Unit 2.1: Demand theory
What you should know by the end of this chapter:
•
•
•
•
•
•
•
Law of demand
Income and substitution effects (HL only)
Law of diminishing marginal utility (HL only)
Demand curve
Relationship between individual consumer demand and market demand
Non-price determinants of demand
Movements along the demand curve and shifts of the demand curve
The importance of markets
The market is a central feature of the study of microeconomics. A
market for a good or service exists where buyers and sellers interact
and the price and quantity of the product traded is established. Markets
can be narrowly defined (the market for the touch screen iPad in
Australia) or broadly defined (the world market for oil).
The world market for oil is worth $86 trillion
Neoclassical economic theory is the behaviour of markets based on demand and supply. The theory
is focused on four basic theoretical market structures that are used to analyse how markets behave.
The four structures are:
•
Perfect competition
• Monopolistic competition
• Oligopoly
• Monopoly
*Detailed theory on these market structures is set out in chapters 2.11(2) - 2.11(4).
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Defining demand
Demand is the willingness and ability of consumers to pay a sum of money for a good or service at a
given price and at a given point in time. Demand theory comes from the ‘human wants’ part of the
central economic problem. Individuals want to buy goods and services because of the satisfaction
they gain from consuming them. For example, the demand for social media sites like Facebook and
Instagram is partly based on the human desire to interact with different groups and individuals.
The law of demand – how price affects quantity demanded
*In the analysis of demand and supply in Unit 2.1 and Unit 2.2 both the demand and supply curves
are used in the diagrams to illustrate how different variables affect demand and supply in markets.
In the coverage of demand in this chapter, an upward sloping supply curve is used to represent the
output of firms in different markets. This is covered in detail in Unit 2.2. Changes in demand and
supply in markets will affect price and output in markets and this is covered in detail in Unit 2.3 on
competitive market equilibrium.
The law of demand states that as the price of a good or service rises, the quantity demanded falls
and as the price of a good falls, the quantity demanded rises (ceteris paribus). As such, there is a
negative relationship between price and quantity demanded.
The demand curve
The demand curve or demand schedule
shows the negative relationship between
the price and quantity demanded of a
good or service. This is shown in diagram
2.1 where the quantity demanded of the
iPad increases from 20m units to 30m
units as the price of them falls from $400
to $300. In this case, the price has fallen
because the supply of the iPad has
increased because of improvements in
technology.
Real income effect (HL)
The real income effect can be used to explain the law of demand because a change in the price of a
good affects the income households have available to buy the good. As the price of a good falls, the
quantity demanded increases partly because of the real income effect. At a lower price, consumers
can afford more of the product than at higher prices. In this case, the fall in the price of the iPad
from $400 to $300 makes them more affordable to consumers, so the quantity demanded rises. The
opposite occurs if the price of the iPad rises and consumers have effectively less real income to buy
the good.
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Substitution effect (HL)
The substitution effect is based on the price of a good or service relative to alternative products
consumers can buy to satisfy the same or similar human want. As the price of a good falls, the
quantity demanded rises partly because the good offers greater satisfaction to the consumer per
unit of money spent compared to its substitutes. For example, if the price of the iPad falls, it offers
more satisfaction per unit of money spent compared to its substitutes. This means consumers
substitute towards the iPad away from PCs. The opposite occurs if the price of a good rises and it
offers less satisfaction per unit of money spent compared to its substitutes.
The law of diminishing marginal utility
Utility
Utility theory is based on looking at demand in terms of the satisfaction an individual receives from
consuming a good or service. The more satisfaction an individual receives from consuming a good
the greater their demand for that good. A person’s satisfaction can be measured in terms of the
number of utils they gain from consuming a good or service. A util is a unit of satisfaction. Total
utility is the total satisfaction an individual derives from consuming successive units of a good.
Marginal utility
Marginal utility is the satisfaction an individual receives from the last unit of the good they consume
and is measured in utils. In demand theory, you can relate the marginal utility someone gets from
consuming a good to the price they are prepared to pay for the good. The higher the marginal utility
a person gets from consuming a good, the higher the price they are prepared to pay for the good.
The law of diminishing marginal utility states that for each extra unit of a good consumed by an
individual, the marginal utility they receive from consuming the good falls. This is shown in the table
where a person is consuming increasing units of chocolate biscuits.
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For each extra biscuit, the individual consumes the marginal
utility falls. Consider the utility data in the table. When you are
hungry the first biscuit will give you lots of satisfaction (15 utils)
but as you consume increasing numbers of biscuits the marginal
utility of each extra biscuit falls because you get less and less
satisfaction from consuming each biscuit. Eventually, you will
reach a point of consumption where you get no satisfaction at all
from the good, which is the case with the fifth biscuit (0 utils).
Relationship between total utility and marginal utility
The relationship between total utility and
marginal utility and units consumed is shown
in diagram 2.2. If you relate the marginal
utility from consuming each biscuit to the
price the individual is prepared to pay for the
biscuit in the table, you can see the price the
individual is willing to pay falls as
consumption increases because the marginal
utility falls.
Marginal utility and the law of demand
The law of diminishing marginal utility can be used to explain the law of demand. If individuals get
less marginal utility from the higher quantities they consume, they will be willing to pay a lower
price. As quantity increases, price decreases. If an individual receives more marginal utility from less
quantity consumed then they will be willing to pay a higher price. As quantity decreases, price
increases.
This is shown in the table where the amount the individual is prepared to pay for the chocolate
biscuits goes down as their marginal utility diminishes. For example, the individual in the table is
prepared to pay 0.75c for the first biscuit they consume because they receive 15 utils (marginal
utility) of satisfaction from its consumption, but are only willing to pay 0.20c for the fourth biscuit
because they get 3 utils (marginal utility) of satisfaction from its consumption.
Relationship between an individual consumer’s demand and market demand
The market demand curve for a good or service is derived by summing the demand curves of all the
individuals in the market. In the market for music streaming, for example, the quantity demanded of
each consumer at a given price is added together to get the market demand at that price.
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Price of related goods and demand
Substitutes
A substitute for a good is an alternative
product that can be used to satisfy a
similar want in place of a good. A
substitute for the iPad, for example,
would be laptops. The more precisely a
good is defined the easier it is to find
substitutes for it.
One brand of laptop computer, such as Sony, has many close substitutes from firms such as
Panasonic, LG and Lenovo. There are also substitutes for Sony laptops such as personal computers
and smartphones, but these are not as close as the branded alternatives.
There is a positive relationship between the price of a substitute for a good and the demand for the
good itself. If the price of laptops, a substitute for the iPad falls, then the demand for the iPad will
fall as consumers substitute away from the iPad to the relatively lower-priced laptop.
Changes in the price of a substitute for a good cause a change in demand for the good and the
demand curve shifts. This means the quantity demanded for a good changes at each price. In our
IPad example, a fall in the price of laptops causes the demand for the iPad to shift to the left. The
fall in demand for the iPad is shown in diagram 2.3. As demand falls, the price of the iPad and the
quantity traded both fall.
Complements
A complement is a good that can be consumed together
with another good. The complements for the iPad include
goods such as broadband connection, iPad stylus, cases,
screen protectors, and apps. For example, if you buy an
iPad you may also want to get a broadband connection in
your house to access the internet on your tablet or buy
some apps to access different web-based services.
The complements of the personal computer.
There is a negative relationship between the price of a complement for a good and the demand for
the good itself. If the price of a complementary good for the iPad, such as broadband connection
falls, then the demand for the iPad increases. This is shown in diagram 2.4.
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Income and demand
There are four basic relationships between
the demand for a good and consumer
income.
Normal goods
Normal goods demonstrate a positive
relationship between income and
demand. As income rises the demand for
normal goods rises, and as income falls,
demand falls.
This is shown by shifts in the demand curve for a good. Most goods are normal goods. If household
incomes rise they will spend more money on food, transport, housing, furniture etc. For example, a
rise in income would lead to a rise in demand for the iPad, as shown in diagram 2.4 with a rise in
price and quantity sold.
Necessity goods
Necessity goods are a type of normal good. They are goods that consumers need to sustain their
normal lives. They include basic staple foods like bread and rice, housing, electricity and clothing. As
household incomes rise, demand for necessity goods will increase, but at a less than proportionate
rate than the increase in income. For example, if a person gets a 5 per cent pay rise may well use
more electricity, but we might expect their consumption of electricity to rise by only 2 per cent.
Luxury goods
Luxury goods are another type of normal good. Economists
sometimes refer to luxury goods when there is a strong
positive correlation between income and demand. As
household incomes increase, the demand for luxury goods
increases by a greater than proportionate amount relative to
the rise in income.
This normally applies to goods and services consumers do not need to buy to sustain their lives, such
as holidays, branded clothing, restaurant meals and tickets to the cinema.
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Inferior goods
Inferior goods show a negative relationship
between income and demand. As household
incomes rise, the demand for an inferior goods falls
and as incomes fall, demand for an inferior goods
rises. This relationship often applies to lowerpriced goods such as tinned fruit and vegetables,
processed meats and manmade fibre clothing.
Diagram 2.5 shows a rise in demand for tinned fruit
as incomes fall in a recession.
Other factors that change demand
Population and demographics
Population changes can have a significant impact on the demand for a good because it affects the
number of consumers in the market. Population growth at a national or local level will cause a rise in
demand for many goods and services, but it is often most noticeable in the demand for goods such
as transport, housing, education and healthcare. At a global level, a rise in the world’s population
leads to a rise in demand for goods such as food and water. In terms of population structure, there is
an ageing population in many developed countries which has led to a rise in demand for healthcarerelated goods and services.
Consumer taste
Consumer tastes change over time due to social and cultural
changes. The rise in demand for vegetarian and vegan food is
partly due to social change, as more people give up eating meat for
animal welfare, and environmental and health reasons. Firms can
influence consumer taste through advertising and promotion. The
huge sums spent by the sports businesses Nike and Adidas have a
major impact on the demand for the products they sell.
Price expectations
The demand for a good or service in the present can be affected by consumers’ expectations of what
the price for that product might be in the future. If, for example, a government plans to increase
indirect taxes on new cars, consumers may decide to buy their car now rather than wait until the tax
increases the price of the car in the future. This could increase the demand for new cars in the
present.
Expectations are particularly important in asset markets like shares and houses. Expectations of a
future rise in house prices can increase the demand for houses in the present and this makes the
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price of houses rise now and into the future. For example, if a person expects the price of houses to
rise by 10 per cent next year, then they buy a house now and own an asset that may be worth 10 per
cent more in a year’s time.
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Unit 2.2: Supply theory
What you should know by the end of
this chapter:
•
•
•
•
•
•
Law of supply
Assumptions underlying the law of supply
Supply curve
Relationship between an individual producer’s supply and market supply
Movements along and shifts of the supply curve
Non-price determinants of supply
Defining supply
Supply is the willingness and ability of producers to offer a given quantity of a good for sale at a
point in time and at a given price. Supply refers to the resource element of the central economic
problem of scarcity. The factors of production (land, labour, capital, and enterprise) are used to
produce goods and services on the supply side of a market.
For example, supply in the sportswear market is made up of the
workers who work for businesses like Nike and Adidas, the capital used
to manufacture their sportswear products, the raw materials used in
production, and the entrepreneurs who organise and manage the
companies in the sportswear market.
The law of supply – how price affects quantity supplied
The law of supply states that an increase in price leads to an increase in the quantity supplied of a
good or service, and a decrease in price leads to a fall in quantity supplied. There is a positive
relationship between price and quantity supplied.
The supply curve
The positive relationship between price and quantity
supplied is illustrated by the supply curve. Diagram 2.6
shows that a rise in the price of soft drinks from 60c to
80c leads to a rise in quantity supplied from 2 million
to 3 million units. As the price changes, there is a
movement along the supply curve.
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Profits and supply
The law of supply can be explained by how a rise in price can lead to an increase in producer profits.
The increase in profit from a higher price gives producers a greater incentive to increase supply. The
higher price also means a higher unit cost of production can be covered by the price. For example, if
the unit cost of producing an extra unit of a soft drink increases as a firm produces more, the higher
price can cover this extra cost and make the increase in production profitable.
*The law of supply can be explained using the law of diminishing returns and how this affects a
firm's costs of production. This explanation is covered in detail in Unit 2.11(1).
Non-price determinants of supply
Cost of factors of production
Changes in the costs of the factors of
production used to produce a good or
service will affect supply and cause the
supply curve to shift. If, for example, the
cost of coffee beans used by coffee shops
increases, then the supply of coffee from
coffee shops will fall and the supply curve
will shift to the left. This is shown in
diagram 2.7 where the supply curve for
coffee sold in coffee shops shifts from S1
to S2 and the price of coffee and the
quantity of coffee traded falls.
A decrease in the cost of factors of production would lead to an increase in supply, and the supply
curve would shift to the right. For example, a reduction in the minimum wage would reduce the cost
of labour for businesses like coffee shops and would increase supply.
Competitive supply
Many firms produce a range of goods, and a change in the price of one good a firms sells may affect
the quantity supplied of other products they sell. An agricultural producer of soft fruit, for example,
might sell strawberries and raspberries. If the price of strawberries rises, the farm may allocate more
land to strawberries, which means less land is allocated to raspberries. As a result of this, the supply
of raspberries will fall, and the supply curve for raspberries will shift to the left. If the price of
strawberries falls the producers might reduce their supply of strawberries and allocate more land to
raspberries which increases the supply of raspberries.
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Joint supply
When a production process yields two or more goods at the same time this is called joint supply.
This means increasing the supply of one good directly leads to an increase in the supply of a good it
is in joint supply with. Joint supply often occurs in the agricultural industry with examples such as
beef and leather, wheat and straw, and mutton and wool. Another example of joint supply occurs in
the production of oil. The refinery process for oil also produces the chemical bases for plastics. This
means an increase in the supply of oil will lead to an increase in the supply of plastic.
Technology
As technology in the production process
advances the production capacity of firms
increases. As a result, businesses supply
more to the market. This has been the
case with manufactured goods like
computers, mobile phones, televisions
and cars. You can also see the impact of
advances in technology on supply in
service industries such as online music,
games and film streaming services.
Diagram 2.8 shows an increase in the supply of mobile phones as a result of improvements in
technology in the mobile phone market. As the supply of mobile phones increases it leads to a fall in
their price and a rise in the quantity traded.
Supply-side shocks
A country or region may experience supply-side shocks
which lead to a decrease in supply. This is particularly true
in agricultural markets where the weather can impact on
growing conditions. Cold conditions in coffee-growing
areas can dramatically reduce the output of coffee
producers and the supply of coffee. The Tsunami in Japan
in 2011 led to a significant fall in the production of cars as
many manufacturers were forced to reduce output for a
period of time.
The destruction caused by a Tsunami that hit Japan in 2011
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Price expectations
Producer supply decisions can be affected by their expectations of what may happen to the price of
a good or service in the future. If, for example, a construction company believes that the price of a
building will be worth 20 percent more in two years, they may wait for two years before they put the
building onto the market which reduces supply. If producers expect prices to fall, they may increase
supply in the present. For example, housebuilders might increase the supply of housing in the
present if they expect house prices to fall next year.
Number of producers in the market
As more firms enter a market, the supply in the market increases and as firms leave a market, the
supply falls. The growth of online shopping has led to a rise in the number of delivery businesses. As
more delivery firms enter the market, the supply of this service increases.
Taxes
When indirect taxes are levied on goods and services supply decreases as a tax adds to a firm's costs
of production. For example, taxes on cigarettes, alcohol, and petrol cause the supply curve of these
goods to shift upwards leading to an increase in price and a decrease in market output. *The impact
of taxation on supply is covered in more detail in Unit 2.7(1).
Subsidies
A subsidy on a good or service leads to an increase in supply as the cost of production decreases. For
example, subsidies on agricultural goods and renewable energy cause the supply curve to shift
downwards leading to a decrease in price and an increase in market output. *The impact of
subsidies on supply is covered in more detail in Unit 2.7(1).
The impact of tax and subsidies on supply are covered in Unit 2.7(1)
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Unit 2.3: Competitive market equilibrium
What you should know by the end of this chapter:
•
•
•
•
•
•
•
Resource allocation through the price mechanism
Signalling function of price
Incentive function of price
How price rations goods and services in a market
Consumer Surplus
Producer surplus
Social/community surplus maximisation
What is market equilibrium?
Equilibrium in markets occurs where
demand equals supply and the marketclearing price and output are
established. The equilibrium price is
known as the market-clearing price
because at that moment in time all the
consumers who are willing and able to
buy the product at the equilibrium price
can purchase it and all the producers who
are willing and able to sell the product at
the equilibrium price can sell it.
Disequilibrium
If the price of a good is not at the equilibrium level there is natural market pressure to push it to the
equilibrium price. Diagram 2.9 illustrates the market for a music festival. The equilibrium price is
$100 and the equilibrium quantity is 10,000 tickets. If the price is above the equilibrium at $150
there will be excess supply and there will be natural pressure for the price to fall to the equilibrium.
At a price of $40 which is below the equilibrium, there is excess demand and the price rises to the
equilibrium.
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The rationing function of price
The central economic problem of scarcity means there is always a limited supply of goods and
services to be shared out amongst consumers. Price has a rationing function in this situation because
it distributes goods so there are no shortages or surpluses. All the consumers in the market who are
willing and able to buy a good at the market price can buy it and all the firms in the market who are
willing and able to sell their goods at the market price can sell it. The example of festival tickets in
diagram 2.9 illustrates the rationing function of price.
Changes in equilibrium
The equilibrium price and quantity in a market will change if there is a change in either demand or
supply.
Change in demand
A change in a non-price demand factor
that shifts the demand curve will lead to
a change in the market equilibrium price
and quantity. The rise in the popularity
of music streaming services because of
taste and fashion has increased the
demand for music streaming services.
This leads to an increase in the equilibrium price from $10 to $15 and an increase in the quantity of
music streaming from 2 million to 3 million units. This is shown in diagram 2.10.
Change in supply
In the same way as a change in non-price
factors changes demand, a change in a
non-price supply factor will shift the
supply curve and lead to a change in the
equilibrium price and quantity. An
improvement in technology in the
television market has led to an increase
in the supply of televisions in diagram
2.11. This results in a fall in the price
from $400 to $300 and an increase in
the quantity of televisions traded from 5
million to 6 million units.
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Functions of the price mechanism
The allocation of resources
Resource allocation is the distribution of the factors of production to different markets in the
economy. In free markets, the price mechanism guides resources to different markets through what
Adam Smith called ‘the invisible hand’. In this theory, price is seen to have two functions in
allocating resources, the signalling and incentive functions of price.
The signalling function of price
When a price changes in a market, it
sends information (a signal) to producers
and consumers that market conditions are
changing, and the price change provides
them with information to make decisions
on how they might act in response to the
price change. Diagram 2.12 shows the
market for olive oil. If there is an increase
in demand for olive oil, there will be
excess demand at the existing market
price of $4 per litre. For the market to
clear the market price needs to rise.
The rise in price is a signal to consumers and producers in the olive oil market that market conditions
are changing and provides them with information to make buying and selling decisions.
The incentive function of price
Once a price change has sent a signal to consumers and producers, they react to the price change
based on the incentive to try and maximise their profits, in the case of producers and utility in the
case of consumers. As the price of olive oil rises in diagram 2.12 producers have the incentive to
increase the quantity they supply because the higher price means they can earn more profit from
increasing the quantity supplied to the olive oil market. The quantity demanded of olive oil falls as
the price increase means consumers receive less utility for each $ they spend on olive oil. When
quantity demanded equals quantity supplied the market reaches an equilibrium price of $5 with 6
million litres traded.
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Opportunity cost
As the quantity supplied of olive oil
increases more resources are attracted to
the olive oil market. This is shown by a
movement along the PPC in diagram
2.13. As more resources are allocated to
the olive oil market output rises from 140
units to 200 units. This results in an
opportunity cost of 30 units of corn oil as
fewer resources are allocated to the corn
oil market and output falls from 70 units
to 40 units.
Market efficiency
Allocative efficiency
Market allocative efficiency occurs when
the quantity of resources allocated to a
market maximises the community or
social surplus in that market. This means
resources are allocated so that the
consumer and producer surplus are both
maximised. This occurs when demand
equals supply in a market.
Consumer surplus
The consumer surplus is the difference between the price the consumer is willing to pay for a good
and the market price of that good. The demand curve expresses the price the consumer is willing to
pay for the product. For example, the market price for hamburgers is $5 and this is shown in diagram
2.14.
The demand curve shows that some consumers are willing to pay more than the market price of $5.
Some consumers, for example, may be willing to pay $6 for a hamburger but they only need to pay
the market price of $5, which is a consumer surplus of ($6 - $5) $1.
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The consumer surplus is shown by the green shaded area in diagram 2.14. The consumer surplus is
an important concept and it has many applications in economic analysis. The consumer surplus can
be calculated by working out the size of the green shaded area in diagram 2.14. In this example, the
calculation is:
($9.00 – $5.00 x 600,000) / 2 = $1,200,000
Producer surplus
The producer surplus is the difference between the price
the producer is willing to sell their good for and the market
price of the good. The price the producer is willing to sell
for is expressed by the supply curve which is based on the
cost of producing the good. The producer could sell for less
than the equilibrium price, but it would not be rational to
do this because the producer can make a higher profit by
selling at the market price.
A producer in our hamburger example might be willing to sell a hamburger for $2 which is a
producer surplus of ($5 - $2) $3. The producer surplus is shown by the yellow shaded area in
diagram 2.14.
The producer surplus can be calculated by working out the size of the yellow shaded area in diagram
2.14. In this example, the calculation is:
($5.00 – $2.00 x 600,000) / 2 = $900,000
Social (Community) surplus
Welfare is maximised in society when the social or community surplus in a market is maximised. This
is where the benefit to society of the production and consumption of a good is equal to its cost. The
social surplus is the sum of the consumer surplus and producer surplus in a market. In diagram 2.14
this is the total area represented by the green and yellow triangles. In this example, the calculation
is:
($9.00 - $2.00 x 600,000) / 2 = $2,100,000
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Unit 2.4(1): Behavioural economics (HL)
What you should know by the end of this chapter:
•
•
•
•
•
•
•
•
Rational consumer choice
Assumptions of consumer rationality, utility
maximization and perfect information
Limitations of the assumptions of rational consumer
choice
Biases: rule of thumb, anchoring and framing
Bounded: rationality, self-control, selfishness
Imperfect information
Choice architecture
Nudge theory
Rational consumer choice
Behavioural economics considers consumer behaviour in a more complex
way than classical economic theory. It introduces human psychology into
the buyer decision-making process and considers how factors other than
utility maximisation might affect whether someone buys a good or not. If,
for example, you are going to the cinema you might not choose the film
you think would give you the most utility.
If you are with friends you may go to the film they want to watch to keep them happy, or you go to a
film starring a particular actor out of habit even though you do not think the film will be that good.
You might also be influenced by imperfect information about the film from a misleading '5-star'
rating on the film's promotional poster which draws you to a film that is not as good as you think it
will be.
Biases
Biases are the factors that influence individuals in decision-making situations and take them away
from rational judgments. Herbert Simon (1916-2001) was a behavioural economist who believed
that individuals who are confronted by complicated decision-making situations resort to heuristics.
Heuristics simplify decision-making when individuals cannot work out the option that will give them
the greatest utility. In buying situations people use mental shortcuts that allow them to make
decisions in the time frame they are normally faced with. For example, when you are at the cinema
you probably will not spend an hour researching all the films on offer, but spend a few minutes
before deciding to watch the ‘crime thriller’ you know you would normally enjoy.
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Rule of thumb
This approach to decision-making in Economics is based on the belief people make quick judgments
(heuristics) based on what they normally consider to be an expected outcome. When, for example, a
person is in a Thai restaurant they might choose their favoured spicy option rather than base their
decision on the expected utility of each item on the menu. By using a rule of thumb individuals are
not making decisions based on perfect information so they are trying to optimise their utility from
consumption rather than maximising their utility. By understanding how consumers use a rule of
thumb when they are making buying decisions firms can make marketing decisions to increase their
revenues. For example, a restaurant might anticipate what will be the most popular items chosen
from their menu based on the way their customer's usual (rule of thumb) choices and make sure
they produce enough of those items to meet anticipated demand.
Anchoring bias
Anchoring bias is a reference point in an individual’s mind
based on the first piece of information an individual
experiences and it strongly influences a decision they make.
Anchoring is another aspect of how bias affects decisionmaking in behavioural Economics.
Anchoring bias comes from a series of past experiences and it can even be formed in the mind of a
consumer from their first experience of buying a good. When Apple first launched the iPad it was
reported that the company would set a price of $999, but the actual launch price was $499. With a
$999 'anchored' in the mind of potential consumers the $499 was a relatively attractive price and
may well have led to higher initial sales than if the first reported price was $499.
Businesses can use anchor prices in the mind of consumers to increase sales. For example, an
electrical retailer might promote the normal price for a laptop computer at $500 and then discount
it by 40 percent to a price of $300. It is a $300 computer but the anchor in the mind of the consumer
at $500 and this makes them feel like they have got a good deal and they are more likely to buy the
laptop. When individuals are buying personal computers, cups of coffee or cans of soft drinks, etc,
the firms selling these products will build anchoring by consumers into the way they market these
goods.
Framing bias
Framing bias is the way decisions made by individuals are affected by the way choices are presented
to them. The important aspect of framing is the way information is presented in terms of the
content of information and the use of language. In a supermarket, for example, you are faced with a
low-fat chocolate mousse. The packaging could highlight, ‘20% fat’ or ‘80% fat-free’.
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Research shows that most people will be attracted by the ‘fat-free’ label even though both options
offer the same product. Framing is another example of behavioural bias. In this case, people may
well see the benefit of losing 80 percent fat as more attractive than gaining 20 percent from buying
the mousse. Research shows that framing something in positive terms is more attractive to
consumers than in negative terms. Retailers often frame the word ‘free’ in marketing (buy one get
one free, 40% extra free, etc) because it attracts consumers.
Availability bias
Availability bias considers how individual decision-making is affected by information that comes
easily into our minds. This information is often based on our experience of recent events and how
the outcomes of these recent events affect our decision-making. In many situations, our exposure to
events distorts our view of the world and has too much influence on the decisions we make. For
example, you are thinking of buying a train ticket and the probability of being delayed is 20 percent.
You have made several train journeys over the last year, and you have not been delayed once so
expect a good journey so you are more likely to book a train ticket. If, on the other hand, you have
experienced several trips where delays have occurred then you might expect a delay on your next
trip and be less likely to buy a ticket. In both cases, the probability of a delay is 20 percent but your
decision to travel by train is likely to be influenced by your recent experience. Lottery ticket
businesses, for example, will emphasise past winners when promoting tickets to consumers to make
them think there is a better chance of winning than there actually is.
Rationality
Rational behaviour by individuals underpins much of traditional economic theory. Behavioural
economists see this assumption as too simplistic, so they have developed alternative theories of
rationality.
Bounded rationality
Bounded rationality is based on the theory that individuals make a decision that offers them a ‘good
enough’ outcome rather than an ‘optimal’ or utility maximising outcome. The theory sees people as
satisfiers, people who seek a satisfactory or acceptable outcome. If someone, for example, is in a
fast-food restaurant like Macdonald’s they do not research their choice by asking other diners in the
restaurant or by reading numerous online reviews, they might make a quick choice on what looks
appealing and what they have eaten before. Consumers face three challenges when they are trying
to make rational decisions in buying situations:
•
Consumers might have limited time to assess all the possible options when they are
choosing a good. For example, when someone is rushing to buy a drink in a coffee shop in
their break.
•
If there are too many choices on offer for the consumer they might opt for the most familiar
option such as choosing a certain brand of biscuits in a supermarket.
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•
A lack of information may also lead consumers to buy a product they know about rather
than spending time researching alternatives. For example, when someone is choosing a
novel to read they might choose the author they are familiar with rather than finding about
a book by an author they do not know.
Bounded self-control
Bounded self-control is where individuals consume beyond the
point where they maximise their utility when consuming a good.
Utility theory predicts consumers will consume a good to a point
where their total utility is maximised. There is, however, lots of
evidence to show that consumers might not stop consuming a
good even if it makes sense to do so. People, for example, might
binge eat fast food beyond the point where they are still enjoying
it.
Online gambling firms often see their customers betting beyond the level they can afford. People
often think in terms of current satisfaction when they are making buying decisions and do not
consider the long-term implications of current consumption and how this might adversely affect
their health and finances. A person might consume alcohol for the utility it gives them in present and
ignore the future health consequences.
Bounded self-control can be important to governments when they are trying to regulate the
consumption of certain goods. For example, a government policy to try and reduce the consumption
of 'fatty' food may need to account for bounded self-control.
Bounded selfishness
Bounded selfishness means individuals make decisions that benefit other people as well as
themselves. Classical economic theory considers individuals to be concerned with their own welfare
and satisfaction and not others. If people make choices to achieve the highest utility for themselves,
there approach is a selfish one. Behavioural economists see this as a simplistic assumption because
people often act with the welfare of others in mind. When, for example, a group of people is
deciding on a restaurant for the evening, some individuals within the group may well accept the
choice of others to make the whole group happy with the choice. Bounded selfishness is important
for charitable organisations that rely on people acting in the interests of others rather than
themselves. This can also be true when consumers buy fair trade products and pay a higher price for
a good knowing it will benefit a fair trade producer.
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Imperfect information
When individuals make decisions, traditional economic theory assumes their
decisions are made using perfect information. This means people buy goods and
services and know what they are buying, and they can make an informed buying
decision based on this. When, for example, you buy a loaf of bread for $1 you
understand the nature of the good and the benefits it will bring to you. The $1 you
pay reflects the money value of the utility you believe you will get from consuming
the bread.
People are, however, often in situations where they do not understand or know enough about the
product they are buying and are therefore unable to put an informed valuation on the good. This is
particularly the case in markets where products are very technical and difficult for uninformed
consumers to understand. Computer virus software, for example, is difficult for buyers with a basic
knowledge of computers to make an informed buying decision. A person may end up paying $100
for software that may not be worth that price. The products sold by the financial services industry
such as pensions are often seen as services that people buy based on imperfect information.
Choice architecture
Choice architecture is where a business sets the layout, sequence, and range of choices available to a
consumer in a particular way to encourage them to make a buying decision. Behavioural economists,
Richard Thaler and Cass Sunstein, researched how decision-making by individuals is influenced by
the environment where a decision is taken. This environment is known as choice architecture and
the person who designs the environment is known as a choice architect.
Supermarkets, for example, are laid out to affect your buying decisions. Milk, for example, is often
put at the back of the shop to make you walk through the store where you might make impulse
purchases of other goods. The supermarket might also group complementary goods such as soft
drinks and crisps together so you buy both goods. Another example is where shops put
confectionery by the checkout might get you to buy a packet of sweets while you are waiting to be
served.
Default choices
In this theory of behavioural economics, the default choice is the option the consumer selects as
their normal course of action. This could be the brand of soft drink you always buy, the destination
you always go to on holiday, or the news website you always use. The choice is normally the easiest
one for the consumer and requires the least effort. Research shows consumers rarely change their
default option and opt for an alternative. Choosing the default option in a decision-making situation
strongly affects consumer behaviour.
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Insurance companies often send out the details of a car
insurance policy to existing customers before they have
decided to renew their insurance. They often say someone's
policy will continue next year if they ‘do nothing’. This is
probably the easiest option for the consumer and the one
many people decide to take.
This default choice means an insurance company can more easily sell policies by offering customers
automatic renewal. Insurance companies often increase the price of their car insurance for people
who automatically renew their policy.
Restricted choices
Restricted choice is based on the theory of bounded rationality. If buyers are faced with too many
choices they struggle to make buying decisions because they do not have the time to work their way
through too many alternatives. This means it is easier for businesses to sell to consumers if they
offer them a limited number of choices. For example, a retailer selling computer software to nonspecialist buyers might offer their customers a limited choice of software to make the buying
decision easier for buyers. This also means the retailer can carry a narrower range of stock which
reduces their costs.
Mandated choices
A mandated choice is one where the consumer is forced by law to choose an option before they take
part in an activity. Mandated choices are important in aspects of government policy where the state
wants people to decide on something. In the case of pensions, for example, people find it difficult to
assess the benefits of a pension because they may not think about the long-term advantages of a
pension and they also find the financial products associated with pensions difficult to understand.
For this reason, governments in many countries force workers to choose a pension scheme from a
set of alternatives.
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Nudge theory
Nudge theory is an area of behavioural economics
developed by the Economists, Richard Thaler and Cass
Sunstien in their book ‘Nudge’. Thaler won the Nobel
Prize in Economics in 2017 for his work in this area.
Nudge theory means using choice architecture (the way choices are presented to individuals) to
encourage people to make decisions that will improve their own welfare and society’s welfare. A
‘nudge’ means changing any part of the choice environment an individual faces to affect their
behaviour by making small alternations to the factors that affect their decisions.
In the book Nudge, Thaler and Sunstien set out several examples of how nudge theory can be
applied in different situations to solve economic problems. Here are three examples:
The obesity problem
Obesity is a major health problem in many countries. A major cause of
this is how much people eat. Growth in portion sizes and the calorific
content of food and drink has been an important contributing factor
in causing people to put weight on. Obesity is associated with
significant economic costs such as higher government spending on
healthcare and reduced labour productivity at work. Tackling obesity
is a problem for individuals. Low-fat diets, fitness programmes, and
weight-loss drugs are some examples of how people try to reduce
their weight.
In the book, ‘Nudge’ Thaler and Sunstien put forward an alternative approach. They suggest people
are creatures of habit and will unthinkingly do what they always do. For example, if people go to the
cinema, they will always eat all the popcorn in the bucket they buy whether they are enjoying the
remaining popcorn at the bottom of the bucket or not. The book also looks at an example of people
consuming soup in an experiment where their soup bowls are automatically (unknowingly to the
people in the experiment) re-filled. In the experiment, people kept on eating the soup beyond the
amount they would normally consume because of a habit of consuming everything on their plate.
The popcorn and soup examples show how out of habit people eat and drink what is put in front of
them.
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The Nudge Theory approach to losing weight would be for people to buy smaller plates, reduce the
quantity of food they buy and ‘keep less in the fridge’. This approach might be a useful guide for
governments looking to promote weight loss in society.
Saving money
Saving for retirement is an important decision for individuals and governments. People need to have
enough money to live on when they finish work so they can enjoy a certain standard of living. Saving
for retirement is also important for governments that might have to support people who have not
saved enough through the transfer payments the government will have to pay them.
The economic problem of saving for retirement is that people tend not to save enough. Retirement
is often seen as a distant point in the future for many people and they would rather enjoy a higher
standard of living in the present than save for the future. Many employers set up retirement
schemes where people can choose to save money in the scheme which often has some tax
advantages. Employers will also top up an individual’s pension contribution with extra payments.
This is a significant benefit for employees, but people often choose not to enrol in the pension
scheme.
In the book, ‘Nudge’ Thaler and Sunstein advocate an opt-out scheme rather than an opt-in scheme
for pension contributions. In the opt-out scheme, someone who gets a job is automatically enrolled
in the pension scheme and has to choose to not make payments. The ‘nudge’ associated with
changing from opt-in to out-out works because people no longer have to ‘act’ to be in the pension
scheme – it is easier for them to stay part of the pension scheme when they start work. To opt-out
people are also more likely to look at the pension scheme arrangements and then make a more
informed judgment about its benefits. The change from opt-out to opt-in can have an important
effect on government pension scheme design when they are trying to encourage more people to
save for their retirement.
Reducing carbon emissions
Climate change is one of the world’s most significant problems.
Governments use a variety of different approaches to climate change
through policies such as tax, regulation, and tradeable permits. A nudge
theory approach to reducing carbon emissions would be a method that
uses small changes to the choice environment that create incentives for
firms and households to make decisions that encouraged them to cut
their carbon emissions.
