consumer satisfaction may be high due to improved quality/technology.
4. Cpi does not measure food/oil rates: This eliminates the sudden swing in prices of food/fuel. However, food
and fuel may make up a significant proportion of total expenditure.
Food and oil is not part of the CPI due to their price volatility. This is done through considering the core cpi which does
not include this.
Producer price index: A basket of goods made up primarily of intermediate products such as capital, raw materials and
energy. Increase in PPI will affect AS, and the costs of production of firms.
Consequences of inflation
Disadvantages:
- Greater uncertainty: inability to predict what inflation will be in the future mean people will be less inclined to
make economic decisions. Firms cannot make future plans about cost and revenue due to uncertainty, and be
unwilling to invest. This could negatively affect AD
- Reduced purchasing power: For individuals whose income does not rise, there is a loss in purchasing
power/standard of living due to a decreased real value. Especially hurting fixed income earners.
- Reduction of competitiveness: High inflation means goods are less attractive to foreigners due to their
comparatively higher price. Will negatively affect AD within an economy.
- Savers and Lenders hurt: Higher rates of inflation will hurt people who will save money, due to a decrease real
value in savings, and also hurt lenders due to interest rate being lower in real terms.
- Fiscal drag: individuals who demand a higher income may find themselves dragged into a higher tax bracket,
thus meaning they lose out more.
- The inflationary spiral:
1. When demand pull inflation occurs, the economy produces beyond it’s full level of employment.
2. The expectation of high demand means workers demand higher wages in order to offset the decline in
real wages caused by higher prices. (Known as inflation expectations)
3. This results in an increasing scarcity in factors of production, which will lead to cost push inflation.
4. This inflation means an increase in spending, due to a decreased value in interest rate, and a reduction
in the value of previous debt accumulated, leading to more demand pull inflation.
Benefits:
- Provides greater working incentive: while the increase in wages less than inflation rate might not actually mean
an increase in real income, this provides a greater incentive for workers to work harder.
- Benefits firms: Firms can increase wages at a value where it is still lower than the inflation rate. This will allow
them to save money, investing it in other areas to promote growth or to help it survive if future recessions
occur.
- Promotes stable levels of consumption: By having a continually stable rate of inflation, consumers are
incentivised to keep on spending due to decreased interest rate and the expectation of high price. This will help
generate growth, create income etc.
Types of inflation:
- Demand pull inflation:
An increase in demand will lead to an increase in the nation’s price level. An excess of aggregate demand over
aggregate supply at the full employment level of output. Caused by an increase in aggregate demand.
-
The degree to which inflation increases price depends on the point on the SRAS. If it is near full levels of
employment, an increase in demand will simply push prices up,
However, if the economy is in a recession, an increase in aggregate demand will result in a relatively small
increase in price level.
-
Policy makers need to be aware of the point in the economy at which it is currently producing, which means
that if it is a recession, a increase in aggregate demand will be highly beneficial.
Cost push inflation
Arises when the costs of production to a nation’s firms increases. This depends
on the cost of production of the nation’s firms. (described using Neo-monetarist
model) bear in mind that the gap cannot be called a deflationary gap as it is
caused by supply not demand.
-
Decrease in productivity, or increase in costs of production will shift a
nation’s SRAS inwards.
Leads to both inflation and a fall in real GDP. (with more
unemployment), known as stagflation. This contrasts with demand pull
inflation which results in less unemployment.
Deflation:
(in japan from 1999 to 2006)
Supply side deflation: Occurs when aggregate supply shifts outwards, and the economy has become more productive.
This increases employment, output and the real income of households.
● Can arise from a rightward shift in the LRAS, so that the new equilibrium occurs at a lower price level.
● This is ‘good’ deflation as it is associated with economic expansion, rising income and output and growth.
Deflation due to fall in AD:
Demand deficient recession leads to rising unemployment and puts downward pressure on price. This is unlikely due
to the presence of sticky wages, however if low demand persists over a long time, the price level falls.
- This is associated with recession, falling incomes, and cyclic unemployment
Consequences:
●
●
●
Redistribution effect: opposite of inflation.
Deflationary spiral:
1. Consumers postpone making purchases as they expect prices to fall.
2. The real value of interest rate increase, and the real size of debt increases. This further disincentivizes
spending.
3. Firms receive less revenue, and lay off workers.
4. Consumption decreases.
Bankruptcy: as the real value of debt increases, individuals cannot pay back banks. This leads to large financial
institutions going bankrupt, and causing a financial crisis.
Economic growth and equity
Economic growth: an increase in real GDP
PPC: shows combination of maximum output that can be produced by an economy with fixed resources and
technology, provided there is full employment of resources.
-
-
An outward shift in a nation’s PPC shows that the nation is able to
produce more of everything. This means that the productivity of the
labour and capital with an economy has increased (shift in LRAS)
- Increase in quantity of resources.
- Increase in the quality of resources.
When there is a point moving from inside the curve to the actual curve,
this is considered economic growth (a decrease in inefficiency) . This
would be a movement from a point below full employment to a level of
full output. (an increase in the short run)
- Decrease in unemployment/productive inefficiency
In the short run, if an economy is producing at full employment experiences a rise in
AD, it will produce at level beyond full employment level. This will cause overheating,
and eventually the AD will fall back due to an increased cost in labour.
An increase in AD puts pressure on the limited resources in an economy, possibly
leading to demand-pull inflation, and thus a decreased SRAS. This depends on how
much spare capacity the economy has to meet rising level of demand.
However, in the long run, an increase in GDP is achieved when the nation’s full employment level of output increases
(when LRAS shifts outwards as a result in an improvement in the quality/quantity
of resources) .
Without an increase in AS, the economy's ability to grow is restrained to the fullemployment level by it’s limited supply of land, labour and capital. A nation’s
LRAS, reflects its production possibilities given its existing stock of resources.
Causes of economic growth:
An increase in economic growth can be achieved through investment in these areas:
- Physical capital: human made resources which are employed in the production of goods and services
- Increases in the quantity and quality of physical capital are among the most important sources of
economic growth over long periods of times.
- Human capital: improvement of human productivity (skills abilities, knowledge and health which can be
improved through education/healthcare. )
-
Increase in quantity are unlikely to be helpful, but increases in quality is an important source of growth
(germany 1960s)
- Natural capital: land/natural resources. Can be improved through planting more forests, improving soil quality
etc.
- Consistent investment in natural resources is necessary for long term growth.
Productivity: quantity of output produced for each hour of work of the working population.
Consequences of economic growth:
-
Increased in employment. This is due to how demand for labour is derived from the demand for goods. This
leads to a further increase in standard of living.
- Fiscal dividend: a growing economy boosts tax revenue, providing the government with more money to
finance spending projects
- Accelerator effect: Increasing consumer demand and output encourages investment in new fixed
capital machinery, allowing for further increases in aggregate supply.
Negative effects to the environment and physical health
Increase in inflation: Growing costs of living due to higher living standards, however this depends on the state of the
economy, and whether or not the economic growth is accompanied by an increase in long run aggregate supply.
Unequal income distribution: Gain in income may only be to a selected few
Balance of payments: increased in income is likely to demand more foreign goods. This will generally cause a trade
deficit, and may result in foreign nations purchasing domestic assets.
Income inequality:
Equality: Where everyone has equal amount of resources.
Equity: The idea of ‘ fairness’
Due to the inequality in the ownership and the cost of the factors of production, income inequality eixsts between
different parties. Others who possess little education, and skills which aren’t economically productive will recieve less.
Transfer payments: receiving income or funds without any provision of good/services or ‘work’ . Government payments
to vulnerable groups within society to help with income distribution.
- Old age pensions, child allowances, unemployment benefits.
Governments often provide goods directly, or subsidise a variety of socially desirable goods and services. This is
because it is underprovided by the market, or too costly, as governments must ensure this is accessible to the lower
class as they are considered basic human rights. (free primary school care, and the NHS within the UK)
Class of taxations
- Proportional tax: tax for which the percentage remains constant as income increases. The rich will pay more
tax than the poor in absolute terms, but the burden of the tax is equal.
- Regressive tax: Tax for which a larger burden is placed on lower income households. Indirect taxes are
considered regressive tax, because both parties pay the same amount in absolute terms, and due to the lower
income of those with low income, this is a greater percentage.
-
Progressive tax: tax for which percentage increases as income increases
- Most income/direct tax
Policies to redistribute income
1. Increasing progressive tax , while reducing regressive tax:
- Poor will be able to keep a greater quantity of their income, while simultaneously allowing tax revenue from
the rich to be used to help provide monetary assistance/spending on government infrastructure.
- Taxing higher incomes at higher rates creates a disincentive to work: Acts as a disincentive to save or work
particularly among high income earners. Will reduce the incentive to take risks, start businesses etc. This
reduces the quantity of labour available in the market, reducing LRAS, and lowering AD. Overall, this will mean
lower taxes due to lower high income earners.
- Lower tax revenue if regressive tax reduced: may lead to future austerity measures.
- Allocative inefficiency: taxation affects the allocation of resources, making it different from the output within a
free market economy.
2. Increasing transfer payments: a payment made or income received in which no good or services are being paid for.
- Poor benefit significantly: Increase standard of living. Including universal benefit (transfer payments) and means
tested benefit (benefit which will be taken away once someone exits poverty)
- Increased risk of poverty trap: Low incentive to leave poverty, as they no longer have access to employment
benefits. Greater strain on public fund.
3. Legislation:
- Anti-discrimination, hiring/firing mechanisms: Reduce the unequal distribution of income, making it more
difficult for firms to lay off labourers.
- Reduces negative externality: This form of government intervention can be used to correct misallocation of
resources or loss of social surpluses.
