O
X
F O
R
D
I B
S
T
U
D
Y
G
U
I D
E
S
2020 edition
Economics
F O R
T H E
I B
D I P L O M A
Constantine Ziogas
Marily Apostolakou
2020 edition
Economics
F O R
T H E
I B
D I P L O M A
Constantine Ziogas
Marily Apostolakou
3
Acknowledgements
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Contents
Unit
1:
Introduction
1
.1
What
1
.2
How
Unit
is
economists
approach
the
world?
Unit
Markets
2.2
Markets
2.3
Competitive
2.4
Critique
consumers
–
of
7
4.2
Types
trade
4.3
Arguments
of
the
and
Elasticity
2.7
Role
2.8
Market
of
maximizing
producers
Elasticities
2.6
13
equilibrium
of
of
16
behaviour
of
(HL)
of
trade
supply
or
33
in
common
Market
2.10
failure
Market
asymmetric
2.1
1
microeconomies
36
resources
3.1
3:
and
–
55
power
(HL)
56
economic
in
and
Macroeconomic
3.4
Economics
3.5
Demand
variations
71
activity—
aggregate
supply
objectives
inequality
and
75
84
poverty
105
management
(demand-side
Demand
of
its
economic
demand
3.3
policies):
monetary
policy
1
14
management
(demand-side
policies):
3.7
Supply-side
3.8
Macroeconomic
strengths,
54
(HL)
market
illustrating
Variations
aggregate
3.6
goods
Macroeconomics
Measuring
activity
3.2
failure
scal
policy
policies
124
132
policies—
limitations
and
and
control
and
protection
156
integration
159
4.5
Exchange
rates
164
4.6
Balance
4.7
Sustainable
4.8
Measuring
4.9
Barriers
of
payments
177
development
187
development
188
growth
4.10
to
and/or
Economic
economic
economic
growth
development
and/or
conicts
139
of
strategies
key
191
economic
43
–
information
149
and
access
public
failure
Market
Unit
–
protection
145
Economic
Glossary
2.9
for
trade
25
failure—externalities
pool
international
4.4
development
common
economy
22
demand
governments
global
Benets
10
-supply
The
4.1
against
demand
market
4:
2
Microeconomics
2.1
2.5
economics
economics?
do
2:
to
terms:
www.oxfordsecondary.com/9781382009423
197
1
.1
What
Economics
The
social
as
a
is
social
nature
of
economics?
science
economics,
economics
which
Social
sciences
are
academic
disciplines
that
human
behaviour
from
different
perspectives
psychology,
anthropology,
political
science
Economics
is
one
of
the
social
sciences
as
Promoting
extent
it
able
while
with
human
deploying
to
the
of
testable
the
collection
and
actions
social
and
analysis
falsiable
and
social
scientic
of
and
hypotheses
interpreted
income
or
to
wealth
refer
is
to
inequality,
distributed
equity
is
a
signicant
issue
for
in
a
societies.
which
create
markets
greater
or
governments
equity
or
less
should,
inequality
or
in
an
is
is
an
area
of
much
debate.
relationships
method,
data
to
to,
economy
concerned
of ten
how
and
are
others.
is
to
and
The
include
apply
systematically
society.
study
inequity
may
which
the
about
Economic
refers
formulation
social
Economic
by
the
well-being
well-being
members
of
relates
an
to
the
economy
living
and
standards
includes
the
enjoyed
dimensions:
phenomena.
•
security
in
terms
of
income,
wealth,
employment
and
shelter
Microeconomics
and
macroeconomics
•
Economics
is
divided
into
two
main
the
ability
to
meet
transportation,
microeconomics
and
are
meaning
Greek
words
macroeconomics
small
and
—“micro”
large
and
Microeconomics
•
the
ability
is
concerned
with
the
individual
the
economy;
economy
•
such
it
as
rms,
Macroeconomics
whole;
it
deals
deals
is
with
with
individual
consumers
concerned
or
with
aggregates
units
within
total
output
of
•
as
economy
the
as
overall
a
the
The
time
nine
and
the
central
average
health
care,
an
economy
and
price
make
economic
personal
choices
fulllment
with
and
feel
a
personal
sense
of
nances
employment
ability
to
its
maintain
all
the
above
over
time.
Sustainability
level
of
refers
to
the
ability
of
the
present
generation
growth
to
through
housing,
clothing)
the
markets.
the
such
to
and
Sustainability
unemployment ,
(food,
childcare,
parts
and
of
needs
education,
“macro”
respectively.
security
•
basic
branches
meet
its
needs
without
compromising
the
ability
of
future
level.
generations
to
that
generations
current
meet
their
own
needs.
should
be
It
relates
good
to
the
stewards
of
idea
the
concepts
environment .
The
nine
key
concepts
that
are
central
to
economics
and
that
Change
we
will
be
discussing
throughout
this
book
are
as
follows.
The
economic
world
is
not
static ;
it
continuously
changes.
Scarcity
In
Scarcity
is
fundamental
to
economics,
as
it
is
the
terms
societies
face.
It
refers
to
the
excess
of
human
wants
can
actually
be
produced
to
fulll
these
wants.
are
unlimited.
In
contrast ,
the
resources
of
a
certain
variable
available
study
of
these
wants
are
focuses
not
economic
variable
but
on
the
on
the
change
in
from
one
situation
real-world
to
another.
phenomena,
it
is
With
always
respect
subject
to
to
to
continuous
fulll
economics
Human
the
wants
theory,
over
that
what
economic
problem
level
all
of
change
at
institutional,
structural,
technological,
limited.
economic
and
social
levels.
Choice
Interdependence
Since
resources
are
scarce,
not
all
wants
can
be
satised.
Economic
Choices
must
therefore
be
made.
Societies
have
to
and
between
which
goods
or
services
to
produce
and
how
nations
each
they
want .
Economics
is
thus
also
concerned
over
competing
alternatives
together
with
agent
economic
and
future
consumers,
each
other.
producers,
Any
governments
action
will
impact
other
agents,
of
any
indicating
agents
are
interdependent .
The
that
intended
and
their
unintended
current
as
with
with
all
choices
such
interact
much
economic
of
agents
choose
consequences
of
these
interdependencies
must
consequences.
therefore
be
considered.
Efciency
Intervention
Scarce
resources
must
be
used
in
the
best
possible
way
to
Intervention
produce
the
combinations
of
goods
and
services
that
workings
optimum
for
society.
This
is
known
as
allocative
efciency.
same
time,
it
is
important
to
use
resources
in
a
way
best
minimum
waste.
This
is
known
as
technical
a
Equity
mechanism
do
fail,
that
to
the
idea
of
fairness.
Fairness
is
an
2
as
it
means
different
things
to
different
only
people.
In
is
involvement
markets
organize
room
the
subject
that
the
elusive
market
concept ,
to
creating
not
contentious
guarantee
refers
government
despite
being
in
the
considered
economic
activity.
as
Markets
for
government
intervention.
efciency.
Note
Equity
to
markets
that
of ten
ensures
of
At
the
the
refers
are
outcomes.
of
extent
debate
outcome
of
of
government
but
any
also
there
intervention
is
intervention
no
will
improve
choice
and
Scarcity
resource
allocation.
disappearing
Scarcity
is
the
fundamental
problem
that
all
It
refers
to
the
excess
of
human
wants
over
what
sh
stock s
be
produced
to
fulll
these
wants.
Human
unlimited,
as
individuals
typically
or
prefer
to
have
better
goods
produce
all
of
and
the
more
services.
goods
and
Yet ,
services
it
is
to
not
is
due
to
the
fact
that
resources
are
all
(factors
of
resources
services
are
•
and
four
Land
refer
are
factors
and
provided
natural
deposits,
be
•
into
are
is
used
as
are
the
both
in
inputs
human
in
rivers.
The
of
The
if
available
for
working
Capital
input ,
of
in
is,
are
at
skills.
The
non-
area
as
used
oil
oil,
and
and
now,
to
raw
will
example
and
any
The
point
in
of
is
that
work
is
referred
manufactured
means
capital
and
to
as
the
other
capital
in
speech
where
thus
and
the
time,
number
the
would
labour
of
(a
resources;
production.
limited
The
supply
equipment).
economics
is
people
Entrepreneurship
individuals
is
have
factors
not
of
is
to
in
world
of
Note
different
refer
to
the
other
has
factories,
that
from
capital
willingness
take
risk s
production.
identical
being
future.
to
and
the
a
risk s
must
about
who
do
to
an
available
the
book s
used
in
are
exist .
ability
manage
When
They
these
or
not
called
important
must
a
that
the
is
new
involve
risk s
to
the
and
choices
all
has
the
to
to
wants
would
problem
how
For
most
and
produce
between
much
it
of
wants
these
how
produce.
have
of
to
be
scarcity
are
of
also
Scarcity
which
each
The
in
of
the
great
manner.
increasing
or
The
goal
improving
the
For
for
the
next
cost
best
no
of
is
cost
choosing
implies
example
foregone
opportunity
of
example,
land
wheat ,
the
of
that
has
alternative
any
any
cost
activity
sacriced.
would
producing
been
opportunity
choosing
sacrices
to
some
be
If
necessary,
good
or
service
versus
free
goods
are
goods
to
has
and
avoid
of
to
economic
cost
and
in
services
order
goods,
of
in
examples,
basic
related
Scarcity
questions,
unknown
for
free
that
them
goods
production,
their
as
require
to
be
have
there
production.
perhaps
at
a
zero
resources
seawater
price
have
economic
forces
every
are
scarce
produced.
a
were
There
and
not
been
are
no
scarce
very
air.
Note
few
that
free
used
in
up
the
to
economist ’s
produce
them.
or
the
questions
economy
independently
development
them.
of
to
answer
their
economic
level
system
three
of
fundamental
economic
adopted.
What
to
produce?
Choices
must
be
made
in
all
economies
The
How
necessitates
which
goods
will
be
produced
or
want
cannot
because
the
goods
is
book s
and
produce?
use
there
were
no
their
All
economies
resources
a
and
capital
(machines)
less
and
less
good
in
Should
capital
given
enjoy
to
to
services.
and
in
what
quantities.
on
be
must
order
to
produced
or
make
choices
produce
using
perhaps
rely
on
goods
and
more
labour
more
on
labour?
all
For
whom?
All
economies
must
make
choices
about
how
the
number
limited.
how
and
services
produced
are
to
be
distributed
among
It
population.
Should
all
enjoy
education
and
health
many
scarcity,
Should
all
enjoy
the
same
amount
of
all
goods?
no
a
second
important
of
it
is
important
services
wasting
that
any
to
produce
society
scarce
answering
the
economic
questions
consequence.
versus
government
intervention
the
values
the
resources.
A
market
provide
should
answers
the
be
to
thought
the
market
of
three
can
as
a
mechanism
fundamental
that
questions.
can
For
determine:
sustainability
sustainability
is
closely
related
to
whether
effects
of
current
patterns
of
this
good
or
that
good
will
be
produced
and
in
the
what
environmental
sacriced
made.
scarce,
goods
and
concept
sustainable
available
product ,
sacriced
venture
•
The
use
is
some
other
goods
they
society
two
many
If
be
scarce
example,
Scarcity
to
it
entrepreneurs.
example,
tables
decide
to
resources
combination
a
sacrice.
the
goods
goods
to
Markets
Since
others
scarce
resources.
unlimited,
available
if
Means
The
for
also
zero.
services?
it
the
cost
The
opportunity
the
tables
on
sustainability,
make
undertake
consequence.
choose
and
resources.
and
required
somehow
are
even
natural
opportunity
goods
trees
to
ordinary
3.
of
threat
money.
Entrepreneurship
assess
whether
so
produce
the
in
and
alternative
value
contrast
how
Societies
services
a
of
2.
choice.
polluted
machines,
Choice
has
pose
available
them
using
were
be
about
Scarcity
so
activities
words,
1
.
people
human
limited
meaning
that
as
and
to
management .
considered,
Someone
judgments
becoming
of
of
sense
but
or
severely
force
goods
three
of
This
real-world
•
are
choice
choice.
resources
tools
use
agricultural
sacriced.
zero
of
be
resources
involves
corn
resources
mental,
total
other
of
choice
produce
coal
they
for
cost
Every
renewable.
physical
force
and
land
resources,
sh,
both
labour
are
and
In
stock
world
population.
includes
produced
is
impact
activities
not
that
Opportunity
resources
•
the
atmosphere
current
Such
stock
Economic
or
the
preserving
Economic
people
of
There
deposits,
such
be
available
production
world’s
they
and
below.
mineral
Other
stock
goods
production.
into
resources,
future.
number
produce
agricultural
pastures,
Some
the
parts
limited.
dened
example
the
and
to
factors
as
non-renewable:
production.
limited
and
limited.
(timber)
Labour
for
forests,
lakes
available
forests
known
materials
land,
are
is
production,
nature,
gas,
materials
also
are
production)
whatever
of
raw
by
agricultural
not
to
many
the
will
Given
should
Resources
forests
rewood)
wants.
importance
Resources
or
possible
satisfy
future.
This
virgin
timber
more
as
to
in
that
environment .
and
that
for
wants
demonstrates
are
fact
down
can
depleted
actually
The
cut
societies
that
face.
(being
T I N U
and
: 1
scarcity
N O I T C U D O R T N I
of
O T
problem
S C I M O N O C E
The
quantities
production
3
•
which
a
•
production
good
how
will
Yet,
income
a
rm
should
use
to
produce
market
is
no
from
too
for
as
society ’s
owner
point
to
of
care
the
of
and
these
mechanism
much
that
succeeds
society
a
excessively
each
factor
of
production
to
not
market
view.
Sometimes
results
in
questions.
fails.
For
outcome
the
best
Many
example,
is
the
the
best
it
economy,
step
for
rates
lower
risky
of
other
times,
markets
unemployment ,
income
lending
enough
in
and
may
the
lead
households;
practices
by
or
to
they
inadequate
may
nancial
lead
In
the
of
households
basic
scientic
research.
creates
a
role
for
questions.
decide
to
Then
attempt
to
government
correct
the
is
Households
what
goods
markets
the
better.
However,
there
is
no
thus
a
the
ensure
command
land.
failure.
to
help
answers
governments
failure
is
provide
also
priori
are
guarantee
production
The
as
production
the
necessarily
better,
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much
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160
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one
for
an
the
additional
additional
consumes
per
h o u r,
s at i s f a c t i o n
individuals
and
individual
m o re
unit
d ay,
e n j oy e d
units
s at i s f a c t i o n
of
a
additional
per
will
c o n s u m e r.
be
of
per
week
good
to
of
If
pay
per
a
and
d e c re a s e s .
willing
a
good.
units
less
period
demand
the
price
of
demanded
vertical
curve
a
over
axis;
horizontal
illustrates
good
a
and
time
quantity
axis.
the
the
relationship
quantity
period.
Price
demanded
Given
that
the
is
of
is
the
between
measured
measured
relationship
In
good
on
on
Figure
will
the
be
paribus.
the
willing
between
2.1
.1
,
willing
If
the
and
quantity
demanded
is
inver se
(law
of
demand)
has
A
a
curve
is
negative
demand
more
from
sloping
from
lef t
to
to
per
to
increases
buy
unit
buy
Q2
Q1
to
is
P2
units
P1
then
units
per
then
per
consumers
period,
ceteris
consumers
period,
ceteris
will
be
paribus.
per
right:
(P)
it
slope.
curve
usually
derives
downward
price
able
price
able
the
unit
demand
the
price
Price
and
if
and
can
for
be
the
for
an
whole
adding
up
at
individual
market .
each
The
price
consumer
market
the
P2
or
demand
quantities
P1
demanded
at
the
to
buy
by
price
all
of
three
consumer s
$2.00,
and
able
market
consists
to
of
a
consumer
cappuccinos
willing
in
buy
per
ve
these
market .
A
is
week
For
willing
while
cappuccinos
two
consumer s
example,
and
able
consumer
per
B
week .
then
at
If
the
is
the
price
D
of
$2.00,
market
demand
is
eight
cappuccinos
per
week .
0
Diagrammatically
the
horizontal
the
market
summation
of
demand
the
curve
individual
is
derived
demand
The
non-price
than
the
the
if
that
demand
good
to
This
(or
in
means
service)
demand
price
The
one
less
If
of
at
the
each
of
constant
curve
price
Or,
causes
to
the
the
good
determinants
of
the
a
(or
This
quantity
to
in
higher
is
The
of
one
that
A
typical
goods,
will
market
demand
curve
demand
as
The
same
to
to
a
per
period
(Q)
curve
the
lef t
inferior
the
shown
in
lower
decrease
products.
for
and
D2,
typically
lead
quality
increase
the
decrease
implies
service)
demand
to
some
demand
ceteris
causes
shif ts
2.1
.1
income
are
Particularly,
change
demand
lef t .
the
demand
curve
more
if
under
Quantity
factors)
For
other
They
determinants
shif ts.
of
(“shif t ”
factors
demand.
non-price
demand
demanded.
demand
quantity
be
the
are
Q1
curves.
demand
affect
determinants
then
shif ts
can
to
of
of
demand
demand
the
that
curve
non-price
any
the
of
is
of
that
assumed
increase
determinants
the
are
price
changes,
change
right .
own
assumption.
demand
a
determinants
good’s
factors
paribus
of
determinants
Q2
by
Figure
Non-price
T I N U
The
curve
: 2
demand
as
Figure
is
goods
goods,
demand
consumers
This
demand
quality
in
the
may
case
of
decreases
curve
shif ts
to
an
and
a
increase
shif t
switch
inferior
when
the
of
to
in
the
S C I M O N O C E O R C I M
The
other,
goods.
incomes
lef t
from
D1
to
2.1
.2b.
the
of
good
may
behave
as
inferior
good
a
normal
good
in
one
society
the
or
market
in
a
and
as
an
in
another.
For
example,
then
at
country
with
a
generally
low-income
population,
an
each
increase
in
income
for
cars,
may
lead
to
an
increase
in
the
demand
demanded.
include
the
used
higher
following.
to
a
whereas
incomes,
decrease
in
a
in
further
the
another
country
increase
demand
for
in
where
income
used
people
levels
may
have
lead
cars.
Income
Price
Changes
in
consumers’
income
may
affect
of
related
Substitute
As
income
rises,
demand
called
normal
for
most
goods
will
rise.
are
goods.
Therefore,
an
increase
will
lead
to
an
increase
in
the
demand
for
a
in
competitive
and
the
demand
curve
will
shif t
to
the
right
from
D2
as
shown
in
Figure
unit
considered
one
or
the
and
substitutes
consumers
if
typically
other
Examples
as
include
the
goods
Pepsi
and
satisfy
the
same
Coca-Cola,
need
coffee
and
or
tea,
and
burgers.
For
instance,
the
demand
for
Coca-Cola
is
2.1
.2a.
(a)
Price
are
consumption
D1
pizza
to
goods
normal
want .
good
two
are
in
buy
income
goods:
Such
they
goods
goods
demand.
Normal
good
(b)
Price
per
unit
(P)
Inferior
good
per
(P)
D2
D1
D1
D2
0
Figure
2.1
.2
The
effect
of
an
increase
in
Quantity
per
period
(Q)
income
on
the
demand
for
0
a
normal
and
an
inferior
Quantity
per
period
(Q)
good
1
1
expected
Pepsi.
as
to
increase
More
substitutes
lead
to
an
shif t
to
the
then
right
a
if
an
increase
Price
if
generally,
supermarket
good
X
increase
and
in
the
in
the
demand
from
D1
to
D2,
increases
good
price
for
as
Y
X.
the
are
of
good
Demand
shown
in
price
of
Price
Y
(P)
will
for
Figure
per
unit
considered
X
will
2.1
.3.
per
unit
(P)
D1
D2
0
Figure
For
2.1
.4
The
example,
effect
the
of
an
increase
heavy
in
the
promotion
price
of
Quantity
per
period
(Q)
of
a
complement
adopting
a
healthy
of
certain
D2
D1
0
Figure
2.1
.3
The
effect
Complement
if
they
are
of
an
goods:
increase
two
consumed
in
goods
together
the
are
price
eating
Quantity
per
period
(Q)
of
a
products
high
complements
consumed”),
such
butter
and
jelly
or
coffee
and
sugar.
For
price
of
coffee
increases
then
the
demand
instance,
for
decrease.
people
as
More
generally,
complements
if
goods
then
an
X
and
increase
Y
of
good
Y
will
lead
to
a
decrease
in
the
X.
Demand
shown
in
for
Figure
X
will
shif t
to
the
lef t
demand
from
The
and
more
demand
observing
T
astes
other
of
curve
future
for
will
such
shif t
price
deemed
to
to
products
the
be
of
will
right .
changes
that
the
likely
to
price
buy
of
a
more
good
now
is
going
before
its
to
rise
price
in
the
goes
to
an
increase
in
demand
and
a
rightward
up.
shif t
the
demand
D1
the
price
curve.
of
a
In
the
product
same
will
way,
fall
in
if
consumers
the
future,
anticipate
they
are
likely
for
to
withhold
their
purchases
now
to
take
advantage
of
the
D2,
future
price.
Thus,
the
demand
for
the
product
will
now
2.1
.4.
preferences
desirable
it .
are
lead
decrease
Tastes
demand
demand
are
the
lower
as
The
that
are
in
to
good
the
expect
they
will
that
price
value.
quinoa
popularity
sugar
of
considered
and
the
if
This
may
and
increased
kale
Expectations
future,
the
as
has
as
If
peanut
such
nutritional
increase
substitute
considered
(“jointly
behaviour
people
are
Number
nd
affected
consumers,
and
or
a
good,
the
more
by
advertising,
by
by
considerations
they
will
fashion,
of
As
by
the
and
of
demand
of
consumers
increases,
vice
curve
will
shif t
to
the
lef t.
consumers
number
market)
health.
the
demand
in
for
a
market
most
(or
the
size
products
will
a normal
good
of
tend
a
to
rise
versa.
Recap
Non-price
determinants
Income
of
•
demand
An
a
increase
of
related
•
goods
•
If
goods
X
and
•
preferences
If
X
price
a
of
•
changes
If
the
and
then
Number
of
•
consumers
shif t
other
a
in
the
than
change
along
demand
the
in
the
will
Movements
A
If
price
X
demand
the
has
of
to
when
a
an
inferior
demand
more
demand
curve
is
for
decrease
and
in
vice
then
movement
say
along
a
that
an
to
shif t
consumers
good
to
the
will
rise
and
market
the
a
lef tward
the
to
as
price
the
in
to
the
the
increases,
of
of
and
curve
occurs
when
there
is
a
change
in
the
the
the
good;
demanded.
quantity
12
we
then
Given
an
demanded
say
there
increase
is
also
is
in
a
change
price,
known
as
a
the
in
the
Y
income
demand
will
of
Y
will
lead
lead
advertising,
demand
then
price
curve
will
and
lead
to
an
increase
to
a
decrease
its
is
demand
expected
will
demand
fashion,
curve
shif t
will
to
will
to
the
increase
trends
will
fall
shift
now
in
or
to
health
the
in
right.
increase
the
future,
lef t .
and
the
demand
curve
curve
demand
a
price
whereas
decrease
the
is
rise
also
in
quantity
known
as
an
demanded
that
“extension”
of
the
along
price
the
of
demand
the
good
Shif t
of
the
non-price
demand
curve:
determinants
of
curve:
changes
when
any
demand
of
follows
demand.
the
in
in
in
price
“contraction”
a
curve.
quantity
decrease
to
to
versa.
when
of
of
good
the
Movement
demand
for
consumers’
shif t
price
result
demand
in
lef t .
future,
if
demand
right .
the
a
Or,
in
increase
increase
in
right .
increase
an
in
shif t
increase
will
demand
determinant
we
to
and
will
an
that
shif t
consumers
the
to
to
However,
increase
curve
expected
will
now
right ,
of
an
curve
attractive
demand
lead
good
complements,
the
will
will
curve.
substitutes,
product
of
the
changes;
A
are
income
demand
for
the
then
demand
shif ts
occurred.
Y
a
number
occurs
good
the
are
and
demand
shif t
and
curve
of
its
Y
appears
price
the
of
and
and
for
good
X
considerations,
Expectations
future
and
for
If
consumers’
demand
demand
goods
factors)
shif t
in
demand
T
astes
in
rightward
decrease
Prices
(shif t
the
changes
The
concept
various
The
of
of
of
and
good
merely
and
the
a
way
to
summarize
corresponding
analytically
quantities
that
the
rms
behaviour
are
willing
of
to
rms.
offer
It
is
per
dened
time
as
period,
the
relationship
ceteris
between
paribus.
supply
between
supplied
quantity
is
prices
relationship
quantity
supply
supply
possible
law
The
T I N U
Denition
will
supplied
supplied
per
price
also
is
and
referred
period
quantity
increase,
will
as
to
as
supplied
producers
the
increase,
law
ceteris
of
will
per
be
supply.
period
willing
The
is
to
law
direct
offer
of
(positive),
more
supply
per
meaning
period.
states
that
if
that
This
the
if
the
positive
price
price
increases
relationship
rises
then
the
then
between
quantity
price
of
a
paribus.
HL
Behind
the
law
of
in
supply
costs
returns,
The
producer
is
assumed
to
seek
to
maximize
prots.
because
the
a
rm
has
xed
productive
capacity,
producing
quantities
of
a
good
becomes
more
and
more
is,
more
and
more
marginal
costly).
returns
This
and
is
the
result
increasing
of
the
marginal
specically,
law
that
as
the
more
law
and
of
diminishing
more
units
of
a
marginal
variable
are
used
with
a
xed
factor
(usually
point
beyond
which
total
product
will
capital),
continue
a
decreasing
rate,
or
equivalently,
that
start
to
decline.
Marginal
cost
is
the
to
marginal
extra
resulting
The
supply
The
the
a
from
supply
price
given
a
is
a
good
period
increase
in
output;
it
is
quantity
there
direct
(the
law
of
graph
and
time.
that
the
The
supplied
positive
relationship
of
supply),
slope
but
eventually,
when
are
diminishing
less
will
and
start
less
to
rise.
If
an
additional
additional
output ,
then
unit
to
additional
units
required.
It
of
output ,
follows
that
more
the
and
more
additional
units
cost
cost)
rise,
be
of
additional
clear
that
if
the
units
will
be
additional
increasing.
cost
of
producing
is
and
more
units
is
increasing,
then
a
rm
will
be
willing
but
offer
more
and
more
units
only
at
a
higher
and
higher
price.
product
more
units
will
be
offered
per
period
only
at
a
higher
of
supply.
price,
(additional)
thus
the
reects
the
direct
relationship
of
the
law
change
shows
quantity
price
is
the
of
relationship
the
good
measured
on
between
supplied
the
over
increased
offer
Q2
to
is
measured
on
the
and
between
the
can
supply
be
price
curve
drawn
as
and
is
upward
shown
in
per
per
unit
then
producers
will
be
axis.
to
per
Given
(P)
S
supplied
sloping:
Figure
willing
period.
vertical
horizontal
quantity
P2
units
unit
the
returns
costs
to
be
now
Price
axis;
diminishing
there
curve
curve
of
an
will
marginal
which
cost
the
equal
should
Thus
will
to
as
(usually
to
at
in,
leads
labour
more
a
Due
initially
returns
factor
It
labour)
output .
fall
of
(the
states
in
may
costs.
of
More
marginal
set
labour
achieve
diminishing
cost
difcult
of
(that
change
ever-
returns
increasing
a
Assuming
increasing
that
of
marginal
: 2
Markets—supply
S C I M O N O C E O R C I M
2.2
it
has
a
2.2.1
.
P2
A
supply
market
curve
supply
may
be
curve
an
(that
individual
is,
the
rm’s
supply
supply
curve
of
curve
the
or
a
whole
P1
industry).
derives
by
all
with
from
and
price
of
each
$5.00,
month
the
adding
producers.
rms
per
As
So,
is
market
up
if
the
a
priced
at
quantities
market
willing
then
demand,
the
to
$5.00
per
200
market
supplied
consists
offer
market
the
of
units
supply
will
at
100
per
be
supply
each
price
identical
month
20,000
at
the
units
unit .
0
In
Figure
willing
2.2.1
,
to
offer
if
the
Q1
price
units
is
per
P1
then
period,
producers
whereas
if
will
the
The
the
non-price
good’s
that
are
price
assumed
changes,
the
determinants
own
assumption.
of
determinants
If
the
to
any
be
of
supply
determinants
that
supply
affect
constant
the
shifts.
supply
are
supply
the
supply.
under
non-price
curve
of
of
can
of
the
factors
They
ceteris
determinants
Particularly,
causes
are
supply
if
to
a
(“shif t ”
other
the
than
factors
paribus
of
Q2
Quantity
per
period
(Q)
price
Figure
Non-price
Q1
be
increase
in
supply
more
then
typical
price
curve
shifts
quantity
one
then
one
A
market
supply
curve
factors)
in
supply
change
2.2.1
of
the
less
the
of
to
the
the
right.
good
determinants
supply
curve
quantity
of
(or
of
shifts
the
This
means
service)
supply
to
good
the
(or
is
that
causes
left.
at
supplied.
This
service)
each
Or,
supply
implies
is
if
to
price
a
change
decrease
that
at
each
supplied.
the
13
(a)
Price
(b)
per
unit
Price
S2
(P)
per
unit
(P)
S2
S1
S1
P2
P
P1
0
Figure
The
2.2.2
non-price
Q2
The
effect
on
determinants
Q1
supply
of
of
an
supply
Quantity
per
period
(Q)
increase
include
in
wages
the
0
in
costs
of
factors
of
following.
Goods
in
in
input
prices
increase
(for
example,
if
the
wages
paid
to
or
the
price
of
a
raw
material
the
to
decrease.
good
increases)
used
in
the
the
then,
supply
ceteris
curve
paribus,
is
supply
expected
to
likely
each
willing
Figure
price,
to
rms
offer
2.2.2
will
each
shows
be
unit
the
willing
at
a
to
offer
higher
effect
of
an
less,
is
shif t
price
or
than
using
Assume
that
the
original
increase
supply
a
will
change
also
in
have
the
an
price
effect .
of
a
Other
curve
more
a
protable
farmer
with
a
if
their
xed
prices
amount
it
to
produce
carrots
and
potatoes.
If
the
of
price
the
carrots
goes
they
will
up,
farmers
may
decide
to
reduce
potato
lef t.
in
order
to
produce
more
carrots.
The
supply
of
be
potatoes
will
lef t
S1
decrease
and
the
supply
curve
will
Figure
2.2.4.
shif t
to
the
before.
in
is
become
consider
expected
to
the
from
S1
.
to
S2,
as
shown
in
wages
Price
paid.
to
example,
production
At
supply:
supply
production
of
So,
competitive
competitive
are
For
land
of
(Q)
labour
rise.
increase
per
period
production
goods
If
Quantity
paid
good
Changes
Q
Look
per
at
S2
unit
Figure
2.2.2a—before
an
increase
in
wages
paid,
rms
(P)
were
S1
willing
to
increase
to
offer
offer
then
only
each
price
refer
to
so
Figure
will
willing
Prices
Goods
of
in
per
period
costs
per
Q
to
for
decreases,
units
offer
all
at
Q
units
related
joint
will
period
2.2.2b—before
offer
holds
units
supply
to
be
units
production
Q2
willing
same
Q1
units
so
price
rise,
at
so
price
shif ting
an
price
at
only
supply
to
Af ter
at
If
The
the
in
will
lef t
to
wages,
willing
holds
S2.
price
shif ting
at
Now
rms
increase,
higher
decreases,
paid
be
same
wages
the
wages
rms
P
.
increase
P1
.
P
.
were
rms
P2.
lef t
The
to
S2.
goods
supply:
sometimes
when
one
good
is
produced,
0
another
said
to
good
be
is
also
goods
in
produced
joint
at
supply.
the
A
same
farm
time.
that
is
These
is
also
producing
wool.
If
the
price
of
per
period
(Q)
producing
Figure
lambs
Quantity
are
lamb
2.2.4
The
effect
of
an
increase
in
the
price
of
a
good
in
competitive
meat
supply
increases
increase
the
in
the
the
supply
market,
quantity
of
wool
lamb
farmers
supplied
will
of
increase
will
lambs,
and
its
have
but
at
supply
an
the
incentive
same
curve
will
to
time
Indirect
Changes
to
the
right
Price
from
S1
to
S2,
as
shown
in
Figure
taxes
and
subsidies
shif t
in
government
policy,
such
as
indirect
taxes
and
2.2.3.
per
subsidies,
affect
affect
cost
the
costs
of
of
production.
producing
an
Indirect
extra
unit
of
taxes
a
and
good.
subsidies
An
indirect
S1
unit
(P)
tax
is
a
payment
to
the
government
by
rms
per
unit
of
output
S2
produced,
whereas
government
increase
a
shift
shift
unit
production
of
decrease
a
per
of
the
0
Quantity
the
supply
price
14
2.2.3
The
effect
of
an
increase
in
the
price
of
a
jointly
the
their
and
stock s
and
costs
curve
to
to
only
to
left,
lead
the
is
payment
produced.
the
future
supply
a
lead
and
product
reduce
a
An
rms
indirect
decrease
whereas
to
an
by
a
in
the
tax
subsidy
increase
will
supply
in
and
will
supply
and
right.
price
changes
expected
now.
release
to
They
them
to
are
on
to
rise,
producers
likely
the
to
build
market
may
up
when
per
price
rises
in
the
future.
At
the
same
time
they
may
(Q)
install
Figure
of
is
output
curve
of
temporarily
the
period
of
production
the
subsidy
costs
supply
Expectations
If
a
supplied
good
can
be
new
machines
ready
to
or
supply
take
more
on
more
when
labour,
the
price
so
has
that
they
risen.
Improved
good
at
supply
the
same
curve
cost
technology
of
to
price,
the
Number
allows
to
increasing
right .
producing
rms
more
supply
Improved
each
offer
and
units
shif ting
technology
additional
unit
of
of
the
C ha n g e s
the
affect
decreases
the
the
rms
the
s u p p l y.
supply
good.
of
in
will
right ,
size
As
tend
since
of
the
m o re
to
at
ma r ke t
rms
join
i n c re a s e ,
each
(the
a
shif ting
price
number
ma r ke t ,
m o re
the
for
of
supply
units
will
rms)
e x amp l e ,
be
c u r ve
to
of f e re d .
: 2
the
in
technology
T I N U
Changes
Non-price
Changes
of
determinants
in
costs
of
of
supply
factors
•
production
Prices
of
(shif t
An
increase
will
related
goods
•
If
lead
goods
an
•
factors)
If
to
X
goods
to
X
a
the
costs
decrease
and
increase
lead
in
a
in
Y
are
the
and
Y
of
in
in
joint
supply
are
decrease
in
in
factors
supply
of
of
supply,
good
supply
of
to
an
X
competitive
the
production
and
(such
lef tward
increase
and
to
a
supply,
good
X
shif t
in
as
of
the
price
rightward
an
to
a
in
raw
supply
of
shif t
increase
and
wages,
the
good
of
the
lef tward
the
Y
will
supply
price
shif t
material
prices)
curve.
of
of
lead
good
the
to
curve.
Y
will
supply
curve.
Indirect
taxes
and
subsidies
•
An
to
•
A
indirect
a
subsidy
of
future
price
•
changes
If
the
the
Changes
in
technology
•
Improved
the
Number
of
rms
•
If
The
principle
effect
of
a
along
the
along
here
change
supply
is
in
the
and
same
price
curve.
If
is
with
any
other
of
the
curve
the
costs
supply
product
will
shif t
technology
costs
supply
will
is
of
of
production,
production,
the
(such
as
costs
of
rms
of
demand
enter
by
a
the
curves.
a
lead
market ,
supply
The
movement
determinant
production,
leading
to
to
rise,
an
in
whole
supply
increase
in
curve
supply.
will
A
shif t .
lef tward
A
number
rightward
shif t
to
an
producers
an
increase
in
supply
will
supply,
increase,
decrease
in
supply
and
increase
in
supply
and
to
may
reduce
supply
now
and
shif ting
the
supply
curve
shif ting
the
supply
curve
to
to
of
curve
Movement
when
of
the
shif t
illustrates
along
price
of
the
the
supply
good
curve:
changes
supply
of
the
supply
curve:
when
any
of
the
producers)
non-price
the
a
lef t .
Shif t
changes
to
curve.
expected
to
leading
curve.
right .
shif ts
illustrated
of
the
right .
more
the
Movements
price
increase
of
decrease
shif t
supply
will
shif t
will
rightward
Expectations
tax
lef tward
S C I M O N O C E O R C I M
Recap
a
determinants
of
supply
changes
illustrates
decrease
supply.
15
2.3
Market
The
at
will
consumers
demand
market
equilibrium
equilibrium
price
market
Competitive
which
be
and
and
a
good
will
determined
producers
by
be
sold
the
(that
in
a
is,
by
the
other
competitive
interaction
a
between
interaction
words,
greater
consumers
of
supply
supply).
or,
quantity
Consider
the
market
demand
and
supply
shown
in
Figure
will
be
the
price
that
will
prevail
in
the
producers
are
a
is
of
the
willing
surplus
supplied
are
good
and
able
equal
than
to
is
willing
and
compared
to
line
buy.
to
able
the
There
distance
demanded
is
offer
excess
(hf).
then
to
quantity
If
the
at
P2
price
more
cannot
at
that
level;
it
will
tend
to
decrease.