A government could apply a ‘nudge’ by making firms sign up for a Greenhouse Gas Inventory where
businesses have to report the amount of carbon they emit into the atmosphere. If this information is
widely available to the public then companies that are the largest emitters would have an incentive
to act. Being high up in the inventory league table would attract media attention and would bring
bad publicity. Consumers may also choose to buy from firms who performed well in the inventory
league table which would put even more pressure on the big polluters.
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The Greenhouse Gas Inventory would be a low-cost policy decision by the government to ‘nudge’
producers to reduce carbon emissions through a published league table.
These examples of how nudge theory can be applied are useful to individuals, businesses, and
governments in terms of making decisions about increasing a person’s welfare and overall welfare in
society.
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Unit 2.4(2): Business objectives (HL)
What you should know by the end of this chapter:
The following different objectives of businesses:
•
•
•
•
•
Profit maximisation
Corporate social responsibility
Achieving market share
Satisficing
Business growth
Introduction
An important influence over the allocation of resources in markets is the
supply decisions firms make. Those supply decisions are based on the
objectives businesses set when they are producing in different markets. There
are a variety of different business objectives firms are influenced by when
they are making a supply decision and the importance of these different
objectives will vary between producers and markets.
Profit maximisation
Profit maximisation is a central theme of classical economic theory. Classical economists believe that
business decision-making is guided primarily by an entrepreneur’s desire to achieve the highest
possible profit their firm can make from producing its goods and services. Profit is important to
entrepreneurs because it is the reward they earn from the risk of setting up and starting their
business. We know that profit maximisation as a business objective is crucial in guiding the
allocation of resources in free markets through the incentive function of price.
Profit as an aim influences business decision-making across different markets and between
businesses of different sizes. For example, profit will affect producer decision-making from a small
firm operating as a sole trader right the way up to a large multinational company that distributes its
profit in the form of dividends to its shareholders. For example, a local takeaway restaurant run by
family owners might aim to make a profit of $50,000 per year whereas fast-food multinationals like
McDonald's might aim for a profit of several billion dollars.
The aim of profit maximisation has important implications for business decision-making. Producers
in a market will set price and output that achieves the revenue and costs which give them the
highest level of profit. This might mean, for example, a bicycle manufacturer using advertising and
promotion to achieve the highest level of demand possible and negotiating the lowest price possible
for the raw materials and components it uses in production.
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Corporate social responsibility aims
Corporate social responsibility (CSR) is a set of business objectives based on environmental, ethical
and social factors. Many firms set environmental objectives because they have to follow government
regulations. This is particularly the case in industries such as energy and agriculture where
production can have a significant impact on the environment. Large numbers of firms also adopt
environmental objectives because it is important to their stakeholders such as employees,
customers and shareholders. The oil companies Shell and BP have, for example, set the objective of
achieving carbon-neutral production by 2050.
Many businesses often target the environment with one eye on sales and profits because having an
environmental outlook gives them a positive image in the mind of the consumer. Airlines, for
example, have a negative reputation for carbon emissions and might take action to offset carbon
emissions and promote their environmental aims as a selling point to consumers.
An ethical objective is where a business makes decisions to achieve positive moral outcomes.
Starbucks, for example, buys Fair Trade coffee from suppliers in developing countries where lowincome farmers are paid a premium for their output to give them a better quality of life. Some firms
have an ethical outlook because of the philanthropic outlook of their owners.
Microsoft owner, Bill Gates, has set up a $50 billion foundation to
support healthcare and education in developing countries. Similarly
to environmental objectives, ethical aims often give an organisation
a positive image in the mind of the consumer which can help sales
and profits.
Market share
Market share is the percentage of total market revenue an individual
firm's revenue accounts for. It is calculated as:
individual firm’s total revenue/market’s total revenue x 100 =
individual firm’s market share
If, for example, a firm's total revenue is $25 million and total market
revenue is $200 million then the market share would be:
$25m / $200m x 100 = 12.5%
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Increasing market share is a useful objective for businesses to judge their relative performance
compared to other firms in the same industry. If a business' market share rises then it suggests its
performance is better than its competitors. Coca-Cola, for example, might judge its performance
based on its market share of 43 per cent of the US soft drinks market as compared to Pepsi's 23 per
cent share. Market share is an effective measure of relative performance whatever the market
conditions. A business might have falling revenue, but its performance might be good if total market
sales are falling in a recession.
Increasing market share can also be useful to a firm looking to achieve greater market influence. A
strong market share position might allow a firm to influence the market price, have promotional
power over consumers and give it greater bargaining power when dealing with suppliers. The French
supermarket retailer Leclerc, for example, has the largest share at 21 per cent, of the supermarket
industry in France. This makes its presence very strong in the mind of French consumers and this
gives it a strong bargaining position with its suppliers.
In terms of market share, Samsung is a dominant business in the smartphone market. Last year, 25
per cent of all smartphones sold in the world were Samsung phones. Samsung has been among the
top 5 smartphone producers in the world since 2009. As other firms such as Nokia have declined
Apple and Samsung have become the two dominant businesses in the market. Samsung currently
has the largest market share at 25 per cent. This gives the firm huge marketing power in the minds
of consumers and buying power in the minds of its suppliers.
Satisficing
Satisficing is where a business sets an aim that is satisfactory rather than optimal. Instead of trying
to maximise profits, a firm might set an acceptable profit objective. The firm can then meet the
needs of its shareholders as well as its other stakeholders such as its employees and the local
community.
The owner of a small business that makes computer games may, for example, aim for a comfortable
living for themselves and their small team of game designers ahead of maximising profits. Satisficing
might give them time to enjoy a good quality of life, although there will be an opportunity cost in
terms of lower profits and wages.
Business Growth
For many firms, the growth of their profit, revenue and market share is
a key objective because it represents progress. A business that is
reaching more customers, operating in more countries and has a
higher asset value is often seen as successful in terms of growth. This
is closely linked to profit maximisation but it is not quite the same. A
firm, for example, may look to discount its products to achieve sales
growth at the expense of short-term profitability.
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Unit 2.5(1): Price elasticity of demand (PED)
What you should know by the end of this chapter:
•
•
•
•
•
•
•
•
Concept of elasticity
Price elasticity of demand (PED)
Degrees of PED: theoretical range of values for PED
Changing PED along a straight line downward sloping
demand curve (HL)
Determinants of PED: number and closeness of
substitutes, degree of necessity, the proportion of
income spent on the good, time
Relationship between PED and total revenue
Importance of PED for business and government decision making
PED of primary goods and manufactured goods
Elasticity
Elasticity is an economic concept based on change. It measures how consumers and producers
respond to changes in variables that affect demand and supply. Elasticity is important because it
allows us to analyse what happens to demand and supply in markets when change takes place and
to evaluate the consequences of change. For example, when the price of electricity rises we can use
elasticity to analyse how consumers and producers will respond to the rise in price.
Definition and measurement of price elasticity of demand
Price elasticity of demand is the responsiveness of quantity demanded for a good to a change in its
price. It is measured by the equation:
% change in Qd / % change in P
For example, if the price of film and
TV streaming services such as Netflix
increases from $20 per month to $24
(20 per cent increase) and quantity
demanded falls from 10 million
subscribers to 7.5 million subscribers
(25 per cent decrease). This is shown
in diagram 2.15 and is calculated as:
-25% QD / +20% P = -1.25 or 1.25
(PED)
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Interpretation of PED
The value of PED is normally negative because of the law of demand. The negative value is often
ignored because the PED value is nearly always negative. In future calculations, the PED will be
expressed as a positive value.
Price elastic demand
If the PED value is greater than 1 then the good’s demand is price elastic. This means a change in
price leads to a proportionately greater change in quantity demanded. In the film and TV streaming
service example, the value is 1.25 which means for every 1% increase in price, the quantity
demanded decreases by 1.25%. This is a price elastic relationship because the proportionate change
in quantity demanded is greater than the proportionate change in price.
Theoretically, the demand curve can be perfectly horizontal or perfectly elastic. This gives a PED of
infinity. This is applicable in the theoretical market form of perfect competition.
Unitary elasticity of demand
If the PED value is 1 then PED is unitary.
This means that for every 1 per cent
change in price quantity demanded
changes by 1%. It is unlikely a good will
have a PED of 1 but the value could be
close to 1. This is shown by a demand
curve which is a rectangular hyperbola and
is represented in diagram 2.16.
Price inelastic demand
If the demand for a good has a PED value
of less than 1 then it is price inelastic. This
means that a change in the price of a good
leads to a less than proportionate change
in quantity demanded. For example, if the
price of rice rises from $0.50 to $0.55 and
the quantity demanded falls from 4m
units to 3.8m then the PED of rice is
calculated as:
-5% QD / +10% P = 0.5 (PED)
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The PED value of 0.5 means for every 1% change in the price of rice, the quantity demanded changes
by 0.5%. This is shown in diagram 2.17. In theory, a perfectly vertical demand curve represents
perfectly inelastic demand. This gives a PED of 0.
Demand curves with differing elasticities
Diagram 2.18 shows demand curves of
different slopes to represent different
PEDs. A horizontal demand curve is
perfectly elastic (D) and with a relatively
flat gradient (D1) is relatively elastic. A
vertical demand curve (D3) is perfectly
inelastic and one which has a relatively
steep gradient is inelastic.
All demand curves (except the perfect ones) have a PED that changes from elastic to inelastic as the
price of the good is reduced and this is shown in diagram 2.18. The demand curves that represent
elastic and inelastic demand situations are useful for illustrating the effects of price changes.
Elasticity along the demand curve
As the price of a good decreases along the demand curve the PED value falls. Diagram 2.19
illustrates the demand curve for training shoes. As the price of the shoes falls from $50 to $45 the
quantity demand increases from 2m units to 3m units. This is a PED of:
+50% QD/ -10% P = 5 (price elastic)
On the upper section of the demand curve, PED is price elastic.
When the price of the training shoes is reduced from $20 to $15 the quantity demanded rises by 8m
to 9m units. This is a PED of:
+12.5% QD / -25% P = 0.5 (price inelastic)
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PED falls as you move down the
demand curve because a change in
price at a relatively high price level has
a greater proportionate effect on
quantity demanded than the effect of a
change in price at a relatively low
price. On the upper section of the
demand curve in diagram 2.19, PED is
price elastic because of the way
percentages are calculated. A $5 price
reduction from a price of $50 is a
smaller percentage change than a $5
price reduction from a $20 price.
Similarly, a 1m quantity increase from 2m to 3m is a larger percentage increase than a 1m increase
from 8m to 9m. When the PED is calculated it will have a greater value at higher prices on the
demand curve and a smaller value at lower prices.
Determinants of price elasticity of demand
Number and closeness of substitutes
The greater the number of close substitutes a
product has the more price elastic its demand
tends to be because consumers can easily swap
between alternatives when the price of the good
changes.
This relates to the way you define the market for a good: the more precisely defined the market for
a good, the more close substitutes it tends to have. There are many different brands of biscuits on
the shelf of a supermarket, so any one brand of biscuit tends to be relatively price elastic. A rise in
the price of Oreo biscuits, for example, may well lead to consumers switching to alternative brands
such as Jaffa Cakes. If the market definition broadened from brands of biscuits to biscuits as a
product, then there are fewer close substitutes (chocolate bars, crisps, cakes, etc.) and the demand
for biscuits will be more inelastic.
Luxury or necessity
The demand for goods that are a necessity for a consumer tends to be more price inelastic than the
demand for luxury products which tend to be more price elastic. This is because consumers need to
keep buying necessity goods when their price increases. For example, if the price of electricity rises,
quantity demand will fall by a proportionately smaller amount because people still need to use
electricity to light their homes and run their appliances.
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Consumers do not, on the other hand, need to keep consuming luxury products if their price
increases. For example, if the price of long-haul air tickets increases, people can take fewer holiday
flights and the quantity demanded would fall by a relatively greater amount.
Proportion of income
The demand for goods that account for a smaller proportion of household income tends to be more
price inelastic. This is because any change in price will have a relatively small impact on household
income. For example, consumers might spend a relatively small amount of their income on chewing
gum each month, whereas they might spend a larger proportion of their income on train travel. A 20
per cent increase in the price of $1 a pack of chewing gum is likely to have a smaller impact on
consumer income than a 20 per cent increase in the price of a $15 daily train ticket, so the PED of
chewing gum tends to be more inelastic than the train tickets.
Type of consumer
High-income consumers tend to be less responsive to price changes for goods than people on lower
incomes. This is because any price change will have a smaller real income effect on high-income
consumers compared to low-income consumers. For example, if the price of a prestige watch rises
from $2000 to $2500 then it may have little impact on a wealthy buyer who has an income of a
million US$ per year. This is why the demand for luxury goods sold to wealthy individuals tends to be
relatively price inelastic. The demand for high-end fashion labels such as Prada and Armani have
relatively inelastic demand for their goods because they are targeted at wealthy consumers.
Time
Over time PED tends to become more
price elastic because consumers can
alter their consumption patterns in
response to a price change. In the short
run an increase in the price of petrol,
for example, will lead to a relatively
small decrease in the quantity
demanded because petrol buyers can
cut back on some leisure journeys, but
they still have to get to work and take
their children to school.
In the long run, buyers could change to a more fuel-efficient car and move to a house nearer to
where they work. Thus the demand for petrol becomes more price elastic in the long run.
Diagram 2.20 shows how the PED for petrol increases from:
-25% QD / +20% P = 1.25 PED to
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-60% QD/ +20% P = 3 PED
Price elasticity of demand and revenue
Revenue is the value of income a business receives from selling a good. It is calculated by:
price x quantity = total revenue
For example, an airline sells 500,000 seats a year at a price of $200 then the total revenue is:
500,000 x $200 = $100,000,000
Firms can use an understanding of PED to
increase their total revenue. When the demand
for a good is price elastic, total revenue rises
when the price is reduced and decreases when
the price is increased. When the demand for a
good is inelastic, total revenue rises when the
price is increased and decreases when the price
is reduced.
An airline sells seats to a holiday destination. Ticket A is sold during the school summer holidays
when demand is relatively price inelastic because families need to travel at that time and the seats
are considered a relative necessity. Ticket B is sold outside school holiday time when demand is
relatively price elastic because people do not have to travel at that time and seats are considered
more of a luxury.
The table shows the price, quantity and revenue for tickets A and B before and after a 20 per cent
increase in the price of seat tickets from time period year 1 to time period year 2. The total revenue
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for ticket A, which has price inelastic demand, increases by $128,000 and the total revenue for ticket
B, which has price elastic demand, decreases by $84,000.
Diagram 2.21 shows how an increase in
price for seat ticket A leads to a rise in
total revenue. Area EFBG shows the total
revenue after the price increase which is
greater than area ABCD, which is the
total revenue before the price increase.
Diagram 2.22 shows how an increase for
seat ticket B leads to a fall in total
revenue. Area ABCD shows the total
revenue before the price increase, which
is greater than area EFBG which
represents the total revenue after the
price increase.
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The impact on total revenue of changes in PED along the demand curve
The business response to PED could be to
make a judgement about the PED of the
demand for the good they sell and then
increase or decrease the price of their
good to increase revenue and hopefully
profits. It is important to remember that
PED changes as you move along the
demand curve and this will affect the
revenue from a price change. In diagram
2.23 we can see that a rise in the price of
the airline seat ticket with inelastic
demand will lead to an increase in total
revenue, but as PED raises the rate of
increase of total revenue will slow down
and peak when PED is unitary.
Any increase in price as we move onto
the elastic section of the demand curve will lead to a fall in revenue. The same thing happens if the
price is reduced on the elastic section of the demand curve. Revenue rises and peaks when PED is
unitary and then falls when PED is inelastic.
Government decision-making and price elasticity of demand
PED will be useful to governments when they are making policy decisions that affect the price of
goods and services. PED will have an effect on tax, subsidy, maximum price and minimum price
decisions made by governments. The specific effects of PED on these policies are covered in Unit 2.7
Governments and markets.
The price elasticity demand of commodities compared to
manufactured goods
Economists are often concerned by the differences in PED between
commodities and manufactured goods. The demand for agricultural
goods tends to be relatively inelastic because they are often
necessities and have fewer close substitutes compared to
manufactured goods. If the price of a commodity such as rice
increases then households reduce the quantity demanded by a
proportionately smaller amount than the increase in price. This is
because households depend on rice as part of their diet and there are
relatively few close substitutes for it.
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Manufactured goods such as personal computers (PCs) are often relative luxuries
so the demand for them tends to be more price elastic. The demand for
manufactured goods is also considered price elastic because of the number of
substitutes they have. If the price of a PC rises people could buy a substitute for a
PC like a new mobile phone or tablet computer.
Evaluating price elasticity of demand
PED is used extensively by businesses looking to increase revenue and profit from their pricing
strategies. There are, however, some limitations to PED:
•
It can change over time as consumer behaviour changes. A new competitor might enter the
market for a good which makes the PED for a good more elastic.
•
PED is based on the ceteris paribus assumption that price is the only variable that is
changing. Income and the price of related goods, as well as other factors that affect demand,
are all changing at the same time as the price of the good.
•
When a firm changes price there is always going to be uncertainty about how consumers will
react. If the price of a good rises above its anchor point then the quantity demanded might
fall more than expected.
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Unit 2.5(2): Income elasticity of demand (YED)
What you should know by the end of this chapter:
•
•
•
•
•
Definition of income elasticity of demand (YED)
Calculation of YED
Measuring the YED of normal, necessity, luxury and
inferior goods
Importance of YED for firms (HL)
Use of YED explaining changes in the sectoral structure
of the economy. (HL)
Definition and measurement of income elasticity of demand
Income elasticity of demand is the
responsiveness of quantity demanded to
a change in household income. It is
measured by the equation:
% change in Qd / % change income = YED
For example, if a 5 per cent increase in
household income leads to a 7 per cent
increase in quantity demanded for
computer game consoles such as the
Sony PlayStation the YED would be:
+7% QD / +5% Y = +1.4
This means that for every 1 per cent increase in household income the quantity demanded of games
consoles will increase by 1.4 per cent. This relationship is shown in diagram 2.24 where a rise in
income causes the demand curve for game consoles to increase and shift to the right.
Interpretation of income elasticity of demand
Normal goods
Normal goods have a positive YED. Quantity demanded rises as income rises, and quantity demand
falls as income falls. The +1.4 YED value for computer games consoles shows they are normal goods.
Most goods are normal because as incomes rise people will demand more of most goods, but the
rate of increase will be different for different types of goods.
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Necessity goods
Necessity goods are normal goods that have a YED between 0 and 1. For example, if there is a 5 per
cent rise in household incomes and the quantity demanded for electricity increases by 1 per cent.
+1% QD / + 5% Y = +0.2 YED
The demand for necessity goods such as basic food, energy and public transport will have YED values
between 0 and 1.
Luxury goods
Luxury goods are normal goods and the demand for them has a YED of greater than 1. This means a
rise in income will lead to a greater than proportionate increase in quantity demanded, and a fall in
income will lead to a greater than proportionate fall in quantity demanded. If, for example, the
quantity demanded for 5-star hotels increases by 8 per cent following a 6 per cent rise in incomes
then the YED would be:
+8% QD / +6%P = +1.33
This YED value means the quantity demanded for 5-star hotels increases by a more than
proportionate amount relative to the change in income. Luxury goods such as prestige cars, designer
clothing and exclusive restaurants will have YED values of greater than 1.
Inferior goods
The demand for inferior goods will have a negative YED because the quantity demanded for inferior
goods fall as household incomes rise and rise as incomes fall.
For example, the quantity demanded of dried packet soup falls by 3 per cent following a 4 per cent
rise in household income. This is calculated as: -3% QD / +4% Y = -0.75.
Inferior goods such as tinned food, bus travel and synthetic clothing will often have negative YEDs.
Although this will vary between countries.
The chart summarises the YEDs of inferior, necessity and luxury goods.
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Engel Curve (HL)
The nineteenth-century German economist, Ernst Engel studied how the demand for different goods
and services changed with income over time. The Engel Curve relationship between income and
demand is shown in diagram 2.24(1). In this example, the diagram shows how the demand for rice
changes with income over time.
When income increases for poorer households the demand for rice increases as rice is considered a
normal or luxury good by households on low incomes. Beyond point A, households are on middle
incomes where rice becomes a necessity good to these consumers. This means that any increase in
income beyond A leads to a less than proportionate increase in the demand for rice.
Once household incomes rise above point B any increase in income will lead to a fall in demand for
rice because it is now considered an inferior good by the consumer. Above income level B,
households will not demand as much rice and switch to luxury good alternatives. Individuals might
substitute rice-based meals for meat-based meals.
The Engel curve is useful in showing how the income elasticity of different goods changes over time.
For example, the demand for goods such as smartphones would have been luxury goods when they
were first launched with a YED of greater than one, but their YED falls as smartphones become a
more established product amongst consumers. Very basic smartphones can become inferior goods
over time.
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Application of income elasticity of demand (HL)
Structural changes in the economy
YED data can be used to show how industrial structure changes in the economy over time, as
household incomes rise when the economy grows. The YED for primary goods or commodities,
which are often considered necessities, tend to have a YED of between 0 and 1. This means the
demand for commodities tends not to grow as incomes rise in the economy over time.
An economy that specialises in primary commodities, as some developing countries do, will
experience slow growth as the world incomes rise.
Manufactured goods such as cars and computers have greater positive YED values because
consumers are more likely to buy this type of good as their income increases. When incomes
increase over time, these industries may experience significant growth. Policymakers often see the
development of manufacturing in developing countries as an effective way to deliver economic
growth as world incomes rise.
The service sector of an economy such as tourism and leisure tends to have the highest positive YED
values. YED can be used to explain why the industrial structure of many economies is increasingly
dominated by the service sector as household incomes rise.
Business strategy
Businesses respond to income changes by adapting
what they sell. As incomes have generally increased
over time in most economies, many firms have
responded by improving the quality of the products
they sell because the demand for these goods has a
positive YED value. Ice cream brands like Haagen
Das and Ben and Jerry's, have marketed their luxury
good ice cream brands in response to rising
incomes.
In economic recessions when household incomes tend to fall, businesses that market inferior goods
can see the demand for their goods rise as consumers switch to lower-priced inferior goods. Food
producers, for example, might plan to increase the output of products that are inferior such as
tinned, dried and frozen food.
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Unit 2.6: Price elasticity of supply
(PES)
What you should know by the end of this chapter:
•
•
•
•
Definition and measurement of price elasticity of supply (PES)
Range of values for PES
Determinants of PES: time, mobility of factors of production, unused capacity, ability to
store, the rate at which costs increase
Reasons why the PES for primary commodities is generally lower than the PES for
manufactured products (HL)
Introduction
Price elasticity of supply (PES) changes the emphasis of elasticity away from the consumer to the
producer. PES is the measurement of how producer supply responds to changes in the price of the
product they sell. The value of the PES in a market is determined by the willingness and ability of
producers in the market to change output in response to a change in price.
Definition and measurement of price elasticity of supply
Price elasticity of supply is the responsiveness of quantity supplied of a good to a change in its price.
It is measured by the equation:
% change in Qs / % change P = PES
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For example, if the price of strawberries
increases from $2 per kg to $3 per kg (50
per cent increase) and quantity supplied
increases from 400,000 kgs to 500,000
kgs (25 per cent increase). This is shown
in diagram 2.25 and is calculated as:
+25% QS / +50% P = +0.5
Interpretation
The value of PES is normally positive because of the law of
supply. In the strawberry market example, the PES value of
+0.5 means that for every 1 per cent increase in the price of
strawberries, the quantity supplied increases by 0.5 per
cent.
Price elastic supply
If the value is greater than 1 then the good’s
supply is price elastic. This means a change in
price leads to a proportionately greater change in
quantity supplied. If, for example, a 10 per cent
increase in the price of hairdresser haircuts leads
to a 15 percent increase in the supply of
hairdresser services, the PES would be:
+15% QS / +10% P = +1.5 PES
This means for every 1 per cent increase in the
price of haircuts quantity supplied increases by
1.5 per cent.
This is a price elastic relationship because the proportionate change in quantity supplied is greater
than the proportionate change in price. This is shown in diagram 2.26. Theoretically, the supply
curve can be perfectly horizontal or perfectly elastic. This gives a PES of infinity.
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Unitary elasticity of supply
If the value is 1 then PES is unitary. This means that for every 1 per cent change in price, quantity
supplied changes by 1%. In reality, it is unlikely a good will have a PES of 1, but the value could be
close to 1. Any straight-line supply curve that passes through the origin has a PES value of 1.
Price inelastic supply
If the supply of a good has a PES of less
than 1 then its supply is price
inelastic. This means that a change in
the price of a good leads to a less than
proportionate change in quantity
supplied.
For example, in diagram 2.26(1) the price
of cement rises from $200 per unit to
$300 and quantity supplied increases
from 15m units to 18m units supplied
then the PES of cement is calculated as:
+20% QS / +50% P = 0.4 PES
This means for every 1 per cent increase in the price of cement quantity supplied increases by 0.4
per cent. This is a price inelastic relationship because the proportionate change in quantity supplied
is less than the proportionate change in price.
Theoretically, the supply curve can be perfectly vertical or perfectly inelastic. This gives a PES value
of 0.
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Determinants of price elasticity of supply
Time
In the short run, the supply of a good
tends to be inelastic. This is because
producers find it difficult to increase
output when the factors of production
used to produce the good are difficult to
change quickly when price changes.
Over time, producers find it easier to
respond to an increase in price because
they can change the factors of
production used to increase output, and
supply becomes more price elastic. This
is shown in diagram 2.27.
If, for example, a house-builder knows that the price of new houses is increasing at an annual rate of
10 per cent then they can plan to build new houses, but it will be several months or even years
before they can complete construction and increase supply. Diagram 2.27 shows an increase in
quantity supplied in the short run of 5,000 houses or 5 per cent which is a PES of:
+5% / +10% = 0.5 PES
In the long run, the quantity supplied of housing increases by 20,000 houses or 20 per cent which is
a PES of:
+20% / +10% = 2 PES
In the long run, the supply of new houses has become more price elastic.
Availability of factors of production
The easier it is for producers to access factors of
production, the more elastic PES tends to be. Roadside
car cleaning businesses are generally quick to set up
and operate because the land, labour and capital
needed to clean cars is relatively accessible.
On the other hand, electricity supply through power stations has an inelastic PES because the
resources needed to set up and operate a power station are more difficult to access. Where
resources are relatively difficult to access, costs tend to rise quickly when producers try to increase
output, and this will make the supply of electricity relatively inelastic.
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Stock and used capacity
Where producers have spare capacity and available stock, supply tends to be relatively price elastic.
For example, in a recession, a car manufacturer may have plenty of spare capacity in production and
a high level of unsold stock because of low demand for cars. If the price of cars increases the car
manufacturer can increase supply by utilising unused production facilities and selling available stock
which makes the supply of cars price elastic.
Application of price elasticity of supply (HL only)
Commodities
The supply of primary commodities tends to be relatively
inelastic because it is difficult for producers to respond to a
change in price. The supply of the agricultural sector, for
example, is limited by the growing seasons of farmers. If a coffee
producer plants a coffee bush it takes 3 to 4 years before it can
be harvested and coffee plants can only be harvested twice a
year. This makes the supply of coffee relatively price inelastic.
Manufactured goods
The supply of manufactured goods is more price elastic in comparison to primary products because
producers can change supply in response to a change in price more quickly. This is because
manufacturers are not limited by growing seasons. Assuming a manufacturer of smartphones has
spare capacity, they can increase supply almost immediately if there is a price increase.
Manufactured goods can also be stored more easily than agricultural goods which tend to be
perishable. If manufacturers hold a stock of goods then they can respond to an increase in price by
releasing that stock onto the market. Similarly, if the price of a manufactured good decreases
producers can hold their output in stock and relatively easily decrease quantity supplied.
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Unit 2.7(1): Governments in markets - tax and subsidy
What you should know by the end of this chapter:
•
•
•
•
•
•
•
•
•
Reasons for government intervention in markets: raise government revenue, support
producers and consumers, and influence production and consumption
Types of indirect taxes
Reasons for the use of indirect taxes
Effects of indirect tax on a market using graphical
analysis
Consequences of indirect taxes for different
stakeholders and for welfare
Subsidies
Reasons for the use of subsidies
Effects of subsidies on a market using graphical analysis
Consequences of subsidies for different stakeholders and for welfare
Importance of government intervention
Governments play an important role in all economies. The table sets out
government expenditure as a percentage of GDP for the world's 10
leading industrialised countries. With an average government spending
in these countries of over 40 per cent of GDP, you can see how
influential governments are in different countries. This is a
macroeconomic way of looking at levels of government intervention,
but governments are heavily involved at a microeconomic level as well
through taxes and subsidies.
Market failure and equity
The IB Economics course looks in detail at the reasons why governments intervene in markets under
the topics of market failure and equity. These reasons will be covered in detail in the market failure
sections of this textbook in Unit 2.8(3).
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Reasons governments for government intervention
Raise government revenue
Governments raise revenue to pay for public services like health and education. Taxation is a very
important source of government finance and indirect taxation of goods and services is a key part of
this. In developed economies, indirect tax accounts for about 30 per cent of all tax receipts.
Support to producers
Many businesses and organisations in the economy are important to the
overall welfare of society and are assisted by the government. Farming is
supported by governments because food supply is crucial to a country’s
population. This is particularly true when making food affordable for
people on low incomes. Governments also look to help businesses
involved in healthcare, education, energy and infrastructure, etc.
Support for households on low incomes
An objective of many governments is to improve equity and reduce income inequality in society.
State support for households on low incomes by subsidising healthcare, energy and housing, etc. is
one way of achieving this. For example, free healthcare gives households on the lowest incomes
access to doctors, medicine and hospital treatment. If this improves the health of the poorest in
society then it gives them the opportunity to make progress in other areas of life such as
employment.
Influence the level of production in a market
Some industries can have a negative impact on welfare in society and the state often tries to reduce
production in these industries. In recent years the use of fossil fuels is seen as increasingly negative
to welfare because of their contribution to climate change. The Paris Climate Agreement has seen
governments seek to reduce and phase out the use of coal, oil and gas.
Conversely, the government looks to encourage production in other areas to increase welfare. This is
true in markets like energy, healthcare and education. Many governments are now encouraging the
use of renewable energy to combat climate change.
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Influence the level of consumption in a market
Governments intervene in markets to reduce consumption to protect the welfare of their citizens.
For example, the market for recreational drugs is heavily regulated in nearly all countries.
There are also situations where governments encourage the consumption of certain goods and
services. This is in markets such as healthcare, where people are, for example, encouraged to get
vaccinations because of the benefit to the individual and wider society.
Indirect tax
Definition
An Indirect or expenditure tax is the tax added to the price of a good or service and collected by the
firm selling the good or service and then paid to the government. It is an important source of
revenue for governments and it allows the government to affect consumption and production in
different markets.
Types of indirect tax
There are two main types of indirect taxation:
•
•
Ad valorem tax is a fixed percentage tax added to
the price of a good such as value-added tax (VAT).
If you buy a computer for $960 you will pay $160
in VAT if the rate is 20 per cent.
Specific tax or duty is a set money value of tax
added to the price of a good. Specific taxes are
placed (levied) on goods like petrol, alcohol and
cigarettes.
Reasons for the use of indirect tax
Indirect taxation is an important source of government revenue. In many countries, it represents
around 30 per cent of all tax collected. If all tax was put on household income it is likely this would
adversely affect worker incentives.
Governments also use specific taxes to reduce the consumption of goods that they think have
significant social costs and negatively affect welfare*.
* This aspect of tax is covered in detail in the chapter on market failure where we look at demerit
goods and negative externalities.
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Market analysis of an indirect tax
Indirect tax affects supply in a market
because it increases the costs of
production. For example, an airline’s cost
of supplying a flight is $700 and a $50
specific tax is imposed. The supply cost of
that ticket will now be $750 ($700 + $50).
This means the supply curve for airline
tickets shifts vertically upwards by the
specific tax of $50. Diagram 2.28
illustrates the impact of an indirect tax on
the market for airline tickets.
The effects of a specific tax of $50 levied by the government on the airline market would be:
•
The producer (airline) would like to pass on all the $50 tax to the consumer. But if they raise
the ticket price from $700 to $750 there would be excess supply so the price falls to the new
equilibrium at $720 where demand equals supply after the tax is levied.
•
The total tax collected by the government is calculated by multiplying the quantity sold
multiplied by the indirect tax per unit. In this case $50 x 950,000 = $47,500,000 which is
partly paid by the consumer and partly by the producer.
•
The consumer pays $20 x 950,000 = $19,000,000. This is known as the consumer incidence
(yellow area) of the tax and it leads to a reduction in the consumer surplus.
•
The producer pays $30 x 950,000 = $28,500,000. This is known as the producer incidence
(green area) of the tax and this means a reduction in the producer surplus.
Importance of elasticity
Price elasticity of demand and supply will affect the size of tax revenue received by the government
as well as the incidences of tax paid by the consumer and the producer.
Price elasticity of demand
Governments often favour taxing goods with price inelastic demand because the revenue collected
is high and the tax incidence falls more on the consumer than the producer. A higher incidence on
the producer is more likely to result in a cut in output which could cause unemployment. In
addition, if output falls significantly then the tax revenue will be lower. The example in diagram 2.28
has a PED of: 4.77 [-13.64% / +2.86%]. Diagram 2.28 shows price elastic demand in this case which
means the producer incidence is greater than the consumer incidence.
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In diagram 2.29 an ad valorem tax of 20
per cent is put on the price of household
electricity. Notice that when an ad
valorem indirect tax is put on a good the
supply curves diverge as the price
increases.
If the price of a good is $100 the indirect
tax is $20 and if the good costs $500 the
tax is $100.
Because the PED of electricity is price
inelastic the incidence of tax falls more
heavily on the consumer (yellow area) relative to the producer (green area) and the tax revenue for
the government is greater.
Price elasticity of supply
PES also affects the tax collected by the government and the size of the incidence on the consumer
and the producer. When the PES of a good is greater than the PED the consumer incidence is greater
than the producer incidence and when PES is less than PED the producer incidence is greater than
the consumer incidence.
For example, if a tax is put on agricultural
goods like avocados which is a luxury item
where PED is relatively elastic and PES is
relatively inelastic then the producer has a
higher incidence of tax. In diagram 2.30 a
tax of 0.40c is levied on avocados where the
consumer has an incidence shown by the
yellow area and the producer the green
shaded area.
Impact on stakeholders
Consumers
Individuals who buy goods that have been taxed pay a higher price and experience a loss of
consumer surplus. It can be argued that when people are buying goods associated with social costs
like alcohol, the higher price reduces their consumption and this increases their welfare in the long
term.
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Producers
Businesses in markets that are taxed must pay their incidence of tax and this reduces their producer
surplus. This may lead to a fall in business profits which reduces long-term investment and this could
lead to workers being made redundant.
Government
Governments benefit from the revenue they receive from indirect taxes which they can use to spend
on public services. There may also be benefits from a reduction of goods associated with social costs
such as alcohol. There may, however, be some negative political consequences from an industry
badly affected by a tax. The collapse of an airline following the imposition of air passenger duty
could be damaging to a government.
Welfare
When a tax is applied to a good it will change the allocation of resources in the market. Diagram 2.31
shows the welfare loss associated with a $0.40 tax on petrol. This is made up of two elements:
Consumer welfare loss
When the price increases from $1 to
$1.30 consumer surplus of the people
who would have bought the petrol at $1
but will not buy it at $1.30 disappears.
This is called the consumer welfare loss
and is shown in diagram 2.31 by the dark
blue shaded area.