- Costly to businesses: Firms may shut down due to high cost, increasing unemployment. Firms may also leave to
different nations.
- Cost of enforcing
4. Government spending/training
- Reduces poverty
- Increase productivity of the economy in the long run: Labourer becomes more skilled, shifting LRAS outwards,
allowing higher wages/higher standard of living. Tackles the root cause of poverty.
- Extremely expensive
- Long time to take an effect
The Lorentz curve
Graphical representation of a country’s income distribution, where the x axis
represents the percentage of the population which owns a certain percentage of the
total income within a nation.
The line of equality is a 45 degree line, representing a country in which each
percentage of the population earns exactly the same as every other percentage. This
is used as comparison between different countries.
The gini coefficient: The ratio of (A/A+B) is known as the Gini coefficient. Gini index
is this value multiplied by 100. The lower the gini coefficient, the lower the
inequality.
Absolute poverty: percentage of a population that falls below a defined ‘poverty line’ \
Relative poverty: poverty defined through the comparison to a median income within a society.
Causes of poverty:
-
Low incomes
Unemployment: without a steady source of income individuals are more likely to become poor, as
unemployment benefits are usually smaller in comparison.
Lack of human capital: low levels of education and skills translate into low incomes due to the positive
correlation between education and income. Firms are unwilling to provide a high amount of wage for low levels
of capital.
Consequences of poverty:
-
Low living standards: low living standards stemming from the inability to purchase goods and services due to
low wage
Lack of access to health care/education: low income mean inability to improve human capital. This leads to
perpetually low human capital, productivity and incomes.
Economic policies
Government revenue is derived from taxation and the sale of government owned resources.
Government expenditure:
- Current expenditure: government spending on day-to-day items that are recurring. (goods that are used
/consumed). Medical, education supplies etc.
- Capital expenditure: Public investment on the introduction of physical capital.
Government budget
Government expenditure> Tax revenue= Deficit
Revenue> expenditure= Surplus
Fiscal policy: Government manipulation of taxes and expenditures with the goal of increasing or decreasing the level
of aggregate demand in an economy.
Automatic fiscal policies
Automatic ‘ built in’ functions of the economy which help reduce the severity of a recession or boom.
Economic Growth:
- Government spending on social protection, personal social services and health will naturally decrease due to
how fewer people will be collecting benefits went economic growth is high
- Tax revenues will also increase as a result with higher income and expenditure. The more progressive the
greater this effect.
- Less government spending and more tax automatically decreases aggregate demand, offsetting inflationary
pressures.
Recession
- Government spending on social protection, personal social services and health will naturally increase with
more people collecting benefits
- Tax revenues (both personal and firms) will decrease as a result of lower income and lower profits, reducing the
severity of the recession. The more progressive the greater this effect.
- More government spending and less tax which slightly increases aggregate demand, offsetting demand
deficiency.
Both of these reduces the extent of inflation/recession, and slows down these processes.
Discretionary fiscal policy:
Policy in which government explicitly spends money on public goods and services, while also reducing the level of
taxation within an economy. (Barack Obama’s American Recovery and Reinvestment act (ARRA) which included over
200 billion in tax cuts and $500 billion in new government spending)
Expansionary fiscal policy
Increases in the level of AD in the nation through policies
like decreasing tax and expenditure will be able to fill a
recessionary gap resulting from low private spending,
however a government must consider the impact of such a
move (especially inflation).
- There is a rise in disposable income: leading to an
increase in consumption spending
- After tax business profits increase, which makes it more
likely to lead to high investment, and therefore, higher AD.
-
Such a move can also impact aggregate supply. There will be an increased incentive for firms to invest in R and
D, and purchases capital goods, which will shift LRAS. This can be further stimulated by a decrease in tax rates,
which will make investing attractive.
Direct stimulus
There can also be a direct effect on LRAS through fiscal policy.
-
Government spending on infrastructure as well as on research can improve technology, and the capital available
within a nation.
Government spending on human capital can also be used to help boost the productivity of the work force.
Contractionary fiscal policy
Contractionary fiscal policy involves the use of greater taxes and a reduction in spending, which can be used to reduce
AD by reducing consumption and investment. This would put a downward pressure on the rate of inflation and move the
economy closer to maximum output.
- As personal income falls, consumption spending and aggregate demand falls.
- After-tax profits fall as well, resulting in a decrease in investment, and causing aggregate demand to fall.
Evaluating fiscal policy
Direct impact
-
It is important to note that government spending is a lot more effective than tax cut (meaning less has to be
borrowed) Spending is a direct injection into the circular flow, whereas a tax cut is simply an indirect injection
because households are able to determine how much of it ends up being on domestic output, how much goes to
imports and how much is saved, especially if they have low confidence. As opposed to monetary policy.
Can affect potential output
-
Fiscal policy can also help with improving LRAS through either offering incentives to invest, or direct investment.
Can target specific sectors
-
Fiscal policies can target specific sectors, which can help target disparity and social problems as a result
(includes education, healthcare/social groups, merit goods etc.)
Can target failing industries (e.g america’s auto industry)
Can discourage negative externalities/Positive externalities.
Deals with inflation and low economic activity, and can help bring outback to full employment.
Crowding out
- When a government runs a budget deficit when it
attempts to stimulate an economy and reduce
unemployment, the problem of ‘ crowding out’ arises.
- To run a budget deficit, the government has to borrow
money, which is achieved through selling government
bonds such as treasury bonds or bills. (loans from banks to
the government)
- This results in an increase in demand for loans from
banks, meaning that less are left for consumers, which
pushes up interest rates.
Higher interest rates reduces incentive for corporations and individuals to invest. As such, when an injection is made,
even though public spending increases, private spending also decreases, meaning that the total rise in aggregate
demand does not largely increase.
Neoclassical economists argue that crowding-out ultimately will offset the expansionary effects of a tax cut, combined
with an increase in government spending. However, during 2008-2009, due to the extremely large reserve of loanable
funds due to the low confidence of consumers, where supply of loanable funds rapidly increased (uncertain
consumers) and consumer demand for loans was incredibly low.
Time lags:
-
The time taken for policies to be recognized (which can take months or years) mean that the economy might
already out of recession by the time such policies take effect.
Political influence:
-
-
Governments may offer fiscal policy simply based on maintaining a higher votership, which may not in fact make
sense economically. Unsuitable tax policies may be enacted which include an increase in government
spending and a decrease in tax , even at the point of full employment.
President’s bush fiscal stimulus package was enacted during a recession including a very high tax rebate. This
lack of government spending pushed the economy greater into recession .
Burden on government budget:
- May be costly, and there may be a opportunity cost of such a move.
Inability to deal with supply-side effects
- If stagflation occurs, (when SRAS shifts left and the economy becomes unproductive due to high production
costs ). High inflation and high unemployment occurs, fiscal policy alone is unable to solve both problems.
Monetary policy:
Central bank: Government institutions which are free from political interference, which controls the supply of money
within an economy, acting as the government’s bankers
-
-
Banker to government:
- Holds the government’s cash and makes payments for them
- Manages government borrowing, sells bonds to commercial banks and the public
Regulator of commercial banks
- Holds deposits and makes loans in times of needs to banks.
- Lender of last resort.
Interest rate: Percentage charged to consumers when loans are made. The price
of money.
As interest rate falls, demand for goods decrease. This demand depends on the
desire for parties within an economy to buy essential goods and services (consumption
and investment) . Decreases due to higher associated cost, resulting in AD shifting left.
Supply for money is a fixed line determined by the central bank. It is not
affected by changes in interest rate.
Monetary policy; Using interest rate to change the demand within an economy.
Contractionary and expansionary monetary policy refers to policy which reduces and increases aggregate demand
respectively. Change in money supply followed by shift in AD. ‘
Like other forms of fiscal policy: How much this will actually affect price levels depends on the point at which demand
is increasing along the SRAS CURVE.
Effect of monetary policy
-
Investment:
-
-
Interest rates most directly affect investment, because firms will choose to borrow if they can earn
more than the interest they pay.
- Large scale projects are usually undertaken with borrowed money
Consumption
- Consumer spending dependant on the total cost consumers will have to pay in the long term, in
addition to the speed they will be able to repay their debt.
Inflation targeting
Many countries will aim for a certain rate of inflation. They will do this through the manipulation of the interest rates,
rather than focusing on the maintenance of both high employment and low inflation.
Evaluating monetary policy (brexit)
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-
-
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-
Quick implementation: Can immediately implemented without the need to debate policy. Improves the chances
that the policy is appropriate for that time.
No political constraints: Prevents the desire of voters from influencing the central bank’s policy. Independence
means that the government can implement decisions that are in the longer term interests of the economy.
Greater freedom in pursuing policies.
No burden on budget
Precise changes can be made (fiscal is inflexible as government spending can only be cut in large amounts):
Small precise changes can be made, and as such, it can be used to make sure that the economy is producing
closer to maximum output.
Time lags: However, despite the quick implementation, there are still delays related to the elasticity of demand
for investment, and may take a while for individuals to change their consumption habits. Lag until problem
takes effect.
Investors reluctant to borrow: During a time of deep recession, consumer and investor confidence is at a low
point. This means that even with low interest rates, individuals and firms do not spend as they doubt their
ability to pay back loans. Banks may also fear that consumers will not pay back, and so are unwilling to give out
money. (happened in great depression of the 1930s)
Inability to due with supply side instability/stagflation (mentioned earlier on)
Inflation control:
The spread of inflation during the 1970s meant that because of the unpopularity of tax increases, reducing inflation
would be in the hands of the central bank, which would be controlled via interest rates. Maintaining a low level of
inflation ( a target inflatioN) over full employment.
