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IGCSE Economics
Opportunity cost and the basic economic problem
Definition
Opportunity cost: the cost of any activity measured in terms of the value of the next best
alternative forgone (that is not chosen)
Production: the act of creating output, a good or service which has value contributes to
the utility of others
Producer: people who make and sell goods/services
Consumption: The final purchase of goods and services by individuals
Consumer: Individuals who purchase the good/services to satisfy their wants and needs
Consumption Expenditure : Spending of consumers
Exchange: A marketplace in which securities, commodities, derivatives and other financial
instruments are traded
Trade: An economic activity that involves multiple parties participating in the voluntary
negotiation and then the exchange of one's goods and services for desired goods
and services that someone else possesses.
Entreprenuers: individuals who, rather than working as an employee, runs a small business
and assumes all the risk and reward of a given business venture, idea, goods,
or service offered for sale.
Human resources: the company department charged with finding, screening, recruiting
and training job applicants, as well as administering employeebenefit programs. Also known as Labor.
Natural resources: resources occurring in nature that can be used to create wealth
Also known as Land. Examples include, seas and rivers.
Factors of Production;
Definition : inputs that are used in the production of goods or services in the attempt to make an economic profit.
The factors of production include land, labor, capital and entrepreneurship.
Factors
1. Land
Land refers to the resources available including the seas nad rivers, forests and deserts all manner of
minerals from the ground; chemicals from the air and earth’s crust.
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2. Labor
Labor refers to the physical and mental effort produced by people to make goods/services. The size and
ability of a economy’s labor force are very important in determining the quantity and quality of the
goods/services produced. The greater the number of workers the better educated and skilled they are, the
more an economy can produce.
3. Enterprise
Enterprise refers to the ability to run a production process, employ and organize resources in a firm (an
organization that owns a factory or a number of factories and even shops, where goods/services are
produced).
4. Capital
Capital refers to already-produced durable goods that are used in production of goods or services. It is not
wanted for itself but for its ability to help in producing other goods. It is also known as man-made resources.
Division of labor/Specialization
Definition: A system whereby workers concentrate on performing a few tasks (instead of finishing the entire product
by themselves) and then exchange their production for other goods/services
Advantages
1. More goods/services can be produced
When workers become specialists in the jobs they do, repetition of the same operation increases the skill and
speed of the worker and as a result more is produced.
2. Full use is made of everyone’s abilities
With the division of labor there is greater chance that people will be able to do those things at which they are
best and which interest them the most.
3. Time is saved
Time is wasted when a worker has to switch from one task to another. Time can also be saved when training
people. It would take many years to train someone to be able to build a car, for example, but a person can be
trained quickly to fulfill one operation in the production process.
4. It allows the use of machinery
As labor is divided up into specialist tasks, it becomes worthwhile to use machinery which allows a further
saving in time and effort. For example, cars are painted by machines instead of by hand. This, in turn, allows
machinery to take over people’s jobs leaving many unemployed.
Disadvantages
1. Work may become boring
A worker who performs the same operation every day is likely to be unsatisfied/low morale. To combat this,
many firms play music to their labor forces, or allow them to have a rest during part of each hour. Longer rest
hours and annual holidays may also be introduced although this will shorten the working week.
2. People become too dependent on each other
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Specialisation and divisiol of labour means that people come to rely on others for the provision of
goods/services. For example, people who produce food rely on the provision of tractors, fertilizers, etc.
3. Workers may feel alienated
Workers may feel unimportant because they can no longer see the final result of their efforts. Some firms are
trying to reverse this by introducing workers to a greater variety of tasks
4. Standardization of goods
Goods produced under a system of specialization are usually turned out in vast numbers and share the same
design. Whether this is a disadvantage depends on people’s opinion. For example, there is probably variation
in the color and design in clothes to please most people. However, it is not possible to please everyone
because in most factories it would be difficult and expensive to change the production process to suit one
person’s wants since most factories practice mass production in order to produce the greatest number of
goods in the lowest cost possible.
What is economics?
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. It
studies how individuals, governments, firms and nations make choices on allocating scarce resources to satisfy their
unlimited wants. Economics can generally be broken down into: macroeconomics, which concentrates on the
behavior of the aggregate economy; and microeconomics, which focuses on individual consumers.
Market Systems
Definition:
Market: One of many varieties of systems, institutions, procedures, social relations and
infrastructures whereby parties engage in exchange. It consists of all those people
or firms who wish to exchange a given good or service.
Market system: Any systematic process enabling many market players to bid and helping
bidders and sellers interact and make deals. It is not just the price
mechanism but the entire system of regulation, qualification, credentials,
reputations and clearing that surrounds that mechanism and makes it
operate in a social context.
Price mechanism: Refers to the consumers and producers who negotiate prices of goods or
services depending on demand and supply. This is also known as market
forces.
Types of market systems
Market system
Definition
Free economy
An economy in which
Mixed economy
An economic system in which
Planned economy
An economic system in which
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Advantages
Disadvantages
decisions regarding
investment, production and
distribution are based on
supply and demand and the
prices of goods and services
are determined in a free
price system.
 Capital return. Capital
flows to where it will get
the greatest return,
expanding the total size
of the economy to its
maximum level.
 Supply and Demand.
Supply and demand are
closely linked: Someone
who has a good idea or
product can quickly put it
into the market so that it
is available to those who
want it. Conversely,
when a certain type of
product is desired by
enough people, it is a
simple matter for
someone to provide it.
 Economic freedom. In a
market economy, it is
easier for someone with
initiative and virtue to
create a better life for
themself and their
family; economic
freedom makes it eaiser
to transform hard work
and perseverance into
material wealth.
 Unequal wealth
distribution. a small
percentage of society has
the wealth while the
majority lives in poverty.
 No economic stability.
greed and
overproduction cause
the economy to have
wild swings ranging from
times of robust growth
to cataclysmic
recessions.
both the state and private sector
direct the economy, reflecting
characteristics of both market
economies and planned
economies.
decisions regarding production
and investment are embodied
in a plan formulated by a
central authority, usually by a
government agency.

Provides fair competition.
The presence of private
enterprise ensures that there
is fair competition in the
market, and the quality of
products and services are not
compromised.
Well regulated. Market
prices are well regulated. The
government with its
regulatory bodies ensure that
the market price do not go
beyond its actual price.
Efficient use of resources.
Optimum utilization of
national resources. In a mixed
economy, the resources are
utilized efficiently as both
government and private
enterprises are utilizing them.
It does not allow monopoly at
all. Barring a few sectors, a
mixed economy does not
allow any monopoly as both
government and private
enterprises enter every
sector for business.

Inefficient. It's efficiency
property reduces in
progressively higher degree,
the more its mixed nature
embraces more and more of
government / state
intervention and State
planning and reduces the
reliance on competitive
market economy
management mechanisms.
Less reliance on
competition.Mixed economy
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Stability. Long-term
infrastructure investment
can be made without fear
of a market downturn
leading to abandonment of
a project.
Meeting collective
objectives. Planned
economies may be
intended to serve collective
rather than individual
needs. The government can
harness FOP to serve the
economic objectives of the
state.
Advantages over free
economy. It is not subject
to major pitfalls of market
economies and markedoriented mixed economies.
A planned economy does
not suffer from business
cycles, does not experience
crises of overproduction. It
does not result in asset
bubbles – massive
misallocations of resources.
Inefficient resource
distribution. Planners
cannot detect consumer
preferences, shortages, and
surpluses with sufficient
accuracy and therefore
cannot efficiently coordinate production.
Suppression of economic
democracy and selfmanagement. Without
economic democracy there
can be troubles with the
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Examples
system has a natural
tendency to move further
and further away from
reliance on competitive
market mechanism to greater
and greater bureacratic
controls and interventions.
Encourage state monopolies.
Mixed economy systems tend
to encourage more state
monopolies, higher and
higher tax to GDP ratio and
dominant public finances,
making the government a
large economic player as
compared to corporate or
individual entities.
Canada, Germany, UK
flow of knowledge as is
shown with the initiative
for backyard furnaces and
other efforts in the Great
Leap Forward.
Too competitive. A
competitive environment
creates an atmosphere of
survival of the fittest.
This causes many
businesses to disregard
the safety of the general
public to increase the

bottom line.
USA, Japan, Brazil
China, Cuba, North Korea
The ownership of the factors of production controls:
 What is produced
 Where to produce
 How to produce – the method of production (labour intensive/ capital intensive)
 How much goods and services to produce
Economic sectors
Primary: The extraction of natural resources e.g. oil drilling, quarrying, forestry
Secondary: The manufacturing of goods using natural or man-made resources e.g. car assembling,
property construction, toy manufacturing
Tertiary: The provision of services to consumers or producers e.g. education, accounting, marketing
Quaternary: The provision of R&D, software development and information processing e.g. research
into fiber optics, development of search engines.
Production – Productivity & Wealth Creation
Definition
Productivity: A measure of the efficiency of production. It is the amount of output that can be
produced from a given amount of resources
Labor productivity: the amount of goods and services that a worker produces in a given amount of
time
Production Possibility Frontier: A graph that compares the production rates of two commodities
that use the same fixed total of the factors of production.
Profit = Revenue – Cost ( Productivity (↑ CELL; FOP) ↓ Cost)
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Productivity
 Labor productivity = Output ÷ No. of workers
o E.g. Firm A: 10 units of labor & 20 units of output
Firm B: 20 units of labor & 60 units of output
 Ways to increase productivity may mean:
 Using same number of Factors of Production to produce more output
 Using less Factors of Production to produce same amount of output.
 What is increased productivity = lower business cost
 Increased productivity means greater wealth for owners of firms and the economy (in general)  PPF shift
outwards (economic growth)
How
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to
improve
productivity of land
Increased use of fertilizers – Fertilizers allow previously barren land to produce crops, and
fertile lands to improve higher yields
Improved drainage – Reduces soil erosion and assists in the reduction of phosphorus in
streams.
It allows crops such as hay, corn and soybeans to produce higher yields.
Improved irrigation – In dry areas, improved irrigation will allow plants to receive more
water and produce a higher yield.
Increased use of machinery – Machinery such as tractors help take in the yields much more
quickly.
Introduced genetically-modified high-yield crops – Genetically-modified crops produce
higher yield as they can be altered to
fight against pests, herbicides, cold, disease or
drought.
Build multi-functioned buildings (e.g. skyscrapers) - By building multi-functioned buildings,
land can be allocated more efficiently as
buildings such as skyscrapers can
accommodate a wide range of business
activities
How to improve productivity of labour
 Implement division of labor – Division of labor allows production to be more efficient.
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Increase use of machinery (to aid tasks) – Machinery allows the increase of production as
well as the quality of the finished product to be
better.
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Specialization – There is a higher output. Total output of goods and services is raised and
quality can be improved. A higher output at lower costs means more wants
and needs might be satisfied with a given amount of scarce resources.
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Skill training – Skills training increase productivity. In addition to learning how to complete
new tasks and take on more responsibility, employees can learn advanced
techniques to help those complete everyday tasks more efficiently. Also, it
improves job satisfaction of the employee. Investing time and money in
employees’ skills make them feel valued and appreciated, and it challenges
those to learn more and get more involved in their jobs. Higher job
satisfaction ultimately results in reduced turnover and higher productivity.
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Motivate workers with financial incentives (pay raises, profit sharing), increase job satisfaction (better
working environment)
Nationalization
Definition: The process of taking an industry or assets into government ownership by a national
government or state. It usually refers to private assets, but may also mean assets
owned by lower levels of government, such as municipalities, being transferred to the
public sector to be operated and by the state.
Advantages
 The ability of the state to direct investment in key industries
 The distribution of state profits from nationalized industries for the overall national good
 The ability to direct producers to social rather than market goals
 Greater control of the industries by and for the workers
 The benefits and burdens of publicly funded research and development are extended to the wider populace
Disadvantages
 Costly management. The management of the nationalized industry is complicated and unwieldy. There are
numerous departments and paid persons i.e. directorate, regional office conduct its management.
 Lack of decision making. All the necessary matters are decided by various official and committees. In case of
conflicting views, quick decision cannot be made for the urgent matters which are dangerous in business.
 Lack of efficiency. Nationalized industries are managed by salaried persons who are generally found less
efficient as compared with privately owned concerns. There is also lack of flexibility and adaptability which
are asset of private ownership.
 Bureaucracy. There is extensive and rigid procedure of the state machinery by which event is dealt. Such
stipulated rules has made the process of work very complicated which results in delay and loss of initiative.
 Absence of profit motive. The salaried persons are not concerned with profit. Therefore, nationalized
undertaking hardly run successfully due to lack of personal interest
 Chances of loss. The loss of the nationalized enterprises is regarded as the loss of the nation. So the structure
of nationalized economy will greatly affected by the failure of such scheme.
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Limited investment. Investors hesitate to invest large sum of money due to risk of nationalization. Therefore
the volume of investment remains limited in private sector.
Privatization
Definition: The incidence or process of transferring ownership of a business, enterprise, agency, public
service property from the public sector (the state or government) to the private sector
(businesses that operate for a private profit) or to private non-profit organizations.
Advantages
 Increased efficiency. Private companies and firms have a greater incentive to produce more goods and
services for the sake of reaching a customer base and hence increasing profits. A public organization would
not be as productive due to the lack of financing allocated by the entire government's budget that must
consider other areas of the economy.
 Specialization. A private business has the ability to focus all relevant human and financial resources onto
specific functions. A state-owned firm does not have the necessary resources to specialize its goods and
services as a result of the general products provided to the greatest number of people in the population.
 Improvements. Conversely, the government may put off improvements due to political sensitivity and special
interests—even in cases of companies that are run well and better serve their customers' needs.
 Capital. Privately held companies can sometimes more easily raise investment capital in the financial markets.
While interest rates for private companies are often higher than for government debt, this can serve as a
useful constraint to promote efficient investments by private companies, instead of cross-subsidizing them
with the overall credit-risk of the country. Investment decisions are then governed by market interest rates.
State-owned industries have to compete with demands from other government departments and special
interests. In either case, for smaller markets, political risk may add substantially to the cost of capital.
Disadvantages
 Job Loss. Due to the additional financial burden placed on privatized companies to succeed without any
government help, unlike the public companies, jobs could be lost to keep more money in the company.
 Natural monopolies. Privatization will not result in true competition if a natural monopoly exists.
 Profit. Private companies do not have any goal other than to maximize profits. A private company will serve
the needs of those who are most willing (and able) to pay, as opposed to the needs of the majority.
 Goals. The government may seek to use state companies as instruments to further social goals for the
benefit of the nation as a whole.
Demand theory
Definitions
Demand: The ability and willingness to pay a price to purchase a good/service
Quantity demanded: The total amount of goods or services that are demanded at any given point in time.
Ceteris Paribus: The relationship between both the price and the quantity demanded of an
ordinary good.
Effective demand: the demand for a product or service which occurs when purchasers are
constrained in a different market
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Notional demand: The demand that occurs when purchasers are not constrained in any other
market
Individual demand: The ability and willingness of a consumer to purchase a good/service
Derived demand: Demand for one good or service occurs as a result of the demand for another
intermediate/final good or service
Types of income

Real. Income of an individual or group after taking into consideration the effects of inflation on purchasing
power.