The
effect
of
market?
excess
Price
P2
2.3.1
.
remain
What
at
quantity
per
the
supply
price
to
(or,
of
a
decrease
surplus)
(that
is,
is
to
to
create
drive
the
a
tendency
price
for
downwards).
S
unit
(P)
Again,
excess
supply
since
there
cannot
be
the
In
fact ,
there
to
move
is
price
is
a
tendency
that
only
one
will
for
the
prevail
price
from
in
price
the
which
to
change,
P2
market .
there
is
no
tendency
P2
f
h
equals
away—the
quantity
price
where
supplied,
quantity
namely
P
.
At
demanded
P
there
is
per
period
neither
excess
e
P
demand
the
nor
price
excess
that
will
supply
prevail
so
in
the
the
market
market
“clears”.
and
it
is
Thus,
called
P
is
the
excess
j
equilibrium
price.
equilibrium
quantity.
P1
found
QS1
QD2
Q
QS2
QD1
at
supply
D
0
the
point
curve—at
2.3.1
The
determination
of
equilibrium
price
in
a
the
price
per
unit
period
exceeds
words,
at
P1
is
at
quantity
P1
,
then
quantity
supplied
consumers
are
as
willing
QD1
competitive
and
demanded
>
greater
quantity
of
the
good
Qd
QS1
.
able
to
In
per
If
other
>
compared
to
Qs
the
demand
more
are
or,
a
willing
quantity
cannot
and
shortage
is
remain
able
equal
demanded
at
that
to
to
than
level;
it
offer.
line
is
will
There
is
distance
supplied
tend
to
of
excess
demand
(or,
of
a
for
the
price
to
then
If
at
the
increase.
shortage)
increase
Since
cannot
be
there
the
is
price
a
(that
tendency
that
will
is
is,
to
to
for
the
prevail
in
supplied
the
or
the
exceeds
Changes
Market
if
in
supply
per
quantity
and
will
a
create
drive
price
the
at
P2,
as
Qd
change
in
the
one
will
of
the
either
curve
will
to
2.3.2a
a
has
h
>
quantity
QD2.
only
unchanged.
equilibrium
determinants
or
either
shows
increased.
where
=
16
is
Q1
.
the
A
>
Qs
the
to
rises
Qd
is
excess
➞
there
falls
the
is
➞
market
price
is
to
not
demand
➞
equilibrium
excess
not
supply
➞
equilibrium
clears
change
in
➞
➞
equilibrium,
supplied,
change.
intersection
and
price
the
in
and
Market
of
market
quantity
no
tendency
equilibrium
quantity
there
is
no
demanded
tendency
equilibrium
is
for
determined
the
demand
is
equilibrium
and
the
is
the
the
supply
curve.
equilibrium
equilibrium
price,
quantity.
In
will
If
be
so
long
either
as
demand
formed.
increase
that
in
the
chocolate
curve
shif ts
to
demand
bar s
the
price
of
demand
decrease
to
the
and
right
changes,
in
or
to
turn
the
the
lef t .
then
demand
demand
distance
are
for
a
right
P1
,
the
case
where
demand
for
Initially,
the
market
is
at
equilibrium
rise
in
price
consumer
is
P1
chocolate
normal
from
there
is
D1
bar s,
good.
to
D2.
excess
assuming
The
At
demand
the
demand
original
equal
supplied.
price.
the
the
As
supply
(D2)
price
curve
from
as
quantity
This
from
k
exerts
increases,
to
h
g.
to
At
g,
g,
demanded
to
an
upward
there
and
the
is
a
exceeds
pressure
movement
along
excess
the
new
demand
on
the
along
demand
has
been
chocolate
and
the
new
equilibrium
is
established
at
a
equilibrium
and
incomes
(hk),
quantity
price
P2
and
a
higher
equilibrium
inter section
quantity
there
price
market
price
the
higher
point
Qs
price
quantity
eliminated
bars
the
equilibrium
change,
curve
Figure
intersects
demand
increase
shif t
curve
market
price
line
If
the
a
equilibrium
A
is
market .
then
QS2
unchanged
remain
new
is
demand
equilibrium
remain
supply
changes,
unit
demanded
market
equilibrium
demand
price
the
which
Info
The
Symmetrically,
the
are
The
at
P1
is
P1
price
the
upwards).
called
quantity
excess
(jv).
equals
tendency
Q
and
quantity
When
effect
e,
price
purchase
the
for
producers
quantity
equilibrium
market
If
a
where
point
the
If
corresponding
The
Q /period
If
Figure
The
v
demand
leads
to
an
of
D2
with
S).
quantity
Q2
(given
by
the
Increase
in
(b)
demand
P/unit
Decrease
in
demand
T I N U
(a)
P/unit
S
S
g
h
: 2
k
P2
P1
h
g
k
P1
D2
D1
D1
0
Figure
Figure
bars
2.3.2b
has
point
h
where
as
bars.
to
is
At
supply
a
a
the
on
the
demand
been
is
A
the
has
to
line
the
shif t
the
and
D2
k
the
and
with
to
P1
of
as
P1
,
a
there
to
and
At
g,
quantity
A
at
good,
chocolate
curve
there
from
is
is
a
D1
is
supply
(given
by
new
h,
where
is
change
in
A
a
shif t
other
the
S).
•
A
if
one
turn
In
the
of
then
the
Figure
shifts
price
say,
the
P1
,
quantity
begins
curve
h.
At
due
there
non-price
to
is
to
fall,
j
excess
by
h
determinants
an
from
P2,
S1
supply
there
supply
are
to
equal
results
a
the
has
been
but
a
of
S1
equal
on
Figure
to
the
At
line
demand
equilibrium
by
the
a
curve
to
has
price
j
to
h
lower
of
there
an
causing
and
is
along
reached
eliminated,
and
is
and
shif t
P1
,
to
causes
Equilibrium
been
P2
This
P1
increase,
from
h.
price
(kj).
to
due
are
lef tward
initial
begins
k
say,
equilibrium
quantity
distance
demand
from
2.3.3b
initial
and
shown
S2.
which
(S2)
The
price
is
to
price,
excess
in
and
quantity
Q2.
in
one
shif t
to
in
the
curve
the
the
leads
new
demand
supply
to
a
movement
intersection
curve
curve
to
leads
the
along
the
point .
to
new
a
movement
intersection
point .
A
shif t
S2
for
Q1
.
At
to
the
line
and
at
along
and
j
supply
Both
in
the
(S2)
since
there
price
demand
from
is
a
quantity,
k
demand
Sometimes
equilibrium
(jk),
curve
curve
to
the
leads
new
to
a
movement
intersection
along
point .
lef t .
where
Therefore,
curve
the
demand
in
the
technology,
original
equilibrium
and
to
increase
distance
movement
supply
or
is
An
agricultural
eliminated
(a)
right
wheat
in
supply
decrease
demanded.
new
higher
of
or
the
and
in
S2.
quantity
along
intersection
to
P1
improvement
exceeds
and
increase
either
equilibrium
quantity
excess
price,
the
either
shif t
curve
and
to
will
will
initial
and
supplied
equilibrium
(given
the
price
supply
from
h,
curve
2.3.3a
equilibrium
supply,
supply
supply
supply
curve
higher
curve
the
changes,
the
shown
subsidies.
supply
•
Similarly,
in
from
along
supply
is
farm
demand,
pressure
along
A
Q/period
has
established
Q2
Q1
equilibrium
curve
movement
there
of
decrease
excess
at
new
supply
where
The
the
supply
j
the
a
movement
excess
point
Q1
.
is
in
elimination
upward
excess
supplied
the
decrease
an
downward
equilibrium
lower
for
Q2
equilibrium
chocolate
substitute
along
the
market
equilibrium
quantity
exerts
on
equilibrium
and
demand
price
g,
for
at
a
falls,
g.
new
a
is
demand
the
(hk),
h
is
price
This
price
from
from
P2,
in
demand
demand
price
0
Q/period
in
market
equilibrium
curve
(D2)
of
in
Q2
change
where
distance
As
a
the
demanded.
price.
price
of
decreased
lef tward
eliminated
intersection
case
Initially,
original
curve
effect
decrease
supply
lower
The
equilibrium
bars,
quantity
pressure
at
Q1
.
equal
exceeds
along
the
cereal
There
D2.
shows
decreased.
quantity
such
Q1
2.3.2
D2
S C I M O N O C E O R C I M
P2
to
lower
a
both
demand
both
curves.
the
point
the
new
price
and
and
how
and
where
of
this
the
old
equilibrium
change
change.
curves
In
have
according
cases,
the
depends
which
to
on
the
how
can
the
lead
simply
effect
This
of
change,
might
equilibrium
changed.
to
might
This
intersected
such
quantity
supply
diagrammatically
to
happens,
intersect.
much
supply
determinants
supply
When
ones
and
number
a
shift
moves
point
on
in
from
where
equilibrium
much
be
two
causing
to
demand
determined
shifts
is
larger.
Q2
D).
Increase
in
supply
(b)
P/unit
Decrease
P/unit
in
supply
S2
S1
S1
S2
h
P2
j
k
j
k
P1
P1
h
P2
D
D
0
Figure
2.3.3
Q1
The
effect
of
a
change
Q2
in
supply
Q /period
on
market
0
Q2
Q1
Q /period
equilibrium
17
The
role
The
operation
invisible
hand
markets
in
of
a
to
the
of
the
(a
phrase
reach
competitive
producing
supply
of
in
price
to
either
in
the
the
a
price
market ,
same
as
more
a
or
mechanism,
allocation
product ,
to
and
less
the
of
scarce
there
a
a
signal
also
by
known
Adam
automatically.
where
leads
of
mechanism
introduced
equilibrium
product
acts
price
are
change
change
also
in
for
more
the
a
of
some
kale
price
change
resources.
or
excess
the
case
where
demand
for
a
product
has
example,
the
spreading
of
the
health
benets
value
of
kale
(a
green
leafy
an
increase
of
in
in
Figure
the
demand
for
kale
vegetable)
in
the
to
a
along
rise.
will
be
new
new
in
creates
the
the
price
cutting
of
the
in
the
h
to
back
quantity
it
f.
on
At
is
is
now
there
the
their
The
for
kale,
reached
its
at
in
There
to
j.
price
j
an
purchases
demanded.
f
is
same
increase
curve—from
market
equilibrium
incentive
as
increases,
market.
demand
the
market,
curve—from
decrease
the
also
to
as
out
exists
A
So,
supply
dropping
It
kale
As
is
a
long
will
when
kale
reaches
P2
and
the
equilibrium
quantity
the
Q2.
What
and
has
is
market .
happening
is
that
the
higher
price
of
the
good
is
led
This
that
consumers
are
willing
to
see
resources
diverted
is
from
shown
the
demand
to
signalling
to
them.
consumers
leads
effectively
nutritional
for
more
increased.
price
For
increased.
offer
along
“contraction”
as
has
to
even
also
continue
Consider
kale
protable
time,
change
leading
thus
for
producers
“extension”
or
This
incentives,
and
demand
rms
demand
price.
produced
the
allows
specically,
many
the
its
creates
good
More
very
in
as
Smith),
other
uses.
This
is
just
what
producers
do:
they
divert
2.3.4.
resources
(such
as
land,
labour
and
capital)
from
uses
and
P/unit
S
allocate
j
P2
them
in
takes
place
More
generally,
and
the
only
as
a
protability.
production
a
result
rise
in
Firms
of
the
of
the
kale.
resource
change
demand
respond
A
by
for
in
a
the
good
increasing
reallocation
price
raises
the
of
its
kale.
price
amount
h
f
P1
of
the
good
goods
with
protable.
Q1
Q2
This
amount
Q /period
less
Figure
2.3.4
Increase
in
demand:
the
market
for
the
market
is
in
equilibrium
at
is
at
P1
per
unit
and
quantity
is
h
at
whereby
Q1
per
the
time
price
some
the
scarce
resources
kale
is
from
illustrated
D1
equal
on
production
to
the
to
D2.
the
price
information
by
At
line
of
of
a
of
land,
good.
labour
there
distance
The
thus
The
rightward
P1
,
kale.
and
the
is
and
(hf)
shif t
as
a
of
puts
in
the
signal
in
the
excess
that
increase
acts
increase
now
the
demand
they
is
for
offer
produce.
divert
that
scarce
incentive
good
to
society ’s
in
an
they
goods
to
resources
have
resources
signalled
Resources
to
market.
will
are
by
producers
the
from
become
a
more
reallocated.
fall
in
price.
decrease
The
again
the
goods
be
are
now
reallocated.
such,
producers
capital
and
demand
an
to
of
We
in
kale
is
pressure
kale
producers
only
to
acting
changes
in
in
their
own
relative
self-
prices
their
kale
have
a
is
seen
market .
free,
then
emits
of
behaviour
It
as
if
an
and
are
responsible
invisible
hand
for
guides
the
their
new
behaviour.
for
curve
for
upward
price
consumers
responding
allocated
demand
demand
and
of
outcome.
to
fall
so,
to
period
adjust
with
of
a
as
protable
interest
kale
acts
do
kale
As
Initially
then
To
prices
Therefore,
Symmetrically,
D2
D1
0
offered.
lower
meaning
whoever
determined
that
that
They
is
prices
also
that
there
willing
price
have
have
will
a
is
and
end
a
signalling
rationing
no
government
able
up
and
to
with
pay
the
incentive
function.
the
If
a
role
market
intervention,
market-
good.
Recap
The
functions
of
The
signalling
The
incentive
the
price
mechanism
function
Changes
function
Changes
the
The
rationing
function
operation
resources
Market
may
the
The
price
as
signals,
create
market-determined
to
mechanism
competing
act
price
communicating
incentives,
pay
that
moves
price
price
are
markets
to
will
the
guarantee
ones
be
but
(as
pay).
We
For
the
worth
as
it
pay.
18
is
surplus
willing
you
it
is
say
sake
90
to
nd
pay
that
worth
that
of
cents
worth
The
who
equilibrium
will
and
$1
.00
for
a
cold
sof t
drink
at
is
15
is
therefore
to
market
participants
participants.
to
respond
to
that
the
end
up
buyers
with
determines
the
who
the
are
willing
and
good.
allocation
of
scarce
cents.
the
price
is
only
75
cents.
You
the
to
more
you
consumer
you
argument ,
you.
more
to
enjoyed
to
You
you
a
the
assume
would
than
surplus
than
you
price
consumer
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that
buy
market
enjoyed
you
surplus
buy
a
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this
25
the
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consumer
equal
to
40
surplus
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from
You
consuming
were
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at
for
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two
units
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much
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they
were
the
worth
and
you
ended
up
paying
only
to
$1
.50.
to
is
unit
have
second
$1
.90
the
cents.
unit
second
price
from
have
of
The
the
you)
drink
information
market
uses.
most
beach
motivating
efciency
Consumer
You
of
between
price
in
information.
able
The
in
to
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More
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and
For
how
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curve
how
much
Q
in
the
much
a
illustrates
consumer
surplus
consumers
they
actually
demand
how
are
to
at
the
the
difference
most
to
pay
distance
to
the
pay.
diagram,
much
refers
willing
that
the
vertical
specic
unit
is
worth,
at
the
(or
to
consumers.
distance
pay
P
price
dollars
was
dotted
that
QH)
even
line),
last
at
to
the
Q.
Q
most
slightly
then
unit
Unit
in
Figure
consumers
to
buy
higher
they
as
it ,
not
Equivalently,
at
a
Q’
worth
P
of
P’
If
the
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worth
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more.
level
been
is
be
cent
the
have
unit
is
would
not
(say,
would
2.3.5
they
to
to
the
grey
to
buy
additional
never
unit .
it .
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Later
the
cost
accept
of
producing
anything
minimum
you
will
marginal
it
less
would
realize
cost
(MC)
that
to
that
be
extra
accept
the
curve
unit .
willing
is
the
supply
of
the
to
cost
curve
Q’F)
as
that
is
the
most
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of
is
would
extra
producing
nothing
but
consumers
be
S,
MC
: 2
distance
rm
rm.
P/unit
(or
A
offer
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F
to
pay
to
acquire
it .
The
vertical
distance
to
a
demand
curve
P
measures
the
marginal
benet
(MB)
enjoyed
from
T I N U
most ,
that
unit .
P/unit
F
J
H
0
Q
Q
Q /period
P
Figure
So,
F
2.3.6
for
a
Producer
rm
to
surplus
be
willing
to
offer
unit
Q
in
Figure
2.3.6,
the
P
lowest
D,
0
Q
Q
2.3.5
Consumer
less.
If
grey
dotted
the
that
it
happens
that
the
price
in
the
market
is
P
dollars
will
buy
all
units
up
until
(at
the
limit)
unit
Q,
of
these
units
is
worth
more
to
them
than
the
market
require
them
it
Q.
For
to
pay.
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would
not
buy
any
units
dollars
would
example,
they
(or
be
they
distance
willing
would
be
to
Q
units
would
Q’F)
pay
forced
are
not
buy
unit
Q’
as
it
is
they
which
to
for
to
worth
would
is
the
them
it
at
pay)
is
(this
the
is
most)
higher,
at
as
much
and
P
the
as
a
market
area
(0QHF)
to
dollars.
consumers
It
as
have
sum
been
of
all
willing
vertical
to
pay
to
distances
to
price
enjoy
consumed.
Q
of
P
units,
Consumer
between
dollars,
they
will
end
a
diagram,
or
the
surplus
area
price
is
per
unit
therefore
(0QHF)
the
good
rm
may
market
rm
would
less
(say
would
be
not
willing
at
the
have
to
level
been
offer
of
the
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fewer
units
to
per
is
all
and
area
and
surplus
above
the
is
for
the
the
(PHF),
required
is
rm
P’
to
(or
be
willing
distance
to
Q’F).
that
be
the
market
willing
to
price
offer
per
is
P
dollars
period
all
per
units
unit ,
up
unit
Q.
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would
not
be
willing
to
until
offer
require
more
(P ’
or
distance
Q’F)
than
unit
they
get
require
from
the
to
market .
be
willing
It
to
follows
that
offer
units
Q
the
is
minimum
area
rms
(0QHJ),
is
the
market
sum
price
of
of
P
all
vertical
dollars
per
distances
unit ,
up
rms
until
will
unit
actually
Q.
Given
earn
these
(0QHP)
by
selling
Q
units
or
the
price
per
unit
(P)
times
Q.
quantity
offered
(Q).
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producer
surplus
is
area
(JHP),
the
area
between
area
(0QHP)
and
area
(0QHJ).
quantity
the
a
diagram,
producer
surplus
is
the
area
above
the
(0QHP).
the
price
Equivalently,
payment
the
unit
paying
times
area
Q.
area
line
for
below
the
curve
good
and
below
produced
and
the
price
line
for
the
units
of
sold.
the
units
of
consumed.
Producer
A
consumer
curve
slightly
the
It
least
would
would
the
demand
cent
follows
until
up
will
would
supply
On
Q.
unit
the
happens
they
On
difference
a
(what
that
enjoy
up
not
Q’
difference
(0QHP)
not
they
price
the
Given
even
then
unit
including
as
area
units,
QH),
worth
a
amount
was
line),
last
rms
which
that
distance
past
Q’
P’
price
but
unit
so
and
unit
(or
price
then
would
dollars
as
If
each
P
then
offer
consumers
is
surplus
period
If
required
MB
Q /period
offer
Figure
price
S C I M O N O C E O R C I M
H
P
surplus
be
price
willing
is
$3.00
to
Social
or
Social
community
or
consumer
offer
then
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the
unit
rm
of
a
will
good
for
certainly
$2.00.
decide
If
to
the
of
community
surplus
surplus
and
the
surplus
is
dened
producer
as
the
surplus.
sum
It
is
a
of
the
measure
welfare.
offer
P/unit
that
unit.
We
say
that
the
rm
enjoys
a
producer
surplus
equal
S
h
to
$1
.00.
the
next
price
it
a
is
Assume
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if
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producer
from
that
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the
price
rm
surplus
offering
both
the
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was
would
of
80
these
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at
least
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cents.
units
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have
$2.20.
offer
The
been
this
Since
unit,
producer
$1
.80.
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willing
the
to
market
enjoying
surplus
required
at
offer
it
from
enjoyed
least
$4.20
e
P
to
be
More
willing
offer
generally,
between
to
to
the
receive
actually
to
the
these
producer
minimum
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receive
units
amount
offering
it
surplus
producers
some
from
but
earned
refers
(rms)
of
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the
$6.00.
to
the
would
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difference
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and
willing
what
they
f
amount .
D
0
For
each
curve
Q
in
a
illustrates
supply
the
diagram,
minimum
a
the
vertical
rm
distance
requires
to
be
to
offer
that
specic
unit .
This
would
be
nothing
Q /period
the
willing
Figure
to
Q
but
2.3.7
Social
surplus
the
19
In
Figure
2.3.7
,
given
a
market
price
P
and
an
equilibrium
P/unit
S,
quantity
Q,
consumer
surplus
is
equal
to
area
(heP)
MC
while
$18.00
producer
surplus
surplus
it
is
follows
area
that
it
(Pef).
is
Given
equal
to
the
denition
area
of
social
A
(feh).
$14.00
F
J
P
Recap
H
$ 8.00
B
Consumer
the
surplus:
much
difference
between
how
$ 6.00
the
most
they
Producer
surplus:
consumers
the
to
pay
actually
would
be
and
willing
how
at
much
pay
difference
minimum
are
D,
between
producers
willing
to
the
(rms)
receive
Figure
some
amount
of
the
2.3.8
what
they
actually
Figure
offering
this
2.3.8,
point
units
up
surplus:
the
sum
of
producer
consumer
and
surplus
is
equal
It
is
cost
efciency
goods:
apples
and
oranges,
and
one
to
Determine
some
allocation
of
land,
which,
in
some
being
amount
produced.
of
apples
The
and
question
more
unit
(a
kilogram,
a
ton)
of
some
that
amount
arises
is:
should
more
land
go
apples
to
The
The
one
(measured
the
the
it;
is,
be
cost
it
when
cost .
for
the
from
yes
is
from
than
if
the
production
following
it
value
more
would
that
what
the
the
valued
society
vertical
(Q)
society
sacriced
distance
by
up
that
last
that
be
will
produced
increased
reects
is
from
a
free
lead
and
allocation
price
to
long
value
from
(=
of
is
competitive
the
as
optimal
and
(=
to
to
pay,
produce
that
Q
society ’s
market ,
amount
point
extra
point
to
to
towards
of
benet
the
extra
gain
of
not
to
be
(the
sum
of
the
consumer
and
of
each
view.
=
Allocative
efciency
is
generally,
For
the
last
to
enjoy
unit
marginal
Q
benet
(MB)
(MC).
why.
unit
Q’
Referring
to
which
We
be
is
to
Figure
produced
more
could
unit ,
Q’.
say
society
Similarly
would
surplus
up
as
cost
of
than
that
would
for
to
$6.00
until
much
view
(JHF)
What
if
and
as
unit
as
it
the
if
2.3.8,
is
worth
$6.00
the
gain
Q’’,
produce
from
it
market
a
as
it
would
did
surplus
is
($8.00);
unit
including
it
would
would
forces
good
less
Q’’.
unit
cost
all
cost
than
follows
that
surplus
is
have
units
have
Q
by
FH.
is
to
It
lost
would
the
until
a
have
have
of
and
all
of
worth
more
society
The
Q
same
which
produce
unit
Q
If,
is
it;
of
exactly
that
worth
that
is,
that
unit
produce
lost
lost
units
and
If
worth
unit
from
some
by
for
by
more
per
than
either
is
Then
the
last
less
lost ,
period,
unit
produced,
achieved.
is
P
(=
achieved
MB)
and
=
MC ,
social
then
surplus
it
social
is
efciency
area
they
maximized.
the
to
reason
society?
Social
surplus)
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price
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2.3.9,
which
depicts
the
market
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the
consumer
surplus
quinoa
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consumer
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the
area
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.
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P
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9
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8
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1
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2.3.9
1
The
2
market
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8
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S C I M O N O C E O R C I M
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Consider
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consumer
T I N U
HL
21
HL
Rational
When
with
consumer
analysing
a
model
underlying
choice
consumer
of
rational
rational
Utility
behaviour,
consumer
consumer
economists
choice.
choice
are
The
work
The
assumptions
explained
here.
decide
upon
the
purchase
of
different
goal
choose
baskets
to
•
and
services
Preferences
are
based
on
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considered
the
able
to
rank
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budget
of
that
goods
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and
the
consumer
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to
basket
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or
state
prefers
whether
he
or
she
Preferences
are
transitive,
choices
that
are
if
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basket
meaning
consistent
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prefers
(income).
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to
basket
that
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with
basket
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basket
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information.
consumers
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to
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products
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surrounding
choices.
economic
preferences
and
theory,
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rational
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all
consumers,
available
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reach
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consumption
choice
that
maximizes
consumer
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live
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budget
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constraints.
•
(satisfaction)
allows
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utility
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information,
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consumer
consumer
each
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have
awareness
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instance,
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information
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prices,
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to
For
full
basket
goods
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consumer
services.
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example,
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of
consumer
constraint .
preferences.
complete:
baskets
rational
budget
basket
reach
Perfect
is
the
the
of
their
goods
of
satisfying
her
Consumers
maximization
more
of
a
good
is
better
for
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choice
is
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optimal
choice
and
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the
behaviour
has
been
a
result
of
pure
self-interest .
consumer.
HL
Prominent
behavioural
behavioural
of
good
psychology
Behavioural
rational
theory.
as
and
economics
are
model,
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houses
practice.
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or
higher-ending
more
highly.
example,
estate
perceptions
cheap
exploited
much
all
inuences
relatively
the
participants
individual
and
economic
predictions
that
valued
similarly
(Thaler2015).
standard
from
has
strong
sciences”
by
deviations
indicating
than
social
argues
many
Richard
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other
decision-makers
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standard
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agent
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economics
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choices
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more
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presented
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rules
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decision-making
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specically,
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to
contribute
reduced.
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choice
have
is
based
perfect
on
the
information.
assumption
Yet ,
cannot
access
to
full
and
in
practice
perfect
their
choices
are
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fully
informed
and
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cannot
be
optimal.
attention
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have
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at
result ,
least
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goal.
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consumer
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choice
believe
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plays
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part
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model
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rational
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possibilities.
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therefore
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regret .
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engage
information—so
costs
on
face.
consumers
necessarily
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bounded
idea
that
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choices
soon
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information,
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decision-making.
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time
making
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highlight
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can
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smartphone
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self-control.
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recall.
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use
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interfere
choice
with
an
architecture
individual ’s
and
nudges
freedom
to
claim
choose.
if
people
decisions
are
are
always
made,
inuenced
complete
by
the
freedom
of
context
choice
in
is
feasible.
Perhaps
to
prevent
people
from
being
intervention
is
required.
With
proper
regulations
it
is
able
likely,
but
not
necessary,
that
the
choices
people
make
guest
was
better
choices.
used
choose
assumes
that
prots:
maximizes
total
to
HL
maximize
that
and
cost
pursue
not
misled
objectives
producer
total
the
those
people
included
area
reducing
they
are
satisfaction
from
to
that
your
enterprise
more
to
sent
in
An
some
plate
Letters
people
were
payments
up
the
they
really
with
10
more.
waste.
social
collection.
of
or
which
experiment
tax
out
payments”
T
ax
letters
with
“9
Having
recycle
food
as
tax
However,
Similarly,
aid
such
date
that
less
UK
phrases
a
the
(see
the
is,
of
2.1
1).
other
of
to
difference
section
range
goal
that
a
enable
produce
long
the
rm
term.
between
out
However,
dominance
goals
of
to
Also,
business,
in
raise
prices
increasing
which
the
and
market
reduces
enjoy
share
more
may
competition
prot
force
and
in
the
rivals
increases
market .
instead
Satiscing
of
maximizing
its
prots.
These
include
the
following.
The
Corporate
social
term
and
Firms
may
mode
line
of
of
the
child
which
both
may
or
of
strict
may
of
the
avoidance
labour
a
and
interests
operate,
involves
from
operation
with
they
depart
local
a
free-market ,
pursue
the
wider
and
activities
dangerous
create
satiscing
was
introduced
by
Herbert
Simon
responsibility
negative
prot-maximizing
objectives
that
community
global
such
image
are
pollution,
conditions,
with
in
which
communities.
as
working
in
the
all
because
within
not
strives
use
level
of
a
aim
This
of
consumers.
derives
as
well
achieve
a
or
at
and
as
of
the
informational
prots
least
or
some
revenues.
satisfactory
“sufce”.
objectives
maximizing
prots
achieve
“satisfy ”
conicting
rm
at
to
of
from
It
describes
various
limitations,
revenues.
means
a
Instead
pre-determined
This
that
when,
stakeholders
rm
it
does
only
minimum
rms
aim
to
outcome.
Overall,
Growth
corporate
business
that
lives
at
social
and
include
of
the
a
responsibility
sense
goals
of
involves
obligation
encompassing
workforce
and
their
to
ethical
satisfy
positive
families
ways
doing
long-term
impact
as
of
well
on
as
of
goals
the
society
large.
Firms
By
into
total
of ten
share
output
seek
increased
24
also
A
wish
output
larger
different
to
sold
growth
rm
is
maximize
subject
the
also
markets
as
to
rm
in
a
well
growth
may
be
better
as
(that
is,
non-negative
into
able
to
position
lower
to
different
the
prots).
unit
diversify
products.
share
The
Market
of
maximizing
costs.
Market
may
volume
is
the
that
to
a
percentage
business
increase
market
their
share
can
of
has
total
in
market
a
sales
share.
increase
(by
specied
This
market
value)
market .
occurs
power
or
Firms
since
and
may
consequence
lowering
the
of
volume
chosen
equal
such
associated
of
level
the
of
output
of
risk s.
The
without
output
average
diversication
the
costs
condition
incurring
average
incurred
is
an
to
maximize
losses
revenue
(see
overall
is
that
earned
section
2.1
1).
at
the
should
Price
of
elasticity
elasticity
quantity
The
of
of
demand
demanded
following
demand
formula
to
is
(PED)
a
used
Q2
−
=
the
responsiveness
Q2
−
P1
Q1
=
P2
T I N U
PED:
Q1
=
%∆P
P/unit
price.
calculate
Q1
%∆Qd
PED
to
in
demand
(PED)
measures
change
of
: 2
Price
Elasticities
−
P2
P1
P2
×
−
Q1
P1
P1
P1
Price
that
the
and
quantity
reects
ratio
of
the
demanded
law
change
demanded,
that
of
of
demand.
two
move
have
in
an
inverse
Therefore,
variables—price
opposite
relationship
since
and
PED
is
quantity
directions—PED
is
always
D
a
negative
number.
However,
the
minus
sign
can
be
ignored
0
and
that
PED
the
is
usually
minus
treated
sign
should
as
a
positive
not
be
number.
ignored
in
Note
calculations.
Figure
As
Degrees
of
2.5.2
Demand
shown
is
price
elastic
if
PED
>
1;
that
is,
the
in
quantity
demanded
is
larger
than
the
in
Price
in
inelastic
Figure
demand
in
price
2.5.2,
(from
P1
when
to
P2)
demand
is
leads
a
to
price
inelastic ,
a
proportionately
change
in
quantity
demanded
(from
Q1
to
Q2).
This
percentage
means
change
Q /period
percentage
smaller
change
Q1
PED
change
A.
Q2
though
that
demand
in
this
range
is
relatively
unresponsive
price.
to
price
S C I M O N O C E O R C I M
2.5
changes.
P/unit
Tip:
to
you
draw
the
draw
a
the
price
inelastic
demand
demand
curve
quite
curve
steep
make
and
also
sure
far
from
origin.
P2
P1
Note
that
even
along
a
linear
(that
is,
a
constant
slope)
D
demand
curve,
changes.
C.
0
Figure
Q2
2.5.1
Price
elastic
Q1
Q /period
D.
demand
Demand
shown
in
Figure
2.5.1
,
when
demand
is
price
elastic ,
a
price
change
(from
in
demand
Tip:
in
to
draw
P1
to
quantity
this
draw
the
P2)
range
a
leads
to
demanded
is
price
change
in
price.
demand
curve
is
in
if
on
PED
elastic
leads
to
an
if
but
page
=
demanded
perfectly
price
constant,
section
elastic
quantity
Demand
not
1;
is
continuously
26.)
that
equal
PED
→
innitely
is,
to
∞;
the
the
that
large
percentage
percentage
is,
a
small
change
in
change
demanded.
a proportionately greater
(from
relatively
elastic
unit
HL
in
quantity
in
is
the
is
change
change
As
(See
PED
Q1
demand
quite
to
Q2).
responsive
at
curve
and
to
This
price
make
also
far
means
that
E.
sure
from
Demand
in
changes.
price
is
perfectly
has
The
following
•
A
demand
•
A
demand
no
is
inelastic
effect
shown
on
in
if
PED
quantity
Figure
=
0;
that
is,
a
change
demanded.
2.5.3.
you
curve
of
zero
elasticity
curve
of
innite
is
a
straight
vertical
line.
the
elasticity
is
a
straight
origin.
horizontal
•
B.
Demand
is
price
inelastic
if
0
<
PED
<
1:
that
is,
A
demand
the
change
percentage
in
quantity
change
in
demanded
is
curve
of
unitary
elasticity
is
a
rectangular
the
hyperbola,
percentage
line.
smaller
so
that
the
demand
curve
does
not
touch
the
axes.
than
price.
Note
is
that
the
constant
three
cases
throughout
above
the
are
length
exceptions
of
the
and
PED
curve.
25
P/unit
P/unit
P/unit
D
PED
=
0
PED
–>
∞
P
D
PED
=
1
D
0
Figure
Q
2.5.3
Constant
PED
0
Q /period
throughout
the
length
of
the
0
Q /period
Q /period
curve
Recap
Price
If,
elasticity
PED
>
of
1
demand
demand
(PED)
is
price
elastic
so,
%∆Q
>
Draw
%∆P
the
curve
at
but
the
curve
steep
far
from
the
d
origin
If,
0
<
PED
<
1
demand
is
price
inelastic
so,
%∆Q
<
Draw
%∆P
but
far
from
the
d
origin
If,
PED
=
1
demand
is
unit
elastic
so,
%∆Q
=
%∆P
Draw
a
curve
that
never
touches
either
d
axis
If,
PED
→
∞
demand
is
perfectly
elastic
so,
consumers
any
If,
PED
=
0
demand
is
perfectly
inelastic
amount
so,
when
Qd
doesn’t
P
will
at
buy
some
Draw
parallel
Draw
vertical
to
the
Q-axis
price
changes,
to
the
Q-axis
HL
Changing
PED
along
a
a
straight-line
good
is
response
downward
sloping
demand
any
straight-line
demand
curve,
PED
continuously
can
be
calculated
quite
expensive
caused
if
it
then
becomes
a
relatively
more
greater
expensive
cheaper.
In
contrast ,
if
a
good
is
already
or
cheap
varies.
then
PED
be
curve
slightly
Along
already
will
as:
a
relatively
becomes
a
bit
smaller
more
responsiveness
expensive
or
a
bit
will
be
induced
if
it
cheaper.
P1
∆Q
Figure
2.5.4
shows
how
PED
varies
from
innity
to
zero
×
Q1
∆P
along
It
follows
that
PED
is
the
product
of
the
slope
of
the
a
negatively
sloped
demand
curve.
demand
P/unit
function
Q
=
f(P)
or
the
inverse
of
the
slope
of
the
demand
PED
–>
∞
∆Q
curve
(
multiplied
)
by
the
original
price
over
A
quantity
∆P
PED
>
1
P1
ratio
(
)
Q1
The
slope
of
a
straight-line
demand
curve
is
constant
but
PED
=
1
P1
the
ratio
(
continuously
)
varies
as
we
move
along
P
the
M
Q1
demand
curve.
0
Hence,
cur ve.
curve,
PED
is
not
Whereas
PED
Demand
the
varies
is
represented
price
slope
is
at
the
constant
throughout
elastic
by
its
high
slope
for
a
of
the
linear
is
price
inelastic
because
as
a
at
result
low
prices
of
prices
the
PED
and
law
of
<
1
demand
PED
range.
and
low
large
quantities.
demand,
=
10
quantities,
0
and
<
demand
when
Q
B
Q /period
This
price
Figure
2.5.4
The
range
of
PED
values
P1
increases,
quantity
greater
higher
demanded
decreases
so
the
ratio
(
)
is
Refer
to
Figure
2.5.4.
Q1
at
prices
and
so
is
PED.
•
From
at
a
high
less
technical
prices
and
viewpoint ,
price
inelastic
demand
at
low
is
price
prices
elastic
will
be
more
responsive
to
any
point
point
price
change
26
price
is
already
high
than
when
it
is
low.
A
we
At
the
is
approached,
see
that
For
midpoint
when
equal
the
B
PED
PED
is
tends
to
innity,
while
zero.
because
•
consumers
As
instance,
if
to
1
.