Producer welfare loss
The producer incidence of the tax in diagram 2.31 is $0.10c. When this is applied to the petrol
market some producers will fail (go bankrupt) or will choose to leave the market. Their producer
surplus will be lost to the economy and this is shown in diagram 2.31 by the brown shaded area.
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Subsidy
Definition
A subsidy is an amount of money paid by the government to producers to encourage the
consumption and production of a good or service. Examples of subsidies include those made to
farmers to produce food, energy firms to produce renewable energy, and pharmaceutical businesses
to produce new healthcare drugs.
Reasons for subsidies
Government use subsidies to support producers and consumers in different markets:
Consumers
Some goods and services carry significant social benefits to society and their consumption increases
welfare in society. For example, governments often subsidise renewable energy because of the
environmental benefits it brings to society.
*Positive externalities and merit goods are often supported by subsidies and they are covered in
Unit 2.8(2) on market failure.
Producers
Government step into markets to support producers in key industries like farming. Agriculture is
often seen as a strategically significant industry because food supply is important for the security of
the country. You could also consider industries such as steel and energy as strategically
important. By paying a subsidy to producers the government protects supply in these important
markets.
Subsidies are also paid to industries because they are important for economic development and
employment. Subsidies paid to larger manufacturing businesses to encourage investment can lead to
long-term economic growth.
Finally, subsidies are sometimes paid to domestic firms to protect them from foreign competition.
*This is covered in Unit 4.2/4.3 on protectionism.
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Effects of a subsidy on a market
When a good is subsidised the supply
curve shifts vertically downwards by the
value of the subsidy paid to producers in
the market. A subsidy reduces the costs
of producing a good.
For example, if the government decides
to subsidise milk by $0.40c per litre then
the cost of producing each litre of milk
will be $0.40p per unit lower.
This is shown in diagram 2.32.
The effects of a subsidy of $0.40c per litre on the milk market would be:
•
The value of the subsidy paid by the government is calculated as $0.40c x 11m units = $4.4m.
•
As the market price of milk falls by $0.30c the consumer benefits from the lower price and
an increase in consumer surplus. The yellow area in diagram 2.32 shows the increase in
consumer surplus and this can be calculated as: ($0.30c x 10m) + ($0.30c x 1/2m) = $3.15m.
•
The producer also benefits from subsidies because they receive an extra $0.10c per litre for
the milk they sell. Their gain in producer surplus is shown by the green shaded area in
diagram 2.32 and this is calculated as: ($0.10 x 10m) + ($0.10 x 1m/2) = $1.05m.
•
When subsidies are applied there is a welfare loss because resources are drawn into the
market by the subsidy that is not efficient enough to exist under normal market conditions.
This is shown by the blue shared area in diagram 2.32 and can be calculated as: $0.40 x 1m/2
= $0.2m
Importance of elasticity
Price elasticity of demand and supply will affect the size of subsidy paid by the government as well as
the subsidy benefits paid to the consumer and the producer. The PED and PES will also affect the size
of the welfare loss of the subsidy.
Price elasticity of demand
The impact of the subsidy on milk shown above will be affected by the PED of milk. The more
inelastic demand is the greater the reduction in price and the bigger the relative benefit to the
consumer. The milk example shows this. As a relative necessity milk has inelastic demand which can
be calculated as: [+10% / -25% = 0.40] which means the gain in consumer surplus is great than the
gain in producer surplus.
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If demand is price elastic the gain in producer
surplus is greater than the gain in consumer
surplus. This is because the price does not fall
as much as it would do if demand was price
inelastic, which means the surplus gain is not
as great for the consumer. In diagram 2.33 a
subsidy is put on electric cars which have
relatively elastic demand. The green shaded
area is the gain in producer surplus and the
yellow shaded area is the gain in consumer
surplus.
The blue welfare loss triangle is bigger when supply is inelastic because more inefficient producers
are drawn into the market when demand is price elastic compared to inelastic.
Price elasticity of supply
The impact of a subsidy will also be affected by PES. If the PES of a good is more elastic than demand
as in diagram 2.32 then consumers gain more surplus than producers. If PES is less than PED as in
diagram 2.33 then producers gain more than consumers.
For example, the market for rented housing is likely to have a higher PES than PED. If a subsidy is
introduced by a government on rented housing and the quantity supplied increases as new landlords
quickly enter the market then the price will fall more and less producer surplus will be available to
each producer. The significant fall in price means there is a greater gain in surplus by the consumer
relative to the producer.
Impact on stakeholders
Consumers
Subsidies lead to a fall in prices in a market and this benefits consumers because they experience a
rise in consumer surplus. If the good is bought widely by low-income households then the benefit to
those consumers is likely to be significant. A subsidy, for example, on bread, rented housing or rice,
is likely to benefit consumers more than a subsidy on the theatre or the opera.
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Producers
The gain in producer revenue and surplus that comes from a subsidy will
help producers. The greatest benefit will be when subsidies are targeted
at producers who may not be able to survive without a subsidy. If the
subsidy is paid to a farmer who is a rich landowner then this will have less
impact than the money paid to low-income farmers who struggle to
survive. For example, Prince Charles receives significant amounts of
farming subsidies from the EU.
Government
A subsidy needs to be paid for by the government which means there will be an opportunity cost of
money that has been sacrificed from other areas of government expenditure. A subsidy on electric
cars might mean there is less expenditure on the roads. Alternatively, a government might have to
raise taxes to pay for the subsidy. There may also be a cost to the government in terms of managing
and distributing a subsidy.
Welfare
Subsidies affect the allocation of resources in markets and this can either increase or decrease
welfare. The blue shaded triangles in diagrams 2.32 and 2.33 show the welfare loss associated with
the application of subsidies in markets. Producers and resources are drawn into markets that would
not be there without the subsidy and the cost of those less efficient producers represent a welfare
loss.
Subsidies can, however, also increase welfare if the consumption and production of the goods
subsidised bring significant wider benefits to society. For example, subsidies for the development of
new healthcare drugs might bring much greater benefits to a country than the cost of the subsidy.
*This subject is developed further in the positive externalities in Unit 2.8(1) on market failure.
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Unit 2.7(2): Governments in markets - price controls
What you should know by the end of this chapter:
•
•
•
•
•
•
•
•
•
Price controls
Maximum prices
Reasons for the use of maximum prices
Effects of a maximum price on a market using
graphical analysis
Consequences of maximum prices for different
stakeholders and welfare
Minimum price
Reasons for minimum prices
Effects of minimum prices on a market using graphical analysis
Consequences of minimum prices for different stakeholders and welfare.
Price controls
In free markets where there is no government intervention, the price and output in a market are
determined by demand and supply. Governments often intervene in markets when the market price
and output do not maximise welfare in society. This could be a high price that negatively affects
households on lower incomes or a low price that forces firms out of business in a strategically
important market.
Maximum prices (price ceiling)
Definition
A maximum price or price ceiling is a price set by a government or controlling authority to prevent
the price of a good or service from rising above a fixed level. For example, rent controls in a housing
market are a maximum price where market rents cannot rise above a certain price.
Reasons for maximum prices
Maximum prices are put in place to protect low-income consumers from prices rising in a market to
a level they cannot afford. Maximum prices are normally put on goods that governments feel all
people in society ought to be able to consume such as housing, basic food, healthcare and
education.
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Effects of a maximum price
One of the most famous maximum prices or price ceilings are rent controls
in New York City. Rent controls have existed in the city since the 1940s to
protect low-income families. The number of houses and apartments
subject to rent controls is around 22,000 at present with an average rent
of about $1,300 per month. The average market rent would be around
$2,500 per month.
Diagram 2.33(1) illustrates the impact of
a maximum price on rents in the New
York housing market.
Empirical evidence of the effects of a maximum price set below the equilibrium price would be:
•
If the price falls in the market from $2500 to $1300, the quantity demanded increases from
30,000 units to 36,000 units because of the income and substitution effects (more people
can afford to rent and its cheaper to rent relative to buying a house).
•
The decrease in price reduces the quantity supplied when landlords withdraw from the
market because they make less profit and fewer landlords can cover their costs.
•
Excess demand (shortages) for rented housing develops because the quantity demanded is
greater than the quantity supplied of rented housing at the maximum price.
•
The rationing function of price no longer works effectively. The price cannot rise to clear the
market because of the price ceiling.
•
Other methods of rationing develop such as: queueing (first come, first serve), preferential
consumer selection (landlords rent to tenants they favour), regulations develop (landlords
are forced to prioritise families) and lottery schemes develop (random selection of tenants).
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•
Parallel markets develop where consumers and producers try to find their way around the
ceiling price controls. A landlord and tenant might officially agree on the rent ceiling of
$1300 but also agree on a payment of $1000 per month to be paid unofficially.
•
The quality of rented housing declines because landlords do not have funds to make repairs
and maintain their properties as well as they could do at the equilibrium price.
•
In the long-term new investment in rented housing falls because the market is not as
profitable as it would be without the maximum price.
Impact on stakeholders
Consumers
The consumers who buy the good or
service at a maximum price benefit
because they pay a lower price than the
equilibrium price. The gain in consumer
surplus these consumers receive is shown
by the yellow shaded area in diagram
2.34. Some consumers who would have
paid the market price and cannot buy the
good at the maximum price because of a
shortage lose out.
Consumers may also lose out because of the time they might spend queueing for a good that is in
short supply, or they might encounter extra regulations resulting from the price ceiling. Some
consumers might enter the parallel market where they might have to pay a very inflated price and
risk breaking the law.
Producers
In theory, producers lose when there is a maximum price because they receive less revenue and
profit from selling their good or service. For the landlords in the rented housing market, the
producer surplus is the green shaded which is smaller than the producer surplus at the normal
market equilibrium price. It is, however, possible for some fringe producers to enter the parallel
market and make high profits from selling their good illegally.
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Governments
Governments have the cost of setting up and enforcing the maximum price, as well as the loss of tax
revenue that might come from lower sales in the market (although the good may not be subject to
tax). There are, however, some political benefits from setting a price ceiling because it looks like an
effective policy that reduces prices. This is why governments are often tempted to use them.
Welfare
Empirical evidence suggests maximum prices tend to lead to a loss of welfare because the benefits
of the maximum price are concentrated amongst a relatively small number of consumers and there
are wider dispersed costs on the rest of society. In New York, a relatively small number of tenants
(sometimes wealthy) benefit from the maximum price, but many potential tenants lose out,
landlords see a fall in profits and the government (taxpayers) have to pay for the system.
Minimum prices (price floors)
Definition
A minimum price or price floor is a lower limit set by the government or
controlling authority to stop the price of a good or service from falling below
a certain level. Minimum prices have been used in the past in agricultural
markets, although they are not used as much today. There are, however, still
examples of minimum prices in agriculture in India on Kharif (autumn) crops.
These are crops such as maize and rice.
Reasons for minimum prices
Governments use minimum prices or guaranteed minimum prices to protect producers in markets.
This is often the case in agricultural markets where governments look to support farmers and
protect the food supply. Producers in agricultural markets often struggle because of unstable prices
because of the impact of the weather on their output. A price floor aims to offer them a more stable
income.
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Effects of minimum price (price floor)
The European Union used minimum prices as
part of their Common Agricultural Policy (CAP)
in the 1970s and 80s. Diagram 2.35 is an
example of how minimum prices might work in
the market for wheat. In this example, the
equilibrium price for wheat is €8 per bushel
with 2 million units of output. A minimum
guaranteed price is put in place at €11.
Empirical evidence of the effects of a minimum price set above the equilibrium price would be:
•
As the price rises from €8 to €11 the quantity demand for wheat falls to 1.1m bushels. As the
price increases quantity demanded decreases because of the income and substitution
effects. Wheat is now less affordable, and buyers switch to cheaper alternatives.
•
Quantity supplied increases to 2.7m bushels because the higher price increases producer
profits and covers the costs of higher production.
•
At the minimum price, the quantity supplied is greater than the quantity demanded and
there is excess supply or surplus output. In diagram this is (2.7m – 1.1m = 1.6m units).
•
To maintain the minimum price the government or buying authority needs to purchase the
surplus and put it into storage. If the surplus is allowed onto the market the price will fall –
hence the term guaranteed price. The cost of the government intervention is 1.6m x €11 =
€17.6m
•
The wheat needs to be stored and this is an additional cost of the scheme. This can be
particularly expensive for goods that need to be refrigerated.
•
Additional agricultural producers are attracted to the market by the minimum price which
leads to an increase in excess supply in the long run and reduces supply in other markets.
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Impact on stakeholders
Consumers
Consumers lose out when a minimum price is set
above the equilibrium price because they need to
pay a higher price for the good and their
consumer surplus falls. The loss of consumer
surplus from the minimum price put on wheat is
shown in diagram 2.36. The yellow shaded area
shows the new consumer surplus following the
increase in price from €8 to €11. The increase in
the price of agricultural products affects poorer
consumers badly because buying food is often a
high proportion of their household expenditure.
Producers
Producers gain when a guaranteed minimum price is above the equilibrium price because their
producer surplus increases. This means they will receive higher revenues and profits. The increase in
producer surplus is shown by the green shaded area in diagram 2.36. In the wheat market, this may
well fulfil the government’s aim of stabilising farming incomes and maintaining a long-term food
supply.
Government
Minimum prices represent an opportunity cost to the government. The government or the authority
buys the excess supply and has the considerable cost of purchasing the good, as well as the cost of
storing any excess supply and managing the system.
Welfare
Minimum prices are not used very much anymore because they were expensive for the government
to manage and the benefits of the system were less than its costs. They often led to a misallocation
of resources in agriculture markets with huge surpluses developing at the expense of reduced
production in other markets. There was also considerable waste with excess supply being destroyed
when it could not be sold. In some instances, the European Union sold excess supplies to developing
countries with disastrous effects on their farmers when prices fell in their markets. Like maximum
prices, the gains tended to be concentrated amongst a certain group of stakeholders - in this case,
producers, with dispersed losses for consumers and taxpayers.
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Unit 2.8(1): Market Failure – Externalities
What you should know by the end of this chapter:
•
•
•
•
•
•
Explanation of market failure
Allocative efficiency when the
social/community surplus is
maximised
Social efficiency: marginal social
cost (MSC) equals marginal social
benefit (MSB)
External costs / negative
externalities of production and
consumption
External benefits / positive externalities of production and consumption
Understanding of and calculation (HL) of welfare loss.
What is market failure?
Markets fail when the free market forces of demand and supply lead to an allocation of resources
that does not maximise the welfare of a country’s citizens. It means that the marginal social costs
that result from the production and consumption of a good do not equal the marginal social
benefits. The concepts of social costs and benefits are covered later in this chapter.
Economists often express market failure as a misallocation of resources or where resources have
been allocated inefficiently. In the market theory we looked at in chapter 2.3, market failure occurs
when the community/social surplus (consumer surplus plus producer surplus) is not maximised.
Allocative efficiency
Allocative efficiency is achieved in a market when the marginal benefit of consuming a good is equal
to the marginal cost of producing it. This situation exists when demand equals supply, assuming
there are no externalities in the market. External costs and benefits are explained in the next
sections of this chapter.
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When demand equals supply in a market it is in
equilibrium and the social/community surplus
is maximised. This means the consumer and
producer surpluses are maximised. If all
markets in the economy achieve maximum
social/community surplus the welfare of a
country’s citizens will be maximised.
Diagram 2.37 show the maximisation of the consumer surplus (green area) and producer surplus
(yellow area) at the equilibrium price. This is allocative efficiency because the social/community
surplus is maximised.
Externalities
Externalities are any impact that the production or consumption of a good or service has on a third
party. A third party is someone other than the producers and consumers of a good or service in a
market. Third parties are often stakeholders in a community who can be positively or negatively
affected by the activity in a market.
For example, the Glastonbury music festival brings benefits to the third
parties (local residents and businesses) of this small town in Devon,
England such as local tax income for better public services, and visitors
who shop in the town’s retailers and improvements to the local road
infrastructure. But it comes with costs to third parties as well. When the
festival takes place there will be road congestion, increased amounts of
litter and noise pollution.
Economists divide externalities into:
•
External costs or negative externalities
•
External benefits or positive externalities
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External costs or negative externalities
External costs are the spillover costs that negatively impact third parties which result from the
production or consumption of a good or service. They can be divided into two types: production
external costs and consumption external costs.
Production external costs (negative externalities)
Production external costs arise from the production of a good
or service. A chicken farm, for example, emits a very strong
smell, which adversely affects residents who live within a mile
of the farm, as well as people who travel past the farm.
Marginal private costs
When the eggs are produced the costs of resources used in their production determines the supply
decision of the egg producer. These are the raw materials, labour and capital used by the egg farm.
These are the private costs of production. Each extra unit produced by the farm is the marginal
private cost.
Marginal social costs
The external costs (negative effects) on the local residents of the strong smell of producing the eggs
are not included in the private costs of production. The social cost of producing the eggs is:
marginal private cost (MPC) + external cost = marginal social cost (MSC)
Production external costs and market failure
We can use marginal cost and benefit
analysis to examine how external
production costs lead to market failure.
Diagram 2.38 is used to illustrate this
marginal analysis.
If we assume the only externalities in a
market are production external costs
(there are no other production or
consumption externalities) then demand
or marginal private benefits from the
consumption of the good equals its
marginal social benefits.
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The market output is determined by demand and supply or where marginal private benefits equal
marginal private costs. In the egg market example, this is set where the demand for eggs (MPB)
equals the supply of eggs (MPC) at output Q and price P in diagram 2.38.
Market output: MPB = MPC = output Q
The socially efficient output is set where marginal social benefits equal marginal social costs at Q*,
which is below the market output at Q. This is shown in diagram 2.38.
Welfare loss
A welfare loss to society occurs in a market when the output of a good or service means the social
cost of production is greater than the social benefit of production. The yellow shaded area in
diagram 2.38 shows the total welfare loss in the egg market example. At each level of output beyond
Q* in diagram 2.38, MSC is greater than MSB, which means that the cost to society of each extra unit
of eggs produced is greater than the benefit.
Calculating the welfare loss (HL)
A market’s welfare loss can be calculated by working out the area of the yellow welfare loss triangle
in diagram 2.38. In this case, the data from the egg farm example is:
•
Q*: 300,000 units
•
Q: 500,000 units
•
MSB at Q: $2.00
•
MSC at Q: $3.00
Calculation:
(Q - Q*) x (MSC – MSB) / 2 = welfare loss
(500,000 – 300,000) x ($3.00 - $2.00) / 2 = $100,000
Consumption external costs
Consumption external costs exist when third parties experience
the external cost from the consumption of a good or service. For
example, when people smoke cigarettes, the smell and smoke
from the cigarettes adversely affect other people who are not
smoking. The rate of illness caused by cigarette smoking is also
very high, which means that smokers take up more resources in
a state-run health service than non-smokers do.
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The negative effects of consumption external costs, in this case smoking cigarettes, are not included
in the demand curve or marginal private benefits of cigarette consumption, which means that the
marginal social benefits of smoking are lower than the marginal private benefits. The marginal social
benefits of consuming cigarettes lie to the left of the marginal private benefit or demand curve. This
is shown in diagram 2.39. Marginal private benefit + external cost = marginal social benefit.
Consumption external costs and market failure
If we assume there are no externalities when
producing the cigarettes, then supply equals
the marginal social cost of producing the
cigarettes. As a result, the output of the
cigarette market is set where the demand for
cigarettes equals the supply of cigarettes at
price P and output Q. The socially efficient
level of output for cigarettes is where
marginal social benefits equal marginal social
costs at output Q*. This is shown in diagram
2.39.
In this case, the cigarette market is producing at output Q which is above the socially efficient level
at Q*. This is a market failure because there is an over-allocation of resources in the cigarette
market.
Welfare loss
The yellow shaded area in diagram 2.39 represents the welfare loss to society from the overallocation of resources in this example. At each level of output beyond Q* in diagram 2.39, MSC is
greater than MSB which means that the cost to society of each extra unit of cigarettes consumed is
greater than the benefit.
Calculating the welfare loss (HL)
A market’s welfare loss can be calculated by working out the area of the yellow welfare loss triangle
in diagram 2.39. In this case, the data from the cigarette example is:
•
Q*: 3.6 million
•
Q: 4.8 million
•
MSB at Q: $9.00
•
MSC at Q: $15.00
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Calculation:
(Q - Q*) x (MSC – MSB) / 2 = welfare loss
(4.8m – 3.6m) x ($15.00 - $9.00) / 2 = $3.6 million
External benefits or positive externalities
External benefits are the spillover benefits that positively impact third
parties as a result of the consumption or production of a good or
service. They can be divided into two types: production external
benefits and consumption external benefits.
Production external benefits
Production external benefits occur as a result of the production of a good or service. For example, if
a major new car factory opens in a town.
Marginal private benefits
If a new car factory opens in a town it may employ local workers in the factory, use local businesses
that provide services, and purchase raw materials and components from local producers. These are
private benefits because they benefit the stakeholders directly associated with the location and
operation of the car factory.
External benefits
The new car factory may also bring external benefits when it is set up in the town. For example, the
workers from the car factory spend their income by using services in the town such as shops and
restaurants. The car factory may also set up training schemes for local workers which is a private
benefit to those workers, but an external benefit when those skilled workers become available to
other businesses in the area. The car factory could also improve local infrastructure when new
roads are built and broadband speeds are increased. These developments will also benefit the
community in the town.
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Production external benefits and market failure
The external benefits are not included in
the supply curve (private cost) for the car
factory, but when the external benefit is
added to the supply curve, the marginal
social cost curve exists to the right of the
supply curve. This is shown in diagram 2.40.
We assume that there are no other
external costs and benefits when
consuming the cars.
In the car factory example, the market output exists where demand equals the supply of cars at
price P and output Q in diagram 2.40. The socially efficient output where marginal social cost equals
marginal social benefit at output Q* in diagram 2.40. The market has failed because the socially
efficient output Q* is above the market output Q. There is an under-allocation of resources in the
market.
Welfare loss
The yellow shaded area in diagram 2.40 is the welfare loss to society because of the under-allocation
of resources. The marginal social benefit from the car factory is greater than the marginal social cost
at each level of output from Q to Q*. For extra units produced from Q to Q*, the benefit to society is
greater than the cost. By only producing at Q society is missing out on the welfare more resources
being allocated to the market would bring.
Calculating the welfare loss (HL only)
The car factory's welfare loss can be calculated by working out the area of the yellow welfare loss
triangle in diagram 2.40. In this case, the data from the car factory example is:
•
Q: 50,000 units
•
Q*: 75,000 units
•
MSC at Q: $9,000
•
MSB at Q: $12,000
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Calculation:
(Q* - Q) x (MSB – MSC) / 2 = welfare loss
(75,000 - 50,000) x ($12,000 - $9,000) / 2 = $37.5 million
Consumption external benefits
Consumption external benefits occur when a good or service is consumed and there are spill-over
benefits on third parties. For example, we often see external benefits in the market for healthcare
goods and services when there are benefits to people beyond those who consume healthcare
goods.
Marginal private benefits
For example, when people purchase a flu vaccination they benefit because they are less likely to
catch the flu. This is a private benefit to these consumers, and each extra unit of the vaccination
consumed is a marginal private benefit.
Marginal social benefit
Other people (third parties) in society also benefit because with fewer flu carriers, there are fewer
people to catch the flu from. The people who are less likely to catch the flu because of other
people’s vaccinations represent an external benefit from the consumption of the flu vaccine.
Consumption external benefits and market failure
The demand curve represents the private benefits from the flu vaccine. When we add the external
benefits, we get the marginal social benefit curve. If we assume that there are no other externalities
associated with the production of the flu vaccine, then the supply of the marginal private cost curve
equals the marginal social cost curve.
Diagram 2.41 illustrates the market for
the flu vaccine. The market output is at
the point where demand equals supply or
marginal private benefit equals marginal
private cost at output Q. The socially
efficient level of output is where marginal
social cost equals marginal social benefit
at Q*. This means that the market
output Q is below the socially efficient
output at Q* and there is an underallocation of resources.
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Welfare loss
The yellow shaded triangle in diagram 2.41 represents the welfare loss to society from the flu
vaccination. The marginal social benefit from the consumption of the vaccine is greater than the
marginal social cost at each level of output from Q to Q*. This means from each extra unit of vaccine
consumed between Q and Q*, the benefit to society is greater than its cost. By only producing at Q,
society is missing out on the welfare from more resources being allocated to the market.
The vaccine's welfare loss can be calculated by working out the area of the yellow welfare loss
triangle in diagram 2.41. In this case, the data from the vaccine example is:
•
Q: 1.5 million units
•
Q*: 5.6 million units
•
MSB at Q: $8.00
•
MSC at Q: $2.50
Calculation:
(Q* - Q) x (MSB – MSC) / 2 = welfare loss
(5.6m - 1.5m) x ($8.00 - $2.50) / 2 = $11.275m
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Unit 2.8(2): Market failure - merit goods and demerit goods
What you should know by the end of this chapter:
•
•
•
•
Theory of merit goods
Under-consumption of merit goods as a
market failure
Theory of demerit goods
Over-consumption of demerit goods as a
market failure
Introduction
Merit goods, demerit goods and public goods are all associated with
significant market failure. When this happens there is an important role
for state intervention to correct these market failures. The concepts of
merit, demerit goods and public goods were developed extensively by
Professor Richard Musgrave (UCLA). His analysis of these goods is an
example of why governments need to intervene in certain markets.
Merit goods
What is a merit good?
Merit goods are goods that society says people should consume because they are associated with
significant social benefits. Merit goods are a normative concept because they are based on a
society’s judgement of what is or is not a merit good.
Examples of merit goods
Deciding what is or what is not a merit good is not that easy. Most textbooks focus on goods and
services associated with health and education as merit goods and their provision is supported by
most governments across the world. This can be broadened to include things like healthy food,
recreation facilities, housing, museums and theatres. Where the examples of merit goods stop is
difficult to say precisely and their existence is often influenced by political decision-making by
governments.
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Merit goods are an example of market failure because they tend to be
under-consumed in free markets and this leads to an under-allocation
of resources. Merit goods are often associated with significant
external benefits to society from their consumption, and these are not
accounted for in the free market allocation of resources.
School education is a good example of how there would be underconsumption of a merit good in a free market without any government
intervention. Remember, in the free-market model of the economy
there would be no government-funded and managed state schools.
There are three aspects to the under-consumption school education:
External benefits
When people are deciding to send their
children to school, they do not consider
the external benefits of school education.
There are significant positive externalities
associated with children attending
school: they provide a more skilled
workforce; they learn social skills that
make them better citizens and they are
likely to be healthier because they are
taught how to live healthy lives. Diagram
2.42 illustrates the under-consumption of
school education and its associated
welfare loss.
Undervalued private benefits
Individuals make buying decisions based on their assessment of the private benefits the
consumption of a good will give to them. People often under-value the benefits the consumption of
a merit good will bring to them. Many people in society will value the education of their children
very highly and will always send their children to school. Some people, however, might not see such
a high value in education and would not be willing to pay for their children to go to school.
Low incomes households
School education is expensive, and some people would not be able to afford to send their children to
school in a free market situation. The children of low-income households will miss out on the
significant private benefits of attending school and society will not benefit from the positive
externalities of educating the children of low-income households.
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Demerit goods
What is a demerit good?
Demerit goods are goods that society says people should not consume because their consumption is
associated with significant social costs. Like merit goods, demerit goods are a normative economic
concept and are based on a society’s judgement of whether the consumption of a good should be
discouraged.
Examples of demerit goods
Commonly used examples of demerit goods include alcohol, cigarettes,
firearms and recreational drugs. But these examples can be extended to
violent films, ownership of dangerous animals, junk food and gambling. As
with merit goods, the distinction of what or is not a demerit good depends on
where you are in the world and the political and cultural values of a country.
Demerit goods as a market failure
Demerit goods are an example of market failure because they tend to be over-consumed in free
markets. Without any state intervention in a free market, there will be an over-allocation of
resources. One of the key reasons for this is that demerit goods are associated with negative
externalities.
Alcohol is an example where there is over-consumption in a free market. Its over-consumption can
be explained in two ways:
External costs
There is considerable evidence to show
that the consumption of alcohol leads to
negative externalities that adversely
affect others in the form of poor
behaviour by individuals in public places;
drink driving; absenteeism and low level
of productivity at work and domestic
violence. In addition, people who
consume large quantities of alcohol
often use the healthcare system
excessively and this reduces its
availability to others.
Diagram 2.43 shows how the over-consumption of alcohol and the associated welfare loss.
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Overvalued private benefits
Demerit goods like alcohol are also over-consumed because people do not consider the impact on
their long-term welfare when consuming it. When individuals drink too much alcohol over a long
period of time they might not factor in the impact it has on their physical and mental health.
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Unit 2.8(3): Government intervention to manage
externalities, merit and demerit goods
What you should know by the end of this chapter
Policies to deal with external costs and demerit goods:
• Tax
• Regulation
• Tradable permits
• Advertising
• Education
Policies to deal with external benefits and merit goods:
• Subsidies
• Regulation
• State provision
• Advertising
• Education
Reasons for government intervention
We know from the previous chapters that cover externalities along with merit and demerit good
that they lead to market failure. Without any government, intervention resources are misallocated
and the welfare of a country’s citizens is not maximised. Governments intervene when there is
market failure to affect resource allocation and improve the welfare of their country's citizens.
Governments do this by trying to move output in markets where there is market failure closer to the
socially efficient level where social costs equal social benefits.
Policies for external costs
The market failure associated with negative externalities leads to an over-allocation of resources and
a resulting welfare loss to society. The government policies associated with dealing with negative
externalities are based on the objective of trying to reduce the market output towards the socially
efficient level where marginal social costs equal marginal social benefits.
One of the central problems for any government trying to apply policies to reduce negative
externalities and achieve the socially efficient level of output is the problem of measuring external
costs and establishing where the socially efficient level of output is. For example, governments know
there are negative externalities associated with the consumption of alcohol but it is very difficult to
come up with an accurate measure of the extent to which resources are over-allocated in the
market. This measurement is further complicated by the existence of positive externalities
associated with the market for alcohol such as employment in related industries.
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Demerit goods
Many of the policies used to manage the market failure associated with consumption external costs
can be used to deal with similar market failures associated with demerit goods. The application of
indirect tax, regulation and demand-reducing policies can all be applied to demerit goods.
Taxation (Pigovian tax)
Tax on production external costs
Where an industry is associated with
significant negative externalities
governments can impose indirect taxes
on producers. An indirect tax adds to
business costs causing an increase in the
price of the good and leading to a fall in
output towards the socially efficient
level. This is illustrated by diagram 2.45,
where an energy company pays a
specific tax on the electricity it produces.
The tax is called 'Pigovian' because it was developed from the work of the UK economist, Arthur
Cecil Pigou who did significant amounts of research on market failure. In this example, the tax
increases the market price to P1 and moves output from Q to Q1 which is at the socially efficient
output at Q*. This removes the welfare loss associated with the electricity industry, although it
should be pointed out that in reality achieving the exact socially efficient output is impossible.
Tax on consumption external costs
Tax can also be imposed on negative
externalities of consumption. In many
countries governments tax cigarettes to
reduce their consumption and the
associated social costs. Diagram 2.46
illustrates the impact of an indirect tax
on cigarettes. The effect is similar to a
tax on good on negative externalities of
production, with the price of cigarettes
increasing to P1 and the output of
cigarettes being reduced from Q to Q* at
the socially efficient output. The tax
removes the yellow welfare loss triangle.
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Advantages of using tax:
•
Tax revenue can be used to compensate affected third parties and to pay for the negative
consequences of an externality. For example, the tax revenue from cigarettes can be used to
pay for some of the healthcare costs of people who smoke.
•
Increasing price is an effective way of reducing consumption and production.
Disadvantages of using tax:
•
Tax can reduce the welfare of low-income groups where the price of a good is a significant
proportion of their income. For example, a tax on petrol can have a significant impact on the
incomes of poorer households who rely on their cars.
•
Increasing business costs can lead to lower business profits and even business failure.
Increasing tax can be particularly significant for small businesses.
•
If business costs rise in industries such as energy this could lead to a higher average price
level in the economy and increase inflation.
•
The tax can make domestic firms uncompetitive on international markets and lead to a fall in
exports.
•
If business output decreases because of the tax increase it can cause unemployment to rise
in an industry.
Regulation
Regulation of production external costs
The government can use legislation to regulate markets associated with
external costs. Governments can regulate production externalities by
requiring firms to meet certain criteria when they are producing goods and
services. For example, airlines flying into international airports are not
allowed to land and take off between 23.30 and 0600. The construction
industry is subject to government regulations when it is planning building
projects and needs to meet different planning regulations. There are
regulations on certain substances such as asbestos that cannot be used in
manufacturing processes.
Regulation of consumption external costs
The strictest form of regulation is to make the consumption and production of a good with
significant external costs illegal. This is the case with recreational drugs like cocaine and heroin
where consumption and production are illegal in most countries.
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It is also possible for governments to allow the consumption and production of a good but control
the market. Alcohol, for example, is a legal recreational drug but its consumption is controlled in
many countries in the form of age restrictions, licensing hours, licensed retailers, restricted
consumption in public places, restrictions on advertising and the products need to have health
warnings on their packaging.
Advantages of regulation:
•
They can be targeted more specifically at a negative externality than taxation. If the main
pollutant in the production of a good is a specific chemical, then a regulation can deal more
specifically with that problem than a tax.
•
Whilst regulations can cause an increase in costs, they are less likely to lead to an increased
price than a tax if the firm can comply with the regulation relatively easily.
Disadvantages of regulation:
•
The cost of implementing legal restrictions can be significant for governments. For example,
governments spend huge amounts of money on their anti-drug law enforcement
programmes.
•
Parallel markets arise in regulated markets and the goods provided can be in the hands of
criminal gangs. This is a particular problem in the recreational drugs market.
•
Regulations can drive up business costs increasing prices for consumers. For example,
regulations on the burning of fossil fuels and CO2 emissions have increased the cost of
electricity.
•
Firms can find their way around regulations.
•
Businesses often locate production facilities in countries with lower regulations, which
adversely affects domestic employment and can move the externality problem to another
country.
Tradeable permits
The last 20 years have seen the rise in the market for tradeable
permits or cap and trade schemes, which are a market solution to
the problem of external costs. The market for CO2 emission
permits has become an increasingly important measure used to
control the negative externalities associated with C02 pollution as
a contributor to climate change.
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The system for carbon trading works in the following way:
•
The government sets a total limit on the carbon emissions it will allow from an industry.
•
The total of carbon emissions is then divided up amongst producers that emit carbon and
they are allocated a CO2 allowance.
•
The producers are not allowed to emit more CO2 than their allowance.
•
This gives producers in the industry an incentive to reduce their CO2 emissions because they
can sell any unused allowance they have to less carbon-efficient producers.
•
If the government reduces the number of permits their price and value rise and there is a
greater incentive for producers to reduce their emissions.
To be truly successful in addressing climate change the carbon trading system needs to be an
international market and the emission limits need to be policed effectively. The current market for
CO2 permits is worth about $82 billion.
Advantages of tradeable permits:
•
Carbon credits create an incentive system that is more effective at reducing CO2 than a tax
that firms need to pay whatever their carbon emissions.
•
Using an incentive-based system facilitates innovation and firms develop technology to
reduce pollution.
Disadvantages of tradeable permits:
•
The system is complicated and expensive to set up and administer.
•
The number of permits allowed needs to be tightly controlled at an international level to
have any impact on CO2 emissions and some countries may not follow the system.
•
The permits add to business costs and lead to higher prices.
Reducing demand
An alternative way of dealing with negative externalities is to reduce
the demand for the good associated with the negative externality to
the socially optimum level of output. This can be done through
government-financed advertising campaigns. Many countries run
advertising campaigns that try to persuade people to give up smoking
or taking recreational drugs. Similarly, governments run education
programmes that inform people of the hazards associated with
smoking, drinking alcohol and taking recreational drugs.