Supply side policies
Aims at positively affecting the production side of an economy by improving the quantity or quality of the factors of
production. (shifting LRAS)
Both types of supply side policy aim at shifting supply curve to the right, achieving growth in potential output.
Market based supply side policies
Designed to increase the incentives for labour to work harder and more productively. Institutional changes that affect
structure, institutions, and ‘ Rules’ that govern economic stakeholders, with the idea that a freer market results in
harder work, more innovation, lower prices and better quality.
Reagan’s America and Thatcher’s UK
Encouraging competition
Greater competition forces firms to reduce cost, contributing to greater efficiency in production and improving the
allocation of resources as well as the quality/quantity of the good/service. This improves the productivity of pre-existing
equipment, shifting LRAS to the right.
- Deregulation: Regulations can act as a disincentive for firms to hire workers. A reduction in the number and
severity of the regulations will help increase the aggregate supply. Reduction in the red-tape firms need to face,
as well as any government control on taxes/prices.
- Trade liberalisation: freer trade will increase competition between firms, and also allow the market to become
more efficient, allow for greater allocative efficiency. This will result in greater incentive to invest and compete,
and also allow greater profits.
- Privatisation: transfer of firms from public to private hands. Results in a larger emphasis on earning profits,
improving management and operation, thus giving a greater incentive to produce efficiently, and produce
goods of higher quality without bureaucracy . (Britain and UK in the 1980s).
Labour market reforms:
-
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Reduction in trade union powers: Reducing trade union power will reduce the ability of unions to negotiate
higher costs of labour, lowering the cost of production and stimulating greater production in addition to greater
investment. In addition, it could also be argued that it would allow more workers to move more freely between
employment.
Reduction of minimum wages/ unemployment benefits: A reduction of minimum wage would decrease the
cost of labour and increase aggregate supply due to firms hiring more individuals. . Furthermore, reduction of
benefits encourage unemployed people to take up jobs, and it gives incentive to not accept low income jobs,
reducing NRU.
Increases flexibility of wages, so it can go back to the equilibrium level and producing at full level as fast as possible.
Incentive related policies
Supply siders believe that taxes discourage work and production, and so reducing taxes encourages productivity and
expansion of business. This will mean that tax revenue for governments will increase (according to the economists), and
that too high tax rates will actually reduce tax revenue because of a lack of incentive for individuals to work.
Reducing income tax: Possibility of higher disposable income creates incentive for people to work. Shift in LRAS curve
as potential output increases, along with an increase in AD. Reducing the progressive nature of tax, increasing incentive
for people to work harder and earn more or to pursue employment (reduced NRU) . May mean people work for longer
and are less willing to become retired.
Lowering business tax: Affect AD and AS (increase through investment spending) . Firms have greater resources to
pursue R and D, improving quality etc. Will also promote research and development. The fact that corporations keep a
larger portion of profits mean that they will have more incentive to produce efficiently.
Reduced welfare benefit: increases incentive of workers to remain employed, and thus, contribute to the economy
rather than remaining unemployed and relying on the government.
Strengths:
-
-
Reduces inflationary pressure, causes the shift of aggregate supply and allows for greater production. This
means that it can deal with inflationary pressure
Low cost to government: Low government spending needs to be made to change regulation/legislation within
an economy, and does not burden the government budget.
Raises efficiency and productivity: will allow producers to produce at more allocatively efficient levels, and
forces them to keep costs low and to produce efficiently. Workers are also incentivised to become more
productive, and thus, efficiency is maximised in the long term. Lower prices, and more choice.
May attract more FDI, leading to growth
.
Limitations:
-
-
-
Conflict with equity:
- Unemployment may result due to the firm’s desire to become more efficient. Increases in job
insecurity, a progressive tax system, as well as a reduction in welfare mean those living in poverty will
have a lower standard of living
- Under-provision of infrascture:
- Labour may be exploited to inhumane conditions due to the lack of government regulation, and may be
forced to live a harsh lifestyle to meet ends meet.
- Changing hands from public to private hands may simply mean that because these firms have
monopoly power, they will not feel the need to change the quality of goods. This may mean that the
cost of the product increases beyond what is affordable, damaging and harming lower income groups.
Negative externalities:
- Environmental and social problems arising from deregulations: Increased in wage gap and worker
exploitation in the name of firm efficiency. Pollution, dangerous workplace and unsafe products.
Time lag: Will take several years to take effect
Interventionist supply side policies
Government policy involving government action to improve the factors of production through investment. Also leads to
an increase in aggregate demand as a result of greater firm investment.
Investment in human capital:
Education:
-
Improvement in the skills and productivity of the workforce, reduces natural rate of unemployment and
increases labour productivity and leads to a rise in national income.
Health service
- Government efforts to improve health care means that labour can be more productive, and economy's potential
output increases, along with positive externalities.
Investment in infrastructure: (physical capital)
-
Increase efficiency in capital, increases LRAS in the long term. Also increases AD in the short run. (E.G: building
of a chep lap kok airport in Hong Kong)
Reaps positive externality, and increases labour productivity.
Investment in new technology:
New and improved capital goods, increasing potential output and economic growth.
Possible positive externalities
AD is also stimulated in the immediate term when investment is made.
Industrial policies:
Government policies designed to support the growth of the industrial sector of an economy
- Providing subsidies, tax exemption or business guidance for small and medium sized firms. May also include
business advice. Allows for efficiency, capital formation and more employmen tpossibilties
- Support for ‘Infant industries’ using the above methods which can be used to stimulate regional growth
Limitations:
-
-
-
High costs of re-training (could be argued that the training programs do not match the actual demand within
the economy), and corresponding opportunity cost. Extremely high costs when building infrastructure, which
can be subject to corruption and large amount of waste (three gorges dam)
Time lags: will often take a long time before the actual effect of an overhaul in supply can be felt (especially
training), in which within that time, the economy may have already recovered.
Entrenched corporate interests. Where industries go complacent or uncompetitive due to government
protectionist policies, draw resources away from competitive parts of the economy, and does not produce high
quality products, meaning they might become over reliant and a burden. Government may choose the wrong
sector to support. Promotes inefficiency.
Corruption
Inefficiency may also arise from too much bureaucracy
Benefits: (Asian tigers, use of highly interventionist policies)
-
-
Reduces unemployment: reduces natural rate of unemployment by equipping workers with the correct skills, or
by providing assistance to workers to relocate. This allows for greater income, and thus, reduced poverty, and
greater aggregate demand in the long run.
Increased income equality: well educated workers are more likely to be employed, and thus, income is more
likely to be equally distributed within all members.
-
Decreases inflation: policies allow firms cost of production to remain low through increased efficiency, and thus
deals with stagflation and allows for greater output.
Most economists believe that interventionist and market-based policies should complement each other, and a mix of
policies should be used according to a country’s economic and social conditions. It is unlikely that any policy can yield
positive results without some negative consequences. It also depends on the state of the country, and whether or not
it’s developing or developed.
International trade
Buying and selling of goods and services across country borders: International trade
- Imports: Buying of goods from sellers outside the coutry
- Exports: selling goods and services to buyers outside the country
Benefit for international trade
-
-
-
-
Lower price: Countries can specialize in certain industries. This means more efficient production, and a ‘global
division of labour’ as more output is produced with less resources.
Increased efficiency: A company which is open to international trade, is incentivised to provide lower costs and
offer better service due to greater competition. Competition from overseas will mean that monopolies will not
be without challengers.
Economies of scale: Extreme specialization (such as specialization of labours and the introduction of
technology) brought on by extremely large international demand can lead to massive Economies of scale.
countries can focus on producing goods which it is efficient at producing, and does not ‘waste’ resources on
inefficient production
allows for lower cost in comparison to diversified production (which mean higher standard of living due
to greater revenue) .
- This enables them to take advantage of its resource endowments,and other countries will enjoy lower
costs.
Increased variety/choice:Increased quality of life of consumers (having access to resources they otherwise
would not have)
- Acquisition of needed resources: Firms and countries may have access to resources not available
domestically (oil) so trade can help.
Necessary component for growth and development
World trade Organisation
-
Seeks to expand international trade by lowering barriers and improving the flow of trade
- Trade without discrimination: WTO members are required to treat all goods from nations within the
WTO as equal. A tariff applied to one is applied to all.
- Freer trade through negotiation
- Predictability through binding and transparency: Binding refers to the commitment among members to
keep tariffs below a certain rate. This allows importers to assess markets more accurately and better
decisions encouraging more traders.
Trade protection
Tariffs
Protects domestic industries from competition, or raises
revenue for the government.
Before tariff, the country accepted the world’s supply at Pw. At this
price, domestic suppliers produce Q1, and because demand is at Q4,
the remaining demand is filled with foreign imports. (Q1 to Q4).
The price of other country’s rise by the amount of the tariff. There is a
increase in the quantity supplied by domestic producers (Q2) ,
decrease in quantity supplied by the foreign producer, along with
total quantity demanded.
Consumers: worse off due to higher price, and can only buy a smaller
quantity.
Is a form of regressive tax and it burdens low income earners
Loss of consumer surplus (f) as the wheat is not purchased,
which would have previously been available.
Domestic producers/employment: better off as they receive a higher
price and can sell larger quantities, resulting in decrease in
unemployment within nation due to the increase in output.
Government: gains tariff revenue. As consumers have to pay this added price onto the goods, this money is transferred
from the tax to government hands.
Increases inefficiency: increase in domestic output results in production by comparatively inefficient domestic firms,
where there is a wastage of resources (indicated by the supply of the country being lower than that of the world) as
foreigners are able to produce the same good at a lower cost.
- This is a global misallocation of resources, and this results in a global welfare loss which is caused by
inefficient production (d) and a decrease consumption of a particular good (f)
Quota
- Enforcing a limit to the quantity of a good that can be imported over a
particular time.