M
of
a
linear
demand
curve,
PED
is
at
line
within
segment
the
AM,
segment
corresponding
AP
,
demand
is
to
price
prices
higher
elastic
(PED
>
than
Since
1).
draw
PED
a
think
•
Within
line
than
within
segment
MB,
corresponding
to
prices
(0
<
PED
<
the
segment
PB,
demand
is
price
of
number
more
are,
the
price
of
will
and
a
price
good
easily
draw
make
PED
closeness
substitutes
more
of
there
elastic
with
switch
large
if
has
a
good
price
will
to
are
of
for
many
and
available
a
demand
these
drop
few
Note
or
the
narrowly
is
good,
is
close
and
The
•
If
to
any
that
The
be.
Sprite
nature
a
good
is
a
close
a
to
substitutes
and
so
is
closer
be.
If
rises,
there
and
is
so
a
a
be
to
considered
a
be
more
an
in
drink s,
an
it
change
“sof t
the
price
is
to
in
inelastic
for
the
number
•
the
nature
a
more
in
change
for
price
example,
price
and
inelastic .
for
is
is
such
quantity
a
will
10%.
•
the
time
sof t
lettuce
will
the
such
as
PED
and
good,
a
the
the
can
total
(TR)
is
are
more
is
of
to
reduce
income
of
income
not
affect
price
of
and
higher
is
spent
spent
is
on
on
consumers’
quantity
the
a
the
for
elastic .
demanded
of
his
proportion
elastic
laptops
In
mother
its
to
to
or
monthly
proportion
time
Case
1:
When
the
the
good
of
period
is
difcult
for
consumption
substitutes
an
by
more
a
The
price
on,
or
of
cars
her
by
the
much
The
If
in
to
a
pensioner
their
demand
rises,
or
it
low
is
for
will
on
that
is
expected
the
is
cooking
good
product
(Q)
of
=
price
P
×
times
quantity
bought.
Q
the
same
as
the
prots,
revenues
which
are
collected
dened
and
the
as
costs
the
of
effect
the
that
PED
a
for
price
a
product
change
allows
will
have
on
increases
of
a
good
increases,
be
but
a
it
be
gas.
to
of
the
quantity
law
of
demanded
demand.
is
What
to
a
rm’s
answer
revenues
depends
on
following
the
increase
in
increase
in
PED.
is
results
price
in
a
elastic
larger
(PED
than
>
1),
10%
a
10%
decrease
in
quantity
On
quantity
The
effect
on
total
is
larger
demanded
revenue
fresh
more
of
the
the
decrease
effect
of
the
the
spent
be.
in
price;
therefore,
total
revenue
falls.
on
If
demand
is
price
inelastic
(0
<
PED
<
1),
a
10%
price
For
leads
to
a
smaller
than
10%
decrease
in
quantity
consumer
milk
price
milk
than
for
The
effect
on
total
revenue
of
the
increase
in
an
is
larger
than
the
effect
of
the
decrease
in
quantity
elastic
represents
therefore,
total
revenue
rises.
a
If
demand
is
unit
elastic
(PED
=
1),
a
10%
increase
in
income.
change
takes
patterns
time
to
consumption
short
period
becomes
are
reducing
af ter
likely
because
less
to
typical
for
fresh
monthly
to
It
back
Over
consumers
period
may
the
produces
a
10%
decrease
in
quantity
demanded.
The
involved
cut
price.
substitutes,
time
the
decrease
demand
of
of
more
of
nd
a
by
suitable
good
time
able
to
make
price
a
consumption
be.
price
For
difcult
Given
to
change,
elastic
further.
The
the
instance,
use
if
the
substitute
sufcient
time,
more
though,
of
decrease
in
remains
of
the
quantity
increase
in
demanded;
price
is
matched
therefore,
total
unchanged.
as
Case
2:
The
When
the
price
decreases
is
price
of
a
good
decreases,
quantity
demanded
time
expected
to
increase
because
of
the
law
of
demand.
and
effect
of
on
the
price
decrease
on
a
rm’s
revenue
again
PED.
elastic
fuel
such
revenue
longer
price
price
fuels,
total
following
demand
adjustments
the
on
revenue
depends
the
on
typical
The
nd
spent
expenditure
income.
income
demand
expenditure
consumers
inelastic
as
income
involved.
price
price
to
happen
price?
is
goes
the
addictive
behaviour.
10%
monthly
or
demand
contrast,
immediately.
and
increase
substitutes
whether
good
then
effect
It
available
example,
revenues.
price
The
of
for
be
•
greater
or
Knowledge
predict
demanded;
their
are:
good:
between
production.
rm
price
because
of
following
expected
spending
increases
person’s
proportion
price
demand
unemployed
instead
not
alcoholic
consumption
demand
lettuce
because
small
more
price
gas
revenue
is
not
difference
demanded.
is
cooking
be
increase
example,
or
is
products
•
a
PED
closeness
of
period
revenue
increase
contrary,
coal
price.
TR
demanded
cigarettes
Therefore,
decrease
This
is
one
drinks
in
on
of
necessity
proportion
demanded.
than
so
PED
less
demand
Food
use
of
the
the
price
consumer
do
inelastic .
proportion
in
to
origin.
demand
•
If,
the
changes.
difcult
price.
propor tion
small
from
higher
and
of
•
will
If
that
can
Hint:
the
expected
The
far
and
its
determinants
good
Fanta.
demanded
with
•
Total
its
as
price
addictive,
is
price
we
drinks”
fewer
substitute
substitute
quantity
price
necessities;
increase
more
advised
that
curve?
increase
quantity
good
more
responsive
good
is
it
contrary,
a
If
curves
Determinants
of
•
it
is
a
the
very
above
how
demand
Recap
people
how broadly
example
close
closer
on
oil
Revenues
expected
tips
curve
inelastic
they
the
will
the
drop
denition,
the
not
much
(for
the
On
then
small
depends
dened
necessity,
to
substitutes,
also
broader
the
demanded.
relatively
this
Beer
a
of
is
responsive
the
demand
price
substitutes
the
expected
alternatives
quantity
about
substitutes
expected
whereas
in
good
“Fanta”).
available
if
bring
demanded.
versus
the
adjustments
fuel
The
relatively
in
in
a
a
inelastic
the
The
why
or
1).
Determinants
The
along
elastic
lower
must
P
varies
price
T I N U
P
: 2
Within
S C I M O N O C E O R C I M
•
as
people
oil
coal
will
•
If
demand
fall
results
is
in
demanded.
price
a
elastic
larger
The
effect
(PED
than
on
>
10%
total
1),
a
10%
increase
revenue
of
in
price
quantity
the
increase
27
in
quantity
demanded
is
larger
than
the
effect
of
the
Recap
decrease
•
If
in
demand
fall
results
price;
is
therefore,
price
in
a
inelastic
smaller
total
(0
than
<
revenue
PED
10%
<
increases.
1),
a
increase
10%
in
price
If
price
When
demanded.
The
effect
on
total
revenue
of
changes
the
decrease
demand
is
is
larger
than
the
effect
of
the
increase
in
•
If
demand
price
is
unit
produces
effect
by
therefore,
on
the
total
a
elastic
10%
in
remains
revenue
(PED
=
decrease
revenue
increase
revenue
total
of
the
quantity
1),
in
1
more
than
quantity
price
and
demanded
total
changes
revenue
the
same
direction
as
quantity
changes
demanded.
falls.
a
10%
increase
quantity
decrease
in
demanded;
demanded.
price
is
therefore,
•
If
P
rises,
•
If
P
falls,
If
price
Q
falls
proportionately
more;
therefore
TR
falls.
in
Q
rises
proportionately
more;
therefore
TR
rises.
The
matched
total
When
unchanged.
changes
demand
changes
in
P/unit
>
elastic ,
quantity
in
demanded;
PED
price
in
proportionately
price
and
quantity
(a)
price
in
the
0
price
<
in
a
bigger
quantity
same
•
If
P
rises,
•
If
P
falls,
Q
less
effect
<
as
1
quantity
than
on
price.
total
demanded
direction
Q
PED
inelastic ,
proportionately
has
change
and
is
and
demanded
Thus,
revenue
total
the
than
revenue
change
does
the
changes
price.
falls
proportionately
less;
therefore
TR
rises.
rises
proportionately
less;
therefore
TR
falls.
b
P2
C
a
The
overall
relationship
between
PED
and
total
revenue
P1
is
also
shown
in
Figure
2.5.6,
which
shows
the
typical,
linear,
D
negatively
the
As
origin),
price
from
0
Q2
Q1
P/unit
sloped
F
TR
is
demand
zero
decreases
to
P
,
for
increase
in
that
at
(thinking
quantity
demand
and
curve.
a
zero
of
range
zero
price
walking
demanded
price
At
is
quantity
(H)
down
increases
price
TR
elastic ,
is
the
from
(point
0
the
also
price
to
at
zero.
Q.
axis)
Since
resulting
Q /period
quantity
so
TR
rises.
to
decrease
demanded
Skipping
past
P
the
all
is
proportionately
midpoint
the
way
price
down
to
P
,
if
price
zero,
greater,
continues
quantity
(b)
demanded
inelastic ,
b
P2
a
resulting
smaller,
the
TR
a
rises
Q,
TR
all
maximum.
demand
way
decreases,
curve
So,
it
right
where
Q
to
H.
increase
that
af ter
C
the
from
proportionately
at
P1
increases
so
TR
to
Since
in
quantity
decreases.
midpoint
necessarily
below
PED
=
1
,
demand
the
TR
Q
Having
and
follows
now
that
of
price
is
established
then,
midpoint
is
is
demanded
right
at
the
Q
it
is
linear
maximized.
P/unit
PED
–>
∞
F
PED
D
0
Figure
2.5.5
Q2 Q1
PED
and
total
revenue
between
two
>
1
Q /period
points
PED
=
1
P
Figure
total
2.5.5
shows
revenue.
Total
the
effect
revenue
of
is
an
increase
given
by
the
in
price
area
on
derived
by
0
multiplying
is
price
At
the
elastic
is
price
given
increases
revenue
is
times
quantity.
between
original
revenue
price
price
by
to
given
the
P2
by
the
and
two
the
of
of
P1
areas
quantity
sum
Figure
2.5.5a
<
PED
<
1
demand
points.
quantity,
sum
and
In
and
A
Q1
,
and
B.
decreases
areas
A
and
Q2,
Area
=
0
D
When
to
C.
PED
total
total
B
0
Q
H
Q /period
is
TR
lost
while
larger
area
than
the
Figure2.5.5b,
points.
(area
total
C
is
larger
revenue
gained.
demand
Following
C)
is
revenue
the
is
price
price
than
Since
gained
the
the
(C),
revenue
total
inelastic
increase,
revenue
the
lost
lost
revenue
between
revenue
(areaB)
(B)
is
falls.
the
In
two
gained
and
so
increases.
TR
0
Figure
28
2.5.6
Q
PED
and
the
shape
of
Q /period
the
TR
curve
for
rms
of
and
consumption
greater
government
of
PED
for
PED
permits
revenues
to
a
rm
given
increase
its
demand
for
increase
the
the
of
a
to
predict
price
is
will
thought
price
if
the
change.
revenues
it
its
direction
For
lower
to
be
the
price
demand
is
of
example,
price
rm
of
elastic
price
change
a
a
in
good
and
it
inelastic .
its
higher
inelastic
wishing
a
hairdresser.
if
seeking
will
she
If
she
is
thinking
of
charges
for
a
haircut ,
her
revenues
the
demand
for
consider
her
her
in
services
services
is
price
desirable
inelastic .
and
the
area.
Quantity
of
then
decrease
Her
will
rise.
(because
offered
proportionately
If
her
by
the
services
other
for
price
of
less
are
the
so
law
that
of
her
considered
hairdressers
her
she
PED,
the
because
services
charges
will
for
from
the
tax
produces
in
the
a
be
demand)
a
similar
elastic .
demand
tax
price
revenue
example,
elastic .
explains
why
is
smaller
T
ax
price
revenues
governments
collection
impose
indirect
fuel.
interested
goods
of ten
in
curtailing
referred
to
as
the
consumption
demerit
goods,
of
such
and
alcohol,
also
need
to
have
knowledge
of
as
PED.
is
addictive
means
that
if
so
the
demand
goal
is
is
to
quite
price
decrease
inelastic .
smoking,
but
tax
If
to
she
will
will
be
needed
so
that
the
monthly
a
very
expenditure
will
cigarettes
becomes
a
prohibitively
large
proportion
revenues
neighbourhood
price
haircut
for
is
This
demand
demanded
weekly
very
demand
greater.
when
other
of
the
typical
consumer ’s
in
determining
monthly
income.
PED
will
help
those
how
high
the
indirect
tax
needs
to
be
to
then
curtail
demand
is
clients
from
on
decrease
the
This
increase
different
haircuts
be
Governments
high
will
lower
the
This
hairdressers
The
collected.
demanded
maximize
on,
Tobacco
must
tax .
be
Consider
increasing
will
when
will
to
tobacco
if
the
to
resulting
quantity
than
taxation
certain
price
price
in
collected
•
case
following
revenues
rms
decrease
•
tax
decision-making
the
Impor tance
the
consumption
by
some
specic
target
percentage.
increases
fall
Recap
proportionately
competitors
•
PED
can
also
more
and
helps
shif t
an
her
as
many
weekly
rms
of
tax
clients
revenues
determine
indirect
her
(a
tax
the
on
will
will
switch
to
Importance
decrease.
extent
goods
to
which
and
PED
they
services)
the
consumer.
Ceteris
paribus,
the
more
price
is
important
demand
faced
is,
the
greater
the
proportion
of
the
can
be
shif ted
on
to
the
consumer
in
the
it
allows
form
of
it
price.
The
inelastic
close
have
it
idea
is
implies
intuitively
substitutes
a
relatively
to
that
simple.
switch
small
consumers
If
demand
to
so
impact
the
on
have
increase
quantity
few
in
if
of
PED
for
Governments
looking
an
the
PED
of
is
equal
the
tax
to
a
the
price
determine
indirect
important
price
will
•
it
helps
tax
demanded.
tax
for
direction
of
change
of
change
the
on
to
extent
the
governments
governments
revenues
raising
tax
revenues
to
which
they
consumer.
because:
to
interested
decide
on
in
which
increasing
goods
to
their
impose
an
tax
it
allows
governments
goods
to
be
taxed.
imposed
per
unit
to
estimate
the
size
of
the
must
T
ax
tax
required
to
decrease
consumption
of
revenues
demerit
collected
predict
governments
into
the
to
given
is
necessary
consider
because:
any
•
•
them
shif t
indirect
Impor tance
them
revenues
helps
PED
price
rms
a
can
higher
for
tax
•
that
PED
inelastic
their
the
of
on
•
to
T I N U
PED
: 2
of
S C I M O N O C E O R C I M
Importance
times
the
goods,
such
as
cigarettes
or
alcoholic
drink s.
level
HL
PED
for
primary
commodities
are
versus
of ten
though.
manufactured
commodities
are
goods
derived
directly
from
the
use
price
factor
of
production
land
and
include
both
agricultural
products.
Agricultural
products
include
such
of
as
for
PED
for
such
not
have
primary
as
primary
products
as
well
as
Non-agricultural
manufactured
food
do
potatoes)
cotton.
extraction
The
of
wheat,
is
minerals
products
goods.
price
close
of
income
explain
why
for
their
many
consumers,
demand
is
typically
For
(copper,
tin,
typically
instance,
substitutes.
non-food
commodities
is
inelastic
commodities.
other,
The
Consider
cerium),
the
because
same
is
are
true
lanthanum,
and
the
a
price
change,
responsive
in
quantity
the
case
of
demanded
is
manufactured
than
for
primary
commodities.
for
the
rare
P/unit
coal.
PED
most
necessities
for
a
products
oil
than
demand
they
given
more
commodities
include
lower
elastic .
food
products
(corn,
also
and
generally
non-agricultural
proportion
may
of
Therefore,
the
big
products
more
Primary
a
That
and
majority
earth
P1
mineral
for
of
necessary
hybrid
cars.
lanthanum
cars
will
not
in
the
Given
the
increases,
have
production
much
lack
of
of
the
substitutes,
manufacturers
of
a
batteries
choice
of
and
even
if
batteries
so
they
needed
the
for
will
price
hybrid
be
less
D
responsive
to
the
price
increase.
By
contrast,
the
demand
D
manufactured
products
tends
to
be
more
price
elastic ,
products
usually
do
have
substitutes
as
a
result
of
a
BMW
product
she
planning
consider
may
on
an
differentiation.
also
buying
HP
or
a
consider
a
new
Mac .
a
Dell
If
someone
Mercedes.
laptop
he
Expenditures
If
is
on
2.5.7
Primary
Q /period
commodities
versus
manufactured
products
considering
someone
will
Q1
the
Figure
extensive
primary
because
0
these
manufactured
for
For
is
probably
also
manufactured
goods
small
products
primary
changes
is
more
around
price
P1
,
elastic
demand
for
compared
manufactured
to
demand
for
products.
29
Calculating
4,000
PED
−
12,000
12,000
1
.
Assume
that
price
falls
by
6%
leading
to
an
increase
in
PED
quantity
demanded
of
9%.
What
is
the
=
=
9
PED?
−
(if
GDC
is
allowed
then
EXE)
3
3
To
calculate
PED
enter
the
percentage
changes
into
the
–8,000
formula
with
their
3
sign:
×
%∆Qd
PED
PED
6
=
−0.33
(or,
0.33).
12,000
=
Demand
%∆P
is
therefore
price
inelastic .
9%
PED
=
PED
=
−1
.5
(or,
3.
1
.5).
Assume
that
PED
is
– 0.74
and
price
increases
by
1
2%.
–6%
Calculate
Demand
is
therefore
price
Assume
that
the
price
increases
from
$3
to
quantity
in
quantity
demanded
to
fall
from
the
PED
12,000
quantity
formula
can
be
To
4,000units .
calculate
PED
What
enter
is
the
the
units
=
into
the
%∆Q
=
Q2
−
Remember
P1
Q1
– 0.74
×
12%
=
–8.88%
the
minus
sign
for
PED
in
this
case.
Since
the
price
×
has
−
=
12%
=
P2
change
∆Q%
formula:
Q1
=
%∆P
the
%∆P
values
Q1
%∆Qd
PED
calculate
%∆Qd
– 0.74
−
to
=
PED?
above
Q2
used
demanded:
PED
to
demanded.
$9,
in
causing
change
elastic .
Again,
2.
the
P2
P1
−
increased
it
follows
that
quantity
demanded
will
change
Q1
P1
in
the
opposite
direction
because
of
the
law
of
demand.
P1
Income
Income
of
elasticity
elasticity
demand
the
to
direction
and
on
the
The
formula
a
of
size
of
demand
change
in
change
of
of
of
to
(YED)
YED
demand
curve
calculate
(YED)
measures
income.
demand
used
demand
the
provides
given
a
responsiveness
information
change
in
YED
is
income
YED
•
=
=
=
%∆Y
×
−
Q1
Y2
−
Y1
=
Y1
and
YED
is
income
(plus
sign)
the
ratio
levels,
or
if
number.
to
of
leads
If
to
one
an
less
increase
demanded,
in
quantity
is
in
or
if
YED
(plus
is
a
then
in
and
YED
in
drop
is
a
the
is
leads
a
are
then
YED
in
can
distinguish
between
normal
and
0
in
food
or
an
earn
at
then
income
products
rice
or
least
an
in
will
income
the
may
on
whether
YED
is
positive
or
good
is
If
YED
>
0
the
number.
negative
example,
increase
for
=
1
to
the
YED
the
values
and
is
positively
normal.
If
for
is
three
cases
remains
income
income
•
as
good
is
a
normal
and
consumer
or
demand
change
in
affected
decrease
by
since
same
be
sloped
leads
graphically
a
graph
then
slope
are
change
to
same.
change
in
a
in
income
quantity
5%
is
demanded:
increase
in
If
is
the
shown
on
represented
with
the
YED
is
negative
curve
in
is
income
horizontal
positive
then
Figure
an
the
axis.
and
YED
vertical
by
on
is
then
Engel
vertical
If
the
the
good
negative
YED
is
axis
curve
is
and
zero.
2.5.8.
(Y)
demand
<
slope
0
increases
good
both
direction.
(increases) as consumer income increases (decreases): income
Y2
and demand change in opposite directions.
on
normal
goods,
we
can
state
the
following.
YED
•
If
YED
>
1
then
the
percentage
change
in
=
0
quantity
(income
demanded
is
greater
than
the
percentage
change
income.
rise
in
We
say
income
that
leads
demand
to
a
is
faster
income
rise
(a
elastic ,
as
rises
stays
the
a
proportionately
Y1
greater
most
increase)
services,
example,
in
are
demand
demand.
usually
for
Luxury
goods,
considered
plastic
surgery,
as
income
spa
well
as
elastic .
therapy
or
For
haute
Positive
couture
clothing
is
income
elastic
in
many
If
0
<
YED
<
1
then
the
percentage
change
in
>
0
quantity
Normal
demanded
income.
is
We
smaller
say
that
than
the
demand
percentage
is
income
change
inelastic
in
as
a
rise
0
in
income
leads
to
a
slower
rise
(a
proportionately
smaller
Figure
increase)
30
in
demand.
Basic
goods
slope
markets.
YED
•
(everyday
goods
but
in
Qd
or
2.5.8
YED
represented
by
an
Engel
curve
good
the
All
goods
(decreases):
a
quantity
If YED < 0 the good is an inferior good since demand decreases
Focusing
a
but
number.
inferior
increases
the
where
income.
negative.
good
income
of
example.
just
inferior.
the
percentage
demanded
the
good
in
is
quantity
the
percentage
can
which
good
then
Inferior
(decreases)
increase
market
not
increase
YED
•
a
level
example,
inelastic .
not
in
Negative
based
For
income
average
for
Income
inelastic .
is
chocolate
increase
demand
income.
demanded,
curve,
quantity
an
negative
is
YED
Income
We
milk
5%increase
a
income
For
in
is
leads
If
equal
positive
income
other
to
demand
positive
number.
decrease
income
then
a
YED
sign)
a
sign)
increase
or
in
changes
(minus
an
to
changes
both
negative
leads
decrease
demanded,
if
demanded
demanded,
income
a
that
negative
positive
then
percentage
example,
being
being
sign),
are
For
good
change
(minus
if
a
the
for
=
demand
Q1
•
follows
both
positive
more
it
of
YED
change
Y1
Since
If
usually
×
Q1
∆Y
∆Y
Q2
are
many
following
consumers
following:
Y1
∆Q
Q1
for
Demand
much
the
goods)
demand
shifts.
∆Q
%∆Qd
staple
on
same)
the
and
initially
quantity
her
demand
very
low
and
demanded
of
for
white
then
it
white
bread.
If
increases
bread
by
her
up
Jane
•
to
YED
YED
is
thus
positive
up
to
income
Y1
.
As
increases
more
and
up
until
income
level
proof
Y2,
a
not
consume
sufcient
Y2,
then
and
she
start
more
amount
may
white
per
consider
consuming
bread
week .
If
as
her
switching
more
she
already
income
away
nutritious
and
now
from
bread.
Past
Y2,
YED
is
thus
past
white
and
any
straight
is
manipulating
beyond
our
the
scope
in
Figure
2.5.9.
Normal
goods
(YED
bread
0
<
YED
<
>
for
Jane
an
inferior
is
possible
to
illustrate
formula
here.
and
where
YED
income
=
1
.
To
inelastic
1
YED
>
white
income
elastic
demand,
cuts
the
vertical
inelastic
Income
demand
elastic
cases
of
products
with
most
food;
services;
demand
a
as
product
well
as
the
draw
a
basic
case
day-to-day
line
Engel
curve
(rice,
(nail
spaghetti
goods
goods;
necessities
with:
straight
that
inelastic
canned
axis
cuts
the
demand,
horizontal
draw
a
straight
line
Engel
salons,
cruises,
surgery
tuna,
pencils,
Inferior
goods
used
Figure
2.5.9
More
cases
of
YED
erasers,
by
boats)
<
0)
lower
quality
clothing,
lower
quality
food
Y
0
represented
(YED
cars,
Y
Qd
iPhones,
napkins)
Typically:
0
cars,
sauce,
curve
axis
Y
expensive
income
sail
income
demand
Typically:
products;
haircuts,
•
are
1
dishwashers,
that
simple
cases
bread
plastic
•
that
product .
the
illustrate
using
These
(luxury)
elastic
curve
whole
farm
It
Engel
0)
Typically:
becomes
line
origin.
consumes
rises
expensive
negative
requires
which
Income
wheat
draw
the
she
shown
will
1
,
her
algebra,
income
to
through
will
The
increase.
equal
goes
T I N U
Y1
,
Jane
is
: 2
income
Qd
Engel
0
S C I M O N O C E O R C I M
Consider
Qd
curves
HL
Importance
of
goods
YED
faced
Impor tance
of
YED
for
with
a
would
like
to
know
whether
demand
for
their
highly
to
help
income
them
economic
incomes
expand
Hence,
more
if
an
then
may
have
to
to
may
plan
invest
is
now
for
of
country
goods
growing
foreign
for
In
periods
high
goods
incomes
income
expanding
YED
with
are
elastic
their
Economies
of
will
low
YED.
increasing
products
capacity
to
be
say,
switching
to
potatoes
kiwi
fruit
(that
have
a
higher
YED.
Over
the
long
or
to
term,
and
of
three
the
have
a
on
have
a
slower
agricultural
increase
of
products
their
with
income
a
low
relative
widening
income
consider
what
happens
will
decline.
As
a
higher
YED
YED
YED
will
can
face
avoid
a
large
large
of
will
witness
rest
of
spent
the
will
experience
of
the
2009
so
effects
on
if
an
economy
goods
drop
in
declines
increases
rms
in
a
the
over
high-end
restaurants.
economy
the
primary
services
the
long
change.
certain
the
level
are
sector,
which
As
the
an
carry
considered
of
to
size
products
income
mostly
for
a
economy
relative
agricultural
income
manufacturing
furniture,
are
term,
Many
in
sector,
sector.
threshold
increases
services
once
living,
mostly
and
primary
is
in
a
is
spent
example
higher
have
YED.
an
households
have
attained
a
even
certain
further
on
increases
vacations,
expensive
cars.
spa
in
discretionary
In
treatments,
income
this
way
the
expensive
sector
and
later
of
relative
manufacturing
size
shrink s
of
while
and
of
their
services
sales,
services
in
their
the
manufacturing
in
sales.
For
crisis
incomes
various
while
example,
decreased,
markets.
Firms
In
the
sectors
UK
both
have
the
been
in
agricultural
relative
decline
with
products
sales,
expands.
recession.
the
1960s.
According
to
the
UK
Ofce
for
services
sector
is
National
with
(ONS),
currently
the
the
largest
inferior
as
in
the
UK ,
accounting
for
more
than
75%
of
GDP
.
a
and
production
contribute
less
than
21%
of
with
GDP
,
different
fuel
inequality.
result ,
eurozone
the
and
and
Manufacturing
result
and
furniture
the
sector
goods
to
agro-tourism,
Statistics
low
food
low
since
high
or
the
sectors:
can
once
from
items
and
Incomes
for
and
rise
further
appliances
that
Now
YED
Any
Luxury
the
population,
as
compared
farmers
YED
to
three
sector
sectors
products
clothing
a
such
sales
agencies
YED
incomes
low
reached.
are
producing
have
grows
cars,
demand.
growing,
travel
of
manufacturing
As
standard
which
demand
their
inelastic
increase.
with
and
highly
in
income
investments.
the
markets
increased
farmers
think
in
to
producing
the
moderately
their
markets
economy
meet
or
incomes
compared
rms
Conversely,
YED),
better
growth,
increase,
fast ,
able
elastic
in
product
Impor tance
is
inelastic
decline
rms
retailers,
Firms
income
smaller
and
agriculture
contributes
less
than
0.60%.
offering
31
Calculating
1
.
Suppose
leads
to
that
a
2.
YED
an
increase
4.75%
fall
in
in
bus
national
income
journeys.
of
Calculate
Assume
annual
increase
from
increase
in
bus
YED
the
the
number
levels
Rmb
in
61
,600
Shanghai
leading
of
manicure
appointments
to
percentage
to
41
3,000.
Calculate
the
YED
for
manicure
=
changes
into
Enter
the
formula
the
above
values
remembering
into
the
%∆Qd
=
formula:
Q2
−
Q1
=
signs:
%∆Y
Y1
×
Y2
−
Y1
Q1
– 4.75%
YED
=
YED
=
−1
.98
YED
+2.4%
Note
that
here
the
negative
sign
must
be
kept .
It
informs
32
bus
journeys
in
this
economy
are
inferior
products.
413,000
–
350,000
61
,600
–
55,000
=
55,000
×
YED
=
350,000
us
Demand
that
an
from
treatments.
YED
the
to
YED
%∆Y
the
income
journeys.
%∆Qd
Enter
capita
55,000
2.4%
350,000
for
per
Rmb
for
this
service
in
Shanghai
is
income
elastic .
1
.5
Price
of
elasticity
elasticity
quantity
of
of
supply
supplied
to
supply
(PES)
a
in
supply
(PES)
measures
change
T I N U
of
the
responsiveness
B.
Supply
price.
the
The
following
formula
is
used
Q2
to
−
is
price
percentage
calculate
inelastic
change
percentage
in
if
0
<
PES
quantity
change
in
<
1;
that
supplied
is
is,
: 2
Price
Elasticity
the
smaller
than
S C I M O N O C E O R C I M
2.6
price.
PES:
Q1
S
P/unit
Q1
%∆Qs
PES
=
=
Q2
−
Q1
P2
−
P1
=
%∆P
P2
−
P1
P1
×
Q1
P1
Price
and
reects
the
supplied
of
quantity
in
of
the
A.
ranges
Supply
two
supply.
of
in
is
and
If
vice
have
a
price
positive
increases
versa.
variables—price
same
Degrees
PES
of
increases
change
move
law
supplied
direction—PES
relationship
then
Therefore,
and
is
since
quantity
always
a
that
P2
quantity
PES
is
supplied,
positive
the
ratio
that
P1
number.
PES
value
price
from
elastic
change
in
quantity
change
in
price.
zero
if
to
PES
supplied
innity.
>
1;
is
that
larger
is,
the
than
percentage
the
0
percentage
Figure
2.6.2
Q1
Price
inelastic
Q2
Q /period
supply
P/unit
As
shown
change
in
in
Figure
price
2.6.2,
(from
P1
when
to
P2)
supply
leads
is
to
price
a
inelastic ,
a
proportionately
S
smaller
means
P2
price
change
that
in
quantity
supply
in
this
supplied
range
is
(from
Q1
relatively
to
Q2).
This
unresponsive
to
changes.
P1
A
C.
D.
0
Figure
As
in
Q1
2.6.1
shown
price
change
Price
in
Figure
(from
in
elastic
P1
quantity
Q /period
P2)
A
in
price
this
range
elastic
is
when
supply
to
is
price
elastic ,
a proportionately
(from
relatively
supply
is
Q1
to
Q2).
This
a
change
E.
curve
responsive
must
cut
P/unit
the
to
price
means
vertical
elastic
in
quantity
change
in
price.
Supply
Supply
greater
unit
supply
change
is
in
perfectly
in
quantity
leads
supplied
Supply
if
must
PES
=
supplied
elastic
leads
to
if
an
cut
1;
is
the
that
equal
PES
->
is,
to
∞;
innitely
horizontal
the
the
that
large
axis.
percentage
percentage
is,
a
small
change
in
supplied.
is
price
price
curve
perfectly
leads
to
inelastic
no
change
if
in
PES
=
0;
that
quantity
is,
a
change
supplied.
that
The
supply
inelastic
change
supply
2.6.1
,
to
Q2
price
following
is
shown
in
Figure
2.6.3.
changes.
•
A
supply
curve
•
A
supply
curve
•
A
supply
of
of
unitary
innite
elasticity
elasticity
passes
is
a
through
straight
the
origin.
horizontal
line.
axis.
curve
P/unit
of
zero
elasticity
is
a
straight
vertical
line.
P/unit
S
S
S1
S2
P
S
PES
PES
PES
=
2.6.3
Qs
Constant
PES
=
0
∞
1
0
Figure
–>
throughout
the
length
0
of
the
Qs
0
Q
curve
33
Recap
Price
If,
elasticity
PES
>
of
1
supply
supply
(PES)
is
price
elastic
so,
%∆Q
>
%∆P
The
curve
must
“cut ”
the
vertical
axis
<
%∆P
The
curve
must
“cut ”
the
horizontal
=
%∆P
The
curve
must
go
s
If,
0
<
PES
<
1
supply
is
price
inelastic
so,
%∆Q
axis
s
If,
PES
=
1
supply
is
unit
elastic
so,
%∆Q
through
the
origin
(any
slope)
s
If,
PES
→
∞
supply
is
perfectly
so,
elastic
a
small
leads
to
change
change
an
in
quantity
Effectively,
rm
is
If,
PES
=
0
supply
is
perfectly
so,
inelastic
Determinants
of
it
shows
willing
amount
at
when
quantity
in
innitely
to
the
price
price
that
time
period
in
economics
does
short
run
and
the
curve
vertical
the
Q-axis
to
the
Q-axis
not.
inelastic
(0
<
changes
PES
in
<
price.
1).
If
Producers
demand
can
only
increases
marginally
there
will
be
respond
both
an
involved
is
distinguished
into
the
momentary
the
long
in
quantity
supplied
and
an
increase
in
price,
yet
the
run,
effect
the
Draw
to
price.
increase
Time
parallel
the
changes,
to
The
curve
any
current
PES
the
supplied.
offer
supplied
Draw
large
on
price
will
be
proportionately
greater.
run.
P/unit
P/unit
S
S
P2
P1
P2
P1
D2
D2
D1
D1
0
0
Figure
Figure
2.6.4
PES
in
the
momentary
the
momentary
run
2.6.6
(market
period)
all
factors
of
the
considered
xed;
rms
supply
can
thus
make
no
adjustments.
As
to
is
any
perfectly
change
inelastic
in
price.
If
(PES=
0).
demand
Producers
increases,
by
remains
the
same
and
only
price
the
both
the
all
long
run
factors
rm;
all
of
production
adjustments
are
are
considered
possible.
capital
and
labour
(that
is,
it
can
The
rm
change
its
can
scale
cannot
operations).
As
a
result ,
supply
is
price
elastic
(PES
>
1).
quantity
Producers
supplied
in
run,
a
of
respond
Q /period
production
change
result,
PES
long
variable
are
Q2
run
In
In
Q1
Q
can
fully
respond
to
changes
in
price
and
the
rm
is
increases.
able
to
increase
in
size.
If
demand
increases
there
will
be
both
S
an
increase
in
quantity
supplied
and
an
increase
in
price,
yet
P/unit
the
effect
on
Therefore,
elastic
as
quantity
over
rms
time,
can
supplied
supply
make
will
tends
more
be
to
and
proportionately
become
more
more
greater.
price
adjustments.
S1
S2
P2
P/unit
S3
P1
S4
P
D2
S5
D1
0
Figure
In
2.6.5
the
xed.
Q1
PES
short
For
in
run,
the
at
example,
short
least
the
Q2
Q /period
run
one
factor
capital
of
production
employed
by
the
is
rm
considered
is
xed
but
0
it
can
change
the
number
of
workers
or
the
hours
they
Figure
Thus,
34
some
adjustments
are
possible.
As
a
result,
Q
work.
supply
is
price
2.6.7
PES
over
time
Qs
factors
of
usually
production
and
The
mobility
of
labour
is
relevant .
If,
for
example,
labour
or
geographically
immobile
then
it
will
be
to
meet
an
increase
in
the
demand
for
a
farmers
product
be
labour
is
mobile
between
occupations
or
between
extent
to
which
spare
(excess)
to
a
rm
increase
though
to
capacity.
is
operating
at
full
output .
Supply
is
increase
output
if
For
example,
a
capacity,
capacity
price
it
is
inelastic .
does
factory
it
have
that
has
very
A
idle
will
easily
be
able
to
increase
is
available
able
if
in
price.
the
The
more
greater
the
responsive
extent
of
quantity
there
spare
and
increase
in
price.
Supply
is
more
therefore
is
need
for
skilled
as
opposed
It
an
is
economy
easier
more
is
price
not
be
there
rms
workers
more
may
for
in
are
that
order
elastic .
able
to
more
use
to
increase
will
unskilled
When
nd
specialized
and
than
labour
output.
employ
skilled
to
nd
Supply
labour
more
a
long
grapes
time
and
means
that
for
the
an
crops
increase
to
in
mature
price
very
insignicant
output
response.
can
The
the
oil
and
a
It
the
copper
takes
production
new
oil
eld
a
industries,
and
into
long
it
time
takes
a
to
which
bring
long
production.
new
time
Supply
to
is
inelastic .
speed
higher
by
the
which
costs
additional
rise
as
(marginal)
output
costs
of
increases
producing
be
output ,
the
more
difcult
it
will
be
for
rms
to
to
output
following
an
increase
in
price,
so
the
more
elastic .
to
unskilled
unskilled
a
into
price
inelastic
is
of
workers.
and
the
hire
product
needed,
labour
as
supply
will
be.
