Cambridge International AS & A Level Economics
Workbook answers
Cambridge Assessment International Education bears no responsibility for the example answers
contained in this publication.
1 Basic economic ideas and resource allocation
(Chapter 1)
Multiple-choice
1
B
2
D
Data response
1
a
Human capital is an intangible asset including things like an employee’s experience and skills
and capabilities. In Ukraine, the 4% of firms planning to increase investment in workforce
training and development would be investing in the human capital of their employees.
Physical capital, on the other hand, consists of human-made goods that assist in the creation
of other goods. An example of investment in physical capital would be when a firm acquires
items such as additional manufacturing equipment or machinery used in the firm’s
production processes.
b
The extract suggests that environmental sustainability may only be obtained with the
opportunity cost of lower economic growth. This means that a sustainable environment is a
scarce resource and choices have to be made.
There is an opportunity cost associated with greater environmental sustainability which may
be fewer cars and lorries on the road, for example, which would reduce the economic
activity that creates the growth. Therefore, choices must be made over whether a country
should create the economic growth that provides housing and food or be more concerned
about the preservation of natural capital and the sustainability of the environment.
c
Labour productivity is defined as output per unit of labour input. The physical product or
output of a worker is partly determined by their physical and mental health. If a worker
suffers poor physical and mental health, they are less likely to have the capability and
motivation to produce greater levels of output. Hence poor health can lead to reduced
labour productivity.
The notion of production possibility refers to the maximum possible output combinations of
two goods/services or classes of goods/services that an economy can achieve when all
resources are fully and efficiently employed.
When the workers of a country suffer poor health – for example, through malnourishment –
the total output combinations that they can produce are limited by their condition. This will
lead to a lower production possibility compared to the situation where workers are better
nourished and in better health.
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d
A free good, such as the air within an ecosystem, is a good that does not suffer scarcity and is
available without limit. It can be consumed in as great a quantity as desired without a choice
being made to forgo alternative consumption. A free good therefore has zero opportunity
cost to society.
An economic good, such as the capital machinery used by an entrepreneur, does have an
opportunity cost. This is because an economic good has a degree of scarcity and therefore
an associated opportunity cost.
Essay style
2
A production possibility curve (PPC) shows the maximum possible output combinations of two
goods (or services) that an economy can achieve when all resources are fully and efficiently
employed. Such a PPC is used in the diagram below to illustrate the production possibility of
onions and sweet potatoes for an economy.
Consider the economy originally producing 300 tonnes of onions and 180 tonnes of sweet
potatoes. If the economy then reallocated scarce resources from onions to sweet potatoes, to
produce 250 tonnes of sweet potatoes (70 more tonnes), this would involve an opportunity cost
in terms of 50 tonnes of onions (300 – 250) that can no longer be produced.
The concave downward nature of the PPC means that if the economy were to continue to
increase its allocation of scarce resources to the production of sweet potatoes – for example, to
produce another additional 70 tonnes (to 320 tonnes) – the opportunity cost would be the
increasingly large amounts of onions that would need to be forgone (greater than 50 tonnes) in
order to produce the additional sweet potatoes. This illustrates, through the use of a PPC
diagram, the concept of increasing opportunity cost as resource allocation changes.
2 The price system and the microeconomy
(Chapters 2–4)
Multiple-choice
1
B
2
A
3
B
4
D
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5
A
6
C
7
A
8
C
9
C
10 B
Data response
1
a
Income elasticity of demand is calculated using the formula:
% change in demand/% change in income
In 2024, the % change in demand is estimated at 9.4%.
In 2024, the estimated % change in income is:
(15,102.15 – 13,969.54) × 100/13,969.54 = 8.1%
Estimated income elasticity of demand = 1.16.
The income elasticity of demand is estimated to be greater than 1, which means that as
income increases, the demand for pea protein products is estimated to increase by
proportionately more. This means that pea protein products sold in China are classed as a
normal luxury good.
b
Demand describes the entire relationship between the various quantities demanded over a
range of prices, while the quantity demanded is the amount demanded at a given price.
Applying this to the extract, a shift in consumer preference towards healthy preparations will
lead to an increase in demand over the whole range of prices, whereas a rapid increase in
supply would lead to a reduced equilibrium price and an increase in quantity demanded at
the new lower price.
c
Joint supply refers to a situation where the production of one good can deliver two or more
outputs.
An example would be the farming of yellow peas where the protein can be used in the
supply of meat substitutes and sports drink supplements.
d
The extract states, ‘Globally the [pea protein] growth rate in demand is estimated to be 12%
a year’ and ‘Some bakery and confectionery preparations will also experience a rapid
increase in supply.’ These conditions will lead to an increase in demand for and supply of pea
protein. The impact on the market for pea protein is shown in the diagram below.
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With an initial equilibrium price and quantity of P0 and Q0, an increase in demand will shift
the demand curve to the right from D0 to D1 and an increase in supply will shift the supply
curve to the right from S0 to S2. The new equilibrium quantity will be Q2 which is an increase,
and, in the diagram, the new equilibrium price is P0. However, the actual new equilibrium
price would be indeterminate.
The new equilibrium price will increase if the relative increase in demand is greater than the
increase in supply. However, the new equilibrium price will decrease if the relative increase
in supply is greater than the increase in demand. The final impact will also depend on the
relative price elasticities of both demand and supply.
e
Substitute goods are goods that consumers regard as alternatives, where the demand for
one will fall if the price for the other falls. One example from the extract is pea-protein-based
meat substitutes which can be consumed as a substitute for meat.
f
Price elasticity of demand (PED) measures the responsiveness of the quantity demanded of a
good or service to a change in its price. Total expenditure on a product is found by
multiplying the product’s price by the quantity demanded.
Pea protein has price inelastic demand. If the price of an inelastic good is lowered, the
demand for that good is relatively unresponsive and increases by proportionately less. The
proportionately smaller increase in quantity demanded than the decrease in price would
result in reduced total expenditure on pea protein.
g
Pea protein is produced from the yellow pea, which is an agricultural product. The supply
plans of firms producing pea protein will be affected by changes in natural conditions,
especially the weather. Unfavourable weather for growing yellow peas will affect a firm’s
ability to supply. In the case of adverse weather conditions, this would interrupt the
continuity, reduce supply and shift the supply curve to the left.
Essay style
2
a
Consumer surplus is the value that a consumer gains from consuming a good or service over
and above the price paid. It is the sum of the differences between the prices that consumers
are willing to pay and the equilibrium market price.
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The diagram below shows a market in equilibrium with demand D and supply S, with
equilibrium at E and price P and quantity traded Q. The initial consumer surplus at this point
is given by the triangle APE.
The introduction of a producer subsidy into this market will reduce the cost of production
and so will shift the supply curve to the right (S to S1), establishing a new equilibrium at E1
with a new lower equilibrium price of P1 and greater quantity traded of Q1.
As a result of the subsidy, the consumer surplus in the market has increased and is now given
by the (larger) triangle AP1E1.
The value of the consumer surplus increases because there is a new lower market price of P1,
but the price preferences of the consumers have not changed. This leads to an increase in
the sum of the differences between the prices that consumers are willing to pay and the
equilibrium price in this market.
The extent to which the consumer surplus will increase is largely dependent on size and
duration of the subsidy. The larger the subsidy, the greater the shift to the right in the supply
curve and the lower the new equilibrium price. If this subsidy and price decrease are
permanent then the increase in consumer surplus will also be permanent, ceteris paribus.
b
Knowledge of the value of price elasticity of demand (PED) allows a firm to predict how a
change in price will impact on the demand for its product and on its total revenue. If the
demand is relatively price elastic, due to the large number of substitutes, the firm knows
that it can decrease the price to increase the total revenue because the quantity demanded
will rise by a larger percentage. This knowledge is useful for any firm that is considering
altering its pricing strategy and is concerned about total revenue.
The extent to which this might prove useful in reality depends on the accuracy of the
estimate of the PED. It can be difficult for firms to obtain accurate data and therefore gain
accurate PED estimates. The response of competitor firms in the market to the price change
is also important. These reactions are unknown to the firm. Therefore, any impact on total
revenue predicted from a price change and knowledge of the PED may prove less accurate or
useful if other firms also implement such a price change.
Knowledge of the value of income elasticity of demand (YED) allows a firm to predict how a
change in income will impact on the demand for its product. A firm will find this useful,
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assuming it knows whether its product is an inferior good (negative YED) or a normal
necessity or luxury good (positive YED), because it will be able to anticipate an increase or
decrease in demand. Furthermore, the absolute value of the YED will help to predict the
scale of the increase or decrease in the demand for its product or service as income changes.
This knowledge will help the firm to make key decisions with respect to producing more
luxury goods during periods of income growth; or with falling incomes, firms might decide to
produce more inferior goods.
The extent to which this knowledge might prove useful depends on the accuracy of the
calculation of YED. As with PED it can be difficult to obtain accurate estimates for the YED
value. Care must also be taken over the issue of whether the market segment that a firm
sells to is significantly affected by the change in income, which is likely to be derived from a
national average. This could mean predicted changes in demand do not occur and the
reactive decisions of firms may prove incorrect.
Knowledge of PED and YED will undoubtedly prove useful to the decision making of firms so
long as the data are accurate. It could be argued that the PED value is of more use because it
allows the firm to make proactive decisions regarding its strategies whereas knowledge of
the YED allows reactive decisions to be made to changes in a variable that is out of the firm’s
control.
3 Government microeconomic intervention
(Chapter 5)
Multiple-choice
1
B
2
A
3
D
4
A
Data response
1
a
The Gini coefficient is a statistical measure that attempts to quantify the equality of income
distribution in a country. The coefficient measures the dispersion of income among the
members of a population.
In published data, the Gini coefficient is expressed as a percentage. A Gini value of 0%
indicates a perfectly equal distribution of income within a population. A Gini value of 100%
represents perfect inequality when one person in a population receives all the income, while
other people earn nothing.
By comparing the Gini values of Mexico (48.2%) and Sweden (24.9%) it is possible to
conclude from one summary statistic that the inequality of income distribution in Mexico is
approximately twice that of Sweden.
b
A progressive income tax can be said to create a fairer redistribution of income because it
imposes a lower tax rate on low-income earners compared to those with a higher income.
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This means it is based on taxpayers’ ability to pay, resulting in a lower percentage being
taken from low-income earners than from those commanding high incomes.
Additionally, this view would argue that the redistributive power of a progressive income tax
policy can be seen through the government raising increased revenues to finance public
expenditure. This would include spending on transfer payments, health and education that
tend to favour low-income households.
c
An increase in transfer payments could allow the government to effectively alter the final
distribution of income. They comprise welfare payments made available through the social
security system including, for example, unemployment benefit, child benefit and housing
benefit (where available). The main aim of transfer payments is to provide a basic floor of
redistributed income or minimum standard of living for low-income households.
However, government transfer payments do not boost production or economic activity. For
example, increasing unemployment benefits could arguably reduce incentives to take paid
work and redistribute income more effectively. This leads some to argue that reducing
transfer payments, thereby increasing the incentive to work, and the opportunity cost of not
working, could lead to a more effective redistribution of income.
The reduction in transfer payments would be most effective at redistributing income when
combined with policies that ensure there is paid work available for those unemployed who
are incentivised to try to find it. This will be even more effective in redistributing income if
the skill sets of the unemployed are addressed in order to ensure that they have the skills to
match the available jobs that they are incentivised to seek.
Essay style
2
A minimum price involves a government imposing a price that is above the free-market clearing
price. In the case of the market for alcoholic drinks in Wales, the minimum price of US$0.63 per
unit of alcohol would represent an attempt to limit alcohol consumption and improve the
wellbeing of consumers.
The impact on the market of the minimum price is shown on the diagram below.
In this example the minimum unit price (US$0.63) for alcohol is above the free-market price of PE
and would increase the price of alcoholic drinks in the market. This, in turn, would create an
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excess supply of QD to QS. This illustrates the contraction in the quantity demanded from QE to QD
and the extension in the quantity supplied from QE to QS.
Within this market there will be a reduction in the quantity of alcoholic drinks consumed, which
will effectively reduce the size of the market to QD and so help to reduce the adverse effects of
excessive drinking.
The extent to which the minimum price impacts on the market for alcoholic drinks will depend
upon a number of factors. These include the extent of the difference between the free-market
price (PE) and the minimum price imposed. The greater the difference, the greater the impact on
the market and the reduction in the quantity of alcohol consumed.
The impact of the minimum price on the market will also depend on the price elasticity of
demand for alcoholic drinks. The more price elastic the demand, the greater the reduction in
quantity demanded for any given price increase. However, due to the habit-forming nature of
alcoholic drinks, it may be that the quantity demanded is particularly price inelastic and that
consumers may not behave in strict accordance with rational economic theory.
4a The macroeconomy (Chapters 6 and 7)
Multiple-choice
1
C
2
C
3
D
Data response
1
a
Gross domestic product (GDP) is the total market value of all finished goods and services
produced within a country in a set time period. It does not matter where the producer
originates from.
Gross national income (GNI), on the other hand, is a measure of a country’s income. It is the
value of all the income earned by a country’s residents and businesses. This includes any
income earned by nationals employed abroad and sent home as a remittance.
The remittances sent home by Nepalese workers employed overseas will therefore add to
the measure of Nepal’s GNI but not its GDP.
b
There are several pieces of evidence in the extract that suggest Nepal has taken the Asian
Development Bank (ADB) advice with respect to gross fixed capital formation. First, Figure 1
shows that since 2016, gross fixed capital formation as a percentage of GDP has increased
substantially in Nepal from 33% in 2016 to 56% in 2019. Over the same period, gross capital
formation as a percentage of GDP in other (high-growth) economies has decreased.
The president of Nepal has also actively sought investment from China in tourism
infrastructure, including transport, hotels and resorts and technological innovation. This is
clearly in line with the ADB guidance.
Finally, the 2020/21 budget in Nepal granted tax exemptions to the agriculture, industrial
and service sectors. This would increase the possibility of these sectors increasing their gross
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capital formation as a result of the greater funds they are able to retain. This too is in line
with the ADB guidance.
c
The circular flow model is a representation of the level of national income in an economy
that shows the movement of factors of production and goods and services between sectors
and the flows of payments in monetary terms that correspond.