The government limits the amount of the good that can be imported to
Q3, Q2.
- This shifts the supply of the good from Sd to Sdq, while the world supply
curve becomes irrelevant. This is the total amount of the good within
society. The new equilibrium is formed.
-
The government distributes licences to governments of exporting countries, which means exporting countries
can buy the good at price pw, and then sell at Pq, allowing for a gain in revenue for them.
-Domestic consumers hurt
-Domestic producers/laborers better off
- Domestic income distribution becomes worse
-exporting country may be worse off.
- Global inefficiency: decrease in consumption and the shift of production
towards inefficient domestic firms creates a misallocation of resources.
Subsidy
Can be split into production subsidy (subsidy to compete with
imports) and export subsidy (subsidy to compete with foreign
domestic products.
The implementation of the subsidy increases the ability of
domestic producers to produce more at every given price, shifting
the supply downwards, forming a new intersection.
-
Decrease in imports, and an increase in domestic supply.
Consumption of the good is not affected. This value remains
the same. Consumers simply buy more of the domestic good whose
production has increased. (they only buy goods at the world supply
curve)
Domestic producers better off: receive the price PS (the cost in
addition to the subsidy itself) and produce more output, thereby decreasing domestic unemployment within the
economy
Detrimental to government budget/worse off to taxpayers: Money has to be spent on production subsidies.
Inefficiency in production: more inefficient firms are selected over efficient international corporations. Global
misallocation of resources results.
Subsidy>Tariffs
Although they encourage inefficient production, they do not have negative effects on consumption, and the loss of
welfare benefit is reduced.
Administrative barriers
Governments can employ various obstacles to trade in form of legislation. Includes inspections, valuation and a high
level of bureaucracy. Also involves the enforcement of safety regulations.
Protectionism
When countries try to protect some industries from unpredictability and the threat of foreign competition.
Argument for protectionism:
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To protect sunrise or infant industries: some countries can argue that their industries are underdeveloped, and
have not grown large enough to achieve lower costs through economies of scale. It can be argued that their
industries should be sheltered until they can face other firms on equal terms, when they have gained
economies of scale otherwise they will go out of business. (used by developing nations)
- Often only used until the point in which the industry has gained economies of scale, in order to allow it to
become competitive.
National security: certain industries are necessary for national defence. These industries should be protected in
the event a war breaks out.
Maintenance of health, safety and environmental standards:Standards exist to protect consumers from
hazardous products, as well as to ensure a reputation of quality production. These standards will raise the cost
of production, and reduce externalities in the process.
Questionable arguments
- Government revenue: Custom duties can provide a source of money for governments, which can be spent on
infrastructure or funding economic objectives.
- Problem may lie with inefficient tax system, which might have an impact on income distribution.
Affects allocative efficiency.
- Balance of payments deficit: can be used to overcome BOT. Could result in trade retaliation, worsening the
problem. Only works in the short term, does not deal with the actual problem of the deficit.
- To prevent the dumping of foreign goods: when one country exports at a price below the cost of production.
This means that exporters are attempting to steal away domestic consumers, eventually raising the price when
domestic firms go out of business. Thus, it is justifiable in these situations to protect domestic industries.
- To protect domestic employment: They will keep local jobs safe from foreign competition. By having to produce
greater output, unemployment falls.
- However, this means that unemployment increases in the foreign country. Retaliation may occur,
causing damage domestically. Macroeconomic policies can be considered instead .
The case against Protectionism
Misallocation of resources: Countries that protect declining industries compel their consumers to pay higher prices
than is normally needed. This draws income to inefficient producers, which draw more workers and capital. Resources
are spent on a politically connected firm rather than an efficient firm.
Dangers of retaliation/Trade war: Trade can grind to a halt and economic growth can decrease as a result of two
countries establishing extremely strict regulations to each other.
Potential for corruption : Higher tariffs mean more revenue for certain producers, which creates a very high incentive to
bribe lawmakers.
Increased cost of production: Protected firms may soon realise that their revenue comes from being protected, and
spend more energy in persuading the public of this. They have less of an incentive to modernize/innovate or to lower
their prices. Consumers face higher cost due to this complacency, (inefficiency) harming the ability of domestic firms
to produce (reducing potential output) while also lowering standard of living for consumers and decreasing choice.
Exchange rates
Floating exchange rates: where the value of a currency is determined by the demand and supply for currency on the
foreign exchange market.
Therefore, in a market those demanding AUD are those who have $US
and want $A. (those who own a foreign currency and want the
domestic currency)
- This will decrease/increase depending on the amount
of good or service a foreign country is demanding from
Australia.
Those supplying AUD are those who own the domestic currency and
want the foreign currency (in order to obtain US dollars, they will have
to exchange AUS, thus increasing the supply on the foreign exchange
market) .
- This will decrease/increase depending on the amount of foreign good Australians are demanding
Factors affecting exchange rate
-
Demand for goods and service/FDI: as demand for a country’s exports increase, there is an increase in the
demand for a country’s currency, as this is needed to purchase foreign goods. The opposite is true for a foreign
market demanding domestic goods.
- This can be self correcting. For example, if the value of a foreign currency is low, then demand for the
goods will increase due to the lower price, increasing the value of the currency.
- Speculation: Holders of foreign currency also speculate on future value, as buyers will buy currency hoping it will
appreciate, and sell it when it has reached peak value.
- Relative interest rates: If the interest rate to depositors (savers) increase,individuals and banks will be attracted
to this higher relative interest rate, and a chance to drastically increase profits. This will increase the demand for
the currency, as there needs to be a conversion in currencies for deposits. This is called ‘Capital inflow’.The
opposite is true.
- Income: If there is a greater income tax, those subjected with this higher income tax will have a ‘decreased
supply of currency’, lowering exchange rates. The demand for foreign currency will also decrease, due to the
lower pool of resources available for consumers.
- Relative rate of inflation
Appreciation: Increase in value of one currency against another, making domestic goods more
expensive, imported goods cheaper, but increasing purchasing power.
Advantages:
- Less expensive imports: Increased value means that buying imports is relatively less expensive than before. A
country can enjoy cheaper foreign consumer goods, and capital goods. Help both firms with importing raw
materials, and consumers in maintaining a higher standard of living.
- Competitive pressure on domestic exporters: Domestic firms seeking to export to other countries are at a price
disadvantage. This will force firms to innovate and cut costs.
Disadvantages
- Greater imports hurt domestic production and export levels are reduced: Both domestic goods and improted
goods may be hurt. If these industries cannot match the exchange rate, their share of the market and their sales
may drop. Leading to unemployment.
Reduces inflationary pressure, helping with economic growth. Reduce exports and real GDP, likely to further reduce
employment. The balance of trade is likely to move to a deficit.
Depreciation: Decrease in value of one currency against another. Makes domestic goods cheaper,
imported goods more expensive, and decreases purchasing power.
Advantages:
- Expansion of domestic industries: Foreign consumers will see exports as cheap, and so are likely to import
more. This raises revenues in these exporting companies and could increase employment. The relative increase
in the price of imported goods will also seek to benefit domestic firms, and if resources are spent on capital AS
can rise/shift . Allows for economic growth. (Reduces domestic unemployment: as more people will consume
good/service, output will be increased, and employment will rise. )
Disadvantages
- Imported inflation:when countries need to import significant levels of raw materials, a decrease in exchange
rate can bring ‘imported inflation’, where the high cost of imports mean that the goods and services available
for citizens can become expensive. (cost push inflation/ not demand pull, as demand is for foreign goods)
- Reduced purchasing power: Certain individuals might lose out if goods/services are provided largely by foreign
firms.
- Less competitive pressure: firm might become stagnant and reliant on exchange rate.
Increase inflationary pressure, which may slow down economic growth. However, this is also likely to increase exports
real GDP, the balance of trade, as well as adding to employment.
Advantage of free floating exchange rate
-
-
Interest rates can be used on domestic policies (such as controlling inflation etc.)
The floating exchange rate should theoretically balance itself. This is because when there is a current account
deficit, demand for exports will be low, so the supply of the currency will be high , meaning that the currency
will depreciate.
No need to keep high levels of foreign reserve: financial resources can be allocated more efficeintly, and can be
used to purchase goods.
DIsadvantages of free floating exchange rate
-
-
Creates uncertainty: businesses will find it difficult to plan ahead, as they will not know what will happen in the
future/cost and revenue. This will lower confidence and hence, consumption and investment. Reduced FDI as
well.
Not necessarily self adjusted: political tensions, domestic social turmoil can affect the exchange rate and
prevent self adjustment in order to eliminate current account deficit.
May worsen existing levels of inflation: If a country has high inflation, other nations will have a decreased
demand for their exports. This results in their currency devaluing, leading to cost-push inflation due to imported
inflation (cost-push)
Government intervention:
Within a fixed exchange rate system, the value of a currency is pegged into the value of another. The central bank
determines this value and enacts constant intervention to maintain this established rate. This is done by buying and
selling currency reserves, and making adjustment via monetary policy.
Devaluation: Depreciation of a currency via government intervention
Revaluation: Appreciation of a currency via government intervention
Government methods to manipulate the exchange rates:
1. Using their reserves of foreign currencies to buy or sell, foreign currencies
- If the government wishes to increase the value of the currency, they can use it’s reserves of foreign currency to
buy it’s own currency on the foreign exchange market. This will artificially prop up demand, and thus, the
exchange rate. (taking money away from the market)
- If the government wishes to lower the value of the currency, then it simply buys foreign currency on the foreign
exchange market, increasing its foreign currency reserves, and thus increasing supply of it’s currency as more
domestic currency will be in the market .