For
example,
heavy
mining
labour
equipment
In
instance,
an
price
The
For
takes
capacity
supplied
price
seedlings
This
industries.
bring
increase
an
to
mines
additional
available,
It
that
The
increase
about
applies
copper
nd
spare
machines
output
plant
extractive
The
are
lags.
exists
difcult
rm
time
products.
regions.
are
When
to
harvested.
bring
same
The
long
than
only
if
by
agricultural
more
and
difcult
are
is
for
occupationally
characterized
apples
a
expensive.
expand
used
For
a
output
in
the
extraction
mining
given
company
the
industry
it
is
additional
very
cost
is
extremely
difcult
of
to
acquiring
such
equipment .
rm
quickly
so
Recap
supply
is
a
delivery
food
more
price
rm
mental
institution
require
specialized
inelastic .
to
to
hire
nd
For
more
more
example,
workers
doctors;
it
will
than
the
it
be
will
former
easier
for
be
a
for
does
Determinants
The
ability
Quantity
able
to
onto
store
supplied
hold
the
For
owers
but
time
can
stock s
market
elastic .
The
to
of
very
example,
not
of
lags
in
contrast
the
easily
the
be
that
increased
product .
rms
the
PES
is
determined
by:
latter.
•
the
time
period
•
the
mobility
•
the
extent
•
the
need
•
the
ability
•
the
time
•
the
speed
product
quickly;
fresh
to
of
not
PES
labour,
Goods
therefore
can
when
can
supply
maintain
the
be
is
stock s
rm
the
of
factors
of
production
is
to
which
spare
(excess)
capacity
exists
released
more
of
for
skilled
as
opposed
to
unskilled
labour
price
plastic
owers.
characterize
T I N U
of
: 2
mobility
S C I M O N O C E O R C I M
The
production
to
store
lags
that
by
the
product
characterize
which
costs
rise
the
as
production
output
process
increases.
process
The
to
longer
respond
the
to
time
price
lags,
the
longer
increases.
it
Primary
takes
sector
for
producers
products
are
HL
PES
for
primary
commodities
products
versus
of
manufactured
primary
commodities
usually
have
a
lower
able
to
manufactured
products.
This
is
due
to
time
lags
that
characterize
the
production
of
Calculate
if
the
PES
PES
the
PES
number
of
for
from
2,140
increases
from
S$50
the
values
foot
massage
appointments
increases
Enter
at
least
a
goods.
In
planting
the
case
season
into
to
to
the
2,568
S$55
services
offered
when
per
per
the
respond
to
higher
prices.
In
the
case
of
to
other
products,
to
such
make
the
as
oil,
natural
necessary
gas
and
minerals,
investments
for
time
extraction
primary
to
for
that
1
.
to
needed
and
Calculating
manufactured
need
the
is
long
to
farmers
PES
primary
compared
opposed
products
be
Overall,
as
agriculture,
in
begin
foot
supply
production.
massage
is
price
services
Singapore
is
2,
which
means
elastic .
Singapore
2.
week
market
price
If
PES
8%
for
wax
increase
candles
in
price,
is
estimated
calculate
the
at
1
.4
and
response
there
in
is
an
quantity
supplied.
appointment .
Enter
formula:
the
values
into
the
formula:
%∆Qs
Q2
−
Q1
PES
=
%∆P
Q1
%∆Qs
PES
=
=
%∆P
Q2
−
Q1
P2
−
P1
=
P2
−
P1
P1
∆Qs%
×
1
.4
2,568
–
2,140
=
Quantity
–
50
=
1
1
.20%
supplied
for
wax
candles
will
increase
by
1
1
.20%.
50
×
55
∆Q
8%
P1
PES
=
Q1
PES
=
2
2,140
35
2.7
Role
Government
Governments
of
governments
intervention
intervene
in
markets
for
in
in
microeconomics
markets
various
reasons,
which
St
include
to:
P/unit
•
support
certain
•
support
low
producers,
usually
farmers
S
and
income
services
households
services,
such
as
ensuring
food
and
that
basic
housing,
goods
are
a
Pc
affordable
•
inuence
the
level
of
output
in
a
market
•
inuence
the
level
of
consumption
•
correct
P
of
the
good
or
e
service
Pp
fail
•
to
market
reach
promote
failures
the
(that
socially
is,
cases
efcient
where
market
b
forces
outcome)
equity.
D
Indirect
taxation
0
What
are
indirect
Figure
Indirect
taxes
are
Q’
Q /period
Q
taxes?
taxes
on
goods
or
services,
or
2.7.1
Impact
of
an
indirect
tax:
market
for
sugar-sweetened
on
beverages
expenditures.
taxes
and
amount
per
cigarettes).
of
a
They
ad
good
are
valorem
unit
Ad
(for
of
distinguished
taxes.
the
Unit
good
valorem
(for
taxes
example,
the
into
taxes
unit
are
example,
are
a
15%
a
(specic)
xed
$4.00
percentage
GST
in
New
on
The
“dollar ”
per
pack
the
of
price
by
decreases
Zealand).
do
governments
impose
indirect
the
taxes
are
imposed
collect
tax
revenues
to
price
shif t
the
the
tax
increases
Q'.
to
to
Producers
consumers
supply
St .
Pc
As
and
now
pay
a
the
earn
minus
curve
vertically
result ,
beverage
tax
upwards
market
equilibrium
per
the
the
price
quantity
Pp,
which
(ab).
tax
revenues
the
government
collects
are
equal
to
the
to:
tax
•
pay
will
of
taxes?
The
Indirect
tax
amount
consumers
is
Why
indirect
the
needed
to
nance
per
unit
(ab)
times
the
new
equilibrium
quantity
Q'.
This
government
is
area
(PpbaPc)
or
area
(1
+
2
+
4
+
5).
expenditures
The
•
decrease
the
consumption
of
demerit
goods
such
as
proportion
(
tobacco,
alcohol
individual
•
and
consumer
decrease
production
decrease
the
decrease
imports
use
of
sugar
but
that
also
processes
fossil
harm
society
that
not
at
only
the
the
tax
paid
by
as
the
incidence
consumers
is
equal
to
)
PcPp
It
large
generate
of
PPc
pollution,
or
It
is
referred
follows
to
that
the
incidence
of
of
the
the
tax
tax
to
to
consumers.
producers
is
PPp
fuels
(
)
PcPp
•
in
certain
industries
and
thus
help
Note
domestic
producers
and
that
valorem
Analysing
indirect
the
above
taxes
using
a
tax
(except
indirect
tax
is
considered
an
additional
cost
of
as
a
result ,
it
decreases
supply,
shif ting
the
Consumers
lef t
or,
better
yet ,
vertically
upwards
by
the
>
P)
the
tax .
If
the
tax
is
a
specic
tax
the
shif t
is
original
supply
curve.
If
the
tax
is
an
ad
parallel
valorem
tax ,
supply
tax ,
curve
and
so
is
the
is
bigger
at
steeper
vertical
higher
because
distance
the
“dollar ”
between
amount
the
two
In
the
Figure
P
36
and
on
market
2.7.1
,
an
market
for
equilibrium
D
is
an
ad
worse
enjoy
off
less
as
of
they
the
pay
good
a
(Q'
higher
<
Q).
price
Consumer
taxed
is
by
a
area
(1
demerit
+
2
good
+
3).
then,
Of
at
course,
least
in
if
the
the
lower
level
of
consumption
and
the
long
resulting
of
benets
Note
that
make
them
indirect
better
taxes
are
off,
despite
considered
the
higher
unfair
as
prices.
outcomes
sugar-sweetened
demand
tax
supply
they
Impact
the
S).
stakeholders
decreases
the
price.
curves,
if
than
the
health
the
same
to
term,
new
for
are
and
product
the
the
steeper
amount
surplus
of
is
is
supply
(Pc
curve
St
production
•
and,
that
diagram
Consequences
An
analysis
workers.
and
supply
quantity
Q.
If
beverages,
S
lead
to
shown
a
in
market
price
are
two
individuals
amount
higher
This
regressive
of
the
explains
why
heating
oil)
tax
Chapter
(see
in
respect
purchase
tax
proportion
with
the
to
same
is
the
same
of
the
income
basic
many
3,
goods
countries
section
consumers’
for
of
the
(basic
are
3.4).
good,
both,
but
the
it
poorer
food
income.
“dollar ”
represents
products
typically
a
individual.
not
or
subject
to
<
P)
are
and
worse
sell
off
fewer
as
they
units
earn
(Q'
<
less
Q).
per
The
unit
Why
revenues
decrease
from
area
(0QeP)
to
area
(0Q'bPp).
To
decreases
by
area
(4
+
5
+
6).
Since
less
of
the
be
produced
and
sold,
workers
may
be
laid
increase
off
so
are
be
adversely
affected.
Also,
if
the
good
taxed
input
income
for
will
the
production
increase,
forcing
of
other
rms
to
goods
raise
then
price
is
used
in
their
sales
and
in
employment
The
government
area
(1
+
2
education,
+
4
collects
+
5)
health
tax
that
care
revenues
may
be
suffer
considered
a
loss
services
to
and
so
Consumers
area
(1
+
collects
and
2
+
tax
+
4
+
on
on,
to
which
infrastructure,
so
this
revenues
resulting
5
together
+
6)
equal
welfare
is
and
are
being
they
net
value
produced
should
as
loss
have
lost
a
Note
tax
though
but
to
is
lose
since
area
equal
by
result
been
was
that
imposed
generate
(1
to
society
of
from
there
on
pollution
surplus
the
+
2
equal
to
in
is
+
area
the
4
(3
from
+
+
To
decrease
does
depend
An
to
may
To
Q'Q
tax ,
lower
loss
an
of
tax
demerit
cases
welfare
goods
a
point
loss
or
lower
is
if
on
level
of
the
sales
of
indirect
a
tax
burdens
an
both
counterintuitive
pre-tax
as
price
result
depends
but
indirect
they
help
price
inelastic
the
on
than
consumers
as
they
tax.
both
industries
that
production
to
is
more
price
wind,
solar
the
producers
is
very
a
socially
is
greater.
%
of
tax
in
By
inequality
to
migration.
promote
Agricultural
food
decrease
low
the
the
self-
income
price
of
food,
households
and
poor.
of
indirect
consumers
To
increase
not
tax
and
producers.
in
order
to
signicant
In
general,
and
avoid
the
PES.
a
•
demand
of
then
the
incidence
is
To
to
forced
incidence
If
proportion
of
than
demand,
then
The
following
determining
the
the
relationship
incidence
on
tax
more
certain
goods
and
affordable
basic
rent
food
are
to
or
services
low
so
products,
also
income
gasoline,
sometimes
public
subsidized.
industries
the
grow:
for
adoption
example,
of
green
subsidies
are
technologies
hydro
panel
and
geothermal)
industry
in
the
by
rms.
USA ,
Subsidies
China
responsible
for
its
growth
over
and
such
as
Airbus,
have
government
the
other
past
been
years.
accused
subsidies.
consumption
of
care
consumption
merit
goods
such
as
education
optimal.
are
greater
inelastic
helpful
for
manufacturers,
receiving
health
only
services:
benets
the
individual
of
these
consumer
but
services
also
society
large.
protect
assist
domestic
them
governments
Analysing
in
rms
from
increasing
may
grant
subsidies
import
export
penetration,
or
competitiveness,
subsidies.
using
a
diagram
is
subsidy
decreases
production
costs
of
rms
and,
as
a
greater
tax.
increases
supply.
This
shif ts
the
supply
curve
to
the
If
or,
better
yet ,
vertically
downwards
by
the
amount
of
incidence
subsidy.
The
shif t
is
parallel
to
the
original
supply
curve.
applies,
Impact
which
price
Beyond
are
of
the
on
they
among
promote
to
right
supply
slowly.
income
and
producers
PED
supply,
pay
the
become
(solar,
result ,
on
rural–urban
considered
important
certain
Aircraf t
A
more
rural–urban
though
often
charged
of
average
view.
the
of
considered
incidence
typically
and
more
not
even
at
sound
grow
This
on?
indirect
This
the
grows
incomes
income,
addition,
transportation
and
What
economy
5),
6).
units
indirect
society ’s
no
because
both
In
households.
government
•
consumption
an
does
nutrition
countries
•
As
cannot
granted
represents
so
also
very
improves
•
the
typically
products
society.
producers
3
farm
levels.
that
•
most
a
•
be
producers:
for
production
and
equal
spent
particular
demand
farmers’
farmers’
sufciency.
•
rms?
as
subsidies
decrease
of
as
inelastic .
increase,
decreases
costs
revenues
farmers,
increasing
an
to
they
incomes
will
subsidies
good
is
will
grant
Producer
these
surplus
government
they
•
collect
do
T I N U
(Pp
: 2
Producers
S C I M O N O C E O R C I M
•
on
market
outcomes
incidence:
In
PES
consumers
the
market
for
rice
shown
in
Figure
2.7
.2,
demand
D
and
=
%
The
sum
of
of
tax
the
incidence
two
on
producers
percentages
is
of
supply
PED
course
100%
since
S
lead
to
a
market
price
P
and
an
equilibrium
quantity
Q.
P/unit
S
if,
for
example,
the
incidence
on
consumers
is
80%,
then
Ss
the
incidence
relationship,
onto
on
it
producers
becomes
consumers
100%
must
clear
of
an
be
that
20%.
rms
indirect
Inspecting
will
tax
if
be
able
either
this
to
shif t
demand
Pp
a
is
1
2
perfectly
price
inelastic
(vertical)
or
supply
is
perfectly
elastic
P
(horizontal).
If
it
happens
that
PES
=
PED
then
an
indirect
3
tax
will
will
be
split
illustrate
50%–50%.
the
Carefully
constructed
diagrams
Pc
b
above.
Subsidies
What
are
subsidies?
D
A
subsidy
is
a
payment
by
the
government
to
rms
that
aims
0
to
decrease
production
their
and
production
costs
consumption
of
and
the
so
price
good.
For
and
to
example,
since
1980,
rice
farmers
receive
a
of
Malaysian
ringgit
for
each
ton
of
rice
2018
governments
around
the
world
were
rice
paying
the
subsidy
amount
US$35
billion
in
subsidies
to
their
shing
on
fuel
subsidies)
to
decrease
their
a
subsidy:
market
for
rice
cost
will
of
of
shift
the
the
subsidy
supply
to
Ss.
curve
As
a
vertically
result,
the
downwards
market
pay
for
rice
decreases
to
Pc
and
the
price
equilibrium
eets
quantity
(mostly
of
an
consumers
estimated
Impact
harvested.
by
In
2.7.2
pre-determined
The
amount
Q /period
Q
in
Figure
Malaysia
Q
increase
produced
and
consumed
increases
to
Q'.
Rice
inputs.
37
producers
buyers
now
pay
earn
plus
per
the
unit
subsidy
of
rice
(ab)
sold
paid
Pp
by
which
the
is
the
have
price
or
government .
to
cut
tax
Financing
The
cost
of
the
subsidy
to
the
government
is
equal
to
Q'.
paid
This
is
per
area
unit
(ab)
(PcbaPp)
times
or
the
area
(1
new
+
2
equilibrium
+
3
+
4
+
5
for
Consumers
are
enjoy
•
6).
Since
a
subsidy
and
better
more
increases
off
as
they
pay
a
lower
price
(Pc
<
Producers
area
of
the
good
(Q'
>
Q).
Consumer
>
P)
are
and
by
area
(3
+
4
+
also
sell
from
better
more
off
units
as
they
(Q'
>
earn
Q).
more
per
Revenues
(1
of
area
increases
produced
(0QeP)
to
area
(0Q'aPp).
if
the
and
by
area
sold,
(1
more
subsidized
+
2).
Since
workers
product
of
other
goods
permitting
is
then
producers
(1
more
will
be
used
as
+
output
and
The
government
of
the
is
equal
both
consumers
enjoy
an
and
increase
in
producers
surplus
better
equal
nance
to
area
(1
+
2
3
+
4
+
5)
resource
it
seems
that
allocation
social
improves.
welfare
This
case.
In
addition,
we
have
to
is
consider
to
the
government ,
which
is
equal
the
to
+
3
+
4
area
+
(6)
5
+
6),
and
results,
thus
which
greater.
represents
A
welfare
net
from
units
QQ'
now
being
produced
value
even
society ’s
an
input
for
Note
though
point
costs
lower
that
of
view,
there
is
they
no
should
welfare
not
loss
have
been.
involved
if
the
the
was
granted
to
increase
consumption
of
merit
would
price
or
use
of
pollution-abating
technologies.
More
and
cost
of
this
the
welfare
effects
of
a
subsidy
have
to
3
+
4
+
5
+
by
weighing
the
expected
benets
for
be
society
of
subsidy,
6),
so
it
policy
subsidized
against
its
cost
(that
is,
the
value
will
what
society
will
have
to
sacrice
to
nance
it).
Recap
Impact
Impact
•
of
of
indirect
an
Consumers
taxes
indirect
pay
a
tax
and
on
higher
subsidies
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good.
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subsidy
borrow
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government
a
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demerit
good
or
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production
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pollution.
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a
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merit
to
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good
benets
Policymakers’
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impose
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may
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income
taxes
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taxes
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for
decrease
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beverages.
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it
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to
impose
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taxes
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curb
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want
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38
goal
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nature
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price
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2.7.1
,
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market
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40
charge.
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specically
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are
better
off
supply
as
result
stakeholders:
instance,
•
droughts
on
T I N U
Fluctuations
incomes
their
incomes
are
stabilized
and
increased.
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fact ,
for
producers’
revenue
increases
from
area
(PeQe0)
to
area
(P'bQs0).
•
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agricultural
may
be
sector ’s
decreasing.
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share
of
national
economies
grow,
income
the
(4
as
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the
income
products
is
products
elasticity
rather
low.
grows
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but
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over
decrease
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relatively
and
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to
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in
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and
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this
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area
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areas
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in
from
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India,
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be
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goods.
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example,
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ab);
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that
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price
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the
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imposing
and
new
imposing
that
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there
taxes
higher
is
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government
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taxes
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later
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on
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example,
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some
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of
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government
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as
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consumers
surplus
Indian
price
+
their
Specically,
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good
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will
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are
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6).
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imposed,
diagram
In
5
price-controlled
Mexico
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corn
times
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+
the
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will
4
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employment
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•
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3
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good.
manufacturing
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to
incomes
5)
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demand
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for
+
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: 2
farmers.
resources;
of
one
welfare
of
too
the
much
particular
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good
land
farm
to
society
and
is
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turn
the
allocated
product .
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S C I M O N O C E O R C I M
•
to
is
inefciency.
purchases.
Policymakers’
perspective
P/unit
S
z
Despite
the
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b
a
1
Minimum
is
2
6
3
waste
required
and
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price
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the
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not
safe
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argue
implemented.
e
a
minimum
that
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price
policy
policies
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with
the
should
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expected
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of
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5
the
4
D
+
expected
expected
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example,
incomes
Qd
Qs
Qe
a
Q /period
2.7.4
The
impact
of
imposing
a
price
does
the
government
store
•
the
subsequent
if
there
is
for
destroy
a
government
the
and
period
crop
the
countries
sell
the
do
with
the
large.
means
surplus?
release
to
the
avoid
failure—but
the
stock
into
price
storage
the
rising
market
too
involves
additional
Also,
to
government
surplus,
and
is
Price
a
which
which
Imposing
has
simply
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a
the
terrible
case
in
many
2020
in
waste
oors
is
Brazil
at
surplus
average
disrupt
the
of
it
such
for
a
policy
a
should
minimum
acceptable
migration
may
prove
support
rural
level
be
the
adopted.
price,
and
slows
as
down
benecial
may
poverty,
maintaining
abroad
in
other
markets
usually
at
a
cost
(a
practice
known
as
dumping),
trade
relations,
as
local
farmers
will
lower
a
price
also
wage.
1
1
.97€
at
farmers’
a
result
to
then,
at
society
a
be
necessary
which
country ’s
may
as
also
social
a
be
fabric .
about
wage
is
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found
In
the
labour
Luxembourg
per
hour,
$1
.80
to
in
in
per
in
labour
markets
the
Greece
hour.
guarantee
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The
market
in
the
minimum
at
3.94€
reason
socially
per
for
form
wage
hour
setting
acceptable
of
in
and
a
level
price
income
to
unskilled
workers.
In
Figure
2.7.3,
the
vertical
which
measures
the
money
wage
rate
(W)
per
worker
and
the
suffer
horizontal
from
an
wave
alleviate
are
minimum
axis
may
than
in
much
of
below
such
imposing
at
temporarily,
minimum
•
greater
may:
surplus
a
costs
by
remain
important
•
are
oor
at
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then
if
rural–urban
least
What
society
D
0
Figure
for
government
purchases
h
benets
axis
depicts
the
number
of
workers
(L).
price.
41
Wage
rate
only
S(L)
L1
workers.
The
excess
supply
(surplus)
of
labour
L1L2
(W)
(or
h
hf)
represents
unemployment .
Minimum
f
W
A
minimum
wage
policy
will
benet
some
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wage
those
will
who
will
typically,
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but
up
not
with
a
job
necessarily,
at
W'
instead
create
of
We.
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unemployment
We
(L1L2)
would
though,
have
without
and
had
one,
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will
job
namely
unemployment
if
especially
without
individuals
rms
are
hurt
this
able
L1Le.
to
the
policy
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keep
worker s
who
but
are
now
may
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increase
money
lef t
wages
D(L)
below
0
L1
L2
Le
Number
workers
the
competitive
of
(L)
Policymakers’
Figure
2.7.5
Minimum
wage
demand
labour
to
produce
the
goods
and
services
the
minimum
It
is
negatively
sloped,
as
at
higher
wage
rates
try
to
substitute
capital
for
labour.
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offer
services
to
the
labour
market .
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supply
of
labour
the
has
shown
minimum
sloping
as
at
higher
wage
rates
the
opportunity
leisure
to
be
increases
the
(it
becomes
labour
more
market)
so
expensive
more
for
increase
work
for
the
wage
labour
rate
government
rate
at
(We)
W',
than
then
the
services.
sets,
is
L2
be
now
too
the
is
competitive
We
with
considers
at
number
At
at
low
rms
of
and
W'
Le
will
that
are
the
want
wage
the
market
to
set
a
to
hire
willing
rate
looking
then
individuals
decides
individuals
higher
individuals
not
modest
resulted
at
in
least ,
higher
in
One
costs
reason
for
caused
by
this
the
outcome
is
minimum
that
wage
small
relative
modest
to
most
relative
to
rms'
the
overall
wages
costs
paid
to
and
low
wage
leisure.
market
will
increases,
have
will
workers.
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then
Empirical
someone
individuals
only
substitute
high
increase.
is
is
outside
exorbitantly
necessarily
cost
the
of
not
that
wage
unemployment .
upward
is
not
their
in
labour
may
rms
evidence
will
wage
they
unemployment
produce.
perspective
policy
If
Firms
level.
W'
for
to
job
the
wage
wage
individuals
offer
the
increases
If
determined
minimum
fewer
that
a
equilibrium
employed.
their
labour
government
while
rms
On
will
faster
minimum
workers’
and
top,
requires
wage
when
wage.
may
more
have
employment
and
there
is
or
no
of
to
buy
the
to
more
which
the
discernible
wage
in
money
Hence,
low
employment
increase
demand,
workers.
little
that
adds
them
higher
prospects
an
pay
allows
creating
hiring
suggests
Increased
income
services,
evidence
goods
in
turn
minimum
effect
on
the
workers.
hire
Recap
Price
ceilings
(maximum
Aim
to
prices)
protect
Price
vulnerable
consumers
oors
(minimum
Aim
prices)
to
protect
typically
Price
is
Results
set
below
in
market-determined
•
a
•
non-price
•
the
•
worse
price
Price
is
Results
shortage
rationing
set
above
in
mechanisms
•
a
of
parallel
•
the
and
in
the
government
buy
the
burdening
long
cost
of
on
some
worse
are
better
on
sellers
they
Impact
on
welfare
inefciency
rent
others
are
off
Impact
Examples
off,
are
sacrice
Impact
the
by
policy
of
on
some
or
other
project
they
are
worse
off
are
better
off
consumers
worse
off
and
controls,
welfare
food
price
Impact
on
sellers
they
loss
Impact
on
welfare
inefciency
and
controls
Examples
agricultural
price
minimum
42
forced
surplus
taxpayers
government
consumers
being
resulting
term
in
Impact
price
wider
the
shortages
market-determined
markets
•
quality
producers,
surplus
to
emergence
vulnerable
farmers
wage
welfare
loss
supports,
Free
markets:
The
is
fundamental
scarcity:
what
In
a
economic
limited
necessitates
about
How
will
economy,
mechanism.
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versus
which
scarce
the
and
problem
resources
choices
quantities.
market
successes
of
that
all
societies
unlimited
goods
is
to
given
demand
or
common
wants.
produce
be
by
and
face
achieved,
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and
point
in
are
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to
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and
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of
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outcome
is
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markets
socially
are
efcient .
right
amount
and
and
of
the
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consumed,
social
from
scarce
surplus
is
society ’s
resources
maximized.
the
real
at
the
socially
world
however
the
necessary
and
outcome
are
conditions
seldom
to
present .
arrive
Markets
do
not
work
either
too
much
to
the
best
interest
of
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and
lead
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Allocative
efcient
with
trying
each
free
the
produced
allocated
In
will
or
too
little
of
the
good
produced
and
be
When
this
happens,
resources
are
misallocated,
competitive
social
then
is
optimally
consumed.
produced
just
view
market
to
maximize
resources
allocated?
of ten
consumers
access
failures
resources
answer
interaction
pool
: 2
common
and
efciency
surplus
is
not
maximum
and
so
the
market
fails.
One
is
such
circumstance
is
the
case
of
externalities.
Externalities
An
or
externality
third
not
parties
pay
for,
whenever
costs
of
is
present
consumption)
of
for
if
imposes
which
they
respectively.
there
is
a
economic
on,
do
not
or
or
get
private
are
also
(production
benets
compensated,
an
between
between
Externalities
activity
creates
Equivalently,
divergence
production
consumption.
an
costs
externality
private
and
referred
to
do
social
benets
as
production
the
exists
and
social
for,
or
spillover
effects.
labour
costs
but
leads
to
a
market
failure
as
either
more
or
which
also
of
be
the
socially
optimal
amount
is
produced
or
case
forces
alone
fail
to
lead
to
an
efcient
above
with
a
production
means
resources
taken
any
into
in
the
production
the
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negative
process
they
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include
costs
form
that
of,
exceed
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say,
supply)
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are
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rm,
taken
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a
just
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the
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externality.
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not
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In
be
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or
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whole
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then
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below
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MSC
drawn
another
than
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include
case
the
This
other
by
the
externality
of
process.
and
consideration
a
An
T I N U
failure — externalities
S C I M O N O C E O R C I M
Market
2.8
the
MPC
(the
supply)
curve
as
there
is
an
external
resource
production
benet
involved
in
the
process.
allocation.
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are
known
process,
in
If
considered
generate
arise
in
production
which
externalities.
are
may
as
case
they
they
they
production
are
impose
negative
benets
the
externalities,
known
costs
on
as
consumption
In
considered
the
where
in
third
externalities.
are
process,
or
parties
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positive
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if
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externalities.
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Marginal
benets
private
private
benets
individuals
unit
pay
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an
benets
demand
of
enjoyed
curve
a
are
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additional
for
benets
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always
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from
good.
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is
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the
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determined
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thus
as
that
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the
of
by
of
the
to
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additional
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an
consumers
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enjoyed
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from
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consuming
additional
Marginal
Production
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are
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Negative
Positive
private
but
in
Marginal
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and
private
private
costs
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as
the
the
additional
lie
below
rm
They
incurs
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of
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of
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a
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that
the
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of
a
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good
as
that
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are
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costs
of
by
producing
society.
of
all
resources
that
are
sacriced
the
benets
third
individual
include
consumers
(the
the
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demand)
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that
curve.
on
If,
others
demand)
may
the
enjoy
MSB
though,
then
curve,
a
lies
individuals’
the
as
as
curve
MSC
there
curve
is
of
consumption
generated
by
the
an
process.
Types
of
Externalities
and
an
Impact
industry
fuels
They
in
the
Production
and
(coal,
Externality
power-plants
oil,
natural
in
gas)
many
in
their
countries
use
production
additional
reect
But
the
burning
of
fossil
fuels
releases
several
the
greenhouse
value
any
benets).
imposes
Negative
Heavy
(MSC)
borne
cost
Four
process.
unit
by
each
benets
always
fossil
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from
social
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rm.
costs
enjoys
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decision-making
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regarding
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society
good.
other
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that
good.
costs
external
a
MPB
consumption
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dened
addition
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above
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denitions
costs
that
consumed.
benets
of
benets
benets
unit
the
result
Relevant
social
the
units
gases
that
contribute
to
global
warming
specic
43
and
climate
extreme
change
weather
and
lead
conditions
to
rising
sea
(droughts
waters,
and
B.
Negative
When
oods,
hurricanes),
crop
failures,
health
problems,
of
species
and
other
costs.
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people
reects
the
marginal
private
benet
of
buyers,
to
marginal
social
benets
as
no
work
external
consumption
costs
are
of
assumed.
such
rms
Supply
(that
is,
reects
the
costs
the
for
wages,
energy
and
materials).
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of
liquor
pay,
no
entails
that
external
society
costs
in
sacrices
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more
form
than
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consideration.
of
the
Society
pollution.
sacrices
The
environmental
marginal
social
bigger
than
the
marginal
private
costs
of
the
external
costs
created
costs
given
(ab)
in
the
gure
below
and
so
by
the
by
the
MSC
the
S,
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the
in
for
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causes
tax
environmental
on
every
damage
can
Externalities
be
Indirect
(Pigovian)
difcult
in
pioneering
the
case
economist
of
Pigou
an
generated
the
the
take
rm’s
the
rm
principle
‘polluter
pay
it
for
taxes.
costs
The
Pigovian
on
he
to
and
below
the
to
all
taxes
generate
illustrates
polluting
rms
in
principle
would
force
would
raise
of
the
social
This
force
effect
the
steel
of
costs
as
to
as
the
to
Pigovian
a
if
the
tax
MPC
the
PED
the
total
amount
=
(MPC
+
is
given
economy.
the
the
all
to
good.
in
monetary
to
If
other
of
If
then
up
area
to
the
demand
present
for
the
price
still
pollution-generating
the
Qs*,
by
the
MSC
dependent
very
be
costs
output
between
is
may
of
is
in
not
addition,
generated
Qs*)
demand
does
these
In
rate
may
amount
involved
product
pollution
the
collected
correct
costs
a
production
environmental
the
collected.
generated
Moreover,
only
tax .
optimal
of
the
taxes
damage,
the
level
output
pollution
of
administrative
equal
for
If
minimal
estimating
revenues
total
curves
for
the
leads
the
preferences
St
are
analysis.
amount
of
environmental
(which
the
small
collecting
tax
of
and
relatively
costs
there
and
the
size
high
industry.
the
the
outweigh
activity
the
imposing
Also,
much
might
causes
then
worth
tax .
research
goods
imposing
even
level.
polluters
referred
the
to
of
be
cause
the
would
optimal
referred
that
are
external
in
it
process.
is
the
requires
some
not
tax
socially
solution
of
of
damages,
the
would
that
level
the
intervention
Cambridge
size
tax
The
production
this
they
the
sense
to
to
proposed
indirect
the
output
principle’
gure
tax
equal
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in
the
limit
pollution
attributed
when
(MPC)
with
to
is
government
consideration.
underlying
pays
the
tax
rm.
into
associated
induce
the
externality
production
(MSC)
The
to
rms
(1920)
indirect
by
internalize
rm
recommending
polluting
A .C .
imposition
cost
of
work
Estimating
taxes
terms
The
task .
: 2
–
a
T I N U
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intervention
any
and
on
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unacceptably
activities
good
generation
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reects
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ignores
tax)
P/unit
future
generations,
which
will
be
hardest
hit
by
polluting
f
activities.
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Another
issue
is
that
the
effects
of
polluting
MPC
activities
taxation
extend
does
Therefore,
beyond
national
border s
but
Pigovian
not .
instead
of
imposing
Pigovian
taxes
on
nal
consumer
S C I M O N O C E O R C I M
Government
P*
products,
taxes
as
economists
far
generally
upstream
in
recommend
the
production
at
level
applying
process
as
Pigovian
possible.
An
h
Pm
upstream
This
is
MPB
=
the
Carbon
A
carbon
in
is
case
–
fuels
D,
tax
for
steel:
effect
of
a
Pigovian
tax
is
government
rms
estimates
create
the
and
size
of
imposes
the
an
pollution
indirect
tax
amount
which
above.
addition
curve
The
to
with
Steel
is
given
their
the
market
by
the
manufacturers
manufacturing
tax
will
has
shif ted
adjust
to
the
so
are
below.
to
the
tax
levied
amount
of
on
carbon-based
carbon
dioxide
fossil
emitted
and
energy
use.
Such
sources
a
such
tax
as
raises
oil,
the
coal
price
and
of
natural
provides
vertical
now
distance
costs.
to
the
have
to
Thus,
level
Pigovian
tax
pay
the
of
(fh)
the
new
the
by
reduce
incentives
induced
their
to
tax
to
users
switch
burden.
to
At
to
conserve
sources
the
of
same
energy
energy
time,
that
users
produce
carbon
emissions
and
are
thus
taxed
at
lower
rates.
As
to
in
result ,
the
external
costs
of
production
decrease
and
the
the
socially
gure
inputs.
(external)
equal
a
that
Pigovian
production
would
lower
that
a
proportion
and
it
thus
costs
analysed
production
tax
as
The
taxes
raw
Q /period
gas
Market
carbon
of
taxes
carbon-based
Qm
of
the
MSB
during
Qs*
imposed
tax
optimal
level
of
output
increases.
The
gure
below
in
illustrates
the
effect
electricity
industry.
of
the
imposition
of
a
carbon
tax
in
the
supply
MSC
moving
curve.
to
a
new
P/unit
equilibrium,
quantity
with
Qs*.
a
The
higher
tax
has
price
of
resulted
P*
in
for
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steel
and
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lower
level
of
1
steel
MSC
production.
where
social
the
costs.
of
a
other
marginal
producers,
form
In
a
Also,
words,
social
note
portion
price
steel
benets
that
of
the
increase
is
even
tax
for
is
steel
produced
only
are
to
equal
though
passed
(from
the
on
Pm
the
tax
to
to
to
the
S,
MPC
=
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marginal
was
levied
buyers
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point
in
This
on
MSB
=
MSC1
MSB
=
MSC2
the
causes
Pm
buyers
A
to
cut
gasoline
back
tax
to
is
their
an
purchases
example
driver's
cost
cover
driving
automobiles.
the
In
of
a
negative
the
from
Qm
Pigovian
to
Qs*.
tax .
externalities
United
States,
the
It
raises
created
federal
the
by
gas
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tax
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was
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imposed
per
Trust
examples
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on
per
gallon
gallon.
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to
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in
The
pay
taxes
pesticides
and
2019.The
revenue
goes
for
roadway
on
products
on
average
chemical
into
state
the
the
Other
tax
MPB
tax
0
federal
maintenance.
include
gas
Market
for
electricity:
Q*s1
effect
of
a
carbon
Q*s2
Qm
Q /period
tax
of ten
fertilizers.
47
The
external
the
lower
shif ts
the
to
from
the
carbon
of
to
is
of
level
is
and
fall
in
output
the
carbon
as
so
a
result
the
MSC
external
to
market
between
required
fuel
decrease
fuels
The
of
to
distance
the
content)
MSC2.
closer
vertical
size
production
carbon-based
optimal
which
decreased
that
of
MSC1
socially
Q*s2
costs
use
costs
increase
from
outcome
Qm.
MPC
tax
and
on
buy
(lower
carbon
tax
Columbia,
per
of
ton
of
British
revenue
i.e.
Canada.
carbon
to
capita
have
Af ter
by
tax
is
total
since
equal
and
this
years
of
30
an
effect ,
subject
compared
of
new
with
high
enough
cases
led
the
to
cost
they
carbon
higher
of
however
as
living
tax
energy
and
may
hurt
dollars
the
cuts
was
of
is
in
Canada
the
to
bills
be
reluctant
on
for
even
help
resulting
as
the
Low
Income
in
around
per
found
to
to
In
set
carbon
addition,
in
power-generating
households
more
protect
higher
Climate
residents
with
collected
is
excess
can
of
so
the
lower
which
income
low-income
prices,
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lump
of ten
redirect
lower
the
T
ax
sum
the
A
carbon
taxes
revenue
tax
and
2015
(EEA)
income
or
social
of
energy
may
rms
Although
to
has
the
market
incentive
can
it
level
do
to
buy
but
it
of
cheaper
than
to
results
that
to
lower
permits.
pollution
cost
will
effectively
from
had
carbon
can
be
matched,
carbon
among
Also,
taxes
for
security
taxes.
In
also
create
a
the
technological
to
EU’s
to
decrease
the
European
was
mostly
as
and
gas
22%
world.
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energy-using
plants)
countries,
by
countries
the
heavy
greenhouse
reduced
according
in
industrial
these
Emissions
31
it
well
covers
emissions.
between
1990
Environment
driven
by
emissions
generation.
tradable
lead
reducing
permits
level,
to
an
they
increase
emissions
newer
in
theory
may
fall
bring
under
in
the
level
drastically
technology),
the
pollution
certain
of
for
permit
down
circumstances
emissions.
some
price
rms
will
fall,
If
costs
(those
with
older
technology
to
cheaply
purchase
allowing
more
and
actually
control
increase
emissions.
lead
Surprisingly,
to
more
better
pollution
rms.