Monetary flows in and out of the system in this model are referred to as injections and
leakages. A leakage occurs when money is not passed on but moves out of the circular flow
in the form of savings, taxation and imports. When a leakage flows out of the system, the
value of the money left in the system decreases. This represents a contraction in national
income.
In terms of the information provided, the tax exemptions from 25% to 75% for small and
micro enterprises in Nepal would constitute a reduction in the value of leakages from the
Nepalese circular flow of income. As the leakages decrease, so the value of the circular flow
will increase, representing an increase in national income in Nepal.
d
The position of the long-run aggregate supply (LRAS) curve will be determined by the
decisions taken by profit-maximising firms about production levels at any given price level.
Over the short run, the state of technology is assumed to be fixed. However, one important
influence on the position of the long-run aggregate supply (LRAS) curve is the level of
innovation and developments in technology. If the Nepalese president is successful in
securing Chinese investment in technological innovation in Nepal, this could improve the
efficiency with which other inputs are utilised. Such developments can reduce firms’ costs
and increase the amount of aggregate output that can be produced. Over the long run this
would shift the LRAS curve to the right.
e
An increase in aggregate demand would shift the entire aggregate demand curve to the
right. This is illustrated for Nepal in the diagram below.
Consider the short-run position showing an original equilibrium with real GDP at Y0 and price
level P0, with AD0 and SRAS. The planned increase in aggregate demand will shift AD0 to AD1.
The Nepalese economy will move to a new equilibrium position, with a higher output level Y1
and a higher price level P1.
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There is no guarantee that the new equilibrium will be at the full-employment level of real
GDP in Nepal. The full-employment level of output is the level at which the economy is
operating at its full potential capacity. It is entirely possible that Y1 is a lower level than the
full-employment level of real GDP (YFE). To reach YFE a greater level of AD is required,
illustrated by AD*. It is also possible in the short run that an equilibrium above YFE is
achieved, but this will be unsustainable.
Essay style
2
An increase in unanticipated costs such as that of electricity is known as an external supply shock
and will alter the position of the short-run aggregate supply (SRAS) curve. The SRAS curve
represents the combined output that firms are willing to produce at different price levels in
order to maximise profits.
The equilibrium in this model represents the price level and output level at which planned
aggregate supply equals planned aggregate demand and is shown in the diagram below.
Originally with AD and SRAS0 there is an equilibrium with a real GDP of Y0 and a price level of P0.
The increase in the cost of production caused by the increase in price of electricity used by firms
will influence the position of the SRAS curve. In the case of an increase in cost the SRAS curve will
shift to the left, from SRAS0 to SRAS1 in the diagram, which represents a movement along the
static AD curve.
This will cause a new equilibrium with a higher price level at P1 and a reduced level of real GDP at
Y1. The equilibrium level of output in the economy has decreased and therefore the derived
demand for labour to produce the output will have decreased. This would be expected to lead to
reduced employment in the economy.
The extent to which the increase in the price of electricity will shift the SRAS curve and therefore
have the impacts described here will depend on the proportion of the cost of electricity in the
overall production costs of firms. The greater the importance then the greater the relative cost
increase and the greater the shift in SRAS and impact on the price level, real GDP and
employment. The slope of the aggregate demand curve will also be a consideration. The greater
the price level elasticity of aggregate demand, the greater the relative size of the reduced real
GDP and reduction in employment, and the smaller the increase in the general price level in the
economy.
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In the long run, the impact of a supply shock such as the unanticipated increase in electricity
prices will depend on whether the shock led to a temporary or a permanent change.
4b The macroeconomy (Chapters 8–10)
Multiple-choice
1
B
2
C
3
D
4
C
5
A
Data response
1
a
An economist may wish to measure the rate of growth of the productive potential of the
economy. This would be illustrated by the rate of shift of the production possibility curve
over time or the rate of increase in long-run aggregate supply/the full-employment level of
output.
However, this is not what will be measured if the economist calculates the rate of change of
GDP in the economy. The rate of change of GDP will show the actual rate of growth that the
economy has achieved at a point in time. This may be constrained by insufficient aggregate
demand and will not reveal any growth in the productive potential of the economy that the
economist was attempting to measure.
b
The travel and tourism industry contributes 21% of GDP to the Greek economy. In 2020, due
to the Covid-19 pandemic, Greece stayed closed to all foreign tourism for the beginning of
the tourist season, which would lead to a reduction in demand for tourism services. There
would be a corresponding fall in GDP. If real GDP is below the full-employment level, then
unemployment will occur during the time when the economy is adjusting back to its long-run
equilibrium. This will be cyclical unemployment in the Greek economy.
The tourism industry in Greece is ‘seasonal’ in any relatively normal year. The demand for
labour in the tourism sector will peak significantly in the summer months. During the winter
months of 2020 the demand for labour in Greece will be significantly less because of the
seasonal effects. This will give rise to seasonal unemployment in Greece.
c
The extract states that unemployment in Greece is measured by the International Labour
Organisation method. This is a measure based on the Labour Force Survey – a survey of the
population that identifies the number of people available for work, and seeking work, but
without a job. It then expresses the percentage of the workforce who are without a job at a
particular time.
d
The extract reports that Greece’s CPI fell by 1.6% from a year earlier in June 2020, following
a 1.1% decrease in the previous month. It was the third consecutive decline in consumer
prices. This shows a quarter of deflation for the Greek economy. Deflation is defined as a
reduction of the general price level in the economy and reflects an increase in the value of
money over time.
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Real GDP is equal to nominal GDP adjusted for inflation. The increase in the value of money
means that when nominal GDP is adjusted for the effect of the deflation in the Greek
economy, the value of real GDP will be greater than its nominal value.
e
The increase in economic activity associated with actual economic growth (increasing GDP)
brings benefits but also brings costs. One clear and significant cost is pollution. As the extract
states, GDP per capita increased by 50% between 1990 and 2016, and global trends for air
pollution followed a similar upward trajectory. In particular, Figure 1 shows that from 2014
to 2016 the rate of increase in air pollution was far greater than the rate of economic
growth.
As economic growth increases, inevitably industrial output, energy production and transport
will increase. These are among the contributors to the consequential increase in air
pollution. The problems associated with increasing air pollution are those of poor health and
restrictions on the quality of life.
It is also clear from Figure 1 that for individual countries it is possible to achieve economic
growth without the negative consequence of increased air pollution. Norway, between 2014
and 2016, was able to achieve stable per capita economic growth while significantly reducing
its level of air pollution from almost 9 to below 8 PM2.5.
This can be achieved through strict regulation of production processes, taxation to
incentivise cleaner production methods and investment in sustainable energy practices with
particular application to the transport industry. However, not all countries are willing and/or
able to go to the lengths that Norway has to achieve its outcome.
Essay style
2
a
The quantity and quality of the labour force are key factors that can contribute to increases
in productivity and economic growth. A lack of skilled labour can affect the overall
productivity of the entire labour force. This subsequently impacts on a country’s rate of
growth of GDP per capita and its potential for future economic growth.
The AD/AS diagram below shows an economy initially in equilibrium with AD0, SRAS0 and
LRAS0 without unemployment and with a price level of P0.
If AD increases to AD1, there will be a temporary increase in real GDP to Y1 with a price level
of P1 as existing workers work overtime. However, this situation is unsustainable and in time
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the economy will return to the full-employment level of output at YFE but with a new higher
equilibrium price level of P2.
The key point is that if there had been more skilled workers in the economy, capable of
greater productivity, then LRAS0 would have shifted to the right, representing economic
growth, and there would have been an increase in equilibrium real GDP. Thus, it is the lack of
skilled labour that has restricted economic growth.
One solution to skilled labour shortages is for governments to look abroad for skilled
workers. Offering higher wages for specific skills could encourage migration from other
countries to fill immediate skilled labour shortages and increase economic growth. However,
the quantity of migration is not under the direct control of the domestic government and
there will be times when such wage incentives will have little impact.
The government could alternatively increase education and training in order to increase the
supply of skilled labour. This should raise the skill level and increase productivity and
economic growth, but there will be an opportunity cost and there could also be a long period
of skilled labour shortages because it will take time for the labour market and educational
institutions to adjust.
A combination of migration as a short-term fix to labour shortages and a longer view of
investment in the human capital of the domestic labour force would be the most effective
overall strategy.
b
Inflation is the positive rate of change of the average price level in an economy over a period
of time and is calculated from the consumer price index. Inflation will have consequences for
consumers and firms in the economy, but the significance of these consequences will
depend on a number of factors.
As the rate of inflation increases, consumers, especially those on fixed incomes, will find that
they can purchase fewer goods and services. This is because the prices have increased but
their incomes have not, or have increased by less. There will also be a negative consequence
for consumers (and firms) who have savings. This is because the real value of savings will
reduce because the amount of goods and services that they can purchase will be less.
Firms and consumers will both face greater uncertainty over current and future prices. The
consequence is that they will have to conduct more extensive and intensive price research,
which will cost more in terms of time and money. This will especially be the case when
making significant purchases. Some consumers may even bring purchases forward in order
to avoid further price rises.
Firms will find their revenue and profit may decrease as their costs increase and their sales
reduce. In the case of firms engaged in international trade, they may find their goods
becoming less competitive in overseas markets, again leading to falling revenue and profit.
Similarly, all firms may be affected by the now relatively cheaper imports coming into the
economy. In terms of labour costs, firms may face increasing wage demands from workers
anticipating further price rises and trying to protect their real income. One of the most
important consequences for a firm of rising inflation is the degree of uncertainty it brings to
the economy. This may affect consumer confidence and consumers’ desire to purchase the
firm’s products or services.
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The extent to which these consequences will have a significant impact on consumers and
firms will depend on a number of factors. The first is the extent to which the inflation is
anticipated. Anticipated inflation can be prepared for over a period of time and thus the
negative aspects somewhat negated. Moreover, if the increase in inflation is stable, even
within the government’s target rate, then this can actually benefit firms and consumers as
future nominal wage increases and consumer expenditure can be better planned for.
If firms are suffering from unanticipated inflation but are able to cut some of their costs of
production, the overall consequence of the increase in inflation may not be as severe.
Similarly, if there is even greater inflation in the overseas market, the increase in inflation in
the domestic economy may not impact on export sales with the same negative consequence.
In conclusion, while an increase in the rate of inflation has the potential to deliver negative
consequences to consumers and firms, if the increase is small, short-lived, anticipated and
stable then the negative consequences for consumers and firms will be far less significant
and the increase could even be beneficial over the short term.
5 Government macroeconomic intervention
(Chapter 11)
Multiple-choice
1
C
2
B
3
A
4
A
5
D
Data response
1
a
A government budget deficit is a situation in which government expenditure exceeds current
government revenue. This may occur because the government has identified expenditure
needs that it deems important for the economy – for example, the ‘Emergency Economic
Measures’ in Japan to cope with the Covid-19 pandemic. This situation need not necessarily
be a problem in itself.
The national debt is the accumulated stock of past public debt. The projected national debt
ratio for Japan of well above 240% of GDP in 2020 and 2021 means that any additional
budget deficit will add to the cost of paying interest on the government’s debt. In Japan this
debt repayment will become very high. This may lead to higher taxes and lower government
spending in the future, which could adversely affect economic growth and living standards
for many years. This makes the projected national debt of Japan for 2020/21 potentially a
larger problem than the government’s budget deficit.
b
Between 1975 and 1990 tax revenue and government expenditure in Japan did not diverge
greatly. This in turn led to a relatively consistent amount of national bonds issued each fiscal
year.
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However, after 1990 Japan’s tax revenue situation deteriorated but government expenditure
continued on its upward trend. As the increase in expenditure was greater than the tax
revenue, the government needed to borrow more. This can be seen from the increase in
national bonds issued, which broadly speaking continued from 1990 until around 2000 when
government expenditure stabilised and even fell.
c
A tax system is progressive when taxation takes a greater proportion of income from higher
income earners.
Sales taxes are regressive because they take a larger proportion of income from lower
income earners. The increase in the rate of sales tax from 8% to 10% in October 2019 made
the overall tax system in Japan more regressive and therefore less progressive, ceteris
paribus.
d
The incentive effects produced by corporation tax deferrals for firms are an important aspect
of supply-side policy. Supply-side policies are designed to increase aggregate supply through
an increase in the quantity and/or quality of the factors of production and so raise the
productive capacity of the economy.
In 2020, the rate of investment had not decreased in Japan; rather there was a deceleration
in the pace of increase in firms’ fixed investment. The corporation tax deferral will act as an
incentive for firms to increase their investment further because it will increase their post-tax
profits. In theory, this will increase funds available to fund capital investment, e.g. in new
plant, factories and technologies. This will lead to an outward shift of long-run aggregate
supply (LRAS) as a country’s productive capacity increases. The increase in aggregate supply
will lead to a reduction in the equilibrium price level in the economy.
However, there are conditions under which this will not necessarily be the outcome. The
confidence of firms is very likely to be low at this time and this will reduce the size and speed
of the increase in aggregate supply and therefore that of the price level reduction.
Moreover, corporation tax reductions will have the largest effects on firms that are making a
taxable profit. It is likely that firms’ profits will be lower than usual at this time, so there will
be a smaller increase in investment and aggregate supply than at other times and therefore
a smaller reduction in the equilibrium price level in Japan.
Essay style
2
An expansionary monetary policy is intended to stimulate aggregate demand. As part of an
expansionary monetary policy, the interest rate can be reduced.
Reduced interest rates are likely to cause consumption to increase because it will be cheaper for
households to borrow money as less will need to be paid back in interest. Also, the activity of
saving will be less rewarding because the interest paid on saved funds is likely to fall. This means
that the opportunity cost of consumption falls and therefore consumption is more likely to take
place.
A reduction in the rate of interest is likely to increase investment. This is partly because the
opportunity cost of firms borrowing funds to invest falls. Moreover, firms may be incentivised to
invest because they expect to need to meet the increased consumption that occurs as a result of
the increased household borrowing.
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Consumption and investment together represent a significant proportion of total aggregate
demand. Therefore, as consumption and investment increase, so does aggregate demand. This
increase in aggregate demand will lead to an increase in equilibrium real GDP in the economy.
This represents an increase in economic activity and should, therefore, be accompanied by an
increase in the derived demand for labour and an increase in employment in the economy.