Disposable. Amount of money that households have available for spending and saving after income taxes
have been accounted for. Disposable personal income is often monitored as one of the many key economic
indicators used to gauge the overall state of the economy.

Discretionary. Amount of an individual's income that is left for spending, investing or saving after taxes and
personal necessities (such as food, shelter, and clothing) have been paid. Discretionary income includes
money spent on luxury items, vacations and non-essential goods and services.
Factors that affect the demand for goods/services
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Good's own price. The basic demand relationship is between potential prices of a good and the quantities
that would be purchased at those prices. Generally the relationship is negative meaning that an increase in
price will induce a decrease in the quantity demanded. This negative relationship is embodied in the
downward slope of the consumer demand curve. In other words, the lower the price, the higher demand,
ceteris paribus
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Price of related goods. The principal related goods are complements and substitutes. A complement is a
good that is used with the primary good. Examples include hotdogs and mustard, beer and pretzels,
automobiles and gasoline. If the price of the complement goes up, the quantity demanded of the other good
goes down. The other main category of related goods is substitutes. Substitutes are goods that can be used in
place of the primary good. If the price of the substitute goes down, the demand for the good in question
goes down.
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Personal Disposable Income. In most cases, the more disposable income (income after tax and receipt of
benefits) you have the more likely you buy. Any changes in the level of income tax rates and allowances are
therefore likely to result in a change in the quantity of goods/services demanded. In a normal good, demand
for a product tends to rise as incomes rise. If the demand tends to fall as incomes rise the product is said to
be an inferior good.
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Tastes, preference or habits. The greater the desire to own a good the more likely you is to buy the good.
There is a basic distinction between desire and demand. Desire is a measure of the willingness to buy a good
based on its intrinsic qualities. Demand is the willingness and ability to put one's desires into effect. It is
assumed that tastes and preferences are relatively constant. For example, if consumers around the world are
demanding good/services that are environmentally-friendly, the derived demand for those goods/services
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will increase. Advertising also plays a part. Persuasive and informative advertising tends to increase brand
awareness and as a result, increase the demand for the good/service.
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Consumer expectations about future prices and income. If a consumer believes that the price of the good
will be higher in the future he is more likely to purchase the good now. If the consumer expects that her
income will be higher in the future the consumer may buy the good now. In other words positive
expectations about future income may encourage present consumption.
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Seasonal demand. A hot summer can boost sales of cold drinks and ices while a cold winter can boost the
demand for fuel for heating.
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Higher interest rates can increase the demand for savings schemes but reduce the amount of money people
want to borrow, including mortgages for house purchases.
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Population change. An increase in population tends to increase the demand for many goods and services in a
country. For example, in a country where there is an aging population, demand for walking sticks and
retirement homes may increase.
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Location of consumers. There is unequal distribution of income and wealth in different areas of the country.
In a richer area of the country, the demand for superior goods will be higher in an area of low income.
Price Elasticity of Demand
Definition:
PED. A measure used to show the responsiveness, or elasticity, of the quantity
demanded of a good or service to a change in its price. The elasticity of the demand
curve will also affect the amount of revenue as the price changes
Formula
PED = % change in Quantity Demanded
% change in Price
,
PED = (New QD – Old QD) x100
(New P – Old P) x 100
Inelastic : The PED value is between 0 and -1. It tends to have few substitutes, is necessities, and/or can be
addictive, e.g., alcohol, cigarettes, or petrol.
Elastic
: The PED value is between -1 and -∞. It has a lot of substitutes and may be an inferior good.
Revenue
Definition: Revenue is the amount received by the producer from the sale of the goods or service. It is calculated
by the multiplying the price charged by the quantity sold (R = P x Q). The only difference between revenue and profit
is the costs
Price elasticity of Supply
Definition:
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PES: A measure used to show the responsiveness, or elasticity, of the quantity supplied of a good
or service to a change in its price. The PES is always a positive number
Formula
PED = % change in Quantity Supplied
% change in Price
PED = (New QS – Old QS) x100
,
(New P – Old P) x 100
Inelastic : The PED value is between 0 and 1. It tends to have few substitutes and takes time to alter the
quantity of production.
Elastic
: The PED value is between 1 and ∞.
Note: The amount supplied is not always equal to supply and may create shortages and surplus.
Economies of scale
Definition:
Economies of scale:
Diseconomies of scale:
The cost advantages that an enterprise obtains due to expansion.
The forces that cause larger firms and governments to produce goods and services at
increased per-unit costs.
Advantages of large-scale production
Internal
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Lower average unit costs. Scale of production because of a change in the way a firm is run. For example,
larger firms can afford more effective advertising. They can spread the cost of advertising over a larger
number of products.
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Efficiency. For example companies can shut down small firms and open one large firm and paying fewer
managers to run it. Another is technological economies, meaning that larger firms can buy more efficient
and larger machinery and equipment, leading to lower average unit costs

Research and Development. Firms can afford to spend large amounts on research and development
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Purchasing. They can afford to buy materials in bulk and therefore the unit costs are cheaper as they may be
given discounts for buying in large quantities.
External
`
 Geographical advantage. An area has an excellent reputation for producing a particular good/service or a
pool of skilled labour may develop in an area where many firms are concentrated. This helps reduce training
costs and probably makes recruitment easier.
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Risk-bearing economies. When borrowing from a large loan, the company can use assets from profitable
firms are collaterals and spread the risk of the loan over several firms.
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Firms may cooperate with each other.
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Similar and related firms. There may be firms in the area in related industries with similar expertise and
knowledge.
Disadvantages of large-scale production

Managerial deos. Breakdown of communication as firms get too large. This can lead to a delay in making
decisions.
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Labor deos. Decrease in staff morale as it is difficult to retain close personal contact with staff because of the
size of the organization
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Jobs may be broken down into specialist parts and the workers may find their jobs too repetitive and boring.
Advantages of small firms

Flexibility. Small firms can adapt readily to consumer needs, designing products to meet individual
requirements, whilst some products cannot be mass produced.
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Industrial relations. The boss of the small firms tends to have a wide general knowledge of the performance
of their employees, and may have a friendly relationship. This could increase morale and motivation. There is
also less chance of poor productivity as there are less people in small firms.
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Customer relations. Likewise, small firms are more likely to know their customers and to be able to offer
personalized services to their customers. Personal attention is more feasible in small businesses, such as
private music/sports tuition.
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Local monopoly. Some firms supply only to a small market, and specialist businesses are not interested in
these markets.
Public and Merit Goods
In a mixed economy the government exists alongside the free market to provide certain goods and services. These
tend to be public goods and merit goods because a free market would either fail to provide them or not provide
them in sufficient quantities.
Public Goods
These are things like street lighting, coast guard, police, fire brigade, and the army. It is clear that people want
streets to be lit and to be kept safe from attack so why doesn’t the market react and satisfy these wants? Why do you
believe that private firms would be reluctant to provide these? They have two distinctive features: They are nonrivalry, meaning that anyone can use it, and they are non-excludable, meaning that they can’t stop people from
using it and it is difficult to prevent “free riders”.
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Merit Goods
Merit goods are not provided enough by the private sectors because it is not profitable. They are things like
healthcare, education, libraries, sports centers, country parks, public housing, and public hospitals. Public housing
and hospitals are public because the people who use these facilities have no or low income to afford it. Again,
people want to be kept well and want to be educated. The market can provide these goods; ESF is a private
education provider whilst in the USA healthcare is almost exclusively carried out by the private sector. Why then in
many countries do governments step in and provide healthcare?
Trade Unions
Definitions
Trade Unions: An organization of workers that have banded together to achieve common
goals, promote and protect the interests of their member.
Collective bargaining: a process of negotiations between employers and a group of employees
aimed at reaching agreements that regulate working conditions and pay.
Open shop : A firm that can employ unionized and non-unionized labour
Closed shop : All workers in a place of work have to be union members. The closed shop is
outlawed in some countries because it gave unions too much power to dictate
who a firm could employ
Shop Steward: One of the firm’s employees who is granted time off, during working hours,
to deal with trade union matters. In some larger companies, a shop steward
may be employed full-time on industrial relations. His or her
Wage Councils: These organisations set minimum wages (not National) for their relevant
industries. Wage councils have declined dramatically in numbers since 1979.
Employment Laws: Laws passed by the government or the European Union that set out rules of
behaviour for workers, employers and trade unions with regard to employment
Single union agreement: An agreement between an employer and a union such that the union will
represent all the workers at a particular workplace. This means that one
union can represent all the workers, whatever their occupation, in the
same workplace.
Industrial relations: The relationships between employees and employers
Trade Unions Past and Present – The change of trade unions
Since their establishment, the membership and influence of trade unions continued to grow until the early 1980s.
The Conservative government at that time responded to public anger over strikes by introducing laws that restricted
the unions’ activities. In addition, rising unemployment and the decline in the manufacturing industries (that formed
the traditional base of the unions) have reduced union membership.
The increase in part-time jobs and the increased number of women working have also had an impact on union
membership. In the past, neither of these groups have been strong supporters of trade unions. In addition, the
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1980s and 1990s have seen a dramatic increase in the number of self-employed people - who are not usually
unionized.
In response, unions have tried to improve their image by making their services more appealing and relevant to
today’s world - e.g. the ATL union (Association of Teachers and Lecturers) has a “no strike” policy. Many unions now
offer their members loans, mortgages, insurance, credit cards, discount holiday vouchers and discount car hire.
Today, some trade unions also provide grants for college courses, or arrange retraining programmes (the process of
developing new skills), for their members who have been made redundant. In addition, they also provide
representatives for members in cases of redundancy, grievance, disciplinary hearings and legal action (e.g. on equal
pay).
Trade Union Membership Around the World
According to the International Labour Organisation, only 25% of the world’s 1.3bn workers were members of trade
unions in November 1997. However, since the ILO also concluded that trade unions are adjusting to the realities of
today, it is likely that trade union membership will increase over the next ten years.
In a recent ILO survey of 92 countries, only 14 had a unionised workforce of over 50% (and 48 countries had less than
20%). Results of selected countries are shown below
Trade Union Density in selected countries (ILO):
Country
Sweden
Italy
South Africa
Australia
UK
Germany
New Zealand
Japan
USA
South Korea
France
1995 density
91.1
44.4
40.9
35.2
32.9
28.9
24.3
24.0
14.2
12.7
9.1
% change since 1985
+8.7
-7.4
+130.8
-29.6
-27.7
-17.6
-55.1
-16.7
-21.1
+2.4
-37.2
Source: adapted from ILO Labour Report 1997
Types of Trade Unions
Although the number of trade unions and the number of members in unions have declined steadily since 1979, we
can still distinguish between four different types of trade unions:
1.
Craft Unions
These are the oldest type of unions, which were formed originally to organize workers according to their particular
skill. For example, engineers and printers formed their own respective unions. Today, the GPMU (Graphical, Paper
and Media Union) has members working in the printing, paper, publishing and media industries. The decline in the
demand for some particular crafts has led to many of the older unions to recruit semi-skilled and unskilled workers.
15
2.
Industrial Unions
These unions attempt to organise all workers in their industry, irrespective of their skills or the type of work done.
The National Union of Mineworkers (NUM) is an example. National Union of Teachers (NUT), Trade Union Congress
(TUC)
3.
General Unions
These unions are usually prepared to accept anyone into membership - regardless of the place they work, the nature
of work, or industrial qualifications. These unions have a very large membership of unskilled workers. The TGWU
(Transport and General Workers Union) is a very large General Union in the UK. Their members include drivers,
warehouse workers, hotel employees and shop workers.
4.
‘White Collar’ Unions
Also called non-manual unions and professional associations, these recruit professional, administrative and clerical
staff (salaried workers) and other non-manual workers. They are very strong in teaching, banking, the civil service
and local government.
The Role/Functions/Aims of Trade Unions
The primary role of Trade Unions is to protect the workers’ interests. Examples include:

Collective pay bargaining – trade unions are able to operate openly and are recognized by employers, they
may negotiate with employers over wages and working conditions.