Nevertheless,
this
can
be
avoided
by
by
reducing
total
number
of
permits
issued.
in
–
Direct
regulation
a
can
also
address
the
issue
of
negative
cut
externalities
by
resorting
to
direct
regulation.
higher
incentive
and
can
other
with
the
technology
whole
rebates
lower
addition,
innovations
the
were
system
1
1
,000
and
between
in
tax
governments
example,
powerful
trading
than
Union
operates
through
The
receive
paid.
European
programme
credits.
households
they
the
which
more
of
EU
the
desired
actually
of
families.
the
can
directly
regulate
the
level
of
output
of
for
polluting
energy-saving
rms
stations
power
Governments
cost
an
their
nd
households
Credit
equally
in
production
in
open
permits
ET S),
from
the
Governments
taxes.
lower
that
taxes
many
increase
government
tax
divided
income
carbon
of
emissions
percent
and
the
population
have
to
rms
the
launched
(EU
(power
in
some
revenue
in
those
operating
45
Agency
Canada.
EU
Emissions
pollution
provides
hand,
cost .
largest
airlines
permits
the
least
emissions
plants
from
by
Scheme
the
is
Columbia’s
tax
rest
or
and
using
Yet ,
pollution
installations
All
programme
rebates
2005,
limits
77%
emissions.
tax
the
businesses.
placed
hurt
incentive
allocation
the
reductions
Governments
an
other
permits
decreased
Trading
British
estimated
British
to
to
in
Canadian
gas
carbon
through
in
fuels
19%
to
affects
Columbians
four
2008
greenhouse
through
consumption
declined
place
dioxide
British
taxes.
in
The
Columbia’s
have
the
lower.
been
generated
returned
other
has
a
have
In
A
level
Thus,
implies
on
additional
their
Q*s1
The
cleaner
permits
pollution;
allows
MSC2
the
saved
of
curve
stimulate
rms,
the
prices
they
charge,
where
they
may
or
new
may
not
locate
as
well
as
the
type
of
machines,
lters
and
markets.
fuel
–
Tradable
pollution
permits
(‘cap
and
For
schemes)
Besides
tradable
pollution
schemes,
whereby
permissible
level
specically,
the
emissions
if
and
greenhouse
currently
this
by
issued
the
another
40
10
to
of
gas
the
tons
(4
only
for
and
is
cap
desired
particular
policy
tons.
reduced
and
The
over
specic
is
to
permits
cap
so
of
are
will
fall.
The
permits
can
initially
be
on
the
basis
of
past
emissions
or
can
be
75%
thus
Still,
from
highest
bidders.
Firms
are
then
able
to
among
them
in
the
open
market .
The
auctioned
price
is
determined
simple
through
demand
for
market
permits
demand
and
and
(vertical)
a
can
that
of
a
that
supply
supply
forces
of
by
the
amount
specialized
of
and
In
many
cost-effective
authorities
resources
that
instruments.
set
of
and
solutions
education
whereby
to
change
the
preferences
and
the
government
practices
and
of
rms
by
increasing
their
of
awareness
costs
of
certain
activities
they
undertake.
By
of
the
making
as
children
aware
of
the
benets
of
recycling
today
the
permits
lower
their
pollution
and
save
permits
at
aims
at
creating
citizens
who
will
make
better
about
less
than
what
they
can
earn
by
selling
such
issues
in
future.
When
polluting
rms
a
the
bad
publicity
their
alter
48
adherence
the
coasts.
implement
permits.
certain
and
for
illustrate.
can
is
and
ships
benets
and
in
more
permit
exposed,
cost
from
ports
tradable
a
permits
choices
Firms
to
design
or
realistic ,
awareness
different
government
diagram
to
close
in
to
school
a
to
signicant
manpower
Increasing
external
is
monitoring
a
result
emissions
(IMO)
sulphur
for
consumers
freely
easier
will
for
environmental
living
taxation
considered
a
oxide
and
Organization
limit
total
allocated
trade
sulphur
usually
the
regulation
people
Pigovian
are
This
health
for
allocating
attempts
the
are
to
in
Maritime
substantially
ships.
major
especially
requires
International
decrease
they
range
the
decreased
have
compared
This
free
use.
board
Regulations
–
emissions
on
solution.
be
hence,
that
will
cases
reduce
would
(and,
time
goal
example,
country
oil
world,
More
For
recently
than
trade
a
national
goal
then
fuel
involves
allocated
accordingly.
a
the
as
is
emissions.
the
tons),
million
permits)
gas
sets
million
36
rm
permits
emissions
response
known
greenhouse
million
of
also
emitting
government
percent
number
permits
each
issues
emit
government
can
example,
has
taxation
they
trade’
their
practices.
they
receive
may
force
them
to
are
specic
market
appropriate
pollution
control
policy
the
will
circumstances.
While
economists
the
market-based
solutions
such
as
Pigovian
tradable
permits
there
are
situations
lead
might
not
be
the
best
choice
when
is
issues
localized
direct
and
regulation
tax
not
and
can
the
set
a
cap
resulting
of
tradable
permits,
on
total
pollution
advance
will
be
tax
as
it
will
depends
adjust
on
their
prices.
Thus,
if
how
rms
behavior
the
levels
certainty,
be
the
below
regulations
best
options.
a
or
and
to
the
policy
‘cap
the
with
even
is
to
in
tax
cleaner
may
be
and
other
level
trade’
hand,
can
be
technologies
preferable.
politically
if
In
the
difcult
theory,
a
is
the
Still,
as
pollution
revenues
from
a
taxes—but
this
may
the
or
more
can
permit
politically
lobby
systems
popular,
policymakers
on
tax
objective,
taxes
can
very
tax
are
may
not
the
be
by
in
receive
if
hand
rms
free
tend
to
believe
Goods)
many
will
minimal
be
of
even
the
other
a
negative
the
costs.
consumption
consumption
Indirect
world
taxes
a
tax
Sof t
t hat
20%
is
tax
on
qu a l i t y
on
of
the
externality
good
the
generating
is
taxes
there
have
on
in
Drinks
drinks
those
indirect
decrease
higher
are
also
red
are
one
taxes
been
meat
place
in
option.
on
In
tobacco
placed
may
the
Industry
Levy
containing
with
of
the
may
tax
5–8g
tax
be
equal
supply
price
is
very
is
expenditure
of
the
on
monthly
of
deterring
demand
consumption.
also
spent
on
the
depends
good.
tax
on
higher
income
The
individuals
studies
point
higher
that
levels
the
of
prevalence
income
and
of
the
in
the
case
dr i n k i n g
of
is
alcohol,
a
c o n s i d e re d
tax
aiming
rat h e r
re a s o n
is
t hat
t h e re
vo d ka ,
a re
wine,
ve r y
white
ma ny
cider
a re
ve r y
ma ny
d i f f e re n t
etc .)
b ra n d s
and
and
differ
dramat i c a l l y
i mp o s e d
on
in
alcoholic
price.
dr i n k s
Thus,
then
a
i f,
s ay,
‘ c ha i n
ju s t
may
ve r y
start
switching
with
to
ma ny
l ow e r
substitutes
so
p o o re r
priced
t hat
addicted
and
ove ra l l
l ow e r
c o n s u mp t i o n
little.
consumers
market
may
where
also
most
on
soon
UK
seek
8g
(SDIL),
of
the
sugar
tax
per
of
sugar
per
will
and
to
so
induce
correct,
achieved.
the
The
the
external
increase
a
lower
socially
gure
the
level
to
buy
paid
to
the
the
good
in
a
government .
even
may
worse,
therefore
not
health-related
decrease
problems
as
expected
may
result
if
quality
while
the
countries
products
are
of
a
lower
or
dubious
earns
that
puts
in
successive
tax
revenue.
T
ax
governments
in
hikes
on
Greece
tobacco
have
specically,
Ofcially
100ml
less
and
a
charge
and
have
contributed
to
a
loss
of
tax
revenues
as
called
smokers
18p
switched
to
parallel
markets.
of
keep
in
mind
that
indirect
taxes
are
regressive.
Thus,
a
consumers
will
be
burdened
proportionately
more.
100ml.
costs
price
of
of
of
consumption
the
good.
consumption.
optimal
below
is
goal
drinks
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2018.
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introduction
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example
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apple
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nicotine
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generating
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Negative
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Carbon
•
Tradable
(Pigovian
taxes)
taxes
consumption
Positive
production
Positive
consumption
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externalities
externalities
•
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Direct
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Legislation
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taxes
and
provision
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pollution
and
trade”
permits
schemes)
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and
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and
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awareness
education
regulation
awareness
provision
awareness
education
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51
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52
is
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53
2.9
Public
A
good
the
Market
failure—public
goods
is
considered
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two
a
public
good
if
it
is
characterized
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it
air
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television
good
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to
all.
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listen
to.
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produced
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their
public
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possible
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to
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care
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education.
benets
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to
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security
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radio
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broadcasting.
radio
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is
public
normally
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household
with
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receiver
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private,
for
54
if
one
person
listens
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and
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of ten
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How
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Market
T I N U
2.10
failure—asymmetric
information
(HL)
in
the
than
the
other
Adverse
Adverse
occurs
sold
information
transaction
has
party.
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such
in
to
a
market
more
or
situations
when
better
one
party
allocated
information
resources
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selection
selection
one
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relates
party
other
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to
limitations
knows
more
on
about
information
and
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being
product
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insurance.
party.
the
health
used
car
about
market .
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Sellers
condition
of
have
their
potential
buyers.
to
offered.
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offer
to
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asymmetric
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price
based
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withdraw
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sellers
of
better
from
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market .
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than
results
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status
health
quality
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fewer
sold.
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price
buyers
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average
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leaves
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someone
number
car
market
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thins
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out
and
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contract
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other
have
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become
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and
possibly
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cover
and
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on
regulation
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quality
and
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market
large
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in
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when
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in
activities
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way
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insuring
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way
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of
are
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quality
reliably
cars.
necessary
place
when
information
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that
you
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apply
individuals
from
to
other
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purchase
insurance
to
observable
health
company
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insurance,
demand
of
your
sicker
health
status
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an
applicants—customers
attempt
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will
to
refuse
insure
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also
insure
only
provides
a
at
very
very
high
good
premiums.
example.
Auto
Insurance
information
staff
may
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know
whether
you
are
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careful
accuracy.
place
conveys
the
have
insurers,
supplies
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party
with
information
that
will
but
people
in
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other
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instance,
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resemble
your
premiums.
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data
on
the
prole—and
some
cases,
accident
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this
use
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rates
those
be
superior
make
them
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reputable
However,
nobody
can
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the
insurance
seem
companies
credible
the
the
quite
information
easily
contract
than
the
happens
to
data
takes
the
actions
this
less
that
purchasing
responses
Signalling
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takes
characteristics.
driver,
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of
examples,
warranties—promises
cars
they
additional
company
possibly
be
offer
the
against
that
insurance
collection
side
own
know
However,
to
information,
one
both
they
cause.
put
to
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decisions.
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because
might
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safety
order
control
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buyers
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consumers
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insurance
HL
you
Governments
damage
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costs
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because
car
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malpractice
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cost
information
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with
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buyers
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insurer
contract
example,
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incentive
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party
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behaviour.
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procedures.
in
medical
cars
responses
and
legislation
•
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customers.
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and
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medical
healthy
customers
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potential
health
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amount
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costs
its
for
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market
collapse.
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individuals
cost .
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monitor
Responses
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the
company
HL
behaviour
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insurance
insurance
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withdrawn.
to
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customers
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have
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can
used
less
alter
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hazard.
happens
know
As
premiums,
average
Moral
fails.
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buyers
the
of
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moral
health
company ’s
the
leading
market
than
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willing
being
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asymmetric
more
cars
the
cars
and
similar
A
expenses.
information
are
and
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HL
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•
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than
occurs
access
S C I M O N O C E O R C I M
Asymmetric
: 2
HL
are
right
on
average.
used-
55
2.1
1
Market
Focusing
on
failure—market
HL
Paying
factor
prots,
typically
denoted
with
the
Greek
letter
the
of
equal
to
the
from
difference
selling
Q
between
units
of
a
the
total
good
revenues
minus
the
costs
(TC)
incurred
in
producing
these
=
TR(Q)
is
necessary
and
is,
of
to
secure
course,
an
the
scarce
element
costs.
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prots
are
the
necessary
of
minimum
(TR)
to
secure
Q
units,
paid
to
the
scarce
labour
are
factor
an
of
entrepreneurship.
element
of
economic
Since
costs,
or:
normal
π(Q)
rate
labour
total
wages
economic
wage
π,
return
collected
market
production
economic
are
(HL)
rms
Prots
Economic
power
prot
is
also
an
element
of
economic
cost .
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TC(Q)
−
prots
the
thus
value
differ
of
all
from
accounting
resources
prots
sacriced
in
in
the
that
they
production
include
process.
Revenues
Total
Q
revenues
units
are
or
sales
dened
as
revenues
the
(TR)
product
collected
of
the
from
price
(P)
selling
per
Average
Average
charged
times
the
number
of
units
sold,
costs
=
P
×
(AC)
are
dened
as
costs
per
unit
of
output
or:
produced.
TR(Q)
costs
unit
Q
units
(Q)
This
is
total
costs
(TC)
divided
by
the
number
of
so:
TC
Average
revenue
AC
=
Q
Average
revenue
(AR)
is
revenue
per
unit
sold,
so:
Prot
maximization
TR
AR
=
We
Q
typically
prots
Since
TR
=
P
×
Q,
it
follows
that
average
revenue
is
even
to
the
price
charged
by
the
TR
P
=
×
that
output
since
the
since
level
Q
average
demand
the
the
revenue
curve
at
is
that
=
curve
which
always
a
goal.
P
To
rm
a
it
rm
will
equal
faces
is
faces
be
to
shows
absorbed
price,
also
its
it
at
follows
AR
that
are
scarce,
that
produce
this
terms
to
a
question,
we
cost
cost
(and
explicit
marginal
returns)
cost
(MC)
an
of
in
economic
economics
costs
we
is
care
tricky.
Since
about
the
change
value
of
sacriced
payment
is
in
the
into
made
production
or
explicit
“out-of-pocket ”
to
pay
not .
process,
Economic
whether
is
dened
additional
unit
as
of
value
a
of
and
costs
supplier.
rm-owned
premises
rm
implicit
costs
costs.
are
owned
can
in
use
her
earned
is
the
in
total
a
rm
has,
for
example
Implicit
costs
include,
for
by
resources.
a
rm,
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but
payment
they
are
is
them.
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consider
an
rm.
had
We
she
must
been
include
working
start
to
cost
made
“sacriced”
wages
another
the
short
costs
that
include
an
is
something
also
a
scarce
entrepreneur
cannot
costs
entrepreneur
she
more.
factor.
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(TC)
following
at
the
thus
invests
same
also
requires
return
could
have
time
in
also
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certain
be
line
invested
56
in
it
is
output:
=
the
total
cost
decrease
function.
and
Typically,
then,
This
behaviour
is
af ter
the
some
result
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point ,
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law
when
xed
at
least
(typically,
one
factor
capital;
of
think
production
of
it
is
initially
easy
to
increase
the
output
rm’s
because
is
a
lot
of
opportunity
output
for
implies
that
produced
labour
the
from
additional
an
specialization.
cost
additional
The
of
an
worker
additional
rises.
unit
produced
include
the
to
remain
in
a
minimum
line
of
is
known
as
normal
prot .
in
been
the
earned
next
best
if
this
return
is
that
rate
not
if
then
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earned,
rm
they
is
will
then
not
not
the
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business.
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with
prepared
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is
to
willing
of
decreases.
some
point,
though,
the
there
is
additional
less
and
output
less
from
room
an
for
additional
employed
starts
set
in.
to
decrease.
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output
This
is
when
continues
diminishing
to
added
to
the
production
process
but
at
a
rise
as
workers
diminishing
follows
that
the
additional
cost
(the
MC)
of
an
rate.
additional
unit
to
output
produced
will
at
that
point
start
to
rise.
The
behaviour
capital
same
workers
for
returns
the
described
for
the
MC
gives
rise
to
the
“Nike-swoosh”
shape
risk.
viable—in
work
and
This
equal
the
not
pay
to
MC)
of
return
entrepreneurial
alternative
(the
elsewhere.
of
way
change
that
just
invested
market
a
entrepreneurial
of
same
of
would
It
this
cost
generally,
rm.
are
If
More
also
marginal
was
additional
good.
returns.
run,
considered
worker
what
the
no
specialization
minimum
diminishing
for,
as
After
Economic
of
prot
entrepreneurship
business
of
initially
increase.
diminishing
output
capital
and
revenue
example,
This
Economic
introduce
when
entrepreneur
the
for
slope
costs
additional
Normal
rst
marginal
costs
there
have
how
thus
Explicit
premises)
working
is
Q
is
other
must
a
an
In
say,
answer
prot-maximization
TC
of
the
its
law
all
they
has
maximize
other
resources
marginal
it
to
be
curve.
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to
aim
may
costs
distinguished
refer
rms
there
must
and
the
MC
resources
rm
achieve
marginal
Marginal
the
concept
that
seen,
each
and
producing
The
question
to
answer
the
Marginal
Economic
have
Q
demand
price
The
output
explain
Note
we
Q
=
Q
economics
rm.
much
AR
in
as
always
objectives.
equal
assume
though,
the
MC
curve
shown
Figure
2.1
1
.1
.
At
output
level
q1
,
the
the
law
of
diminishing
MC
starts
the
that
in
rm.
to
rise.
marginal
returns
begins
to
take
effect
and
P
,
T I N U
MC
MR
F
: 2
MC
Q1
(ped
=
1)
Q
D,
Figure
2.1
1
.1
The
MC
AR
curve
0
Marginal
S C I M O N O C E O R C I M
m
Q
H
revenue
Q /period
Marginal
revenue
(MR)
is
the
additional
revenue
collected
from
MR
selling
an
additional
unit
of
a
good.
More
generally,
it
is
the
Figure
change
in
total
revenues
(TR)
following
a
change
in
2.1
1
.3
The
MR
curve
if
the
rm
is
a
a
marginal
price
maker
output:
sloped
demand
curve
will
have
revenue
curve
TR
MR
with
=
double
the
slope
of
the
demand
curve.
Q
Note
There
are
two
the
Case
In
1
this
what
as
It
in
the
the
rm
which
other
it
a
price
rms
taker.
is
very
operates
homogeneous).
is
in
this
This
In
rm
this
small
and
compared
produces
market
must
case
offer
the
good
(the
accept
marginal
a
to
is
market
revenue
of
the
identical
good
the
size
is
to
known
price.
the
Right
PED
shown
from
in
Figure
selling
prevailing
one
in
the
2.1
1
.2.
more
The
unit
additional
will
always
marginal
equal
curve
above
the
of
decreases,
decrease,
revenue
cuts
Q,
that
where
is
is
(FH).
price
marginal
1
double
Q
MR
of
is
the
Remember
inelastic ,
line
equal
because
revenue
slope
of
to
point
that
then
must
segment
as
total
be
zero,
m
is
the
price
revenues
negative.
for
prot
maximization
collected
to
the
price
To
maximize
Qfor
market .
prots,
a
rm
must
choose
a
level
of
output
which:
MR
P
,
has
midpoint
curve
segment
demand
so
the
output
demand
line
if
it
constant ,
revenue
be
of
midpoint
Rule
as
since
demand
(0H).
case,
market
that
cases.
=
MC
MR
Very
of ten,
condition
level
of
then
we
students
that
the
output
know
can
enjoys
abnormal
say
return
that
level
zero.
that
prots
we
be:
is
incorrectly
It
required
(or
will
in
become
are
the
just
case
we
normal
to
above
a
rm
that
but
if
that
zero
(in
prots,
remain
that
=
MC
maximum
the
rm
which
the
in
at
MR
these
say
prots;
entrepreneur
the
by
clear
maximum
which
enjoys
from
enjoyed
supernormal)
rm
by
prots
prots
positive,
the
of
infer
case
minimum
that
line
of
MR
P
business);
economic
To
or
even
losses
understand
Assume
per
that
hour)
negative
and
the
is
and
is
not
above,
currently
it
making
(in
which
even
earning
consider
is
a
rm
producing
prots
case
5
equal
the
normal
per
$18.00.
is
making
prots).
producing
pencils
to
rm
pencils.
period
If
(say,
the
Q
Figure
2.1
1
.2
Case
The
MR
curve
if
the
rm
is
a
price
taker
additional
revenue
6th
is
of
2
it
In
this
case
(shown
in
Figure
2.1
1
.3),
the
rm
faces
pencil
producing
produce
it?
sloped
demand
curve
and
so
it
can
choose
at
which
it
wishes
to
sell
its
product .
It
is
a
price
it
wishes
to
sell
more
units
per
period,
it
must
lower
per
However,
period,
revenue
not
this
just
collected
lower
the
will
price
will
additional
thus
be
less
apply
(last)
than
to
all
unit .
the
units
for
the
rm’s
output .
A
rm
that
to
its
by
producing
$3.00)
$1
.00
(so
prots
and
MC
be
if
the
=
and
offering
additional
$1
.00),
instead
of
a
cost
should
5
it
is
producing
6
pencils
per
period?
pencils
Prots
and
equal
$20.00.
What
if
for
an
additional
would
pencil
MR
is
equal
to
$3.00
and
MC
is
equal
to
$2.00?
(the
Should
rm
be
increasing
output
to
7
pencils
per
period?
Yes,
as
by
sold
increasing
output
to
to
Pushing
7
pencils,
it
would
further
increase
prots
Marginal
new
lower
$21
.00.
faces
a
this
logic
further,
it
should
be
a
rm
increase
clear
that as
price
long
charged
will
=
the
the
price.
equal
What
collect
MR
maker.
7th),
If
is
can
(so
the
increase
price
it
it
a
perperiod,
negatively
$3.00
as
MR
exceeds
MC
then
it
pays
to
output
negatively
per
period
because
by
doing
so,
its
prots
will
be
increasing.
57
if
MR
>
MC ,
keep
on
increasing
output
•
…
The
type
p ro d u c t
…
until,
for
the
last
unit
produced,
MR
=
that
level
of
output
at
which
MR
=
will
be
p ro d u c t
of
What
if
the
rm
was
producing
5
pencils
per
period
making
losses
additional
equal
revenue
to,
it
say,
can
$30.00?
collect
by
Assume
that
again,
producing
and
offering
in
a
6th
pencil
is
$3.00
(so
MR
=
is
d i f f e re n t i at e d
$3.00)
and
the
include
salon
producing
it
is
equal
to
$1
.00
additional
p rov i d e r s
produce
of
pencils
the
per
6th
pencil?
period,
the
(so
What
rm
MC
=
$1
.00).
Should
Losses
would
decrease
will
was
its
prots
producing
be
6
if
to
$28.00.
What
(an
MC
additional)
is
equal
to
pencil
$2.00.
(the
for
7th),
Should
MR
the
is
rm
equal
be
to
selling
7
pencils
per
period?
Yes,
as
by
7
pencils,
Pushing
MR
the
this
exceeds
rm
logic
MC
would
further,
then
it
be
it
further
should
pays
this
per
period
So,
because
for
this
by
…
MR
>
until,
increasing
that
keep
the
level
clear
so,
its
rm
long
all
making
=
if
a
MC
of
rm
for
maximum
whether
to
up,
these
compare
are
losses
increasing
unit
output
will
is
the
to
car s,
va n i l la
ice
of f e re d
c re am
in
a
phone
sold
ma r ke t
if
it
is
c o n s i d e re d
identical
is
a c ro s s
If
it
is
b ra n d e d ,
l i ke
the
rms
MR
the
bottled
it
is
wat e r
not
of f e re d
c o n s i d e re d
by
d i f f e re n t
rms
homogeneous.
can
be
c o n s i d e re d
being
Ve r y
homogeneous,
rms
t h ey
have
of f e r
the
i n c e n t i ve
f ro m
w hat
to
other
s o m e h ow
rms
in
d i f f e re n t i at e
the
of f e r.
By
d i f f e re n t i at i o n
rms
can
s am e
i n c re a s e
without
w hat
a re
risk
of
e x amp l e s
losing
of
all
customer s
homogeneous
or
sales.
p ro d u c t s ?
So,
One
of f e re d
by
d i f f e re n t
mining
c o mpa n i e s
in
is
the
be
…
=
at
which
MR
=
be
prots
or
unit
to
ma n u f a c t u re r s .
revenue
a
level
minimum
zero
c o mpa n i e s ,
farmer s
a ro u n d
p r i ma r y
sector
such
Another
the
as
as
is
Ke l l o g g ’s
the
world.
or
w h e at
E x amp l e s
commodities
a re
Nestlé,
t hat
a re
buy
found
c o n s i d e re d
in
f ro m
the
“gif ts
MC
n at u re ” .
MC ,
Whether
or
not
barriers
exist
preventing
entry
of
other
minimum
of
produced,
or
(AR)
output
then
losses.
negative
and
it
To
is
average
for
entry
either
into
the
into
which
a
will
market .
market .
be
A
barrier
There
discussed
are
is
anything
different
that
types
of
deters
barriers,
later.
determine
prots,
cost
we
need
(AC).
Recap
•
If
AR
>
AC
then
prots
are
positive
(abnormal
or
Characteristics
used
to
distinguish
supernormal).
market
•
If
AR
=
AC
then
prots
are
zero
(the
rm
is
just
prots).
If
AC
•
•
AR
<
then
the
rm
is
making
losses
structures
making
The
normal
three
the
characteristics
number
of
rms
are:
in
the
market—it
can
be
very
(negative
many,
few
or
one
prots).
•
Market
In
structures
economics,
distinction
•
The
is
number
many
there
based
rms,
of
are
on
rms
few
four
in
rms
types
the
or
of
following
market
three
market .
just
one
There
rm
in
structure.
The
•
can
the
be
very
On
market .
of
of
rms
product
Very
of
the
entry
the
basis
product
offered—it
conditions—barriers
of
distinguished
Monopoly
the
in
can
be
homogenous
may
or
may
not
above,
four
market
structures
58
conditions
many
Homogeneous
No
barriers
are
Oligopoly
competition
One
Very
(Unique)
Differentiated
many
Few
Either
homogeneous
differentiated
Entry
exist .
economics.
Monopolistic
competition
Type
type
characteristics.
Perfect
Number
the
differentiated
the
exist
Barriers
(and
perfect
information)
(and
perfect
factor
mobility)
in
va n i l la
increase
will
output
produced,
producing
last
positive,
average
or
price
rms
MR
p la i n
mobile
as
•
which
la p t o p s ,
services,
losses.
that as
loss-making
doing
on
last
losses
Summing
in
output
of
At
rms
pa c ka g i n g .
rm:
MC ,
for
ju s t
$3.00
food
if
a c ro s s
eve n
eve r y t h i n g :
p ro d u c t
consumer s.
p ro d u c t s
world
decreasing.
or
one
copper
output
differ s
producing
decreasing
be
of
c re am
ma r ke t
to
A
s u p e r ma r ke t s ,
w hat
and
it
per
as
and
The
homogeneous.
instead
pencils
if
ey e s
f ew
more
ma r ke t .
or
the
in
period?
the
cost
ice
5
if
banking
or
s u p e r ma r ke t s .
the
rm
in
qu a l i t y
nearly
services,
homogeneous
of
of f e re d
d i f f e re n t i at e d
and
service
the
be
maximum
ha i r
was
can
c ha ra c t e r i s t i c s ,
E x amp l e s
So:
p ro d u c t
MC ,
terms
prots
the
MC
A
At
of
of f e re d
do
exist
No
barriers
exist
Barriers
do
exist
or
or
of
market
or
structure
determine
to
of
a
each
large
of
the
extent
power
different
their
market
Policymakers’
behaviour.
Their
market
behaviour,
in
turn,
affects
In
performance.
Performance
refers
to
the
degree
to
which
most
each
market
structure
achieve
relevant
societal
countries,
specialized
goals.
and
rm
behaviour.
market
economy,
these
goals
refer
to
producing
the
output
that
is
optimal
from
society ’s
point
of
view
the
lowest
possible
the
most
to
important
which
rms
performance
innovate.
outcome
Innovations
is
refer
most
and
new
desirable
production
market
Competition
Division
of
the
in
the
European
Department
Competition
and
Markets
of
Justice
Authority
processes
outcome
in
a
and
are
vibrant
the
Competition
Commission
of
in
India.
the
to
degree
of
market
power
that
a
rm
possesses
is
new
important
for
policymakers
who
focus
on
considered
the
a
the
and
extremely
products
for
Antitrust
USA,
UK
The
extent
the
prices.
the
Another
monitor
the
and
in
charging
that
include
level
Union,
of
exist
Examples
In
Directorate-General
a
ofces
rms
market
in
perspective
their
: 2
characteristics
types
market
and
way
different
markets
operate.
We
will
later
see
dynamic
that
if
in
a
market
the
degree
of
market
power
is
very
economy.
high,
These
goals
are
closely
related
to
the
degree
of
policymakers,
rms
have.
Market
power
refers
to
the
ability
of
to
inuence
price
and
is
prevalent
in
most
power
for
We
is
will
see
desirable,
rms
to
that
it
is,
even
on
though
the
other
lack
hand,
of
A
any
usually
•
There
abuse
is
considered
perfectly
competitive
if
the
following
goods
services
and
rms
without
to
includes
product
are
is
no
addition,
to
have
very
many
The
rms.
pushing
lower
the
ensure
the
perfectly
horizontal,
above
takers.
entry
The
goal
policymakers
of
consumers
competition
have
most
competitive
access
prices
to
and
to
innovate.
the
price,
is
competitive
no
rm
elastic
what
incentive
is
there
for
it
incentive.
is
thus
demand
a
price-taker.
curve
at
the
It
faces
market
price
which
is
also
its
average
revenue
(AR)
barriers.
perfect
information
competitive
assumptions
This
determined
and
perfect
factor
and
also
its
marginal
revenue
(MR)
curve.
In
perfect
mobility
means
that
imply
each
rms
that
rm
are
from
the
additional
selling
such
must
price.
there
Why?
are
very
A
rm
many
cannot
other
rms
are
accept
charge
rms
in
price-
the
revenue
the
identical
product .
Buyers
Short-run
a
the
(MR)
aware
of
incentive
to
this
Why
do
whole
market
price.
as
so.
a
result
sell
Why
market
If
a
not
(a)
is
a
not?
that
rm
of
at
it
so
also
in
assuming
lower
The
can
Typical
rm
sell
small
price?
is
all
that
so
it
it
higher
the
A
the
typical
equal
to
rm
the
price.
equilibrium
for
the
perfectly
rm
price
of
the
quinoa
market,
market.
Let ’s
a
give
good
a
example
name
to
of
the
a
perfectly
typical
are
focusing
on.
Let ’s
call
it
Felipe.
Figure
quinoa
2.1
1
.4b
shows
rm
the
perfect
small
can
quinoa
is
market
rm
wants
sell
firm:
P/kg
unit
market ,
we
information.
additional
market
competitive
producing
an
price-takers
Think
because
the
that
incentive
perfectly
competitive
to
power.
the
There
market-determined
are
intervene.
if
assumed.
Perfectly
all
to
homogeneous.
collects
The
at
down
price?
competition,
are
market
is
curve
In
of
authorities
determined
•
reason
intervene
necessary
a
The
to
innovate.
market
•
sufcient
reason
competition
market
The
have
have
market
applies.
•
competition
real-world
that
Perfect
may
denitely
suspect
markets.
the
a
They
rm
specically
market
authorities,
power
and
S C I M O N O C E O R C I M
The
and
T I N U
“Structure—Conduct—Performance”
has
quinoa
market
and
Market
demand
Figure
2.1
1
.4a
shows
Felipe’s
rm.
no
and
market
supply
for
quinoa
determine
compared
at
the
more
the
equilibrium
the
horizontal
market
price
P
.
Note
that
the
scale
of
going
axis
differs.
It
is
thousands
of
kilos
for
the
output
Felipe
(b)
Quinoa
P/kg
MC
market
D
ATC
b
P
P
π
>
0
D,
AR ,
MR
C
a
S
0
q*
0
q /period
Q
(kgs)
Figure
2.1
1
.4
Perfect
competition:
short-run
equilibrium—case
with
abnormal
Q /period
(thousands
(or
supernormal)
of
kgs)
prots
59
market
(Figure2.1
1
.4b)
(Figure2.1
1
.4a).
but
Felipe,
as
only
kilos
explained
for
the
above,
typical
will
(a)
rm
have
to
accept
Typical
quinoa
firm:
Felipe
P/kg
MC
the
market
(horizontal
any
the
determined
price
demand)
P
amount
market)
revenue
he
at
and
at
offers
that
here
He
he
also
P
.
thus
knows
(remember
price
it
as
P
.
it
is
Demand
reects
his
faces
that
very
a
perfectly
consumers
small
always
will
his
AC
buy
compared
reects
marginal
elastic
to
average
f
revenue.
P'
D,
Prot
maximization
perfectly
Focusing
choose
competitive
on
to
Figure
offer
determine
for
q*
2.1
1
.4,
units
whether
to
of
these
the
negative,
we
have
to
MR
rm
maximize
quinoa,
as
maximum
prots,
at
q*,
prots
Felipe
MR
are
=
will
MC .
To
positive,
zero
0
or
AR ,
typical
compare
the
rm’s
AR
with
its
q /period
q'
ATC .
(kgs)
Note
that
that
the
This
is
the
MC
the
ATC
on
curve
its
result
way
of
a
in
up
Figure
cuts
strict
2.1
1
.4a
the
ATC
relationship
is
U-shaped
curve
at
its
between
and
(b)
minimum.
marginal
Quinoa
market
P/kg
S,
costs
and
average
costs,
which
is
explained
in
the
box
MC
below.
Info
Relationship
between
marginal
costs
P'
and
average
Consider
it .
a
classroom
Assume
their
costs
that
the
temperature.
with
any
school
Their
number
nurse
average
walk s
of
in
students
and
temperature
in
takes
is
36.6°.
D
If
one
more
student
temperature
is
temperature
of
What
if
her
(marginal)
37.2°
the
what
class?
temperature
temperature
of
Generalizing,
the
we
can
will
The
was
class
now
happen
answer
36.1°?
would
write
walk s
to
is
in
and
the
that
Then
her
average
it
will
the
0
rise.
Marginal
>
Average
Figure
decrease.
2.1
1
.5
Marginal
<
Average
Average
increases
start
→
Average
supply
shif ting
quinoa
on
the
MC
and
AC
curves
this
implies
that
cost
is
decreasing
then
marginal
cost
must
(that
is,
be
less
than)
average
increasing
then
marginal
cost
cost.
must
If
average
be
greater
than)
average
cost.
It
lie
above
follows
that
cost
is
at
a
minimum
(as
it
is
(or
normal,
must
be
equal
to
average
to
(ATC)
segment
average
when
(q*a)
total
or
cost ,
Felipe
(0C).
this
is
is
be
equal
to
segment(CP)
no
number
of
units
(0q*)
U-shaped)
(Ca),
we
arrive
producing
price
(=
making
per
Felipe
at
the
q*
AR)
units
is
positive
are
or
supernormal)
for
existing
place
(as
equal
to
the
unit .
sells
size
prots
rectangular
greater
at
If
the
typical
prots,
what
with
or
short-run
it
is
in
earning
the
same
risk).
entrepreneur s
market .
As
so
the
to
a
area
market
than
Multiplying
which
of
the
Felipe
There
is
rms
the
This
position
number
of
are
competed
normal).
If
away
prots
and
earned
rms
are
in
making
the
the
quinoa
minimum
market .
for
more
rms
to
enter
and
There
also
to
exit .
Each
rm
is
no
achieving
goal
(MR
=
MC)
and
no
entry
or
its
exit
are
equal
positive
is
There
the
AC).
This
condition
is
referred
for
to
long-run
as
long-run
equilibrium
chosen
output
Q':
P
(=
AR)
=
MR
is
=
MC
=
AC .
is
shown
in
Figure
a
perfectly
2.1
1
.5.
2.1
1
.5
depicts
market .
long-run
In
Figure
equilibrium
2.1
1
.5a,
the
in
typical
rm,
to
is
achieving
its
goal
to
maximize
prots
as
at
Q':
economic
earning,
positive
prots
next
incentive
are
start
rms
=
the
by
=
MC .
In
addition,
there
is
no
reason
for
new
rms
to
which
or
in
is
for
any
earning
earning
making
in
an
will
to
of
the
existing
rms
to
exit
as
the
typical
(CabP).
normal
earn
enter.
new
is
could
pushing
when
than
long-run
more
entrepreneur s
competition,
60
rm
to
stop
economic
rm
From
prots
is,
remain
rms
AR
So,
that
enter
are
will
will
start
equal
MR
(abnormal
Entry
curve
will
marginal
Felipe,
segment
to
incentive
competitive
the
supply
supply
where
Figure
prots
the
costs.
Since
rm
down.