However, such an expansionary monetary policy aimed at increasing aggregate demand would
be far less beneficial in terms of increasing real GDP if the economy were already close to (or at)
full employment. In that case the major impact would be on the price level rather than real
output.
In terms of employment, it is not guaranteed that the increase in real GDP will drive an increase
in the demand for labour. In economies where there is sufficient capital available, firms may
expand their output through increased capital-intensive production, leaving employment
unaffected. It is also possible that the additional demand in the economy could be
accommodated through existing underemployed workers being invited to increase their hours of
work. In such a situation the expansionary monetary policy would not increase the number of
workers employed.
The conclusion is that expansionary monetary policy should only be used to stimulate aggregate
demand when there is sufficient slack in the economy to absorb the increase in aggregate
demand. The impact on employment will depend on entrepreneurs’ preferred capital to labour
ratio and the conditions in the labour market.
Part 6 International economic issues
(Chapters 12 and 13)
Multiple-choice
1
B
2
A
3
C
4
D
5
B
6
C
Data response
1
a
Comparative advantage refers to an economy’s ability to produce goods at a lower
(opportunity) cost than that of trade partners. Raw material prices are similar when sourced
in global markets, wherever the location. This means that, once a firm is established, labour
costs are likely to be the main difference in manufacturing costs between nations, and
labour costs are also an important determinant of comparative advantage.
The data in Table 1 show that China and India have the lowest manufacturing costs in the
world, primarily driven by low labour costs. The fact that China and India are also reported to
be the largest recipients (in Table 1) of foreign investment into their respective
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manufacturing sectors in 2019 is evidence that the theory of comparative advantage, driven
by low labour costs, helps to explain the location decisions of manufacturing firms.
b
One impact of import restrictions placed on South Korean exports by the USA and India
could be a reduction in aggregate demand because exports are a component of aggregate
demand. This could lead to a decrease in equilibrium real GDP and a reduction in
employment in the South Korean economy as a potentially vital source of income is reduced.
The import restrictions could also lead to a reduction in the surplus on the current account of
the balance of payments of South Korea because South Korean exports will fall in value
compared to their imports.
The extent of the impact of the import restrictions will depend on the goods affected and the
relative importance of the USA and India as trade partners in value terms.
The extract states that almost 150 of the 210 import restrictions will be placed on steel and
chemicals. Neither of these individually accounts for more than 10% of South Korean
exports. Furthermore, neither the USA nor India is South Korea’s major trade partner – this is
China, the destination for over 25% of South Korean exports. The conclusion is that, while
these import restrictions will have some impact on the South Korean economy as described,
the impact will not be relatively so significant.
c
One reason why the USA may have introduced the protectionist measures with respect to
South Korean steel imports is to protect jobs in the US steel industry.
It is possible that South Korea is able to produce steel more cheaply than the USA and export
it at a lower price into the US market, undercutting domestic producers. This would lead to a
reduction in demand for US-produced steel and also in the derived demand for US steel
workers. The protectionist measure of introducing a tariff or quota, for example, would
reduce this loss of US steel jobs.
d
The demand and supply diagram below represents the US dollar (US$)/Indonesian rupiah
foreign exchange market.
The initial equilibrium is at the exchange rate of e0 rupiah per 1 US dollar. The economic
uncertainty resulting from the Covid-19 pandemic led to the selling of the currencies of a
number of emerging economies, such as Indonesia, and an increase in the purchase of more
stable currencies, particularly the US dollar, perceived as a less risky ‘reserve currency’.
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This would lead to a rightward shift of the demand curve for the US dollar in the rupiah/US$
market, from D0 to D1. This represents an increase in demand for the US dollar.
The result is that the value of the US dollar would appreciate to a new equilibrium value of e1
rupiah per 1 US dollar.
e
One important factor to have contributed to the current account surplus in South Korea
could be an undervalued exchange rate. The IMF has calculated the South Korean currency
(won) to be undervalued by as much as 12% in recent years. An undervalued currency means
South Korea’s trade partners will need less of their currency to purchase a won. This will
make South Korean exports more competitive and make them appear cheaper to foreigners.
This will increase demand for exports, making a current account surplus more likely.
A second factor could be linked to the increasing saving propensity of households in South
Korea. The result of increased saving is likely to be reduced consumption, including a
reduction in the purchase of imports. This will also make a current account surplus more
likely.
Essay style
2
Expansionary policy seeks to encourage economic growth. Expansionary fiscal and monetary
policy is intended to boost business investment and consumer spending by injecting money into
the economy.
Expansionary fiscal policy includes tax cuts, transfer payments and increased government
spending on projects such as transport improvements. These are designed to increase aggregate
demand as the government’s strategy puts more money into the economy than it is taking out.
Expansionary monetary policy works by decreasing short-term interest rates or expanding
the money supply faster than usual. The easier access to domestic funds will both stimulate
domestic spending and attract an inflow of financial capital from overseas, which will result in an
appreciation of the domestic currency.
While the expansionary policies may work to increase real GDP, the increase in aggregate
demand will put upward pressure on the overall price level. This will reduce the competitiveness
of the exported goods while imports become less expensive to domestic residents. Similarly, the
appreciation of the domestic exchange rate will make domestic exports more expensive and
imports appear relatively cheaper. The combined effect of this decrease in exports and increase
in imports could be a deterioration in the current account of the balance of payments.
The extent of the negative effect on the balance of payments depends on the price elasticity of
demand (PED) of the exports and imports. If the combined PED of imports and exports is greater
than 1 (relatively elastic) then the negative effect on the balance of payments will be greater.
However, if the combined PED is less than 1 (relatively inelastic) then there will be a reduction in
the current account deficit.
The conclusion is that the combined impact of the expansionary policies will be a deterioration in
the current account of the balance of payments unless the combined PED of exports and imports
is inelastic.
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7a The price system and the microeconomy
(Chapters 14–16 and 20)
Multiple-choice
1
B
2
C
3
A
4
B
5
D
6
B
7
A
8
C
9
B
10 A
Data response
1
a
Marginal utility is the change in total utility or satisfaction from consuming an extra unit of a
good – in this case, takeaway food such as pizza slices. Traditional economic theory states
that the marginal utility from each additional pizza slice eaten by a consumer will diminish as
more is consumed.
With less satisfaction gained from each additional pizza slice consumed, the rational
consumer will be prepared to pay less for each of these additional slices. This reveals that as
the quantity demanded increases, the price the consumer is willing to pay for each additional
slice will decrease. This means that the demand curve for takeaway pizza slices will be
downward sloping from left to right.
The limitations of this theory are revealed when we consider the ease with which utility can
be valued or measured. There is no objective way to achieve this and therefore this limits the
usefulness of the theory, especially when attempting to compare individuals’ relative utility
derived from pizza consumption. Also, the analysis relies on the rationality of consumers
when making their pizza consumption choices. This too cannot be fully relied upon.
b
An indifference curve reveals the combinations of two goods that give equal utility to a
consumer, while a budget line represents the boundary of an individual’s consumption set,
given the amount available to spend and the prices of the goods.
A consumer will maximise utility by consuming on the highest indifference curve possible
subject to their budget constraint. On the diagram below, representing takeaway food and
bottles of cola as the other good, this will be at point A.
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Takeaway food has been categorised as an inferior good by the Adam Smith Institute. When
the price of takeaway food increases, less takeaway food can be consumed, and the budget
line will pivot inwards from BL0 to BL1.
The movement from point A to point C (on the notional budget line) represents the
substitution effect of the price change, which is a reduction in the quantity consumed of
takeaway food. The movement from C to B represents the income effect on an inferior good,
showing an increase in the consumption of takeaway food as income falls.
The negative substitution effect is greater than the positive income effect and therefore the
price increase of takeaway food leads to an overall reduction in its consumption.
There are two fundamental limitations to the use of indifference curve analysis in this
context. The first is that it is not practically possible to map the indifference curves of a
consumer, so these are actually theoretical constructs that cannot be observed.
The second is that indifference curve analysis, in this context, relies on the assumption of
rationality and consistency of behaviour on the part of the consumer. Neither of these can
be relied upon in reality, thus creating a considerable further limitation of indifference curve
analysis.
c
There are two aspects to productive efficiency. One involves selecting the most costeffective possible inputs. This is known as cost efficiency. The other involves making the best
possible use of those inputs to produce as much output as possible. This is known as
technical efficiency. Once these two conditions are satisfied, productive efficiency can be
achieved.
If Just Eat Takeaway and Grubhub are able to organise their newly merged firm to satisfy
these conditions, they will achieve productive efficiency whereby they operate at minimum
average cost. Operating at minimum average cost will increase their profit potential, which
will generate the chance to reinvest in their operations, leading to high-quality growth.
While productive efficiency is concerned with the fixed set of existing resources that Just Eat
Takeaway and Grubhub have to work with, dynamic efficiency goes one step further by
considering the effects of innovation and technological progress on productive efficiency in
the long run. Attaining dynamic efficiency for Just Eat Takeaway and Grubhub will involve
undertaking investment in research and development in the meal delivery sector, which
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means their services can be carried out more efficiently in the future. This research and
development activity will generate the chance to reduce costs and develop new services,
leading to further ‘high-quality and profitable growth’.
d
In order for markets to allocate resources efficiently, consumers need to have access to and
receive full and accurate information about market conditions and the products they
consume.
Takeaway food is deemed a demerit good and is likely to be overconsumed because of
imperfect information. The consumption of takeaway food creates several external costs, of
which the consumer is unaware, due to the presence of imperfect information.
It is the fact that the consumer of takeaway food is unable to process the long-run health
problems they could face from a poor diet which creates overconsumption of the demerit
good.
e
Allocative efficiency is achieved when a market is producing the appropriate bundle of goods
in accordance with consumer preferences. This will be at the point where the market price
equals marginal cost.
When considering whether the meal delivery market is achieving allocative efficiency, it is
important that all costs are accounted for. This includes the private cost of firms like Just Eat
Takeaway and Grubhub, but also any external cost of their activity. Meal delivery is
traditionally made using motorised vehicles that create polluting emissions. These emissions
are an external cost because it is paid for by third parties rather than the meal delivery firm
or consumer. It is therefore not accounted for in the market price.
This provides evidence to suggest that the meal delivery market will not achieve allocative
efficiency because the market price of a delivered meal will not equal the true marginal cost.
f
A monopoly can be said to exist when one firm is able to dominate a market in terms of
either the price charged or the quantity traded. A monopoly firm will be able to utilise its
market power to disadvantage consumers by restricting output, leading to a higher market
price than would have been the case in a competitive market. This activity will lead to an
inefficient allocation of resources, which is market failure.
g
Market failure occurs when the free market misallocates resources, resulting in a suboptimal
outcome. This can be the result of a divergence between marginal private cost and marginal
social cost.
The market cost and price of food deliveries include the private costs of Just Eat Takeaway
and Grubhub. However, the marginal external cost of the motor vehicle pollution of each
delivery is difficult to estimate but would be somewhat in excess of the simple private costs
of Just Eat Takeaway and Grubhub. Therefore, when the market price only reflects the
private cost of manufacture, the price is considerably less than the cost to society.
The commercial delivery decisions of Just Eat Takeaway and Grubhub are based on their own
costs. This will lead to a misallocation of resources because they will overproduce their
deliveries based on a marginal private cost that is lower than the marginal social cost. The
increased demand for the services of Just Eat Takeaway and Grubhub during the Covid-19
pandemic would lead to them being responsible for a greater market failure than previously.
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It is worth noting that the reduction in the movement of other polluting road vehicles in
areas with significant lockdown during the Covid-19 pandemic is likely to mean that the
overall market failure of this nature is reduced.
h
The polluting journeys made by the vehicles of food delivery service firms create
externalities which mean the social cost of their activity is greater than the private cost. The
deadweight welfare loss of such an externality is the loss in social welfare that arises when
the existence of the externality moves a market away from its optimum position.
The diagram below shows the extent of the deadweight welfare loss.
If the firm considers only its private costs (MPC), then the equilibrium in the market will be at
E2 with a price of P2 and quantity of Q2. The existence of significant externalities would lead
to the marginal social cost curve (MSC1) being above the marginal private cost curve and
there would be a significant deadweight welfare loss shown by the triangle AE1E2.
The sharing of technology between Just Eat Takeaway and Grubhub, such as that reducing
the delivery distances travelled to service the same number of customers, will reduce the
external costs created by the firms from the operation of their business, as their emissions
decrease. This will shift the marginal social cost curve to the right, from MSC1 to MSC2
towards the marginal private cost curve MPC.
The impact will be to reduce the size of the deadweight welfare loss shown by the now
smaller triangle BCE2.
i
Organic growth occurs when a firm grows internally, by reinvesting its own profits and
developing the existing resources and markets of the firm. Human capital is a measure of the
economic value of an employee’s skill set.
The investment in the skill sets of the workforce at Grubhub would enable the existing
workforce to work more efficiently. Grubhub is likely to grow organically as a result because
a more efficient workforce will be able to process the needs of a far greater number of
customers with new more innovative products and services. This will increase Grubhub’s
reputation and growth as it works towards restoring its 50% share of the US meal delivery
market.
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j
The price elasticity of demand for the food delivered by Just Eat Takeaway and Grubhub is
greater than 1. This is price elastic demand.
Total revenue is found by multiplying the price charged by the quantity demanded.
If there is a decrease in the price of food delivered by Just Eat Takeaway and Grubhub, with
price elastic demand there will be a proportionately larger increase in the quantity of the
food demanded and delivered. This will lead to an increase in total revenue for the food
company.
This will therefore also lead to an increase in the total revenue earned by Just Eat Takeaway
and Grubhub because they are receiving a fixed percentage price of a volume of sales that
has a greater total value than before the price decrease.
However, this does not necessarily mean they will enjoy an increase in profit. The discussion
here is about total revenue and we know nothing of how the costs of Just Eat Takeaway and
Grubhub will behave as the quantity of deliveries increases. We would need this information
before we could comment on the impact on total profit of Just Eat Takeaway and Grubhub,
which would be calculated by total revenue minus total costs.
k
Limit pricing is a pricing strategy used by an incumbent firm which involves setting its price
so low that it makes it difficult for new firms to enter the market and make a profit. This
pricing strategy could be used to deter the entry of new firms or expansion of fringe firms in
the market, protecting and growing the position of the incumbent firm.