2. By changing interest rate:
- If the government wishes to increase the value of the currency, then they may raise the level of interest rate.
This will attract foreign direct investment (savings within banks) and increase demand for a particular currency
- To keep exchange rates low, a government will decrease the value of the currency, to discourage individuals
from investing in the market.
Other methods include limiting imports, having exchange control (the amount of foreign currency that can be bought
by domestic residents)
Advantage of fixed exchange rate
-
Reduce uncertainty for all economic agents in a country. Businesses will be able to plan ahead, encouraging
investment and spending within the economy. Simplifies business plans.
Inflation control: when locked into a fixed rate exports are vulnerable to domestic inflation. This could
therefore act as incentive for governments to manage inflation to keep export prices competitive.
Protection against speculation: speculators have less incentive to make action against the currency’s value,
which destabilizes the economy.
Disadvantage of a fixed rate
-
-
Limitations on domestic policy: if exchange rate is falling, the government has to raise interest rate. This will
have a deflationary effect on the economy, potentially increasing unemployment. (certain goals have to be
sacrificed)
Need for the maintenance of a high level of foreign reserve: opportunity cost for the buying and selling of
resources
Difficulty in setting exchange rate: too high, and the nation’s firms might find themselves uncompetitive. Too
low, then it might cause economic dispute with other nations.
Currency valuation
When the supply and demand meet, and a country holds a currency above or below that equilibrium.
Managed exchange rates:
Exchange rates are free to operate over long periods of time, however the central bank will occasionally come in to
intervene. This is used to prevent large fluctuations in exchange rates that could arise if completely controlled by market
forces.
Overvalued currencies: Developing countries may wish to import capital goods or materials at a cheaper price, and so
high rates will enable this. However it hurts exports, leading to a trade balance deficit. Overvaluation can also hurt
domestic industries, which now face competition from cheap import.
Undervalued currencies: By keeping exports cheap, it can improve exports and reduce attractiveness of imported goods,
while encouraging inflation. Countries use this to gain access to greater amounts of foreign exchange, and to
accelerate economic growth. However, this may be viewed by competitors as an unfair trade promotion, leading to
trade wars.
The Balance of Payment
A statistical statement that summarizes the economic transaction of an economy with the rest of the world.
Credit: inflow of money into the country
Debit: outflow of money from the country
The current account
Known as the ‘Balance of trade’, as it measures the transactions involving goods and services produced by workers,
and sold in other countries. Consists of:
-
-
Balance of trade in goods
Balance of trade in services
Income balance: The transfer of income back to the income earner’s country of origin. Includes the wage
income earned by a country’s citizen from employment by foreign companies. Also refers to the investment
income, such as interest and dividends earned on investments in foreign bonds or stocks.
Current transfer balance: Unilateral payment made from one nation to another, that is not in exchange for any
goods or services. Such as a gift, grant, or donation.
The capital account
Measures the transactions involving the ownership of capital.
Capital transfer: when a nation’s government or private sector gives money to another nation for the
purchase of a fixed asset.
- Debt forgiveness: the cancellation of debt, considered and outflow of capital.
- Non life insurance claim
Purchases of non produced, nonfinancial assets: Assets which are intangible, and non-financial (not stocks or
bonds). Includes patents, copyrights, trademark, and the acquisition of land.
The Financial account
Measures the exchanges between a nation and the rest of the world that involves the ownership of financial and real
assets. Involves the ownership of assets, not the purchase of the nation’s output of goods and services. (E.g, if an
American office building is sold to a Chinese textile manufacturer, ownership would be transferred, and there would be
a flow of money into America. )
Direct investment (known as foreign direct investment): Measure of the purchase of long-term physical assets, where
the purchaser is aiming to gain a lasting interest in a company in another economy.
- Includes inflows due to direct investment of foreigners domestically,
- Outflows due to locals investing overseas.
Portfolio investment abroad: A measure of stock and bond purchases, which are not direct investments since they do
not lead to lasting interest in a company.
When domestic investors sell shares to foreigners (and thus meaning the domestic government
borrow money) , there is an inflow of financial capital, increasing the financial account.
When domestic investors buy foreign bonds (and thus lending money out to foreign governments) this
is an outflow of financial capital, decreasing the financial account.
If a foreign firm decides to invest domestically, there is an inflow within the financial account. However,
there is then an outflow in the current account if the foreign firm repatriates the profit from the
investment)
Reserve assets: Reserve assets of gold and foreign currencies, which all countries hold and are itemized in the official
reserve account. Used to influence the value of the currency.
If a nation sells the foreign currency and buys it’s domestic currency, this is a inflow and thus, a credit in the
account.
If a nation sells it’s domestic currency to buy foreign currency, this is an outflow and will appear as a debit.
The current account balance is matched by the sum of the capital account balance and the financial account balance
(including errors and omissions) .
Interdependence of current and financial account
If there is a current account deficit, there must be a financial account surplus which provides domestic citizens
with the foreign exchange it needs to pay for the excess imports over exports.
If there is a current account surplus, the country will have an increasing amount of foreign exchange, which it
can use to buy assets abroad, while also adding to their reserve asset, causing a deficit in the financial account.
Exchange rates and the Balance of Payments:
Free floating exchange rates
A current account deficit leads to a depreciation, while a current account surplus leads to an appreciation. This will lead
However, this appreciation/depreciation will make goods less/more desirable, meaning the exchange rate will change
until current account deficits and surpluses is eliminated.
Managed exchange rates
Intervention is mostly carried out through buying and selling of currency, involving the reserve assets within the financial
account.
If there is a deficit in the balance of payment (current account) , there is excess domestic currency which would
normally cause it to depreciate.
Thus, by selling foreign currency and buying back the same amount of domestic currency as the current account
deficit, there is an increase in the financial account (a credit), offsetting the debit in the current account.
Fixed exchange rates
- Maintains exchange rate through similar ways described within the managed exchange rate
- At some point the bank will run out of foreign currency to sell, if it is attempting to correct a debit. The bank
can raise money through increasing interest rate, which will attract foreign investment or the government can borrow
abroad through loans, both of which increase credits.
-
It can also decrease debits through certain protectionist policies.
Economic integration
Economic cooperation between countries and coordination of their economic policies.
Preferential trade agreements: agreement between two or more countries to lower trade barriers between each other
on goods/services. However, can also take the form of other issues such as labour standards, intellectual property etc.
Trading Blocs
Bilateral trade agreements: trade agreement between two countries
Multilateral trade agreements: trade agreements between many countries.
Trading bloc: a group of countries that have agreed to reduce tariffs and other barriers to promote free trade.
Free trade area: a group of countries that agree to gradually eliminate trade barriers between members.
Includes NAFTA and ASEAN.
A product may be imported into a FTA by a country that has a lower external trade
barrier, and then sold to countries within the FTA with higher external barriers. Lack of coordination
arising from different non-member policies can cause disagreements, and complicated rules regarding
the origin of goods need to be put into place.
Customs union: a group of countries that works to eliminating trade barriers within members, while also
having a common policy towards non-member countries. Includes CEFTA (central European free trade agreement) .
All members act as a group in trade negotiations and agreements with non-member.
Thus, may lead to disagreements and arguments due to differing economic needs.
Common market: continue to have a common external policy, while also eliminating all restrictions on the
movement of factors of production within the common market. (labour and capital are of importance). Examples include
the EEC (European economic community)
- However, means that government must give up certain policy making authority,
requiring greater policy coordination between member nations
Advantages
-
Increased competition: Imports increase, forcing domestic producers to compete with foreign good/services.
This will mean lower prices for consumers, greater variety and higher quality as firms will try to reduce cost.
-
Increased investment: enlarged markets often give rise to increased investment by firms that want to take
advantage of greater market size. Multinational corporations from external nations will have an incentive to invest as
they can sell their good/service free of tariff or other protection imposed by the block to goods from the outside.
-
Improved allocation of resources (only applies for common market) : If a certain region is more profitable to
invest in, this will lead to capital gravitating to this country. Resources will be provided to maximise economic gain
within a greater geographical region. Disparity as more economically developed countries will receive higher quantity
of skilled labourers.
-
Political advantage: reduced hostility between member nations, and become more interdependent through
increased trade etc.
Disadvantage
- Creates obstacles to achieving free trade with all nations: the creation of blocs may limit the WTO’s goal of
free trade for all. This would lead to a worse global allocation of resources, lower global output, and a loss of
competition.
-
Unequal distribution of gains and possible losses: Countries in a trading bloc may not necessarily gain equally
from it’s operation, which might cause internal conflict. (
-
Loss of economic sovereignty: the need for coordination means that countries are limited in certain economic
actions and thus may sacrifice economic well being for the bloc.
Monetary union
Occurs when the member countries of a common market adopt a common currency and a common central bank
responsible for monetary policy. Includes the EU.
Advantage
- Single currency eliminates exchange rate risk and uncertainty: Benefits non-member importers as it
eliminates large fluctuations, and opens up the possibility to trade in other member nations without fear of fluctuations.
- Eliminates uncertainty, benefiting importers, exporters and encouraging trade and inward investment amongst
members. This allows for a more efficient allocation of resources.
-
Encourages price transparency: consumers and firms can more easily see price difference quickly and
accurately across countries, allowing the promotion of competition and efficiency. Puts pressure to lower prices, but can
increase prices as well.
-
Removes transaction costs of currency conversion: according to the rules of a bloc, some countries cannot
spend given a certain level of debt.
-
Low rate of inflation give rise to low interest rate, allowing more investment and greater output: a single
currency committed to maintaining price stability will allow for growth
- Larger influence in world affairs
Disadvantage
Loss of exchange rate as a mechanism for adjustment: If there is a trade deficit, the currency will not naturally
depreciate. Members countries also cannot use devaluation/depreciation as a method to make their goods more
competitive.