Subscription – Early trade unions, like Friendly Societies, often provided a range of benefits to insure
members against unemployment, ill health, old age and funeral expenses. In many developed countries,
these functions have been assumed by the state; however, the provision of professional training, legal advice,
support for members that are mad redundant and representation for members is still an important benefit
of trade union membership.

Political activity – Trade unions may promote legislation favorable to the interests of their members or
workers as a whole. To this end they may pursue campaigns, undertake lobbying, or financially support
individual candidates or parties (such as the Labour Party in Britain) for public office.

Industrial action – Trade unions may enforce strikes or resistance to lockouts in furtherance of particular
goals.
Aims of the Trade Union
 Defending their employee rights and jobs
 Securing improvements in their working condictions, including hours of work and health and safety of work
 Improving their pay and other benefits, including holiday entitlements
 Improving sick pay pensions and industrial injury benefits
 Encouraging firms to increase worker participation in business decision making
16
 Developing and protecting the skills of Union members.
Aims of the workers:
Workers will aim to maximize:

Higher Wages – matching inflation (index-link salaries to CPI)

Job security – no sacking without notice or reasons

Working conditions - Health & Safety; working hours

Career progression opportunities: Training and up-to-date information

Health and Safety at work

Perks, Health insurance, pensions, car, education allowance
Aims of the employers
For the employer, targets to maximise may include:

Profits

Sales

Lower costs
Industrial disputes
Definition: Disputes with the workforce and/or their representatives - and any resulting industrial action - are costly
and damaging to both the business and workers.
Causes
1. Economic Cause
 Demand for increase in wages on account of increase in all-India Consumer Price Index for Industrial Workers.
 Demand for higher gratuity and other retirement benefits.
 Demand for certain allowances such as: House rent allowance, medical allowance, demand for paid holidays
and reduction of working hours, Better working conditions, etc.
2. Personnel Causes. Sometimes, industrial disputes arise because of personnel problems like dismissal,
retrenchment, layoff, transfer, promotion, and more vacations etc.
3. Indiscipline. Industrial disputes also take place because of indiscipline and violence on the part of the workforce.
The managements to curb indiscipline and violence resort to lock-outs
4. Misc. causes. Some of the other causes of industrial disputes can be workers' resistance to rationalization,
introduction of new machinery and change of place, non-recognition of trade union, rumors spread out by
17
undesirable elements, working conditions and working methods, lack of proper communication behaviour of
supervisors to inter-trade union rivalry.
How collective bargaining is organized
Definition: the process whereby representatives of the workers (in a particular industry) negotiate
say pay settlements - with representatives of the employers (in that industry).
Generally, an individual worker is in a weak bargaining position - the main purpose of a trade union is to remove this
weakness by “forcing” the employer to negotiate with the representatives of his/her work force.
Trade unions are autonomous bodies - they have complete freedom to act in their own interests. Most unions,
however, are affiliated to the Trade Union Congress (TUC), which is the largest trade union. It has an important role
in bringing trade unions’ points of views on a national scale, possibly affecting government decisions - e.g. the TUC
have been at the forefront of the National Minimum Wage negotiations.
If the more powerful unions make full use of their bargaining strength, they could succeed in getting larger and/or
more frequent wage increases than the weaker unions. This highlights the importance of “unionisation” within trade
unions - the larger and more united the union, the better the bargaining position, ceteris paribus.
How is it organized
Collective bargaining is organized depending on the relationship between a union and firms that employ unionized
labor.
 In a open shop, a firm can employ unionized and non-unionized labor
 In a closed shop all workers in a place of work have to be union members. The closed shop is outlawed in
some countries because it gave unions too much power to dictate who a firm could employ. A union could
also call the entire workforce in a firm/industry out on strike. In these ways, a union may act like a monopoly
and restrict the supply of labour so as to force up the market wage for a job/occupation.
 A single union agreement allows a union to represent all the workers, whatever their occupation, in the same
workplace. This is usually in return for certain commitments from the union on pay or production levels, and
for agreeing not to take strike action. Negotiating with a single union rather than several at a time is much
easier for a firm.
The Challenges facing Trade Unions

Decline of manufacturing industries

Growth in part-time employment

Switch from male to female employment (in terms of percentage increases.

Co-operation with management

Government legislation (which seeks to reduce union influence)
The Basis for Wage Claims
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Trade union demands for higher wages are normally based on one or more of the following:
1.
A rise in the cost of living (e.g. due to inflation) has reduced the real income of their members.
2.
Workers in comparable occupations have received a wage increase.
3.
The increased profits in the industry justify a higher return to labour.
4.
The productivity of labour has increase
How can Trade Unions raise wages?
1.
Restricting the Supply of Labour
Unions can restrict the supply of labour in an industry, for instance, by pushing for longer apprenticeships or tough
examination (entry) requirements. This increases the wage rate in the industry from W1 to W2 in the diagram below.
S2
S1
W2
W1
D
Q2
Q1
Employment
However, a problem has arisen - the quantity of labour able to enter the industry is restricted by Q1 to Q2.
2.
Increasing the Demand for Labour
Unions can influence the demand for labour by use of productivity deals. They try to persuade workers to increase
productivity (which in turn helps to increase the Marginal Revenue Product of Labour - recall that the MRPL is the
demand for labour). In return, trade unions negotiate wage increases for their members, justified by their increased
productivity.
SL
W2
Productivity deals have the
effect of raising the MRPL
curve from D1 to D2,
thereby raising wages from
W1 to W2. The advantages
of this method are that
productivity deals help to
19
W1
D2 = MRPL2
D1 = MRPL1
Q1
Q2
Employment
Externalities
Calculations
Social Costs = Private + External Costs
Social Benefits = Private + External Benefits
Definition
 Social costs and benefits are therefore the costs and benefits incurred by the entirety of society (producer,
consumer and third party) as a result of the production and/or consumption of a good or service.
 Private costs and benefits are the costs and benefits incurred by individuals directly involved in the
production and/or consumption of a good or service.




Where no market failure exists social costs would be equal to private costs.
If external benefits exist more of the said good should be produced and consumed (it is being underconsumed or under-produced) thus the market system is not supplying the optimum resource allocation.
If external costs exist than less of the said good should be produced and consumed (it is being consumed or
produced in excessive quantities) thus the market system is not supplying the optimum resource allocation.
Firms and individuals will not consume/produce any good or service unless the private benefit of their
activity exceeds the private cost incurred in their activity.
The government will make sure that:
 Merit goods (goods with external benefits) are encouraged (to prevent under-consumption or underproduction from occurring.)
 Demerit goods (goods with external costs) are discouraged (to prevent over-consumption or overproduction from occurring.)
 Demerit goods do not have prices which account for their external costs.
 Smoking and alcohol are examples of demerit goods.
The government will:
 Subsidize merit good producers to reduce the costs of production and thereby encourage production of such
goods whilst causing prices to be lowered as a result of the increase in supply and the decrease in prices of
production caused by subsidization.
 Tax demerit good producers to increase the costs of production and thereby discourage production of such
goods whilst causing prices to increase as a result of the decrease in supply caused by taxations as well as by
the increase in the price of production.
 Sometimes the government may choose to nationalize certain industries that are producing externalities to
regulate and control them and so force them to produce at the socially optimum level.
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




Laws and regulations –Limits on the level of emissions of certain chemicals through use of the law and a
fining system to punish firms for infringement.
Ban on the use of certain chemicals which may result in significant external costs through use of the law and
a fining system to punish any infringement.
Forcing firms to internalize all costs: Pollution permits (these can be traded to firms who can then pollute
more at a reasonable price). Pollution permits are given out to firms by the government before any trading is
done. (Equivalent and derived from the Carbon Credits used internationally to restrict national pollution). But
this scheme is costly (administration costs are high) to implement, it is difficult to measure pollution levels
accurately, rich firms may simply buy their permits off poorer firms and so pollution may not have been
decreased at all, it is hard to calculate how many pollution permits to give out.
If external benefits exist then the public would be willing to pay more for a certain good to assure that it is
produced at the socially optimum level. (Increase in demand, extension along the supply curve).
If external costs exist that the public would be willing to pay more to assure that it is produced at the socially
optimum level. (Decrease in supply, contraction along the demand curve.)
Government Regulation
These are used to:

Promote competition.

Resolve externalities where market failure exists:

Provision of public goods.

Taxing demerit goods.

Enforce law and order.
Influence the location of firms:

Prevent overcrowding in cities.

Prevent regions from being neglected.
Governments do not desire oligopolistic or monopolistic markets as such markets are uncompetitive when
compared with competition based markets. Often, a government will restrict the formation of such markets by:



Breaking up larger firms into smaller ones
Providing incentive for other firms to set up in the market
Preventing merges that may prove detrimental to competition
How does the government regulate private enterprises?

Investigate existing monopolies and suggesting ways in which competition may be introduced into these
monopolist-dominated markets.
 Investigate proposed mergers and prevent such merges from taking place if they are believed to be
detrimental to competition.
Influencing the Location of Firms:
Why is this done?
 o Some regions may be economically depressed, usually due to the decline of a traditional industry (this may
lead to regional unemployment).
 o Some regions may be overcrowded with too much pollution, traffic congestion, insufficient housing and
public services as a result of too many firms choosing to set up in the said regions.
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How is this done?
Give firms incentives to set up in depressed regions:

Low loan interest rates.

Grants for the construction of infrastructure.

Grants for the training of workers.

Tax holiday/allowance.

Low rent/free premises.

By building and improving the infrastructure present in the said depressed region.

Persuade firms in congested regions to move to depressed regions (stop granting licenses to operate in a
congested region).
Monopoly
Definition: A monopoly is a situation where the market is dominated essentially by one firm. The
legal definition of “monopoly” is a firm that has 25% or more market share in the
market.
Advantages and Disadvantages of Monopolies
Advantages
 Firms usually makes higher profits
 The firm can use profits to invest in new or improve upon existing products
 Price Maker because does not face any competitors
 Economies of Scale: Increased output will allow average unit prices of production to drop. This can be passed
onto consumers in the form of lower prices, so customers may be more inclined to buy the firms products in
the future.
 A firm may become a monopoly through efficiency; A monopoly is thus a sign of success and not inefficiency.
Disadvantages
 Consumers may have to pay higher prices due to lack of competition
 Consumers have less choice because market is dominated by the monopolistic firm.
 Less innovation of products
 Firms may not be efficient with allocation and utilization of resources because they do not have any pressure
to reduce costs.
Oglipoly
What is it?
 An oligopoly exists when there are several dominate firms in one market.
 If there are only two sellers in one market than that the market structure of the said market is a duopoly
which is a special case of an oligopolistic market.
 Examples include the petroleum industry, TV broadcasting industry (duopoly in HK), supermarket industry
and the banking industry.

Please note that, as a general rule of thumb, even if a market has hundreds of providers, if the top 3 –7
providers together possess 50% or more of the market’s total market share then that market is said to be
oligopolistic.
Main Features
 A few sellers dominate market supply/or a few sellers supply a major part of the total market supply
irrespective of the total number of smaller suppliers in the market
 The same goods but which are heavily differentiated by use of advertising, branding and other such methods.
22



These firms produce similar but heavily differentiated products; this differentiation makes the goods look
different to the consumer. (Heterogeneous goods)
These firms engage in many forms of non-price competition but rarely deign to involve themselves in price
based competition as such competition can lead to price wars which only benefit the consumers and no one
else.
Brand image is often very important for such firms. (Coke and Pepsi test).
1. Oligopolistic firms will advertise a lot more than monopolists in the attempt to build a strong brand image and to
differentiate their goods from the products of their competitors.
2. If one firm has a better brand image, even with an inferior product, the said firm may be able to sell more of its
product than another firm with a worse brand image.
 Entry into such markets is restricted either because of governmental decrees or because of the huge startup
capital or technology requirements needed in order to open shop in the said market. Furthermore, because
of the furious level of competition between existing oligopolistic firms, these firms generally produce at a
very low price, a feat which would be very difficult for smaller firms which do not wield the same level of
economies of scale as the larger oligopolistic firms.
 Market information is restricted and often incomplete as no firm knows what another competitor will do. To
combat this, such firms often collude to form cartels (trade agreements) and conduct themselves with all the
advantages, and disadvantages, of monopolists. These agreements are generally illegal.
 The actions of one firm will affect what the other competing oligopolistic firms will do as such firms will react
very quickly to the actions of a competitor. (Sellers are highly interdependent).
Barriers to Entry
 Existing firms are well established and have strong brand images.
 Existing firms enjoy economies of scale and are much more efficient.
 Existing firms enjoy customer confidence.
 The government may have issued rules that govern entry, sometimes for a certain number of years, into a
certain market. These rules would have been put in place to encourage entrepreneurs to enter into a market
where one would require large startup capitals. (Mobile phone industry in China).
Pricing Strategies:
 Price wars.
 Price Leadership:
 When the dominate firm in a market determines the price of a good other firms have no choice but to
follow their example or lose market share unless they choose to lower their prices even further and risk a
price war.
 Sometimes they will even collude to prevent price wars from happening.
Price collusion:
 Forming a cartel.
 Predatory pricing otherwise known as destruction pricing.
Advantages
 Economies of scale (low average cost achieved on account of a high level of output).
 Excess (abnormal or supernatural) profits.
 Promotes research and development because these firms can spread the potential costs involved in R&D
over a much larger range of income sources thus lowering the risk of R&D.
Disadvantages
 Lower output levels and higher prices as these firms control such things
 Less choice for consumers.
 The need for government regulation to prevent oligopoly firms from overusing their powers.
23
Economic growth
Definition
Recovery: The period where the economy moves between a recession and a boom.
Boom: This period is fast economic growth. Output is very high due to increase in demand, and
unemployment is very low. Additionally, consumers may be confident about the economy
so this may lead to extra spending
Recession: Economic Growth slows down and level of output may have a negative impact.
Unemployment increases and consumers are likely to save instead of spend, so there is
less money circulating in the economy.
Slump: A period where output starts to decrease. Consumer confidence may also begin to deplete.
GDP: The total or national output of a country over a period of time.