In 2019, Just Eat was operating as a technical monopoly in the food delivery market. The
limit price strategy would involve Just Eat charging a price lower than the estimated average
cost of potential entrant or fringe firms. The outcome would be that Just Eat could protect
and grow its market share without competition from these rival firms. This would require
Just Eat to be willing to sacrifice profits in the short run to prevent their entry.
l
A merger is a process that unites two existing firms which agree to form a new company
combining the assets of both. When the two existing firms are at the same stage of
production in the same market, as in the case of Just Eat Takeaway and Grubhub, this
integration is said to be horizontal in nature.
The advantage of the merger with Grubhub for Just Eat Takeaway relates to the increased
size of its operation. This is now the largest food delivery firm outside of China with more
than 70 million active customers who place close to 600 million orders a year, giving the new
larger firm a much more secure market share.
The larger scale of the merged operation will increase their combined access to economies
of scale. These may arise through discounted bulk buying opportunities or the combined
managerial efficiency of two independently successful firms. The merged firm believes it can
benefit from sharing technology to increase efficiency and reduce the delivery distances. This
is an advantage because the economies of scale gained will allow the average cost of
production to fall and profits and productive efficiency to increase.
The new larger firm is also able to make efficiency savings by streamlining duplicated tasks
between the two firms in the short term. Over the longer term it can expand operations as a
new larger firm by consolidating further or by continuing to grow at an increased organic
rate. This is illustrated in the extract where it is reported that ‘Analysts have said that
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consolidation in the meal delivery industry is long overdue as companies have to spend huge
amounts of money to gain, service and retain their customers.’
The extent to which the merger will be an advantage to Just Eat Takeaway will depend on a
number of factors. The streamlining of the duplicated tasks must be quick and effective. If
the duplicated tasks are allowed to continue for too long, this will lead to X-inefficiency and a
loss of profit. Moreover, the merger will involve the integration of the two firms’ cultures,
which, unless addressed quickly, can cause inefficiencies.
In conclusion, the merger will be of considerable advantage to Just Eat Takeaway, especially
because Grubhub is also a successful firm. However, the process needs to be managed
effectively to ensure the maximum benefit is derived.
Essay style
2
External growth can occur through both vertical and conglomerate integration. Each has its own
specific advantages depending on the firms’ objectives. Each also has its potential disadvantages
that the expanding firms must be aware of.
Vertical integration involves firms joining together in the same industry but at different stages in
the production process. It is termed ‘forward vertical integration’ when the firm joins with
another business closer to the customer, such as the owners of a tea plantation purchasing a tea
processing firm. The growth is termed ‘backward vertical integration’ when the firm integrates
with another business further from the customer, such as Amazon.com buying a book publishing
business.
External growth achieved through vertical integration can lead to some economies of scale in the
areas of shared business practice. This could lead to a somewhat lower average cost of
production. Vertical integration is particularly preferable if control of the supply chain is
important to the firm. For example, an aircraft manufacturer might purchase a component
supplier. This is important because it ensures certainty and continuity of supply for the business
while controlling quality and costs of key inputs vital to the firm.
The major disadvantage of vertical integration, which can make it less attractive, is the potential
for diseconomies of scale, leading to increasing average costs of production. Diseconomies of
scale might result from corporate cultural differences where the different objectives and
operational practices of the two firms lead to inefficiencies. Diseconomies of scale could also
result from communication problems between the extended departments of larger firms
potentially operating with different home languages in different time zones. This could result in
inefficiency, wastage and ultimately higher average costs of production, leading to reduced
profitability.
External growth can also be achieved through conglomerate integration. This occurs when two
or more firms in different industries join together. For example, Associated British Foods owns
SPI Pharma (pharmaceuticals) and the retail clothing firm Primark.
Conglomerate integration would be preferred if the firm was concerned with a broader
reduction of risk. This is because operating in more than one industry or economy means there is
the possibility for the business to be successful across its operations even if one of its markets is
in the declining phase of its economic cycle. There is also the possibility of transferring skills and
knowledge between markets. This is because transferable practices from one industry may bring
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cost reductions and efficiencies when applied in another industry within the same organisation.
These efficiencies are sometimes termed ‘economies of scope’.
Less popular than vertical mergers, conglomerate integration has the major disadvantage that
the company may need to shift its focus from its core business activity. This could be detrimental
to the overall performance and profitability of all of the conglomerate enterprises, thus
detracting from overall efficiency. Conglomerate merger could also be less preferred if too little
is known of the market of the potential takeover and too high a price is paid to acquire the target
firm. This creates a disadvantage not experienced in vertically integrated merger. Similarly, in a
conglomerate merger it is difficult to merge different cultural values and working practices.
These differences are more pronounced than in a merger between firms in the same industry.
The extent to which one of these methods of external growth is preferred over the other will
depend on a number of factors. The preferred method will depend on the capacity of the
business in terms of operations and management. If risk diversification is the objective but there
is little experience of this within the existing firm, vertical integration may still be the preferred
route to growth.
Conglomerate merger is often regarded as riskier in the short run, making finance more difficult
to obtain. If the finance is not obtained on favourable terms, this may cause difficulty for the
profitability of the business in the longer run. This may lead to a preference for expansion
through vertical integration.
The impact of regulation is also important in determining the preferred expansion route.
Aggressive vertical integration may attract the attention of the competition regulator, which can
seriously restrict the activities of expanding firms in one industry or sector. This may lead to a
preference for conglomerate merger instead, which is less likely to suffer the same scrutiny.
In conclusion, the objectives of the owners will be a key factor in selecting their preferred
method of external growth. However, their preference for growth, either through vertical or
conglomerate merger, will need to be informed by, and may even need to be directed by, the
other considerations discussed here.
7b The price system and the microeconomy
(Chapters 17–19)
Multiple-choice
1
C
2
C
3
B
4
D
5
C
6
C
7
A
8
D
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9
C
10 B
Data response
1
a
One fixed cost in the extract is the rickshaw rental charge paid by the drivers who rent their
vehicles. One variable cost is the payment for the fuel they use in order to operate their
rickshaw.
b
The law of diminishing returns states that, as the rickshaw manufacturer adds increasing
amounts of a variable factor input, such as labour, to a set of fixed factors, the marginal
output of the firm will at first increase. As this process continues, the marginal output will
reach a maximum. Then, as the quantity of labour is increased further, while all other factors
of production are still held constant, the marginal output will decrease and continue to do
so.
Assuming the rickshaw manufacturer can purchase each additional unit of labour for the
same wage rate, then initially, as additional workers are responsible for additional marginal
product, the marginal cost of the additional output will fall. However, in the phase where the
additional worker is responsible for a reduction in the marginal product, the marginal cost of
the additional output will increase.
Thus, the shape of the rickshaw manufacturer’s marginal cost curve is such that it will first
fall, reach a minimum and then rise, as output increases. This shape is determined by the
fundamental nature of the law of diminishing returns.
c
The expansion in output of a rickshaw manufacturer, as suggested by the extract for the
years to 2024, may result in higher average costs of production. The source of the increase in
average cost could be related to control issues.
For one of the larger firms such as Bajaj Auto, as the expansion takes place it becomes more
difficult for the management to monitor the work of their employees as closely as
previously. The result could be a fall in productivity as it becomes increasingly difficult to
coordinate all aspects of production. Hence Bajaj Auto could incur extra costs and the
average cost of producing a rickshaw could increase.
However, diseconomies of scale are not certain to occur. In fact, a much smaller firm such as
Scooters India may actually gain economies of scale as it expands. This would result in a
decreasing average cost as it produces more rickshaws. Such economies of scale could derive
from the average cost saving from the bulk purchase of materials as output expands.
In conclusion, it really depends where the firm is operating in relation to its own minimum
efficient scale (MES). It is possible that a large-scale rickshaw manufacturer such as Bajaj
Auto will have large fixed costs, meaning the expansion could result in further economies of
scale within its MES range, rather than diseconomies of scale.
d
Barriers to entry are factors that make it more difficult, or even impossible, for new firms to
enter a market. The existence of barriers to entry makes the market less competitive. The
greater the barriers to entry, the less competitive the market.
One barrier to entry that will determine the degree of competition in the rickshaw
manufacturing market in India is the extent of the economies of scale of the incumbent
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firms. The larger existing manufacturing firms such as Bajaj Auto and Piaggio could be
expected to have achieved significant economies of scale and correspondingly low average
costs of production. Hence potential market entrants would find it difficult to compete on
price and would be less likely to enter the market. This is especially the case if the incumbent
firms adopt a strategy of limit or even predatory pricing.
A second issue for potential entrant firms is that of legal barriers. This involves the need to
meet safety criteria that ensure the rickshaws produced will meet the regulations of the
Indian authorities. The cost of compliance with such standards, which are becoming
increasingly strict in relation to emissions for example, may deter potential market entrants
who feel they may not be able to afford the cost of meeting the standards. The result will be
a less competitive market.
e
The key characteristics required for a market to conform to the structure of monopolistic
competition are a large number of suppliers capable of being price makers and a large
number of independent buyers, all of which are relatively small in terms of market power.
There need to be low barriers to entry and exit, and some product differentiation between
the profit-maximising suppliers.
The rickshaw taxi hire market in Delhi conforms to this model to a large extent. There are
many profit-maximising rickshaw drivers who all offer a very similar service. This means
competition is high and the concentration rate is low. In the main, drivers are able to alter
the price they charge somewhat for a journey in line with the card rate. The service they
offer is differentiated by the power, relative comfort and fuel of their vehicle. The cost of
entry to the market is reasonably low because rickshaws can be rented for a monthly fee by
the drivers rather than an outright purchase being made. There are a large number of buyers
in the market and at times the demand for the services of a rickshaw is greater than the
supply.
To some extent the rickshaw taxi hire market in Delhi does not conform to the market of
monopolistic competition. This is because the process of obtaining and renewing a driver’s
operating licence can sometimes be difficult, making entry into the market more restricted.
For the drivers who cannot obtain a monthly rental agreement, there is a considerable initial
cost in the purchase of the rickshaw. Moreover, a second-hand petrol rickshaw is becoming
increasingly difficult to sell because of the increasingly tough government regulation of such
vehicles. This presents a considerable barrier to exit which is not a characteristic of the
model of monopolistic competition.
f
An oligopoly is a market structure where a few large firms dominate the market. The extent
of the dominance can be quantified through the concentration ratio.
The concentration ratio in an industry is a measure of the percentage market share of the n
largest firms in the industry and can give an indication of the type of market structure. The
three-firm concentration ratio for the rickshaw manufacturing market in India is 92.1%.
A three-firm concentration ratio of 92.1% is relatively high and consistent with the market
dominance of a few large firms and therefore oligopoly.
The rickshaw manufacturing market in India can also be classed as an oligopoly because it is
characterised by significant barriers to entry: for example, the considerable sunk costs
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associated with setting up in vehicle manufacture and the extent of the economies of scale
enjoyed by incumbent firms such as the relatively large Bajaj Auto and Piaggio.
The rickshaw manufacturing market in India can further be classed as an oligopoly because it
satisfies the condition of product differentiation and non-price competition. The rickshaw
drivers engage in non-price competition through the promotion of the benefits of using their
particular rickshaw: for example, its comfort or the lack of environmental damage caused by
its fuel system.
g
The rickshaw manufacturing market in India could be classed as an oligopoly. This is based
on Table 1, which shows the market is dominated by a few large manufacturing firms with a
relatively high three-firm concentration ratio of 92.1%.
One representation of the equilibrium position of a firm operating under conditions of
oligopoly is the kinked demand curve model that can be seen in the diagram below.
A profit-maximising firm such as Bajaj Auto will operate where MC = MR. This will give an
equilibrium output level for the firm of Q and a price of P. At the profit-maximising level of
output, the marginal cost will be MC. This is lower than the price, resulting in allocative
inefficiency.
Productive efficiency is achieved when production takes place at the minimum average total
cost (ATC). This occurs when as few scarce resources as possible are used in production. As
the diagram shows, this is not achieved because Q is not at the minimum ATC.
In terms of dynamic efficiency, this is theoretically possible in the model of oligopoly; indeed,
it is arguably likely. The supernormal profits earned by firms such as Bajaj Auto and Piaggio
mean they are able to invest in the ‘designing and development of more efficient and
affordable e-rickshaws’ rather than compete on price. This means allocative and productive
efficiency could be improved over the longer term as the improved e-rickshaws that
consumers want are provided and their average cost falls.
h
In the strict sense, a contestable market is one in which there are no barriers to entry or exit
and the incumbent firms can make only normal profit.
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In theory, legally, the rickshaw taxi hire market is contestable because any potential rickshaw
driver has the right to acquire an appropriate vehicle and apply for an operator’s licence to
work in the market.
The option for potential drivers to hire their vehicle greatly reduces the initial cost involved
in entering the market. Brand loyalty is not a particular issue in the rickshaw taxi hire market
and there is a pool of potential drivers waiting to take the opportunity to enter the market
when allowed. This degree of actual and potential competition keeps the prices and profits
lower than they otherwise might be. The rickshaw taxi hire market therefore does possess
some of the characteristics of a contestable market.
However, there is the possibility of a potential driver not obtaining an operator’s licence.
Also, if a potential entrant driver cannot access a vehicle rental agreement then there are
relatively high start-up costs for the individual, even with the government’s financial
incentives. These create potentially significant sunk costs. There is also the issue of
incumbent drivers potentially operating a limit/predatory pricing policy that would allow
them to restrict the entry of new drivers and maintain above normal profit.
It appears that the rickshaw taxi hire market has limited contestability. The extent to which
the market is contestable depends upon the extent of the barriers to entry and the size and
market power of incumbent drivers. The larger these two factors, the less contestable the
market will be.
Essay style
2
An increase in competition from new entrants into the renewable energy market will lead to
reduced market share and demand for individual incumbent firms, as supply in the industry
increases. This will lower the profit-maximising price of firms in the industry.
Profit-maximising incumbent firms will be in equilibrium at a price above their minimum average
cost. The greater competition and lower price will mean the firms will want to lower their
average cost, moving it closer to their marginal cost and thus achieving greater productive
efficiency. The firms will be motivated to do this in order to maintain profits in the face of falling
prices and to retain existing customers or continue to attract new customers.