Loss of monetary policy as economic policy: Each country is unable to carry out it’s own monetary policy to
influence the rate of interest and hence, making it difficult to deal with specific issues in it’s borders. This in turn could
also mean that the policy undertaken by the central bank of the customs bloc could even harm a specific nation due to
the varying needs of nations. (A low interest rate will likely to be determinantal to a country experiencing high inflation.)
Convergence requirement: Certain customs union has restrictions imposed on the fiscal spending certain
nations can do, further limiting their ability to alter the economy. Reduces automatic stabilizers.
Economic Developments
Economic growth: an increase in real GDP over the previous year.
Development: An improvement in the general social and economic conditions.
- A reduction in poverty,
- the raising of incomes, and a reduction of income inequality.
- improvement of general living standards
- Increasing employment opportunities.
Sources of Economic growth:
-
-
-
Human capital: This can be increased by encouraging childbirth with better healthcare. Can also be
accomplished by encouraging immigration to the country, adding to the labour force. Productivity of human
capital can be improved through training, education and better (shifting LRAS)
Physical capital: (Buildings, machinery, vehicles, offices and equipment).
- The quantity of physical capital is affected by the level of saving, domestic and foreign investment, as
well as government involvement.
- The improvement of quality comes from a more highly educated workforce, research and development
etc.
- Capital widening: when extra capital is used with an increased amount of labour, but the ratio of capital
per worker does not change. Total production will increase, but productivity won’t
- Capital deepening: when there is an increase in the amount, or the quality of capital for each worker.
This means an improvement in technology, and lead to rise in both total production and productivity.
- Some capital is inappropriate, and may be overtly expensive for use in poor districts where it is difficult
to repair. Governments have to focus on providing appropriate technology. Can lead to growing
unemployment.
Institutional changes: Political stability is prerequisite for growth. An adequate banking, legal (protect
businesses encouraging investment) and education system is needed for economic growth (necessary for
human capital) .
Development and growth:
Growth without Development
Many poor countries will have to rely on either resource extraction or the production of agricultural commodities. These
both have their problems. Many LDC find it difficult to escape from these sources of production as they do not receive
enough revenue to purchase the capital needed for secondary production.
1. Resources extraction: Many poor countries (such as mining in Chile, and Burma) lack the resources needed to
extract resources. Because these are capital intensive, they auction rights to multinational corporations. This
profit is then leaked into a foreign country rather than their own nation.
a. many of the gains in capital are limited to a specific industry.
2. Agricultural commodities: These markets are extremely volatile, depending on weather.
a. Increased productivity stemming from developed countries use of machinery, has suppressed prices,
b. Protectionist policies of foreign nations.
Resource rich countries become heavily dependant on production and exports of primary commodities, leading to short
term volatility in prices, poor fiscal performance, and long term deteriorating terms of trade. Relative to other goods
(YED is extremely low) so even when world income levels rise, they remain at the same price, while manufactured
goods.
Corruption can also occur, where resources are not use efficiently to help improve the general standards of living in a
nation.
War might mean the disruption of any government social services, or a failure for the institution to implement policies.
Destruction of the environment (negative externalities)
Diminishing terms of trade contributes to economic degradation. Within LDCs the pressure to produce more crops, can
contribute to deforestation, soil depletion and water contamination, as lower costs are seeked. In larger economies,
demands for energy increase as GDP increases.
Income inequality
Although higher levels of economic growth may lead to higher GDp per head, the end effect will depends on how fairly
this income is distributed. There might be little to no difference in the quality of life of many, while only a small group
significantly benefits.
Growth with development
In many cases, there is a high correlation between high income and high levels of development. However, growth
should be expected to enhance many aspects of the standards of living in a country, provided it is well spent.
- An increase in welfare, stemming from greater tax revenue derived from growth, will lead to longer life
expectancy and an increase in literacy rates.
- These provisions of resources, and the promotion of sustainable growth where a country’s Aggregate supply
(training the local population) increases will help with a transition from primary industry to secondary industry,
allowing vast improvements to the standards of living.
- Growth will also encourage further spending on firms, creating more jobs, and further improving standards of
living.
Development without growth
Possible in countries like North Korea, which focus heavily on weaponry and defence. Here, development can be
achieved through a reallocation of resources. An improvement of non-economic institutions such as the banking and
political system can also result in development, especially initiatives which combat corruption.
Characteristics of Economically less developed countries (PP SAG)
1. Low levels of GDP/Capital
2. Low standards of living: Experienced by the majority of the population.
3. High agricultural dependence: developing countries rely heavily on agricultural production. These people are
most vulnerable to weather changes and volatile markets. Low income elasticity of demand means this source
of income will be unable to generate large amounts of income.
4. Large urban informal centres: unsupported by the state and it’s institutions. Large proportions of the economy
operating informally, allowing for potential negative externalities, tax evasion, corruption and crime. Those who
lose their jobs, and possess low skill are forced to seek work in the informal sector.
- Occupied by rural workers; who do not have the skills found in the formal sector.
5. High rates of population growth: results in a high dependency ratio, where those of working age will have to
support a larger proportion of children. This can lead to a large burden and worsen problems of poverty. This is
often due to the lack of welfare, so people often seek economic security from children.
6. Low level of productivity: low level of health and education and scarce capital goods results in low levels of
productivity of labour. Improvement in productivity is needed for economic growth, and this in turn is made
possible increases in the quantity of physical capital.
7. Caught in a poverty trap: Without an adequate source of income, (worsened by a high dependency ratio)
individuals are unable to invest in physical or human labour for their children. This means a radical decrease in
productivity, transmitting poverty from generation to generation as stagnant productivity will lead to low
returns.
- These people will often have to rely on the intervention of the government, which must take investment in human
capital, or physical capital (infrastructure).
- The government must take the necessary steps to ensure that poor people can participate in private sector activities,
such as ensuring funds are available for them to take part in private sector spending.
Differences:
-
-
Natural resources endowments/Climate: countries vary with respect to the natural resources they possess
History: Experiences as colonies have influences on one’s economic development. ‘ The systems the colonisers
put in place to extract resources while maintaining their own dominance, rather than to encourage economic
development, have often proved tragically difficult to reform’
Political systems/Stability: The elite can affect the way in which a country is run, and these differ between
developing countries. A stable government is needed for effective decision making and implementation of
policies.
- Instability creates uncertainty within economic policy, property rights, and taxation, which makes
domestic/foreign investment less favorable.
- Instability leads to outflow of financial capital as people seek safety for their assets.
- Political instability increases vulnerability to hunger and famine, depriving governments of capacity to
provide relief.
Millennium development goals
A global statement of commitment to eliminating extreme poverty, hunger, disease and environmental damage.
Measuring development
GDP per capita: Level of output per person within a country’s border.
GNI per capita: level of income received by residents in a country per person. Better indicator of the standards of living
of a country.
The difference in these two values depend on the inflows/outflows of income. Foreign workers who send their wages
back home increases difference between GNI and GDP, while domestic workers oversea decreases the difference.
Developing countries
-
While the difference is small for developed countries, multinational corporations will often send profits back
hope (profit repatriation), making GNI smaller than GDP for developing nations.
However, in some scenarios, there might be large remittances sent home by workers, but the output produced
within the country are low.
Purchasing power parity
However, the differing price levels within countries mean that the same amount of real money will be able to purchase
different amounts of goods.
PPP: the amount of a country’s currency that is needed to buy the same quantity of local goods and services that can be
bought with US$1 within the US.
Developing countries: GDP figures based on PP are higher than those based on exchange rate. Goods and services tend
to be lower in countries with lower per capita GDP.
Developed country: GDP figures based on PPP are lower than those based on exchange rate. Goods and services tend to
be higher in countries with higher per capita GDP.
This suggests that within developing countries, the standard of living is underestimated. PPP is used to eliminate the
influence of price differences on the value of output or income.
Health indicators
Life expectancy at birth: Number of years one can live, calculated as the average number of years of life in a population.
Infant mortality: Number of infant death from the time of births
More resources are provided to the necessary services and appropriate living conditions for the population. However,
other factors, such as adequate public health service with a broad reach , safe resources, a high level of education and
an absence of serious income inequality all result in greater health.
-
Limited resources are not always the most important cause of poor health outcomes. Most countries can do
more with their resources to meet economic development goals, allocating resources towards provision of
social/merit goods.
It can also be said that it is bad to only consider one indicator of health, as life expectancy and infant mortality both
reflect different aspects.
Education indicators
Adult literacy rate: percentage of people 15+ who can read and write
Primary school enrolment: Percentage of school age children enrolled in primary school.
However, these education indicators do not take into account the quality of instruction and the duration of a typical
student’s education. Secondary education is not accounted for as well, which could mean that although basic education
may be provided, a move into competitive sectors may still be difficult. Typically, the higher the economic output, the
more educated citizens are.
Composite indicators
Indicators which take into account more than one measure. An example of this is the UNDP’s human development
report, carried out every year. This is measured by:
- Healthy long lives: measured by life expectancy at birth
- Access to knowledge: mean years of schooling and expected years of schooling
- Decent standard of living: GNI per capita
Each dimension is expressed as a value between 0 and 1. The HDI is the average of these three values.
Generally, more developed countries have a higher HDI figure, however, there are exceptions, due to the limitations of
these form of measures, as expressed earlier.
- Countries can be inefficient with resources, resulting in a lower HDI than GNI/GDP.
- If GNI<HDI (efficient with resources), and it will be worth trying to understand what causes this.
- HDI<GNI (not accompanied by equivalent improvement in education and healthcare). Under providing merit
goods, and benefit is not maximised for population.