GDP
It measures the total amount of income earned in a macro economy – national income.
Changes used to measure economic growth – Real change in GDP over time.
National Output = National Income = National Expenditure
Total value of output produced by all domestic firms within economy.
GDP = Consumption + Government Expenditure + Investment + Net imports
Some of the output income will flow overseas, as people from other countries may achieve output in your
economy
GDP is measured in terms of money.
However, money is subject to change in its value and inflation. To solve this problem, the real value of
output or GDP is adjusted for inflation so we know how much is really generated from economic growth and
how much is simply due to rising prices.
Inflation
Definition
Inflation: A general and sustained rise in the level of prices of goods and services – prices of vast
majority of goods and services on sale to consumers keeps rising over time.
Stagflation: Persistent high inflation combined with high unemployment and stagnant demand in
a country's economy.
Hyperinflation: Prices rise at phenomenal rates in short periods of time, rendering money
worthless. Usually, the inflation rate is in double digits
Deflation: The prices of goods and services fall. This is usually negative inflation.
Disinflation: Fall in the rate of inflation.


Ideas
Price change over time (inflation) is always given per period of time.
Deflation can be a cause for concern – deflation will usually occur when demand for goods and services
are falling, causing firms to lose profits, profits and reduce workforce.
24


This will reduce household incomes, causing further reduction in goods and services. The value of debts
held by people and firms will rise in real terms as prices fall and burden of making loan repayments rises.
Eventually the economy goes into recession.
How to measure inflation
Measured by
• CPI (Consumer Price Index)
•
RPI (Retail Price Index)
1. A base year or starting point is chosen. This becomes the standard against which price changes are
measured.
2. A list of items bought by an average family is drawn up. This is facilitated by the Living Costs and Food Survey.
3. A set of weights are calculated, showing the relative importance of the items in the average family budget the greater the share of the average household bill, the greater the weight.
4. The price of each item is multiplied by the weight, adjusting the item's size in proportion to its importance.
5. The price of each item must be found in both the base year and the year of comparison (or month).
This enables the percentage change to be calculated over the desired time period.
Calculating the CPI/RPI:










Indices express change in prices of a number of different products as a movement in a single number.
Average of ‘basket’ of products in first year calculation or base year is given the number 100.
If on average the basket rises overall by 25% next year, then index becomes 125.
If in second year it rises another 10%, then 125 x 1.1 = 137.5 – 37.5 becomes average price rise in two year
period.
To construct a CPI, a sample of households are taken and surveyed – their spending patterns observed for 12
months which is the base year. The proportion of income spent on each category is recorded.
Average prices of different goods and services (minus fuel and food) are recorded from a sample of shops.
The proportion of income spent on each category is used to weight average prices of each type of
good/service to find their weighted average prices.
This shows how big an impact a change in price of a particular type of good or service will have on cost of
living for the average household.
The proportional of household income spent on a certain type of good/service is multiplied by the average
price of the good/service purchased in the category, to generate its weighted average price – these weighted
prices are then all added together, which is the overall average price for goods and services in the basket.
The weighted total price of the basket can be compared each year to work out percentage changes in
average consumer prices.
Uses of CPI/RPI Data:
1. As economic indicator – CPI is widely used measure of price inflation, and therefore is measure of changes in
cost of living. Governments try to control inflation using macro-economic policies. The CPI will be used by
workers to seek wage increases, and used by entrepreneurs in business making concerning purchases and
setting wage and prices.
2. As a price deflator – Rising prices reduce purchasing power, value, of money. Rising prices can therefore
affect real value of wages, profits, pensions, savings, interest payments, tax revenues and other economic
variables important to people and decision making. CPI therefore used to deflate other economic series to
25
calculate real inflation-free values. i.e. wages go up 10% but inflation is 15%, therefore real wages fallen by
almost 5% less.
3. Indexation – involves tying certain payments to rate of increase in CPI. E.g. pensions may be indexed.
Similarly, savings may be index-linked, meaning interest rate is set equal to CPI, protecting real value of
people’s savings. Many workers may also be covered by collective bargaining agreements that tie wage
increases to CPI changes. Government may also index threshold at which people start to pay tax or higher tax
rates to stop people paying more or less tax.
Problems with Price Indices:
Over time typical household basket of goods and services will change.
CPI needs to take account of this, but deciding how and when to make them can be difficult.
Changes due to:
o Fashion and taste
o Introduction of new goods and services
o Change in population and household size due to migration, birth/death rates, marriage timing and
numbers etc.
o Similarly CPI needs to take into account changes in quality of goods and services over time, how and
where households buy goods and services such as internet and new shops.
o International comparisons of CPIs are hard to make due to different household compositions and
spending patterns.
o Argued that exclusion of food, energy, house prices and income taxes means CPI cannot accurately
measure change of living cost.
Inflation
 Economists today tend to agree main cause of inflation is ‘too much money chasing too few goods.’
 This means people are able to increase spending on goods and services faster than producers can supply
goods and services, boosting aggregate demand and forcing prices up.
 A government can allow supply of money to increase in an economy by issuing more money or allowing
banking system to create more credit – lending more to people and firms.
 A government may do so to :
o Increase total demand in economy to reduce unemployment.
o In response to increase in demand for goods and services for goods.
o In response to workers demand for higher wages, or rise in other production costs.
o As money supply rises, people’s purchasing powers rise and inflation can occur.
o To stop excessive inflation, a monetary rule government’s should follow is to only allow supply of
money to expand at same rate as increase in real output or real GDP over time.
o If money supply increases faster than output, then inflation will occur.
o Stagflation – when inflation and unemployment are both high and increasing – often due to rising
living costs causing increased demand for higher wages and less labour demand.
Causes of inflation
 Increase in Money Supply – an increase in money supply would increase the spending
power of the average consumer, thus increasing demand and hence pushing up prices. This then causes
inflation.
 Demand Pull Inflation – When aggregate demand is increased, firms are no longer able to
meet demand in production and thus prices inflate. To finance this, firms may borrow more or money supply
increased.
 Cost Pull Inflation – When the cost of producing goods is increased, firms may want to offset these increased
costs to consumers to keep a certain level of profit, thus the extra cost is added to price of the good or
service, causing inflation. Wage Price Spiral is when workers demand higher and higher wages, causing cost
push inflation and prompting them to ask for higher wages again.



26

Imported Inflation – rising prices in one country may be exported to another country through international
trade in many different goods and services. Many countries have been able to enjoy stable inflation as
China’s large supply of goods and services is produced through cheap labour.
Consequences and Costs of Inflation:

Personal Costs:
o Reduce purchasing power
o Real income falls
o People like pensioners and students on fixed incomes will suffer from inflation.
o Low paid and non-unionized workers often fail to get sufficient rises to stop real income falling.
o Professional workers may ask for wage increases that protect or cause increases in real wage levels.
o Savers and lenders may be hurt by inflation rate if interest is less.
o People who borrowed may benefit.
o Demand-pull inflation increased spending can boost company profits, while cost-push may reduce
profits. Rising profits could yield more tax, however government may have to pay more for goods
and services.
o Economical Costs:
 Possible unemployment – purchasing power drops, less demand
 Some people save more, reducing economic activity and overall output
 Causes goods and services to become uncompetitive internationally
 Benefits:
 Economic growth
 Reduce debt values – falling value of money reduces real debt values
 Higher stock value
 Values of fixed assets could rise – financial security
 Possible increased employment
 Stimulate technological advancement
Economic Growth and Inflation
Most governments hope that they can achieve steady economic growth without it causing acceleration in demandpull and / or cost-push inflationary pressures. The dangers of a booming economy is that inflationary pressures build
and that the economy must slow down or fall into recession for these inflation risks to be controlled.
27