Allocative efficiency occurs when firms produce the service that consumers demand while
charging a price that equals the marginal cost of producing renewable energy. Allocative
efficiency is likely to increase because, in order to survive in the more competitive renewable
energy market, the incumbent firms need to provide the precise products that the consumer is
demanding. This will involve them selling their energy at a price closer to their marginal cost. In
order to achieve this effectively, firms must also remove any organisational slack in their
operations in order to reduce their X-inefficiency.
The greater competition in the market could also lead to dynamic efficiency gains. Energyproducing firms will need to invest in greater research and development in the renewable sector
in order to develop and market the more innovative products or more efficient production
processes. This will lead to greater future allocative and productive efficiencies.
Finally, if the increase in competition is taking place because the entire renewable energy
industry is growing, there will be benefits to all renewable energy-producing firms due to
external economies of scale with an associated reduction in long-run average cost.
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It is, however, possible that the increased competition will not lead to gains in efficiency. This
could be the case if one renewable energy-producing firm has a natural monopoly. In this case
and in the face of increased competition, possibly as a result of legislation, the incumbent firm
would not be able to gain such large economies of scale because its output would decrease,
which could reduce its productive efficiency. This could theoretically also force its price up
further above its marginal cost, which would move it away from allocative efficiency.
There could also be a potential loss of dynamic efficiency in the long run. This would result from
the loss of long-run supernormal profits due to the increased competition. This would leave less
to reinvest in research and development activity and cause a loss in future allocative and
productive efficiencies.
Finally, the increased competition may result in energy firms trying to cut costs and hence
compromising health and safety standards and creating greater negative externalities. This
would create a misallocation of resources, with the firm operating at inefficient capacity levels in
the pursuit of greater profit, leading to greater pollution.
The extent to which there would be gains or otherwise in efficiency in the renewable energy
sector would depend on the scale of increased competition. It follows that, if there were just a
small increase in competition, this would have a much smaller impact on either increasing or
decreasing efficiency.
Some economists, such as William Baumol, would argue that it is not simply the level of
competition in the market but the threat of competition and therefore the contestability of the
market that will determine the behaviour and therefore the efficiency achieved by incumbent
firms.
In conclusion, the impact of competition (or the supposed threat of competition) can lead to
greater efficiency in the renewable energy market. The case where this is least likely to occur is
natural monopoly, where the impact on efficiency is likely to be most harmful.
3
A monopoly provider in a product market refers to a situation whereby one dominant firm is the
only provider or seller of a good in that market. The monopoly firm is assumed to follow the
objective of profit maximisation. The equilibrium position of such a monopolist is shown in the
diagram below.
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The profit-maximising firm will produce where MC = MR with an output of Qm and a price of Pm.
This will lead to the monopoly being allocatively and productively inefficient. This is because in
the absence of a competitive incentive to produce at minimum average cost, the monopolist will
actually produce with an average cost of ACm. The result is that the equilibrium marginal cost is
below the equilibrium price and also below the equilibrium average cost, which results in
allocative and productive inefficiency.
The same lack of competitive incentives can lead to organisational slack and the emergence of Xinefficiency for the monopolist. This can be compounded by low staff morale and motivation,
and management and communication problems across the large scale and spread of the firm.
The outcome is likely to be diseconomies of scale as the average cost of production rises with
output, leading to even greater inefficiency.
A monopoly provider in the product market need not always lead to such inefficiency. The theory
of natural monopoly can be used to explain how there are likely to be efficiency gains associated
with the kind of large-scale dominance of production enjoyed by a single provider in a market.
A natural monopoly occurs in an industry where there are such substantial economies of scale
that only one firm is viable in the industry. In this case the supernormal profits of the natural
monopolist could be used to invest in research and development. This creates dynamic efficiency
gains.
These gains will be felt by the firm and therefore the industry and the consumer, as the
production processes and products improve such that it is possible for the monopolist to reduce
its price closer to the marginal cost, and the average cost also closer to the marginal cost, such
that the firm and therefore the industry move towards (but will not necessarily achieve)
allocative and productive efficiency.
The extent to which a monopolist remains inefficient in the absence of competitive pressure will
depend on the level of potential contestability and the threat of contestability. If the threat were
significant and real, the monopolist may be forced to behave as if the competition actually
existed, leading to greater allocative and productive efficiency.
The monopolist may also be subject to the governance of a regulator that requires price to be set
close or equal to marginal cost, for example, thus leading to allocative efficiency. This would
create difficulties for the natural monopolist, however, because its marginal cost is below its
average cost at all output levels, making a condition of price equal to marginal cost unprofitable
and requiring potentially inefficient subsidy payments.
In conclusion, an unregulated monopoly provider in the product market will lead to significant
inefficiencies. These inefficiencies could be reduced if the authorities are willing to regulate the
monopoly provider. They also depend on the extent to which the authorities are willing to allow
natural monopolies that may also require regulation.
8 Government microeconomic intervention
(Chapters 21–23)
Multiple-choice
1
C
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2
D
3
C
4
A
5
C
6
D
7
A
8
B
9
C
Data response
1
a
Government failure is a misallocation of resources arising from government intervention to
correct a market failure. In effect, the intervention causes a less efficient allocation of
resources and imposes a welfare loss on society.
The effect of the increased sales tax of over 20% imposed by the government in Turkey can
be illustrated through the demand and supply diagram below, using the market for
cigarettes as an example.
The increase in the sales tax is paid by the firm to the government while the incidence of
such a tax is shared by the consumer and by the seller. The sales tax affects the supply curve,
shifting it to the left. The outcome is a new higher equilibrium price, moving from P0 to P1,
and a lower quantity traded, moving from Q0 to Q1.
Once the tax is imposed, the government of Turkey would then be able to spend the sales
tax revenue on the provision of merit goods, such as health and education, that would
otherwise be underprovided in the free market.
However, allocative efficiency requires satisfaction of the condition that the equilibrium
price is equal to the marginal cost of production. The increase of a sales tax in Turkey implies
that the equilibrium market price will move (further) away from marginal cost and therefore
away from allocative efficiency.
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This means that despite the tax revenue being used to correct one market failure, the
underprovision of merit goods, the increased sales tax causes the government to create a
misallocation of resources elsewhere, in the market of the sales tax. The imposition of the
sales tax is therefore the cause of government failure.
b
The poverty trap is a situation in which an individual has no incentive to take a job or work
longer hours because the loss of benefits outweighs the gain from increased earnings.
Human capital refers to the stock of skills and expertise and other characteristics that
contribute to a worker’s productivity.
In the extract Jeffrey Sachs means that when individuals have a very low stock of skills and
expertise or other characteristics that contribute to their productivity, they will generate a
low marginal revenue product. This means the wage they can command through taking (or
increasing their) employment will be less than the benefit they forgo in terms of their lost
transfer payments. Therefore, there is little incentive to take paid work because the
opportunity cost is too high. This consigns such an individual to the poverty trap, from which
they can never earn enough to escape.
One government intervention from the extract to combat this outcome would be a policy to
raise the human capital of individuals in the poverty trap. This could be achieved through
targeted programmes to improve the health, education, skills and nutrition of those
individuals suffering in the poverty trap. This creates a problem for the government, which
recognises the need to provide economic protection for the poor, while also wanting to
provide incentives for individuals to work. Achieving the correct balance between these two
issues can prove difficult.
c
As a result of the interventionist policies of the Turkish government, the more educated
workforce may be more skilled at their jobs and create less waste of resources. This will help
the move towards productive efficiency because, with fewer resources used, the average
cost of producing goods or of providing services will fall. As average cost falls, productive
efficiency is increased.
Equity, on the other hand, is more concerned with the way that resources are allocated in a
society and primarily with respect to the treatment of people in society. One way to view
equity would be the treatment of everyone in the same situation in the same manner.
In the context of the question, as a result of the interventionist policy, the Turkish economy
could achieve technical and productive efficiency while producing on its production
possibility frontier. From this perspective, this would appear efficient. However, at the same
time we know from the article that considerable inequality exists in Turkey, where the
income of the richest quintile is 7.5 times higher than the income of the poorest quintile.
This means the Turkish economy contains sections of the population struggling with
significant relative poverty. This outcome does not achieve equity and highlights the
importance of the distinction between efficiency and equity because government
intervention could create an efficient but inequitable resource distribution.
d
The marginal revenue product (MRP) theory suggests that the demand for labour depends
on the marginal revenue product of a worker. MRP is calculated by multiplying the marginal
physical product (MPP) of labour by the marginal revenue of the output that the labour
produces.
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The increase in productivity achieved by the more highly trained workforce in Turkey will
increase their MPP. As the MPP increases, so their MRP will increase. This will lead to an
increase in the demand for labour as labour is substituted for capital, which will shift the
industry demand for labour curve to the right as in the diagram below.
The initial equilibrium wage rate and quantity of labour employed in the industry are given
by W0 and Q0. The increase in the demand for labour will shift the industry demand for
labour from LD0 to LD1. This will lead to an increase in both the equilibrium wage rate to W1
and the equilibrium quantity of labour employed to Q1.
e
The transfer earnings of labour are defined in terms of the minimum payment that is
required to keep the marginal worker in their present employment. For example, a worker is
likely to choose one job over another because the pay is better. By taking the job, the worker
forgoes the opportunity to work in the alternative employment. The opportunity cost is seen
in terms of this forgone alternative wage, which is a measure of the transfer earnings of the
worker.
If the wage in the alternative employment increases, this will increase the opportunity cost
to the individual of not working in the alternative job. This will also increase the transfer
earnings they require to remain in their current employment.
In any occupation, even those where all workers receive the same wage rate, the transfer
earnings could potentially be different for different workers. This is because the transfer
earnings are determined by the opportunity cost of the employment that each worker has
forgone. This is likely to be different for different workers, who would have different
alternative employment opportunities reflecting a variety of different alternative wage rates.
f
An increase in spending on education and training in Turkey will lead to an increase in the
supply of skilled labour to an industry. The increase in the supply of labour is illustrated in
the diagram below.
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The original equilibrium in the industry is shown with labour demand LD0 and labour supply
LS0. This gives a quantity of labour Q0 and wage rate W0. The supply of labour curve then
shifts to the right from LS0 to LS1.
The newly increased supply of labour will lead to an increase in the equilibrium quantity of
labour employed to Q1, but a lower equilibrium wage rate of W1.
Essay style
2
An economy with a significant number of state-owned enterprises (SOEs) is one in which the
government is able to exercise considerable and somewhat unaccountable control over its
domestic factors of production. It could be argued that such an economy is inefficient and would
benefit from a programme of privatisation. This would involve the transfer of resources from
state ownership to private ownership and control.
Large SOEs tend to be inefficient and wasteful. They do not produce at the minimum of their
long-run average cost curve, making them productively inefficient. They charge a price above
their marginal cost of production, making them allocatively inefficient as well. Moreover,
because they have little economic incentive to innovate, they also lack dynamic efficiency and
exhibit X-inefficiency throughout their structures.
The issues around efficiency could be traced to the lack of accountability of those in charge of
the decision making within the SOEs. This could be seen as an example of the principal–agent
problem. Here, the end consumers are the principals, while the managers within the SOEs are
the agents. In this case the consumer has almost no (short-term) control over the decision
making, actions or motivations of the managers. This will lead to problems of waste and Xinefficiency within SOEs that will further compound the issues preventing allocative and
productive efficiencies being achieved.
A further issue could be that SOEs present a financial drain on the state’s resources. They might
require large state subsidies and financial capital at below the rates that could be obtained on
open financial markets. This financial commitment has an opportunity cost as these state
resources could have been used elsewhere in the wider economy more productively by the
authorities.
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The likely benefits of a programme of privatisation where the state-owned resources are
transferred to the private sector arise because the decision makers in private sector firms would
be accountable to their shareholders. This is likely to increase the drive to make a profit. With
this incentive the firms are more likely to cut costs and achieve, or at least move further towards,
productive efficiency.
Consumer welfare will also be enhanced because the price in a privatised enterprise is likely to
fall to reflect more closely the marginal cost of production. This would therefore move the
enterprise towards producing with allocative efficiency.
As the enterprise is now being operated in a more profitable and accountable manner, there is
also the likelihood of dynamic efficiency as the firm invests its supernormal profit in its own
product and process developments. This will lead to further future improvements in productive
and allocative efficiency.
The government will also face the double benefit of not only losing the cost of subsidising the
SOEs, but also raising significant sums of money from the sale of the SOEs and the tax revenues
generated from their profitable operation. This can then be used to finance public expenditure
elsewhere in the economy.
The extent to which the benefits of privatisation are likely to occur will depend on a number of
factors. Privatisation has been most successful in economies around the world when it occurs
alongside some form of regulation. This is because the newly privatised enterprises could
become natural monopolies and subject to the problems that the SOEs originally suffered. A
regulator could be appointed to ensure the operations are not exploitative in terms of pricing,
for example.
One potential limit to the operation of a regulator in this context is the possibility of regulatory
capture. This occurs when the industry has better information about its operation than does the
regulator. This may require the two to work too closely together in a relationship that loses the
rigour that the regulator should exercise.
If the process of privatisation creates a private monopoly, this may harm consumer interests.
However, if the market is contestable, there is greater scope for efficiency savings and additional
benefits associated with the market economy. The extent of the competition that is viable will be
dictated, however, by the availability of economies of scale in the industry.
In conclusion, the extent of the benefit of a programme of privatisation in an economy with a
significant number of large state-owned enterprises will really depend on the industry in
question. An industry like telecoms is typical of those where the incentive of profit can help
increase efficiency. However, if privatisation were applied to industries like healthcare, the profit
motive and ensuing efficiency gains would be significantly more difficult to manage.
3
External costs are those incurred by third parties when an activity takes place. External costs
cause a divergence between the private costs to individuals engaging in the activity, and the
social costs of the activity incurred by all of society. It is this difference that leads to a
misallocation of resources and market failure. In the case of a negative external cost, this takes
place through overproduction and overconsumption in the market. The market failure referred
to here relates to allocative inefficiency.