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It is also possible for governments to reduce the demand for goods associated with negative
externalities by subsidising products that are substitutes for the ones with the negative
externality. For example, subsidising public transport causes the demand for private car use to fall
along with the negative externalities associated with the use of cars.
Diagram 2.47 shows how an effective
advertising campaign against drinking
alcohol reduces its demand, which in
turn reduces the external cost associated
with its consumption. In this example,
the welfare loss is removed as D shifts to
D1.
Advantages of reducing demand
•
Advertising does not add to business costs so the price of goods does not increase.
•
For some consumption negative externalities such as cigarettes and alcohol, this approach
might be more effective as a long-term solution to the problem because it changes
consumer behaviour.
Disadvantages of regulation:
•
There is an opportunity cost to the government of paying for advertising, education and
subsidies.
•
The effectiveness of advertising and educational programmes are difficult to measure and
are sometimes questionable.
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Policies for external benefits
The market failure associated with positive externalities leads to an under-allocation of resources
and a resulting welfare loss because society misses out on the potential welfare gain from producing
at the socially efficient output. The government policies associated with dealing with positive
externalities are based on the aim of trying to increase the market output towards the socially
efficient level where marginal social costs equal marginal social benefits. One of the central
problems for any government trying to apply policies to increase output to achieve the socially
efficient level is measuring external benefits and establishing where the socially efficient level of
output is.
Merit goods
Government policies aim to encourage the consumption and production of merit goods. This is the
same set of policies discussed with positive externalities: subsidy, state provision, regulation,
advertising and education are applied to merit goods.
Subsidies
Subsidies on external benefits of consumption
When positive externalities exist in a market the government aims to increase market output to the
socially optimum level. The payment of a subsidy provides a financial incentive for producers to
increase output, and consumers to increase consumption of a good associated with positive
externalities. For example, governments subsidise anti-malarial drugs to make them more
affordable in developing countries.
Diagram 2.48 shows the impact of the
subsidy on anti-malarial drugs. Initially,
the market output is at Q below the
socially efficient level at Q*. There is a
potential welfare gain equal to the yellow
shaded area. When the subsidy is added
by the government the price falls from P
to P1 and output rises to the socially
efficient level at Q* and welfare is gained.
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Subsidies on production external benefits
By subsidising the production of a good
with positive externalities firms are
encouraged to increase output towards
the socially efficient level. Subsidies are
often paid to firms who locate in areas of
industrial decline because the positive
externalities of their location help to
stimulate regional economic growth.
Diagram 2.49 illustrates the effect of a
subsidy paid to businesses that locate in
an area that has suffered from significant
industrial decline. The price falls from P
to P1 and output increases to the socially
efficient output at Q*.
Advantages of subsidies:
•
Subsidies create direct financial incentives that will increase output and capture the welfare
gain from external benefits.
•
Low-income consumers benefit from lower-priced goods particularly if they are on necessity
goods such as healthcare products.
•
Producers will be encouraged to increase output which creates employment.
Disadvantages of subsidies:
•
There is an opportunity cost to the government of the subsidy in terms of other public
services they could have financed.
•
The subsidy might take resources away from other products. A subsidy on, for example,
anti-malaria drugs may take resources away from drugs for other illnesses such as HIV
•
Subsidies are often paid to high-income groups such as rich people benefiting from
subsidised healthcare.
•
Subsidies can lead to a welfare loss where inefficient producers are drawn into the market.
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State provision
The government could choose to take the provision of merit goods and
other goods associated with significant positive externalities into the
public sector and provide the goods themselves at the socially efficient
level of output. This is particularly true in the healthcare and education
markets where the provision of these merit goods is seen as being so
important to society.
Advantages of state provision:
•
Government provision of merit goods is the most direct way of increasing output towards
the socially efficient level.
•
Many people believe the state is more likely than the private sector to make decisions about
the provision of merit goods that are in the public interest.
•
Goods can be provided at the price (or zero price) that all households can afford. This is seen
as particularly important in healthcare and education.
Disadvantages of state provision:
•
The cost of providing a state-run healthcare and education systems is extremely high and
carries a significant opportunity cost to the government
•
Some people believe that state provision is less efficient than private-sector provision
because state-run organisations experience diseconomies of scale
•
State-run organisations are often subject to considerable political interference which
compromises their benefits to society.
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Regulation
Governments believe that the consumption of some
goods is so crucial to the welfare of individuals in society
that the government forces people to consume
them. This is particularly the case with primary and
secondary school education where many countries make
it compulsory for parents to send their children to school
through the law.
This is also the case with car insurance where individuals legally need to own third-party car
insurance so people adversely affected by a car accident will be compensated.
Advantages of regulation:
•
Laws compel individuals and businesses to make decisions that increase output to the
socially efficient level.
•
Regulations can be targeted precisely at goods and services with positive externalities.
Disadvantages of regulations:
•
There can be significant costs of policing the system and enforcing regulations.
•
Regulations add to business costs which can reduce employment and increase prices.
•
Some people avoid the regulations and parallel markets can develop.
Increasing demand
Governments can try to increase the
demand for goods associated with
positive externalities to move production
and consumption towards the socially
efficient level of output. For example, the
state can fund the advertising of things
like further education, healthy eating and
exercise to increase the demand for goods
and services in these markets and increase
the resulting external benefits.
Educational programmes can be used to increase the demand for merit goods by informing people
of the benefits, for example, of vaccinating against diseases like measles.
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Diagram 2.50 illustrates the impact of a government advertising campaign to increase the
consumption of fruit and vegetables as part of a healthy living policy. The demand curve for fruit and
vegetable shifts to the right and market output increases from Q to Q1 which is closer to the socially
efficient output Q*. As a result, some welfare is gained and is shown by the yellow area on the
diagram.
Advantages of increasing demand:
•
Education and advertising are not as expensive as using subsidies and do not have the
management problems of regulation
•
The approach can be effective in altering human behaviour which is an effective long-run
solution to the under-provision of goods associated with positive externalities.
Disadvantages of increasing demand
•
The opportunity cost to the government of funding advertising and educational
programmes.
•
It is not always easy to measure the effectiveness of advertising and educational
programmes.
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Unit 2.8(4): Common pool (pool) resources
What you should know by the end of this chapter:
Common pool resources
Tragedy of the commons
Managing common pool resources through:
• Property rights
• Command and control regulation
• Collective self-governance
• Porter hypothesis
• Carbon taxes
• Tradeable permits
• International agreements
What is environmental economics?
If economics is the study of how society allocates scarce resources to satisfy human wants, then
environmental economics considers this statement in the light of how economic activity impacts the
environment. We know from our study of market failure, that the external costs resulting from
consumption and production in free, unregulated markets have a negative effect on the
environment and that governments along with international organisations have an important role in
correcting these failures.
Common pool (pool) resources and sustainability
What is a common pool resource?
Common pool resources are resources that firms and individuals can pool in society without
restriction. Common pool applies to resources like forests for timber, the sea for fish and areas of
land for mineral deposits.
Characteristics of common pool resources
Common pool resources are associated with two characteristics:
•
Common pool resources are non-excludable because they occur naturally in the
environment, and without government intervention, it is very difficult to limit access to
them. Anyone can pool fish in the sea and cut down trees in a forest if there is no legal
system to prevent people from doing this
•
Common pool resources are rivalrous because the consumption of them by one individual
does reduce their availability to others. If someone takes fish from the sea or cuts down a
tree it is not available to someone else.
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Property rights
Property rights exist when an individual or a firm has ownership of a resource. When a farmer owns
a field they have property rights over that field and have the legal right to control its use. They can
put a fence around it and other people cannot legally use the field. Common pool resources do not
have property rights assigned to them and nobody owns them. For example, there are no property
rights on the open sea. The lack of property rights makes common pool resources non-excludable.
Sustainability
This is where the use of resources in the economy meets the needs of the present generation
without adversely affecting the needs of future generations. Unsustainable economic activity is
often associated with the over-consumption of common pool resources which reduces their
availability to people in future. They are also often associated with external costs which have a
negative impact on people in the present and also people in the future. The way the burning of fossil
fuels impacts the atmosphere as a common pool resource is an important example of this.
Common pool resources and market failure
Non-excludability and zero price
The non-excludable nature of common pool resources means
there is no price attached to their consumption. In many cases
common pool resources are also used in production, so free pool
to them at zero price means they are a zero cost to producers who
use them. This leads to their exploitation.
If an area of land can be freely pooled to cut down trees, people will clear a forest in an unrestricted
way until significant deforestation has taken place and there is no forest for future generations to
benefit from. The exploitation of common pool resources means they are being used in an
unsustainable way.
External costs
When common pool resources are over-consumed there will often be significant external costs as
well. Deforestation negatively affects third parties because it adds to climate change and reduces
biodiversity. You can also make the externality argument when the use of common pool resources
now reduces their availability to future generations. Over-fishing now means fish will not be
available to people in the future who would be considered a third party.
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Diagram 2.51 illustrates the external costs
of overfishing the sea. The market output
is at Q which is above the socially efficient
output of Q*. There is an over-allocation
of resources and the yellow shaded area
represents the welfare loss to society.
Developing countries
The exploitation of common pool resources often takes place in less developed countries where
property rights are not established effectively. People in poverty are often forced to exploit cheap
resources available to them. Lots of deforestation takes place in developing countries when people
are involved in illegal logging and mining to make enough income to survive.
Tragedy of the commons
The theory of the tragedy of the commons was put forward by an
ecologist called Garrett Hardin. He argued that the use of common
pool resources leads to a ‘shared-resource system’ where people
over-produce goods using common pool resources because it is in
their self-interest to do so. If a resource can be pooled at zero price
then it is in the producer’s self-interest to make as much profit as
they can from using a zero-priced resource. People are likely to overfish the sea or cut down a rainforest because of the profit they can
make doing this. The tragedy of the commons shows how common
pool resources are a market failure and are not sustainable.
Free rider problem
The free-rider problem also applies to common pool resources where some people choose to
benefit from other people’s actions. All people in the fishing industry might accept there is a need to
reduce fishing in the present to preserve stocks for the future and agree to cut current fishing. But as
a voluntary agreement, some producers might keep fishing at the same level and free ride off the
reduced fishing of others.
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Policy approach to common pool resources
Common pool resources need government intervention because their use leads to an overallocation of resources. This depletes resources for the future which is unsustainable and the overuse of common pool resources leads to negative externalities.
Assigning property rights
Economists often look at the problem of common pool resources as a property rights issue. A
property right is an individual’s right to control what they own and to be compensated when that
right has been infringed. If someone takes flowers from your garden, you can take legal action
against the person who has taken them. The use of common pool resources is un-controlled
because there are no property rights assigned to them. Anyone can pool a piece of common land, a
river or a lake and extra resources without any legal restriction. By assigning property rights to a
forest people who cut down trees have to pay the owner who can use the income to plant new
trees. Without property rights, people will cut down trees and not replant them which means
deforestation will take place.
Advantages of property rights:
•
Property rights provide a market solution to the common pool resources problem. By
allocating property rights common pool resources now have owners and can be made
excludable.
•
Owners of common pool resources have an incentive to manage them sustainably or there
will not be a long-term source of income from them.
•
Allocating property rights is a relatively low-cost way of dealing with the common pool
resources problem.
Disadvantages of property rights:
•
The owner might not have social efficiency as an objective of their ownership of a common
pool resource. An owner of a forest might allow deforestation.
•
Some common pool resources are areas of natural beauty that society wants to be
maintained in a particular way. National parks, for example, are owned and controlled by
governments.
•
The legal costs associated with the resolution of property rights disputes can be significant.
•
It is not always practical to assign property rights. Many external costs are ‘air-borne and
people can’t own the airspace around them.
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Command-and-control regulation
Endangered Species Act (ESA)
The aim of command-and-control regulations is for
government to set specific limits on environmental pollution.
The regulations also set out how technology can be used to
control pollution. Examples of command and control
regulations come from the US in the form of The Clean Water
Act, Endangered Species Act and The Clean Air Act. For
example, the US has government-imposed regulations on
power plants to use cleaning technology in their smokestacks
that removed pollutants like sulphur dioxide. There is also an
Endangered Species Act that prevents the hunting of certain
wild animals.
Advantages of command and control regulation
•
By using the law, it forces firms to take action that reduces the negative externalities of
production that occur with the exploitation of common pool resources
•
It provides a set of regulations to form a national framework that reduces the environmental
costs that are associated with common pool resources
•
Strict command and control regulations can induce firms to develop technology that allows
them to meet the regulations set. This is known as the Porter Hypothesis, named after the
economist, Michael Porter.
Disadvantages of command and control regulation
•
There are no incentives for businesses to improve the quality of the environment beyond
the standard set by the law. Firms do not need to improve their production methods if they
are within the regulations set.
•
The regulations do not distinguish between firms that find it easy to meet the standards set
and those that do not. For those that find it difficult, the regulations will come with a
significant cost and those firms may even go out of business which will lead to
unemployment.
•
Like any regulation, they will increase production costs which could cause unemployment
and lead to higher prices for consumers.
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Collective self-governance
The collective self-governance approach to the negative
environmental consequences of common pool resources is
based on the work of Nobel Prize-winning Economist, Elinor
Ostrom. Her theory viewed government-directed regulation as
bureaucratic and less effective at achieving their environmental
aims as ordinary citizens working together to solve
environmental problems.
Ostrom found evidence across the world of local people working together to solve the
environmental costs associated with the tragedy of the commons. Left to themselves the local
population would find solutions to environmental problems that met their own needs rather than
those of a detached government imposing them from some distance away.
An example of self-governance is Maine’s fishing community that specialises in lobster. In Main’s
fishing towns the local people make and monitor their own rules and have their own set of
punishments for people who break the rules. The fishing territory for lobster is broken up into set
boundaries decided on by the fishing community and groups known as ‘harbour gangs’ are only
allowed to fish in their allocated area. This approach to dealing with common pool resources is
backed by formal government regulation on catching lobsters.
Advantages of collective self-governance
•
This approach allows for the needs of local communities who know and understand the
specific issues they face from common pool resources and are more likely to follow their
regulations rather than those imposed on them.
•
By working at a local level, the negative externalities associated with the common pool
resources can be targeted specifically rather than a ‘one size fits all’ national approach.
•
Collective agreements are more flexible than national regulations and can change as the
environmental situation changes. If the lobster population suddenly declines the catch
regulations can be tightened quickly.
Disadvantages of collective self-governance
•
Without legal backing, the enforcement of rules relating to common pool resources relies on
the goodwill of participants and this may not always be present. What happens if one
business in Maine decides to catch lobsters outside of its area and refuses to follow local
rules?
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•
Collective self-governance might work in the present but may not consider the future in the
same way. If the incomes of people in the lobster industry start to fall, there would be
pressure to catch more now which reduces the sustainability of the industry
•
Many common pool resource issues are global and cannot the effectively managed at a local
level.
Carbon tax
Carbon taxes are imposed on the use of fossil fuels such as coal, oil and gas. Carbon taxes focus
precisely on one of the most significant causes of climate change by directly trying to reduce CO2
emissions from the use of fossil fuels. The tax is levied on firms based on the amount of carbon they
use to produce their good or service. The tax aims to get businesses and consumers to switch to
energy generated by renewable sources such as solar and wind power. Some of the taxes levied on
businesses would increase the price the consumer pays, but this could be repaid to consumers
through a tax credit paid from the tax revenue collected by the government.
Diagram 2.52 illustrates how a carbon
tax affects the market for electricity. The
tax causes the supply curve to shift to
the left and cause the market price to
rise to P1 and output Q to shift to Q1
which is closer to the socially efficient
output at Q*. The welfare loss triangle is
reduced from the yellow-shaded triangle
to the smaller green triangle.
Advantages of a carbon tax
•
The tax focuses on a major source of climate change and acts as an incentive for firms to
switch to renewable sources of energy.
•
Revenue raised by the tax can be used to subsidise innovation in the development of
renewable energy.
Disadvantages of a carbon tax
•
A tax will increase the price of energy to consumers if producers pass on the tax increase.
This could have a significant impact on low-income households.
•
As business costs are increased by the tax it reduces their profits which leaves businesses
less money to invest in developing low-emission technology.
•
Higher production costs resulting from the tax could lead to a reduction in output and cause
unemployment.
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Tradeable permits
The use of tradeable permits or carbon training is seen as an important ‘incentive based’ method for
businesses to reduce CO2 carbon emissions. Air is a common pool resource and tradeable permits
create a market that introduces a limit to the amount of CO2 pollution that can be emitted into the
air.
For detailed coverage of this policy see chapter 2.8(2) on policies to deal with external costs.
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Unit 2.9: Public goods
What you should know by the end of this chapter:
•
•
•
•
•
•
The nature of public goods
Concepts of non-rivalrous and non-excludable
consumption
Free rider problem leading to market failure
Policy approach to the market failure associated
with public goods
State provision of public goods
Alternative methods of provision by the private
sector
What is a public good?
Public goods or pure public goods are goods that bring significant social benefits to society but
cannot be provided by the free market. They are a market failure, which means the government
needs to intervene in the market to ensure they are provided. Because they bring significant social
benefits we also consider them to be merit goods.
Public goods have two characteristics:
Non-rivalrous
Non-rivalrous means the consumption by one individual does not reduce the availability to others.
For example, if a group of people are benefiting from a public good like street-lighting and an extra
person comes along to take advantage of the light the availability to the existing consumers is not
reduced. This means the marginal cost (the cost of providing the good to an additional consumer) of
providing a public good is zero once it is set up and being produced. The extra person who benefits
from street-lighting adds nothing to the cost of providing the streetlight.
Non-excludable
Once a public good is being produced it is impossible to stop people from benefiting from it. Once
streetlights are turned on it is impossible to stop people from benefiting from them, assuming they
can get to an area covered by the lights.
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Examples of pure public goods
There are not many examples of pure public goods, but economic theory
would normally include flood barriers, sea defences, street lighting and
national defence.
Economists often distinguish between pure public goods and quasi-public
goods. Quasi-public goods have some elements of being non-rivalrous and
non-excludable but not in the precise way that defines pure public goods.
Examples include roads, bridges and public parks. Roads have some of the characteristics of public
goods, but the space on a road can be looked at as being rivalrous when too many cars use them,
and they can be excludable if tolls are in place.
Public goods as a market failure
Public goods are considered an example of market failure in pure free markets because they would
not be produced. This is because of the ‘free rider’ problem. Once a public good is set up and being
produced it is impossible to prevent people from benefiting from it (non-excludability) even if they
have not paid for the good: some individuals free ride 'on the back' of the consumption paid for by
others.
Consider the example of a town that keeps being flooded by a river. The town needs a flood
defence. A group of people who live alongside the river think of pooling their money to pay for flood
defences, but they do not have enough money to pay for the barrier unless the whole town
contributes.
Large numbers of people in the town choose not to contribute as they know that once the flood
barrier is built they can benefit from it without paying – they can free ride on the consumption of
those who do pay. This means the market price of the flood barrier will not be high enough for it to
be provided. Public goods like flood barriers often have very high initial set-up costs so even wealthy
philanthropic individuals would not be able to fund their provision.
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Diagram 2.53 shows how the socially
efficient output of the blood barrier at Q*
where MSB equals MSC. The MSC curve
in this case is horizontal at C because the
marginal cost of an additional user of a
flood barrier is zero. Once the flood
barrier is set up the marginal cost of
providing it to each additional consumer
does not change as more consumers
benefit from it.
If the flood barrier costs $1Bn the cost will not change if two million people benefit from it or three
million people benefit from it. Remember, this is hypothetical because in a free market the flood
barrier would not be built. Because the output is zero in the market the whole yellow shaded area is
the welfare loss.
Government intervention to manage public goods
The nature of pure public goods means that they will not be provided by the free market. Where a
public good is something society should provide (street-lighting, defence and flood defences) the
government can intervene through direct state provision. Quasi-public goods like parks, the police
and street cleaning will be under-provided in a free market and governments intervene to produce
quasi-public goods at the socially efficient level of output.
State provision
Where governments see the provision of a public good as crucial to society they will set up and
provide the public good. Most countries have public goods that are set up and provided by the
state. Public goods such as national defence, flood defences and street lighting are directly provided
by the government and funded through taxation.
Advantages of state provision:
•
Government provision of public goods is the only way they can be produced. Remember the
free market will not generate a price that can support the production of a public good.
•
Government are more likely to provide quasi-public goods near the socially efficient output.
•
When the government is providing a public good it is more likely to make decisions in the
public interest compared to private sector businesses that aim to make a profit. This could
be important in the provision of quasi-public goods such as parks.
•
Governments can provide public goods at zero price so they are available to low-income
households.
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Disadvantages of state provision:
•
The cost of providing state-funded and managed public goods is extremely high and there is
a significant opportunity cost to the government in terms of other areas of expenditure.
•
Some people question the efficiency of state-run organisations that provide public goods.
•
State-managed and organised public goods can be influenced by political decision making
which may not be in the best interests of society. For example, expenditure on defence can
be influenced by political rather than welfare factors.
•
It is impossible to accurately know the level of provision of the public good that is socially
efficient.
Private sector operation
Governments can set up and pay for the provision of public
goods that can then be managed by private sector
organisations. This is particularly the case with quasi-public
goods like street cleaning. In this situation, the government
pays private businesses that are contracted to clean the streets
and dispose of waste.
Advantages of private sector provision:
•
This approach has the benefit of making sure the public good is provided, but the
operational management may be more efficient than government-managed provision.
•
Private sector provision means political decision-making is less likely to take place in the
management of the public good.
The problems with this approach:
•
The cost of setting up the provision of the public good still needs to be paid for by the
government which will come with an opportunity cost.
•
A private sector firm may provide the service putting profit ahead of welfare. Private sectoroperated prisons are sometimes criticised for cost-cutting management practices.
•
It is impossible to know the level of provision of a private sector-managed public good to
achieve the socially efficient output.
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Unit 2.10: Asymmetric information (HL)
What you should know by the end of this chapter
•
•
•
•
•
•
The nature of asymmetric information
Adverse selection
Moral hazard
Asymmetric information as a market failure
Market responses to asymmetric information
Policy responses to asymmetric information through
legislation and regulation
What is asymmetric information?
Asymmetric information is an imbalance of information that exists between buyers and sellers in a
market that gives one side an unfair advantage in a transaction. For example, when someone goes to
buy a used car the seller of the car will normally know more about the car than the buyer. The seller
might know that the engine is unreliable but chooses not to tell the buyer about this. As a result, the
seller receives a higher price, and the buyer pays a higher price than if this information had been
made available to the buyer as well as the seller.
Types of asymmetric information
Adverse selection
Adverse selection is an example of where asymmetric information leads to market failure. Adverse
selection is where one party in a transaction has better information than another on which to make
their buying or selling decision. This means the buyers and/or sellers make decisions that do not
maximise welfare in a market and this leads to market failure.
Buyer advantage
When buying insurance, for example, the buyer has more information
about their risk to the insurer than the insurance company selling them a
policy. A buyer of car insurance might drive at high speeds and use their
phone when driving, but the insurance company does not know about this
because the buyer hides it from them. As a result, the buyer gets cheaper
insurance and the insurance company receives a lower price than would
be the case if the company had known about the buyer's risky driving. Other examples include,
where an expert antique dealer buys antiques from inexperienced sellers, or a person takes out a
loan from a bank and lies about their income.
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Seller advantage
Sellers often hold more information about the good or service
they are selling than is available to the buyer. In markets for
complex products, this puts sellers at a significant advantage.
For example, a firm that sells anti-virus software knows how
much protection their product offers the consumers who buy
their software. It is very difficult for a buyer who is unfamiliar
with this type of software to value what they are buying except
by looking at competing products and assessing how much to
pay to stop their computer from getting a virus.
The product might cost the firm $10 to manufacture but they can sell it for $100 to an uninformed
buyer. Other examples include when people buy complex financial products like pensions or a real
estate agent selling a house with structural problems.
Moral Hazard
Moral hazard occurs when there is an incentive for people to change their behaviour because the
negative consequences of their decisions are borne by others. For example, if you hire a car and it is
covered by comprehensive insurance, it means that any accident you might have is covered by the
insurance. Because of the insurance cover, you might drive the car much more recklessly than if it is
not covered by the insurance. The costs of the repairs caused by your reckless driving will add to the
insurance cost of the car hire firm and push up the hire price for everyone else.
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Why is asymmetric information a market failure?
Asymmetric information means buyers and sellers in a market make decisions on information that
does not accurately reflect the value they put on the goods they are buying or selling.
Seller advantage
An example of seller advantage is where
buyers of diesel cars made decisions
about buying them based on the private
benefits they received from owning a
diesel car. Part of this decision may have
been related to the low emissions
associated with diesel cars. The car
manufacturers knew that the emissions
were higher than those they advertised.
This buyer asymmetry means that the marginal social benefit curve of diesel cars is lower than the
marginal private benefit curve. As a result of this, the socially efficient output of Q* is below the
market output of Q, which is shown in diagram 2.54.
Buyer advantage
When businesses, for example, sell health
insurance they set the price for their
insurance based on the health risk of the
people they insure. If someone is
overweight, smokes and does not
exercise, then they are more likely to be
ill and claim on their insurance. These
people should pay a higher price for their
insurance, but if these buyers keep their
unhealthy lifestyle hidden from the
insurance company, they will pay a lower
price than the true value of their
insurance premium.
This means the marginal social cost of providing the insurance is greater than the marginal private
cost. This is shown in diagram 2.55 where the market output is at Q, but the socially efficient output
is Q*. There is an over-allocation of resources and the yellow shaded area is the associated welfare
loss.
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Market responses to asymmetric information
Signalling
Buyers are wary of purchasing goods and services in markets where there is asymmetric information
and they are at a knowledge disadvantage. Sellers know this and try to sell their goods in a way that
makes buyers feel more confident about the goods they are purchasing. One way of doing this is to
offer warrantees or guarantees that offer buyers the chance to get a replacement or their money
back on faulty goods. The second-hand car market has many offers of warranties to attract buyers.
Screening
Buyers in asymmetric information situations can pay an agent or a lawyer who has good knowledge
of a market to advise them on buying decisions. Most people use an estate agent and a lawyer when
they are buying a house to advise them on such a significant purchase. Buyers can also do their own
research to screen the sellers they are buying from. The growth of online independent reviews of
hotels and restaurants is an example of this.
Policies for asymmetric information
Legislation and regulation
When goods are being bought and sold in an asymmetric situation both buyers and sellers face
regulations and laws that try to correct the asymmetry and the market failure associated with it.
Buyers
For the buyers, there is a considerable amount of consumer legislation that protects people in
asymmetric situations when they buy goods and services. Governments set out rules that businesses
legally need to follow such as: ‘goods of a satisfactory quality’, ‘fit for the purpose they are used for’
and ‘meet the seller’s description’. Laws will also state that buyers have a right to a refund or a
replacement for goods if they do not meet necessary standards.
Sellers
When goods are being bought buyers also have to follow rules and regulations to give the seller
complete information before they decided on a sale. For example, when you buy car insurance you
need to give the insurance company accurate information about yourself so the company can make
a judgement on the risk of insuring you. They will then set an insurance premium based on this. It is
illegal to lie to an insurance company when you are applying for insurance.
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Unit 3.1(1): Measuring the level of economic activity
What you should know by the end of this chapter:
•
•
•
•
•
•
•
•
•
•
•
National income accounting as a measure
of economic activity
Circular flow of income model
Income, output and expenditure
approaches to national income
Gross domestic product (GDP)
Calculation of GDP (HL)
Gross national income (GNI)
Calculation of GNI (HL)
Real GDP and real GNI
Calculation of real GDP and real GNI (HL)
Real GDP/GNI per capita at purchasing power parity (PPP)
Business cycle
National income as a measure of economic activity
Economic activity is where scarce resources are allocated to produce goods and services to satisfy
human wants. Macroeconomics is the study of economic activity from a whole economy
perspective.
For example, the German economy is well known for its highperforming manufacturing sector with famous names like
Volkswagen, Daimler AG, Allianz and BMW. Microeconomics
allows us to examine these individual businesses and the
industries they operate in.
Macroeconomics looks at Germany’s manufacturing sector in the context of the whole economy
where it accounts for 47 per cent of the country’s GDP. So, any change in Germany’s manufacturing
sector has a significant impact on its national output.
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The circular flow of income
An economic model
The circular flow of income is an economic model that illustrates the flow of money between firms
and households at a macroeconomic level. It can be further developed to include foreign trade,
government and banking sectors. Whilst the model has been around since the 17th century, its
importance as an economic theory was developed by John Maynard Keynes in his book, General
Theory of Employment, Interest and Money which was published in 1936. The circular flow model is
a useful aid to economic forecasting and policymaking.
How the model works
The model we are going to use in our analysis of the macroeconomy is a simplified version of the
model used by institutions such as banks, universities, hedge funds and governments, but it is still
very useful as a method of understanding how the macroeconomy works.
The flow of income is illustrated in diagram
3.1. It can be explained by considering the
following principles:
•
The economy can be divided into
two sectors, firms and households.
•
Firms combine the factors of
production to produce goods and
services and households buy the
goods and services and consume
them. This is shown by the blue
flows on the circular flow diagram
3.1.
•
To produce the goods and services firms need to employ people from the households which
include labour and entrepreneurs and in return, the firms pay the households an
income. This is shown by the red flows in diagram 3.1.
•
Injections of funds come into the circular of an economy in the form of investment,
government expenditure and exports.
•
Withdrawal or leakages of funds from the circular flow of income go out in the form of
savings, tax and imports.
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Injections to the circular flow
Injections are the flow of funds into the circular flow that come from firms investing, government
spending and exports resulting from foreign trade. The three injections are:
•
Investment by businesses when they buy capital such as new buildings and machinery
•
Government expenditure on public services such as health and education
•
Exports of goods and services to other countries lead to an inflow of funds.
Withdrawals from the circular flow
Withdrawals from the circular flow occur when money leaves the economy through household
savings, taxation by the government and imports resulting from foreign trade. The three
withdrawals are:
•
Savings by households of income they do not spend on goods and services
•
Taxation by governments on household income, business profits and indirect tax on goods
and services
•
Imports bought by firms and households lead to an outflow of funds.
Application of the model
Like the other models we use in Economics, the circular flow model lets us analyse the causes and
consequences of changes in economic variables. The demand and supply model helps us examine
how, for example, changes in household income affect price and output in a market. Here are some
examples of how the circular flow model can be used to analyse how a change in injections and
withdrawals affect the macroeconomy. Consider the following examples:
•
An increase in the value of exports by an economy increases the value of funds in the
circular flow which leads to increases in household incomes and consumption, output by
firms and employment.
•
An increase in taxation in the economy reduces the value of funds in the circular flow. This
leads to a decrease in household incomes and consumption, output by firms and
employment.
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Gross Domestic Product (GDP)
Defining GDP
A country’s GDP is the money value of all final goods and services produced by that country in one
year. It is a statistic used to measure macroeconomic activity. The GDP of a country is normally
considered an annual figure, but economists and governments also use quarterly figures to track
economic growth over time so they can closely monitor what is happening to economic activity. The
GDP is expressed in money terms using the country’s currency, although for international
comparison the value in $US is used.
Using final goods and services
When the GDP of a country is being calculated only the value of final goods is used. The value of
intermediate goods such as raw materials and components are not included because this would lead
to ‘double counting’. If you included the value of a television produced when it is sold by the
manufacturer to a retailer (an intermediate good) and then count it again when it is sold to the
consumer as a final good then you would count the value of the television twice.
Using the circular of income to measure GDP
The circular flow of income gives us 3 ways of measuring the GDP.
Income method
This is the total value of income earned by households in one
year in the form of:
•
Wages paid to labour
•
Interest paid to capital
•
Rent paid to land
•
Profits and dividends paid to entrepreneurs.
It is important not to count income in the form of transfer payments where no economic activity has
been engaged in to generate the income. Transfer payments include pensions, unemployment
benefits and student grants, etc.
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Output method
This is calculated by taking the value-added of firms in different sectors of the economy. The sectors
are:
•
Primary – commodities such as agricultural goods, mining, forestry and fishing, etc.
•
Secondary – manufacturing such as cars, mobile phones, pharmaceuticals and clothing, etc.
•
Tertiary – services such as education, restaurants, tourism and transport, etc.
Value added is the method of calculating GDP to avoid ‘double counting’. Value added is the
monetary difference between the purchase cost of the material inputs used to produce the good
and its selling price. If a car manufacturer, for example, pays for the materials and components to
produce a car valued at $4,000 and sells the car to a dealer for $10,000 then the value added is
$6,000. If the dealer takes the car they have bought for $10,000 and sells it for $14,000 their valueadded is $4,000. The value-added of each sector is used to calculate the GDP by the output
approach.
Expenditure method
This is calculated by aggregating the total expenditure of different sectors of the economy. There are
four types of expenditure:
•
Consumption (C) spending by households on final
goods and services
•
Investment (I) spending by firms on capital
equipment
•
Government (G) spending on public services
•
Net Exports (X-M) The surplus of the value of exports
over the value of imports
The table sets out the GDP of the five largest economies in the world.
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Gross national income (GNI)
Calculating GNI
The gross national income is the total income generated by a country and is calculated by adding net
property income from abroad to the GDP.
GDP + net property income = GNI
Net property income from abroad
Property income is money earned by households on different assets. This income comes in the
following forms:
•
Interest on loans made
•
Profit from businesses owned
•
Rent on property owned.
Net property income is income on domestic assets owned overseas that flow into the domestic
income less income on foreign assets that flow out of the domestic economy.
Examples of property income inflows to the UK economy include income sent back to the UK in the
form of:
•
Interest on UK loans made to German companies
•
Profits made by a UK company in Russia
•
Rent paid to the UK-owned commercial property in the US.
Examples of property income outflows from the UK economy would include income sent to foreign
countries in the form of:
•
Profits made by a German car manufacturer in the UK
•
Interest paid on loans made by an Australian bank to UK businesses
•
Rent paid to Chinese owners of luxury property in London.
GNI per capita
GNI per capita is measuring GNI per head of population. GNI per capita is calculated as:
GNI / population = GNI per capita
Last year the GNI for the US was $20.84 trillion and the population of the US was 328 million
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20,840,000 million / 238 million = $63,537
Economists like to use GNI per capita when analysing national income data because it allows them to
make inter-country comparisons. A per capita figure is much smaller than the total GNI so it is an
easier number to interpret. GNI per capita is particularly useful when measuring a country’s
economic development.
Adjusting for inflation
Importance of real terms
The value of a country’s GDP is adjusted for inflation to turn the GDP in nominal terms into GDP in
real terms. Nominal GDP is expressing GDP with no allowance for inflation. Expressing economic
values in real terms is important because inflation distorts data and makes it difficult to interpret.
For example, if a country’s GDP rises by 3 per cent this would be an acceptable rate of economic
growth. But if that country’s inflation is 3 per cent then the country would not have grown at all.
Calculating real GDP
Calculating real GDP is done by dividing the nominal GDP by the GDP deflator and multiplying by
100. The table below sets out the GDP data for a country. For 2014 the real GDP is:
1792/96 x 100 = 1867
The growth rate is calculated by working out the annual percentage change in real GDP. For 2015
this would be:
1870 – 1867 / 1867 x 100 = 0.16%
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Economic Growth
Measuring growth
Economic growth is the increase in a country’s real GDP over time. The economic growth rate of a
country is the percentage increase in its real GDP over one year. GDP figures are released quarterly
so a country’s economic activity can be continuously monitored.