During the early part of the last decade, the British economy enjoyed a period of steady growth and relatively
low and stable inflation
In 2007-08 the trade-off between growth and inflation worsened
Inflation surged higher – mainly because of external factors such as high food and oil prices
The economy suffered a steep descent into recession following the global financial crisis
In early 2009 the economy experienced recession and higher inflation – some economists warned of a
lengthy phase of “stagflation” conditions
Inflation fell back largely because of the recession. But in 2010 and into 2011, inflation has been rising again
whilst GDP growth has been weak with the risk of a second downturn (a “double-dip”)
Stagflation
Stagflation is a period of economic stagnation accompanied by rising inflation. In other words, both of these key
macro objectives are worsening. It can happen when an economy goes into a downturn or a recession but when
other external forces are bringing out higher inflation. The obvious example of this is when recession is afflicting a
country but the prices of imported products are surging causing prices to rise and real incomes and profits to
fall. The rise in the cost of imports can be shown by an inward shift in the short run aggregate supply curve leading
to a contraction in real national output and an increase in prices.
One of the dangers of stagflation is that the fall in real incomes causes consumer and investment spending to fall and
thus the rate of economic growth suffers too (a deterioration in a third objective of policy). Wage demand may also
pick up as people experience rising prices. The central bank needs to consider appropriate policy responses to this.
Too severe a tightening of monetary policy for example will help to curb inflation but risk causing a deep
recession. The combination of deflation and a sustained drop in economic output is termed an economic depression
An improvement in aggregate supply can help to resolve the growth – inflation trade off. We see in the diagram how
aggregate supply has moved outwards and this allows aggregate demand (C+I+G+X-M) to operate at a higher level
without threatening a persistent increase in the general price level (inflation).
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Overcoming a conflict between economic growth and inflation – increases in AD and AS
Conflicts between objectives – the economics of deflation
Deflation is a sustained fall in the prices of goods and services, and thus the opposite of inflation. Increased attention
has focused on the impact of price deflation in several countries in recent years – notably in Japan (inflation -0.3% in
2010) and in some Euro Area countries such as Ireland Greece where prices have been falling, national output has
dropped and unemployment has been rising.
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It is normally associated with falling level of AD leading to a negative output gap where actual GDP < potential GDP.
But deflation can be caused by rising productive potential, which leads to an excess of aggregate supply over demand.
Greece has suffered from a severe rise in unemployment (right hand scale) and is now seeing her relative living
standards fall. A deflationary depression is a risk for Greece
Possible damaging consequences of persistent price deflation
 Holding back on spending: Consumers may postpone demand if they expect prices to fall further in the
future.
 Debts increase: The real value of debt rises when the general price level is falling and a higher real debt
mountain can be a drag on consumer confidence and people’s willingness to spend. This is especially the case
with mortgage debts and other big loans.
 The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line
with prices. If inflation is negative, the real cost of borrowing increases and this can have a negative effect on
investment spending by businesses
 Lower profit margins: Lower prices hit revenues and profits for businesses - this can lead to higher
unemployment as firms seek to reduce their costs by shedding labour.
 Confidence and saving: Falling asset prices including a drop in property values hits wealth and confidence –
leading to declines in AD and the threat of a deeper recession.
Resolving the threat of price deflation
 Using expansionary Monetary Policy
o Interest rates: Deep cuts in interest rates can be made to stimulate the demand for money and
thereby boost consumption
o Quantitative Easing – printing money in the hope that, by injecting it into the economy, people and
companies will be more likely to spend.
 Using expansionary Fiscal policy
o Keynesian economists believe that fiscal policy is a more effective instrument of policy when an
economy is stuck in a deflationary recession and a liquidity trap
o The key Keynesian insight is that a market system does not have powerful self-adjustments back to
full-employment after there has been a negative economic shock. Keynes talked of persistent underemployment equilibrium – an economy operating in semi-permanent recession leading a persistent
gap between actual demand and the potential level of GDP.
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Keynes argued that this justified an exogenous injection of aggregate demand as a stimulus to get an economy on the
path back to full(er) employment and to prevent deflation.
Unemployment
Definition
Frictional Unemployment: Occurs as workers change jobs and spend time without jobs during this
period.
Seasonal Unemployment: Occurs when consumer demand for certain goods and services are seasonal, and as a
result people are only employed during periods of time.
Cyclical Unemployment: Occurs when there is too little demand for goods and services in the
economy during a recession, and firms are producing less as a result,
employing less labour as a result.
Structural Unemployment: Occurs when the labour market is unavailable to provide jobs for all
workers because of a mismatch between the worker’s skills and the
skill requirement of the jobs. It arises from long-term changes in the
structure of the economy, as entire industries close down due to lack of
demand for goods and services they produce. Workers who become
unemployed and have skills no longer needed are occupationally
immobile.
Voluntary Unemployment: Voluntary unemployment includes workers who reject low wage jobs
whereas involuntary unemployment includes workers fired due to an
economic crisis, industrial decline, company bankruptcy, or
organizational restructuring.
International labour organization
The International Labour Organization (ILO) measure of unemployment assesses the number of jobless people who
want to work, are available to work and are actively seeking employment. It is used internationally so comparisons
can be made between countries. It also enables consistent comparisons over time. The ILO measure is calculated
using data from surveys of a country’s labour force; it can therefore be subject to sampling differences between one
country and another. It differs from the claimant count unemployment tmeasure, which only includes people
claiming unemployment-related welfare benefits. The ILO measure gives a higher figure than the claimant count
measure as it includes those who are classified as available for work but who are not claiming jobless benefits. The
ILO measure may include students who are actively seeking work but may not qualify for jobless benefits. Similarly,
second earners within a household may be reluctant to claim jobless benefits but would be classified as unemployed
under the ILO measure as they are available for work.
Government Policy
Definition
Monetary policy: The process by which the government, central bank, or monetary authority of a
country controls the supply of money, availability of money, and cost of money
or rate of interest, in order to attain growth and stability of the economy.
Fiscal policy: Government policy that attempts to influence the direction of the economy through
changes in government taxes or through some spending.
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Expansionary policy:
Contractionary policy:
Government macroeconomic objectives and policies
Most of the governments round the world have four main objectives. These are
 Keep inflation under control
 Maintain a low level of unemployment
 Achieve a high level of growth rate
 Maintain a healthy balance of payments.
Government Economic Policies
Government influences the economy through its economic policies. These are
Fiscal Policy
It is related with taxes and government spending. This policy is there to control inflation and demand in the economy.
Usually government collects money in the form of taxes and spends money through its development expenditure
such as building roads, bridge, defense, transports etc. Government constantly monitors the aggregate demand in
the economy. Inflation rate gives the correct measure of the aggregate demand in the economy.
When the aggregate demand in the economy is high, prices rise, this shows that the economy is spending too much.
In this case, the government will lower is expenditure budget and cut back on investment spending, such as on road
construction and hospital equipment. On the other hand the government might also increase the taxes, which would
take spending power out of the economy by leaving consumers and businesses with less income to spend.
In the opposite scenario, when the economy is heading for a recession and unemployment is rising, the government
might increase its expenditure plans. There might be a reduction in taxes so as to leave consumers and businesses
with higher disposable incomes.
Monetary Policy
Monetary Policy is related with a change in interest rates by the government or the Central bank. When the forecast
for inflation is that it will rise above the targets set by government, then the Central Bank will raise its base rate and
all other banks and lending institutions will follow. It is usually done when the economy is at the boom stage of the
business cycle.
A higher interest rate will result in…business will not be able to expand as they have to pay more interest to the
bank for their loans and they have less profit left. Businesses that are planning to take loan for expanding may
postpone their decisions and wait for a cut in interest rates. Consumers demand will also fall as they will not be
getting cheap loans to pay for the buying new houses and luxury items.
If inflation is low and is forecasted to remain below governments targets, then the Central Bank may decide to
reduce interest rates.
Supply side policies
It includes all those policies which aim at improving the efficient supply of goods and services. These might include:
 Privatization
 Imparting training and improving the education level of the workforce resulting in higher skills.
 Increase competition in all industries by removing entry barriers, thus leading to more efficiency.
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Factors causing a change in components of AD
Change in consumption
A change in consumption is caused by any of the following factors
 Changes in income: Income increases consumption increases and vice versa.
 Changes in interest rates: Fall in interest rates will make borrowing money cheaper. Consumers will now be
tempted to take loans and purchase goods and services. Consumption will rise. On the other hand if the
interest rates increase, borrowing becomes expensive. Consumers will be more tempted to save rather than
spend. Consumption will fall.
 Changes in wealth: A rise in house prices or the value of stock and shares makes a person feel wealthy.
Consumers feel more confident and tend to spend more .
 Changes in consumer confidence: Higher consumer confidence is likely lead to increased consumption.
Change in Investment
 Interest Rates: If interest rates are low firms will find it easy to borrow funds for investment. Investment
increase when interest rates fall.
 Changes in National Income: If the national income increases, firms will have to invest further to increase
output (induced investment).
 Technological change: Regular changes in technological front demand firms to invest in order to keep up
with the changes and remain competitive.
 Business Confidence: The economic environment in an economy is a major factor in determining the
investment level. When an economy is showing signs of healthy growth, firms will have positive expectation
and will invest in expanding their facilities and to meet higher demands in the future. During troughs firms
will be more conservative in their investments and thus AD will be affected.
Change in Government Expenditure
Government Expenditure depends on
 Macroeconomics objectives: If the government is considering increasing employment then it might increase
its spending on public projects.
 Condition of the economy: During phases of slow economic growth, government is more likely to increase its
spending in order to stimulate the economy.
Changes in net exports
Exports are domestic goods bought by foreigners. Exports will rise when
 Foreigners income rise
 Exchange rate of the exporting country is falling.
 The economy follows a more liberal trade policy i.e. free trade increase
 Inflation rate in the economy is comparatively lower than its trading partners.
Imports are the goods bought from foreign country. Imports will rise when
 Domestic income rises. This is because people will increase their consumption and thus imports will increase.
 Exchange rate of the importing country increase. Now it becomes cheaper for the country to purchase from
outside as their currency is stronger than their trading partners.
 If the economy is following a liberal trade policy i.e. free trade increases.
 Inflation rate is high
Possible conflict between macroeconomic objectives
 It is rare for a country to achieve all of its main objectives at the same time
 Frequently conflicts appear between the different aims and as a result, choices might have to be made about
which objectives are to be given greatest priority.
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
This will vary from one country to another since the needs of different nations will differ according to their
stage of economic development.
Here are some possible policy conflicts:
 Inflation and unemployment: Falling unemployment might create demand-pull and cost-push inflationary
pressures leading to a fall in the value of money
 Economic growth and environmental sustainability: Rapid economic growth and development frequently
puts extra pressure on scarce environmental resources threatening the sustainability of living standards in
the future
 Economic growth and inflation – an overheating economy may suffer accelerating inflation which then has
negative effects on trade performance, business profits and jobs
 Economic growth and the balance of payments: Strong GDP growth fuelled by high levels of consumer
demand for goods and services might lead to a worsening of the trade balance. This is particularly true when
an economy has a high marginal propensity to import.
Unemployment and inflation – the Phillips Curve concept

Falling unemployment might cause rising inflation and a fall in inflation might only be possible by allowing
unemployment to rise
 If a Government wanted to reduce the unemployment rate, it could increase aggregate demand but,
although this might temporarily increase employment, it could also have inflationary implications in labour
and the product markets.
The key to understanding this trade-off is to consider the possible inflationary effects in both labour and product
markets from an increase in national income, output and employment.
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

The labour market: As unemployment falls, labour shortages may occur where skilled labour is in short
supply. This puts pressure on wages to increase and prices may rise as businesses pass on these costs to their
customers.
Other factor markets: Cost-push inflation can also come from rising demand for commodities such as oil,
copper and processed manufactured goods such as steel, concrete and glass. When an economy is booming,
so does the derived demand for components and raw materials.
Product markets: Rising demand can lead to suppliers raising prices to increase their profit margins. The risk of rising
prices is greatest when demand is out-stripping supply-capacity leading to excess demand (i.e. a positive output gap.)
Fiscal policy
The two main instruments of fiscal policy are government spending and taxation.
Changes in the level and composition of taxation and government spending can impact on the following variables in
the economy:
 Aggregate demand and the level of economic activity.
 The pattern of resource allocation.
 The distribution of income.
How fiscal policy work
High rate of inflation
High rate of inflation is caused by too much aggregate demand in the economy. Government will use deflationary
fiscal policy. Government will try to influence aggregate demand by reducing its public spending. The government
will spend less on construction of roads, bridges and other public spending and thus aggregate demand will fall. On
the other hand, Government may increase the tax rates. An increase in tax rates will take away the extra disposable
income out people’s pocket resulting in a lower demand.
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Low rate of inflation
In an economic recession, aggregate demand, output and employment all tend to fall. Now the Government wants to
increase employment in the economy, it can attempt to do so by increasing aggregate demand. The Government will
increase the public spending resulting in a rise in aggregate demand. Government may reduce the tax rates so that
people have more disposable income to spend and instigate demand in the economy.
Role of fiscal policies
The two main instruments of fiscal policy are government spending and taxation.
Changes in the level and composition of taxation and government spending can impact on the following variables in
the economy:
 Aggregate demand and the level of economic activity.
 The pattern of resource allocation.
 The distribution of income.
AD=C+G+I+(X-M)
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As we can see in the above equation that G (Government Expenditure) is a component of AD, it can be used by
Government to influence AD in the economy. The government can use expansionary or deflationary fiscal policy to
get the desired results. Let’s discuss each policy in detail.
Expansionary fiscal policy
Expansionary fiscal policy is used to increase the Aggregate demand in the economy. If the economy is having a
deflationary gap, the government can use expansionary fiscal policy to reduce the gap or totally eliminate it.
Deflationary gap
Deflationary gap is the difference between full level of employment and the actual level of output of the economy.
We can see in the diagram below, that the economy is operating a level ‘a’ below the Yf (full level of employment).
The consequence is that due to deflationary gap all the resources of the economy are not being used in the optimum
level and they are idle. This results in unemployment and low level of output. This is not desirable for any
government. In order to reduce/eliminate the deflationary gap, the government uses expansionary fiscal policy.
Government will either increase its spending or reduce taxes (or both) in order to stimulate the aggregate demand.
Increase Government spending will result me more projects being funded by the government and thus employment
and output will increase. Even a lower tax rate will result in more disposable income for households and encourage
consumption.
Increased G and C will lead to higher AD. However, this might also lead to higher prices/inflation in the economy.
Contractionary fiscal policy
Contractionary fiscal policy involves the reduction of government spending and increase taxes as a measure to
control inflation/AD in the economy. With reduced government spending, the AD will fall and thus reduce pressure
on the economic resources and the average price level in the economy will come down. Similarly, increased taxes will
take away the excess disposable income from the households and result in a fall in AD. Contractionary fiscal policy is
thus used to reduce the inflationary gap.
Inflationary gap
Inflationary gap is when the Aggregate demand exceeds the productive potential of the economy. As we can see
through the diagram, the economy is operating at a level above the full employment level of the output. Due the
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limitation of the economy to fulfil this increased demand the average price level in the economy increases resulting
in inflation.
Problems of fiscal policy
Reduce incentive to work
Raising taxes on income and profits reduce work incentives, employment and economic growth. An effort to reduce
aggregate demand may cause disincentives to work, if this occurs there will be a fall in productivity and Aggregate
supply could fall.
Adverse effect of lowering Public Spending
Reduced government spending to Increase Aggregate demand could adversely affect public services such as public
transport and education causing market failure and social inefficiency.
‘Crowding out’ effect
With an increase in government expenditure, there will be greater competition for limited resources. This will offset
private investments resulting in shrinking of the private sector.
Inaccurate forecasting
If the Government’s estimate or forecasting is wrong or inaccurate the fiscal policy will suffer. For example, if a
recession is expected and the government practices deficit budget, and yet the recession turns out to be a boom, this
will cause inflation.
Implementation of the Policy
Planning for the spending is done once by most of the governments. If there is a delay in the implementation of the
fiscal policy, it might reduce the effectiveness of the policy. Thus the time lag is important.
Poor Information
Fiscal policy will suffer if the government has poor information. e.g. If the government believes there is going to be a
recession, they will increase AD, however if this forecast was wrong and the economy grew too fast, the government
action would cause inflation.
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Time Lags
If the government plans to increase spending this can take a long time to filter into the economy and it may be too
late. Spending plans are only set once a year. There is also a delay in implementing any changes to spending patterns.
Budget Deficit
Expansionary fiscal policy (cutting taxes and increasing G) will cause an increase in the budget deficit which has many
adverse effects. Higher budget deficit will require higher taxes in the future and may cause crowding out (see below
Other Components of AD
If the government uses fiscal policy its effectiveness will also depend upon the other components of AD, for example
if consumer confidence is very low, reducing taxes may not lead to an increase in consumer spending.
Depends on Multiplier
Change in injections may be increased by the multiplier effect; therefore the size of the multiplier will be significant.
Monetary Policy
Monetary policy is generally referred to as either being an expansionary policy, or a contractionary policy.
An expansionary policy increases the total supply of money in the economy and is traditionally used to combat
unemployment in a recession by lowering interest rates. Lowered interest rates encourage the household and the
firms to increase their consumption and investment respectively. This will shift the AD to the right and result in
higher real output and more employment.
Contractionary policy decreases the total money supply and involves raising interest rates in order to combat
inflation. The result will be that investment will fall, and consumption will fall. All of these changes will shift the AD to
the left.
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It is argued that an increase in the money supply causes an increase in the rate of inflation. Maintaining a low and
stable inflation is one of the main macroeconomic objectives of the Government. Government does so by controlling
the supply of money to the economy. This policy is known as monetary policy.
Monetary policy in any country is usually controlled by the Central Bank of that country. The Central bank alters the
interest rates in the economy after assessing the inflationary pressures in the market.
Monetary Policy tools
Central Bank has three tools of monetary policy:
Open market operations
 Open market purchases: The central bank buys government securities to increase the monetary base.
 Open market sales: The central bank sells government securities to decrease the monetary base.
Open market operations have a number of advantages:
 They are under the direct and complete control of the central bank
 They can be large or small.
 They can be easily reversed.
 They can be implemented quickly
Discount loans
When a bank receives a discount loan from the central bank, it is said to have received a loan at the “discount
window.” The Central Bank can affect the volume of discount loans by setting the discount rate:
 A higher discount rate makes discount borrowing less attractive to banks and will therefore reduce the
volume of discount loans.
 A lower discount rate makes discount borrowing more attractive to banks and will therefore increase the
volume of discount loans.
Discount lending is most important during ?nancial panics:
 When depositors lose con?dence in the ?nancial system, they will rush to withdraw their money.
 This large deposit out?ow puts the banking system in great need of reserves.
 The central bank stands ready to supply these reserves by making discount loans. In such situations, the
central bank acts as a lender of last resort.
Changes in reserve requirements
The portion (expressed as a percent) of depositors' balances banks must have on hand as cash. This is a requirement
determined by the country's central bank. It affects the money multiplier; changes in the required reserve ratio can
lead to changes in the money supply. This is also referred to as the "cash reserve ratio" (CRR).
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How money supply works
Money supply includes all the notes and coins in circulation with the public plus the money with banks. It also
includes the deposits in banks and building societies. The later is more significant supply of money and is usually the
target of Governments monetary policy. The ways through which Government controls the money supply are:
Open market operations
Government usually sells treasury bills and bonds to raise money. Private individuals invest in these bonds and bills in
order to get a healthy rate of interest. This reduces the deposits with banks and the money supply.
Variation of legal reserve requirements
Usually, the commercial banks have to maintain a certain percentage of their assets as deposit with the Central Bank.
When the Central Bank wants to reduce money supply it will increase the limit of the deposit kept by the banks. The
commercial banks are left with less money to lend to their customers.
Central banks
Central Banks are charged with regulating the size of a nation’s money supply, the availability and cost of credit, and
the foreign-exchange value of its currency. Regulation of the availability and cost of credit may be designed to
influence the distribution of credit among competing uses. The principal objectives of a modern central bank in
carrying out these functions are to maintain monetary and credit conditions conducive to a high level of employment
and production, a reasonably stable level of domestic prices, and an adequate level of international reserves.
Function of a Central Bank
A central bank usually carries out the following responsibilities:
 Implementation of monetary policy.
 Controls the nation's entire money supply.
 The Government's banker and the bankers' bank ("Lender of Last Resort").
 Manages the country's foreign exchange and gold reserves and the Government's stock register;
 Regulation and supervision of the banking industry
 Setting the official interest rates- used to manage both inflation and the country's exchange rate - and
ensuring that this rate takes effect via a variety of policy mechanisms
Role of taxation in promoting equity
Tax is a fee charged ("levied") by a government on a product, income, or activity.
Why taxes are imposed?
There are different reasons for imposing taxes.
 To finance government expenditure. One of the most important uses of taxes is to finance public goods and
services, such as street lighting and street cleaning.