(that
quinoa
require
equilibrium.
costs
and
Excess
(that
takes
Unit
price
zero
prot-maximizing
cost
right .
supernormal)
to
the
they
reason
average
increase
the
cost
will
is,
will
to
market
down
return
is
equilibrium
lie
are
below
long-run
if
driven
average
competition:
kgs)
decreases
abnormal
Focusing
Perfect
of
that:
→
the
If
Q /period
(thousands
market
If
Q'
average
no
for
the
in
the
market
earn
At
AR
in
zero
the
next
economic
as
much
best
as
prots;
these
alternative
that
is,
it
is
entrepreneur s
Q',
=
AC
=
with
the
same
risk .
(0P').
than
alternative
more
barrier s
entering
could
Q'
prots,
economic
(more
best
at
normal
rms
perfect
quinoa
increases,
If
the
typical
means
that
minimum
Firms
and
in
it
was
would
case
to
making
not
required.
this
switch
rm
it
This
have
their
be
case
the
next
losses
earning
is
in
short
illustrated
incentive
best
the
normal
to
in
exit
alternative
run,
prots,
Figure2.1
1
.6.
this
with
it
the
market
the
same
Typical
quinoa
firm:
Felipe
(b)
Quinoa
T I N U
(a)
market
P/kg
P/kg
MC
ATC
S
g
<
0
P
P
h
D,
AR ,
MR
D
0
q
0
q /period
Q
Q /period
(kgs)
Figure
risk .
As
2.1
1
.6
Perfect
Remember,
the
shif t
least
lef t
and
markets
the
amount
of
view.
to
their
Why
both
all
is
this
in
the
of
additional
cost
It
that
of
Perfect
competition
markets.
Few
few
large
that
rms
usually
than
the
of
are
does
socially
P
worth
the
=
to
the
will
last
MC .
(that
whatever
of
typical
output
of
the
maximized.
produced,
means
more
the
markets
that
than
value
their
P
>
rm,
why
reason
the
is
is
perfect
to
be
exist
in
in
rst
fail
level
of
In
power
prices
for
that
considered
competition.
as
they
competition
manages
fundamental
question.
is
it
It
produced
to
many
is
good
long
markets,
of ten
P
=
is
earning
just
normal
prots
prots).
to
P
=
it
to
indeed
which
that
MC .
is
P
at
produced,
MC .
Q':
to
P
=
up
Focusing
MC
and
that
for
consumers
is
until
on
and
the
focusing
each
on
level
measured
of
by
P
.
competitive
up
is
markets
until
allocative
consumers
=
Remember
worth
pay,
produced
MC ,
are
for
realize
Q':
much
and
enjoyed.
allocative
run
average
present
consumers
output
are
allocatively
considered
answer
question
guarantees
from
we
perfectly
are
charged
real-world
perhaps
Market
higher
optimal
of ten
perfect
that
unit
at
how
MC
which
of
sacriced)
willingness
Since
the
less
as
and
efciency
the
all
units
including
is
lowest
it
for
that
achieved
can
which
unit
and
for
the
price
be.
the
cost,
“how ”
no
that
society ’s
of
just
point
in
best
economics,
the
of
right
view:
is,
it
is
also
question
scarce
of
a
the
is
resources
competitive
lowest
structure
way
as
is
is
achieved.
forced
technically
also
are
to
In
addition,
produce
efcient.
answered
in
This
the
since
with
means
best
in
the
minimum
that
possible
way,
wasted.
markets
prices
good
less
and
cost
pay
price.
measuring
is
charged
marginal
guarantees
possible
a
performance
“what ”
amount
that
The
possible
the
it
rm
Real-
important?
the
efciency
typical
thus
lead
to
the
optimal
output
inefcient .
at
So,
rm
efciency
that
market ,
Perfectly
world
is
including
sum
unit
typical
economic
Allocative
alone,
point
be
the
zero
will
the
This
is,
is,
(appointed
consumers
each
Exit
when
(that
right
society ’s
surplus
for
stop
will
forces
the
allocated
welfare,
rm,
not
can
dominate.
leads
just
kgs)
perspective
markets
approximations
the
rising.
of
losses
mobility.
supply
market
from
social
with
competition:
to
optimally
producing
Policymakers’
then
because
by
start
lead
producer
factor
market
would
will
and
is
and
good
perfect
the
produced
be
the
equilibrium—case
perfect
state,
use)
case?
the
in
will
and
market
price
being
possible
the
the
units
good
exit ,
competitive
the
resources
surplus
assume
market
of
short-run
rms
perfectly
the
best
consumer
the
need
Scarce
also
issues
are
without
we
efcient
Efciency
If
competition:
(thousands
S C I M O N O C E O R C I M
π
: 2
C
judged.
by
of
rms
rod
Thus,
are
against
when
it
may
this
higher
that
market
actual
real-world
means
Policymakers
use
which
in
signicantly
production
more.
Policymakers
market
markets
than
the
consumers
decide
to
enjoy
intervene.
Recap
Two
benets
Perfectly
Firms
•
Consumers
cannot
Allocative
At
•
Just
the
perfect
competitive
•
•
of
charge
enjoy
efciency
is
right
have
more
the
competitive
the
rms
competition
no
than
good
at
market
the
the
power.
competitive
lowest
price
equilibrium
price
(P).
possible.
achieved.
equilibrium
amount
of
the
output
good
is
(Q):
MB
produced;
=
MC
resources
are
allocated
in
the
best
way
and
social
surplus
is
maximized.
61
Monopoly
A
monopoly
is
a
market
where
the
following
conditions
apply.
incurred
when
segment
•
There
is
only
dominating
company,
one
the
rm
producing
market .
Alphabet ,
For
a
good
example,
controls
92.5%
or
one
the
exceeds
average
market ,
with
Bing
controlling
per
equal
world
The
product
is
considered
unit
of
There
are
high
entry
of
rms
that
the
is
are
only
monopoly
demand
curve.
one
rm
The
to
charge
price-setters.
power
is
faces
in
Monopoly
also
often
is
case
equal
to
average
monopoly
rm
is
revenue
earning
(PmC).
Multiplying
this
prots
by
(0Qm)
or
segment
(CA),
we
the
at
the
arrive
economic
prots
this
monopoly
rm
is
equal
to
the
rectangular
area
is
(CABPm).
economic
prots
abnormal
are
(or
positive,
so
supernormal)
the
monopoly
prots.
rm
Consequently,
price-makers
rm
in
the
monopoly
and
this
segment
positive
which
the
market,
negatively
rm
can
it
becomes
sloped
choose
the
rms
this
sense
rms
thus
referred
to
such
have
as
rms
are
market
monopoly
or
entrepreneur s
would
like
to
enter
this
market .
clear
However,
in
monopoly
exist
so
we
assume
that
barrier s
to
entry
market
price
and
entry
cannot
take
place.
It
follows
that
these
it
abnormal
wishes
cost ,
to
units
the
earning
other
there
which
this
barriers.
is
Assuming
in
unique.
These
Monopoly
units
2.5%.
earning,
•
Qm
Since
search
size
•
(0C).
parent
number
engine
or
rm
Google’s
of
producing
(QmA)
price-makers
(or
supernormal)
prots
will
per sist
in
the
long
or
run
and
that
the
long-run
Figure
2.1
1
.7
shows
both
the
short-run
and
power. Market
equilibrium
position
of
the
monopoly
rm.
power.
P/unit
MC
Keep
in
mind
demand
that
curve
it
wishes
If
it
to
it
sell
a
monopoly
faces
per
so
it
period
is
still
cannot
and
constrained
choose
the
price
both
it
by
the
wishes
the
output
to
B
charge.
(AR
decides
to
choose
the
output
rate
it
wishes
to
sell
=)
Pm
per
AC
period
which
to
then
it
it
will
charge
is
be
then
the
market
absorbed;
the
that
if
market
it
will
determine
decides
will
the
determine
the
price
the
it
price
at
wishes
quantity
F
that
A
(AC
will
be
absorbed
equilibrium
To
at
that
position
maximize
prots
of
price.
a
the
Figure
2.1
1
.7
prot-maximizing
monopoly
rm
shows
monopoly
will
=)
C
the
choose
rm.
that
H
level
case
the
of
output
Q
at
output
level
market
will
for
which
Qm.
absorb
MR
To
this
is
equal
determine
output
per
to
the
MC .
This
price
period
at
we
is
the
which
need
to
D,
draw
This
a
vertical
price
losses)
is
we
average
line
Pm.
up
To
need
to
revenue
from
Qm
determine
compare
earned
by
to
meet
now
price
the
the
demand
level
(Pm),
rm,
the
of
which
with
the
prots
is
also
unit
0
(or,
A
monopoly
2.1
1
.7
,
price
at
(P)
equal
issues
rm
the
is
to
(QmH).
the
inefcient .
(QmB)
cost
(MC).
while
Society
have
of
cost
is
wanted
to
output
Specically,
marginal
would
Referring
level
produced.
unit
Qsoc ,
pay,
is
as
equal
intersects
produce
Society
Qsoc
to
the
units
price,
MC
MC
would
have
which
(since
curve).
at
(QmQsoc),
a
measures
that
Since
wanted
Figure
Qm,
equal
2.1
1
.7
Equilibrium
monopoly
rm
competitive
is
This
to
units
level
the
welfare
of
the
is
when
up
the
rm
results
AR
does
equal
a
monopoly
of
a
are
rms
rather
we
will
to
the
same
faced.
The
restrictive
examine
as
those
MC
assumption
the
that
curve
possible
perfectly
thus
and
remains
will
benets
of
be
the
same.
relaxed
larger
size.
this
perfect
competition
with
until
willingness
output
monopoly
loss
units
in
rm
price
more
all
Q /period
MR
Comparing
good
Qsoc
the
monopoly
prot-maximizing
marginal
segment
segment
allocatively
chosen
exceeds
and
Qm
costs
Figure
Efciency
AR
curve.
to
curve
monopoly:
Same
cost
conditions
P/unit
S,
MC
not
area
1
2
Pm
(HBF).
The
welfare
loss
reects
net
value
lost
by
society
from
3
units
(QmQsoc)
not
being
produced
by
the
monopoly
rm
4
5
Pc
7
even
though
they
should
have
been
produced
from
8
society ’s
6
point
with
so
It
it
is
of
view.
is
also
instructive
perfectly
of
market
marginal
to
somehow
a
and
and
leads
quantity
is
as
also
not
perfectly
forced
to
produce
competitive
rms
are,
inefcient .
competitive
cost)
rm
cost ,
make
market
demand
equilibrium
is
monopoly
average
technically
competitive
a
A
minimum
to
direct
a
comparison
monopoly
market
is
market
supply
an
Qc .
monopolized.
shown.
In
now
addition,
The
price
that
a
In
(which
equilibrium
Assume
of
market .
perfectly
Figure2.1
1
.8,
interaction
also
Pc
and
this
assume
D
reects
an
market
that
0
the
Qm
Qc
Q /period
MR
technology
used,
and
the
cost
conditions
faced
by
the
Figure
62
2.1
1
.8
A
perfectly
competitive
market
later
will
be
to
where
Pm.
raise
It
is
price.
MR
monopoly
=
clear
MC .
that
Monopoly
The
the
rm
price
will
monopoly
produces
choose
that
and
will
rm
to
be
produce
restricts
offers
•
A
less
output
than
market
(Qm
<
Qc)
and
charges
a
higher
loss
from
society ’s
Area
(3
>
Pc).
In
addition,
allocatively
efcient
allocatively
inefcient
whereas
(as
at
Qc ,
(since
the
P
at
=
competitive
MC),
Qm,
P
the
>
outcome
welfare
•
The
analysis
is
+
4)
the
area
monopolist
the
price
paid
for
the
units
The
producer
surplus
is
the
area
the
monopoly
increasing
below
the
demand
actually
the
MC
supply
reects
curve
the
(or
the
minimum
below
MC
the
the
curve
rm
price
for
the
requires
of
unit)
for
monopoly
the
are
units
up
to
The
social
surplus
is
the
offer
transfer
but
rm.
actually
in
If
in
more
an
and
become
power
can
is
one
of
the
sold
has
that
price
been
is
(which
in
The
the
ability
formal
sum
of
the
consumer
surplus
Consumer
monopoly
set
of
a
power
Power
marginal
Area
(1
+
2
+
3
+
4
+
Monopoly
5)
Area
(6
+
7
+
Area
(1
+
2
+
3
+
4
+
5
+
6
+
7
+
the
more
power
zero,
as
by
surplus
Area
(1
Area
surplus
+
(3
Area
analysis
•
Consumers
•
The
price.
2)
+
4
+
6
+
are
is
reveals
worse
better
+
(1
+
2
+
3
+
4
+
6
+
off
the
off
as
rms:
rms
or,
more
signicant
desirable
quite
However,
power,
following.
as
it
they
loses
lose
area
on
its
is
to
of
area
(3
+
4
+
the
them
a
to
A
(8)
report
generally,
market
from
few
consumers,
but
it
5).
that
so
point
dominate
they
of
are
in
their
typically
not
above
set
as
part
enjoy
rms
to
for
output
less
of
charge
especially
their
of
view.
large
this.
Their
rms
explained
market
lower
purchasing
this
transfer
a
below
the
the
a
good.
competitive
higher
income
Restricting
of
prices
surplus
income
charged
income
mind
price.
This
is
power.
Consumer
to
the
that
is
since
in
the
by
a
the
that
rm
long
successful
world
marginal
The
cost
degree
the
Lerner
Index
of
difference
a
between
proportion
of
price
price:
MC
is
power
a
can
perfectly
be
used
competitive
Power
rm,
measurement
to
marginal
the
cost .
power)
can
degree
as
set
of
The
it
rm
cannot
price.
It
monopoly
has
no
inuence
does
have
power
much
higher
than
marginal
cost
it
it
has
can
of
course
depends
substitutes
the
cost
on
to
greater
and
the
the
number
consumers.
the
ability
greater
the
and
The
to
fewer
raise
power
the
rm
degree
of
possesses.
rms
with
surplus
through
signicant
of
later
why
may
a
under
even
be
monopoly
market
certain
rms
may
or,
conditions
preferable.
more
benet
This
is
having
the
generally,
society.
case
It
only
of
a
will
one
be
rm
where
having
two
rms
splitting
the
market
natural
would
an
unnecessary
charge
waste
of
resources;
consumers
is
the
typically
price
natural
regulated
It
will
be
explained
that
large
rms
may
by
often
the
be
produce
at
a
lower
average
cost
(this
is
known
as
able
beneting
shrink s
economies
of
scale)
allowing
them
to
decrease
the
price
they
rm.
Also,
because
of
entry
barriers
such
rms
may
maintain
in
the
monopoly
long
run
any
supernormal
prots
earned.
They
thus
have
the
power
to
resources
to
innovations
invest
it
to
is
the
existence
maintain
run
in
depends
of
barriers
to
in
research
benet
and
development,
which
society.
abnormal
(or
and
keep
price
to
as
level.
The
may
to
protecting
a
which
monopoly
on
the
type
of
barriers
eventually
Some
barriers
may
lead
be
monopoly
overcome
positions,
by
while
entrepreneurs
who
supernormal)
signicantly
extent
“entrenched”
entry
a
new
that
or
a
new
competing
technology.
higher
position
to
product
monopoly
positions
are
typically
a
result
barriers
in
state-created
exist
what
barriers
but
in
the
recent
past ,
even
in
the
in
absence
of
state-created
barriers,
there
are
some
any
questionable
market .
that
perspective
competitive
particular
by
Monopoly
dominate
also
the
real
above
power.
)
market
existence
state.
of
prove
so.
it
monopoly
accomplished
the
Entrenched
than
as
−
monopoly
market
can
develop
prots
or
marginal
hurts
households,
transferred
in
others
permit
equal
marginal
monopolies
referred
that
above
inequality.
Policymakers’
in
many
years
level.
leads
Keep
of
substitutes,
that
market
necessary
increases
20
output
the
higher
past
power
charge.
This
price
the
market
rm
available
or
Sometimes
from
and
the
gains
to
decreases
price.
in
card
rms
power,
society ’s
reasons
restrict
then
these
a
(no
a
This
of
available
result
allows
in
monopoly
measured
and
and
how
price.
closeness
monopoly
Consumers
inequality
7)
in
permits
rms
higher
4).
Monopoly
are
income
monopolist
expressed
If
is
power
monopoly
There
a
7)
price
considered
because
consumers
that
the
rm
Index
price
monopoly
surplus
have
power
income
8)
set
market
unequal
charge
dened
cost
Lerner
depends
Monopoly
market
industries,
8)
market
(3
of
by
and
is
area
part
P
surplus
rm
from
be
appropriated
economy
(
surplus
above
to
the
Monopoly
The
income
Qm).
then
Social
of
used
now
increasing
denition
interchangeably.
Producer
produced.
surplus.
Consumer
Social
it
more
reasons
competition
Producer
as
is
P
Perfect
monopoly
produced
each
and
producer
a
monopoly
surplus
will
market
Monopoly
•
since
been
monopoly
to
of
case
not
+
earned,
is
additional
are
8)
have
consumed.
cost .
as
(5
curve,
Note
above
area
should
is
economies
•
the
consumer
This
above
view
represents
to
distribution
is
of
to
that
MC).
revealing.
surplus
point
the
with
consumer
equal
units
is
is
A
and
price
consumers
(Pm
results
output
the
•
competitive
welfare
restricts
charged
T I N U
units
: 2
prot-maximizing
Qm
S C I M O N O C E O R C I M
The
tactics
by
rms
that
have
been
very
successful
are
in
fending
off
potential
competition
in
their
markets.
63
Entry
barriers
What
is
an
entry
has
barrier?
the
An
entry
barrier
can
be
anything
that
deters
entry
of
into
a
market .
Barriers
can
be
distinguished
into
exist .
An
They
state-created
example
books
considered
•
rm-created
•
natural
by
power
State-created
barriers
include
patents,
licenses
and
trade
are
granted
by
governments
to
rms
that
product
owner
to
or
a
new
technology.
A
patent
produce
for
20
the
years.
good
This
or
to
creates
use
a
the
the
incentive
and
in
order
to
corporations
to
to
generate
apply
for
develop.
particulars
invest
in
research
and
innovations.
of
are
rms
and
and
are
Patents
granted
are
patents
obviously
for
but
the
law
may
exclusive
for
a
prove
permits
variety
television
doctors
from
of
that
governments
Licenses
issue
are
to
is
and
in
lawyers
order
are
to
also
individuals.
associations
they
other
also
are
words
barriers
taxes
will
on
also
allocate
licensed
Of
restrict
responsible
to
exert
but
be
some
examined
imports
(quotas)
abroad.
and
They
they
for
a
when
of
at
lead
in
protect
to
into
the
the
maintaining
of
detail
also
try
buy
to
to
prevent
policies
higher
entry
will
maintain
may
of
that
in
brand
is
name,
or
aware
and
engage
cost
the
for
some
of
goods
Examples
the
or
include
distribution
of
Such
one
than
same
are
scale
rms
services
laying
network
or
a
out
a
power
infrastructure
large
rm
costs
supplying
imply
the
the
average
cost
that
whole
each
market
would
have.
of
two
Signicant
present .
are
limit
for
of
a
can
(size)
their
of
dened
rm’s
as
larger
change
all
operations.
for
inputs
terms
decreases
size.
They
in
average
refer
to
the
costs
long
factors
Firms
and
of
so
can
larger
change
size
many
other
reasons.
They
may
may
enjoy
be
in
bulk,
extracting
lower
prices
able
from
They
(lower
may
be
interest
able
to
rates)
borrow
by
being
from
bank s
considered
at
more
4.2.
They
restrictions
on
competition
rms
and
less
risky.
Indivisibilities
of
certain
types
power.
and
capital
they
the
can
explain
their
buyers.
equipment
be
adopted
assembly
why
electricity,
subway
line
in
or
car
and
network,
these
of
only
production
water
spread
to
rms
higher
into
their
prices
certain
by
very
large
rms.
manufacturing.
processes
natural
require
huge
technologies
gas
rms
set-up
such
An
are
costs
that
example
Indivisibilities
as
those
distribution,
that
imply
very
across
involved
or
a
large
a
in
railway
in
huge
is
also
size
scale
or
and
excess
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supernormal)
productive
in
they
drive
that
the
down
to
advertising
extensively
rm
will
so
can
create
differentiate
lower
average
of
costs.
natural
monopoly
may
emerge
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given
market
size,
only
permit
that
rm
can
protably
exist .
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rms
splitting
the
market
both
be
unprotable.
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2.1
1
.9
shows
this.
a
that
the
prot-maximizing
level
of
output
is
at
Q*.
easily
unprotable
and
in
prots.
capacity
incumbent
price
excessive
may
the
resulting
market.
and
Assume
output
case
higher
section
domestic
prices
new
lead
abnormal
maintain
entrant
water
scale
of
suppliers.
would
rms
the
barriers
competition
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may
of
later.
of
one
They
again
extent
A
Restricting
a
advantage
output ,
increase
it
the
eld
monopoly
quantitative
protecting
to
costs.
lower
result
scale
cost
can
potential
behaviour
abuse
bandwidth.
to
course,
entry
degree
(tariff s),
other
aim
do
Firm-created
These
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constitute
to
of
these
examine
and
electricity.
much
creditworthy
Firms
while.
one
granted
better
workers
will
scale
average
are
their
from
a
to
counterproductive.
reasons.
stations
unqualied
medical
imports
for
experts
the
to
include
website
legal
new
necessary,
a
Trade
its
technology
supplying
their
in
on
French
Pharmaceutical
run
fees,
a
development
that
medicine
we
set-up
deliver
the
Economies
that
from
of
huge
economies
they
public
rely
delisted
to
rms
Medical
Amazon
monopoly
network,
market
radio
when
technology
monopoly
that
few
is
permits
grid
exclusively
or
this
barriers
production
railway
Licenses
providing
introduce
requires
drugs
by
crucially
barriers.
The
(R&D)
e-commerce
barriers
natural
protect
of
several
and
Economies
the
of
businesses
barriers.
State-created
new
rival
barriers
Natural
a
centre
barriers
market
Patents
the
other
are:
is
•
as
that
three
publisher ’s
types.
itself
new
to
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established
infrastructure
a
levels.
distinct
their
(Note:
the
intersect.
prot-maximizing
This
is
not
shown,
level
to
of
output
avoid
is
where
cluttering
MR
Figure
and
MC
2.1
1
.9).
product
P/unit
and
offer
very
for
others
set
price
to
many
nd
a
different
niche
varieties
and
enter
to
the
make
it
market.
more
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to
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result
of
the
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the
recent
market
prots
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past
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splitting
supply
f
C'
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are
depressed
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to
when
potential
another
old
questionable
tactic
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one
serving
the
has
market
resurfaced.
Large
rms
with
very
signicant
market
power
h
have
been
threaten
buying
their
out
competitors
dominance.
For
or
any
example,
start-ups
Oracle
that
b
P
may
acquired
LAC
a
PeopleSof t ,
60
other
rms.
companies
even
Siebel,
BEA ,
Google
including
managed
to
Sun
Microsystems
“ vacuumed-up”
YouT
ube
block
and
and
more
than
DoubleClick.
multi-homing
of
all
more
than
C
100
Facebook
social
media
D,
applications
under
one
host .
It
has
since
also
0
Instagram
media.
64
and
WhatsApp,
Amazon
has
cementing
acquired
more
its
than
dominance
100
AR
acquired
in
Q*/2
Q*
social
companies
and
Figure
2.1
1
.9
The
case
of
a
natural
monopoly
Q /period
P
.
price
at
Ave ra g e
ma ke s
which
costs
a b n o r ma l
(CabP).
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n ow
this
for
(or
two
ma r ke t
this
rm
will
a re
s u p e r n o r ma l )
rms
w e re
absorb
e qu a l
to
to
p ro  t s
split
Q*
units
(0C).
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e qu a l
this
is
this
thus
to
ma r ke t ,
(
a
is
n at u ra l
each
re g u lat e d
b e l ow
units,
)
then
together
t h ey
would
still
together
permit
a re a
Q*
p ro d u c i n g
ma r ke t ,
p re s e n t ,
with
one
m o n o p o l y.
by
the
only
the
p ro  t
the
rm
huge
to
Nat u ra l
g ove r n m e n t .
ma x i m i z i n g
economies
p ro  t a b l y
monopolies
Pr i c e s
l eve l
a re
c ha r g e d
to
of
scale
o p e rat e .
e n s u re
This
usually
a re
set
a f f o rd a b i l i t y.
T I N U
The
be
Note
Q*
units
and
the
ma r ke t
price
would
still
that
exclusive
P
( re m e m b e r
the
good
is
homogeneous).
N ow,
s ma l l e r
in
size
rms
will
not
be
able
to
cost
s av i n g s
t hat
the
s i n gl e
la r g e
rm
from
person
cost
for
each
would
be
(0C')
and
thus
ma ke
losses
e qu a l
to
a re a
(PhfC').
a
leading
vital
to
natural
monopoly
resource
is
also
that
offering
the
good
the
land
or
the
service.
For
prevents
example,
owns
all
surrounding
a
pristine
if
beach
The
then
only
he
or
she
decides
who
can
buy
land
in
in
each
order
would
of
e n j oy e d .
Mykonos,
Ave ra g e
barrier
e n j oy
one
the
natural
ownership
though,
others
these
a
be
size
to
build
a
resort
hotel
there.
of
Oligopoly
An
oligopoly
has
the
following
share
characteristics.
risk
•
It
is
•
The
a
market
in
which
only
a
few
rms
produce
either
a
homogeneous
product
steel,
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cement ,
as
offered
cars,
by
oil
or
laptops
the
copper)
or
banking
or
mobile
or
a
differentiated
phones,
insurance
all
or
rms
mobile
phone
High
only
to
barriers
a
few
to
monopolies
at
the
risk
a
few
exist,
Barriers
(for
rms
or
names,
of
the
law,
which
are
the
example,
explains
same
as
economies
why
there
those
of
that
a
result
these
rms
market
the
of
to
operate
limit
if
only
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reaction
protably,
pricing
and
a
few
outcome
if
rms
scale
licenses,
product
its
of
rival
the
that
any
or
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Concentration
rise
creation
total
sales
rivals.
in
the
in
the
market
Interdependence
action
We
of
one
can
market
to
example,
(CR)
accounted
the
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say
are
exists
in
depends
that
a
a
on
of
is
concentration
used
for
four-rm
of
largest
caught
nes
much
and
more
of ten
market ,
for
in
a
by
that
the
market
market
measures
“n”
largest
concentration
ratio
4
rms
in
the
analyse
simplest
a
market
calculate
example
provide
few
rms
a
a
the
more
concentration.
market ,
the
is
initiated,
also
form
of
Through
why
why
is
a
game,
this
in
such
there
assume
price.
more
dominate.
the
97%,
in
a
(CR
)
is
given
CR
in
two
Each
is
a
series
conclusions
series
CR
,
of
historical
there
is
a
the
CR
and
the
USA ,
the
ratios
CR
8
higher
CR
in
the
the
it
the
car
,
20
picture
of
the
concentration
is,
as
CR
it
in
rental
operating
concentration
the
data
trend
through
We
theory
will
is
widely
examine
we
markets,
rms
have
sometimes
an
as
will
the
why
a
understand
price
incentive
cheating
“Prisoner ’s
clearly
to
war
may
collude
be
and
involved.
rms,
A
and
either
B,
each
maintain
with
price
two
possible
high
2.1
1
.10
shows
are
degree
also
towards
of
ratios
indicates
the
dry
industry
systems
is
or
useful
to
concentration
necessary
more
their
“pay-off
or
it
can
matrix ”.
is
the
prot
each
rm
will
earn
from
each
Each
strategy
of
given
the
the
strategy
pay-off s,
but
its
rival
initially
will
we
adopt .
assume
Firms
that
are
there
between
the
two
is
no
rms.
cat
is
ratio
that
food
50%
99%.
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less
to
derive
in
a
determine
safer
high
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price
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million
price
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million
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million
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$35
million
million
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market ,
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but
game
known
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concentration
comprehensive
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smartphone
of
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visualized
sales
oligopolistic
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the
about
as
set-ups.
game
such
can
Figure
communication
2
only
imprisonment .
clearly
by:
mriF
the
be
market.
3
and
but
consequences
proportion
rms
B
is
the
a
4
industry
even
known
oligopolistic
interdependence
niatniaM
of
to
of
facing
hgih
order
degree
uncertainty
monopoly,
market
4
in
a
dilemma”
mathematics
ecirp
a
decrease
were
dilemma”.
Maintain
for
they
they
and
can
×100
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if
interdependent .
4
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getting
namely
of
dilemma”.
aware
For
as
ratios
extent
ratio
colluding
of
adopted,
of
By
prots
“Prisoner ’s
branch
number
concentration
joint
“Prisoner ’s
The
cut
the
of
and
strategies.
determine
the
permit
We
To
at
proliferation).
operating
interdependent .
of
oligopolistic
but
catastrophic
are
give
the
As
rivals,
prove
providers
used
brand
of
could
products
industries,
A
only
expense
which
services).
entry
rms.
the
war
product
the
•
at
price
involved.
maximize
dilemma
of
prots
a
(such
and
as
their
starting
operate.
for
rms
and
of
S C I M O N O C E O R C I M
p ro d u c i n g
: 2
2
whether
concentration.
tuC
To
collude
or
Interdependence
for
this
dilemma
to
in
compete?
oligopolistic
that
markets
oligopolistic
rms
is
responsible
face.
$250
Figure
competition
these
rms
may
increase
their
million
$70
million
Through
own
2.1
1
.10
Pay-off
matrix
market
65
Policymakers’
all
perspective
belong
illusion
Dening
the
relevant
market
is
very
difcult .
not
dened
only
by
the
product
being
produced
but
also
by
geography
and
location.
if
There
very
many
one
fuel
outlet
stations
in
some
in
a
country
remote
area,
but
then
if
there
this
do
ve
secret
local
monopoly;
these
three
if
there
are
a
are
local
only
three
oligopoly.
fuel
The
private
hospitals
many
in
hospitals
many
in
the
countries.
USA
but
There
in
may
only
be
two,
in
which
case
may
certain
this
oligopoly.
may
Or,
to
both
make
be
matter s
owned
by
would
wor se,
the
same
in
the
be
many
markets
products
there
available
may
to
be
a
vast
consumer s,
maintain
it
will
on
earn
the
also
a
high
is
$210
reaction
maintain
a
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million
of
its
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does
or
rival
high
of
a
price
concentration
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these
array
but
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know
A
the
or
B;
namely,
whether
chooses
it
B
is
can
risk
that
see
of
if
a
B
million).
war
($250
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A
some
kind
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maintains
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to
and
also
again
earn
take
into
greatly
will
rm
cut
B
its
raise
can
will
million).
will
cut
a
also
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than
realizes
of
coordination
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high
million)
more
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about
both
its
price.
no
best
rms
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by
it
by
that
cutting
matter
same
strategy
under
in
of
a
they
the
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market
a
as
if
they
do
not
underlying
same
where
four
market
the
may
were
provide
size
ve-rm
one
only
where
market .
consideration
affect
us
with
distribution
rm
concentration
has
have
5%
80%
each,
of
the
but
it
each
Lastly,
of
the
ve
concentration
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ratios
has
do
pricing
competition
behaviour
of
from
imports
domestic
which
rms.
price.
be
oligopoly
exists
price
in
they
Collusion
to
two
verbal
be
the
or
restrict
or
more
behave
formal—in
agreement
rms
agree
competition.
inferred
collectively
can
where
when
order
written,
collude,
if
rm
will
A.
It
earn
more
B
cuts
price,
OPEC ,
by
price
price
($70
million
($210
rm
to
general
realizes
maintaining
rm
referred
there
is
from
as
which
is
if
to
The
conduct .
they
case
informal.
a
x
or
to
agreement
When
rms
were
a
monopoly.
cartel
is
formed—or
When
a
tacit
an
what
this
logic
rm
B
given
set-up
applies
chooses
rm
will
A
’s
to
rm
to
action.
choose
to
It
cut
B
do,
is
uncovered
as
a
illegal.
the
cartel
The
by
by
best
the
competition
press.
known
Organization
international
the
collusive
of
Collusive
formal
Petroleum
exporting
authorities,
cartel
collusive
Exporting
of
14
it
agreements
is
are
agreement
Countries.
in
is
This
countries.
A
instead
collusive
oligopoly,
member
rms
behave
as
if
they
were
a
of
Their
aim
is
to
maximize
joint
prots.
This
is
shown
rm
in
A
market .
in
remaining
result
monopoly.
$35
behave
ratios,
concerning
the
the
20%
Collusion
In
will
and
war
without
price
rm
cutting
why
in
result
agreement
We
oligopoly
may
depends
whether
rm
an
companies
of
they
outcome—whether
$35million—because
rm
price
that
not
but
these
two
tacit ,
Risk
agreements
Collusive
clear.
price.
monopoly
corporation.
Interdependence
Interdependence
a
producer s,
a
may
similar
have
six
be
not
Also,
the
next ,
areas
roughly
hospitals
not
or
information
may
local
just
see
applies
market
there
giving
shall
stations
same
ratio
very
we
monopoly.
of
to
As
is
any
then
companies,
is
one
Regarding
a
two
may
a
only
we
say,
have
be
or
competition.
and
with
sold
one
erce
Markets
even
are
to
of
Figure
2.1
1
.1
1
,
which
can
be
used
to
represent
an
oil
cartel.
thinking
follows
price,
that
Collusive
oligopoly
acting
as
a
monopoly
each
P/unit
earning
$70
million.
Incentive
The
set-up
to
MC
collude
above
assumes
no
communication
and
can
be
b
Pk
called
a
“one-shot ”
game.
In
the
real
world,
there
is
repeated
AC
or,
a
more
precisely,
market .
were
they
Less
to
It
would
make
would
an
Risk
very
of
become
be
better
and
the
tempting
interaction
evident
agreement
both
uncertainty
collusion
continuous
and
off:
to
each
rms
both
rms
coordinate
possibility
for
between
in
would
of
that
price
earn
greater
rms
if
Joint
prots
profits
they
a
changes,
$210
oligopolistic
in
C
million.
makes
markets.
cheating
D,
The
also
structure
explain
of
the
why
pay-off
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matrix
sometimes
in
do
Figure
not
2.1
1
.10
abide
by
AR
may
the
terms
0
Q /period
Qt
MR
of
the
collusive
agreement
made.
Firm
A
realizes
that
if,
Figure
following
price,
it
prots
only
to
alone
($250
$35
agreement
decided
million)
million.
cutting
would
66
the
price
this
In
so
$35
million
may
have
was
been
to
such
to
much
a
rm
B
to
price
it
would
its
under
a
rival
case,
cheat
instead
a
cut
while
only
incentive
with
of
earn
have
rms
$20
tempting
If
a
even
higher
return
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the
million,
pay-off
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strategy
to
2.1
1
.1
1
Collusive
oligopoly:
an
oil
cartel
high
earned
would
particular
materialize.
loss
more
would
both
very
maintain
of
cheating
pursue.
In
order
to
maximize
members
together
members
adhere
will
be
Pk .
Members
each
Joint
will
member
joint
must
to
the
prots
have
will
to
prots,
sell
is
at
the
Qt
agreement ,
will
then
agree
produce
on
and
be
then
output
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the
equal
their
sell.
total
where
to
=
all
MC .
cartel
area
quotas—the
cartel
If
the
price
(CabPk).
quantity
certain
the
of
OPEC ,
much
price
oil
for
following
member
each
oil.
will
Despite
reasons
the
countries
sell
in
the
the
negotiate
market
formal
to
structure
organization’s
goal
and
agree
achieve
is
of
a
that
OPEC ,
difcult
wars
for
to
achieve.
may
a
expense
which
was
Price
still
also
depends
on
demand
There
are
quite
a
members
(such
as
few
large
initiated
oil
USA ,
producers
Canada
who
and
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various
reasons,
members
do
are
other
collusive
to
x
price
cases,
and
executives
then
each
not
of
rm
that
price.
abide
by
the
Secret
or
agreements
hotels.
It
has
companies
sells
of ten
been
yogurt
starting
as
cartel
met
executives
at
of
a
a
Parisian
car
parts
take
reported
café
cartel
the
attract
in
a
USA .
example
more
relatively
Of ten
such
is
at
subscribers
recent
such
the
T-Mobile,
and
mobile
“
Au
met
that
they
can
rms
sustain
have
losses
a
for
place
that
as
it
price
war
rms,
is
it
typically
follows
not
that
in
the
such
interest
rms
of
usually
in
if
a
price
competition
agreement
as
has
a
strategy
been
to
made.
increase
Fear
of
sales,
triggering
cafés,
qui
Tokyo
non-price
can
executives
chien
in
a
secretly
much
price
war
as
well
as
collusive
agreements
result
in
prices
of
“sticky ”
in
oligopolistic
markets.
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if
production
fume”
costs
while
in
meaning
oligopolistic
being
a
to
winner
An
are
share
rules.
a
restaurants
cut
price.
market
while.
even
at
war
pocket ”,
adopt
agree
price
the
gain
not
most
In
a
cutting
circumstances
to
Russia).
Since
•
price
by
when
expects
conditions.
a
the
rivals
considered
“deep
•
start
condently
of
telecoms
•
deliberately
rm
at
decrease,
rms
do
not
decrease
price.