The annual growth rate is calculated by:
GDP current year – GDP previous year / GDP previous x 100 = current year growth rate
Business cycle (trade cycle)
Economies do not grow at a constant rate
because the rate of growth of a country
rises and falls over time and this is called
the business cycle. The average rate of
growth over a number of years is called
the trend rate of growth. Amongst more
developed countries (MDCs) the trend
rate of growth is normally around 2-3 per
cent. Diagram 3.2 illustrates a
conventional business cycle.
Conventional business cycle
Business cycles are all slightly different, but the conventional cycle normally follows the changes set
out below:
•
The boom phase occurs when the rate of growth is above the trend rate. High rates of
economic growth in a boom are normally associated with rising incomes, falling
unemployment, and rising inflation.
•
The slowdown phase of the business cycle is when the economy goes past its peak rate of
growth and the growth rate falls. Household incomes do not rise as fast, unemployment
might start to rise and there is less pressure for inflation to increase.
•
The recession phase of the cycle is when real GDP falls. A recession is technically defined as
a period of two consecutive quarters of negative growth in real GDP. Household incomes
might fall, unemployment normally increases and inflation falls
•
The recovery phase of the business cycle is when the economy emerges from a recession
and the real GDP starts to increase. The rate of economic growth is slow to start with and
then it accelerates. Household incomes start to rise, unemployment starts to fall and there is
upward pressure on inflation.
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Unit 3.1(2): Measuring Economic Development
What you should know by the end of this chapter:
•
•
•
•
Defining and measuring economic development
Appropriateness of using GDP or GNI statistics to measure
economic well-being
Use of national income statistics to make comparisons
over time and between countries
Alternative measures of well-being: OECD Better Life
Index, Happiness Index, Happy Planet Index
Defining economic development
Economic development can be defined as the improvement of the well-being of a country’s citizens
over time. Economic development is, however, difficult to define because it focuses on the
improvement in the welfare or well-being of a country’s population. Welfare or well-being are
subjective terms, which makes defining economic development as 'an improvement in well-being' an
open-ended statement that is difficult to quantify. Economists often view economic development in
a multi-dimensional way that takes into account a number of different factors.
Characteristics of economic development
Many economists look at improvements in welfare by considering the following characteristics:
•
Rising household incomes, which gives the population greater access to goods and services
that improve their material quality of life
•
Falling levels of poverty so everyone in society can enjoy a basic level of welfare
•
Increased provision of public services like education and health to give people the ability to
improve their well-being.
Many other characteristics could be considered, but these provide economists with a basic
framework to understand and measure economic development. The characteristics considered
above are based on the UN Development Programmes, Human Development Index (HDI), which we
will cover later in this chapter.
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Measuring economic development
Real GNI per capita
The principle that the higher the real GNI per capita a country has
the more advanced its economic development is based on the idea
that countries with a higher real GNI per capita will have:
•
Higher average incomes and their households have greater access to goods and services
•
Lower levels of poverty as the poorest in society have more income.
•
Better healthcare and education provision as the government has more tax revenue to
spend on public services.
This means countries with a higher
real GNI per capita will have a better
level of welfare for their population
than countries with a lower real GNI
per capita. The table sets out GNI
per capita for five More
Economically Developed Countries
(MEDCs) in 2020.
Purchase power parity (PPP)
An important element of using GNI per capita to measure economic development is to convert GNI
numbers into a common currency so they can be used for international comparison. For example, to
compare the GNI of European countries with the US, Euros need to be converted into US Dollars. We
could use market exchange rates to do this, but market exchange rates are constantly changing from
day to day because of demand and supply changes in the currency markets. A current market
exchange rate would give a misleading GNI conversion. Countries use a method called purchase
power parity(PPP) to convert their GNIs into US dollars.
The PPP is a long-term exchange rate calculated by considering the ratio of prices in one country
compared to another. A basket of goods is chosen in each country that represents the typical basket
of goods consumers buy.
Price of the basket of goods in the US/price of the basket of goods in the EU = PPP exchange rate
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Income distribution
The GNI per capita is an average and that does not account for the disparity between the richest and
poorest people in society. The GNI per capita of a country may be high, but this can give a
misleading view of welfare if there is a high concentration of income amongst a small percentage of
the richest people in society.
The nature of goods produced
Some goods produced and consumed in a country add more to welfare than others. For example,
$20 million spent on a school may well create more welfare than the same amount spent on a very
expensive yacht because the social benefit to society of the consumption of education is greater
than a yacht. Countries, where a high proportion of output is spent on luxury goods compared to
necessity or merit goods, may have lower levels of overall welfare amongst the population.
Diagram 3.3 shows the production
possibility curves for two economies,
country A and country B. Country A could
be said to have higher welfare amongst
its citizens relative to country B because it
allocates more resources to necessity
goods.
Changes in quality over time
It can be argued that economic growth understates economic
development because the quality of products produced by an
economy improves over time. The cars, computers and mobile
phones consumers buy now are superior to the cars, computers, and
mobile phones they bought 10 years ago.
This will not be reflected in the GNI figures because they only reflect the money value of the
products bought by consumers.
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3
Non-monetary factors
Some factors in a country add to welfare but cannot be measured in money terms, and so will not
show in the GDP/GNI figures. Here is a sample list of factors that can affect welfare and are not
included in real GNI per capita data:
•
Crime rates - a high crime rate will reduce welfare in a country.
•
Political Freedom - greater political freedom in a nation is often seen to increase welfare.
•
Leisure time - societies, where people have more leisure time, can offer their population a
greater quality of life.
•
Climate - favourable weather conditions can offer a better standard of living.
•
Family and cultural values - societies where people feel closer to friends and relatives are
often viewed as happier.
•
Mental health - low levels of stress, anxiety and depression are indicators of good levels of
welfare.
•
Gender and racial equality - more equal societies are often viewed as ones with higher
welfare.
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Alternative methods of measuring economic development
The real GNI per capita figure offers economists an objective figure with which to assess the
economic development of a country, but it has limitations in terms of its use to measure the welfare
or well-being of a country’s population. To consider welfare data in a wider sense, economists have
developed a range of broader-based methods of measuring economic development. Whilst these
alternative measures look at welfare in society in a more sophisticated way than GNI, they do have
weaknesses. As they are averages they do not reflect everyone’s well-being and they try to measure
things that are very difficult to measure, like collective happiness.
Human development index (HDI)
The Human Development Index is used by the United Nations
Development Programme to measure a country's economic
development in terms of life expectancy, education, and material
standard of living.
The following criteria are used in the construction of the HDI:
•
•
•
Life Expectancy in years (health indicator)
Mean years of schooling and expected years of schooling (education indicator)
Real GDP per capita (income indicator)
The three criteria are combined to give a numerical value from 0-1, where the HDI value is closer to
1 the more developed a country is.
OECD Better Life Index
The Organisation for Economic Co-operation and Development has developed a broader measure of
well-being which looks at some of the key factors that affect the welfare of a nation’s
population. The Better Life Index uses 11 criteria that are objectively measured in a country to form
an index number. The criteria include:
•
•
•
•
•
•
•
•
•
•
•
Housing
Income
Employment
Community life
Education
Environmental factors
Governance
Health
Level of happiness
Safety and security
Work-life balance
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World Happiness Report
Along with the Human Development Index, the United Nations has also
developed the World Happiness Report based on a survey of how
people rate their own lives. The survey ranks national happiness using a
survey that asks a sample of respondents to think of their happiness as
a ‘ladder’, with the highest life rating being a 10 and the lowest life
rating being a zero.
The individuals who are part of the survey have to consider factors such as citizen engagement,
communications, technology, education, health, emotion and diversity, etc when they are making
their judgement about happiness. The responses of a sample of individuals within a country are then
aggregated to form the index.
Happy Planet Index
The Happy Planet Index measures sustainable well-being for a nation’s population. It considers the
welfare of a nation in terms of achieving sustainable lives for its citizens. It was introduced by the
New Economics Foundation (NEF) and uses a weighted index that favours countries with smaller
ecological footprints. There are four elements used to construct the Happy Planet Index: wellbeing
(based on the World Happiness Report), life expectancy, inequality of outcomes (based on wellbeing
and life expectancy) and ecological footprint (average impact a citizen on the environment).
Costa Rica is a country that has always performed well in Happy Planet Index. Its relatively good
scores on life expectancy, wellbeing, ecological footprint and inequality give it a Happy Planet Index
score of 44.7 well above its richer neighbour, the United States.
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Unit 3.2(1): Variations in economic activity - aggregate
demand (AD)
What you should know by the end of this chapter:
•
•
•
•
•
•
•
•
Definition of aggregate demand
Aggregate demand curve
Components of aggregate demand
Consumption
Investment
Government expenditure
Net exports: exports minus imports
Changes in aggregate demand caused
by changes in its determinants
Determining economic activity
The level of economic activity in a country is measured by its real GDP which is determined by the
interaction of aggregate demand and aggregate supply of the whole economy. Changes in aggregate
demand and aggregate supply determine the rate of economic growth an economy achieves. For
example, the value of the US GDP is over $19 trillion because of the interaction of aggregate demand
and aggregate supply in the American economy. The application of aggregate demand and supply is
another way of modelling the macroeconomy, similar to the circular flow of income model. The flow
of income, output, and expenditure of an economy in the circular flow model is determined by the
interaction of aggregate demand and aggregate supply.
Definition of aggregate demand
Aggregate demand is the total expenditure on all goods and services produced in the economy at a
given price level and at a given point in time.
Aggregate demand is made up of the following components:
AD = consumption + investment + government expenditure + exports – imports
AD = C + I + G + (X – M)
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The Aggregate Demand Curve
The Aggregate demand curve shows the relationship between the average price level of an economy
and the demand for the real output or GDP of the economy. The average price level of the economy
is the average price of all goods and services produced in an economy at a given point in time.
The relationship between aggregate
demand and the average price level can
be viewed in the same way as the
microeconomic theory of the law of
demand for a good in a particular market.
If the price of mobile phones falls, the
quantity demanded increases. In the
same way, a decrease in the average price
level in the macroeconomy leads to an
increase in the aggregate demand for the
real output of the economy and if the
average price level increases the
aggregate demand for the real output decreases.
One way of explaining this is that a fall in the average price level means households, firms,
government, and the foreign sector can now buy more of the domestic output of the economy with
the same real income. Diagram 3.3 shows how a fall in the average price level in an economy causes
an increase in aggregate demand for the real output of the economy. If there is a rise in the average
price level this means households, firms, government and foreign sectors can buy less of the
domestic output of the economy with the same real income.
Consumption (C)
Definition of consumption
Consumption is household spending on final goods and services. Some goods are intermediate such
as manufacturers selling goods to retailers and this spending is not included in consumption.
Consumption spending would be spending on goods and services like food, energy, consumer
electronics products, cars and leisure activities, etc. Consumption spending in More Economically
Developed Countries (MEDCs) accounts for around 70 per cent of total GDP and is even higher than
this in Economically Less Developed Countries (ELDCs).
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Determinants of consumption
Household income and consumption
There is a positive relationship between consumption and household income. As household incomes
rise, households spend more on normal goods. This includes necessities such as food and energy, as
well spending on luxuries such as new cars and holidays. We know from our microeconomic analysis
that the strength and type of relationship between income and consumption changes depending on
the type of good and its income elasticity of demand.
Interest rates
An interest rate is the cost borrowers pay for borrowed funds and the
reward lenders receive for lending funds (the cost of borrowing and the
reward for lending).
There is a negative relationship between consumption and interest
rates. When interest rates rise consumption decreases and when
interest rates fall consumption increases.
The relationship between interest rates and consumption exists for the following reasons:
•
The cost of borrowing for expensive goods (cars, home improvements, etc.) increases when
interest rates rise and spending for these types of ‘big ticket items’ falls.
•
The reward for saving increases as interest rates rise which increases households desire to
save rather than spend.
•
The cost of existing borrowing, particularly mortgage payments for house purchase, increase
as interest rates rise and this leaves households with less disposable income for
consumption.
Note: the opposite effect occurs when interest rates fall.
Consumer confidence
Consumer confidence is household expectations of their future economic prospects. Consumer
confidence has a significant impact on current consumption spending. If households feel pessimistic
about their job prospects or future incomes, they will reduce current consumption and consumption
rises if they feel optimistic.
Economists see consumer confidence as an important ‘leading indicator’ because it tells them what
might happen to economic growth in the future. In the US consumer confidence is measured by the
CCI which is a survey of households produced by the Conference Board.
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The ‘credit crunch’ in 2008 led to a huge fall in US consumer confidence which reduced household
spending which in turn contributed to falling growth in GDP and this led to a recession in the US.
Household indebtedness
Indebtedness is the value of current household borrowing. The higher the value of debt households
hold the lower their current level of consumption. This is because households have less money for
current consumption if they need to repay debt and have high-interest payments to make on their
outstanding debt.
Wealth
Household wealth is the value of assets households own. These are assets that can be held in the
following forms: cash, property and shares, etc. The most important asset for most households in
the economy is the house they own.
When house prices rise people feel wealthier and this increases their consumption spending. House
prices in the UK increased dramatically from 2011 until 2016 leading to a significant increase in
household wealth which caused a rise in consumption spending in the UK.
If house prices fall households feel poorer and this can lead to a fall in consumption. It was the fall in
US house prices in 2006 that triggered a fall in consumption in the US which was one of the
contributing factors to the recession in the US in 2008 and the subsequent global financial crisis.
Inflation
Inflation can have two different effects on consumption:
•
Rising prices can make consumers bring forward purchases and increase consumption. This
is because waiting to buy goods when they will increase in price in the future makes the
goods more expensive and households will consume more in the present.
•
If prices rise because of increasing costs, this erodes household disposable income and
causes a fall in consumption spending. This is particularly the case if the price of necessities
such as food and energy increases.
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Investment (I)
Definition of investment
Investment is where resources are allocated to produce capital
goods that can build up the future productive capacity of an
economy. Investment is an injection into the circular flow of
income. Economists normally consider investment in terms of
firms buying new plant and machinery. For example, Apple’s
investment spending last year was $16 billion.
Types of investment
Investment spending by organisations can be categorised in five different ways:
•
Fixed investment is where firms purchase plant and machinery. For example, Toyota plans
to build a new electric vehicle plant worth $1.2 billion in the Chinese city of Tianjin.
•
Human investment means that firms allocate resources to education and training which are
used to increase the productive capacity of labour.
•
Research and development is investment in new products and processes. Research and
development account for 7.9 per cent of Apple’s revenue and it spent $14 billion on R&D last
year.
•
Social investment involves allocating resources that can improve the future welfare of a
country’s citizens. Building new schools and hospitals have significant social benefits for
society in the long term.
•
Infrastructure investment means allocating resources to the major physical systems that
serve a country’s population. Infrastructure investment is in areas like energy, transport,
water and waste, flood management and digital communications.
Determinants of Investment
Economic growth and investment
A certain amount of investment takes place in an economy and is not affected by changes in
GDP. Firms often plan major projects years in advance and unless there is a significant drop in
economic growth the projects go ahead regardless of changes in GDP. Replacement investment is
also less affected by changes in economic growth. This is where firms have to replace worn-out
capital and it needs to take place for a firm to operate efficiently.
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Some investment is responsive to changes in GDP. As the economy grows (particularly if the rate of
growth increases) businesses will invest in new capital because they need to increase output to meet
an increase in demand. This is particularly true for firms that sell products with a high positive
income elasticity of demand. For example, service sector businesses like restaurants, cinemas and
gyms will increase investment in new capital to meet a rise in demand when household incomes rise.
Business confidence
Business confidence is manager’s expectations of future profits
and sales. It is important in determining investment decisions. If
managers anticipate a rise in future economic growth, they are
much more likely to decide to open a new factory and buy capital
equipment. Business confidence in different countries is often
measured by using the Purchasing Managers Index (PMI)
Availability of funds
At a macroeconomic level, the funds available for the economy to invest in are determined by the
level of savings. Household savings goes to the banking system and banks then lend these funds to
firms to invest. The higher the level of savings of households the more funds there are for
investment and the greater the amount of investment there will be at a macroeconomic level.
The profits earned by businesses are a major source of funds for firms and the more profits
businesses earn the higher the level of investment. The amount of bank lending affects how much
money firms can access to fund investment projects. The financial crisis of 2008 saw banks cut their
lending dramatically to businesses which reduced the level of investment in many economies.
Interest rates
Because so many investment projects are funded partly or entirely by borrowed funds the rate of
interest has a major effect on their viability. At relatively high rates of interest the cost of borrowing
increases which reduces the profit stream from an investment project which makes the project less
likely to go ahead. High-interest rates also offer firms a relatively good rate of return on holding
funds in the bank so the rate of return of a project has to be greater than the rate of interest funds
could earn in the bank. If interest rates fall then investment rises because the cost of funding
projects falls and the alternative return from holding funds in the bank decreases.
Corporate indebtedness
Indebtedness is the value of borrowing firms currently have. The amount firms can borrow is
reduced if they carry a high level of debt. Large business debts have high-interest costs and make
banks reluctant to lend to firms.
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Government expenditure (G)
Types of government expenditure
Government expenditure has an important influence on macroeconomic activity. Most government
spending accounts for between and 30 and 40 per cent of GDP. Government expenditure is an
injection into the circular flow of income. There are three types of government expenditure in the
economy:
•
Current expenditure on the day-to-day running of the government sector such as paying the
wages of teachers, doctors and military personnel.
•
Capital expenditure on investment projects financed by the government such as roads,
bridges and schools.
•
Transfer expenditure on welfare payments such as unemployment and housing benefits. It
is important to note that government transfer spending is not included as part of aggregate
demand because there is no productive return for the spending by the government.
Determinants of government expenditure
Fiscal policy
Fiscal policy is where government expenditure and taxation are used to achieve a government’s
economic objectives. These objectives include areas such as sustainable economic growth, price
stability, full employment, and balance of payments equilibrium. Government plan their level of
expenditure to achieve these objectives. For example, the government might increase expenditure
to increase economic growth if the economy is in a recession.
Taxation
The amount of money a government can raise through taxation will have a major influence on the
amount governments can spend. Rich developed countries collect more money through direct and
indirect taxation and this enables them to spend more on public services like health and education
than economically less developed countries. The more tax the government can raise the more it can
spend.
Borrowing
When government expenditure is greater than tax revenue the
government needs to borrow money. This is done by selling
bonds in the financial markets. For example, if the US
government sells $500 billion of government bonds, then it will
raise $500 billion in funds to spend on health, education and
defence, etc.
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Investors buy bonds because they earn interest on them and they will be repaid in the future. The
bonds can also be bought and sold on the financial markets. The budget deficit is one year’s
government borrowing and accumulated government borrowing over time is called the national
debt. The current US budget deficit is $2.5 trillion, and the national debt is $25 trillion.
Political objectives
The political objectives of the government will affect the level of expenditure. Left-wing
governments tend to believe in more state involvement in the economy will spend more than rightwing governments.
Net Exports (X-M)
Defining net exports
A country’s net exports are the value of its exports (X) less the value of its exports imports (M). A
positive value for net exports leads to a net inflow of funds into the economy and a negative net
export value leads to a net outflow of funds from the domestic economy.
Exports
Exports are domestically produced goods and services sold in overseas markets that generate an
inflow of funds into the domestic economy. Exports are an injection into the circular flow of income.
Imports
Imports are goods and services produced overseas and sold in the domestic economy that generate
an outflow of funds from the domestic economy. Imports are a withdrawal from the circular flow of
income.
Determinants of net exports
Net exports will change if there is a change in the value of exports and imports.
Economic growth in overseas markets
If there is strong economic growth in overseas markets this will lead to a rise in exports as foreign
households have more income to spend on imported goods (exports) from other countries. The
reverse is true if overseas markets are in recession and foreign households have less income and buy
fewer imported goods (exports) from other countries.
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Economic growth in domestic markets
If domestic economic growth rises households will have rising incomes and will spend more on
imports and this will lead to a fall in net exports. If domestic growth falls household spending on
imports will fall because households will have lower incomes and will buy fewer imported goods
which leads to a rise in net exports.
Exchange rate
If the domestic exchange rate falls, domestic exports may rise as domestic export prices fall in
overseas markets. A fall or (depreciation) in the exchange rate will also lead to a rise in import prices
which may lead to a fall in import expenditure. If the exchange rate rises (appreciates) domestic
goods will rise in price overseas and the demand for exports will fall. A rise in the exchange rate will
cause a fall in the price of imports and a rise in demand for them.
Trading strength
Some countries perform better in international markets than
others. China, Germany and Japan have very strong
manufacturing sectors and have a positive next export value. On
the other hand, countries like the US and UK have weaker
manufacturing sectors and have a negative net export value.
Changes in aggregate demand
Aggregate demand will change if any
one of consumption, investment,
government expenditure and net
exports change. A change in the
components of aggregate demand will
cause the aggregate demand curve to
shift. Diagram 3.4 shows an increase in
aggregate demand and the aggregate
demand curve in the economy shifts
from AD to AD1 changes. A decrease in
aggregate demand is also shown by a
shift in the aggregate demand curve
from AD to AD2.
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Examples of factors that may cause a change in AD:
Decrease in interest rates
If interest rates fall this leads to a rise in consumption and investment as households and firms
respond to lower borrowing costs and this, in turn, leads to a rise in aggregate demand. AD shifts to
AD1 in diagram 3.4.
Fall in business and consumer confidence
If households and firms become less confident about their future economic prospects, then
households will reduce consumption and firms will reduce investment leading to a fall in aggregate
demand and AD shifts to AD2 in diagram 3.4.
Increase in government expenditure
If government expenditure increases as part of expansionary fiscal policy this will lead to a rise in
aggregate demand. This causes AD to shift to AD1 in diagram 3.4.
Rise in net exports
If a country’s exchange rate depreciates and it experiences a rise in exports and a fall in imports,
then aggregate demand will increase, and AD will shift to AD1 in diagram 3.4.
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Unit 3.2(2): Variations in economic activity - aggregate supply (AS)
What you should know by the end of this chapter:
•
•
•
•
•
•
•
•
•
•
•
Defining aggregate supply
Short-run aggregate supply (SRAS) curve
Determinants of short-run aggregate supply
Changes in short-run aggregate supply
Short-run equilibrium national income
Monetarist/new classical view of the long-run
aggregate supply curve (LRAS) curve
Long-run equilibrium at full employment level of output
Inflationary and deflationary/recessionary gaps
Keynesian view of the aggregate supply curve
Equilibrium in the Keynesian model
Changes in aggregate supply over the long run
Definition of aggregate supply
Aggregate supply is the total quantity of all goods and services the economy can produce at a given
price level and in a given time period. At a microeconomic level, we consider the supply of a
particular good in a market produced by all the firms in that market. Aggregate supply adds together
the supply of goods from all the markets in the economy. Aggregate supply is made up of the output
of all the different types of producers in the economy from small and medium-sized enterprises
(SMEs) up to multinational corporations (MNCs) and state-run industries.
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Short Run Aggregate Supply (SRAS)
Definition of the short run
The short-run in this model is the time period when the price level in the economy can change but
the cost of factors of production is held constant.
The short-run aggregate supply curve
There is a positive relationship between
the average price level and the short-run
aggregate supply curve. As the average
price level rises firms will increase output
to take advantage of higher profits from a
higher price level and a higher price
covers the cost of increasing output.
Diagram 3.5 shows how an increase in the
average price level from P to P1 leads to a
movement along the short-run aggregate
supply curve and real output increases
from Y to Y1.
Changes in the short-run aggregate supply
The short-run aggregate supply curve will
shift if there is a change in business costs
brought about by a change in the price of
resources. If wage rates or the cost of raw
materials fall then the short-run
aggregate supply curve will shift to the
right from SRAS to SRAS1 in diagram 3.6.
If wage rates rise or the cost of raw
materials rises, then the short-run
aggregate curve will shift to the left from
SRAS to SRAS2 in diagram 3.6.
Changes in indirect taxation can also cause shifts in the short-run aggregate supply. If a country
increases its rate of VAT from 20 per cent to 25 per cent then aggregate supply will fall and the
short-run aggregate supply curve will shift to the left.
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Short-run equilibrium national income
The short-run equilibrium national income is the real GDP of a country determined by the
interaction of short-run aggregate supply and aggregate demand. When aggregate demand equals
short-run aggregate supply in the economy achieves the equilibrium national income (real GDP) and
the equilibrium average price level.
Changes in short-run equilibrium
A change in either aggregate demand or supply will cause a change in the equilibrium level of
national income (real GDP).
Change in aggregate demand
For example, a reduction in income tax
on households leads to a rise in their
disposable income. This leads to an
increase in consumption and a rise in
aggregate demand. The aggregate
demand curve shifts from AD to AD1 in
diagram 3.8 leading to a rise in the
average price level from P to P1 and an
increase in real GDP from Y to Y1.
Change in short-run aggregate supply
For example, short-run aggregate supply
might fall and shift to the left because of
a rise in the minimum wage in an
economy which increases business
costs. This causes SRAS to shift to SRAS1
in diagram 3.9 and the equilibrium real
GDP falls from Y to Y1 and the
equilibrium average price level rises from
P to P1.
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Monetarist/Neo-Classical Long-run aggregate supply (LRAS)
Definition of the short-run
The long-run in this model is the time period when the price level in the economy can change and
the cost of factors of production can change. This means short-run changes in aggregate demand
and supply can lead to changes in the costs of factors of production which cause further adjustments
in the average price level and real GDP.
Full employment national income
The long-run aggregate supply curve is based on the full
employment income of the economy. This is the level of
national income where all resources available in the
economy are being fully utilised. We normally talk about
this in terms of full utilisation of labour and capital. In
reality, there is never zero unemployment or full
utilisation of productive capacity such as shops, office
space and factories. An economy at full employment will
have a very low level of unemployment and a low level
of under-utilisation of offices, factories and shops.
The level of unemployment associated with full employment is called the natural rate of
unemployment. In diagram 3.10 the full employment level of national income is shown by the
vertical long-run aggregate supply curve at YFE.
Long-run aggregate supply at full employment
The long-run aggregate supply curve is vertical at the full employment level of national income
because Monetarist/Neo-classical economists believe the short-run equilibrium level of national
income will always adjust towards full employment in the long run. This adjustment process can be
looked at from two short-run equilibrium situations.
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From a deflationary gap
Diagram 3.10 shows how the economy adjusts back to full employment when there is a decrease in
aggregate demand after initially being in short-run equilibrium at full employment:
•
Aggregate demand falls in the
economy because, for example,
there is a decrease in business
and consumer confidence which
causes consumption and
investment to fall.
•
As aggregate demand falls the
short-run equilibrium level of
national income falls from Y to Y1
and the average price level falls
from P to P1.
•
The economy now has a deflationary gap where short-run equilibrium national income is
below the full employment level of national income and this is shown by the distance YFEY1.
•
Wages, business costs and prices fall in the long run because of the deflationary conditions
in the economy. For example, a rise in unemployment means there is surplus labour supply
and wages fall.
•
The fall in wages, costs and prices cause the short-run aggregate curve in the economy to
increase and shift to the right from SRAS to SRAS1, causing the short-run equilibrium income
to settle back at full the full employment income at YFE at price level P2.
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From an inflationary gap
Diagram 3.11 shows how the economy adjusts back to full employment when there is an increase in
aggregate demand in the economy when it has started at full employment:
•
Aggregate demand rises in the
economy because of an increase
in consumption and investment
as a result of, for example, a cut
in central bank interest rates
•
As aggregate demand rises the
short-run equilibrium level of
national income rises from Y to
Y1 and the average price level
rises from P to P1
•
The economy now has an inflationary gap where short-run equilibrium national income is
above the full employment level of national income. This means unemployment has fallen
below its natural rate which could be from a rate of 4 per cent to a rate of 3 per cent
•
Wages, business costs and prices rise in the long run because of inflationary conditions in
the economy. Low unemployment leads to a shortage of labour which drives up wages
•
The rise in wages, business costs and prices causes the short-run aggregate curve in the
economy to decrease and shift to the left from SRAS to SRAS1, causing the short-run
equilibrium income to settle back at full the full employment income YFE at price level P2.
Movements of the long-run aggregate supply curve
The long-run aggregate supply curve will
shift if there is a change in the potential
output of the economy. In most cases,
this is a shift outwards as the potential
output of the economy increases.
Diagram 3.12 shows a shift in the LRAS
curve to the right in response to an
improvement in the productive capacity
of the economy. As the LRAS shifts to the
right, the real GDP of the economy rises
from Y to Y1 and the average price level
falls from P to P1.
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Long-run aggregate supply can shift outwards if there is an:
•
Increase in the number of workers in the labour force because of migration.
•
Improvement in the skill level of the labour force because education and training increase
labour productivity.
•
Increase in capital available in the economy because of new investment.
•
Improvement in production technology such as the use of artificial intelligence and robot
technology on production lines.
•
Increase in the availability of a new natural resource such as the discovery of oil and gas.
•
Improvement in the output from existing natural resources resulting from technological
improvement such as the use of genetically modified crops.
The long-run aggregate supply curve can fall if the potential output of the economy goes down. This
could have occurred if there was a war or a natural disaster where capital is destroyed.
Keynesian aggregate supply curve
The Keynesian aggregate supply curve
was developed by the economist, John
Maynard Keynes. It is different from the
Neo-classical/Monetarist view which
looked at aggregate supply in separate
time frames. In the Keynesian theory,
there is a single aggregate supply curve
and it does not distinguish between time
frames. Some economists refer to the
Keynesian aggregate supply curve as a
long-run aggregate supply curve.
Phases of the Keynesian aggregate supply curve
The Keynesian aggregate supply curve shown in diagram 3.13 can be broken down into 3 phases:
Phase 1
When output is below Y in diagram 3.13, the economy has spare capacity and output can increase
and decrease without any change in the price level. Below Y the economy has a deflationary gap
and is operating below the full employment level of national income. In this situation the economy
would have high unemployment and capital would be under-utilised. These macroeconomic
conditions are typical of a recession. When aggregate demand changes on this section of the
aggregate supply curve real GDP will change but the average price level will stay the same.
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Phase 2
From Y to Y1 in diagram 3.13, the economy is approaching full employment and some industries are
nearing full capacity. In this section, any change in aggregate demand will lead to a change in output
and the average price level. If aggregate demand rises, real GDP will increase and so will the average
price level. Rising demand in the economy on this section of the Keynesian aggregate supply curve
will mean some industries nearing full capacity will experience price increases and this will increase
the average price level in the whole economy.
Phase 3
When the economy is at Y2 it has reached full employment. There is no spare productive capacity
and the economy has very low levels of unemployment. The economic conditions in this phase of
the aggregate supply curve are typical of an inflationary gap. When aggregate demand changes real
output does not change but the price level does. If aggregate demand increases at Y2 there will be a
significant increase in the average price level and a rise in inflation.
Difference between the Keynesian and Neo-Classical/Monetarist
view
One of the key issues that arise from the Keynesian aggregate
supply curve is that the economy cannot self-correct when
there is a deflationary gap. This is the key difference between
Keynesian and the Neo-classical/Monetarist aggregate supply
model.
Keynes argued that wages and costs do not fall when there is a deflationary gap because of
minimum wage legislation, trade union activity and firms would prefer to cut jobs rather than wages
in a recession.
Keynesian economists say wages are ‘sticky downwards’ because these pressures stop wages from
falling when aggregate demand decreases in a deflationary gap situation. This means the economy
cannot self-correct as it does in the Neo-classical/Monetarist model where wages and costs fall
causing the short-run aggregate supply to increase and the equilibrium income to return to full
employment.
Implication for policymaking
Because the economy does not self-correct in the Keynesian model, Keynesian economists argue
that the government has to intervene in recessions to bring the economy back to full employment
by using expansionary fiscal policy. For example, if an economy goes into recession and gets into a
negative feedback cycle where rising unemployment leads to falling aggregate demand then this
might cause the economy to get stuck at a level of real income significantly below full employment.
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In this situation, there is a strong case for government intervention using expansionary fiscal policy
to bring the economy back to full employment. It can also be argued that the Monetarist view that
the economy self-corrects might take such a long time (a period of years) that it would be very
damaging to the economy during the period when it is correcting. Once again, there is a case for
expansionary fiscal policy.
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Unit 3.3(1) Macroeconomic objectives: economic growth
What you should know by the end of
this chapter:
•
•
•
•
•
•
•
•
Understanding economic growth
Measurement of economic growth
Short-term growth
Actual output
Long-term growth
Potential output
Interpreting growth using the PPC model
Consequences of economic growth for living standards, the environment and income
distribution.
Understanding economic growth
Economic growth is the increase in a country’s real GDP over a given time period. This is normally
one year although governments release growth data quarterly so they can continuously monitor
changes in macroeconomic activity. Economic growth means the money value of goods and services
produced by an economy is increasing over time.
Measuring economic growth
The growth rate of an economy is measured as the annual percentage change in the real GDP of a
country. The calculation of real GDP using the GDP deflator is covered in detail in Unit 3.1(1). The
economic growth rate for a country in 2020 is calculated using the equation:
real GDP 2020 – real GDP 2019 / real GDP 2019 x 100 = 2020 economic growth rate
For example, if an economy had the following real GDP data: real GDP 2019 $960 billion, real GDP
2020 $983 billion
$983 billion - $960 billion / $960 billion x 100 = 2.4%
Short-run economic growth
The short-run in macroeconomics is the time period when the price level in the economy can change
but the cost of factors of production is held constant. Short-run economic growth is determined by
changes in aggregate demand and short-run aggregate supply. When there is economic growth in
the short run it is described as a change in actual output.
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Actual output
The actual output of the economy is the
level of output the economy achieves
with its current resource utilisation. It is
the value of goods and services produced
by an economy with the land, labour,
capital and enterprise available. This
increase in actual output can also be
shown in diagram 3.14 with a movement
from A to B inside the production
possibility curve.
A rise in actual output in the diagram could be caused by an increase in aggregate demand which
shifts from AD to AD1 and this causes real GDP to rise from Y to Y1 in diagram 3.15.
Actual output will increase if:
•
There is an increase in aggregate
demand and firms produce more
and this increases the utilisation
of available resources
•
Firms experience a fall in
production costs which causes the
short-run aggregate supply to
increase.
Long-run economic growth
The long-run in macroeconomics is the time period when the price level in the economy can change
and the cost of factors of production can change. In the long-run economic growth occurs because of
an increase in potential output.
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Potential output
The potential output of the economy is
the output the economy can achieve if its
resources are fully employed. This is the
economy’s output from the full utilisation
of labour and capital. In reality, the
economy will not achieve this level of
output because there will always be
some unemployed labour and some
unused capital. The economy is operating
at its potential output on the production
possibility curve which is shown in
diagram 3.16 at point F on PPC and point
G on PPC1.
The potential output of an economy will
increase if there is an increase in the
available resources and an increase in the
productivity of the existing available
resources. An increase in the potential
output which leads to long-run economic
growth is shown by the shift outwards of
the production possibility curve from PPC
to PPC1 in diagram 3.16. It can also be
shown by an outward shift in the longrun aggregate supply curve in diagram
3.17.
The following factors could lead to an increase in potential output and long-run economic growth:
•
If new natural resources such as oil and gas are discovered or if existing resources can be
exploited in a new way, such as the use of genetically modified crops.
•
When new labour becomes available in an economy through changes in the birth rate or
immigration.
•
An improvement in labour productivity because of an increase in the skill level of the
workforce through education and training.
•
New investment by firms (factories and equipment) and governments (infrastructure).
•
Improvements in the productivity of capital are brought about by technological advances in
production such as the use of AI and robots on the production line.
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Benefits of economic growth
Household income
Rising household incomes that result from rising real GDP mean people can afford to buy more
goods and services and this increases their material standard of living. The circular flow of income
model illustrates how a rise in real output will also lead to an increase in household incomes.
Reduced levels of poverty
Rising incomes for the poorest people in society may lead to a reduced level of poverty as people
can afford the goods and services needed to satisfy their basic needs.