To reduce consumption of goods that creates negative externalities.
 To control the amount of imported goods i.e. tariffs
 Used as a part of fiscal policy to control aggregate demand in the economy.
 To control income inequality.
Classification of taxes
Progressive taxes
A progressive tax is a tax imposed so that the tax rate increases as the amount subject to taxation increases. In simple
terms, it imposes a greater burden (relative to resources) on the rich than on the poor. It can be applied to individual
taxes or to a tax system as a whole. Progressive taxes attempt to reduce the tax incidence of people with a lower
ability-to-pay, as they shift the incidence disproportionately to those with a higher ability-to-pay. The result is people
with more disposable income pay a higher percentage of that income in tax than do those with less income.
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Regressive Tax
The opposite of a progressive tax is a regressive tax, where the tax rate decreases as the amount subject to taxation
increases. It imposes a greater burden (relative to resources) on the poor than on the rich. Regressive taxes attempt
to reduce the tax incidence of people with higher ability-to-pay, as they shift the incidence disproportionately to
those with lower ability-to-pay.
Proportional Tax
A proportional tax is one that imposes the same relative burden on all taxpayers—i.e., where tax liability and income
grow in equal proportion. In simple terms, it imposes an equal burden (relative to resources) on the rich and poor.
Proportional taxes maintain equal tax incidence regardless of the ability-to-pay and do not shift the incidence
disproportionately to those with a higher or lower economic well-being.
Types of taxes
Direct Taxes
It is a tax paid directly to the government by the persons on whom it is imposed.
Examples
 Tax imposed on peoples’ income-Income tax
 Tax on wealth – wealth Tax
 Tax on firm’s profits.- corporate tax
Indirect Taxes
Indirect tax is a tax collected by an intermediary (such as a retail store) from the person who bears the ultimate
economic burden of the tax (such as the consumer). The intermediary later files a tax return and forwards the tax
proceeds to government with the return.
Indirect taxes are generally included in the price of goods and services, so are less obvious to those paying the taxes
than direct levies. Thus indirect taxes are also known as expenditure tax or consumption based tax.
Examples
 GST (Goods and service tax)
 VAT (Value added tax)
 Consumers are charged a percentage of tax while purchasing a good/service and then the seller pays the tax
collected to the Government.
Other measures to promote equity
The governments also undertake expenditures to promote income equity. These include
Subsidies
Provide directly, or to subsidize, a variety of socially desirable goods and services. These include health care services,
education, and infrastructure that include sanitation and clean water supplies.
Transfer payments
Government provides various kind of assistance to low income groups in the society. The objective is to support them
in maintaining a reasonable standard of living and to lower inequality. These payments are given directly to these
groups in the form of monetary help. Examples include Social Security, unemployment compensation, welfare, and
disability payments.
Government policy to control inflation
Government uses a number of policies to deal with the different types of inflation. These are:
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Demand Side policies-to control demand pull inflation
Deflationary fiscal policy: This involves an increase in taxes and lowering of government spending. Increasing taxes
will result in lower disposable income for household and thus less consumption. Moreover, increased taxes will result
in lower profits for firms and thus less investment by firms. All these factors will lower the AD in the economy.
Deflationary monetary policy: It involves rising of interest rates and reducing money supply. Higher interest rates
mean higher loan and mortgage repayments. This will deter households and firms to borrow, leading to fall in
consumption and investment respectively.
Supply side policies-to control cost push inflation
It includes all those policies which aim at improving the efficient supply of goods and services. These might include:
 Privatization
 Imparting training and improving the education level of the workforce resulting in higher skills.
 Increase competition in all industries by removing entry barriers, thus leading to more efficiency.
Exchange rate policies to control imported inflation
This involves increasing the value of currency to reduce imported inflation. Increase currency rate will also lead to fall
in demand for exports (component of AD).
International aspects
Definition
Exchange rate: The price of one’s currency in terms of another currency
Foreign exchange market: The market where currencies are bought and sold.
Exchange control: Limits on the amount of foreign currency available to importers, which
consequently limit imports
Appreciation: The rise in value of a currency against others. Exports will become more expensive
abroad and imports cheaper at home.
Depreciation: The fall in value of a currency against others. Exports will become cheaper abroad
and imports expensive at home.
Devaluation: Depreciation brought about the government, normally by a government which fixes
the value of its currency.
Exports: The movement of goods or commodities out of the country.
Imports: The movement of goods or commodities into the country.
Protectionism: Policy of protecting domestic industries against foreign competition by means of
tariffs, subsidies, import quotas, or other handicaps placed on imports.
Free trade: A system of trade policy that allows traders to trade across national boundaries
without interference from the respective governments.
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Globalisation
What is it?

It is the increasing integration of countries’ individual economies.
 It is the global movement towards trade, financial and communications integration through the development
of free trade, free flow of capital, and the freedom to tap into cheaper foreign factor markets. (Official
definition)
Benefits





Most efficient form of production:
Because firms will choose to produce where costs are lowest.
Stimulates the economy, particularly that of LEDCs, by drawing in more foreign direct investment.
Employment opportunities
Opening jobs.
Training
• Introduces skills and technology to nations through a company’s implementations of such:
 This increases the productivity of a nation’s workforce, etc.
• Opening new industries in LEDCs such as the white phosphorus mining industry in Yemen.
• Increases competition:

Lowers prices

Less inflation.

Better quality goods.

Better efficiency.
Costs
• Environmental damage.

Because the company is so powerful that it can afford to operate inefficiently for conveniences sake.
• Creates uncertainty:

Foreign firms own most of the market share in a country, not domestic firms.
• May choose to source their resources from abroad and not from locally:
 Thus local resource producers will go out of business.
• Human rights abuses.

Infringements on indigenous rights.
• Terrorism.
• Investments in nations facing political sanctions as a result of their wrong-doings.
• Leaching from government funds:

Large MNCs may be too important for a government to allow to go bankrupt thus whenever said MNC is
facing troubles they will be given aid by their government.
• Price manipulation.
• Labour abuse:

Child labour.

Bad working conditions.

Poor healthcare.

Sweat shops.

Bad wages.

Restrictions to resting hours.
 Anti-Labour-Union policies.
• Using tactics detrimental to competition:

Predatory pricing.
 Monopoly power.
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• Tax evasion:

Through transfer pricing.
• Using illegal methods and materials to produce goods and services.
 Or to force people to buy their goods or services:

Great American Streetcar scandal.
• Blocking of technologies:
 Bribery.

Blocking battery technology for hybrid cars so one can sell more oil.

Concealment of imports.

Causing trade deficit:

Wal-Mart is accused of being one of the largest sources of the trade deficit in the USA.
Objections
Third world debt.
 Debt in the developing, less developed or least developed third world countries in Africa, Asia, Latin America
and the Middle East.

Globalization is leaching resources from these countries and the revenue generated from this leaching is not
fed back into these countries. Furthermore, with population growth causing the needs and wants of these
countries to also grow, these countries are falling into debt in order to pay for these needs and wants.
• Animal rights.
• Child labour.
• Anarchism.
• Anti-capitalist
Exchange rates
Demand for and Supply of a currency
This is what determines exchange rate in a free-floating exchange rate system:
 When a currency has strong demand it will appreciate in value.
 In contrast, when there is a large scale selling of a currency it will depreciate.
Demand for a currency:
 Exports and imports of goods/services
o If a country has a decline in export industries and earnings, yet its people continue buying imports, the
exchange rate is likely to fall.
 This is possibly not true for countries such as Hong Kong which are dependent on imports of oil
and food.
o Fewer exports will mean less demand for the currency to pay for them, so the demand for the currency
will decrease.
o This will lead to depreciation
o When a currency has depreciated, this makes the countries’ exports cheaper abroad.
o Thus, exports should become more competitive overseas.
 Price elasticity of demand for imports
o When a currency depreciates, imports become more expensive.
o If the demand for imports is price elastic, this should lead to a fall in expenditure on imports
o This situation is found where imports compete with home-produced alternatives.
o When countries import necessities, such as food and oil, demand tends to be price inelastic so
expenditure rises when the currency falls.
• Pure speculative demand.
o Speculators often purchase currencies that they think will appreciate in value against their own currency.
• Official buying of the currency by the central bank.
o This might be done for investment or speculation or security or other reasons.
45
•
Comparatively higher domestic interest rate.
o Thus savers will be likely to convert their own money into your currency to save in your nation and enjoy
the comparatively higher domestic interest rates you offer.
Supply of a currency

Imports of goods and services.

Outflows of direct investment.

Outflows of portfolio investment.

Speculative selling of the currency.
 Official selling of the currency by the central bank.

Rate of interest abroad.
Appreciation and Depreciation
• Foreigners will tend to save money in one’s nation.

Thus the demand for one’s currency rises which can cause one’s currency to appreciate in general.
• Depreciation means that the value of the currency in terms of other currencies goes down:
• If the USD depreciates against the RMB then it will take fewer RMB to buy each USD.
• If 1 Euro was worth HKD 10.2 at the start of the year.
• It may depreciate if the Greek government declared that it would withdraw from the Eurozone and go back
to using the Drachma in order to depreciate their currency.
• This will cause others to lose confidence in the Euro and speculation will cause people to sell the Euro.
•
This may end up causing the Euro to depreciate to HKD 7 per Euro.
• In this case the Euro has depreciated against the HKD because it now takes more Euros to purchase each
HKD.
•
But the HKD has appreciated against the Euro because it now takes fewer HKD to buy 1 euro
Advantages of a Strong Currency
 Lower import prices – This boosts living standards of consumers.

An increase in the real purchasing power of HK residents traveling overseas for business and leisure
purposes.
 Cheaper to import raw materials, components and capital inputs – causes an outward shift in short-run
aggregate supply.
 Improvement in the terms of trade (lower import prices).

Helps to control RPI inflation – Domestic producers face stiff international competition and must keep their
prices down. Lower inflation allows the MPC/HKMA to keep nominal interest rates at a lower level than if the
exchange rate was weak.
 An increase in a country’s relative position in international league tables showing real GDP per capita when
expressed in a common currency:
 Even if one’s GDP, as measured in one’s own currency, is no more than previously, because one’s currency
has appreciated in value, the GDP of one’s nation will also increase when it is translated into another
currency.
Disadvantages of a Strong Currency
• Cheaper imports lead to rising import penetration and large trade deficit:
• Import penetration means that a larger portion of the goods and services provided by a nation’s firms is now
provided by foreign firms.
• Exporters also lose price competitiveness and market share thus causing a trade deficit.
• Damaged profit and employment in some sectors to which exporting is the key means of generating revenue.
• Negative impact on economic growth (exports – injections of aggregate demand, imports - leakages of wealth
form the circular flow of income).
46
•
Some regions which have a higher than average dependency on exporting industries are more affected than
others.
Balance of Payments on Current Accounts
What is it?

It is a set of accounts that record a country’s international transactions and which (because double entry
bookkeeping is used) is always in balance with no surplus or deficit shown on the overall basis.
 It serves to highlight a country’s competitive strengths and weaknesses and helps in achieving balanced
economic growth.

Because the international market is so large it is unlikely to adhere to the business cycle.
 Therefore, a country which has a healthy BoP account will likely have balanced growth because the levels of
investment, consumption and capital of the international market is unlikely to fluctuate much and will grow
steadily.
 The demand from the international market is unlikely to fluctuate much and will grow steadily therefore
investment and capital will also grow steadily (this growth happens because people are getting richer, world
population is growing, etc.).