“Café
Non-price
competition
can
take
many
forms.
Perhaps
the
Renoir ”.
single
Note
that
oligopolistic
rms
face
a
negatively
most
curve
collusion
Output
is
is
and,
independently
present ,
less
than
allocative
the
of
whether
efciency
socially
optimal
or
cannot
level
prot
•
P
>
maximization
MR
while
because
allocative
requires
demand
is
efciency
MR
=
of
non-price
competition
is
advertising
be
is
the
sof t
drink s
and
creation
•
developing
industry).
of
Firms
brand
also
names
compete
(an
example
by:
achieved.
and
marketing
new
products
(smartphones
because:
cars)
MC
negatively
requires
method
not
and
•
important
sloped
heavy
demand
sloped;
that
P
=
so
P
>
•
continuously
•
offering
differentiating
their
products
(breakfast
cereals)
MC ,
volume
discounts
(for
shampoos,
conditioners
and
MC .
detergents)
Non-collusive
If
oligopolistic
there
is
a
involved
where
a
very
in
a
rm
oligopoly
rms
decide
signicant
price
war.
attempts
to
•
compete
chance
A
to
price
gain
that
war
by
market
cutting
they
refers
T I N U
case
how
: 2
the
on
will
to
share
a
providing
customers
in
industry)
the
car
with
af ter-sale
service
(customer
plans
S C I M O N O C E O R C I M
In
price
become
•
offering
lengthy
•
offering
gif ts
guarantees
(for
electronics
products)
situation
at
the
and
coupons
(in
newspapers
and
expense
supermarkets)
of
its
rivals
by
cutting
price,
triggering
retaliation
and
•
further
shown
price
in
cuts.
the
Usually,
“Prisoner ’s
Policymakers’
all
rms
dilemma”
end-up
earlier.
worse
off,
Rarely,
rms
approach
perspective
face
a
negatively
sloped
and
thus
charge
a
price
higher
than
they
are
marginal
we
allocatively
inefcient .
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in
an
shall
rms
collude
then
price
may
even
in
if
the
mind
market
that
if
Monopolistic
A
market
following
is
was
there
a
monopoly.
is
a
price
But
war
we
then
they
as
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has
must
price
such
The
rms
monopolistically
competitive
if
the
There
is
no
entry
examples
salons,
restaurants,
each
a
rm
is
negatively
lose
differentiated
some,
of
monopolistic
bars,
sloped
but
not
be
the
extent
diminished.
later,
if
these
oligopolistic
Also,
rms
enjoy
other
benets,
such
as
are
those
economies
is
thus
of
scale.
rather
The
issue
of
efciency
complicated.
power.
However,
there
are
thus
face
very
that
many
many
market
rms
close
in
power
each
substitutes.
is
small.
market
A
This
and
raise
the
price
of
the
pasta
dish
it
offers,
restaurant
but
not
too
products.
as
there
are
many
other
restaurants
around
that
offer
barriers.
producing
a
opticians
of
or
fuel
differentiated
demand
all,
competition
its
curve.
If
it
include
stations.
product ,
raises
customers.
It
it
stations
competitive
rms
have
some
or
and
similar
hair
pasta
dishes.
The
same
issue
affects
fuel
salons.
Since
faces
price
follows
hair
same
it
will
Monopolistic
competition:
Short-run
equilibrium
that
Figure
monopolistically
may
from
because
the
Typical
thus
will
rms.
produce
are
see
markets
monopoly)
much
•
and
bear
can
•
cost
inefciency
competition
considered
many
do).
may
applies.
very
of ten
high
consumers
•
stations
oligopolistic
be
in
as
radio
cost
resulting
market
marginal
allocative
large
so
(as
demand
as
curve
competitions
price
of
Oligopolistic
organizing
as
market
2.1
1
.12
shows
the
short-run
equilibrium
position
of
a
(or
monopolistically
competitive
rm.
67
P/unit
MC
P/unit
MC
B
P
AC
AC
F
A
(AC
=
AR)
=
P
C
D,
H
0
D,
0
Q
Q /period
AR
Q /period
Qsoc
Q
AR
MR
Figure
2.1
1
.13
Monopolistic
competition:
long-run
equilibrium
MR
Efciency
Figure
2.1
1
.12
Monopolistic
competition:
short-run
issues
in
monopolistic
equilibrium
competition
Assuming
that
it
aims
at
maximizing
prots
it
will
choose
Monopolistically
to
produce
and
offer
Q
units
per
period,
where
MR
=
They
and
sell
at
price
P
.
It
will
be
thus
earning
abnormal
produce
prots
equal
to
area
rms
in
this
market
are
earning
abnormal
prots
other
entrepreneur s
will
have
this
to
enter
market
this
are
market .
earning
Why?
more
means
It
than
is
because
normal
in
more
the
than
next
what
best
they
could
alternative
have
with
rms
will
enter
monopolistic
the
market
competition.
As
as
the
there
they
negatively
of
each
rm
faces
“shrink s
and
tilts”.
It
demand
curve
shif ts
lef t .
they
no
too
This
is
will
share.
be
selling
Demand
less
also
the
elastic .
Why?
It
is
because
because
more
at
will
and
stop
even
closer
when
rms
of
their
atter,
consumer s
substitutes.
in
from.
to
this
in
rather
horizontal,
be
in
prots
this
(that
market
as
is,
normal
much
as
prots).
they
If
could
best
alternative
with
the
same
risk,
be
no
reason
for
more
rms
to
enter
or
rms
to
exit .
Long-run
reached.
Figure
2.1
1
.13
then
in
a
monopolistically
Monopolistic
Long-run
Entry
of
closer
curve
and
of
new
will
to
the
It
lef t
can
differentiated.
rms
price
will
P
.
68
AC
Q
each
be
long-run
units,
has
where
are
shif ted
Since
long-run
lef t
signicantly
many
higher
close
than
substitutes
the
in
price
town,
of
a
popular
people
can
meal
easily
The
degree
of
allocative
competitive
markets
In
addition,
demand
faced
is
may
but
since
the
existence
of
very
many
not
close
it
quite
only
at ,
slightly
such
above
rms
the
will
produce
minimum.
with
This
the
result
of
their
constant
attempt
to
may
differentiate
product
even
will
more.
be
So,
even
the
extent
of
technical
small.
importantly,
monopolistically
consumers
with
great
competitive
variety
and
this
markets
is
characteristic
of
this
market
structure.
a
highly
There
and
hair
salons,
for
example,
that
cater
are
to
and
if
there
is
a
niche,
an
entrepreneur
will
soon
every
enter
equilibrium
even
shif ted
made
it
more
the
quite
because
MR
as
until
are
=
MC ,
at
it
Q,
and
AR
equilibrium
=
became
earning
in
the
and
even
demand
price
products
monopolistically
zero
rms
of
have
and
restaurant .
market
to
satisfy
it .
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existence
rm
is
very
market .
horizontal
prots
curve.
represents
the
consumers
if
restaurant
small.
Monopolistic
Prot-maximizing
choose
curve
U-shaped
this
for
never
Economic
demand
and
for
that
have
have
competition:
rms
the
limited.
the
equilibrium
substitutes
at .
competitive
quite
will
the
in
is
the
there
any
equilibrium
shows
possess
zero
taste
been
price
monopolistically
cost
restaurants
incumbent
have
entrepreneur s
earn
for
so
However,
of
earning
valued
be
they
example,
a
makes
average
present
next
and
facing
process
are
curve
power.
more
Most
earn
level
Remember,
diminishing
meaning
will
This
market
demand
monopoly)
power
a
For
in
another
inefciency
economic
MC .
each
their
entry
>
and
also
even
P
barrier s
an
price
output ,
demand
decreases
because
becomes
(or
Consumers
much
substitutes
market
of
sloped
market
charge
cost .
choose
be
price
level
risk .
usually
the
of
monopoly
inefciency
that
chosen
been
same
are
enter,
a
cannot
switch
in
inefcient .
optimal
rms
rises
More
allocatively
socially
prots,
to
earning
the
degree
marginal
which
are
the
the
They
in
at
face
degree
incentive
rms
than
(or
some
supernormal)
output
(CABP).
they
Since
less
(or
because
supernormal)
competitive
MC ,
elastic
AC .
market .
oligopoly.
rms
is
power
are
very
The
of
at
The
monopolistically
to
the
prots,
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to
small
consumers,
is
allocatively
the
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of
these
compared
to
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power
rms
The
fact
competitive
there
which
will
is
and
an
resulting
competitive
offer
that
rms
probably
also
and
extent
monopolistically
consumers.
market
but
market
minimal.
variety
tangent
normal
or
competition
inefcient
inefciencies
pricing
are
competitive
sell
technically
perspective
be
tremendous
there
are
implies
a
rm
advantage.
many
that
for
located
any
near
that
are
monopoly
compared
large
in
power
with
the
size
have
rms
and
have
certain
small
rms
signicant
advantages
in
perfect
market
Large
when
and
rms
position
monopolistic
competition.
the
in
to
long
run.
large
in
size
allows
rms
to
benet
from
scale.
These
rms
can
of ten
produce
at
a
lower
compared
to
smaller
rms.
This
allows
larger
set
a
price
lower
than
the
price
found
in
a
because
market
and
to
offer
an
even
greater
cour se,
resulting
there
from
consumer s
this
will
in
be
positions
or
lowest
Abuse
grow
and
many
case
abuse
in
itself
prices
of
depends
face.
that
are
power
may
invest
in
be
where
such
a
on
the
a
The
not
on
extent
actual
and
to
a
to
which
potential
that
may
to
intervene.
an
it
is
suspected
lead
large
that
a
competitors
rm’s
to
guarantees.
A
to
permit
innovate
but
a
rm
there
to
are
position
has
dominant
position
does
for
rm
to
such
as
Google,
only
others,
They
have
have
governments
abuse
is
acting
prevent
Facebook,
been
been
to
creative
to
described
or
may
with
entry
Apple,
suspected
accused
above.
higher
led
rate
markets
by
of
USA
be
They
aggressively
Justice
Department
companies
have
and
scientists
the
of
intention
new
rms.
opportunities
of
Intel
of
and
abusing
acting
have
in
to
resources
their
to
platforms
has
out
their
complained
agreements
working
suppress
to
rival
the
of
innovations.
The
characteristics
Schumpeterian
monopoly
have
question
make
to
innovate
being
argument
power
prots
at
in
that
the
Harvard
entrenched
avoid
prices
for
them
their
that
innovations
are
swept
long
run.
power,
forced
away
by
favour
maintain
University,
monopoly
but
in
can
Schumpeter,
held
large
that
continuously
the
in
rms
are
to
“perennial
gale
Some
have
used
competition
rms.
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by
may
to
consumers
suffer
and
but
it
may
has
have
caused
decreased
the
collude
abuses
and
result
behave
that
harm
as
if
they
were
consumers
a
(who
monopoly,
are
higher
prices).
The
European
Commission
forced
has
members
of
canned
many
cartels
vegetables,
in
a
vast
area
electronics
of
markets
products,
apple
sauce,
beer,
vehicle
sales
and
car
many
safety
others.
market
all
cases
of
collusion,
the
resulting
market
led
to
consumers.
power
In
the
higher
prices
paid
and
less
choice
for
in
market
for
pharmaceuticals
there
is
a
lot
of
discussion
on
competitors.
that
some
rms
have
managed
effectively
to
extend
patents
some
drugs
to
more
than
40
years
instead
of
the
20-year
deprived
seeking
their
limit .
Some
drugs
companies
have
also
been
accused
better
“paying
for
delaying”
tactics,
where
they
pay
rms
to
extensive
restricting
not
nal
to
competition
that
of
for
producers
rms
pay
delay
legal
production
Amazon,
precisely
restricted
buying
reached
elsewhere.
new
consumer s
Tech
of
job
that
innovation.
current
engineers
question
present
on
hi-tech
innovations.
and
not
how
The
products
competition
the
their
and
tremendous
destruction”.
competing
much
manner
no
market
with
able
of
In
power.
is
economist
not
equipment ,
among
new
(supernormal)
absence
including
giants
to
of
result .
is
rms
innovate
dominant
However,
or
to
Austrian
ned
eliminate
to
striking
what
the
to
if
is
abnormal
are
not
of
pricing
authorities
leads
is
in
research
power
and
reason
from
there
When
constitute
refer
There
likely
Lastly,
monopoly
exposed
which
in
savings
passed
agreements
necessary
position.
cost
be
Entrenched
competition
R&D
the
will
prices.
collusive
and
that
scale
lower
monopoly
to
of
of
rms
long
instances
to
guarantee
form
these
for
of
Monopoly
no
successful
maintained
the
the
the
competition
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people
but
and
The
identied
living
provides
a
Index
for
output .
(OECD)
However,
(BLI)
more
Organization
output
Index
that
The
people
Life
T I N U
argument
of
in
the
bottom
top
engagement
and
life
99%
balance.
earn
very
both
the
little.
high
USA
per
is
standards
•
Per
it
much
in
capita
may
Any
be
For
rising
damaging
a
decade
India
at
the
an
but
30
Green
GDP
in
a
If
also
correct
per
of
the
is
it
by
safe
on
BLI
the
a
conclude
that
instance,
in
dramatically
(CNN
“21
2020).
as
it
the
subtracting
Green
in
GDP
can
GDP
the
high
be
natural
resource
and
environmental
Per
capita
income
statistics
fail
to
In
GDP
is
a
most
important
but
income
levels
its
importance
the
value
of
be
the
is
not
same
of
the
accounted
in
two
difference
whether
people
work
60
well-being
for.
Per
countries,
or
Living
but
standards
also
house
by
or
the
the
are
not
stock
car
a
of
only
35
affected
wealth
family
owns
of
the
contribute
to
hours
by
it
per
current
(signicantly
The
to
level
per
•
Some
health
differ
income
health
point
goods
public
may
capita
quality
at
of
citizens
of
and
care
greatly
care
and
delivery
two
services
public
expenditures
the
education
may
living
been
For
the
made
to
example,
Gulf
of
•
Per
capita
output .
levels
to
recorded
were
for
statistics
may
with
available
the
more
same
High
available
spend
as
of
income
activities
an
the
fail
economies
differ
to
expenditures
made
Two
because
counteract
the
Mexico
adjustment
so
with
different
for
positive
although
that
have
cleaning
addition
to
the
environmental
to
reveal
with
output
the
equal
respect
state
large
proportion
of
its
to
mix .
GDP
that
of
to,
could
other wise
to
their
represents
on
presents
Happiness
to
this
all
these
reasons,
alternative
been
the
developed
World
as
by
Solutions
Happiness
happiness
that
perceive
the
is
“Cantril
asked
present
the
are:
other
the
per
average),
well
as
dimensions
the
United
Network
Report,
a
and
is
survey
ranks
156
themselves
countries
to
be.
To
by
estimate
to
Ladder ”
rank
their
is
used,
where
satisfaction
the
with
best
living
conditions
possible
life
and
from
0–
10
living
(where
conditions
US
harm.
oil
GDP
spill
with
in
no
of
income
that
defence,
been
Index
Finland
is
then
Ladder
of
(7
.63),
unhappiest
African
to
and
calculated
a
2018,
single
the
Norway
countries
Republic
life
by
happiest
the
(3.08)
and
world
and
conditions).
averaging
number.
(7
.59)
in
living
and
the
According
countries
Denmark
are:
in
answers
to
Sudan
the
the
(7
.56)
Burundi
South
The
world
whereas
(2.91),
(3.25).
Planet
Index
(HPI)
The
Happy
New
assess
of
its
Planet
Economics
whether
residents.
Index
(HPI)
Foundation
a
country
It
is
is
made
•
average
life
•
average
subjective
•
ecological
of
has
able
up
been
London
of
to
developed
and
is
promote
the
three
by
the
designed
the
to
well-being
variables
of:
expectancy
well-being
well-being
country
say,
Index
possible
have
catastrophe.
economic
A
they
the
capita
worst
contributions
caused
up
the
Cantril
footprint
(the
impact
of
a
person
or
community
devotes
the
environment ,
expressed
as
the
amount
of
land
sacrices
used
in
to
sustain
their
use
of
natural
resources).
the
the
top
ve
countries
in
the
Happy
Planet
Index
goods.
ranking
For
in
Index
respect
Happiness
free
composition
per
have
pro-development
has
citizens
population
Surprisingly,
production
status
important
Development
global
Happiness
required
resources
of
their
sample
on
a
are
OECD
The
standards.
services
families
be
and
Index
annually
happy
Central
activity
health
the
income
low
week.
services.
economic
than
relatively
Index
Sustainable
Happy
to
a
work
that
education
countries
affecting
permit
has
of
signicant
well-being.
and
between
in
which
terms
having
the
makes
0
•
average
lower
in
with
to
income
population.
provides
their
faced
countries
despite
compared
average
is
within
USA ,
the
The
capita
but
10
signicantly
higher
separate
security.
the
to
earnings,
well-being
Colombia
quality,
job
instance,
it
four
one
weights.
of
the
•
assess
on
personal
and
(much
contrast ,
Happiness
how
a
rate
on
equal
leisure.
of
may
based
rate,
below
based
well-being.
published
people,
GDP
is
is
with
depletion.
include
dimension
to
For
because
above
index
cost
Nations
Leisure
the
averaged
topic
rank s
balance
rank s
The
•
used
capita
Happiness
of
Jobs
countries.
average),
life
of
are
employment
environmental
of
the
that
the
then
per
capita
but
topics
health
unemployment
inequality.
the
1
1
the
across
and
environment .
from
the
example,
OECD
but
of
factors
of
indicators
and
double
and
to
four
long-term
to
home
Each
measures:
but
For
problem
on
rise
•
community
For
levels
incomes
was
cities”
living
environment .
grown
India
that
in
same.
pollution
doubled?
•
have
inequality
claim
production
epic
production
estimated
the
capita
of
this
Denmark
income
cannot
are
to
have
2020
and
but
production
cost
cost
polluted
to
we
increased
incomes
effect
is
of
have
most
detrimental
when
huge
at
so
degradation,
time
attempt
a
USA
levels
countries
ignored.
capita
same
world’s
is
at
standards
per
and
rises
effect
is
environmental
living
two
income
the
income
higher
these
environment
over
example,
capita
: 3
major
measure
S C I M O N O C E O R C A M
The
measures
to
assess
have
GDP
per
capita
levels
below
$10,000.
Costa
Rica
is
wellon the top of the ranking, with Costa Ricans having a signicantly
being
have
been
developed.
higher
well-being
than
the
residents
of
many
rich
nations.
73
The
The
business
real
time.
GDP
of
Typically,
followed
by
business
cycle,
a
1
.
cycle
country
periods
periods
does
during
during
shown
in
not
increase
which
which
Figure
the
the
3.1
.1
,
continuously
economy
economy
refers
to
over
expands
contracts.
these
are
Calculate
Nominal
the
of
an
economy ’s
real
GDP
over
GDP
can
GDP
be
from
the
calculated
expenditure
from
expenditure
approach.
data
using
relationship:
The
nominal
GDP
=
C
+
I
+
G
+
(X
–
M)
short-term
So:
uctuations
nominal
nominal
GDP
=
35.86
+
6.52
+
22.82
+
(8.6
–
9.8)
=
time.
$64.0
billion
2.
Calculate
To
calculate
nominal
GNI
for
Lalaland.
Real
GDP
(or
peak
peak
n
n
o
i
s
n
a
p
x
e
c
o
trendline
n
t
r
a
c
t
i
o
Lalaland’s
property)
income
GNI
from
we
need
abroad
to
to
add
its
net
GDP
factor
gure.
This
is
long-term
equal
paid
to
income
abroad
earned
($1
.3
follows
64.1
–
that
0.2
=
in
($1
.1
billion)
minus
income
billion):
1
.1
It
abroad
–
2015
$63.8
1
.3
=
−$0.2
Lalaland’s
billion.
GNI
was
billion.
trough
The
following
Year
table
Nominal
($
0
Figure
t1
3.1
.1
Between
The
time
(contraction
t2
business
t1
and
phase)
t3
the
since
economy
real
GDP
is
is
is
in
recession
(technically,
an
GDP
GDP
data
for
deator
Lalaland.
Population
billion)
2016
308.12
2017
321
.99
(million)
2018
332.65
98.9
13.27
100
13.34
102.2
13.47
contracting
decreasing.
We
say
that
3.
it
additional
Time
cycle
t2
shows
economy
is
in
recession
if
Calculate
the
level
of
real
GDP
for
Lalaland
for
2016
to
real
2018.
GDP
decreases
for
at
least
two
consecutive
quarters).
At
t1
To
it
was
at
a
peak
and
just
about
to
enter
recession.
The
calculate
divide
characteristic
of
a
recession
is
rising
unemployment .
At
t2
at
a
trough
and
just
about
to
enter
the
GDP
nominal
from
GDP
nominal
data
by
GDP
the
data
GDP
we
deator
need
that
to
year
it
and
is
real
major
multiply
your
result
by
100.
recovery–expansion.
308.12
Between
time
t2
and
t3
the
economy
is
growing
(expansion
2016:
real
GDP
=
×
100
=
$31
1
.55
billion
$321
.99
billion
98.9
phase)
is
too
since
rapid
real
it
GDP
may
is
give
increasing.
rise
to
However,
inationary
if
the
expansion
pressures.
321
.99
2017:
This
economy
trendline
is
is
also
upward
growing
sloping.
over
The
the
long
trend
line
term
is
the
as
real
GDP
=
×
100
=
100
the
average
332.65
annual
long-term
growth
of
the
2018:
economy.
real
GDP
×
=
100
=
$325.49
billion
102.2
An
economy
is
growing
when
real
GDP
is
increasing,
and
4.
it
is
contracting
when
real
GDP
is
decreasing.
The
Calculate
to
rate
of
an
between
is
economy
two
positive,
years.
then
is
the
percentage
change
of
If
the
percentage
change
in
real
GDP
is
increasing,
the
real
GDP
per
capita
for
Lalaland
for
2016
growth
real
real
suggesting
2018.
GDP
To
GDP
calculate
the
that
real
population
GDP
of
the
per
capita
we
must
divide
real
GDP
by
country.
9
the
economy
is
growing.
However,
if
the
growth
rate
31
1
.55
is
2016:
negative,
is
in
then
recession.
real
GDP
Note
is
that
decreasing,
if
the
and
growth
rate
the
is
real
GDP
per
capita
=
economy
positive
x
×
10
6
13.27
×
10
c
=
$23,478
c
=
$24,137
c
=
$24,164
but
9
321
.99
decreasing
increase
(from,
but
at
a
say,
2.1%
slower
to
rate.
0.8%)
It
is
not
real
in
GDP
continues
to
2017:
real
GDP
per
capita
=
x
×
10
6
13.34
×
10
recession.
9
325.49 × 10
Calculations
2018:
The
following
data
refer
to
Lalaland
Variable
Import
74
expenditures
expenditures
Government
Export
2015.
Amount
Consumption
Investment
in
(I)
expenditures
revenues
(C)
(G)
(X)
($
35.86
6.52
22.82
8.6
expenditures
(M)
Factor
income
earned
Factor
income
paid
abroad
abroad
billion)
9.8
1
.1
1
.3
real
GDP
per
capita
=
x
6
13.47
×
10
demand
Aggregate
domestic
per
demand
of
and
aggregate
refers
and
to
the
services
at
total
planned
different
spending
average
price
If
on
people
then
time.
from
on
domestic
households,
means
that
(C),
expenditures
(G)
are
on
the
and
foreign
(X).
=
C
+
and
rms
we
must
I
G
+
+
the
subtract
(X
–
•
some
this
look s
familiar,
it
is
because
GDP
approach
is
the
same
•
by
actual
demand
output
are
not
produced,
at
all
say
the
same
$5.15
GDP
in
whereas
aggregate
demand
shows
the
effect:
more
The
of
price
spending
number
In
at
different
whereas
Figure
3.2.1
,
price
aggregate
aggregate
levels
in
demand
demand
is
a
is
a
and
On
the
horizontal
axis
is
real
level
the
is
the
average
prices
of
all
price
nal
level
goods
an
the
rises
falls,
curve.
at
AD
to
price
home,
so
net
demand,
then
level
abroad
net
increases
while
exports
decrease.
exports
(NX),
Thus,
fall,
then
imports
a
if
the
leading
to
a
curve.
if
the
hold
average
more
price
money
to
level
buy
increases,
the
The
demand
for
holding
same
money
So
increases.
If
the
supply
of
(cash
money
the
bank
is
interest
constant
rate,
rises.
then
the
Higher
“price”
interest
of
money,
rates
decrease
level
GDP
is
(C)
and
investment
(I)
expenditures
as
people
a
and
rms
by
the
will
and
capital
borrow
less
from
banks
to
buy
durables
and
on
the
equipment.
in
of
the
the
So,
if
the
average
price
level
rises
AD
consumption
and
investment
decrease,
leading
to
a
vertical
average
AD
curve.
of
As
in
on
either
all
diagrams,
the
function
will
not
shif t
when
a
variable
economy.
of
the
price
axes
level
changes.
there
will
So,
be
if
no
there
shif t
is
in
a
change
the
AD
in
curve
the
but
price
only
level
average
rises
accounts)
central
is
average
Average
level
services
function.
index
services
consumer
price
in
planned
illustrated
output
(APL),
and
and
AD
competitive
effect:
need
downward-sloping
axis
less;
GDP
Japan
country.
the
services.
cheque
then
curve.
spend
average
goods
sloping
aggregate
rate
people
consumption
of
if
less
attractive
interest
which
2019,
downward
to
the
and
concepts.
trillion
if
the
by
is
tend
Thus,
domestic
downward-sloping
and
aggregate
they
(C).
on
become
average
(M).
M)
measured
sum—but
a
component
goods
expenditure
to
trade
seem
of
government
imports
The
then
If
poorer
fall
spending
exports
government
since
and
This
consumption
(I),
feel
originate
foreigners.
includes
However,
households,
goods,
AD
(AD)
can
expenditures
exports
that
services
government
demand
investment
and
expenditures
make
goods
rms,
aggregate
expenditures
the
supply
expenditures
levels
leading
Spending
activity—aggregate
demand
goods
period
economic
: 3
Aggregate
in
T I N U
Variations
S C I M O N O C E O R C A M
3.2
a
movement
along
it .
(APL)
Aggregate
change
in
demand
demand
any
of
means
will
its
shif t
only
components.
that
there
is
a
if
a
An
shif t
determinant
increase
of
the
AD
in
induces
a
aggregate
curve
to
the
APL2
right
from
means
AD1
that
to
the
AD2.
AD
A
curve
decrease
shif ts
to
in
the
aggregate
lef t
from
demand
AD1
to
AD3.
APL1
These
effects
Average
level
are
shown
in
Figure
3.2.2.
price
(APL)
AD
0
Yr2
Real
Yr1
output
(Yr)
Figure
3.2.1
So,
the
of
if
The
AD
curve
average
spending
on
price
level
domestic
is
at
output
APL1
is
at
then
Yr1
.
If
planned
the
level
average
price
AD2
level
is
at
APL2
then
planned
level
of
spending
on
domestic
AD1
output
is
at
Yr2.
AD3
The
AD
reasons
curve
that
is
downward
the
demand
sloping
for
a
but
single
not
good
for
is
the
same
0
Real
output
downward
(Yr)
sloping,
all
is
as
goods
on
the
and
negatively
not
vertical
the
sloped
axis
price
of
because
we
a
of
have
single
the
the
average
good.
wealth
The
price
AD
effect ,
the
of
curve
Figure
3.2.2
Shif ts
of
the
and
the
interest
rate
curve
trade
Determinants
effect
AD
of
aggregate
demand
effect .
components
•
The
the
wealth
real
pockets
other
effect:
value
or
in
of
the
bank
nancial
if
the
average
money
that
accounts,
assets
they
as
own
price
level
people
well
such
as
as
increases
have
the
in
real
bonds,
then
Consumption
their
value
of
decreases.
households
depend
on
expenditures
on
the
durables
and
(C)
are
dened
non-durables
as
and
spending
services
by
and
following.
75
•
Interest
or
the
rates:
the
reward
expressed
as
for
a
interest
saving
rate
is
money
percentage.
the
cost
over
a
of
Households
leading
borrowing
period
of
borrow
to
to
rightward
time
purchase
of
durables,
such
as
cars
and
appliances,
houses.
An
increase
in
interest
rates
makes
expensive,
resulting
in
less
borrowing
on
and
so
spending,
the
AD
decreasing
curve
to
the
aggregate
lef t .
In
demand
addition,
of
rates
make
saving
more
attractive.
If
to
save
tend
to
more
then
spend
it
less.
automatically
The
reverse
that
in
interest
rates.
Lower
interest
of
and
can
borrowing
of
to
while
an
rendering
increase
in
rates
saving
spending,
demand
and
shif ting
the
AD
Consumer
condence:
this
is
a
reduce
less
the
are
and
how
feeling
secure
secure
and
they
will
tend
to
spend
more.
to
the
of
how
with
low
ination
about
the
about
their
and
condence
and
and
rates:
shif ting
the
AD
curve
to
affect
the
to
of
uncertainty
one’s
over
future
future
income
job
will
Spending
on
durable
so
right .
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the
appliances,
consumer
as
well
as
on
affect
goods,
housing,
is
Household
estate,
own,
minus
and
for
more
wealth
such
what
as
they
example
spending,
such
as
the
greatly
fall,
AD
refers
to
stock s,
owe.
due
to
which
curve
wealth
to
the
value
bonds,
An
of
in
or
Personal
are
paid.
to
will
demand
taxes:
income,
If
disposable
the
to
the
a
the
rise
in
right .
and
property
prices,
aggregate
In
so
decrease
these
which
is
government
income
falls,
decreasing
contrary,
an
to
thus
a
contrast ,
will
and
increase
the
income
AD
and
the
AD
the
if
owe
the
to
If
invest
and
AD
AD
If
as
in
in
drops
curve
curve
a
curve
instead
rm
investment
uses
the
of
its
own
opportunity
keeping
Investment
expected
to
in
costs
them
in
expenditures
decrease,
interest
for
spending
to
the
this
sales
by
shif ting
the
rms
rates
fall
have
the
leading
and
aggregate
to
an
demand
right .
refers
and
are
and
are
to
how
about
so
the
necessary
for
more
optimistic ,
expand,
will
results
they
aggregate
shif t
in
decrease
to
the
in
lef t .
to
a
to
the
businesses
economy.
for
a
feel
Economic
positive
investments
are
more
demand
right .
decrease
in
aggregate
Keynes
with
that
af ter
with
by
taxes
business
to
take
likely
will
to
increase
Business
investment
demand,
considered
respect
of
a
herd
of
to
the
income.
so
will
aggregate
from
this
taking
refers
out
to
they
owe
a
lot ,
and
pessimism,
so
spending
the
the
AD
curve
behaviour
to
investment
of
decisions
(imitation)
many
and,
in
business
they
will
rst
will
try
to
his
opinion,
and
factors,
climate
be
greatly
leading
and
so
due
to
to
to
these
changed
swings
changes
in
in
the
the
level
spending.
lef t .
taxes
much
from
cut
decrease
decrease
can
was
Technology:
industries
where
technology
improves
fast
will
witness
more
investments,
thus
causing
increases
demand
and
a
rightward
shif t
in
the
AD
in
curve.
demand.
or
will
investment
Expectations
unpredictable
investment
of
Consumption
how
loans
they
instability
spirits”.
prevailing
taxes,
aggregate
income
observed
“animal
Business
taxes:
business
taxes
the
affect
increases
rms’
the
prots.
protability
A
decrease
of
in
investment
using
back
their
AD
these
money
on
More
investment
projects
will
be
approved
so
their
spending
will
tend
to
the
AD
increase.
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debt .
curve
will
increase
and
curve
will
shif t
to
will
right .
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increase
in
business
taxes
may
result
in
lef t .
average
of
future
price
price
level
to
level:
if
decrease
households
AD
expect
expectations)
they
may
delay
further
price
purchases
decreases.
since
they
decreases
and
the
AD
As
a
result ,
the
contrary,
if
consumers
curve
shif ts
to
the
expect
they
shif t
of
the
to
may
prices
to
increase
indebtedness:
past
borrowing,
if
rms
they
will
have
be
high
levels
hesitant
to
of
take
debt
loans
and
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more
investments
as
they
will
out
rst
lef t .
to
decrease
debt .
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aggregate
increase
and
expectations)
lef tward
aggregate
try
(inationary
a
come
more
demand
and
curve.
Corporate
due
expect
investment
(deationary
•
76
a
will
of
income
shif ting
personal
disposable
and
demand
Expectations
On
if
project ,
Decreases
stability
rms
decreased
to
more
possible
leads
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the
funds
increases.
lef t .
future
curve
demand
•
Even
investment
Borrowing
evolve
investment
shif t
an
condence:
political
projects.
cards.
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become
fewer
stock
level
lef t
personal
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indebtedness:
households
spending,
to
machines,
consumption.
the
determine
raises
reduction
increase
Household
credit
as
demand,
•
•
will
that
protable.
investment
the
aggregate
will
nd
therefore
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place.
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such
household
•
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then
goods
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disposable
rate
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real
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increases
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will
these
are
their
similar
shif t
rates
of
and
bonds
entrepreneurs
Aggregate
Investment
affected
shif ts
prices
also
the
cars
and
shif ting
now
as
in
Business
though,
to
but
so
insecurity
the
wealth,
and
moods.
wealth:
households
demand
supply
present
climate
•
aggregate
other
and
by
interest
rms
using
curve
about
and
on
aggregate
boost
•
consumption.
the
important
household
prospects
adversely
if
nance
or
shif ting
about
on
growth.
purchase
are
increase
hand,
inuence
equipment
opposite
spending,
increases
is
growing
unemployment
favourably
Investment
Investment
future.
AD
consumer
its
inuence
the
businesses
economy
time.
optimistic
feel
stable
of
economy.
right .
condent
A
by
equipment
attractive
bank s
future
spending
tools,
the
cost
Households
as
following.
Interest
funds
households
dened
machines,
boosting
curve
measure
are
as
a
projects
•
an
economic
expensive
aggregate
(I)
(such
period
of
of
its
long-term
tools,
lead
per
because
nance
cost
a
they
following
•
decrease
and
people
implies
applies
demand
curve.
and
on
will
aggregate
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of
tend
goods
capital
because
interest
expenditures
capital
factories)
both
shif ting
in
AD
less
stock
consumer
the
borrowing
and
more
of
and
rms
of
increase
nance
Investment
the
an
shif t
spending,
the
AD
curve
shif ts
to
the
lef t .
demand
decreases
Government
of
total
spending
(G)
are
in
many
expenditures
is
categorized
on
economies
goods
and
increase,
a
AD
services.
increasing
curve
to
(appreciation)
as:
decrease,
•
current
•
capital
spending
on
goods
and
investments)
spending,
which
refers
on
roads,
ports,
telecommunications,
other
Trade
policies:
as
transfer
payments,
unemployment
section
which
refer
to
pensions
benets;
included
in
note
national
that
transfer
income
since
fall
do
rewards
Governments
and
spend
merit
to
to
current
ensure
goods
productive
US
markets
environmental
may
also
acceptable
net
exports
lef t .
to
restrictions
often
to
imposed
international
by
4.2).
If
that
and
adequate
services
education
and
are
amounts
available,
health
in
their
attempt
standards,
spend
to
care.
the
government
redistribute
is
guaranteed
minimum
all.
of
of
another
one
country
country,
imposes
then
so
net
exports
will
rise,
increasing
imports
aggregate
and
shifting
the
AD
curve
decision
to
to
the
right.
impose
For
tariffs
example,
on
and
aluminum
so
and
that
Such
expected
to
reduce
imports
Chinese
and
net
exports
and
aggregate
demand.
Relaxing
example,
benets,
includes
subsidies
funding
and
state
disability
pensions,
to
affect
aggregate
benets.
demand.
An
can
can
have
lead
to
the
an
reverse
increase
effect.
in
Reducing
imports
and
tariffs
so
to
a
net
exports,
the
AD
which
will
decrease
aggregate
demand,
on.
curve
to
the
left.
socially
governments
or
demand
decrease
Movements
in
government
expenditures
will
cause
aggregate
demand
or
to
or
the
decrease,
left.
(explained
This
in
is
with
part
section
economic
and
spending.
For
the
of
3.6).
political
AD
what
We
may
priorities
instance,
it
curve
is
may
as
therefore
affect
be
shifting
known
a
the
to
of
public
schools
with
smartboards
and
•
the
wealth
that
•
the
trade
to
while
it
may
be
an
economic
priority
student
that
•
the
interest
with
Net
must
exports
(X
spending
by
spending
on
between
of
•
time.
to
of
our
foreign
of
of
on
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Thus,
the
right .