Great availability of goods and services
Economic growth means more goods are produced and are available for households to buy. The
growth in the availability of televisions, mobile phones, washing machines cars and computers to
people on average incomes shows how growth improves people’s material living standards.
Improved public services
Economic growth means firms and households earn
more income and pay more direct tax and they also
spend more and pay more indirect tax. The higher tax
revenue earned by governments because of
economic growth means there is more money for
them to spend on public services like education,
healthcare and infrastructure.
Greater employment
The output of businesses increases as the economy grows which means more jobs are created and
this increases the level of employment in the economy.
Costs of economic growth
Sustainability
Economic growth can increase consumption and production negative externalities. Businesses
increase output which increases industrial pollution and increased consumption of goods and
services by households leads to consumption external costs. This means current economic growth
can have a negative impact on the welfare of people in the future.
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Income disparities
As economies grow income disparities often increase as
higher-income households experience a rate of increase in
income that is greater than the rate of increase in income
of lower-income households. Without government
intervention to correct inequalities through the tax and
benefit system some of the richest countries in the world
would have the widest income inequalities.
Inflation
An increase in real GDP that occurs because of an increase in aggregate demand will lead to an
increase in the average price level in an economy. This may lead to an inflationary gap and demandpull inflation when the economy is operating close to or at full employment.
Balance of payments current account deficit
Economic growth caused by rising aggregate demand can lead to a balance of payments deficit. As
economic growth leads to rising household incomes people will buy more goods and services and a
proportion of them will be imported. The rise in imports can lead to an increased balance of
payments current account deficit.
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Unit 3.3(2) Macroeconomic objectives: unemployment
What you should know by the end of this chapter:
•
•
•
•
•
Measuring unemployment and the unemployment rate
Difficulties of measuring unemployment
Causes of unemployment: frictional, structural, demand deficient,
seasonal, regional
Natural rate of unemployment
Costs of unemployment
Understanding unemployment
Unemployment is normally thought of as an economic problem that
faces all countries to a greater or lesser extent. It is also a challenge
to countries that are constantly changing over time. During
recessions, unemployment tends to rise and can become a serious
social and economic problem. In times of economic growth,
unemployment can fall and not be such a significant issue.
Long periods of high unemployment in countries can be very difficult for the individuals and
communities affected by it.
Definition of unemployment
Unemployment is the count of jobless people in a country who are seeking work but who do not
have a job. Unemployed people need to be in the labour market looking for work and not just be
people of working age who are not working. For example, full-time university students are of
working age and not working, but they are not unemployed because they have not entered the
labour market to look for work.
Rate of unemployment
Unemployment can be expressed as a total number such as 3 million people in a country or it can be
expressed as the percentage of the labour force (unemployment rate). The rate of unemployment is
a better statistic to make comparisons of unemployment between countries and changes over time.
The unemployment rate is the percentage of the labour force that is unemployed and is calculated
as: Number of unemployed / working population x 100 = unemployment rate
For example, if there are 28 million people in a country's labour market and the number of
unemployed is 1.9 million then the unemployment rate would be: 1.9m / 28m x 100 = 6.8%
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The labour-force
The labour force is made up of people in work and people who are unemployed. In all countries, this
leaves a proportion of people of working age who could work but who are not in the labour force.
This is made up of:
•
Homemakers (housewives and househusbands)
•
Carers – people looking after elderly or disabled people
•
Students
•
Early retired
•
Discouraged workers (people who have given up looking for work)
When people of working age are outside the labour market are added to the unemployed, we get
what economists call the ‘economically inactive’. This is a somewhat misleading term as people
who look after their children or elderly relatives are doing work that has significant economic value.
Measuring unemployment
Unemployment is difficult to measure. The labour market is constantly changing as people enter and
leave work as well as enter and leave the labour force. For example, people enter the labour market
when they finish school and university and leave the labour market when they retire. Taking a ‘snapshot’ picture of the number of unemployed at any one time is challenging.
There are two ways of measuring unemployment:
The claimant-count
This is the number of people who are claiming unemployment benefits in a country. The claimant
count unemployment figure for a country might be 3.65 million people. This measure, however,
under-estimates the number of unemployed because many unemployed people do not claim
benefits. This may be because they are only unemployed for a short period of time and do not want
to spend time claiming benefits, alternatively, some people have too much money in savings which
means they do not qualify for unemployment benefits.
International labour force survey (ILO)
The ILO measure of unemployment is a survey of households to establish how many people are
unemployed. The survey reports a higher number than the claimant count because it includes those
who cannot or choose not to claim benefits. It is, however, subject to a statistical error because it is
impossible to survey the whole population. The current ILO measure for unemployment for a
country with a claimant count number of 3.65 million might be 4.5 million.
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Underemployment or hidden unemployment
Some people in the economy may be working but their work might be considered underemployment
and it can mask the true level of unemployment in a country.
It can take the following forms:
Part-time work
This is where people work part-time but would like full-time or to work longer hours. These people
will not be recorded in the unemployment data.
Low marginal product
Some people may work in a job that has such a low marginal product that they cannot be considered
to be working in the normal way. People might be trying to make a living as street vevendorselling
cheap gifts to tourists, but the money they earn is so small that it is difficult to count them as
employed.
Over-qualification
Some highly qualified workers take jobs that are below their level of qualification. This might be
someone who is a qualified doctor who cannot find work as a doctor so they take a job as a taxi
driver instead.
The problems of measuring unemployment
Unemployment data is very important to governments and it is a key indicator of welfare in a
country. Low unemployment is a government macroeconomic objective and it is used as a guide for
policymaking. There are, however, problems with accurately measuring unemployment. These
include:
•
Deciding who is in the labour force is problematic. Some students, for example, may take a
university place because they cannot find a job which means they would not be recorded in
the unemployment data.
•
The under-employed will not be in the unemployed data but they may be considered to be
unemployed in all but name. A qualified lawyer, for example, who can only find part-time
work in a bar.
•
The ILO measure is only a survey so it carries a statistical error.
•
The claimant account measure under-estimates the level of unemployment because some
unemployed people do not claim benefits.
•
Some people claim unemployment benefits and be in the claimant count figure, but they are
working illegally.
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•
The unemployment figure for a country does not tell you about the concentration of
unemployment in different parts of the economy. This could be by region, people of
different genders and ages, along with people of different ethnic groups.
The labour market
The market for labour as a factor of production works in a
similar way to the market for a good service. The price of
labour (wage rate) and the number of people employed is
determined by the demand and supply for labour. The
labour market is in equilibrium when the demand for labour
equals the supply of labour. The labour market can be
looked at from the perspective of the whole economy or
from individual markets within the economy.
Diagram 3.18 shows the equilibrium in the labour market for the whole economy where the
aggregate demand for labour equals the aggregate supply for labour.
Demand for labour
The demand for labour comes from firms
and organisations that employ workers.
Economists derive the aggregate demand
for labour, ADL in diagram 3.18 by adding
together the demand for all the different
types of work in an economy such as
doctors, journalists, taxi drivers and car
manufacturing, etc. It is a derived
demand because firms demand workers
for what they can produce for them.
The demand for labour can be defined as the number of workers a firm is willing and able to hire at a
given market wage rate and at a particular point in time.
In a similar way to the law of demand applies to the goods market, it also applies to the labour
market. As the wage rate falls quantity demanded for labour rises and if wages rise the quantity
demanded for labour falls.
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Supply of labour
The supply of labour is the number of people who will are willing and able to take a job at a
particular market wage rate and at a given point in time. For analysis across the whole economy, we
aggregate (total) the labour supply across all the different labour markets in the same way as
demand. The aggregate supply curve for labour is shown as ASL in diagram 3.18. Similar to the law of
supply in the market for goods and services, as wages rise the quantity supplied of labour increases.
At higher wages there is a greater incentive for individuals to enter the labour market to take a job
and workers will also be prepared to work longer hours. If wages fall the opposite is true and the
quantity supplied of labour decreases.
Changes in the labour market equilibrium
If either the demand for labour or the
supply of labour changes then the wage
rate in the labour market and the quantity
of labour employed will change. For
example, if there is a fall in demand for
workers across the economy in a
recession the aggregate demand for
workers will fall.
In diagram 3.19 the demand for workers falls from ADL to ADL1 and the quantity of workers
employed falls from QL to QL1 and the equilibrium wage rate falls from WL to WL1.
Disequilibrium in the labour market
Many governments in the world use a
minimum wage to try and protect workers
on low incomes and reduce income
inequality in the labour market. This is
shown in diagram 3.20. When the
minimum wage is above the equilibrium
wage rate the quantity supplied of labour
is greater than the quantity demanded
and a surplus exists in the labour market.
This is shown by the distance QL1 – QL2 in
diagram 3.20.
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Some economists argue that minimum wages can lead to unemployment, although the evidence on
this is mixed. Minimum wages are often used to prevent unscrupulous employers from paying very
low wages and gaining a competitive advantage. Minimum wages can also increase wages in the
economy and act as an incentive for individuals to take a job which reduces unemployment.
Causes of unemployment
Frictional unemployment
The labour market is constantly ‘turning over’ as people leave
one job and take time to find another. People leave jobs for a
variety of reasons: they do not like their work, people get
dismissed or they might be seeking a new employment
challenge. This also applies to workers entering the labour
market to find their first job after leaving full-time education.
The search time unemployed people experience when trying to find another job means they will be
unemployed for a period of time. It also takes time for employers to find the right people to fill
vacancies. There is not a ‘frictionless’ movement of workers as they move between jobs.
Frictional unemployment often occurs because there is imperfect communication in the labour
market between potential employers and unemployed workers. It takes time for unemployed
workers to get information about a new job and go through the process of getting that job.
Frictional unemployment is often quite short term and people are often only unemployed for a
matter of weeks or months. It has costs, but economists often see them as relatively minor relative
to other types of unemployment. It is also possible to see the benefits of frictional unemployment as
a pool of unemployed workers in the labour market for employers to fill particular job vacancies.
Structural unemployment
Structural unemployment occurs due to structural changes in the economy that cause workers to
lose their jobs. Workers find it difficult to find new jobs because their skills are not easily
transferable to new employment. Some economists see structural unemployment as a ‘mismatch’ of
skills between unemployed workers and available jobs.
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Structural change in the economy can happen for the following reasons:
The decline in demand for a good or service
The development of high-quality cameras on
smartphones has led to a fall in the demand
for conventional cameras. Many of the
people who were employed in the
conventional camera market would have lost
their jobs as the industry contracted. Some of
the workers in the camera industry would
have found it difficult to find new jobs
because their skills may not have been easily
transferable. Diagram 3.21 shows how a fall
in demand for cameras has led to a fall in the
demand for labour in the camera market.
Foreign competition
Industry in a country may decline because of an increase in foreign competition. The US steel
industry has come under increasing pressure in recent years because of low-priced steel from Asia
and Eastern Europe. This has led to a fall in demand for US steel and a fall in demand for labour in
the US steel industry.
Technological changes
Advances in production technology mean workers are often replaced by capital on the production
line. For example, robot technology in car production has reduced the demand for labour in car
manufacturing and led to structural unemployment.
Demand deficient or cyclical unemployment
Demand deficient unemployment occurs
when the economy is going through a
period of slow economic growth or a
recession. This is typical of a deflationary
gap situation where actual output is below
potential output. As aggregate demand
falls in a recession the demand for labour
falls as firms reduce output as the demand
for the goods they sell falls. Diagram 3.22
shows how a fall in aggregate demand
from AD to AD1 leads to a fall in national
income which causes unemployment to
rise.
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The global economic slowdown following the global financial crisis in 2008 and the current Covid19
pandemic has caused significant amounts of cyclical unemployment in many countries as aggregate
demand decreased.
Seasonal unemployment
Seasonal unemployment occurs when the demand for goods and services changes at different times
of the year in the economy. The tourism industry is typical of this. Summer holiday destinations will
experience a fall in demand for labour in the winter leading to a rise in seasonal unemployment. In
the retail and hospitality sectors of the economy unemployment often rises in January and February
following the Christmas season.
Regional unemployment
Regional unemployment occurs when unemployment becomes concentrated in a particular area of
the country. This often happens when a region has been a major centre for a particular industry
which goes into structural decline. The ‘Rust-Belt’ states in the US such as Pennsylvania, Ohio,
Indiana, and Michigan which were all heavily dependent on heavy industry like steel-making have a
relatively high level of unemployment caused by industrial decline over the last 20 years.
Natural rate of unemployment
The natural rate of unemployment is the rate of unemployment that exists in the long run in the
economy and is predominantly made up of frictional and structural unemployment. Even when a
country has full employment the natural rate of unemployment exists because people are always
leaving jobs or entering the labour market to look for work.
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Consequences of unemployment
Economists focus on the costs of unemployment as a significant challenge for society and
governments. The significance of these costs depends on the level of unemployment in a country.
Unemployment constantly occurs in all nations, but once the rate of unemployment rises above a
certain percentage for a significant period of time the costs of unemployment can be very damaging.
Opportunity cost of the foregone output of the unemployed
Labour is one of the resources used to
produce output in the economy. If labour
is unemployed then it is not producing
goods and services, and this is the forgone
output of the unemployed. This is what
the unemployed workers could have
produced if they were working and is the
cost to society of unemployment. The
foregone output is illustrated by diagram
3.23 where the actual output of the
economy is below the potential output.
Unemployment means the economy is producing inside the production possibility frontier at point X
instead of point Y on the production possibility curve. In the diagram this means the economy
foregoes 200 units of consumer goods and 150 units of capital goods.
The welfare of the unemployed
Unemployment can have a significant negative effect on the welfare of those who are unemployed.
The significance of the cost will depend on the length of time someone is unemployed and their
financial circumstances. A person from a low-income household who is out of work for over a year
with little prospect of work will suffer more than someone with a higher income who is out of work
for a few weeks as they wait to start a new job. The impact on the welfare of the unemployed can
be looked at in terms of loss of income as well as its effect on the mental and physical health of
unemployed people. High levels of long-term unemployment in a country are a major contributing
factor to high levels of poverty, health problems and indebtedness. With low-income households
suffering from long-term unemployment it can also widen the distribution of income.
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Economic growth
High unemployment can lead to a fall in
aggregate demand and a decline in economic
growth because falling household incomes
reduce consumption. High unemployment also
has a very negative impact on consumer
confidence because of the ‘fear of
unemployment’ and this further reduces
consumer spending across the whole economy,
not just amongst the unemployed.
The flow chart above shows how high unemployment can lead to a negative feedback cycle where
unemployment leads to a fall in consumption and economic growth which leads to more
unemployment.
Negative externalities
High levels of unemployment in a region or a city can lead to significant social problems in terms of
crime, use of recreational drugs and social unrest. These negative effects do not just affect the
unemployed but also people in work who live in an area of high unemployment.
Government finance
High levels of unemployment have a negative impact on government finance. Unemployed workers
do not pay tax which reduces government income and the benefits paid to unemployed workers
increase government spending. This is made worse when there is demand deficient unemployment
in a recession when government finance is already under pressure because of falling tax revenue and
increasing government expenditure. For this reason, rising unemployment can increase the
government’s budget deficit.
Impact on business
If there is high cyclical unemployment or high regional unemployment, then this will reduce demand
in many markets and lead to falling sales for firms. This is likely to lead to some business failure and
more unemployment.
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Positive consequences of unemployment
Whilst unemployment is often looked at in negative terms by different stakeholders in the economy.
It can, however, have some positive consequences:
•
There are more workers in the labour market to choose from which makes it easier for
employers to find new workers.
•
There is less pressure on wages to rise which reduces business costs and can reduce
inflation.
•
Workers who are worried about unemployment may work harder and be easier to manage
by employers. Although some firms might exploit this.
•
Some people might use a period of unemployment to redirect their lives and find future
work that is more fulfilling for them.
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Unit 3.3(3) Macroeconomic
objectives: inflation and deflation
What you should know by the end of this chapter
•
•
•
•
•
•
Measuring the inflation rate using a consumer price index (CPI)
Problems of measuring inflation
Causes of inflation: demand-pull and cost-push inflation
Costs of a high inflation rate
Causes of deflation
Costs of deflation
Changes in the price level
The overall price level or average price level of an economy is constantly changing. Managing the
change in the average price level and achieving a low and stable inflation rate is a key objective of
government macroeconomic policy. All countries experience changes in the average level of prices
over time and when these changes become unstable it can be very damaging to the economy. For
example, in the last 10 years, a 10 million per cent rate of hyperinflation in Venezuela or a daily rate
of inflation in Zimbabwe of 98 per cent meant these economies could not really function.
Inflation
Inflation is the sustained increase in the general level of prices in an economy. For example, if an
economy has a current rate of inflation of 1.5% it means that on average prices are 1.5% higher now
than they were 12 months ago.
Disinflation
Disinflation is the fall in the rate of inflation in an economy. This means the rate at which the
general level of prices is increasing falls. For example, a fall in the rate of inflation in the economy
from 2.1%. to 1.5% would be disinflation.
Deflation
Deflation is the sustained decrease in the general level of prices in an economy. If a country has a
rate of inflation of -1.6% then it has deflation and the average price level of the economy is falling.
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Measuring inflation
Measuring the rate of inflation is a difficult thing to do in an economy because of the number of
goods and services being traded and the number of transactions taking place. Prices are constantly
changing in the economy which also makes measuring inflation problematic. Governments use a
price index to measure the rate of inflation and the example that follows is the method used by
European Union to measure inflation and is called the Harmonised Consumer Price Index (HCPI).
Harmonised consumer price index (CPI)
This is how CPI is calculated:
•
The European Central Bank choose a representative basket of goods the average consumer
buys.
•
The index has 700 products in the basket and the prices of the goods in the basket are
measured monthly.
•
The index is weighted based on consumer expenditure. The higher the proportion of
consumer expenditure on a product the higher its weighting will be and the greater impact
its price change will have on the price index. Petrol price changes will have a greater impact
on the index than a change in the price of toothpaste because most consumers spend a
greater proportion of their income on petrol.
•
The annual percentage change in the index is the inflation rate. The current inflation rate for
the Euro Area is 0.4%.
Constructing a weighted price index (HL only)
This is how the inflation rate is calculated using a weighted price index:
Step 1 Goods and services are selected to be put into the index, and they are entered under
different product categories like those set out in the table below. About 700 products are used in
the European CPI.
Step 2 Index numbers are used to calculate how the prices of each category of good have
changed. An index number shows the relative change in the value of a variable between two points
in time. The point in time is called the base year (this is given the value 100) and this is compared to
another point in time called the current year. For example, if the price of bread in the base year is
€1.20 and in the following year (current year) it is €1.30 then the index would be:
current year price / base year price x 100 = price index value
€1.30 / $1.20 x 100 = 108.3
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Step 3 Once the index number for
each category of good has been
calculated we then assign weights
to each category based on the
percentage of income the average
consumer spends on the
category.
In the table below the average consumer spends 22 per cent of their income on housing so housing
is given a weighting of 22. The average consumer only spends 6 per cent of their income on alcohol
and tobacco so the weighting for this is 6.
Step 4 Each category of good in the price index is multiplied by its weighting. The sum of price
multiplied by weighting for each category divided by 100 gives the weighted index.
Σ (weight x price)/100 = weighted index
In the table, the weighted index for 2020 is 104.37
Step 5 The rate of inflation for 2020 is calculated from the percentage change in the weighted index
from 2019 to 2020. The weighted index for 2019 is 101.6 so the rate of inflation is calculated as:
104.37 – 101.6 / 101.6 = 2.73%
Problems of measuring inflation
We have already considered the challenge of measuring the rate of inflation from the sheer scale of
the task of collecting price data that is constantly subject to change. Here are some more specific
problems of measuring inflation.
Average consumer
The inflation rate is an average based on the spending patterns
of the average consumer. This consumer does not exist in
reality so different inflation rates will exist for different
consumers. Young people who eat out in restaurants will have
a different inflation rate compared to families that are more
likely to eat at home because the price changes in restaurants
are likely to be different to the price changes of people who
primarily buy their food in supermarkets.
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Regional variation
Prices differ throughout the economy and so will inflation rates. Capital cities like Paris and Beijing
will experience different inflation rates compared to provincial towns in those countries.
Types of retailer
Prices vary depending on where you buy a product. Large supermarkets will be much cheaper than
small corner shops and the inflation rates between these different types of retailers are going to
differ as well. This makes deciding which retailers to use in constructing the index problematic.
Change in the quality of goods
The quality of goods generally rises over time and this is not accounted for in the index. Computers
are of better quality now than they were 5 years ago, but this will not necessarily be reflected in
their price. This means inflation tends to overstate price increases because it does not allow for
improvements in product quality.
Variations between countries
Different countries use different measures of inflation. The US consumer price index, for example,
includes the change in the price of owner-occupied housing which is not included in the EU’s CPI
measure.
One-off changes in price
Significant one-off changes in the price of a highly weighted good in the index can distort the
inflation rate. A big increase in the price of petrol will cause a significant rise in the index although
the price changes of other goods in the index may be relatively small. Economists try to factor this in
by removing items with big, one-off price changes that distort the index. This is called the core or
underlying rate of inflation.
Predicting the rate of inflation
Economists try to forecast the future rate of inflation and they will look closely at factors that could
build inflation pressures like an increase in the price of oil or accelerating economic growth. They
also look at indices like the producer price index which measures the percentage change in prices
paid by firms for inputs like raw materials. If the producer price index is rising, then there is likely to
be a rise in the rate of inflation.
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Causes of inflation
At the macro level, the causes of inflation can be looked at from a demand-side and supply
perspective. In reality, it is difficult to separate them as causes of inflation because the factors that
affect aggregate demand and aggregate supply are constantly changing. Economists do, however,
often focus on periods of high inflation caused by changes either in aggregate demand or aggregate
supply.
Demand-pull inflation
Definition
Demand-pull inflation occurs when a rise in
aggregate demand in the economy causes
(pulls) the price level in the economy to
increase. Diagram 3.24 illustrates how a rise
in aggregate demand from AD to AD1 leads to
a rise in the average price level from P to P1.
Inflationary gap
Periods of demand-pull inflation often lead to an inflationary gap. The diagram also shows an
inflationary gap where the short-run equilibrium income is at a level of real GDP above the full
employment level of income. This means actual output in the economy is above potential output. It
is quite difficult to understand how this can happen. Remember that potential output or full
employment is not zero unemployment because there are always some unemployed people and
unused capital even when the economy is at full employment. In the short term, actual output can
be above potential output and an inflationary gap occurs.
The following factors can trigger an increase in aggregate demand which can lead to demand-pull
inflation:
•
Reduced interest rates raise the level of consumption and investment.
•
A rise in house prices makes consumers feel wealthier and raises consumption.
•
High levels of business and consumer confidence stimulate consumption spending and
investment.
•
Expansionary fiscal policy by the government is trying to stimulate economic growth.
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Cost-push inflation
Definition
Cost-push inflation occurs when there is
a reduction in the short-run aggregate
supply in the economy and the price level
is pushed up by rising costs. Diagram 3.25
illustrates how rising costs cause the
short-run aggregate supply curve to shift
from SRAS to SRAS1 leading to a rise in
the average price level from P to P1 and a
fall in the real output from Y to Y1.
Reasons for cost-push inflation
The short-run aggregate supply curve will shift to the left if the cost of any of the factors of
production increases.
Wage push inflation
When wage rates rise faster than output unit or average
costs rise, and this can lead to higher prices if firms
choose to pass on the increase in unit costs as a higher
price. This would happen if a trade union in a major
industry like electricity supply negotiated a wage
increase of 10 per cent and labour productivity only
increased by 5 per cent.
A wage-price spiral can be a dangerous situation for an economy where workers respond to a rise in
inflation by asking for a wage increase which in turn feeds through to higher prices.
Raw material costs
Cost-push inflation can be caused by rising commodity prices which increase the cost of
manufactured goods. Commodity price increases in oil, wheat, rice and metals have all triggered
periods of cost-push inflation in economies in the past. Historically, oil price increases have caused
significant periods of cost-push inflation. Where materials and other inputs are imported a fall in the
exchange rate can trigger cost-push inflation as import prices rise with a lower exchange rate.
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Capital costs
If the price of machinery and equipment used by firms increases, this can lead to higher
prices. Governments often respond to higher inflation by raising interest rates, but this can lead to
higher business costs as firms have to pay more interest on loans they have taken out to fund
investment spending.
Entrepreneurial profit
Businesses can add to their profits by increasing prices by more than their increase in costs. In
industries dominated by large firms with significant market power, prices can increase because of a
lack of competition. This is particularly true where a monopoly dominates a market. When you
consider markets like energy, water and public transport are often dominated by large firms, it is
possible to see how inflation can occur if they increase prices because demand is price inelastic and
household spending on the products they sell is a high proportion of household income.
The effects of inflation
Inflation is present in nearly all of the world’s
economies and many economists see low, stable
inflation as beneficial. However, if inflation
increases to high, unstable levels it leads to
significant macroeconomic problems. Countries
like Venezuela and Zimbabwe which have both
experienced hyperinflation in the last 15 years
have seen their economies collapse because of
the price level increasing at such a fast rate.
Impact on the cost of living
As the price level rises in the economy the cost to households increases. If the price level rises faster
than the increase in household incomes, then households will see a fall in their real incomes and
material living standards. This type of effect is normally associated with cost-push inflation.
Redistribution of income
Fixed incomes
Inflation has a negative effect on the disposable incomes of households whose wages cannot keep
up with the increase in the average price level. These households are often made up of pensioners,
people on government benefits and low-skilled workers in weak bargaining positions in the labour
market. In many countries, households with below-average incomes saw their real wages fall after
the financial crisis between 2009 and 2018 because the price level was rising faster than their
wages.
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Borrowers and lenders
Inflation means the real value of money repaid by borrowers is worth less than the money they
borrowed from lenders. If someone borrows $100,000 at 10 per cent inflation then the real value of
the money they repay after one year will be $90,000. There is a redistribution of income from
lenders to borrowers. Lenders can protect themselves against this by charging a rate of interest
above the rate of inflation:
Interest rate 6% - Inflation rate 4% = 2% real rate of interest
The redistribution of income tends to occur if there is a sudden jump in the rate of inflation and
lenders cannot act to protect themselves by increasing interest rates. This is called unanticipated
inflation and at higher rates of inflation, there is a greater probability of unanticipated inflation
because changes in the price level become more volatile. For example, when inflation rises above
10 per cent it becomes unstable and there is more likely to be unanticipated inflation. The increased
risk unanticipated inflation poses to people saving money in banks means that inflation can lead to a
fall in the savings in the economy which reduces the funds available for future investment.
Investment
One implication of higher real interest rates which come with high inflation is that the cost of
borrowing money for investment projects increases and this leads to a fall in the level of
investment. High inflation also makes the business environment more unstable which increases the
risk element of investment projects and this also leads to a fall in investment. If inflation leads to a
fall in the level of investment, then the long-term growth prospects of the economy will be adversely
affected.
Reduced international competitiveness
If a country’s inflation rate is higher than its main international competitors then the country’s firms
will struggle to compete in international markets leading to a fall in exports and a rise in imports.
This could lead to a balance of payments current account deficit. The current account deficit can
lead to a fall in the country’s exchange rate and this adds to inflation as import prices
rise. Venezuela’s inflation rate is significantly higher than its main trading partners in South America
which has led to a fall in its international competitiveness amongst if main international competitors.
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Business costs
An increase in the rate of inflation means that firms have to spend time changing prices as their
costs increase. The time they spend changing prices represents an additional cost to business. This
is particularly significant when inflation goes to very high levels and firms are forced to continuously
change prices because they will lose money if they do not raise prices as costs rise. An economy
with price stability and a 2 per cent rate of inflation will mean most firms will be comfortable
changing their prices once a year. If inflation reaches levels above 10 per cent then prices need to be
changed much more frequently. If inflation reaches 1000 per cent prices will need to be changed
every day.
Allocative inefficiency
The price mechanism is the signalling system in the economy that guides the efficient allocation of
resources. In countries with very high inflation, the price of all goods is rising significantly and it is
very difficult for consumers and producers to interpret what changes in price tell them about market
conditions on which to base buying and selling decisions. This leads to a breakdown of the signalling
and incentive functions of price and resources will not be allocated as efficiently. For example, if
inflation is 50 per cent in a country it is very difficult for consumers and producers to interpret why a
price is rising in any particular market and how to respond to it.
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Deflation
Defining deflation
Deflation is a negative rate of inflation where there is a sustained fall in the general level of prices in
an economy. This is different to disinflation when there is a fall in the rate of inflation in the
economy. Relatively few countries in the world experience deflation at any one time and the rate of
deflation is normally less than 1 per cent. In historical terms, the United States suffered an average
annual rate of deflation of 10 per cent per year between 1930 and 1933.
Causes of deflation
Demand-side deflation
Deflation can occur because of a fall in
aggregate demand and this typically
occurs in a recession. The Japanese have
experienced periods of deflation in the
last 20 years caused by falling aggregate
demand. Diagram 3.25(1) illustrates how a
fall in aggregate demand from AD to AD1
leads to deflation as the average price
level falls and there is a deflationary gap.
Because this type of deflation occurs in a
recession it is seen as damaging to the
economy in terms of falling GDP and rising
unemployment. Economists sometimes
call this ‘bad deflation’.
Supply-side deflation
Deflation that occurs on the supply side
arises when the aggregate supply curve
shifts to the right and leads to a higher
output at lower prices. Improvements in
productivity in manufacturing have led to
significant falls in prices in certain markets
and this has had a ‘deflationary effect’ on
the economy. In diagram 3.26 the shortrun aggregate supply curve shifts from
SRAS to SRAS1 and the average price level
falls. This is often called ‘good deflation’
because it is associated with a higher level
of real GDP.
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Consequences of deflation
The consequences of deflation depend to an extent on whether deflation is caused by changes in
aggregate demand or supply.
Reduced growth and recession
If deflation is caused by falling aggregate demand, then it can lead to falling or even negative
economic growth and rising unemployment. These are the negative consequences of a deflationary
gap and they are often associated with a serious recession.
Falling current consumption
When prices are falling it is argued that households put off buying goods and services now because
they believe they can wait to buy goods in the future when prices are lower. This fall in current
consumption causes a further fall in aggregate demand and leads to more deflation.
Redistribution of income
Lenders gain at the expense of borrowers because the value of repayments rises when prices are
falling. If you borrow $1000 now with 5 per cent deflation, the real value of the repayment will be
$1050. This may mean firms and households are less willing to borrow and this reduces consumption
and investment which in turn causes aggregate demand to fall.
Rise in spending power
As the price of goods falls consumers can buy more with their income. This is the benefit of supplyside or good deflation. Falling prices often applies to goods such as clothing, computers, TVs and
mobile phones.
International competitiveness
If one country’s goods are falling in price relative to their trading partners, then this could increase
that country's competitive advantage in international markets. It could lead to a rise in their exports
and a fall in imports. Japan’s deflation over the last 20 years may well help its trading
competitiveness.
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Conflict between macroeconomic objectives
Low inflation and low
unemployment
One of the main macroeconomic policy
conflicts governments have is the aim of
achieving low inflation and low
unemployment at the same time. The
conflict can be illustrated by changes in
aggregate demand in diagram 3.27(1).
When aggregate demand increases the national income rises from Y to Y1 and this is normally
associated with a fall in unemployment. But the increase in aggregate demand will also lead to a rise
in the average price level from P to P1 and an increase in the rate of inflation. The opposite occurs if
aggregate demand falls leading to a fall in inflation but a rise in unemployment as national income
falls.
The Phillips Curve
The nature of the Phillips curve
The Phillips curve describes the relationship between the rate of
inflation and the rate of unemployment. It was established by
the New Zealand-born economist William Phillips who studied
the relationship between the rate of inflation and the rate of
unemployment in the UK economy between 1861 and 1957.
Phillips used the UK data to establish that as the rate of inflation
decreased the rate of unemployment increased and as the rate
of inflation increased the rate of unemployment decreased.
Diagram 3.27(2) illustrates the basic Phillips Curve.
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Explaining the Phillips curve
The negative relationship between the
inflation rate and the rate of
unemployment can be explained by
aggregate demand and supply analysis. As
aggregate demand increases from AD to
AD1 in diagram 3.27(1) above, the
national income increases leading to a fall
in unemployment from 7 per cent to 5 per
cent in diagram 2.27(2) as the demand for
labour increases. This could be because of
a fall in demand deficient unemployment.
The rise in aggregate demand also leads to a rise in the average price from 2 per cent to 4 per cent in
diagram 3.27(2) in the economy as demand-pull inflation increases the average price level.
The Phillips curve only really works when aggregate demand changes. If there is a fall in aggregate
supply then a rise in the rate of inflation may occur at the same time as a rise in unemployment as
national income falls. Falling national income and rising inflation is sometimes referred to as
stagflation.
Policy use of the Phillips Curve
The Phillips Curve was used by policymakers to guide demand-side fiscal policy policies in the 1960s
and 70s. If governments saw a rise in the rate of unemployment, they would use expansionary fiscal
policy to try and reduce unemployment and this would be traded off against higher inflation.
Similarly, if inflation was too high contractionary fiscal policy would be used and falling inflation
would be traded off against higher unemployment. This was called ‘fine tuning’ the economy.
The Long-Run Phillips Curve
The Phillips Curve relationship broke down in the 1970s when many developed economies started to
experience rising inflation and rising unemployment – Stagflation. Monetarist and Neo-Classical
Economist tried to explain this by using the theory of the Long Run Phillips Curve.
The Long-Run Phillips Curve was based on the principle of the natural rate of unemployment which
is covered in chapter 3.3(2). The natural rate of unemployment is important in understanding the
long-run Phillips curve because the theory is based on the assertion that unemployment will always
return to the natural rate in the long run.
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Monetarist Economists also referred to the natural rate of unemployment as the Non(N)
Accelerating (A) Inflation (I) Rate (R) of Unemployment (U) – NAIRU. In other words, if
unemployment is at this level the rate of inflation does not increase. This rate of unemployment is
shown in diagram 3.27(3).
Explaining the breakdown
This is how Monetarists explain the breakdown of the Phillips Curve:
•
Monetarist economists believed
that the traditional Phillips Curve
is a short-run Phillips curve. The
economy starts on Phillips curve
PC with 2 per cent inflation and
the natural rate of unemployment
of 4 per cent at point A in diagram
3.27(3).
•
The government decides this rate of unemployment is too high and uses expansionary fiscal
policy to reduce it by increasing government spending and cutting taxes. This works in the
short run and unemployment falls from 4 per cent to 3 per cent, and the rate of inflation
rises from 2 per cent to 4 per cent at point B.
•
Monetarists believe that when inflation rises to 4 per cent for any period of time it becomes
established in the economy and becomes the expected rate of inflation by households and
firms. They then build in the expected inflation rate into their decision making and the rate
of inflation stays at 4 per cent.
•
Over time the rate of unemployment drifts back to the natural rate because some workers
find their real wages are eroded by the higher rate of inflation and leave their jobs. The
economy now moves to point C on diagram 3.27(3) with 4 per cent inflation and 4 per cent
unemployment.
•
After a period of time, the government again believes the rate of unemployment is
unacceptably high and once again uses expansionary fiscal policy to reduce it. The economy
is now on PC1 and the rate of unemployment falls below 4 per cent again and the inflation
rate rises to 8 per cent as aggregate demand rises. The economy is now at point D in
diagram 3.27(3).
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•
The 8 per cent rate of inflation becomes
expected by firms and households and in the
long-run unemployment drifts back to its
natural rate of 4 per cent at point E in
diagram 3.27(3).
•
This process continues each time the
government uses expansionary fiscal policy
to reduce unemployment and the economy
experiences higher and higher inflation with
no long-term fall in unemployment.