Factors in economic development
Domestic factors to growth
Education and health play an important role in improving human capital. They are both merit goods with positive
consumption externalities that will otherwise go underprovided.
Positive externalities of education
-
Contributes to improvements in the quality of physical capital, allows for more research and development,
Lower unemployment, increased international competitiveness. Encourages FDI.
Political stability, due to a well informed populace and a suitable living condition.
Economic growth, as education allows for increased labour productivity and greater output.
Positive externalities of healthcare
-
Economic growth, leads to greater worker productivity and output.
Benefits the community by lowering the risk of spreading disease, and decreasing productivity of others.
Longer lifespan to contribute to the economy.
Many studies have shown that East asian countries, which have invested heavily in education have experienced superior
growth and development. Overemphasis on tertiary education leads to a brain drain, where university graduates move
to different countries, and increase foreign productivity.
- Internal brain drains also occur:
- where highly educated individuals cannot find employment (under-employment)
- Skilled individuals may work in the private sector rather than the public sector.
- Research and development may focus on the needs of developed countries which offer higher rewards.
Appropriate Technology
Appropriate technology is technologies suited to particular conditions within the country.
Labour intensive technology: technologies which use more labour in relation to capital. Results in local employment, the
use of local skills, and aids income/poverty alleviation, reducing use of foreign exchange.
Capital intensive technologies: displace workers, and increasing unemployment, reducing incomes. Requires skill which
may be difficult to acquire, and requires use of extensive foreign exchange. (used within developed countries)
As most new technologies are used and developed within developed nations, which have different conditions to
developing nations, there is a real danger of utilizing inappropriate technology.
Banking, credit and microcredit
Banking provides an incentive for people to save. The greater the savings , the greater funds available for investment
and business expansion. Leads to greater growth/output.
However, Commercial banks often only cater to wealthy borrower. This is due to ;
- Lack of collateral: material possession which the bank will seize upon failure to repay loan
- Lack of stable income: due to volatility of agricultural prices, and the existence of unstable informal
markets.
- Influenced by local elites and politics: power is vested in higher ups within society.
Microcredit
Credits in small amount to people who do not ordinarily have access to credit.
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Provides small loans to individuals , allow people to invest in small capital equipment; start up a small business,
which in turn can allow for stable incomes
Mostly lent to women, as they suffer from discrimination and are more likely to invest in businesses.
Problems:
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Business failure: poor individuals often lack the skills needed to run a business. This will mean the business will
go bankrupt, and poor people will have a debt on top of their poverty.
Government disincentive: a government may see microloans as a substitute for policies dealing with poverty.
Poor people may have to pay for their own healthcare and education, and will also may lack certain
infrastructure if government intervention is withheld.
High interest rate: Loan sharks may enter the market with very high interest rates due to poor government
regulation, and thus may not lead to any meaningful improvement in standard of living.
Empowerment of women:
Empowerment: eliminating deprivations and creating conditions of equal opportunities for both genders.
- Poor countries tend to be conservative, and do not offer the resources to further education. Men are also
prioritised, and thus, labour efficiency is not maximised.
- Women also face lower wages, thus leading to a lower standard of living.
Benefits of empowerment
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Improved quality of human resources:
Lower birthrate: more work outside of home means that women often do not have as many chidren. This
lowers the burden on the incomes of the family.
Improvements in child health: as child bearers, increased education of women (e.g learning about basic hygiene
and nutrition) will help reduce child mortality and improve health.
Income distribution
Benefits of income distribution
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High income inequality will lead to lower savings. Wealthy individuals are more likely to spend, and invest
overseas, reducing funds available.
Government spending on merit goods can improve income distribution through improving human capital.
Increased income distribution increases the demand for locally produced goods and services, encouraging local
production and employment.
Greater political stability; if wealth is spread out upon different people, political stability will occur.
Barriers to International trade
Over Specialisation on a narrow range of Primary Products:
Sub-Saharan Africa
- Diversification into manufacturing means that nations are able to create more employment opportunities,
expand into activities which require higher skill/technology and create more varied production activities.
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Inelastic PED/PES/YED of agricultural goods, in addition to low skill level results in limited economic
development. (As world income increases over time, relative demand does not rise).
Price volatility of Primary Products
- Low PED/PES inexplicably means that primary goods are volatile.
Unstable income for producers -> unstable tax revenue -> make it difficult for government and foreigners to make
investment plans/import
Inability to access international markets:
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Tariff escalation from developed nations: When LDC produce raw materials, developed countries enact low
tariffs as they are not in direct competition. However, tariffs quickly rise when manufacturing sectors arise, due
to direct competition with MDC firms, preventing diversification.
LDCS generally receive higher tariffs: stemming from their lower bargaining power.
Trade strategies
Import substitution
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Country begins to manufacture simple consumer goods for the domestic market to promote it’s domestic
industry, while promoting protectionist measures. Latin American countries.
- Used as an opportunity to expand industry/Modernise
- However, can lead to inefficiency, corruption etc. (refer to notes on protectionism)
Export promotion:
Government providing targeted help to strategic industries, which encouraged higher skill levels in order to boost trade,
and fund further growth into foreign markets. East Asian Tigers.
- Includes industrial policies (investment grants, production subsidies), and state control of financial institutions
to allow for lower interest rates.
- Investment into research and development in order to encourage more capital, and greater growth.
(appropriate technology)
- Money from exports used to invest heavily in education and research to increase labour productivity.
- Increased employment
Trade liberalisation:
Removal of trade barriers to achieve free trade within an economy. Involves privatisation, deregulation, lifting
restrictions, moving towards free exchange rates etc. However, this is a limited tool for development:
- Strict trade policies of developed nations: No government support, sunrise firms are unable to compete with
MNCs, and therefore prevent development.
- Economic/trade liberalisation creates winners and losers: Those with pre-existing skills will benefit, as jobs will
go to those who will most efficiently use the resources. However, those without skills, lack collateral, or who live
in geographical isolation will suffer as they are unable to attain jobs when against high competition.
Role of the World Trade Organisation
The WTO is an organisation that promotes free trades, settles trade disputes, and protects intellectual property.
The Uruguay Round: policy which severely lowered tariffs, and offered protection of intellectual property.
- Significant controversy surrounding this program.
- Developed nations received a greater tariff reduction, while also increasing non-tariff barriers. Intellectual
property protection results in LDCs having greater difficulty to acquire capital.
Bilateral and regional trade agreements
Regional trade agreements: Usually yields benefit if nations within the bloc have a similar levels of
development/technological capabilities, market size, commitment to cooperation etc.
- Allows for benefit of economic integration/ fair competition. .
- Larger markets increase investment, join investment/ research policies can be undertaken and allows for ‘fair’
competition which fosters growth.
Bilateral free trade agreements: Agreements that take place between developing/developed countries. It provides
developing countries with access to the market of the developed country and the prospect of gaining such access.
However:
- Developing countries must cut tariffs greater than those required in WTO agreements. This puts even greater
competitive pressure on domestic firms, and may even destroy efficient firms.
- If developing countries from FTAS are competing within the same developed nation, they advantage they gain
is lost, as they all have to compete with each other for access.
- Weaker bargaining power in the WTO compared to a trading bloc.
Diversification
Reallocation of resources into new activities that broaden the range of goods or services that is produced.
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Sustained increase in exports: Diversifying into markets where there is a sustained increase in global demand.
Success depends in entry into higher value-added markets for manufactured goods.
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Development of technological capabilities/skills : allows for higher income, education, skills etc.
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Ability to use domestic primary commodities: countries that already possess the necessary raw materials can
work to stimulate industry. ‘Vertical diversification’
Reduced vulnerability to volatility/long-term price declines: pre-existing income reduces the effect of
fluctuating export prices/terms of trade.
Capital Liberalisation
Free movement of financial capital in and out of a country. Through the elimination of exchange controls (restrictions on
changing currency)
- Reducing exchange control: allows for trade to occur in competitive markets, where prices determined in free
markets acts as signals to convey information. Allows for efficient resource allocation in current account assets.
- Increased exchange control: increased exchange control exists within the financial account.
- Prevents capital flight (large scale transfer of funds to another country), as it results in the loss of
financial capital that could be invested domestically.
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Avoid currency speculation.
Assist in monetary policy: if a low interest rate is used domestically, domestic firms will want to invest
overseas, resulting in depreciation. By restricting investment this will not happen.
A nation must have stable interventionist policy oriented, strong financial institutions, and policies that work to avoid
fluctuations if they are to allow for liberalisation.
Foreign sources of finance and debt
FDI: Investment by firms based in one country in productive areas in another country. Firms which undertake FDI are
known as multinational corporations (MNC)
Why multinational expand into these countries
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Cheap labour: lax regulations and lower standards of living mean LDCs often possess lower costs for MNCs.
Greater revenue: Many developing nations have large or rapidly growing markets, which offers the potential for
large increases in sale and revenue.
Bypass trade barriers.
Pre-existing natural resource: It is far less costly for MNCs to locally source resources than import them, due to
transportation costs.
Characteristics of MNCS which attract FDI
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Macroeconomic stability: prevents disruption of profits and instability within nations. Includes political stability,
low inflation, stable currency, acceptable levels of debt etc.
Low production costs: low labour costs, or favorable tax.
Fully formed political and legal system: allows trade disputes to be resolved
Ease of repatriation: Freedom to repatriate profits, engage in foreign exchange transaction (no exchange
control) and lowered restrictions regarding foreign ownership.
Liberalised economy:
Advantage and disadvantages of FDI for LDC
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Transfer of technical, management skills and technology: Improvements to human capital and physical capital
can take place. These techniques can then be learned and adopted by local labour forces, allowing for
development.