Capital in this case should indicate the money invested in businesses to generate income:

If investments grow so too will capital because capital is the money already invested and investments are
the source of capital.
The Balance of Payments Account

The current account, capital account and financial account.

The capital and financial accounts used to known collectively as the capital account.
The BoP is always balanced

When the news talks about a BoP surplus or deficit they are usually referring to the net transactions of the
Current Account or just the Balance of Trade.

Calculated by subtracting the total value of imports from the total value of exports
BoT is Balance of Trade
 Positive figure (surplus) – Value of imports < Value of exports.
 Negative figure (deficit) – Value of imports > Value of exports.

A negative BoP indicates that a country’s exports are not competitive enough to compete with those
produced by other countries:

Thus there is a net leakage of wealth from the country.
Correcting trade imbalances
Large trade imbalances, whether a big deficit or a big surplus, can cause problems for a national economy.
Problems with a trade surplus
 There may be political and economic pressure on the government from other countries to reduce its trade
surplus so they can reduce their trade deficits
 Exporting firms will enjoy significant overseas revenues – profits and wages may rise – but the increase in
demand may cause demand-push inflation
 A surplus causes the value of the currency to appreciate or stay high, and may eventually reduce demand for
exports and cause a loss of jobs.
47
Problems with a trade deficit
 If more money is paid out for imports than is earned from exports then this loss of money from an economy
may mean less can be spent on domestic goods and services. Domestic firms facing a fall in demand for their
products may cut back production and their demand for labour resulting in higher unemployment.
 The value of the exchange rate will fall, causing imports to become more expensive and resulting in imported
inflation. If demand for price-inelastic goods or services falls, more money will be paid out for imports and
the demand for domestically-produced goods/services will decrease.
 The trade deficit might be a symptom of a declining industrial base, with fewer firms in the economy over
time producing goods and services for export.
Economic growth and trade balance
A period of fast growth may come into conflict with the balance of payments. Much depends on the income elasticity
of demand for traded goods and services. In the case the UK, the evidence is that consumers have a high propensity
to consume imports; the income elasticity of demand is strongly positive. Say for example, real disposable incomes
grow by 3% and that the income elasticity for imports = +2.5. That would lead to a 7% rise in the volume of imports.
Unless there is a corresponding rise in exports, we expect to see a worsening of the balance of trade (i.e. a widening
trade deficit).
In a recession, this effect works in reverse as demand for imported products including raw materials, components
and ready to consume goods and services declines. The trade balance will improve although the root cause is a drop
in economic activity.
Correcting trade balances
1. Do nothing, as a floating exchange rate will correct it.
Trade deficits and surpluses can be self-correcting if allowed to adjust freely.
2. Fiscal policy
A contractionary fiscal policy is when the government may cut public expenditure and raise taxes to reduce
the total demand in their economy so people have less to spend on imports. This will help reduce the trade
deficit. However, a fall in demand may also affect domestic firms, who may cut output and employment in
response to the fall in demand
An expansionary fiscal policy is when the government lowers tax rates and raise public expenditure. This
boosts spending on imports and help to correct a trade surplus. However, it may also help domestic firms if
demand for their goods and services also rises, and may help to halt any decline in the industrial base.
3. Monetary policy
An expansionary monetary policy is when the government attempt to attract more inwards investments to
their economy to help offset a trade deficit by raising interest rates. Higher interest rates will also make
borrowing more expensive and reduce the demand for loans by consumers and firms that may be used to
pay for goods and services supplied overseas.
A contractionary monetary policy is when the government lowers interest rates to help correct for a trade
surplus by lowering the cost of borrowing from firms and consumers, and will lower the return overseas
investors can expect on their inward investments in the economy so that they invest elsewhere instead.
4. Protectionism
This is when a country uses trade barriers such as tariffs to make imports more expensive or limit the amount
of imports in order to correct a trade deficit.
48
Visible and Invisible
Visible Trade
Visible trade involves trading of goods which can be touched and weighed. Examples include trade in goods such as
Oil, machinery, food, clothes etc.
Visible Trade consists of
 Visible exports: Selling of tangible goods which can be touched and weighed to other countries.
 Visible imports: Buying of tangible goods which can be touched and weighed from other countries.
Balance of trade
It is the difference between the value of visible exports and value of visible imports of a country.
If the value of visible exports is more than visible imports the country will have a surplus balance of trade.
If the value of visible imports is more than visible exports the country will have an Unfavourable balance of trade.
Invisible trade
Invisible trade involves the import and export of services rather than goods. Example include services such as
insurance, banking, tourism, education.
If a UK student comes to Singapore to study, it would be invisible export for Singapore as it is earning foreign
exchange by providing educational services.
If a Singapore citizen travels to UK for a holiday. It will be invisible import for Singapore and invisible export for UK.
Balance of invisible trade
It is the difference between the value of invisible exports and value of invisible imports of a country.
Comparative advantage
The theory of comparative advantage states that a country should specialise in the production of good or service in
which it has lower opportunity cost and it should import commodities which have a higher opportunity cost of
production.
Example
Suppose for example we have two countries of equal size, Northland and Southland. Both produce and consume two
goods, Food and Clothes. The productive capacities and efficiencies of the countries are such that if both countries
devoted all their resources to Food production, output would be as follows:
 Northland: 100 tonnes
 Southland: 200 tonnes
If all the resources of the countries were allocated to the production of clothes, output would be:
 Northland: 100 tonnes
 Southland: 100 tonnes
Assuming each has constant opportunity costs of production between the two products and both economies have full
employment at all times. All factors of production are mobile within the countries between clothing and food
industries, but are immobile between the countries. The price mechanism must be working to provide perfect
competition.
Southland has an absolute advantage over Northland in the production of Food. Both countries are equally efficient
in the production of clothes. There seems to be no mutual benefit in trade between the economies. The opportunity
costs shows otherwise. Northland's opportunity cost of producing one tonne of Food is one tonne of Clothes and vice
versa. Southland's opportunity cost of one tonne of Food is 0.5 tonne of Clothes. The opportunity cost of one tonne
of Clothes is 2 tonnes of Food. Southland has a comparative advantage in food production, because of its lower
opportunity cost of production with respect to Northland. Northland has a comparative advantage over Southland in
the production of clothes, the opportunity cost of which is higher in Southland with respect to Food than in
49
Northland.
To show these different opportunity costs lead to mutual benefit if the countries specialize production and trade,
consider the countries produce and consume only domestically. The volumes are:
Food
Clothes
Northland
50
50
Southland
100
50
World total
150
100
Production and consumption before trade
This example includes no formulation of the preferences of consumers in the two economies which would allow the
determination of the international exchange rate of Clothes and Food. Given the production capabilities of each
country, in order for trade to be worthwhile Northland requires a price of at least one tonne of Food in exchange for
one tonne of Clothes; and Southland requires at least one tonne of Clothes for two tonnes of Food. The exchange
price will be somewhere between the two. The remainder of the example works with an international trading price
of one tonne of Food for 2/3 tonne of Clothes.
If both specialize in the goods in which they have comparative advantage, their outputs will be:
Food
Clothes
Northland
0
100
Southland
200
0
World total
200
100
Production after trade
World production of food increased. Clothing production remained the same. Using the exchange rate of one tonne
of Food for 2/3 tonne of Clothes, Northland and Southland are able to trade to yield the following level of
consumption:
Food
Clothes
Northland
75
50
Southland
125
50
World total
200
100
Consumption after trade
Northland traded 50 tonnes of Clothing for 75 tonnes of Food. Both benefited, and now consume at points outside
their production possibility frontiers.
Assumptions in Example 2
 Two countries, two goods
o The theory is no different for larger numbers of countries and goods, but the principles are clearer
and the argument easier to follow in this simpler case.
 Equal size economies
o Again, this is a simplification to produce a clearer example.
 Full employment
50
o






If one or other of the economies has less than full employment of factors of production, then this
excess capacity must usually be used up before the comparative advantage reasoning can be applied.
Constant opportunity costs
o A more realistic treatment of opportunity costs the reasoning is broadly the same, but specialization
of production can only be taken to the point at which the opportunity costs in the two countries
become equal. This does not invalidate the principles of comparative advantage, but it does limit the
magnitude of the benefit.
Perfect mobility of factors of production within countries
o This is necessary to allow production to be switched without cost. In real economies this cost will be
incurred: capital will be tied up in plant (sewing machines are not sowing machines) and labour will
need to be retrained and relocated. This is why it is sometimes argued that 'nascent industries'
should be protected from fully liberalised international trade during the period in which a high cost
of entry into the market (capital equipment, training) is being paid for.
Immobility of factors of production between countries
o Why are there different rates of productivity? The modern version of comparative advantage
(developed in the early twentieth century by the Swedish economists Eli Heckscher and Bertil Ohlin)
attributes these differences to differences in nations' factor endowments. A nation will have
comparative advantage in producing the good that uses intensively the factor it produces abundantly.
For example: suppose the US has a relative abundance of capital and India has a relative abundance
of labor. Suppose further that cars are capital intensive to produce, while cloth is labor intensive.
Then the US will have a comparative advantage in making cars, and India will have a comparative
advantage in making cloth. If there is international factor mobility this can change nations' relative
factor abundance. The principle of comparative advantage still applies, but who has the advantage in
what can change.
Negligible Transport Cost
o Cost is not a cause of concern when countries decided to trade. It is ignored and not factored in.
Assume that half the resources are used to produce each good in each country.
o This takes place before specialization
Perfect competition
o This is a standard assumption that allows perfectly efficient allocation of productive resources in an
idealized free market.
Absolute advantage
A country has an absolute advantage over another in producing a good, if it can produce that good using fewer
resources than another country.
For example if one unit of labor in Australia can produce 80 units of wool or 20 units of wine; while in France one unit
of labor makes 50 units of wool or 75 units of wine, then Australia has an absolute advantage in producing wool and
France has an absolute advantage in producing wine.
Australia can get more wine with its labor by specializing in wool and trading the wool for French wine, while France
can benefit by trading wine for wool.
Example 1
 Country A can produce one widget using one unit of labour.
 Country B can produce one widget using two units of labour.
 Country A has an absolute advantage over Country B in producing widgets.
Example 2
 Country A has 100 units of labour. It uses 20 to produce 80 units of Parachutes, and 80 to produce 20 units of
Barbie dolls.
51