•
It is important to remember that this analysis of the breakdown of the Phillips Curve took
place after it had happened, and governments were unaware this process was occurring.
Policymakers just thought over time (normally when there was an election looming) that
unemployment needed to be reduced.
The implication of the Long Run Phillips Curve
One of the implications of the Long Run Phillips Curve is for macroeconomic policymaking. If a
government tries to use expansionary demand-side policies to reduce unemployment below its
natural rate it will lead to higher inflation in the long run with no reduction in unemployment. This
means governments need to use supply-side policies to reduce the natural rate of unemployment.
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Unit 3.4(1) Economics of inequality and poverty
What you should know by the end of this chapter:
•
•
•
•
•
•
•
•
•
•
•
Relationship between equality and equity
The meaning of economic inequality
Unequal distribution of income and wealth
Measuring economic inequality using the
Lorenz curve and Gini coefficient
Construction of a Lorenz curve from income
quintile data (HL)
Meaning of poverty
Difference between absolute and relative
poverty
Measuring poverty: international poverty lines, minimum income standards,
Multidimensional Poverty Index (MPI)
Difficulties in measuring poverty
Causes of economic inequality and poverty
Impact of inequality on economic growth, standards of living and social stability
The difference between equality and equity
Equality
Equality in economics is the way the economic outcomes for different people in society are the
same. We often consider equality in the way the income generated by the economic activity of a
country is shared out amongst the country’s population. We know from the circular flow of income
model that the GDP of a country produces an income that is distributed to different households of
that country. But the model does not tell us how the income is shared out.
Many economists, leaders in industry and politicians take the normative view that a more equal
distribution of income in society is a good thing. The reality of the world economy is the widening of
income inequality. All nations experience income inequality to a greater or lesser extent, where
income is distributed unevenly amongst the population with a minority of high-income households
accounting for a relatively high proportion of the income or wealth generated by a country.
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Equity
Equity in Economics is about fairness in terms of everyone in society having an equal opportunity to
achieve an economic outcome. This is another normative economic concept and takes the view that
all individuals should have the opportunity to achieve a certain economic outcome. This might mean
an individual has the opportunity to get a job that allows them to achieve a certain quality of life.
Inequity is unfairness in society that prevents individuals from achieving a particular economic
outcome. This might mean a group in society cannot access certain jobs because of their ethnicity,
gender or socioeconomic group.
Inequality in the distribution of income and wealth
In all countries, there is an unequal distribution of income and wealth. Although they are quite
similar principles there is a distinct difference in terms of:
•
An unequal distribution of income means that a greater proportion of the income of the
economy goes to the richest households than the rest of the population.
•
An unequal distribution of wealth means that a greater proportion of the value of assets incountry is owned by the richest households compared to the rest of the population.
Income is the money a person earns, and wealth is the value of assets a person owns. Examples of
the assets people own include houses, shares, bonds and money in the bank.
Measuring economic inequality
There is two indicators economist use to measure income inequality in a country.
The Lorenz curve
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The Lorenz curve is a graphical illustration
of the income distribution of a country.
The Lorenz curve divides the population
into quintiles and then shows the
cumulative percentage of income
accounted for by each quintile. The table
sets out the income data for Country A
and Country B. Each country’s
households are set out in ascending order
from the poorest quintile to the richest
quintile.
The Lorenz curve graphs the distribution
of income by plotting each quintile with
the cumulative percentage income. These
Lorenz curves for Country A and B are
shown in diagram 3.28. From the data in
the table, Country B has greater income
inequality, and this is shown by the larger
deviation its Lorenz curve has compared
to Country A from the line of perfectly
equal income distribution.
Gini coefficient
The Gini coefficient can be used to measure the size of a
country’s income inequality. It can be calculated by using
the Lorenz curve. In diagram 3.29 the area above the Lorenz
curve and below the line of perfect income equality is
calculated as a proportion of the total area below the line
of perfect income equality. In diagram 3.29 this is calculated
by the equation:
area A / area A + area B = Gini coefficient
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This Gini coefficient value can either be considered as a percentage or a value between 0 and 1. If
the answer is 0 there is perfect equality and the closer the Gini-efficient is to 1 the more uneven the
income distribution of a country. The table opposite shows the 10 countries in the world with the
highest Gini coefficient values.
Meaning of poverty
The United Nations defines poverty as the ‘denial of choices and opportunities and a violation of
human dignity. A household in poverty lacks the basic capacity to participate effectively in society’.
This definition of poverty can be viewed as households in a country lacking the income needed to
achieve a basic standard of living.
Poverty can be considered in two ways:
Absolute poverty
Absolute poverty exists when household income is below the level needed to meet a person’s basic
needs of life including housing, food, safe drinking water, education and healthcare, etc. It is difficult
to state an income level where someone experiences absolute poverty, but an income of less than
$700 a year or $2 a day is given by the UN, although this will vary from country to country because
of different price levels.
Relative poverty
Relative poverty is where a household’s income is significantly below a country’s average
income. Many countries define relative poverty as a person that earns less than 50 per cent of the
average household income. Households in this position may not be in absolute poverty, but they
often do not have enough income to afford anything more than the basic goods and services needed
to sustain their lives.
Measuring poverty
Countries can measure poverty using the following approaches:
Poverty lines
A poverty line is the minimum level of income needed for a
basic standard of living in a country. The World Bank
international poverty line is set at an income of $1.90 per
day. Different nations set their poverty lines based on
relative poverty. For example, a country might set a relative
poverty line at 50 per cent of average incomes and then the
percentage of people who fall below this level is used to
measure the level of relative poverty.
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Multidimensional Poverty Index (MPI)
The Multidimensional Poverty Index (MPI)
uses a number of weighted criteria to
measure poverty in a country based on a
survey of households. This data is
aggregated to give a national measure of
poverty. The lower the MPI of a country the
greater the level of poverty. The criteria
used to measure the MPI are set out in the
table. These criteria are used to measure
poverty by applying a set minimum level for
each indicator.
For example, the standard of living poverty indicator, cooking fuel, would measure poverty based on
the number of households cooking with dung, wood, charcoal or coal and the nutrition indicator
would be based on the number of people in a household who are undernourished.
Problems of measuring poverty
The following factors make it difficult to measure the level of poverty in a country:
•
Like a lot of economic data, measuring poverty is based on a survey which means using a
sample of households to represent the whole population. All samples come with a sampling
error, so there is inevitably some inaccuracy in the data.
•
The variety of different methods used to define poverty such as relative and absolute
poverty make it difficult to measure. Using the phrase ‘to meet a person’s basic needs’ is
open to a variety of interpretations. We know access to basic food and shelter is a basic
need but is owning a mobile phone?
•
Some of the most powerful human feelings associated with poverty are almost impossible to
measure. The anxiety of not knowing where your next meal is going to come from is real, but
measuring that anxiety is extremely difficult.
•
Governments draw lines of absolute and relative poverty, but they are very difficult to apply
in reality. A certain level of income per day might be a very low but sustainable income in
some countries, but completely inadequate to live on in others.
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•
Poverty data is open to manipulation by governments who want to show a falling level of
poverty in their country. The income value of absolute poverty should rise with inflation, but
it is in the interests of governments not to do this because it might make the numbers in
absolute poverty increase.
•
Attempts to use a weighted index to measure poverty, such as the MPI, are effective in
representing the broad-based nature of poverty, but increasing the number of indicators
and then weighting them is always going to create difficulties. For example, how do you
decide on the weighting of asset ownership or sanitation in measuring poverty?
Causes of inequality and poverty
It is possible to combine the causes of inequality and poverty in society because the cause of both is
so closely related. For example, if one person is the owner of a highly valued property then they
might earn plenty of income from renting the property. If another person owns no property then
instead of earning rent they will pay rent and this would lead to a high level of inequality between
two people. The person who owns no property is also more likely to live in poverty.
Inequality of opportunity
Inequality of opportunity means people do not have the same access to a good quality of life in
terms of income, education, employment and healthcare. Without these opportunities, people get
stuck in low-paid work with little chance of progression, and this means they cannot access good
healthcare and education. Lack of opportunity can come from a parental background, education,
gender, ethnicity and social class. High-income households, for example, can pay for the best
education for their children who will go on to the best universities, which in turn secures them
highly-paid employment and they can then do the same for their own children.
Resource ownership
Low-income households own very little or no capital at all. This means their only source of income is
from low-paid work. High-income households on the other hand often own assets and are holders of
wealth. This can be in the form of property or shares in companies that earns them a stream of
income in the form of rent on property and dividend on shares. Wealthy individuals can use their
surplus income to buy more assets which earns them even more income.
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Human capital
High-income individuals tend to work in high-skilled jobs producing products for firms that can make
those businesses high profits. Skilled workers in these situations are valued highly by the businesses
that employ them and they are paid a high wage for the work they do. Low-income individuals are
often in low-skilled jobs doing work that does not bring as much profit to the business that employs
them, and they are paid a lower wage. Another important aspect of this is that highly skilled workers
are scarcer in the labour market than the low skilled worker, which gives the highly skilled worker a
stronger bargaining position when negotiating their wages.
Discrimination
Inequality can occur because of discrimination by employers. This can be based on ethnicity, gender,
age and socioeconomic status. Women in most countries are paid significantly less than men partly
because of discrimination. Inequality can also take place in education. Universities in some countries
have been accused of not allowing access to students from ethnic minorities and low-income
households.
Status and power
High-income individuals often reach positions of political
influence. This can be done by directly running for office and
gaining political power. Donald Trump and Hilary Clinton both
come from wealthy backgrounds and spent about $100 million
each on their campaigns for the last Presidential election in
2016. It is much more difficult for low-income individuals to
reach positions of power. Wealthy people can also influence
the political process by lobbying and financing politicians to
make decisions that favour them and their organisations.
Government policies
Government can make policy decisions that can widen income inequality. Reducing direct taxation
will normally favour high-income households because they earn much more taxable income than
poorer households. Cutting income tax tends not to benefit low-income households that much
because they are probably paying very little income tax anyway. Governments that cut spending on
public services such as education and healthcare will have more effect on the poor who rely on
these services than richer households. Low-income households will also be adversely affected when
governments use market-based supply-side policies such as reducing the lower of trade unions and
removing regulations that protect employees.
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Globalisation
Globalisation often involves greater competition in domestic markets from foreign competition as
trade barriers are removed between countries. This increase in competition often favours producers
in low-wage economies that outcompete producers in higher-wage countries. This often means
producers who cannot compete either shut down or reduce wages in an attempt to compete. This
process has the effect of driving down incomes in many countries, widening income inequalities and
leading to poverty.
Impact of income and wealth inequality
Social stability
Countries with very uneven income distributions often suffer from high crime rates. It can be argued
that wide income inequality creates a sense of unfairness in society and this can lead to an increase
in crime and social unrest. Poor people may also be more likely to be pushed towards crime because
it may be the only way to make a sustainable living. For example, poor people might sell recreational
drugs in communities where there are few job opportunities.
Economic growth
A high level of income and wealth inequality can restrict economic growth in two ways:
Demand-side
Domestic aggregate demand does not grow as quickly when there is wide inequality and a significant
proportion of the population is on relatively low incomes. Low-income households tend to spend a
high proportion of their income so if their income growth remains relatively low then this prevents
aggregate demand from growing.
Supply-side
Where income and wealth inequality results in a high proportion of low-income households then
this might slow the growth in aggregate supply. Low-income households may not able to access the
education, training and healthcare needed to support them as productive workers. If people in the
labour force do not have the income needed for effective education and training, then they will not
be as skilled and as productive as workers. People on low incomes may also lack the financial
incentive to be as productive as if they were able to earn higher wages.
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Standards of living
An uneven income distribution with a high proportion of low-income households can reduce the
quality of life in a country. High levels of poverty amongst poorer households have a negative effect
on their welfare in terms of their access to food, housing, health and education. There is also
evidence that income inequality in society has a negative effect on mental health and personal
happiness amongst poorer households.
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Unit 3.4(2) Policies to improve equality, equity and poverty
What you should know by the end of this chapter:
•
•
•
•
•
•
The role of taxation to improve equality, equity and poverty
Progressive, regressive and proportional taxes
Average and marginal tax rates
Direct taxes and indirect tax on equality
Calculation of total tax and average tax rates
from a set of data (HL only)
Other policies to improve equality, equity and
poverty include investment in human capital,
transfer payments, targeted spending on goods
and services, universal basic income, antidiscrimination laws and minimum wages
The aims of the policies to improve equality, and equity and reduce
poverty
To a greater or lesser extent all governments see improving equity, income equality and reducing
poverty as political and economic objectives. Achieving lower poverty rates along with greater equity
and equality can bring significant benefits to a country in terms of economic growth, improving living
standards, achieving greater social stability and delivering a fairer society.
These are the policy options governments have to increase equality and equity and reduce poverty.
Taxation
Tax systems
Direct and indirect tax can be used to redistribute income by taxing people on higher incomes more
than those on lower incomes and then using the tax revenue to pay for public services and welfare
payments that support lower-income households.
When looking at different tax systems it is important to look at the two different ways of measuring
the tax rate:
Average rate of tax
Average rate of tax is the percentage of tax paid on an individual’s total income and is calculated as:
total tax / total income x 100 = average rate of tax
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If a person’s income is $50,000 and they pay $10,000 in tax then their average rate of tax would be:
$10,000 / $50,000 = 20%
Marginal rate of tax
The marginal rate of tax is the percentage of tax paid on each extra $ of income someone earns and
is calculated as:
change in total tax/change in income x 100 = marginal rate of tax
If a person’s income rises from $50,000 to $60,000 and their total tax paid increases by $5,000 then
the marginal rate of tax would be:
$5,000 / $10,000 x 100 = 50%
Progressive tax
In a progressive system, the rate of tax rises as an individual’s income rises which means their
marginal rate of tax increases with income. The table below sets out how a progressive tax system
works in a country. One of the aims of a progressive tax is to achieve a more equitable distribution of
income by taxing people on higher incomes at a higher rate than those on lower incomes. Individuals
A, B and C earn different levels of income. The progressive tax system shown in the table sets out
how the rate of tax increases as income increases. Each individual pays zero tax on their first $8,000
of income, 20 per cent on the next $32,000, 40 per cent on the next $40,000 and 50 per cent on any
income above $80,000. The income levels where the rate of tax changes are called tax thresholds.
The relationship between total tax paid and household income is shown in diagram 3.30.
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Corporation tax on company profits is often progressive with a higher rate charged to more
profitable businesses. Some politicians and economists have supported the use of a progressive
wealth tax on the value of assets a household owns rather than on their income. Many high-income
individuals can use tax avoidance schemes to reduce their income tax burden, but they would find it
more difficult to avoid a one-off wealth tax. A wealth tax of 10 per cent on a household with a net
asset value of $10 million would mean them paying $1 million in tax.
Regressive tax
A regressive tax is where the average rate of tax falls as an individual’s income rises. This applies to
indirect tax where people on lower incomes spend a higher proportion of their income on goods
where they have to pay indirect tax compared to people on higher incomes. The table below
illustrates the situation of three individuals paying indirect tax. It is assumed that the only indirect
tax paid by each individual is VAT set at 20 per cent.
The amount of VAT paid by, for example, individual A calculated as:
•
Spending by individual A on VAT-taxed goods is $14,000
•
20% of the $14,000 is paid in VAT ($14,000 / 1.2 = $11,667) which means $11,667 individual
A's spending is taxed
•
$14,000 - $11,667 = $2333 is the tax paid by individual A
•
$2,333 / $15,000 x 100 = 15.56% is individual A's average rate of tax.
Diagram 3.30 shows the relationship between the total tax paid by an individual and the regressive
tax they pay. Regressive taxes are seen to do little to correct inequalities because the average rate of
tax for an individual falls as their income increases. The tax collected can, however, be used to spend
on public services that do benefit poorer people in society.
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Proportional tax (flat tax)
A proportional tax is a direct tax system
where the average rate of tax remains
constant as income increases. In the
example above, the individuals on
$15,000, $60,000 and $100,000 would all
pay the same rate of income at, for
example, 20 per cent. Estonia, for
example, uses a proportional tax system
with a rate of 20 per cent.
The relationship between progressive, regressive and proportional taxes and income is shown in
diagram 3.30. Similar to regressive taxes, the proportional tax does little to correct inequalities, but
again the tax revenue can be used to support low-income households.
Problems of using tax to reduce inequality
•
High rates of tax on high-income groups can have a negative impact on this group’s incentive
to work. This can be important for entrepreneurs who are crucial for starting new businesses
which employ people on lower incomes.
•
If tax increases are concentrated on indirect tax then this has a very negative effect on
poorer groups in society because they pay a higher proportion of their income on taxes like
VAT, duties on alcohol, cigarettes and petrol.
•
Raising marginal tax rates too high can lead to a reduction in tax revenue because richer
people avoid high taxes by leaving the country or by using tax avoidance schemes. This
leaves less money for the government to spend on public services to benefit poorer groups
in society.
•
Raising indirect tax pushes up the cost of producing goods which can lead to higher prices
and this has a negative impact on low-income households.
•
If a country has relatively high tax rates compared to its international competitors, it may
struggle to compete because domestic business firms will have higher costs and foreign
direct investment is less likely to come to countries with high tax rates. This can negatively
impact the employment prospects of low-income households.
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•
Other policies to improve equality, equity and reduce poverty
An alternative government policy approach to equity, equality and poverty is centred on the
provision of public services, laws and regulation.
Education and training
Government policies that target the poorest people in the country are seen as important in creating
the opportunity for individuals to access the types of skilled, high-paying jobs that take people out of
poverty. Education and training policy can take the following forms:
•
Free access to primary and secondary education for all children. By making school
attendance a legal requirement the government tries to make sure all children benefit from
a school education.
•
Creating support structures for low-income families when their children are in school such as
literacy and numeracy schemes.
•
Wide provision and funding of higher education for all low-income groups to enable
everyone to have the opportunity to gain the qualifications needed for the most skilled
work.
•
State funding and provision of employment training programmes to support low-income
groups entering the labour force and improving their skills when they are in work.
Healthcare
Governments use wide healthcare provision to everyone in the country as a way of supporting the
poorest in society and also as a way of creating economic opportunities. People often get stuck in
poverty in countries that do not have widely available free healthcare. The cost of paying for
healthcare is often expensive and poorer people spend a high proportion of their income on paying
for doctors, hospital fees and drug expenses. These expenses can leave low-income individuals with
little money to pay for other goods and services. In addition, low-income households may have low
levels of productivity at work because of their health or they cannot go to work because of poor
health. This would also apply to family members who cannot work because they are looking after
dependents.
Transfer spending
Tax revenue collected by the government can be redistributed to low-income households through
the benefits system. Unemployment, housing, and disability benefits can all be targeted at lowincome groups in society.
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Capital spending
Investment spending by the governments on infrastructure can be an effective way of creating
opportunities for people in poorer households to improve their employment prospects and incomes.
Better connectivity through public transport means people can have greater access to employment
and education. Investment by the government in high-speed broadband is also a way households on
lower incomes can gain access the employment opportunities and education to improve their future
incomes and reduce inequality.
Anti-discrimination
To improve the income, employment and educational prospects of certain groups in society
government can put in place laws and regulations that prevent employers, schools and universities
from discriminating based on gender, ethnicity, religion, sexual orientation and age.
Universal basic income
Universal Basic Income is where a government makes an
unconditional, regular payment to everyone in a country.
This is a policy governments are investigating, but no
government have fully put a universal basic income into
place. Many economists are concerned that future
advances in technology through artificial intelligence may
lead to such significant job losses that a universal basic
income will be needed to support the population.
Employment protection laws and regulations
Government can put in place specific laws and regulations that stop employers from exploiting lowincome workers. These regulations include:
•
Minimum wages to make sure all workers are paid a fair wage for the work they do.
•
Redundancy and dismissal regulations mean workers cannot be made redundant or
dismissed by their employer without a fair procedure.
•
Protection and support of trade unions who act in the interest of their members.
•
The right to paid holiday, sickness benefit and leave for maternity and paternity.
•
Regulations to ensure the safety and security of working conditions for all employees at their
place of work.
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Problems of using these policies to reduce inequality
•
Government spending on policies such as infrastructure, health and education needs funds
to pay for them. This can be paid for out of tax revenues by raising taxation or by cutting
government expenditure in other areas which represents an opportunity cost. Alternatively,
the funds can come from borrowing which has an interest cost and adds to the national
debt.
•
Critics of government spending say that resources are allocated and used inefficiently. This is
because governments might spend money on politically motivated projects and government
enterprises do not have the pressure of competition or profit to make them efficient. People
often criticise government training schemes for this reason.
•
Governments are such large organisations that they struggle to operate effectively at a
micro level because of diseconomies of scale. Government bureaucracy can result in
decisions in healthcare, education and infrastructure being slow and ineffective.
•
Increased workplace regulation to protect low-income workers can increase business costs,
increase prices and reduce an economy’s international competitiveness.
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Unit 3.5 Government management of
the economy – monetary policy
What you should know by the end of this chapter:
•
•
•
•
•
•
•
•
•
•
Aims of monetary policy
Control of money supply and interest rates by the central bank
Monetary policy to achieve different macroeconomic objectives
Money creation by commercial banks (HL)
Tools of monetary policy (HL)
Determination of interest rates through the demand and supply for money (HL)
Real and nominal interest rates
Expansionary monetary policy
Contractionary monetary policy
Evaluation of monetary policy
The aims of monetary policy
Governments have different economic tools they can use to target their macroeconomic objectives:
•
Sustainable economic growth
•
Low unemployment
•
External balance on the current account balance of payments
•
Low inflation or price stability
The government can use demand management or a demand-side approach where it affects
aggregate demand in the economy to achieve these objectives. The government demand
management approach can be broken down into monetary policy and fiscal policy. This chapter
considers how monetary policy can be used to try and achieve the government's macroeconomic
objectives.
Understanding monetary policy
Monetary policy is where the government uses interest rates and the supply of money to achieve its
macroeconomic objectives. For example, the central bank of a country uses interest rates and the
supply of money to manage the rate of inflation.
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Importance of the central bank
The central bank in an economy is the key institution the government
uses to apply monetary policy. In the US the central bank is the Federal
Reserve, in the EU it is the European Central Bank and in Japan, it is the
Bank of Japan. In recent years many countries have made their central
bank independent from the government so it can apply monetary policy
without too much political influence on decision-making. The central
bank applies monetary policy by using the following tools:
•
Base interest (discount) rates
•
Quantitative easing
•
Open market operations
•
Minimum reserve requirements
Determining the supply of money - credit creation (HL)
Credit creation is the way commercial banks in an economy create money from the funds deposited
with them. Credit creation has an important influence on the money supply of the economy and the
way monetary policy works. The process of credit creation is based on the following assumptions:
•
One bank represents the whole banking system. In reality, the banking system is dominated
by a number of large banks, but in this model, the whole banking system is considered to
operate as one bank.
•
The firms and households that deposit money in banks will only withdraw a certain
proportion at any one time to make transactions. This is realistic if you think about the way
most people use their money. For example, we can assume that most customers will only
withdraw 20 per cent of their deposit at any one time.
•
A minimum reserve asset ratio requirement is set based on the withdrawal rate of the bank's
customers. In this case, it is 20 per cent.
•
The money withdrawn from the bank will be redeposited bank in the bank and not held
outside the banking system.
•
Banks make a profit by charging a higher rate of interest to borrowers than they pay to
depositors. Thus, banks have an incentive to lend as much as it is safe for them to do.
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The credit creation process
Based on these assumptions This is how credit creation works in an
economy where a single bank represents the whole system:
Step 1 An initial deposit of $200,000 in cash is put into the bank.
Step 2 The bank can use the $200,000 as a 20% reserve asset to cover cash
withdrawals. In this case, it will use $40,000 of the initial $200,000 deposit
to cover withdrawals from the customer who made the $200,000 deposit.
The remaining $160,000 can be used to cover cash withdrawals from any
loans the bank makes.
Step 3 An individual asks for a loan from the bank to buy a house for $200,000. The banks will make
this loan because they can use $40,000 of the $200,000 initial deposit as a 20 per cent reserve to
cover a withdrawal that might occur from the $200,000 loan made. After the loan is made and the
borrower buys the house, the individual they bought the house from will deposit the $200,000 back
in the bank. As a result of this, the bank has created $200,000 of credit and this money is now
circulating in the economy.
Step 4 A firm applies for a $600,000 loan from the bank to buy a new machine. The bank has
$120,000 of the initial deposit left ($200,000 - $80,000) to cover the 20% reserve asset ratio
requirement for the loan for the $600,000 machine. Another $600,000 has been created with this
loan so the total amount of credit creation of is $800,000 ($200,000 + $600,000).
Step 5 The bank will not make any new loans now because it has reached its 20% reserve asset ratio
limit where it has $200,000 backing $1,000,000 of funds ($200,000 initial deposit + $200,000 house
loan + $600,000 machine loan).
The money multiplier
The money multiplier is the amount of credit that can be created from a certain quantity of money
deposited. The money multiplier can be calculated by using the equation:
1 / minimum reserve requirement = money multiplier
1 / 0.2 = 5
5 x $200,000 = $1,000,000
This example of credit creation shows how an increase in bank deposits of $200,000 can lead to a
$1,000,000 increase in the money supply when the reserve asset ratio is 20 per cent.
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Interest rates
The influence of the base rate
The base interest rate has an important influence over the interest rates set throughout the
economy by banks and other lending institutions. The base rate is the interest rate charged by the
central bank to the commercial banking sector. The financial system in the economy is set up so that
commercial banks need to continuously borrow money from the central bank. If the central banks
change the base rate the commercial banks will pay a different rate and they will then pass on this
change in interest rate to their customers and the interest rate change will filter through the
economy. For example, if the base rate is increased it means commercial banks have to pay more to
the central bank, they will then pass the interest rate increase to their customers and interest rates
throughout the economy (personal loans, mortgage and credit card interest rates) will increase.
Market interest rates
The other important influence on interest rates in the economy is the interest rates set in the money
markets. The market rate of interest is determined by the demand and supply of money.
Demand for money
Firms and households demand money
because they need to make transactions
when they buy goods and services.
There is a negative relationship
between the rate of interest and the
demand for money because as the rate
of interest increases the quantity
demand for money falls as the cost of
borrowing increases.
This means firms and households borrow less and therefore demand less money to buy goods and
services. This is particularly true of goods such as cars and goods associated with home
improvements. As interest rates decrease the quantity demand for money increases as the cost of
borrowing decreases. The demand for money is shown in diagram 3.38.
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Supply of money
The supply of money in the economy is set by the central bank and the banking system. The central
bank controls the money issued to the banking system and the banking system creates credit that
determines the amount of money circulating in the economy. The supply of money is fixed in a given
time period and is perfectly inelastic. This is shown in diagram 3.38.
Equilibrium interest rate
The equilibrium rate of interest rate is set where the demand for money equals the supply of money
in diagram 3.38.
Changes in the market rate of interest
The market interest rate will change if
there is either a change in the demand
for money or the supply of money. For
example, if there is a fall in aggregate
demand in a recession there will be
fewer transactions and the money
demand curve will fall from Md to Md1
causing a fall in the market of interest.
This is shown in diagram 3.39.
Nominal and real interest rates
Nominal interest rates make no allowance for inflation. Most of the economic data used to report
the state of the economy use interest rates stated in nominal terms. If a central bank increases
interest rates from 1 per cent to 2 per cent this will lead to an increase in the nominal interest rate.
The real interest rate makes an allowance for inflation. It is calculated as:
Nominal interest rate – inflation rate = real interest rate
If a country has a nominal interest rate of 5 per cent and the inflation rate is 2 per cent, the real
interest rate is:
5% - 2% = 3%
The real interest rate is used by firms and households to give them information about the returns
they pay or receive on money borrowed or saved. For example, if an individual saves money at a
nominal interest rate of 4 per cent and inflation is 5 per cent they know the real value of their
savings will be falling.
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The tools of monetary policy (HL)
The government has a number of monetary tools it can use to achieve its policy objectives. In many
countries, the government sets the direction of monetary policy through its macroeconomic
objectives and the central bank makes decisions on how the different policy tools are applied.
The minimum reserve requirement
The minimum reserve requirement is the quantity of cash banks must hold as a reserve or keep in
deposit at the central bank. It is a safety net that protects banks in situations where depositors
withdraw more money from their accounts than they normally do and threaten the bank's liquidity
(the amount of cash it holds). If the central bank wants to reduce the money supply it can increase
the minimum reserve requirement of commercial banks and this reduces their ability to create credit
because they have to hold more cash. If the minimum reserves requirement is reduced by the
central bank the banking system can create more credit and there is an increase in the money
supply.
Open market operations
Open market operations are a monetary tool used by the central banks to regulate the money
supply by buying and selling government bonds. If the government sells government bonds in the
financial markets, buyers will purchase them using cash. As cash is taken out of the financial system
there is less money for the banks to use to create credit and the money supply falls. If the central
bank buys government bonds in the financial markets, more cash enters the system and the money
supply increases.
Quantitative easing
Quantitative easing was used extensively
by central banks following the global
financial crisis to increase aggregate
demand. Quantitative easing involves
central banks using open market
operations to increase the money supply
by purchasing large quantities of
government and corporate bonds.
The banking system uses the additional cash from quantitative easing to create credit and the
money supply increases which reduces interest rates. The impact of quantitative easing is shown in
diagram 3.40. As market interest rates are pushed down by quantitative easing this increases
consumption and investment which increases aggregate demand and economic growth.
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Expansionary monetary policy
Expansionary monetary policy is where
the government reduces interest rates
and increases the supply of money to
increase consumption and investment to
increase aggregate demand.
Expansionary monetary policy is normally
used to increase economic growth and
reduce unemployment.
How the policy works
When the central bank reduces its base rate, it charges a lower interest rate to commercial banks
and they pass on this reduction in interest rates to households and firms in the form of lower
interest loans (personal loans, mortgages and credit cards). Lower interest rates will also mean less
interest is paid on the money firms and households hold in banks. This causes consumption and
investment spending to rise which increases aggregate demand. The increase in aggregate demand
leads to a rise in GDP as firms respond by producing more. This also leads to an increase in
employment.
This is sometimes called the monetary transmission mechanism and is shown in diagram 3.41 where
a rise in aggregate demand and the subsequent rise in the demand for labour reduces
unemployment. Expansionary monetary policy also closes the deflationary gap. The flow diagram
shows the monetary transmission mechanism as interest rates are reduced.
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Evaluation of expansionary monetary policy
Strengths
•
Expansionary monetary policy is relatively quick to apply which gives it flexibility in the way
it can be applied. If the central banks have evidence of a rise in unemployment or a fall in
economic growth they can respond by immediately decreasing base interest rates.
•
Monetary policy can be applied incrementally so it can be adjusted to changes in the
economic growth and unemployment rate. If the growth rate is falling or unemployment is
rising month by month, interest rates can be continuously adjusted to tackle the changes in
those rates.
•
Because central banks are independent of governments in most countries they have some
freedom from government political influence. An independent central bank can stop a
government from using expansionary monetary policy to increase economic growth in the
run-up to an election to create economic boom conditions which could lead to inflation.
Weaknesses
•
When an expansionary monetary policy is being applied there may be a rise in average price
level and an increase in inflation. This is particularly true if the rise in aggregate demand
leads to an inflationary gap. This is shown in diagram 3.41 where the increase in aggregate
demand leads to an increase in the average price level from P to P1.
•
When interest rates are very low and even close to zero the central bank has little room to
reduce rates in response to a rise in unemployment or falling economic growth.
•
Commercial banks may not pass on an increase in interest rates. When the central bank
uses expansionary monetary policy and interest rates are being reduced commercial banks
can often increase their profits by not passing on the interest rate reduction. The interest
rate reduction means commercial banks pay a lower interest cost to the central bank but
can still receive the same interest rate from their borrowers if they do not decrease their
own interest rate.
•
A decrease in the Interest rates in the economy relies on households and firms changing
consumption and investment in response to the interest rate change. In a recession, low
levels of business and consumer confidence may mean firms and households do not
increase consumption and investment because they are worried about spending in an
uncertain economic environment. This is particularly true of large investment projects by
firms and the purchase of expensive items by consumers.
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•
There are time lags in the application of monetary policy that make it difficult to manage. It
is estimated that it takes 18 months for the full effects of an interest rate change to have an
impact on the macroeconomy. This means there can be policy mistakes in the application of
expansionary monetary policy. For example, a government might decrease interest rates
and see little increase in consumption and investment in the short run so the government
might cut interest rates again and this leads to a surge in consumption and investment
which causes inflation.
•
An expansionary monetary policy where interest rates are reduced can lead to
a depreciation in the exchange rate as currency investors sell the domestic currency
because of the lower interest returns they receive from domestic banks. As the exchange
rate depreciates it can make imports more expensive and this adds to inflation.
Contractionary monetary policy
Governments and central banks apply contractionary monetary policy when they increase interest
rates and reduce the supply of money to reduce the rate of inflation.
How the policy works
If inflation rises in the economy the central bank raises its base rate which is the interest rate it
charges to commercial banks. The commercial banks then pass on the higher interest rate to their
customers and this raises interest rates throughout the economy. Households and firms start paying
higher interest costs on loans and receiving greater interest returns on money held in banks.
As the interest rates rise throughout the
economy consumption and investment
fall and this reduces aggregate
demand. As aggregate demand falls in
an economy the average price level falls
from P to P1 and inflation falls. In
diagram 3.42 the fall in aggregate
demand closes the inflationary gap as
output falls from Y to YFE.
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The flow diagram illustrates the monetary transmission mechanism of contractionary monetary
policy.
Evaluation of contractionary monetary policy
Strengths
•
Contractionary monetary policy can be applied quickly which gives it flexibility as a policy. If
the rate of inflation rises the central bank can react almost immediately to increase interest
rates to reduce aggregate demand and inflation.
•
Contractionary monetary policy can be applied incrementally so it can be adjusted to
changes in the inflation rate. If the inflation rate is rising month by month, interest rates can
be continuously increased to tackle the problem.
•
Because central banks are independent of governments in most countries they have some
freedom to apply contractionary monetary without political influence. For example, a rise in
inflation might need a rise in interest rates but the government might not want to do this for
political reasons, but an independent central bank can still increase the rate of interest to
reduce inflation.
Weaknesses
•
When a contractionary monetary policy is being applied the fall in aggregate demand may
lead to a reduction in economic growth and even a recession and this will lead to a rise in
unemployment. This is shown in diagram 3.42 when aggregate demand falls from AD to AD1
because of a rise in interest rates.
•
An increase in interest rates by the central bank in its application of contractionary
monetary policy may not be passed on by the commercial banks. The lending market is
competitive and if banks are competing to make loans to new customers, they might not
pass on the increase in interest rates so they can keep attracting new borrowers with lower
interest rates.
•
Similar to expansionary monetary policy, there are time lags in the application of the policy
that makes it difficult to manage. The estimated 18 months it takes for the full effects of an
increase in interest rate to have an impact on the macroeconomy leads to policy mistakes. If
the government increases interest too much this can lead to a fall in economic growth and
even a recession.
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•
An increase in interest rates as part of contractionary monetary policy can lead to
an appreciation in the exchange rate as foreign currency investors are attracted to the
domestic currency by higher interest rates in domestic banks. As the exchange rate
appreciates it makes export prices more expensive and import prices cheaper and this can
lead to a balance of payments current account deficit.