- Limited infrastructure pertaining to a single industry: these infrastructure will be unable to boost
economic development and foster diversification.
- Weak link between MNC activities and local economy: Costly to train domestic workers, and MNCs may
simply hire foreign personnel, not improving labour skills. Foreign firms may be unwilling to give up
technology due to their competitive edge.
Can supplement foreign exchange earnings: Credit in financial account may be able to offset current account
deficit. Exporting of goods to other nations will increase export earning and the country’s balance of trade
position.
- Repatriation of profits or importing of resources from foreign nations to produce goods: may mean
net inflow of foreign exchange is low.
Increased employment: MNCs will need to hire labourers in order to help with investment. Other firms will also
receive greater revenue as MNCs will rely on them for the provision of certain goods.
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Investment may happen in capital intensive industries
Firms might hire local personnel
Domestic firms will be out-competed within domestic market: Economies of scale and existing
technologies will drive local firms out of the market, damaging job opportunities.
Greater tax revenue: Government can use this to aid other local industries
- Influence of MNC on policy making may result in tax concessions: This will result in little revenue.
Foreign aid
Aid: A flow of concessional capital given by developed to developing countries that is non-commercial (at a more
favorable rate than the market rate)
ODA : Aid given by the official government
Unofficial development assistance: Aid given by non-governmental organisation. (nations are meant to only be partially
reliant)
Humanitarian aid: Aid consisting of food, medical and emergency relief aid.
Development aid: aid consisting of grants, concessional long-term loans, support for schools/hospitals, programme
support for education/financial sector. Aimed to help developing nations achieve economic growth/development.
Bilateral aid: Aid from one country to another
Multilateral aid: Aid given by the world bank or the IMF
Grant aid: aid that does not need to be paid back
Soft loans: Loans that are given at a low rate
Motivations of providing aid
1. Humanitarian: Following on from disaster or famine. Aid is provided to achieve the millenium development
goals and to alleviate extreme externalities on other nations.
2. Economic: Providing aid will allow access to certain market in addition to favorable trade deals. Countries to
which they have strong economic ties to are assisted in order to boost trade revenue.
3. Political: Political and strategic motives have played a role in motivating donor countries. During the cold war,
the US provided aid to restrict the spread of communism. Allow for better relationship between two nations.
Tied aid: aid that is given on the condition that it is used to buy goods and services by donor nations.
- Recipient nations may consume capital-intensive technologies inappropriate for their own economic
situation:
- Recipient nations cannot seek lower price alternatives for goods and services they are forced to buy from
donor countries. This will result in inefficiency, a loss in value of aid, and a higher opportunity cost.
Pros and cons of Aid
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Can be used to break out of poverty cycle: Very poor societies trapped in a cycle face a savings-investment
constraint due to their low incomes. To emerge from a poverty cycle, poor communities need the government
to intervene through improving human/physical capital. Aid provides the means to subsidise this growth.
Improved income distribution: Allow low income groups access to basic amenities, which can improve
productivity and employment opportunity. Allow for more productive population.
Aid can be used to assist millennium development goals.
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Conditional aid: Aid could be used as a tool to force developing nations to make policy changes, such as
promoting a free-market economy, damaging the nations in the long run. These policy preferences may
incorrect, and not suit the government's development strategy.
Aid volatility: variation in levels of aid make it difficult for governments to implement policies that depend on
aid funds, so restricting growth. It replaces government funds, creating a reliance rather than fostering
development.
Aid will not reach those in need: Corruption and inefficient use may minimise the effect of aid on the actual
standard of living in those in LDCS. Militarisation policies may be selected rather than economic development
policies.
Aid are given by NGOs, resources are used inefficiently as the effort is un-coordinated.
International debt
Foreign debt: refers to eternal debt (total amount of debt) incurred by borrowing from foreign creditors.
- Debt occurs as it allows nations to pay for an excess of imports over exports.
- Nations spend money on capital goods, which will accelerate growth and allow them to pay back a loan over
the long term.
Debt rescheduling: New loans by commercial banks to domestic banks but on better terms.
Problems of having too much debt:
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Opportunity cost of interest payment: spending money on debt repayment means forgoing spending on other
development objectives, which might help poverty alleviation/development.
Balance of payment problems: Loans borrowed in hard currency; E.G USD. Debt will be paid back in foreign
exchange. Export earnings are usually low, meaning nations need to borrow more to pay debt. This will put a
pressure on the BOP, while requiring a constant quest for foreign exchange.
Caught in debt trap: countries must borrow to pay back existing loans.
Humanitarian level: Country will have to sacrifice high amount of standard of living to repay debt
HIPC program (Heavily indebted poor country)
- Organisation that provides debt relief or cancellation for poor nations.
- They must show that they are following certain elements of IMF and world bank policies, prove they are
poor/heavily indebted, and must commit themselves to pursuing a poverty reduction strategy.
Criticism of HIPC
- Level of debt reduction considered insufficient
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Moral hazard: When people don’t bear the full brunt of their error, it encourages people to take risks again
Multilateral assistance
World bank: Development assistance organisation that extends long term loans to developing nations for the purpose of
promoting economic development/structural change.
International monetary fund: established jointly with world bank. Established loans on commercial terms, and stabilize
macroeconomic policies within nations.
- World bank dominated by rich nations
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Conditional lending: Deprives nations with the ability to control their own domestic economic activities,
resulting in the imposition of inadequate or unsuitable policies.
Extensive use of market-oriented supply side policy: Both organisations are dominated by free-trade
economists from the United states, which places an emphasis on trade liberalisation, lax government
intervention, balanced budgets, high interests rate and reduced wages (to prevent further reducing in external
debt and balance of payment problems) .They want to maintain a steady exchange rate.
- This often lowers economic growth, creating a recession with increasing levels of poverty. Cuts in
government spending on merit good and food subsidies, imposition of fees for schooling/health care
along with increased poverty from liberalisation often results in detrimental results.
Balance between markets and intervention
Market oriented policies: policies based on encouraging market efficiency
- Market based supply side policies: Encouraging competition (deregulation, privatisation and anti-monopoly
regulation)
- Labour market reforms
- Incentive related policies
- Freer trade
- Decrease in exchange control (limitations in the amount of a foreign exchange that can be purchased
with domestic currency )
Strengths:
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The pursuit of self interest by all economic decision makers gives rise to incentives for hard work, risk taking,
innovation and investment, which lead to higher levels of output and higher standards of living. (consumers)
More competitive.
Therefore, with greater competitions, these policies can be said to result in greater efficiency, lower prices,
improved quality and a better allocation of resources for firms. (firms).
Weakness
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Cannot deal with market failure e.g Negative environmental externalities, common access resources or the
failure to provide public/merit goods. The free market will be unable to deal with such effects.
Weak or missing market institution: to be able to function effectively there must be some institutional
framework to help coordinate economic activities and to help reduce economic insecurity. E.G, property rights,
legal contracts. In the absence of these conditions, markets are highly imperfect.
Development of dual economies: a situation in which there are two different and opposing set of circumstance
that exists simultaneously (wealthy and poor economy). Outcome of market forces that do not work to the
benefit of most because of the presence of market failures, geographical isolation and government policies
which only seek to support one sector.
Income inequality: the loss of protection resulting from labour market reforms and increases in unemployment
due to market liberalization often leads to income inequality. Some people may also be unable to take
advantage of certain opportunities presented by the market.
Interventionist policies: policy based on government intervention in markets intended to correct market deficiencies
and create an effective economic environment.
Strengths:
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Investment in human capital: Education and health are major factors behind increases in productivity that
contribute to economic growth, and they also directly lead to greater economic and human development.
Provision of infrastructure: can be used to correct market failures/ decrease income inequality. Increases
productivity, and improves standard of living. Role for government in order to ensure the provision of the
appropriate infrastructure with appropriate access.
Stable macroeconomic environment: includes price stability, full employment, a budget deficit, a reasonable
balance of trade. Divergence away from volatile, commodity economies. A free market cannot provide this on
it’s own, and it’s important to help economic decision makers plan their future, ensuring confidence within both
consumption and investment. Necessary for investment in capital, leading to economic growth.
Provision of a social safety net:in order to lower income inequality, the government can secure enough income
to ensure basic needs. This prevents negative externalities, ensuring that standards of living remain adequate.
Weakness
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Excessive bureaucracy: too many rules and red tape can lead to high administrative costs and inefficiency,
resulting in unproductivity./ Planning specific public provisions of merit goods may run into problems, resulting
in a highly bureaucratic and inefficient waste of resources.
High cost
Corruption: the abuse of public office for private gain. When it takes the form of payment, it acts as a tax that
makes private investment more costly, reducing the overall level of investment. It can also act as a regressive
tax for the poor, taking money away from things which could improve the standard of living/provide public
goods. It can also weaken sustainable development, and result in the pursuit of uneconomic policies.
Good governance
Economic growth depends on the effectiveness of governments, and the interaction between society and government.
Better governance is related to more investment and greater economic growth.
Providing a balance
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Very strong government intervention in the market has been discredited as a strategy for economic growth:
very strong government intervention leads to misallocations, inefficiencies and results in lower rate of growth.
Market led economic development strategy, does not take into account the special set of circumstances faced
by developing countries: If pursued over an extended period, it is likely to only lead to limited progress in
economic growth and development and increase inequality, as a result of persistent poverty (due to lack of
investment in education, health, infrastructure which are unfavorable to MNC and market-led development
strategies) .
Most economists support the idea of protectionism of domestic industries within poor countries through the
use of industrial policies, protecting infant industries.
Developing countries are more likely to lack the necessary institutions needed for markets to work well. As
such, a relatively large degree of government intervention is necessary. However, as the market matures,
government can allow market forces to control.