Country B has 100 units of labour. It uses 40 to produce 100 units of Barbie dolls, and 60 to produce 20 units
of Parachutes.
If the countries maximized their potential, Country A could produce 400 units of Parachutes, and country B
could produce 250 units of Barbie dolls. Through trade, the two countries would achieve a more efficient
allocation of resources and increase their prosperity.
Free trade
Definition: International trade left to the mechanisms of demand and supply without influence of protectionist
methods.
Reasons for Free Trade
 Domestic Non-availability
o A nation trades because it lacks the raw materials, climate, specialist labour, capital or technology
needed to manufacture a particular good. Trade allows a greater variety of goods and services.
 Cost effectiveness
o It is cheaper to buy from other countries rather than producing themselves.
Benefits of Trade
 Lower prices for consumers
o When there is free trade, consumers can free to buy goods from the producer who is willing to sell at
the lowest prices. Hence consumers gain from lower prices.
 Greater choice for consumers
o With free trade, consumers have access to variety of goods and services from different producers
across the globe. This means more choice.
 Ability of producers to benefit from economies of scale
o Producers have access to a larger market thus they can produce more at lower cost and benefit from
economies of scale.
 Ability to acquire needed resources
o Through free trade producers can not only sell in a large market but also gain from purchasing from
suppliers across the world.
 More efficient allocation of resources
o When there is free trade, the most efficient producers get the opportunity to produce due to their
cost efficiency. This leads to productive efficiency.
 Increased competition
o In free trade producers from different regions can compete with each other in terms of price, quality
and variety. Increased competition leads to efficient allocation of resources.
 Source of foreign exchange
o Free trade involves the transaction of goods and services between nations. In order to purchase
goods from abroad (imports), we need foreign currency. This is possible through exporting of goods
to other countries.
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Free Trade diagrams
Protectionism methods
The chief protectionist measures, government-levied tariffs, raise the price of imported articles, making them less
attractive to consumers than cheaper domestic products. Import quotas, which limit the quantities of goods that can
be imported, are another protectionist device.
Tariffs
A tariff is a tax on foreign goods upon importation. Tariff rates vary according to the type of goods imported. Import
tariffs will increase the cost to importers, and increase the price of imported goods in the local markets, thus
lowering the quantity of goods imported.
53
Quotas
An import quota is a type of protectionist that sets a physical limit on the quantity of a good that can be imported
into a country in a given period of time. This leads to a reduction in the quantity imported and therefore increases
the market price of imported goods. Quotas, like other trade restrictions, are used to benefit the producers of a good
in a domestic economy at the expense of all consumers of the good in that economy.
Administrative Barriers
Countries are sometimes accused of using their various administrative rules (eg. regarding food safety,
environmental standards, electrical safety, etc.) as a way to introduce barriers to imports.
Embargo
An embargo is the prohibition of commerce and trade with a certain country, in order to isolate it and to put its
government into a difficult internal situation, given that the effects of the embargo are often able to make its
economy suffer from the initiative.
Subsidies
Government subsidies (in the form of lump-sum payments or cheap loans) are sometimes given to local firms that
cannot compete well against foreign imports. These subsidies are purported to "protect" local jobs, and to help local
firms adjust to the world markets.
Anti-dumping legislation
Supporters of anti-dumping laws argue that they prevent "dumping" of cheaper foreign goods that would cause local
firms to close down. However, in practice, anti-dumping laws are usually used to impose trade tariffs on foreign
exporters.
Externalities, Market Failure and Import Controls
Protectionism can also be used to take account of externalities and dealing with de-merit goods. Goods such as
alcohol, tobacco and narcotic drugs have adverse social effects and are termed de-merit goods. Protectionism can
safeguard society from the importation of these goods, by imposing high tariff barriers or by banning the importation
of the good altogether.
54
Non-Economic Reasons
Countries may wish not to over-specialise in the goods in which they possess a comparative advantage. One danger
of over-specialisation is that unemployment may rise quickly if an industry moves into structural decline as new
international competition emerges at lower costs.
The government may also wish to protect employment in strategic industries, although clearly value judgments are
involved in determining what constitutes a strategic sector. The recent trade dispute arising from the decision by the
United States to introduce a tariff on steel imports is linked to this objective. The US steel tariff was declared
unlawful by the WTO in July 2003 and eventually the United States was pressurized into withdrawing these tariffs in
the late autumn of 2003.
Tariffs are not usually a major source of tax revenue for the Government that imposes them. In the UK for example,
tariffs are estimated to be worth only £2 billion to the Treasury, equivalent to only around 0.5% of the total tax take.
Developing countries tend to be more reliant on tariffs for revenue.
Economic Arguments against Import Controls
Protectionism – hurting customers
Tariffs, non-tariff barriers and other forms of protection serve as a tax on domestic consumers. Moreover, they are
very often a regressive form of taxation, hurting the poorest consumers far more than the better off. In the EU for
instance, the nature of existing protection means that the heaviest taxes tend to fall on the necessities of life such as
food, clothing and footwear.
According to Professor Jagdish Bhagwati, “the fact that trade protection hurts the economy of the country that
imposes it is one of the oldest but still most startling insights economics has to offer.”
The folly of protection has been confirmed by a range of studies from around the world. These indicate that that it
has brought few benefits but imposed substantial costs. Among the main criticisms of protectionist policies are the
following:
 Market distortion: Protection has proved an ineffective and costly means of sustaining employment.
a. Higher prices for consumers: Trade barriers in the form of tariffs push up the prices faced by
consumers and insulate inefficient sectors from competition. They penalise foreign producers and
encourage the inefficient allocation of resources both domestically and globally. In general terms,
import controls impose costs on society that would not exist if there was completely free trade in
goods and services. It has been estimated for example that the recent tariff and other barriers placed
on imports of steel into the US increased the price of every car produced there by an average of $100
b. Reduction in market access for producers: Export subsidies, depressing world prices and making
them more volatile while depriving efficient farmers of access to the world market. This is a major
criticism of the EU common agricultural policy. In 2002 the EU sugar regime lowered the value of
Brazil, Thailand and South Africa’s sugar exports by over $700 million – countries where nearly 70
million people survive on less than $2 a day.
 Loss of economic welfare: Tariffs create a deadweight loss of consumer and producer surplus arising from a
loss of allocative efficiency. Welfare is reduced through higher prices and restricted consumer choice.
 Regressive effect on the distribution of income: It is often the case that the higher prices that result from
tariffs hit those on lower incomes hardest, because the tariffs (e.g. on foodstuffs, tobacco, and clothing) fall
on those products that lower income families spend a higher share of their income. Thus import protection
may worsen the inequalities in the distribution of income making the allocation of scarce resources less
equitable
 Production inefficiencies: Firms that are protected from competition have little incentive to reduce
production costs. Governments must consider these disadvantages carefully
 Little protection for employment: One of the justifications for protectionist tariffs and other barriers to
trade is that they help to protect the loss of relatively low skilled and low paid jobs in industries that are
coming under sever international competition. The evidence suggests that, in the long term, tariffs are a
55


The
costly and ineffective way of protecting such jobs. According to the DTI study on trade published in 2004,
since 1997 UK employment in textiles manufacturing has fallen by 45%, in clothing manufacture by nearly
60%, and in footwear manufacturing by around 50% - and this despite the protection afforded to European
Union textile manufacturers. The cost of protecting each job runs into hundreds of thousands of Euros for
the EU as a whole. Might that money have been spent more productively in other ways? Often there is a
huge opportunity cost involved in imposing import tariffs.
Trade wars: There is the danger that one country imposing import controls will lead to “retaliatory action” by
another leading to a decrease in the volume of world trade. Retaliatory actions increase the costs of
importing new technologies
Negative multiplier effects: If one country imposes trade restrictions on another, the resultant decrease in
total trade will have a negative multiplier effect affecting many more countries because exports are an
injection of demand into the global circular flow of income. The negative multiplier effects are more
pronounced when trade disputes boil over and lead to retaliation.
diagram
below
shows
the
welfare
consequences
of
imposing
an
import
tariff
In a new study of the benefits of global trade and investment published in May 2004, the UK Department of Trade of
Industry outlined their opposition to import controls (protectionism)
Higher taxes and higher prices
Protectionism imposes a double burden on tax payers and consumers. In the case of European agriculture, the cost
to tax payers is about €50 billion a year, plus around €50 billion a year to consumers via artificially high food prices –
together the equivalent of over £800 a year on the annual food budget of an average family of four.
Furthermore huge distortions in international agriculture markets prevent the world’s poorest countries from trading
in the products they are best able to produce. Continuing barriers to trade are costing the global economy around
$500 billion a year in lost income.
Protectionist policies rarely achieve their aims. They can be costly to administer and they nearly always provide
domestic suppliers with a protectionist shield that encourages inefficiencies leading to higher costs.
Protectionism is a ‘second best’ approach to correcting for a country’s balance of payments problem or the fear of
rising structural unemployment. And import controls go against the principles of free trade enshrined in the theories
of comparative advantage. In this sense, import controls can be seen as examples of government failure arising from
intervention in markets.
56
Economic nationalism
Economic nationalism is a term that has become used more frequently in recent years. It is used to describe policies
which are guided by the idea of protecting a country's home economy, i.e. protecting domestic consumption, jobs
and investment, even if this requires the imposition of tariffs and other restrictions on the movement of labour,
goods and capital. Economic nationalism may include such doctrines as protectionism and import substitution.
Examples of economic nationalism include China's controlled exchange of the yuan, and the United States' use of
tariffs to protect domestic steel production. The term gained a more specific meaning in 2005 and 2006 after several
European Union governments intervened to prevent takeovers of domestic firms by foreign companies. In some
cases, the national governments also endorsed counter-bids from compatriot companies to create 'national
champions'. Such cases included the proposed takeover of Arcelor (Luxembourg) by Mittal Steel (India). And the
French government listing of the food and drinks business Danone (France) as a 'strategic industry' to pre-empt a
potential takeover bid by PepsiCo (USA).
Sample IGCSE Questions
1. When the exchange rate of a currency depreciates, the balance of trade improves. Do you agree with this
statement? Give reasons for your answer. (6)
Depreciation is referred to as the decrease in the value of currency relative to another country. It is often
linked with the balance of trade, the amount of exports subtracted by the amount of imports. When the
balance of the trade improves, this means the value of exports is greater than the value of imports; a trade
surplus. This means that the value of exports is cheaper overseas so people are able to buy more of the
country’s exports so demand for the good increases and thus they would have higher purchasing power to
buy your good. This causes the country to export more. Another reason is that because of depreciation,
imports become more expensive so demand for imports decreases as prices for imports rise.
However, exports may not rise if another country has depreciated its currency even further or produced that
good at a lower cost. Exports may not even increase if there are a lot of substitutes for the good, such as
coffee beans. If the exports are inelastic, there is little change in quantity demanded. Countries like Hong
Kong are dependent on food and oil, they are forced to pay a higher price and quantity demanded will not
fall too much.
In general, currency depreciation should improve the balance of trade.
2. Apart from depreciation of the currency, identify and briefly explain two measures that a government may
use to increase exports. (4)
a. Demand-side policy  promotion of products made in the country, for example, The British Council
has an annual trade fair on British goods to attract more buyers. Similarly, for Hong Kong, it is the
Hong Kong Trade and Development Council (HKTDC).
b. Supply-side policy  Subsidies to export companies to lower production cost and increase supply.
For example, China’s subsidies to solar panel producers.
3. To what extent is international borrowing by a developing country likely to lead to an increase in the
standard of living? Give reasons for your answer. (6)
International borrowing is when countries or government borrowing money from banks overseas. Standard
of living is the welfare of individuals. One example of international borrowing is when the Chinese
government borrowed from the International Monetary Fund (IMF) to build the Three Gorges Dam. By
building this dam, it allows people in China to have access to clean water which reduces cholera and other
water-borne diseases outbreaks and increases their health. Another added benefit of building this dam is
57
that it is a hydroelectric plant and produces a large supply of electricity to power businesses and therefore
increase productivity. Irrigation can also be provided by the dam to improve the marginal agricultural areas.
Thus, farmers in these areas can produce more agricultural products and increase their standard of living.
Another important benefit is that by building this dam, it creates jobs for construction workers as well as
engineers, architects and many others.
However, international borrowing results in high interest rates and in the long-term, debt. The disadvantage
of building a dam is that the surrounding wildlife and habitat will be destroyed and some people will be
relocated and thus, this will decrease their standard of living.
In conclusion, for the majority of the people, the standard of living will increases due to international
borrowing.
4. How does combatting inflation affect the exchange rates? (6)
Raising benchmark interest rates is the preferred plan of action when it comes to the central bank's fight
against inflation. It's the easiest and simplest strategy, and the results can sometimes be quicker compared
to other methods. All a monetary body does, in this instance, is increase the benchmark that most
commercial and retail banks refer to when creating client loans. These products include mortgage, student
and car loans, along with commercial loans for businesses. Once these rates rise, the cost of money
increases. This isn't a good thing for customers or companies. (For more on the relationship between
interest rates and inflation. Global investors constantly search for high interest rate returns combined with
relatively low risk. The same goes for foreign exchange investors. So, when a central bank elects to raise
rates, you can be sure that demand for that currency will rise. For example, the Australian dollar benefited
from this phenomenon beginning in June 2010. The central bank of Australia raised rates several times
between late 2009 and early 2011. By January 2011, the Australian dollar had risen by 26% compared to the
U.S. dollar in response As the Australian economy rebounded quickly amid a slumping global economy, the
country's central bank was forced to raise rates more than once – by 25 basis points each time – in order to
fight inflation. The decisions led to higher demand for the Aussie, especially against the U.S. dollar, during
that time.
An equally effective strategy for central banks is to raise the reserve requirements of banking institutions.
When a central bank elects to raise the reserve requirements, is limiting the amount of money or cash in the
system - referred to as the monetary base. An increase in the reserve requirement increases the minimum
cash reserve that a commercial bank is governed to hold, so this adjustment prevents the bank from lending
out that cash. This restriction of money will slow the rise in prices as there will be less money chasing the
same expensively priced goods (hopefully suppressing demand). The Chinese government favors this policy
due to its own semi-fixed currency policy. Since the beginning of 2011, the People's Bank of China has elected
to raise the reserve requirement three times – increasing the rate by 50 basis points each time.
The decision to raise reserve requirements should eventually slow down the inflation of a nation's currency.
More often than not, such a decision also helps to fuel the foreign exchange rate's upward trend in value
due to speculators. So, the central bank's decision holds significance for the foreign exchange investor.
By increasing the reserve requirement, the central bank is acknowledging that inflation is a problem and is
aggressively dealing with it. However, this could increase a currency's attractiveness to forex investors, as
they anticipate another round of reserve requirement increases. As the supply of money thins - a result of
higher reserves held by banks - speculation helps to support and even propagate a higher currency valuation
(thus lowering inflation). Referring back to the Chinese yuan, the effects of speculative demand are apparent:
The currency gained by almost 4% following a series of reserve rate increases from June 2010 to January
2011, as speculators anticipated further reserve quota increases for Chinese domestic banks.
58
5. Changes in rate of exchange meant that exports of good from Egypt decreased a they became more
expensive in other countries
a. Explain what is meant by a rate of exchange. (3)
A rate of exchange is the rate at which one currency can be exchanged for another on the global
foreign exchange market. It is therefore the market price of one currency in terms of another
currency, for example, the price of euros in terms of US dollars
b. If exports from Egypt become more expensive, how might that affect production and employment
both in Egypt and in countries importing Egyptian goods? (7)
If exports from Egypt become more expensive, global demand for them is likely to fall. Unless global
demand is price inelastic this will
lose revenue and their profits will fall. In response, exporters
may cut back their production and reduce their employment of labour. If exports are a major source
of revenue for Egypt, this could result in a significant loss of income and high unemployment.
In the country importing Egyptian goods there could be inflation, especially if the Egyptian goods
make up a significant proportion of total imports and are used by firms in the production of other
goods and services. However, consumers in this country may be able to buy similar products from
domestic producers instead. Domestic firms are likely to respond by increasing their output and
demand for labour rise. However, if consumers also switch some of their demand to other imported
goods from other countries then the potential for growth and employment in their country will be
reduced.
c. Describe the structure of balance of payments on current account of a country (4)
The balance of payments of a country records international transactions with other countries. The
current account within the balance of payments records payments made to other countries for
visible and invisible imports and payments received from overseas from the sale of visible and
invisible exports. The balance of trade is therefore the difference between the value of goods
exported and the value of goods imported by a country. The balance of invisibles is the difference
between the value of services purchased by overseas firms and residents and the value of services
purchased from by domestic firms and residents.
The current account also records income flows into and out of a country including wages earned by
residents working overseas or paid out to migrant workers from overseas, and any international
payments of interest, profits and dividends. It also records current transfers including payments of
taxes and excise duties by visiting residents of other countries, or similar payments mad overseas.
d. Discuss what might lead to an improvement in the current account of a country (6)