When applied to the market failure created by the emission of toxic fumes in a production
process, the associated misallocation of resources arises from the cost to third parties of the
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emissions. These emissions create the negative externality and the allocative inefficiency
associated with an equilibrium whereby the price charged (or average revenue) is not equal to
the marginal cost of production. This is shown on the diagram below.
Unregulated firms will only take account of their own marginal private costs, shown by MPC, but
the firm’s production creates higher costs than this for society. These are the external costs of
the toxic fumes that the firm does not account for. The marginal social cost curve S (MSC)
represents the supply curve that includes these additional external costs.
The equilibrium in the unregulated market will be at Q1, and price will be P1. This is an inefficient
outcome for society, as it is clear that there is a divergence between the price and the ‘true’
marginal cost that reflects all of the costs to society.
The marginal unit of the good sold imposes higher costs on society than the marginal benefit
derived from consuming it. There is overproduction. The optimum position is where the marginal
social cost equals the marginal social benefit at Q* with a price of P*. Less of the good will be
consumed, but also less pollution will be created, and society will be better off than at Q1.
The externalities created by the production emissions lead to a welfare loss to society,
represented by the shaded triangle area on the diagram, which is equal to the cost of the
overproduction multiplied by the extent of the overproduction.
This outcome may prompt the government to attempt to regulate the polluting activity. This may
take the form of taxation paid by the firm. The extent of the taxation should exactly match the
external cost incurred by society of the emission of the toxic fumes. This would raise the
marginal private cost of the firm to the level of the S (MSC), thus reducing the overproduction
and allocative inefficiency in equilibrium.
Alternatively, legislation and regulations may be applied to the firm, forcing it to reduce its
emissions through cleaner production processes or placing a limit on the amount of the polluting
activity that is permitted. However the regulations are applied, the purpose of the regulation
would be to reduce the external cost.
The extent to which government intervention can be used successfully to correct market failure
created by toxic fumes will depend on a number of factors. The introduction of taxation to
encourage producers to decrease output and enable allocative efficiency may be an imprecise
intervention. This is because it is difficult to measure the precise value of the external cost
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created by the toxic fumes. It is therefore difficult to be precise about the exact taxation that
should be applied.
Complex taxation regimes can also be costly to administer. These funds could have been directed
to alternative purposes by governments. This means governments will have to make a value
judgement when deciding whether to impose such taxation. Moreover, the imposition of the
taxation and the higher price paid by consumers may create market failures of their own.
There is also the time factor to consider. An increase in taxation can sometimes take a long time
to have an effect on price and output. This can be due to inertia in the market on the part of
consumers, in adapting to the new price as a permanent feature.
The benefits of regulation may not be clear-cut, as there may be considerable costs and
problems of enforcement, or appropriate standards may not be set. Moving forward, there
would also be limited incentive for any improvement in toxic emissions levels once standards
have been met.
In conclusion, there may be unintended consequences of the regulation and it would be
extremely difficult to get the level of taxation exactly right. The effectiveness of the intervention
will depend upon the extent of the government failure that might arise and the extent to which
the various intervention measures are successfully imposed as part of an integrated strategy.
9 The macroeconomy (Chapters 24–27)
Multiple-choice
1
B
2
C
3
C
4
D
5
C
6
D
7
D
8
B
Data response
1
a
Investment is expenditure undertaken by firms to add to their capital stock. Induced
investment is that portion of investment that is caused by a change in output. In the extract,
as the South African economy recovers from recession, aggregate income will begin to
increase. This means firms must undertake investment in order to expand their production
capacity. This part of investment by South African firms is induced investment, caused by
changes in demand in the economy.
Autonomous investment, on the other hand, is investment that occurs for reasons other
than changes in output. One key determinant of autonomous investment is the rate of
interest, or the cost to a firm of borrowing money. If the rate of interest is relatively high,
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firms may be discouraged from spending on investment goods. Also, if the rate of interest is
relatively high, there is a greater opportunity cost to the firms of using their own retained
profit in order to invest, again making them less likely to undertake such autonomous
investment.
However, the rate of interest is not the only determinant of autonomous investment. Firms
will also need to form expectations about the future performance of the economy. For
example, if the indications are that the South African economy, and therefore the demand
for South African firms’ products, will not grow, then this will be an important influence on
their current investment decisions. Increasingly, as firms and economies become globally
integrated, it is not just expectations with respect to the domestic economy that are
important but also those of major trade partners. These can be more difficult to predict with
the same degree of confidence.
b
The multiplier refers to a process where an initial increase in an injection to the circular flow
of income has multiple impacts on real GDP. An injection into the circular flow of income is
an amount that is introduced from outside the system that has not been passed on from
within the circular flow system. One injection into the circular flow comes in the form of
additional government expenditure such as that allocated in South Africa to learning and
culture and to social development.
Whenever there is an increase in an injection into the circular flow of income, there will be
an increase in incomes in the economy. Whatever is not withdrawn from the economy will
cause a second round of additional spending and further increases in economic activity. This
is the multiplier process that causes the level of real GDP in the economy to increase by
more than the initial change in the injection.
The multiplier effect can be seen using the withdrawals–injections model. The diagram
below shows an economy in equilibrium at Y0, with total injections (J) equal to total
withdrawals (W). If the South African government increases spending to G1, as in the article,
then injections increase from J0 to J1, and equilibrium income goes from Y0 to Y1. The effect
of the multiplier is seen in the way that the increase in income (Y1 − Y0) is greater than the
original increase in injections (J1 − J0).
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c
The business cycle is a phenomenon whereby GDP fluctuates around its underlying trend. An
economy such as that of South Africa will be in the recession phase of the business cycle
when GDP is falling for two consecutive quarters. The move from the recession phase into
the recovery or growth phase can be assisted by certain factors.
The weaker value of the South African rand means exports will appear relatively less
expensive and therefore more competitive in overseas markets. Similarly, imports into South
Africa will appear relatively more expensive and so should fall. Net exports are a component
of aggregate demand (AD), so as net exports increase, AD should also increase, raising
equilibrium GDP and helping South Africa to move out of the recession phase of its business
cycle.
The extent to which a weaker currency will lead to an increase in the value of net exports will
depend on the price elasticity of demand for the exports and imports. So long as the sum of
the price elasticities of demand of the exports and imports is greater than 1, the increase in
net exports will have a positive impact on the trade cycle recovery.
Consumption and investment are major components of aggregate demand. The stimulation
of consumption and investment from their current low level by the reduction in the interest
rate enacted by the South African central bank in March 2020 is expected to increase
aggregate demand significantly. This will help the South African economy to move from the
recession to the recovery phase of its business cycle.
The extent to which the interest rate reduction will impact on the recovery in the business
cycle depends on the size and method of the intervention. The interest rate reduction may
be too small or not last long enough. This may not create the confidence required in the
economy and may not increase consumption and investment among South African
households and firms. This would reduce the impact of this factor on South Africa’s move
from the recession phase of its business cycle.
d
Disequilibrium unemployment is unemployment that arises because the economy is away
from equilibrium, and this is likely to be associated with a negative output gap characterised
by a level of GDP below its full-employment value. This is the type of unemployment
referenced by the president of South Africa in his 2020 ‘State of the Nation Address’.
The increase in government expenditure (G) in South Africa on learning and culture and on
social development would increase aggregate demand (AD) because G is a component of AD.
This would lead to multiple increases in the equilibrium level of real GDP, moving the
economy towards its full-employment level of output while closing the negative output gap.
The increase in real GDP would increase the derived demand for labour, which would
effectively reduce the level of disequilibrium unemployment in South Africa.
One important assessment to make is to consider the extent to which the economy of South
Africa would have returned to equilibrium at the full-employment level of output anyway
without any intervention. This is the classical idea of how the macroeconomy operates.
A second consideration with such intervention concerns the impact on inflationary pressure
in the economy of South Africa. The increase in AD could increase the overall price level
through demand-pull inflation without any long-run gains for the economy.
e
Frictional unemployment is always present in an economy – it is the result of time
mismatches between voluntary employment transitions as workers move between jobs.
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Structural unemployment, on the other hand, is a longer-lasting form of unemployment
caused by fundamental shifts in an economy. It can occur because workers lack the skills
required or live too far from regions where jobs are available.
The data in Table 1 support the case that unemployment in South Africa is structural. This is
because 64.8% of those unemployed in South Africa have been so for more than 1 year. This
is far too long to be classed as a transition between jobs and is indicative of structural
problems in the South African labour market. Large-scale mismatches are indicated between
the skills held by unemployed workers and those required for employment vacancies.
The OECD average of those unemployed who have been so for more than 1 year is 25.8%.
This is significantly less than the figure for South Africa, which is the second highest in Table
1. The consequence for those unemployed workers in South Africa could be serious in terms
of their income, standard of living and wellbeing. This is because Unemployment Insurance
Fund (UIF) benefits are only available to workers who contributed to the UIF while they
worked. Employment in the informal sector of the economy is not credited. In countries in
which there is little social security protection, the long-term unemployed may be forced to
enter the informal economy. This problem is widespread in some otherwise upper-middleincome economies such as South Africa.
f
One role of the South African Reserve Bank (SARB) referred to in the article is the regulation
of the financial sector. This function is important because it ensures the efficient and
prudent operation of the financial system in South Africa. An unregulated financial sector
could lead to unsustainable and inefficient lending as witnessed in the period before the
financial crisis of 2008.
A second role of the SARB referred to in the article is the implementation of the
government’s monetary policy. This includes setting an interest rate that delivers the
government’s preferred target rate of inflation. The execution of this role is important
because it helps to create the stable and confidence-inducing environment that generates
the sustainable long-term growth of the economy.
Essay style
2
Sustainable economic growth is one of the primary macroeconomic objectives of most
governments. Economic growth is commonly measured through an increase in a country’s real
gross domestic product (GDP). This measures the growth in the value of goods and services
produced in an economy over a period of time and can be referred to as actual economic
growth. Potential economic growth reflects an increase in productive capacity. While the
benefits of economic growth are easily recognised, there can also be significant costs associated
with an increase in economic activity.
During times of economic growth, it is likely that employment opportunities will increase. This
will bring benefits to workers in the economy through increased opportunities and a greater
wage potential. This is known as inclusive growth. The benefits of economic growth will be felt
by consumers as the variety, choice and quality of the goods and services that they purchase
increases. This will increase their material standard of living.
As employment increases, the government will have the benefit of a smaller welfare bill. This is
because there are fewer individuals claiming a range of benefits as a result of their poverty
and/or employment status. At the same time, the government will benefit from receiving greater
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revenue from taxation, specifically from increased income tax, corporation tax and sales tax
receipts generated by the additional economic activity. The net benefit of the reduced
expenditure by the government and an increase in its revenue is that the government is able to
balance its budget more closely and is in a better position to invest in public services and provide
merit goods. For greater long-term benefits, it is important that the economic growth is
sustainable, which means that the economy grows at a rate that can be continued in the present
without harming the potential for growth in the future.
There are also costs associated with economic growth. These include the opportunity cost of the
inevitable shift in production from consumer to capital goods. This could reduce the availability
of some goods and consumer choice somewhat. There is also the environmental cost to consider
as pollution and congestion, for example, are likely to increase as the level of production and
economic activity grows.
One specific cost associated with actual economic growth is the way in which emissions of
greenhouse gases warm the planet. Sea levels are rising, and major climate change appears
imminent, to most informed observers. On a different level it is also possible that there are costs
of actual economic growth to individuals in an economy, such as increased stress levels as
growth brings pressure in the workplace.
It is apparent that economic growth will bring both benefits and costs. To be beneficial overall
the benefits must be more significant than the costs. The extent to which this will be the case
depends on a number of factors. If there is initially little spare capacity in the economy, the
growth may need to be achieved through a more significant loss of consumer goods output. This
is because scarce resources are required to produce more capital goods. In such a situation, the
economic growth is likely to be less beneficial overall.
In a similar sense, the greater the sustainability of the growth, the more beneficial it is likely to
be over the longer term. If non-renewable resources are used to depletion in a short-term
growth spurt, the chance of future generations achieving similar growth is reduced, as are the
longer-term benefits.
Actual economic growth is most beneficial when associated with an increase in aggregate supply
(AS). If the economic growth is purely a result of an increase in aggregate demand (AD), this can
bring the extra costs associated with increased demand-pull inflation. If, however, AS is also
increasing in an accommodating fashion, the dual benefit will be that the sustainability of the
growth will be increased, and the inflationary pressure reduced.
The manner in which the environmental and climate change costs associated with economic
growth are dealt with will help to determine the extent to which the benefits of growth outweigh
the costs. The additional pollution and congestion generated by economic growth can both be
effectively dealt with through interventionist regulation or market forces. The benefits of growth
are more likely to outweigh the costs when such issues are dealt with effectively by the relevant
authorities.
In conclusion, for economic growth to have the greatest positive impact on the wider economy,
the benefits of the growth must be equally and inclusively distributed among the population.
This will help to ensure the benefits outweigh any costs present. In a similar way, for growth to
have an effective net benefit across the economy, it must be occurring at a faster rate than that
of the increase in the nation’s population. Otherwise real incomes will fall. The objective of
sustainable economic growth remains at the heart of most governments’ range of objectives.
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This would suggest that, on balance, the benefits of economic growth outweigh the costs for
most economies.
3
Quantitative easing (QE) is a monetary policy tool in which a central bank/monetary authority
purchases securities from the market in order to increase the monetary base (or money supply)
in the economy. Economic growth is commonly measured by an increase in a country’s real gross
domestic product (GDP). This measures the value of goods and services produced in an economy
over a period of time and can be referred to as actual economic growth. Potential economic
growth reflects an increase in productive capacity.
QE works through the central bank creating electronic money, then using this to purchase
securities including government and corporate bonds from banks. As the commercial banks sell
these assets for cash, the banks increase their liquidity. This is a process that may also reduce the
interest rate, unless the liquidity trap has already been reached.
Theoretically, with greater liquidity, the commercial banks should be more willing to lend to
consumers to increase their consumption and firms to increase their investment. The consumers
and firms should also be more motivated to borrow at new lower rates of interest. Effectively,
this additional lending will be important for increasing investment and consumer spending,
which leads to an increase in aggregate demand (AD) in the economy and the stimulation of
economic growth.