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Unit 3.6 Government management of the economy – fiscal
policy
What you should know by the end of this chapter:
•
•
•
•
•
•
•
•
•
Objectives of fiscal policy
Sources of government revenue
Types of government expenditure
Expansionary and contractionary fiscal policy
Keynesian multiplier (HL)
Crowding out
Strengths of fiscal policy
Weaknesses of fiscal policy
Automatic stabilisers
The objectives of fiscal policy
Governments can use fiscal policy as a demand-side policy to achieve their macroeconomic
objectives in a similar way to the application of monetary policy. Fiscal policy involves governments
using tax and government expenditure to achieve macroeconomic objectives. The tools of fiscal
policy can be used to target the following objectives:
•
Sustainable economic growth
•
Low unemployment
•
External balance on the current account balance of payments
•
Low inflation or price stability
•
Achievement of a more equitable distribution of income
Sources of government revenue
Government can access revenue to fund its expenditure from the following sources:
•
Direct taxation on household incomes in the form of income tax and tax on business profits
in the form of corporation tax.
•
Indirect taxation such as VAT and specific duties on goods and services.
•
Profit from the operations of state-run organisations. Many governments own
organisations in the transport and energy sectors and make a profit from them.
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•
Asset sales when governments privatise industries. When governments sell the assets of
state-owned enterprises it leads to an inflow of funds to the state.
Government borrowing
Government borrowing is an important part of fiscal policy because it is needed when government
expenditure is greater than taxation. Government borrowing is financed by selling bonds in the
financial markets. For example, the Indian government might sell $200 billion of government bonds
to raise $200 billion in funds to spend on health, education and defence, etc.
The budget deficit is one year’s government borrowing. The current Indian budget deficit is $137
billion.
The national debt is accumulated government borrowing over time. The current Indian national
debt is $2219 billion.
Types of government expenditure
There are three types of government expenditure:
•
Current expenditure on the day-to-day running of the government sector such as paying the
wages of teachers, doctors and military personnel.
•
Capital expenditure on investment projects financed by the government such as building
roads, bridges and schools.
•
Transfer expenditure on welfare payments such as unemployment and housing benefits.
The influence of the Keynesian multiplier on fiscal policy
The application of fiscal policy by governments is affected by the Keynesian multiplier. This is
because the application of fiscal policy in an economy involves changing the injections into the
circular flow of income in the form of government expenditure and withdrawals out of the circular
flow of income in the form of taxation.
Defining the multiplier
The government expenditure multiplier is the ratio of change in government expenditure to a
change in national income. A multiplier effect occurs when a change in injections brings about a
greater proportionate change in national income. The multiplier can occur because of a change in
any one of the injections into the circular flow of income: investment(I), government expenditure (G)
and exports (X).
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The multiplier can be measured as the ratio of change in any one of these injections (J) to a change
in national income (Y).
multiplier = change in national income / change in injections
The government expenditure multiplier involved with fiscal policy would be:
government expenditure multiplier = change in national income/change in government expenditure
Multiplier situations occur when funds are injected into the circular flow of income through
investment, government expenditure and exports and this leads to a greater final change in the
value of the national income than the value of the change in the injection.
Diagram 3.31 shows the
circular flow of income with
injections (I, G and X) and
withdrawals (S, T and M). The
increase in injections causes a
multiplier effect to take place,
but the strength of the
multiplier is determined by the
level of consumption and the
withdrawals from the circular
flow, savings, tax and imports.
For example, an increase in government expenditure will cause an increase in national income which
will lead to a rise in consumption by households and also a rise in the amount saved, paid in tax and
spent on imports.
Calculating the value of the multiplier
The value of the multiplier can be calculated by using the following equations:
Multiplier = 1/(1-MPC) or 1/(MPS+MPT+MPM)
Marginal propensity to consume (MPC)
This is the proportionate change in consumption brought about by a change in income. It is
calculated using the equation:
MPC = ∆C/∆Y
If household income rises from $10,000 and consumption rises by $6,000 then the MPC will be:
+$6,000 / +$10,000 = 0.6
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Marginal propensity to save (MPS)
This is the proportionate change in saving brought about by a changing income. It Is calculated using
the equation:
MPS = ∆S/∆Y
If household income rises by $10,000 and savings rise by $500 then the MPS will be:
+$500 / +$10,000 = 0.05
Marginal propensity to tax (MPT)
This is the proportionate change in tax brought about by a changing income. It Is calculated using the
equation:
MPT = ∆T/∆Y
If household income rises by $10,000 and tax rises by $2,000 then the MPT will be:
+$2,000 / +$10,000 = 0.20
Marginal propensity to imports (MPM)
This is the proportionate change in imports brought about by a changing income. It Is calculated
using the equation:
MPM = ∆M/∆Y
If household income rises by $10,000 and imports rise by $1,500 then the MPM will be:
+$1,500 / +$10,000 = 0.15
Calculation
In this case, the value of the multiplier would be:
1 / 0.05 + 0.20 + 0.15 = 2.5
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Example of the multiplier
The multiplier process can be explained using the
following example where the government decides to
spend $2 billion building a new bridge as part of the
improvement in the infrastructure of a region of the
country.
These are the stages of the multiplier effect brought about by the rise in government expenditure:
Stage 1 $2Bn is paid to factors of production to build the new bridge. This will partly be wages paid
to labour who work directly on the construction of the bridge. Funds will also be paid to firms that
supply construction equipment, raw materials and services like law and architects. These payments
will generate income for the workers and for the owners of the businesses who supply factors of
production to build the bridge.
Stage 2 The $2Bn income paid to the factors of production to build the bridge will be partly spent as
consumption expenditure and the rest will be leaked out of the economy in the form of savings, tax
and imports. The size of the extra income consumed depends on the MPC of the economy and the
amount leaked depends on the MPS, MPT and MPM of the economy. In our example the MPC is 0.6
so $1.2Bn will be consumption expenditure and the MPW is 0.4 so $0.8Bn will be withdrawn from
the economy as savings, tax and imports.
Stage 3 The $1.2bn of consumption spending by households will be on buying goods and services
produced by firms and this will become income for the factors of production employed by these
firms. The households that receive the $1.2bn of income will spend part of this income (0.6 x $1.2Bn
= $0.72Bn) on consumption and the rest will be withdrawn (0.4 x $1.2Bn = $0.48Bn) from the
economy as savings, tax and imports.
Stage 4 The $0.72Bn is another spending round that works in the same way as the previous spending
rounds with income to households which is partly spent on consumption and partly withdrawn out
of the economy. This process continues with each spending round getting smaller and smaller until
they no longer add to the total national income.
Stage 5 The flow chart shows how
adding together the income generated
by each spending round gives us the
final change in national income.
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Calculating the final change in national income
The final change in national income in this example is calculated using the equation 1/1-MPC or
1/MPS + MPT + MPM
In this case:
•
MPS = 0.05
•
MPT = 0.20
•
MPM = 0.15
1/0.05 + 0.20 + 0.15 = 2.5
The final change in national income brought about by the $2 billion government expenditure on the
bridge is calculated as:
2.5 x $2Bn = $5Bn
The final change in national income resulting from the government expenditure of $2 billion on the
bridge is $5 billion.
Graphical interpretation of the multiplier
When there is an increase in injections
into the economy aggregate demand in
the economy increases. In our example,
when the government spends $2 billion
on the bridge aggregate demand in the
economy initially increases from AD to
AD1 in diagram 3.32. The additional
spending rounds cause aggregate
demand to increase further and the final
change in aggregate demand is at AD2 in
diagram 3.32.
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Evaluation of the multiplier
The Keynesian multiplier has strengths and weaknesses when it is applied to the economy.
Strengths of the multiplier
•
It is useful for building models of the economy and analysing how changes in national
income are affected by changes in government expenditure, investment and exports.
•
The multiplier can be used to improve economic forecasting.
•
The government can use the multiplier to analyse the impact of a change in government
spending across the whole economy and at a local level.
Weaknesses of the multiplier
•
The marginal propensities to consume, save, tax and import can be difficult to measure and
can change over time. This makes establishing a multiplier value difficult.
•
Isolating the impact of a change of one item of expenditure is difficult to do because
different items of expenditure are all changing at the same time. The government might be
spending funds on a new bridge at the same time as firms are investing in new factories.
•
Many expenditure projects take place over a long time period so expenditure gradually
comes into the economy rather than as one sum of expenditure all at the same time. The $2
billion of government expenditure on the bridge might take several years to be spent.
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Expansionary fiscal policy
Expansionary fiscal is where the government decreases taxation and increases government spending
to increase aggregate demand. For example, the US government has agreed to a $2 trillion increase
in expenditure to deal with the fall in economic growth caused by the Covid19 crisis.
How the policy works
As a component of aggregate demand, an increase in government expenditure will directly increase
aggregate demand. Cutting direct and indirect tax will increase consumption as households have
more disposable income to increase their spending and firms have more profit to fund increased
investment. As consumption and investment increase aggregate demand increases.
Diagram 3.33 shows how an increase in
aggregate demand will shift AD to AD1
leading to an increase in national income
from Y to YFE and the average price level
increases from P to P1. The rise in
national income also closes the
deflationary gap. The rise in national
income can increase the rate of
economic growth and reduce
unemployment.
The flow chart
shows the
transmission
mechanism of
expansionary
fiscal policy.
Increased employment
As aggregate demand increases there is a rise in real GDP which means businesses might produce
more and employ more workers to do this. This is illustrated in the labour market diagram where the
demand for labour increases from ADL to ADL1 and the rise in employment reduces unemployment.
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Fiscal policy and crowding out
An issue with expansionary fiscal policy is the impact it can have on interest rates in the financial
markets. An expansionary fiscal policy can lead to an increase in the budget deficit that in turn leads
to a rise in money market interest rates. This makes financing a budget deficit more difficult and can
make borrowing costs increase throughout the economy. The crowding out process associated with
an expansionary fiscal policy can be summarised in the following way:
•
Stage 1 - Expansionary fiscal policy leads to a budget deficit.
•
Stage 2 - To fund the deficit the government sells bonds in the money markets.
•
Stage 3 - The government needs to make the bonds attractive to buyers which means
increasing the rate of interest paid on the bonds which pushes up market interest rates.
•
Stage 4 - As the government borrows more there is a higher demand for borrowed funds in
the money markets which also pushes up market interest rates
•
Stage 5 - Higher market interest rates reduce consumption and investment, and this leads to
a fall in aggregate demand.
•
Stage 6 - Where expansionary fiscal policy means higher government borrowing in the
money markets this is seen as a situation where public sector spending ‘crowds out’ private
sector spending.
Credit rating
Credit rating agencies can also look unfavourably on
expansionary fiscal policy when it leads to an increase in the
budget deficit. Credit rating agencies such as Moody's and
Standard and Poor, are organisations that make judgements
about the security of government borrowing.
The credit rating agencies may look at very large government deficits unfavourably and downgrade
the government credit rating, which makes the money markets charge higher interest rates to the
government because they appear to be a greater risk. This happened to Greece and Spain in 2012
when they increased their budget deficits following the global financial crisis.
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Evaluation of expansionary fiscal policy
Strengths
•
Fiscal policy is most appropriate for demand deficient unemployment in a recession where
the fall in aggregate demand has caused the rise in unemployment and expansionary fiscal
policy increases aggregate demand.
•
Increasing government expenditure and reducing taxation have a direct impact on the
economy. Cutting taxation directly increases consumer incomes and an increase in
government expenditure directing increases aggregate demand as it is one of the
components of aggregate demand.
•
Fiscal policy does not affect the exchange rate in the way monetary policy does when
interest rates are changed. A decrease in interest rates when an expansionary monetary
policy is applied causes a country’s exchange rate to depreciate and this will not happen
with an expansionary fiscal policy.
Weaknesses
•
Cutting taxes and increasing government spending will lead to an increase in a
country’s budget deficit and national debt. This may be particularly difficult for a
government when there is already a budget deficit because the economy is in a recession
where government transfer spending rises and tax revenues fall.
•
Crowding out of the private sector by public sector spending when a government budget
deficit increases market interest rates.
•
Some economists question the effectiveness of tax cuts in a recession. Tax cuts rely on
households spending the extra disposable income they receive, and they may save it when
they are fearful of spending in a recession when households are uncertain about their
employment.
•
Increasing government spending may lead to an inefficient use of resources. Government
spending on projects just for the sake of spending may mean resources are used to improve
roads that do not need improving or money gets lost in the bureaucracy associated with
government expenditure projects.
•
Fiscal policy lacks flexibility because the government can only change tax and expenditure a
certain number of times each year. The process of changing tax, for example, is difficult
because firms and households need to be told of the proposed changes and they have to be
worked through by the tax authorities.
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•
Increasing aggregate demand through expansionary fiscal policy may lead to a rise in
inflation. This is particularly true if the policy is used when unemployment is not that high
and is not caused by falling aggregate demand. The economy could be operating at full
employment and expansionary fiscal policy just leads to inflation.
•
Expansionary fiscal policy will only really tackle demand deficient unemployment. and fails
with other types of unemployment such as structural and frictional unemployment because
they are not directly caused by falling aggregate demand.
Contractionary fiscal policy
How contractionary fiscal policy reduces inflation
A contractionary fiscal policy is where the
government increases taxation and
decreases government expenditure to
reduce inflation and close an inflationary
gap. A rise in taxation will reduce
consumption if household income taxes rise
and reduce investment if business taxes are
increased.
An increase in tax combined with a decrease in government spending leads to a fall in aggregate
demand. This is shown in diagram 3.35 where AD shifts to AD1 which leads to a decrease in the
average price level and inflation falls. There is also a decrease in real GDP from Y to YFE and the
inflationary gap is closed.
The flow diagram shows
the transmission
mechanism of
contractionary fiscal
policy.
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Evaluation of contractionary fiscal policy
Strengths
•
Fiscal policy does not rely on a transmission mechanism in the same way monetary policy
does and has a more direct effect on aggregate demand. For example, increasing taxation
will directly decrease household income whereas an increase in interest rates relies on the
banking system passing the increased interest rate on to households.
•
Because fiscal policy has a more direct effect on the economy compared to monetary policy
there is a shorter time lag associated with the use of contractionary fiscal policy compared
to monetary policy.
•
Changing tax and government expenditure does not affect a country’s exchange rate in the
way a change in interest rates can change a country’s exchange rate. Contractionary
monetary policy means increasing interest rates which can lead to appreciation in the
exchange rate.
•
Fiscal policy can be targeted more specifically at different sectors of the economy to reduce
inflation. For example, reducing indirect tax will directly reduce the price of goods and
services.
Weakness
•
Raising taxes may have a negative impact on the motivation of workers and entrepreneurs
because of the potential reduction in their income. Reduced incentives might have a
negative effect on the supply side of the economy if, for example, entrepreneurs are less
likely to start businesses because of higher taxation.
•
Higher indirect taxes can add to business costs and higher direct taxes on workers might
mean they ask for higher wages to make up for their reduction in income. Higher business
costs may increase cost-push inflation.
•
Reducing government expenditure and increasing taxation can lead to austerity which has a
negative effect on welfare in society. For example, reducing government expenditure may
mean reducing the quality of public services like education and healthcare.
•
Fiscal policy lacks flexibility because it is difficult to change tax rates and government
expenditure more than a certain number of times a year. On the other hand, interest rates
can be changed much more regularly.
•
Increasing tax and cutting government expenditure can lead to a fall in aggregate demand
which reduces the rate of economic growth and could even lead to a recession and rising
unemployment.
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Automatic stabilisers
Automatic stabilizers are a part of fiscal policy and occur because tax and government expenditure
automatically change during the business cycle, and this has consequences of inflationary and
deflationary gaps.
Inflationary gap
The boom phase of the business cycle may lead to an inflationary gap in an economy where inflation
rises. Automatic stabilisers can reduce the strength of the inflationary effect in the following ways:
•
Direct tax rises in the economy because household income and business profits increase.
•
Government expenditure falls because there is less transfer spending on benefits such as
unemployment payments.
Diagram 3.36 shows how the rise in tax
and fall in government expenditure
causes aggregate demand to fall from
AD1 to AD2 when the automatic
stabiliser starts to work when there is an
inflationary gap.
Deflationary gap
In the recession phase of the business cycle, there may be a deflationary gap and a rise in
unemployment. Automatic stabilisers can reduce the strength of the deflationary effect in the
following way:
•
The amount of direct tax falls as household incomes fall and firms make lower profits. The
indirect tax also falls as households spend less.
•
Government expenditure on benefits increases as unemployment rises and the government
pays more unemployment and related benefits.
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Diagram 3.37 shows how the fall in tax
and rise in government expenditure
causes aggregate demand to rise from
AD1 to AD2 when the automatic
stabiliser takes effect when there is a
deflationary gap.
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Unit 3.7(1) Market-based supply-side policies
What you should know by the end of this chapter:
•
•
•
•
•
•
•
Aims of supply-side policies
Use of the long-run aggregate supply curve to show the
effect of supply-side policies
Explanation of market-based policies: competition policy,
deregulation, privatisation, trade liberalisation,
monopoly regulation
Explanation of labour market policies: reducing the power of labour unions, reducing
unemployment benefits, reducing minimum wages
Explanation of incentive-related policies: decreasing income tax and business tax
Market-based supply-side policies to increase economic growth, reduce unemployment and
achieve price stability
Evaluation of market-based supply-side policies
Aims of supply-side policies
Government supply-side policies aim to affect aggregate supply and achieve the macroeconomic
objectives of:
•
Sustainable economic growth
•
Low unemployment
•
External balance of the current account balance of payments
•
Low inflation or price stability
Supply-side policies and long-run economic growth
Long-term growth
Supply-side policies are often viewed as a long-term strategic set of policies to facilitate future
economic growth over a period of time. For example, increasing the numbers in university education
to improve the skill level of the labour force may take 10 to 20 years to have a significant effect on
the growth of the economy.
Increasing productive capacity
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To achieve long-term economic growth, supply-side policies are often targeted at improving the
productive potential of the economy. This means using policies that increase potential output,
shifting the production possibility curve and long-run aggregate supply curve of an economy
outwards.
This is illustrated by diagram 3.43 where
the long-run aggregate supply curve
increases from LRAS to LRAS1. A
government spending programme on
significant improvements to
infrastructure in the economy would be
aimed at increasing productive capacity.
What are market-based supply-side policies?
The market-based approach
The market-based supply-side approach involves the government trying to increase aggregate supply
by using policies that allow markets to function more efficiently and to achieve the macroeconomic
objectives of sustained economic growth, price stability and low unemployment. Through marketbased supply-side policies, the government tries to create the market conditions needed to allow
the private sector of the economy to find solutions to economic problems.
Market-based supply side can be looked at as three distinct policy approaches:
•
Policies that encourage competition in markets. This is based on the assumption that more
competition between businesses increases economic efficiency.
•
Policies that try to increase efficiency in the labour market. This is particularly important for
employment and worker productivity.
•
Incentive-related policies to increase efficiency, investment and innovation.
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Increasing potential output
The increase in investment and
innovation brought about by marketbased supply-side policies will cause the
long-run aggregate supply curve to shift
outwards from LRAS to LRAS1 in diagram
3.43. This can also be shown by a shift
outwards in the production possibility
curve from PPC to PPC1, which is shown
in diagram 3.44.
Increasing actual output
The improvement in efficiency brought
about by market-based supply-side
policies can lead to an increase in actual
output which is illustrated in diagram
3.45 by a shift from A to B as the
economy moves closer to potential
output.
A market-based approach to achieve long-run economic growth
Deregulation of markets
Over time, markets can become increasingly regulated to protect workers, the environment, health
and safety and the consumer. For example, a clothing manufacturer might be required by law to pay
a minimum wage, put in place health and safety systems on the production line and use sustainable
materials when manufacturing its products. Even though the aims of these regulations might be to
improve welfare they can add to business costs and reduce productive efficiency by making decision
making more complex. By reducing or removing regulations, business costs might fall and productive
efficiency might increase.
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Privatisation of industries
Many industries have been owned and controlled by the government. This is particularly true in
utilities such as energy and water, but also transport and communications. In the UK, for example,
British Gas, Royal Mail, British Telecom, British Rail and British Airways have all been state-run
enterprises in the past. Over the last 30 years, all these industries have been privatised. This means
the assets have been sold to private investors and they have employed management to run the
businesses. The theory of privatisation is that private sector organisations run more efficiently than
public sector enterprises, and this increases overall efficiency in the wider economy.
Trade liberalisation
Most economists believe that free international trade increases
efficiency in an economy through increased competition and
specialisation of resources. Many countries use trade barriers,
such as tariffs and quotas, to protect certain markets. When
trade is liberalised and trade barriers are reduced or removed,
this increases free international trade and the efficiency gains
that go with it.
The ASEAN free trade agreement, for example, between countries such as Indonesia, Malaysia,
Singapore, Thailand etc, increases trade liberalisation and the efficiency gains that go with it.
Monopoly and competition regulation
When monopolies become established in markets they reduce competition and this leads to a fall in
business efficiency. Section 2.11 of this book focuses on monopoly as a market failure and how the
existence of monopolies reduces economic efficiency. As part of a market-based supply-side
approach, the government puts in place laws and regulations that prevent monopolies from
occurring or regulate monopolies if they do exist. The European Union, for example, has specific
laws in its Single Market that prevent monopoly practices such as cartels occurring amongst member
countries of the EU.
Reducing the power of trade unions
A trade union is where a group of employees join together to try to maintain and improve the wages
and employment conditions of their members. Many economists who advocate a market-based
supply-side approach believe that the power of trade unions should be reduced because they reduce
business efficiency and prevent innovation and change. In 2019 many transport workers in France
went on strike because of proposed changes to their working conditions. The French government
were trying to push through market reforms that could reduce business costs and increase
efficiency.
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Changes in taxation
Changes to tax rates and the tax system are seen as an important way of creating greater incentives
in the economy to increase efficiency, investment and innovation. Cutting taxes means that workers
will keep a larger proportion of their income, which may increase their incentive to work harder and
improve productivity. Reducing corporation tax on businesses means they can keep a higher
proportion of their profits, which they can use to fund new investment and research and
development. Lower tax on businesses may also encourage new firms to start up in the economy.
Evaluation of market-based supply-side policy to achieve economic growth
Strengths
•
Market-based supply-side policies use the power of the market to achieve economic growth.
The interaction of private business and consumers might be more powerful in affecting
economic growth in the long run than interventionist supply-side policies.
•
The market-based approach does not involve the government expenditure costs of the
interventionist approach.
•
Similar to interventionist supply-side policies, the market-based approach does not cause
inflation in the same way as expansionary demand-side policies do.
Weaknesses
•
A market-based approach can work in the long run, but it is relatively ineffective compared
to expansionary demand-side policies in achieving an increase in the current rate of
economic growth. The market-based approach will not be as effective in a recession when a
government needs to respond quickly to a fall in economic growth.
•
If the deregulation aspect of the market-based approach involves reducing environmental
laws, it can have a negative effect on the environment.
•
The market-based approach can have a negative impact on low-income workers who may
see their incomes and working conditions negatively affected if the government decides to
decrease minimum wages and cut back on employment protection.
•
If the market-based policy involves reducing income and corporation tax, this could widen
income inequality in the country.
•
Trade liberalisation involves a country reducing trade barriers, which leads to some
industries being exposed to low-cost foreign competition which could cause business failure
and unemployment.
•
Privatisation of certain industries may lead to private sector monopolies which may cause
prices to rise. In the energy and public transport markets, this can have a particularly
negative impact on the consumer.
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Market-based supply-side approach to unemployment
Direct tax and benefits
Reducing direct taxation creates a greater incentive for workers to take available jobs which can
reduce the amount of unemployment. If governments reduce unemployment benefits this also
increases the incentive for workers to accept jobs. A combination of lower direct tax and reduced
benefits makes the opportunity cost of not accepting a job higher because the difference between
someone’s income in work increases relative to the transfer payments they might receive if they are
out of work.
Trade unions
Reducing the power of trade unions takes away some of the
impediments that prevent firms from hiring new workers. This is
particularly true where trade unions negotiate wages above their
market equilibrium level and cause the quantity demanded of
labour to fall.
Minimum wages
Minimum wages can cause a disequilibrium in the labour market, which means the quantity
demanded for labour is less than the quantity supplied of labour. If a government reduces the
minimum wage in the economy, the quantity demanded for labour rises and there is a decrease in
unemployment. Reducing minimum wages is often seen as important to small businesses and this
can encourage them to hire more workers.
Labour market regulations
Governments can reduce the amount of labour market regulation that prevents firms from taking on
new employees. If there are over-protective regulations, such as statutory redundancy payments,
then firms are less likely to take on workers because of the high cost of making workers redundant.
Evaluation of market-based supply-side policy to reduce unemployment
Strengths
•
Market-based supply-side policies can make the labour market more dynamic and reactive
to change. For example, reducing regulations can make it easier for firms to take on workers
more quickly when they are expanding.
•
There is evidence that the private sector is better at creating jobs than the public sector.
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•
The increased incentives associated with market-based supply-side policies can increase
worker productivity.
Weaknesses
•
Market-based supply-side policies can have harsh effects on the unemployed. If
unemployed people cannot find jobs in a recession, then cutting their benefits will lead to
increased poverty.
•
Decreasing employment regulation can reduce the protection workers have in their jobs,
which in turn leads to greater job insecurity and can cause the exploitation of workers.
•
Reducing direct tax might mean unscrupulous employers reduce pay rates because they
know workers are going to receive a rise in their disposable income.
•
Taking away minimum wages legislation means pay rates will fall in certain industries, which
can lead to greater levels of poverty.
Market-based supplied policies to reduce inflation
Monopoly and competition regulation
Market-based supply-side policies that increase competition in the economy and reduce the power
of monopolies can lead to increased efficiency and lower prices. This is illustrated in diagram 3.43
where the increase in long-run aggregate supply from LRAS to LRAS1 causes the average price level
to fall and reduces the rate of inflation.
Reducing the power of trade unions
Trade union activity can push up wages in the economy, which increases business costs. This can
lead to cost-push inflation. Market-based supply-side policies to reduce the power of trade unions
mean that union activity is less likely to push up wage costs.
Changes in taxation
Reducing direct and indirect tax can lead to lower business costs and increase business efficiency,
which leads to reduced inflationary pressures in the economy. For example, a reduction in VAT can
directly reduce the average price level in the economy.
Privatisation of industries
The increased efficiency privatising key industries can bring to the economy can lead to lower prices
and reduced inflation. Privatisation of energy companies can be particularly significant because gas
and electricity costs are a major part of consumer expenditure and business costs.
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Deregulation of markets
Removing and reducing regulations on businesses can increase efficiency and reduce business costs,
which creates the conditions for lower prices and reduced inflation.
Evaluation of market-based supply-side policy to reduce inflation
Strengths
•
The market-based supply-side approach can reduce the average price level and inflation in
the long run at the same time that national income increases. Contractionary demand-side
policies reduce inflation, but often at the cost of falling national income.
•
Increasing economic efficiency and competition in markets can create the conditions for
price stability in the long run.
Weaknesses
•
A market-based supply-side approach is a long-run approach to achieving price stability and
often a rise in inflation requires an immediate policy response. Governments normally use
contractionary fiscal and monetary policy to achieve this.
•
Reducing inflation using a market-based approach can have negative consequences in terms
of inequality, workers’ rights and increased foreign competition.
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Unit 3.7(2) Interventionist supply-side policies
What you should know by the end of this chapter:
•
•
•
•
•
Explanation of interventionist supply-side
policies
Types of interventionist supply-side policies
include education and training, access to
healthcare, research and development,
provision of infrastructure and industrial
policies
How interventionist supply-side policies
increase long-run aggregate supply and the production possibility curve
The application of interventionist supply-side policies to increase long-run economic growth,
reduce unemployment and achieve price stability
Evaluation of interventionist supply-side policies
What are interventionist supply-side policies?
An interventionist supply-side policy is where
the government becomes more actively
involved on the supply side of the economy to
achieve its macroeconomic objectives. Diagram
3.46 shows how the application of
interventionist supply-side policies can increase
the long-run aggregate supply curve from LRAS
to LRAS1 through, for example, government
investment in infrastructure.
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Methods of supply-side intervention to increase long-run economic
growth
The following methods are used as part
of interventionist supply-side policies
that can increase potential output in the
economy and cause the production
possibility curve in diagram 3.47 to
increase from PPC to PPC1 increasing
the potential output.
Education and training
Education is a crucial part of government intervention in the economy as an interventionist supplyside policy because it affects the productive potential of the labour force. This is also true of
government-provided and funded training schemes. More skilled workers can achieve higher levels
of productivity in their work which increases the overall productivity of the economy and increases
potential output.
Healthcare
State involvement in healthcare is important in a similar way to education. A healthy population is
likely to be more productive in employment because employees are less likely to be absent from
work. In addition, physically and mentally healthier workers are likely to be more efficient when
they are doing their jobs. There is also the effect of health on families where family members have
to be carers when there is no effective healthcare. Family members who become carers are either
taken away from the labour market or their productivity at work is reduced. Many governments
invest a high proportion of their total expenditure in healthcare services to make sure the
population has access to high-quality, low cost or free healthcare.
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Infrastructure
State provision and funding for effective infrastructure is crucial to the supply side of the economy.
Infrastructure is the capital and systems that support the overall functioning of a country's economy.
Infrastructure can be in the following forms:
•
Transport systems like roads, bridges, ports, airports and rail services
•
Utility provision in the form of electricity, gas and water supplies
•
Communication networks such as mobile communications, broadband, digital services and
postal services.
Countries where governments have provided well-funded and planned infrastructure create the
conditions for long-term economic growth. Good infrastructure means businesses can achieve
higher levels of productivity, communicate efficiently, easily move their goods around and
effectively access labour.
Research and development
Governments often use a supply-side approach to facilitate innovation and the development of new
technology. This can be done through grants, subsidies and tax incentives for research and
development. Innovation in production systems is very important in leading long-run economic
growth on the supply side. Many economists regard government support for the development of
information technology and communications as important in providing the conditions for significant
advances on the supply side leading to long-term economic growth. For example, many
governments are now providing large-scale support for the development of renewable energy to
make economic growth more sustainable.
Industrial policies
As part of an interventionist, supply-side policy governments can use a targeted industrial policy as a
strategic approach to certain industries to achieve long-run economic growth. Governments often
try to change the structure of production in the economy and target industries that are the most
likely to facilitate economic growth. For example, China and South Korea used a set of industrial
policies in the 1980s and 1990s to focus on their manufacturing sectors so they could target growing
export markets. The government are now looking to use industrial policies to support industries
involved in artificial intelligence, robotics and automated vehicles.
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Evaluation of interventionist supply side to increase economic growth
Strengths
•
Interventionist supply-side policies to increase economic growth can be targeted at areas of
the economy in a way demand-side policies cannot. For example, demand-side policies
cannot effectively deal with the problem of a shortage of skilled labour that is holding back
economic growth, but a training and education policy can.
•
Expansionary monetary and fiscal policy used to increase economic growth often have the
trade-off of increasing the rate of inflation. Supply-side policies do not have this as a
disadvantage and can even lead to lower prices in certain sectors of the economy.
•
Demand-side policies increase the actual rate of economic growth whereas interventionist
supply-side policies increase potential growth which is more likely to deliver economic
growth in the long run.
•
There can be significant social benefits associated with an interventionist approach to
increasing economic growth. Improving the provision and quality of healthcare and
education brings with it external benefits and enhanced economic development as well as
economic growth.
Weaknesses
•
Interventionist policies can come at a significant opportunity cost to the government in
terms of government expenditure in other areas and also the increased tax revenue needed
to fund the policy.
•
Government intervention is often criticised for inefficiency and bureaucracy. State-managed
enterprises and services often suffer from diseconomies of scale which reduces their
efficiency.
•
All government involvement in the economy is subject to some political influence which
might conflict with the economic benefits of the supply-side policy. For example, a
government might provide funding for infrastructure projects in an area of the country
where it needs to encourage support from voters.
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Methods of supply-side intervention to reduce unemployment
Many of the policies used to achieve economic growth may also create employment, but there are
also interventionist supply-side policies that are aimed specifically at reducing unemployment.
Education and training
Governments often use education and training to reduce
structural unemployment. Where workers need to re-skill to find
work, government-funded and managed training schemes can
support unemployed workers as they try to transfer to new types
of employment.
Trade protectionism
Country’s sometimes resort to trade barriers to reduce foreign competition for domestic firms which
protects domestic employment. This has been a key policy of Donald Trump’s administration. The US
government has used tariffs on many manufactured goods such as steel and cars to try and protect
American workers.
Employment agency
Government-financed and run employment agencies to improve information flows in the labour
market can particularly target frictional unemployment, although it can reduce all types of
unemployment. Many government services in this area take place through the internet. For
example, the Indian government has an employment service portal where potential employees can
register for work and be matched with potential employers.
Direct government employment
Governments can try to reduce unemployment by directly employing workers in the public sector.
This can be in state-owned and managed enterprises such as transport, postal services and
healthcare. For example, over 40 per cent of China's and Russia’s working populations are employed
by the state.
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Employment subsidies
Employment subsidies involve the state
paying part of the wages of workers
employed by private-sector employers.
This reduces the cost for firms of taking
on employees and acts as an incentive for
them to take on new workers. The impact
of a wage subsidy is shown in diagram
3.47(1). The subsidy paid by the
government in the labour market cause
the labour supply curve to shift from SL to
SL1. For businesses, this reduces the cost
of employing workers and leads to an
increase in employment from QL to QL1.
The German government, for example, operates a scheme called Kurzarbeit. This is an employee
subsidy scheme where the government pays up to 60 per cent of the wages of a worker who has had
their working hours reduced. This means workers are not made redundant but employed on fewer
hours by their employer. This subsidy prevents unemployment from rising in a recession and was
used extensively during the recession in Germany caused by the Covid19 pandemic.
Evaluation of interventionist supply side to reduce unemployment
Strengths
•
Interventionist supply-side policies are effective at specifically targeting frictional and
structural unemployment. Training and education and employment agencies are particularly
good at doing this.
•
Supply-side policies can also have some impact on demand deficient unemployment in a
recession. Employment subsidies and direct state employment can be used to target certain
sectors of the economy when there is a recession.
Weaknesses
•
Government training and employment agencies cost money to set up and operate and
represent an opportunity cost in terms of other areas of government expenditure.
•
Government training schemes and employment agencies also cost money and can be
bureaucratic and inefficient.
•
Trade protectionism often leads to retaliation from other countries so protecting jobs in one
industry can lead to unemployment in another.
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•
Employment subsidies cost the government money and can be abused by employers who
take on workers with the subsidy rather than paying workers themselves.
•
On their own, interventionist supply-side struggle to deal with a significant rise in
unemployment caused by a recession.
Methods of intervention to reduce inflation
Incomes policy
An incomes policy involves the
government setting a limit on wage
increases to try and break a wage-price
spiral. Diagram 3.48 shows how the
application of an incomes policy reduces
the rate at which short-run aggregate
supply falls when there is cost-push
inflation. With the incomes policy, SRAS
only shift to SRAS1 rather than SRAS2
and the price level only reaches P1 rather
than P2. This approach reduces the
impact of cost-push inflation.
Evaluation of interventionist supply side to reduce inflation
Strengths
•
Incomes and price controls can be used to directly target cost-push inflation in a way
monetary and fiscal policy cannot.
•
One of the main problems of applying contractionary fiscal and monetary policy is the way
both policies reduce aggregate demand and economic growth. Interventionist supply-side
policies do not reduce aggregate demand in the same way.
Weaknesses
•
Controlling wages increases to workers when there is high inflation can reduce real incomes
and can lead to poverty.
•
An incomes policy can lead to conflict and unrest where workers take industrial action such
as going on strike because they cannot get a wage rise to cover inflation.
•
Firms can find their way around wage controls by changing job titles or offering fringe
benefits like company cars.
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•
Wage restrictions distort the operation of the labour market and can lead to labour
shortages.
•
Firms can find their way around the price controls by changing the goods they sell such as
altering the size or name of a product they sell.
•
Maximum prices distort the operation of the goods market leading to shortages and parallel
markets.
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