One advantage of QE as a tool of monetary policy is that it can help to avoid deflation when
interest rates are already ineffectively low, as in the case of the major external shock of Covid-19
that occurred in 2020. A further advantage of QE is that it can help to make the country’s exports
more competitive. The process of QE will keep interests rates lower than they otherwise would
be, which will lead to an outflow of ‘hot money’ from the economy and a depreciation of the
exchange rate. The new lower exchange rate will increase the relative competitiveness of exports
and of domestic goods relative to imports. The combined increase in exports and decrease in
imports will further increase AD in the economy and stimulate economic growth.
There are, however, significant downsides to the process of QE in terms of creating economic
growth. There is the threat of increased inflation, especially when the central bank creates new
(electronic) money with which to purchase the assets from the banks. If the process of QE
increases the money supply faster than the growth in real output, this will cause inflation
because there is more money chasing the same number of goods. The increase in inflation, if
above the government’s target rate, could significantly reduce confidence in the economy
among consumers and firms. This could reduce the extent to which they are motivated to
increase their activity. This would reduce the economic growth that they would have otherwise
generated.
The effectiveness of a policy of quantitative easing in promoting economic growth will depend
on a number of factors. First, there is the possibility that if QE suppresses interest rates to an
artificially low level, capital market distortions will be created. This means that otherwise
inefficient firms are allowed to survive on cheap borrowed money. These so called ‘zombie firms’
will create longer-term inefficiencies in the economy, negatively affecting the future growth
potential.
The effectiveness of QE will also depend on the timescale under consideration. Due to the
dynamic nature of the macroeconomy, it is not at all clear what time lag will be in effect or even
the precise nature of the relationship between QE and GDP growth.
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There is also the issue of whether the central bank should become a major holder of government
debt as created by QE. Moreover, there is the issue of the sustainability of growth that becomes
overly dependent on ‘cheap money’. It might be necessary to move back to a more
fundamentally ‘normal’ interest rate if future economic growth is to be sustainable.
In conclusion, QE can be effective as a policy to promote economic growth when used selectively
and in conjunction with complementary policy options. It is particularly effective when a liquidity
trap occurs and cutting interest rates fails to increase economic activity and growth because,
despite low interest rates, banks are reluctant to lend and/or consumers and firms are reluctant
to borrow.
10 Government macroeconomic intervention
(Chapter 28)
Multiple-choice
1
B
2
D
3
C
4
B
5
A
6
B
Data response
1
a
The short-run Phillips curve demonstrates a relationship first observed in the 1950s between
unemployment and inflation rates. The relationship shows that as the rate of unemployment
increases, the rate of inflation decreases. This relationship is shown in the diagram below.
The trade-off between the variables exists because an increase in unemployment leads to a
surplus of labour that encourages a decrease in wage rates and a subsequent decrease in
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prices. The implication is that there cannot be a simultaneous reduction in unemployment
and reduction in inflation in the short run.
The data on unemployment and inflation between December 2019 and March 2020 in Brazil
conforms to this notion. This is because the rate of unemployment increases from 11.63
million to 12.85 million while the inflation rate decreases from 4.31% to 3.30%. Thus, to
some extent the short-run Phillips curve does explain the unemployment and inflation
situation in Brazil.
b
Calculation:
(49.78 − 2.11) × 100/2.11 = 2,259.24%
Crowding out refers to the process by which an increase in government expenditure
increases the cost of borrowing such that private sector activity is reduced or ‘crowded out’.
The increased government expenditure in Brazil between February and June 2020 was
substantial. However, interest rates were already low and falling over the same period, so
the likelihood of ‘crowding out’ occurring was very low. This means that the increase in
government expenditure would have a larger net impact on real GDP.
c
i
A decrease in the interest rate (relative to that in other economies) is likely to reduce
inward foreign investment and encourage an outflow of ‘hot money’ currently resident in
the economy. This will create downward pressure on the exchange rate as the supply of the
currency increases relative to demand.
ii
The decrease in the interest rate reported for the Brazilian economy from 6% to 2.5%
between September 2019 and June 2020 occurred at the same time as there was a
significant appreciation of the Brazilian real from 6.0 BRL to 1 US dollar in September 2019 to
4.8 BRL to 1 US dollar in June 2020. Therefore, there is no evidence to suggest the
relationship identified in question c i is evident in the article.
d
The balance of payments records financial transactions between one country and the rest of
the world. One of the government’s macroeconomic objectives is to maintain stability in the
balance of payments because a surplus in the current account can cause a deficit on the
financial account and affect the operation of macroeconomic policy and the value of the
exchange rate. The achievement of the objective in relation to the balance of payments may
conflict with other macroeconomic objectives such as the control of inflation.
The surplus in the current account of the balance of payments experienced by Brazil for the
majority of the period in question could be addressed by a loose monetary policy of interest
rate reductions. This could be used to reflate the Brazilian economy and increase the number
of imports to restore some balance to the current account.
However, such a correction of the surplus in Brazil’s current account of the balance of
payments could create a serious conflict with the government’s key macroeconomic
objective of maintaining stability in the price level. The reduced interest rate may lead to an
increase in aggregate demand (AD). As AD increases and resources become increasingly
scarce, there is likely to be an increase in the price level through demand-pull inflationary
pressure. The extent of the pressure on the price level will depend on the size of the
negative output gap. If there is significant slack in the Brazilian economy, as is likely to be the
case, then demand-pull inflation is less likely to occur.
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Essay style
2
Aggregate supply (AS) is the total supply of goods and services available in an economy. Supplyside policies are designed to increase aggregate supply through an increase in the efficiency of
factor and product markets.
Supply-side policies which succeed in increasing the quantity or quality of the factors of
production will raise the productive capacity of the economy. Interventionist supply-side policies
are those that directly involve the government in attempting to influence conditions of
efficiency. An interventionist supply-side policy aimed at increasing human capital through
increased education and training is likely to have the impact of increasing skills and efficiency
and therefore labour productivity over the longer term. The result would be an increase in
economic growth and a reduction in inflation.
Investment in infrastructure, such as a major national rail construction project, is another
interventionist supply-side policy. This will lead to a more efficient use of the factors of
production through greater mobility and reduced transport times. This could also lead to an
increase in the potential capacity of the economy and cost savings that reduce the price level.
A further interventionist supply-side policy is government investment in new technology through
research and development. This would allow firms to operate more efficiently and produce
greater output from a given set of inputs. This too would increase the productive potential of the
economy while potentially reducing the price level.
The effect of these interventionist supply-side policies on the macroeconomy is illustrated in the
diagram below, which incorporates the Keynesian approach to the long-run aggregate supply
curve.
The economy is originally in equilibrium at E1. The interventionist supply-side policies analysed
above lead to an increase in long-run aggregate supply from LRAS1 to LRAS2, which moves
equilibrium from E1 to E2. This results in economic growth, represented by an increase in real
GDP from Y1 to Y2, and a reduction in the equilibrium price level from P1 to P2. This analysis
provides evidence to support the statement that interventionist supply-side policies enable a
government to achieve multiple objectives simultaneously.
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However, the effectiveness of interventionist supply-side policies in always achieving these
multiple objectives simultaneously is questionable and will depend on a number of factors.
Some supply-side policies, such as an increase in spending on education and training, may take
many years (if ever) to have an impact on productivity and so influence aggregate supply. Some
beneficiaries of the education and training may go to work overseas. This is a particular problem
if the skills learnt are being quickly superseded by new skills needed as technology also advances
rapidly. This means that any associated positive impact on economic growth and inflation might
never actually take effect.
Major infrastructure projects are notoriously expensive both in real terms and in terms of the
opportunity cost of the expenditure. In order to undertake some of these major supply-side
projects, taxation may need to be raised to pay for the policy. If the additional taxes increase the
costs of firms, this may lead to reduced incentives to produce and also to cost-push inflationary
pressure. This may reduce the effectiveness of the supply-side policy in achieving multiple
objectives simultaneously.
Finally, supply-side policies may have very limited impact on actual economic growth if the
economy is already operating with a (significant) negative output gap. This is because, with
considerable spare capacity in the economy and an existing demand deficiency, any increase in
productive potential following the implementation of interventionist supply-side policies will add
little to real GDP.
In conclusion, it is possible to show that interventionist supply-side policies do not always
achieve their multiple objectives of increased economic growth and reduced inflation
simultaneously. Inefficiencies can still exist that may require coordinated market-based supplyside policies in order to fully exploit potential efficiency gains and achieve multiple objectives
simultaneously.
11a International economic issues
(Chapters 29 and 32)
Multiple-choice
1
C
2
B
3
A
4
A
5
C
6
D
7
B
Data response
1
a
The key fiscal policy measure that the authorities in India have undertaken to stimulate
economic growth is to reduce income taxation and increase government spending. The
proposed decrease in income taxation detailed in Table 1 would increase disposable income.
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The increase in disposable income is greater for the middle-income earners and is likely to
increase household consumption expenditure in India. This is a component of aggregate
demand (AD), as is government expenditure, which is also increasing by 12.7% according to
the article. The combined effect would be to increase AD and actual economic growth in the
Indian economy.
India is already suffering a current account deficit on its balance of payments, as reported in
the article. The additional consumer spending would include an element spent on imports;
similarly, the increased government expenditure is likely to contain some spending on
imported raw materials or services. The effect, therefore, of the fiscal policy measures would
be to increase net imports, moving the current account of the balance of payments in India
into greater deficit.
The extent of the impact of the fiscal policy measures on the current account deficit will
depend on the marginal propensity to import in India, for both consumers and the
government. The greater the propensity, the greater the increase in the value of imports. It
is likely that the increasingly wealthy middle class in India would use their increase in
disposable income to import more luxury items of relatively high value, such as gold, mobile
telephones and consumer electronic goods, causing a greater increase in the deficit on the
current account of the balance of payments.
b
The article reports that the current account of the balance of payments in India has been in
deficit for a number of years up to June 2020. This account goes into deficit when money
sent outwards exceeds that coming inwards. An expenditure-switching policy would be one
that encourages domestic residents to switch their expenditure away from imports towards
domestically produced goods. For India, a decrease in the import of mobile telephones and
consumer electronic goods in favour of domestically produced items would help to reduce
the current account deficit. One way to achieve this would be through trade protection
methods such as tariffs.
The issue with adopting any protectionist measure is retaliation. For an open and outwardlooking economy like India that arguably enjoys export-led growth, this could be a seriously
damaging issue in both trade and international relations terms.
An expenditure-reducing policy would encourage domestic residents to spend less. This
would move them away from the purchase of so many imported items such as gold, through
a reduction in domestic aggregate demand. This could be achieved through increased
income taxation, for example. For India, the resulting decrease in imports would help to
reduce the current account deficit.
The problem with adopting this approach in India is that the government is actually
undertaking expansionary fiscal policy with lower income tax rates in the pursuit of
economic growth. Expenditure reduction would hinder this and potentially lead to higher
unemployment.
c
The financial account of the balance of payments records transactions associated with
changes in the ownership of a country’s foreign financial assets and liabilities.
India is expected to receive US$73 billion in foreign direct investment (FDI) in 2019/20. FDI
occurs when overseas investors purchase assets in the domestic Indian economy. The net
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flows of such foreign direct investment are one of the most important categories of such
transactions recorded in its financial account.
The current account of the balance of payments, however, is the place where any income,
paid overseas to the foreign owners of the assets, would be recorded. Hence the FDI will
create entries in both the financial and the current accounts of the balance of payments of
India over time.
d
India is considering a renegotiation of its trade deals, with a particular focus on the USA, the
EU and the UK. The realignment will include the benefits of trade creation, which are derived
from the replacement of more expensive domestic production or imports with cheaper
output from a new partner within a new trade agreement.
However, the Indian government will also need to be mindful of the possible costs
associated with trade diversion. These occur through the replacement of cheaper imported
goods from existing trade partners by goods from a less efficient and more expensive trading
partner within a new agreement that has relatively high common external tariffs.
e
A monetary union is a situation in which countries in a comprehensive trade agreement also
adopt a common currency. One disadvantage to India of monetary union would be the loss
of sovereignty over its monetary policy decisions. Within a monetary union there is usually a
central banking institution that undertakes the monetary policy for all economies in the
union. This gives rise to the risk of asymmetric shocks occurring. This could disadvantage
India if the monetary response did not align with its current economic circumstances.
Essay style
2
A competitive devaluation of an exchange rate occurs when one country deliberately acts to
lower – that is, devalue/depreciate – the external value of its currency in order to secure a
competitive price advantage in overseas markets. This can be achieved through supplying its own
currency in the foreign exchange market.
The strategy of a competitive devaluation is aimed at the reduction of a current account deficit
through increasing the quantity of exports and decreasing the quantity of imports. The exports
become cheaper because overseas buyers will require less of the importing countries’ currency
to purchase the exporting country’s goods or services. Similarly, a competitive devaluation will
also provide an advantage to the domestic economy by making imports more expensive. The law
of demand will then dictate that the quantity of exports increases while the quantity of imports
decreases.
Whether this strategy will lead to an improvement in the country’s current account deficit,
though, will depend on the responsiveness of the quantity demanded of exports and imports to
the change in their price. This will be determined by their price elasticities of demand.
The more price elastic the demand for exports, the greater the increase in their quantity relative
to their price decrease and therefore the greater the positive impact on the value of the current
account deficit. The more price elastic the demand for imports, the greater the decrease in their
quantity relative to their price increase and therefore, again, the greater the positive impact on
the value of the current account deficit.
In summary, there will only be an improvement in the current account of the balance of
payments if the sum of the price elasticity of demand for exports and imports is greater than 1.
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This is known as the Marshall–Lerner condition and it is this that appears to validate the view
expressed in the statement. If this condition does not hold then the relatively price inelastic
nature of exports means that there will be a relatively small increase in the volume of exports as
the exchange rate devalues. Additionally, the relatively price inelastic nature of imports means
there will be a relatively small decrease in import volumes as the exchange rate devalues. The
combined effect will lead to no improvement in the deficit on the current account of the balance
of payments.
The extent to which the view in the statement is valid will depend on a number of factors. In the
long run, if imported raw materials increase in price significantly, this could affect the price
competitiveness of exports and negatively affect the current account balance moving forward.
The success of the strategy will also depend on the elasticity of the domestic supply of goods. If
this is relatively inelastic and domestic producers cannot increase output sufficiently to meet the
additional demand for exports, then the current account cannot improve in the manner
suggested in the statement.
While a competitive devaluation will make all exported goods cheaper, there is no guarantee
that consumers in overseas markets will be in a position to increase their consumption at that
time. This would not then help to reduce a balance of payments deficit on the current account.
In conclusion, the impact of a competitive devaluation on the current account deficit is not clear
and will depend on a number of factors that are difficult to predict accurately. Higher import
prices will contribute to higher inflation, which may reduce any significant export price
advantages that might otherwise be expected. It is therefore not possible to state that the
success of a policy of competitive devaluation is ultimately determined by price elasticity of
demand.
3
Globalisation refers to the range of processes by which the world’s economies are becoming
more closely integrated. It is globalisation that allows goods or services to be produced,
distributed and exchanged anywhere in the world. The process will have an impact on
consumers, workers and the environment, some of which will be beneficial and some of which
will cause otherwise positive situations to deteriorate, or already difficult situations to get worse.
Globalisation can have the impact of increasing the living standards of consumers in an economy
that engages in international trade. This results from increased specialisation and trade which,
through the law of comparative advantage, reduces costs and prices, leading to increased
welfare and choice for consumers.
Workers benefit from globalisation through the impact of an increase in the number of ‘locationindependent’ transnational companies. This is because such transnational companies are often
encouraged by host governments to locate in areas of high unemployment, bringing jobs,
training and income to the unemployed workforce. Moreover, workers employed in domestic
export-orientated industries will also benefit from greater employment opportunities.
It is possible that the increased ease with which international communications take place under
globalisation and the development of ideas sharing as an expected norm will lead to
environmental benefits. This is because the best practice in environmental safeguarding and
sustainability from around the world will be shared more readily in forums such as the climate
change summit meetings.
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The extent to which globalisation is universally beneficial for consumers, workers and the
environment will depend on a number of factors. The extent to which consumers will benefit
from globalisation depends on the validity of the classical view of free-trade theory. There is
academic and empirical evidence which suggests that the benefits of comparative advantage are
not equitably shared, and globalisation can be detrimental to the standard of living of some
countries and some groups within countries.
The benefits to workers are also not necessarily universal. This is because, while increased
imports cause domestic job losses, there is no guarantee that these will be replaced by the
creation of additional jobs through additional export activity. Unemployment, relative poverty
and wage squeezes may follow and living standards fall, especially among lower-skilled workers.
Moreover, footloose transnational companies can actually cause unemployment as they move
from country to country in search of lower costs of production and increased profits. Moreover,
workers may be exploited in terms of pay and conditions as their interests are poorly
represented and work regulations in some host countries are not of the standard expected
elsewhere.
The increase in economic activity generated by globalisation leads to increasing environmental
destruction and other negative externalities. These include the environmental problems caused
by congestion, pollution and increasing levels of greenhouse gases from increased production.
The notion that goods can be created anywhere in the world, then distributed to end users
anywhere in the world, inevitably involves increased transportation. The external costs created
by this transportation will not necessarily be fully accounted for. This will lead to negative
externalities that contribute to climate change and a reduction in the health and wellbeing of
third parties and ultimately market failure.
In conclusion, despite some demonstrable gains in poverty reduction and increased levels of
economic growth and development, it is possible to show that globalisation is not universally
beneficial for consumers, workers and the environment. As a result of globalisation, consumers
may not benefit from cheaper and better-quality goods and services, and workers may not
obtain appropriate employment. The environment may also suffer from increased resource
depletion and degradation. It is not always possible to enforce the regulations required in a
global context to address the issues highlighted here. Climate change agreements are a good
example of this.
11b International economic issues
(Chapters 30 and 31)
Multiple-choice
1
C
2
B
3
A
4
B
5
B
6
D
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7
A
8
B
Data response
1
a
Simon Kuznets hypothesised that as society develops, income inequality within society
increases and then falls. In early stage agricultural society there is income equality because
most people have very little income. As the economy grows and develops, the wages of
industrial workers rise faster than those of agricultural workers, giving rise to income
inequality. As the economy and society continue to grow and develop, additional wealth is
redistributed through government transfers and access to education. Kuznets essentially
argued that inequality in poor countries is just a transitional phase, and once nations
become economically developed, inequality reduces.
This relationship is shown in the simple Kuznets curve below.
There is some evidence in Table 1 to support the Kuznets curve. The Gini coefficient
measures the degree of income inequality in a country. The highest Gini coefficients
recorded in Table 1 are in the two sets of middle-income countries, ranging from 40.2 to
44.5, while those countries in the upper- or in the lower-income classification have lower
Gini coefficients. Nigeria, another lower-middle-income country, with a Gini coefficient of
48.8, also fits with this specific set of data. However, the data reported in the article are very
limited.
b
One hypothesis is that there is for any country an optimum population level for the
resources available. Under this argument, Nigeria would be seen as having too large a
population that is growing too rapidly. This will result in a number of disadvantages.
First, a rapidly growing population could deplete resources more quickly, which would
reduce the opportunity for future growth in Nigeria.
Secondly, a rapidly growing population will increase the dependency ratio if the rising
population is due to an increase in the birth rate, as is the case in Nigeria. More resources
will have to be devoted to providing primary education and infant and mother healthcare,
and there will be fewer members of the household available to take paid work.
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Finally, an increasing population will lead to overcrowding and lower living standards. This is
especially the case if, as in Nigeria, the infrastructure development is insufficient to keep
pace with the population growth.
c
The Gini coefficient is a commonly used measure of income inequality in a country. It has a
value between 0 and 1. The lower the value, the less the income inequality.
The article reports that the number of people living on less than $1.90 a day has had been
decreasing considerably. According to the most recent estimates, 10% of the world’s
population or 734 million people live on less than $1.90 a day. That is down from nearly 36%
or 1.9 billion people in 1990. This has helped to reduce the global Gini coefficient from 65.7
in 1992.
The Covid-19 pandemic crisis will have a disproportionate impact on the poor, through job
loss, loss of remittances, rising prices, and disruptions in services such as education and
healthcare. This disproportionate impact will cause a rise in the Gini coefficient as the
income gap widens in countries where the more wealthy are less affected, suffering less loss
of income than the relatively poor.
d
An increase in savings can help finance higher levels of investment and boost productivity
over the longer term. This is because if households save more, by increasing their savings
ratio, it enables the banks to lend more money to firms for productive investment. With the
correct levels of the savings ratio and the productivity of capital, stable and sustainable
growth can be achieved.
This approach assumes that a well-functioning financial system exists. The article details the
problems of banking in Nigeria, concluding that despite the efforts of the central bank, the
Nigerian banking system is yet to reach full stability. This means that even if the savings ratio
increased in Nigeria, which is unlikely given the extreme poverty, there would be bottlenecks
and liquidity shortages in the Nigerian banking system. These problems would prevent the
efficient channelling of savings to investment.
The extent to which an increase in savings in Nigeria is likely to lead to an increase in
economic growth is also dependent on the short-term impact of the increase in savings.
Over the short-term, a sharp rise in the savings ratio is likely to lead to a fall in consumption,
which can lead to a recession. This will be more so the greater the percentage of
consumption within GDP. A sustained reduction in consumption can be a significant factor in
economic stagnation. In such a situation, a sharp increase in the savings ratio is less likely to
lead to the anticipated increase in investment and economic growth over the longer term.
Essay style
2
Gross domestic product (GDP) is relatively easy to measure and represents the value of
economic activity in an economy over time. Living standards are a more normative concept,
considering material and non-material aspects of the quality of life. Establishing a causal link
from increases in GDP to increases in standard of living has its difficulties.
Within any economy there are variations felt in the impact of growth created by an increase in
GDP. There will be those individuals in the economy who are unaffected, and in a wider sense,
whole regions of a country that do not benefit from an increase in the GDP. Larger cities will
traditionally benefit disproportionately from economic growth with more rural areas left behind.
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Also, workers with the skills required in the growth sectors will see their incomes increase while
others will not. Those working in sectors that become less valuable to economic growth could
even suffer structural unemployment. This means that for regions and individuals within the
same economy, the increase in GDP growth could produce regional deprivation and very
different experiences in terms of the impact on their standard of living.
The composition of the goods and services that lead to the increase in GDP and growth will also
be important in determining the impact on the standard of living. If more merit and public goods
are produced, material and non-material standards of living are likely to increase. Similarly, but
conversely, if more goods that create negative externalities or demerit goods are produced, GDP
will still be increased but the standard of living could actually decrease. This is because these
goods, which are worse for consumers than they realise, are increasingly overconsumed.
The accuracy of GDP data and therefore growth rates could also create an issue. The national
income accounting calculations that produce a value for GDP come from vast quantities of
diverse economic data. In reality, these data can be subject to errors and omissions and, in some
cases, the deliberate misreporting associated with illegal economic activity. This could lead to
significant inaccuracies that result in the true growth figure for GDP being quite different from
that officially recorded, whereas the population of the economy would experience the actual
standard of living as it occurred. This means increases or decreases in GDP will not necessarily
lead to corresponding changes in the standard of living.
Finally, if the increase in GDP is achieved through an increase in the hours worked, leading to a
poor work–life balance or reduced mental health and wellbeing, there could be an increase in
GDP but a lower standard of living.
The extent to which an increase in GDP will necessarily lead to an increase in living standards will
depend on a number of factors. Specifically, there is more likely to be an increase in the living
standard in an economy if the GDP growth is inclusive and sustainable.
The OECD defines inclusive growth as economic growth that is distributed fairly across all of
society and that creates opportunities for all. The particular group being considered and the
length of the time period will affect how likely it is to identify inclusive growth. This is because,
for certain groups, such as skilled, occupationally mobile individuals, living standards are likely to
increase quickly. In order for others to be included in the benefits, the authorities must ensure
that growth affects all parts of the economy geographically, and any individuals unable to access
new opportunities should be included in retraining or assisted relocation in order to also increase
their standard of living.
Welfare provision by the state can also help to increase standards of living when GDP increases.
If welfare provision by the state is extensive and increased in line with the increase in GDP, the
increase in the standard of living will be more inclusive for all.
For the increase in GDP to increase the standard of living, it also needs to be sustainable. This
means that the growth in GDP today must not compromise the opportunities for those in the
future also to increase their GDP. If the growth in GDP is part of a poorly managed and uncertain
boom-and-bust cycle, resulting from and in poor decision making, then this will lead to
inefficiency and unsustainable increases in GDP, and volatility in living standards.
The sustainability of the growth in GDP and living standards will depend on the extent to which
pollution, created through increased economic activity, is dealt with efficiently and effectively by
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the appropriate regulatory authorities. Rigorous enforcement of the existing standards would
afford a greater link between increased GDP and an increase in living standards over time.
In conclusion, while there is a link, it is not possible to say that an increase in GDP is sufficient to
cause an increase in the standard of living in an economy. Intervention is required to ensure that
any growth in GDP is both inclusively and sustainably managed by the authorities to ensure that
the widespread and long-term benefits are felt through an increase in the standard of living
throughout the population.
3
The Human Development Index (HDI) is a composite measure of the development of an
economy. It comprises developmental and economic criteria in its measure. The HDI provides a
value for the level of human development that can be used to provide a ready numerical
comparison of development between countries and over time.
One of the main attributes of the HDI is that it is a measure of development that uses
internationally accepted criteria. These measures include education, through the mean years of
schooling for an adult aged 25 and expected years of schooling for a pre-school child. This
provides a measure of development reflecting the opportunities offered by the degree of
exposure to education in the country. A measure of health is included in the HDI through life
expectancy at birth. This has the benefit of providing a measure of development reflecting the
standard of healthcare in the country. A measure of economic growth is included in the HDI
through real GNI per capita at purchasing power parity (PPP). This reflects access to
opportunities for higher standards of living and the human development that can stem from
them.
These three components all have an equal weight in the calculation of the Human Development
Index. The mean average of the three provides one overall value for the HDI of a country of
between 0 and 1. A higher value means a higher level of human development. This is because
the country is more successfully creating and providing opportunities for human development.
Countries often achieve a similar ranking in consecutive years (during stable times), providing
reliability in the value of the HDI calculation. In this way the HDI can, therefore, be thought of as
being used successfully to compare levels of development between countries.
A key deficiency in the HDI calculation, in terms of measuring human development, is that no
account is taken of the negative impacts of economic activity on human development, such as
the external costs of production processes.
One further drawback of using the HDI to compare levels of development between countries is
that it fails to record the difference in access across the key indicators between gender groups.
This effectively masks the different life experiences of different members of the population. In
some societies the arrangements for access to health, education and employment opportunities
differ between the genders, for example. This leads to different degrees of human development
within the same economic environment. This will not be captured by the basic HDI statistic.
Additional criticism of the HDI arises because there exists a range of readily available indicators,
such as those relating to access to sanitation or financial networks, that have an impact on
human development but are not directly included in the HDI calculations. This can make the
measure appear arbitrary when key factors are excluded that would impact on the degree of
human development recorded within a country.
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The issue of inequality is not referenced within the HDI. This can be reasonably easily measured
and can be extremely important in determining access to choices and opportunities that
determine human development. Where there is greater inequality, it is more likely that sections
of the population suffer lower human development than the HDI figure would suggest.
Alternative measures of development exist that go some way to addressing the shortcomings of
the HDI. The Gender Human Development Index, for example, measures the access of each
gender to the opportunities and choices afforded by the level of human development in a
country. The Measure of Economic Welfare (MEW) is a further example. Like the HDI, the MEW
includes a value for GNI, but it then makes various adjustments not included in the HDI. These
adjustments include a value for unrecorded or informal production and crucially there are
deductions made for negative externalities such as environmental damage.
The Multi-dimensional Poverty Index (MPI) is another alternative measure of development. The
MPI uses the same broad criteria as the HDI but attempts to reflect the number of deprivations
faced by households across a broader range. Items comprised in the measure of deprivation
include access to electricity, clean water, sanitation and good cooking fuels. These do not appear
in the HDI measure.
In conclusion, the HDI is a useful composite indicator of economic development and standards of
living. However, as a complete measure of human development it has significant shortcomings.
There are both deficiencies in the measure when used for comparative purposes and alternative
measures that, if used together with the HDI, could provide a more valid and holistic comparison
of human development between countries.
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