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Mexico’s
the
rises
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the
if
of
on
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if
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of
in
as
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a
•
leading
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country ’s
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will
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our
For
the
of
price
if
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the
€1
.00
become
USA)
one
euro
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and
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if
and
per
imports,
will
then
which
will
AD
and
will
shif t
tend
to
(in
by:
(C)
resulting
in
interest
rates
•
consumer
•
household
•
personal
•
household
•
expectations
condence
wealth
income
taxes
indebtedness
on
future
price
level
changes
from
in
investment
changes
•
interest
•
business
•
technology
•
business
•
corporate
expenditures
(I)
resulting
in
rates
condence
income
goods
the
exports
aggregate
in
is
the
terms
=
of
in
terms
right .
taxes
indebtedness
decreases,
will
tend
demand
then
the
USA)
EU).
it
of
in
government
expenditures
(G)
resulting
to
changes
in
and
•
economic
•
political
priorities
US
EU
that
is
changes
in
changes
in
net
•
income
of
•
exchange
•
trade
exports
trading
(X
–
M)
resulting
from
partners
example,
rates
exports
abroad
a
country ’s
dollars
this
priorities
a
means
in
become
As
of
another
(so,
competitive
the
price
USD1
.13
USD1
.05)
(from
caused
curve
Mexico’s
partners
our
depreciates
more
domestically
in
rate
expressed
to
are
expenditures
period
increases,
the
Mexican
so
trading
€1
.00
rate
demand
consumption
curve.
expressed
example
aggregate
in
increase.
partners
grows
more
decrease
AD
effect .
difference
economy
shif ting
USA
curve
exchange
exchange
now
attractive
a
the
rate
trading
will
on
an
trading
buy
our
of
and
the
recession,
to
an
currency
currency.
1
.13.
in
effect
•
from
decrease,
effect
changes
changes
say,
by
to:
higher
domestic
the
expenditures
spending
increase
the
as
lead
between
minus
simply,
caused
that
inequality.
difference
income
exports
will
will
income
output
are
level
following.
demand
they
the
import
spending
the
example,
exports
as
more
level
income
demand:
however,
or,
and
their
widening
domestic
partners:
aggregate
aggregate
If,
on
increased
exports.
Americans
so
dened
revenues
increases,
increase
the
are
depend
their
decrease
output
trading
increasing
to
M)
to
foreigners
They
partners
are
–
export
Income
Part
increase
curve
price
a
from
incomes
AD
equip
changes
tablet,
the
average
government
priority
each
the
right
Shif ts
all
in
policy
conclude
level
political
the
scal
along
to
changes
increase
in
shifting
spending,
Lastly,
or
fall
unemployment
increase
turn
to
Aggregate
spend
in
trade
safety,
so
a
is
as
spend
product
conditions
income
for
imports
of
such
They
guarantee
competitive
to
the
Recap
for
trade
governments
effort .
quotas
They
refer
quotas
administration’s
restrictions
defence,
regulate
or
on
and
increase
national
effect;
the
the
rate
not
steel
public
to
shif ting
exchange
payments
they
the
represent
opposite
curve
and
the
and
demand
not
the
AD
in
infrastructure
will
are
these
tariffs
restrictions
•
have
the
demand
increase
schools
(see
and
will
shif ting
An
to
such
spending
aggregate
right .
services
•
(public
the
T I N U
expenditures
proportion
: 3
large
S C I M O N O C E O R C A M
Government
(in
pricier
result ,
net
policies.
the
and
less
exports
77
Aggregate
Aggregate
domestic
levels
same
in
by
shape
different
aggregate
Note
as
of
it
to
under
AS
at
curve
the
how
rather
different
We
and
output
is
price
not
much
different
is
of
average
supply
shows
thought .
the
level
different
aggregate
offer
reects
of
planned
at
supply
the
schools
supply
the
offer
that
planning
macroeconomics
used
as
to
Aggregate
are
The
dened
willing
time.
GDP
.
rms
levels.
is
are
period
real
domestic
price
supply
rms
per
as
supply
the
shown
average
in
Figure
price
level
is
on
the
vertical
axis.
This
is
3.2.3.
the
output
Average
average
level
price
(APL)
SRAS
controversial
assumptions
will
initially
Monetarist /New
discuss
Classical
APL2
model
and,
Keynesian
then,
we
will
present
aggregate
supply
under
the
model.
APL1
Aggregate
New
supply
Classical
Monetarists
(and
under
the
Monetarist/
school
New
Classical
economists)
make
a
0
distinction
between
the
short
run
and
the
long
run.
Yr1
Yr2
Real
output
As
(Yr)
a
result ,
there
long-run
is
a
short-run
aggregate
supply
aggregate
supply
(SRAS)
and
a
(LRAS).
Figure
Shor t-run
aggregate
If
Within
the
aggregate
3.2.3
supply
framework,
the
short
run
is
during
which
the
average
money
wages
are
xed
and
unable
to
changes
basically
earned
what
in
per
time
is
the
average
written
on
a
price
pay
level.
slip
The
(that
money
is,
the
the
other
your
hand,
the
real
wage,
or
wage
the
is
what
you
purchasing
can
power
wage.
The
real
wage
is
rises
xed,
from
then
AP1L
the
to
real
APL2
wage
while
decreases
protability,
which
induces
them
to
and
offer
Yr2
instead
of
Yr1
.
and
thus
caused
by
shif ts
in
changes
short-run
in
aggregate
production
costs.
supply
Note
are
that
buy
of
would
have
to
be
changes
in
costs
of
production
that
your
will
money
greater
output:
Changes
period).
money
level
wage
these
with
price
remain
“dollars”
mainly
On
wages
enjoy
more
is
curve
to
rms
adjust
SRAS
the
money
period
The
supply
simultaneously
affect
most
rms
in
the
economy,
not
thus:
only
rms
of
a
particular
market .
Thus
short-run
aggregate
Wm
Wr
supply
=
will
increase
or
decrease
and
thus
the
SRAS
curve
will
APL
shif t
For
example,
if
the
Edgar ’s
money
wage
is
$60
per
day
price
of
a
small
carton
of
fruit
juice
is
$2.00
then
the
following
his
Money
wages
can
be
thought
of
as
being
30
small
cartons
of
day.
If
Edgar
continues
to
earn
$60
but
the
price
there
of
a
rises
to
$4.00
per
small
carton,
his
real
wage
money
15
of
wages
these
cartons
of
juice
per
day.
Of
course,
in
the
price
of
one
good,
we
use
the
average
instead
price
whether
wages
are
the
real
usually
wage
increased
determined
by
or
means
that
if
the
price
level
in
the
of
long
as
contracts
are
in
effect ,
the
to
for
match
the
change
explanation
based
in
on
the
the
price
idea
wages
level.
that
Energy
adjust
will
their
level)
expectations
and
only
af ter
of
ination
some
time
(of
do
There
workers
a
rising
they
is
also
are
prices
have
affected
their
purchasing
reason
is
money
that
they
wages
are
account
closely
for
the
costs.
As
long
as
money
to
part
wages
average
An
SRAS
Indirect
price
and
so
level
changes
workers,
in
real
only
the
terms,
xed,
or
“pricier ”
specically,
if
to
the
rms,
inducing
average
price
an
level
wage
either
real
offer
wage
more
decreases,
decreases
output .
then
On
the
and
the
real
in
turn
contrary,
wage
rms
if
the
increases
willing
to
offer
less
output .
The
will
output
78
sloping,
where
real
output
is
on
a
wages
a
government
short-run
aggregate
weakens
supply
the
increases
shif ts
to
the
right .
change:
changes
supply
in
in
the
the
price
same
of
way
oil
as
affect
changes
in
the
price
of
oil
decreases
in
short-run
supply
and
shif ts
short-run
the
SRAS
curve
aggregate
to
supply
the
and
lef t;
a
shif ts
curve
taxes
to
or
the
right .
subsidies
will
be
curve
the
costs
of
change:
indirect
production.
taxes,
Therefore,
such
as
higher
increase
price
turn
is
production
supply
and
costs
shif t
and
the
so
SRAS
decrease
curve
to
short-run
the
taxes
on
the
other
hand,
lower
production
lef t .
costs.
example,
rms
if
will
the
VAT
face
in
lower
Greece
costs
decreases
of
from
24%
production
leading
to
supply
to
to
increase
in
short-run
aggregate
and
a
shif t
then
willing
average
in
affect
be
the
SRAS
curve
to
the
right .
Subsidies
also
affect
production
costs.
will
costs
An
increase
in
government
subsidies
level
rms
reduce
of
production
and
so
increase
short-run
will
supply,
which
will
shif t
the
SRAS
curve
therefore
horizontal
rms’
to
right .
upward
and
money
response.
increases,
and
SRAS
curve
increases
aggregate
be
if
become
of
the
contrast ,
if
an
More
because
unions,
increase
taxes,
10%,
“cheaper ”
In
rms’
remain
real
will
curve.
aggregate
of
For
affected
rise,
supply
that
Lower
the
SRAS
aggregate
aggregate
production
production
power.
related
largest
of
aggregate
average
realize
taxes
supply
costs
short-run
a
sales
The
rms’
in
slow
•
rising
for
So,
not
the
price
the
example
prices
decrease
to
in
SRAS
aggregate
second
if,
wage.
changes,
wages.
adjust
change
contracts.
economy
money
increase,
decrease
labour
short-run
as
can
minimum
decreased.
labour
•
This
wages
the
to
and
Money
in
of
level
power
determine
a
shif t
decrease,
using
money
change
decreases
lef tward
to
a
fruit
resulting
juice
is
juice
if
per
change:
real
example,
wage
cases.
and
•
the
in
axis
A
decrease
in
government
subsidies,
on
the
to
the
the
will
raise
short-run
SRAS
production
aggregate
costs
for
supply
rms,
and
a
causing
lef tward
a
shif t
potential
allow
curve.
it
level,
An
increase
shif t
as
a
of
in
the
short-run
shif t
from
aggregate
lef t
from
SRAS
aggregate
curve
SRAS1
supply
SRAS1
to
to
supply
right ,
SRAS2.
means
to
the
means
that
A
the
shown
decrease
SRAS
in
that
there
in
curve
Figure
to
level
the
SRAS3.
price
of
Note
say
to
produce.
is
SRAS1
that
that
the
even
there
that
though
is
natural
(or
is
the
since
in
the
resources
at
its
long
and
potential
economy ’s
long-run
shif ts
to
output
has
Average
level
that
of
this
level
full
run
an
technology
or
natural
employment
is
output
referred
when
this
to
by
the
the
is
the
output
be
we
taken
economy.
some
Monetarists
and
is
labour
increases
implies
meaning
increased.
in
there
not
the
market
is
in
3.3).
supply
increased,
potential
should
unemployment ,
exists
then
of
it
unemployment
real
section
right
has
no
which
aggregate
the
capacity
is
level
(see
at
employment ,
normal)
unemployment
If
full
there
potential
equilibrium
Real
Yp,
its
output .
mean
as
SRAS2
0
Output
considered
unemployment ,
SRAS3
(APL)
to
output ,
whatever
is
At
Average
real
3.2.4
short-run
shif ts
of
produces
which
level
a
level
economy
T I N U
of
in
: 3
hand,
decrease
This
is
and
that
that
the
shown
the
the
LRAS
economy ’s
in
curve
potential
Figure
level
of
productive
3.2.6.
price
(APL)
LRAS
LRAS
Yp
Yp
output
(Yr)
Figure
3.2.4
Shif ts
in
the
SRAS
Long-run
aggregate
In
run,
the
long
money
Monetarist/New
adjusting
price
to
level
supply
wages
Classical
changes
rises
curve
by
in
the
2.4%
are
school
assumed
to
average
then
be
the
exible
price
money
by
level.
wages
and
So,
will
fully
if
the
also
increase
0
by
2.4%.
It
follows
that
the
real
wage
is
S C I M O N O C E O R C A M
other
constant .
As
Real
output
such,
(Yr)
rms
no
longer
changing
their
respond
level
of
to
changes
in
the
price
level
by
output .
Figure
Long-run
aggregate
supply
is
therefore
drawn
as
a
LRAS
curve)
to
show
that
changes
in
the
average
do
long
run
and
not
rms’
response.
real
output .
wages
protability
This
Average
level
affect
money
is
fully
do
shown
in
The
adjust
not
reason
and
change
Figure
is
thus
to
that
the
induce
LRAS
curve
shif ting
to
the
right
in
in
long-run
aggregate
supply
can
be
a
result
of
following.
the
real
an
increase
price
the
level
The
vertical
An
(the
3.2.6
wage
•
quantity
increase
output
3.2.5.
price
The
•
(APL)
in
means
that
output
and
The
quality
levels
of
of
the
the
so
of
factors
of
quantity
economy
the
LRAS
factors
education
production
of
is
to
of
shif ts
the
the
more
real
right .
improves.
improve
An
immigration
producing
to
production
skills
increases.
due
capable
curve
of
and
labour
Greater
quality
of
labour.
LRAS
Workers
•
become
shif ts
to
the
There
are
LRAS
•
of
0
Yp
Real
output
(Yr)
•
will
are
3.2.5
The
LRAS
curve
More
specically,
Classical
school,
according
the
LRAS
to
the
curve
is
it
to
to
shif t
can
the
the
When
as
a
LRAS
curve
activity
and
will
an
economy
produce
LRAS
curve
can
the
of
the
makes
a
so
the
better
greater
shif ts
to
the
in
economy ’s
bureaucracy
increase
to
equipment ,
and
Improvements
increase
amount
shif t
and
output ,
right .
changes.
the
Technological
machines
more
result
the
framework
curve
technology.
produce
to
Therefore,
Reducing
in
improved
institutional
economic
LRAS
able
will
institutional
the
lead
increases.
output .
capacity.
Figure
be
resources,
There
and
right .
can
curve
Efciency
its
productive
improvements
innovation
which
more
the
output
use
of
quantity
right .
the
productive
facilitates
produced;
right .
Monetarist/New
vertical
at
the
economy ’s
79
Recap
Monetarist/New
Short-run
Money
aggregate
wages
The
SRAS
•
average
if
•
Classical
are
curve
price
upward
level
drops,
so
if
decreases,
APL
offer
Shif ts
rms
less
of
supply
assumed
is
offer
Long-run
(SRAS)
Money
xed.
The
sloping:
(APL)
more
the
supply
real
increases,
the
real
wage
•
increases,
so
Shif ts
rms
SRAS
curve
can
•
changes
in
money
wages
•
changes
in
energy
prices
•
changes
in
indirect
the
supply
taxes
occur
or
under
due
to:
Keynesian
run
and
has
average
LRAS
at
real
curve
(LRAS)
exible.
price
the
subsidies.
the
Keynesian
school
increase
•
an
improvement
•
improvements
•
increases
•
institutional
below
school
the
long
there
run
is
and
no
so
distinction
there
is
between
only
one
AS
three
sections,
as
shown
Figure
in
in
the
Such
the
potential
level
wage
can
level
(APL)
do
is
affected.
occur
not
due
not
of
output:
affect
real
to:
quantity
in
in
the
of
factors
quality
of
of
production
factors
of
production
technology
efciency
changes.
full
an
the
employment
economy
level
operates
of
real
output
presumably
in
denoted
deep
with
recession
the
depression-like
conditions.
Unemployment
is
very
high
and
curve,
is
a
lot
of
spare
or
unused
capacity.
3.2.7.
III
is
vertical
at
the
full
employment
level
of
price
output
level
vertical
because
the
Section
Average
is
an
there
which
in
supply
assumed
•
or
short
of
are
curve
changes
Yf.
In
LRAS
output
output
wage
aggregate
wages
output .
the
Aggregate
aggregate
(APL)
Yf.
This
full
employment
level
of
output
is
typically
AS
considered
within
analysis
a
as
the
“ wall ”,
extreme
implying
Keynesian
that
there
framework
is
no
of
unemployment
III
in
the
economy.
Section
II
on
the
which
illustrates
realization
sectors
I
II
and
do
situation
capacity
in
Yf
Real
is
in
others.
reach
may
an
some
employ
may
may
in
to
It
of
with
full
but
different
resources,
together.
than
Some
others.
production:
rise
Yf.
depends
many
types
earlier
coexist
continue
of
conditions
bottlenecks
beyond
curve.
differing
employment
industries
output
AS
consists
employment
as
increase
sloping
economy
that
full
to
cannot
upward
an
full
reach
referred
Real
output
that
industries
not
industries
0
Real
This
spare
employment
as
a
result
of
output
the
capacity
constraints
in
some
industries,
wages
and,
more
(Yr)
generally,
Figure
3.2.7
The
Keynesian
AS
Note
Section
I
is
horizontal,
production
implying
that
higher
levels
of
and
rising.
will
The
output
be
produced
explanation
levels
without
lies
with
corresponding
that,
to
the
the
this
average
price
Equilibrium
Classical
Shor t-run
realization
region
are
that
level
of
strictly
speaking,
aggregate
it
supply
is
as
be
a
rising
mistake
Keynes
the
the
long
will
thus
run
in
his
analysis
of
the
and
so
will
to
was
refer
not
to
long-run
interested
workings
of
an
make
the
distinction
between
short-run
and
signicantly
Monetarist/New
supply
only
for
the
Monetarist/New
Classical
APL
SRAS
equilibrium
output
at
in
the
which
short
run
aggregate
exists
at
demand
APL
is
equal
Figure
to
short-run
aggregate
supply,
as
shown
in
3.2.8.
AD
0
Figure
80
We
long-run
equilibrium
real
in
economy.
equilibrium
the
prices.
real
model
Macroeconomic
that
in
also
level
aggregate
Macroeconomic
may
output
Keynesian
can
costs
curve
Yr
3.2.8
Short-run
macroeconomic
Yr
equilibrium
model.
economy
is
Any
in
of
level
AD
also
of
with
real
output
SRAS.
determined
The
at
Yr
is
determined
average
level
price
at
level
the
of
the
output
as
a
adjusting
result
to
any
of
money
change
in
wages
the
being
APL .
exible
Figure
and
3.2.1
1
fully
shows
this.
APL .
APL
SRAS
shif t
aggregate
equilibrium
average
demand
price
and
will
induce
output
a
levels
change
in
the
in
the
LRAS
same
if
as
the
aggregate
demand
interest
rates,
AD1
AD2.
to
output
as
Yr2
shown
then
This
as
in
change
will
well
aggregate
increases,
the
as
Figure
in
AD
lead
to
a
say,
curve
in
as
will
the
higher
demand.
a
result
shif t
short
For
to
run
average
of
the
to
example,
lower
right
higher
price
: 3
SRAS
direction
level
A1
APL1
from
at
A2
APL2
real
APL2,
APL
3.2.9.
A3
AD1
APL
SRAS
AD2
APL2
Yr2
Yp
Yr
(NRU)
APL1
Figure
3.2.1
1
aggregate
Assume
Returning
to
full
employment
following
a
decrease
in
demand
an
economy
in
equilibrium
at
point
A1
where
real
AD2
output
is
at
its
potential
level
Yp,
unemployment
is
at
its
AD1
natural
0
Figure
Yr1
3.2.9
A
shif t
in
the
AD
Yr2
Yr
is
curve
at
or,
Now
in
short-run
aggregate
supply
will
induce
changes
average
price
level
and
of
equilibrium
output
that
the
opposite
direction.
For
example,
if
oil
prices
assume
since
production
will
decrease,
costs
with
will
the
rise,
SRAS
short-run
curve
the
AD
SRAS1
to
price
SRAS2
level,
in
Figure
APL2,
3.2.10.
There
accompanied
by
to
the
output
average
price
level
and
leading
to
consumer
a
decrease
condence
in
in
the
consumption
expenditures.
shif ting
to
Aggregate
the
lef t
demand
from
AD1
decreases,
to
level
drops
from
APL1
to
APL2
and,
AD2.
since
The
in
short
run
will
lower
be
a
money
wages
are
assumed
xed,
the
real
wage
lef t
and
thus
protability
for
rms
decreases
so
that
higher
output
falls
to
Yr2.
There
is
a
movement
in
the
short
run
equilibrium
along
real
the
aggregate
shif ting
real
average
business
curve
price
increases
from
and
increase
the
supply
that
decrease,
investment
average
then,
(NRU)
are
with
in
rate
in
and
the
normal
APL1
.
economy
Shif ts
T I N U
equilibrium
intersection
S C I M O N O C E O R C A M
The
the
SRAS
curve
from
point
A1
to
point
A2.
Yr2.
Short-run
APL
AD2
SRAS2
(full
equilibrium
with
the
SRAS
employment)
is
at
curve.
level
point
Real
and
so
A2
at
the
output
is
intersection
below
unemployment
its
of
potential
rises
above
SRAS1
its
a
natural
rate
deationary
(NRU).
The
economy
(recessionary)
gap
is
characterized
equal
to
the
by
difference
APL2
between
the
equilibrium
potential
level
of
level
output
of
output
and
the
lower
Yr2Yp.
APL1
A
deationary
gap)
exists
potential
gap
when
(full
(also
referred
equilibrium
employment)
to
real
level
as
a
recessionary
output
of
is
below
the
output .
AD
0
Figure
Yr2
3.2.10
A
shif t
in
the
Yr1
SRAS
In
Yr
the
long
wages
curve
are
decrease
Long-run
equilibrium
that
the
long-run,
equilibrium
will
necessarily
be
at
potential
or
full
employment
level
of
output ,
match
the
money
wages
is
deviation
from
the
potential
level
of
output
can
only
the
short
run
because
money
wages
are
this
assumed
SRAS
curve
money
output
in
the
will
of
short-run
be
equilibrium
temporary
long-run
to
its
and
the
potential
or
from
the
economy
full
a
shift
in
factor
short-run
to
that
the
for
Monetarists,
money
price
level.
short-run
aggregate
money
wages
will
Remember
aggregate
supply
level
always
employment
shifts
to
the
right
to
SRAS’.
Since
increases
the
and
adjustment
level.
is
assumed
Also,
since
full,
the
the
real
real
wage
wage
is
returns
to
unchanged,
xed.
potential
will
decrease
reason,
wages
original
unemployment
Deviations
means
exist
its
in
For
according
as
of
any
which
the
the
economy ’s
however,
to
supply.
In
run,
exible,
level
must
return
to
its
natural
rate
(NRU)
and
of
consequently
real
output
economy
therefore
back
to
its
potential
level
Yp.
The
return
has
moved
automatically
at
point
A3.
of
81
According
(that
is,
through
for
the
to
the
Monetarists,
an
economy
deationary/recessionary
the
adjustment
government
to
of
money
intervene.
will
gap
wages.
The
bounce
will
back
close),
There
question
is
is,
no
of
APL
SRAS
LRAS
only
need
course,
SRAS
APL
how
not
fast
the
economy
specied
and
will
thus
return
the
“ long
to
full
run”
employment .
may
prove
too
It
A3
is
long
a
APL2
period,
especially
Something
for
similar
the
A2
unemployed.
happens
if
there
is
an
increase
APL1
in
AD2
aggregate
demand.
This
is
shown
in
Figure
3.2.12.
A1
Assume
output
an
is
economy
at
its
in
equilibrium
potential
level
Yp,
at
point
A1
where
unemployment
is
at
real
its
AD1
natural
Now
or
normal
assume
increase
right
in
from
and
since
real
wage
that
rate
a
reduction
aggregate
AD1
in
to
the
(NRU)
and
in
demand,
AD2.
short
The
run
the
APL
interest
which
price
money
rates
shifts
level
rises
wages
is
are
at
APL1
.
leads
the
to
AD
from
an
curve
APL1
assumed
to
to
xed,
and
thus
protability
for
rms
increases
run
real
output
along
Short-run
SRAS.
level
the
rises
SRAS
to
equilibrium
Real
and
output
so
Yr2.
curve
is
is
There
from
at
A2
above
at
its
unemployment
is
A1
a
to
the
movement
the
3.2.12
According
intersection
below
(full
its
of
AD2
with
rate
through
wages.
employment)
natural
Returning
to
the
economy
is
difference
greater
characterized
between
equilibrium
the
level
of
by
an
inationary
potential
output
level
of
gap
output
There
output
is
gap
greater
exists
and
The
the
major
model
YpYr2.
than
when
potential
equilibrium
(full
following
an
increase
in
is
an
inationary
adjustments,
no
need
for
namely
gap
the
government
will
increase
close
in
only
money
intervention.
in
the
Keynesian
model
to
difference
described
latter
is
not
mechanism.
inationary
employment
(NRU).
equal
the
An
full
Monetarists,
market
Equilibrium
The
to
demand
short
A2.
potential
falls
in
Yr
so
aggregate
that
Yr2
(U<NRU)
the
Figure
decreases
Yp
(NRU)
the
APL2
between
above
and
equipped
Within
the
the
the
with
Monetarist/New
Keynesian
an
model
automatic
Keynesian
Classical
is
that
adjustment
framework
an
economy
real
may
nd
with
less
itself
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at
an
equilibrium
level
of
real
output
employment)
than
full
employment .
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endogenous
forces
exist
output .
that
will
More
However,
in
the
long-run,
money
wages
are
assumed
restore
specically,
they
will
fully
adjust ,
matching
the
increase
in
price
level.
Short-run
aggregate
supply
easily
adjust
the
SRAS
curve
to
the
lef t
to
SRAS'.
Since
of
money
wages
is
assumed
full,
the
real
to
its
original
level.
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since
the
real
wage
unemployment
must
return
to
its
the
and
consequently
real
output
back
to
the
Yp.
point
The
economy
has
therefore
moved
It
follows
that
they
do
within
demand
is
the
driving
the
force
in
“supply
level
of
economic
creating
its
own
activity.
demand”
Instead
(Say ’s
Classical
school
of
thought ,
which
included
rate
fathers
automatically
Keynes
of
monetarism
turned
things
and
inside
the
out ,
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Classical
postulating
that
at
A3.
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Adjustments
The
case
•
decrease
A
lead
of
to
money
a
A
of
a
the
in
aggregate
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are
in
output
gap
will
will
fall
model
The
demand
the
rms
Classical
gap
in
average
assumed
inducing
deationary
real
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deationary
wages
increase,
•
in
to
xed,
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reduce
arise
since
below
the
the
price
short
level.
real
run
will
•
wage
case
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money
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equilibrium
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level
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in
aggregate
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in
the
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demand
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level.
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potential
an
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output .
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to
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arise
since
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real
run
will
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wage
will
output .
the
equilibrium
potential
output
level.
•
In
the
long
adjust
and
average
so
will
run,
price
the
money
decrease
level.
to
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potential
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match
real
level
of
are
the
wage
exible
and
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will
be
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will
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restored
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and
will
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the
money
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need
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will
the
intervention.
•
82
long
average
output .
government
the
adjust
and
so
•
law
the
potential
school),
level
“sticky
but
is
natural
its
aggregate
equilibrium
intellectual
(NRU)
downwards).
model,
believing
from
unchanged,
assumed
increase
wage
of
returns
are
may
the
behind
adjustment
wages
wages
decreases,
Keynesian
shif ting
money
(money
the
not
average
employment .
exible
downwards”
and
full
intervention.
and
demand”
determines
economy.
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insufcient
for
to
the
(which
we
equilibrium
whatever
establish
reason,
full
call
level
aggregate
of
real
aggregate
employment
demand)
output
in
demand
then
a
an
proves
curve
to
remain
rise
from
will
suffer
a
system-wide
failure,
as
it
will
be
its
own
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is,
without
the
help
of
the
government)
full
employment
the
economy
operating
at
consumer
condence
full
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now
AD1
to
AD2.
the
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real
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APL2.
the
ab
can
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referred
Monetarist/New
to
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the
vertical
axis
as
in
the
strict
the
gap
interpretation
conditions.
of
Consider
APL1
from
(remember
to
is
restore
Yf
unable
gap.
on
right
at
market
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economy
the
will
shown
in
employment .
Figure
A
3.2.13,
collapse
in
Keynesian
model,
full
employment
refers
to
zero
unemployment .
initially
business
the
and
APL
demand,
and
the
causes
AD
curve
a
decrease
shif ts
to
in
the
AS
aggregate
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from
AD1
b
to
AD2.
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employment
level
(recessionary)
real
of
gap
output
output
equal
to
Yf.
Yr2
is
Thus,
below
there
the
is
a
T I N U
“effective
: 3
is
that
APL2
full
deationary
Yr2Yf.
a
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AS
AD2
AD1
Yf
Figure
Note
AD1
3.2.14
that
still
be
it
to
The
the
inationary
idea
of
incorporated
gap
the
in
within
natural
the
the
Yr
Keynesian
rate
of
Keynesian
diagram
unemployment
model.
The
way
can
to
do
S C I M O N O C E O R C A M
it
AD2
Yr2
Yf
Yr
level
of
Figure
3.2.13
The
deationary
(recessionary)
gap
within
the
is
dene
of
the
real
AS
as
the
output
curve
full
to
would
employment
the
lef t
of
intersect
level
where
the
of
the
output
vertical
horizontal
axis.
some
section
This
is
Keynesian
shown
in
Figure
3.2.15.
diagram
APL
As
mentioned
money
wages
adjustment
full
are
a
stuck
level
level.
of
The
“sticky
in
level
a
real
output
government
aggregate
This
be
can
or
push
the
output .
that
must
demand
achieved
loose
the
downwards”.
to
of
to
Keynesian
There
either
monetary
is
below
therefore
and
the
(see
full
to
the
economy
gap;
full
automatic
back
an
AS
school,
no
that
may
is,
employment
intervene
restore
through
policy
is
economy
Therefore,
deationary/recessionary
increase
policy
according
mechanism
employment
remain
at
above,
in
order
to
employment .
expansionary
sections
3.6
scal
and
3.8).
AD1
An
a
inationary
Keynesian
not
gap
is
diagram,
interested
in
more
as
cumbersome
Keynesian
investigating
to
analysis
inationary
illustrate
was
within
AD
originally
conditions.
0
In
any
case,
vertical
if
aggregate
section
inationary
of
gap
a
is
demand
Keynesian
said
to
be
increases
AS
curve
within
(section
3.2.14
shows
an
III)
then
an
Figure
3.2.15
economy
at
the
full
employment
Yf.
causes
aggregate
A
rise
in
business
Yr
An
alternative
on
the
Keynesian
inationary
gap
increase
and
consumer
condence
of
aggregate
demand
to
AD1
creates
an
of
inationary
output
Y1
created.
The
Figure
Yfe
the
gap
equal
to
distance
YfeY1
on
the
horizontal
now
axis.
demand
to
increase
and
thus
shif t
the
AD
83
3.3
Macroeconomic
Economic
Meaning
Economic
through
growth
of
the
growth
economy
objectives
over
term
refers
time:
it
to
is
The
an
increase
dened
as
in
an
the
size
increase
of
of
real
most
important
economic
an
GDP
•
time.
growth
Improved
consumer
increased
spending
increase
Measuring
economic
growth
rate
is
the
percentage
change
in
real
two
periods.
The
periods
are
usually
two
years
Short-term
could
be
two
quarters.
So,
for
example,
the
growth
an
economy
in,
say,
2020
(compared
to
2019)
as
−
growth
lower
would
short-term
condence
in
the
(C)
and
short
leading
rms
(I)
to
may
term.
may
interest
result
rates
from
a
decrease
decrease
the
cost
in
interest
of
borrowing
households
build
and
houses,
to
rms,
buy
who
may
consumer
borrow
more
durables
or
to
to
buy
buy
be:
machines
rGDP
or
build
factories.
Lower
interest
rates
may
also
rGDP
20
Growth
to
rate
or
for
business
households
growth
lead
but
for
they
may
following.
GDP
rates
between
economic
and
by
that
the
growth
•
The
factors
include
19
lead
=
×
to
a
depreciation
of
the
exchange
rate
which
makes
and
imports
100
2019→2020
rGDP
exports
cheaper
and
more
competitive,
pricier
19
and
Using
actual
data
to
calculate
the
US
growth
rate
in
of
real
GDP
in
2019
=
$19,220
GDP
in
2018
=
$
18,783
billion.
19220
Growth
in
2019
attractive,
so
that
net
exports,
another
component
aggregate
demand,
increase.
billion
•
real
less
2019:
An
a
•
−18783
=
×
100
=
increase
in
component ,
A
decrease
in
government
would
expenditures
directly
(direct)
increase
taxation
would
(G)
which,
aggregate
increase
being
demand.
disposable
2.33%
income,
which
could
lead
to
an
increase
in
consumption
18783
This
means
If
the
it
would
that
growth
the
rate
mean
US
economy
gure
that
this
for
a
grew
country
economy ’s
in
in
real
2019
2019
GDP
by
was
−2.5%
2018
and
2019,
so
this
economy
(C).
expenditures
and
as
expansionary
was
in
the
A
depreciation
growth
rate
for
another
economy
in
2018
was
trading
then
one
year
later
it
was
at
2.85%
this
lower
does
not
positive,
slower
is
mean
in
that
real
the
recession.
GDP
economy
Since
the
decreased
continued
growth
to
grow
or
rate
in
that
is
net
also
be
calculated
using
2019,
but
at
a
To
show
per
capita
Growth
over
This
to
resources.
the
short
to
the
thus
growth
Potential
that
(or
is
full
a
result
of
greater
employment)
use
output
of
Growth
is
In
not
could
over
increasing
a
rms
thus
to
rate,
decrease
faster
in
the
growth
degree
of
of
face
can
all
lead
to
an
increase
growth.
growth
leading
growth
you
can
use
diagram
to
growth.
the
short
term
is
a
result
of
aggregate
as
an
increase
in
aggregate
demand
increase
potential,
in
or
real
full
GDP
(assuming
employment ,
the
an
a
Keynesian
where
increase
the
in
AD
real
or
a
curve
The
effect
of
such
output
an
is
demand
can
lead
shif t
not
at
the
right
prove
rise
in
to
growth
the
for
a
increases
variety
any
of
reasons.
component
of
increase
it
to
the
aggregate
investment
exports
(I)
right
and
demand
and
(NX).
increase
includes
government
real
output .
consumption
(G)
on
the
size
of
original
output .
close
to
the
in
increase
generating
its
potential
in
aggregate
growth
(full
if
demand
the
economy
employment)
demand
would
mostly
lead
to
a
as
rise
only
a
small,
if
any,
increase
in
real
in
GDP
.
in
aggregate
Classical
demand
model
would
(Figure
prove
3.3.1b),
ineffective
an
if
was
operating
past
potential
real
output.
The
the
original
any
to
level
of
illustrate
real
any
output
growth
must
in
lie
real
to
the
GDP
left
that
is
of
potential
not
temporary.
Remember
The
(C),
expenditures
also
the
demand
output
shif t
but
on
and
Technically,
aggregate
ineffective
Monetarist/New
equilibrium
that
real
model,
aggregate
with
economy
factor
of
demand
depends
its
In
to
level
GDP
to
output).
increase,
real
aggregate
Keynesian
increase
Aggregate
in
on
demand
will
economy
demand
operating
prices
84
exchange
and
Classical
right ,
increase
the
the
net
referred
existing
was
that
are
policy.
shor t-term
economic
aggregate
the
term
affected.
will
the
and
short-term
equilibrium
refers
lead
government
gures.
in
an
in
taxes
real
and
GDP
direct
the
shif ts
can
of
domestic
exports
Monetarist/New
rates
increase
in
still
rate.
Growth
scal
partners
Illustrating
economy
an
growth
in
rate
that
decrease
3.45%
protection
and
a
recession.
our
If
Note
decreased
•
between
expenditures
2.33%.
as
well
as
Keynesian
show
any
that
an
increase
diagram
increase
in
the
(Figure
in
3.3.1a)
aggregate
average
price
should
demand
level.
be
may
used
not
to
lead
to
Growth
model
Growth
over
over
the
the
long
long
term
T I N U
Keynesian
term
is
a
result
of
more
or
better
AS
becoming
technology.
Any
employment)
The
•
are
i n c re a s e
of
w o r ke r s
of
re a s o n s .
factor
output
following
An
AD2
available
that
in
will
implies
some
the
of
of
for
of
improved
increase
potential
growth
the
size
ava i la b l e
and/or
most
the
over
may
(full
long
important
la b o u r
work
the
term.
: 3
resources
factors.
f o rc e .
The
i n c re a s e
for
number
a
va r i e t y
AD1
Y1
Y2
Real
output
an
inux
Fo r
of
e x amp l e ,
m i gra n t
an
i n c re a s e
w o r ke r s ,
or
an
in
p o p u lat i o n ,
i n c re a s e
in
the
(Yr)
pa r t i c i pat i o n
e x amp l e ,
(b)
Monetarist/New
Classical
of
rat e
of
some
women)
will
p o p u lat i o n
i n c re a s e
the
gro u p
size
(for
of
the
la b o u r
model
f o rc e .
APL
LRAS
SRAS
•
An
increase
in
investments
labour
•
An
stock
of
education
human
and
capital.
health
care
Past
will
increase
productivity.
increase
more
the
in
in
the
machines
stock
and
of
more
physical
factories,
capital.
then
If
the
there
are
productive
AD2
capacity
of
the
economy
increases,
leading
to
long-
AD1
term
growth.
becoming
Y1
Y2
Yp
Real
Note
that
available
is
more
a
and
most
better
infrastructure
signicant
contributing
output
factor
for
a
country
to
achieve
and
sustain
economic
(Yr)
growth
Figure
3.3.1
demand
Growth
in
the
short
term
through
a
shif t
right
of
Figure
•
Historically,
3.3.1a
and
3.3.1b,
aggregate
demand
shif ts
to
from
AD1
to
AD2
leading
to
an
increase
in
real
the
Y1
to
Y2
and
thus
to
short-term
can
also
illustrate
curve
short-term
(PPC)
growth
diagram.
agriculture,
located
moving
towards
Such
of
a
goods.
of
this
existing
would
Think
growth
using
of
and
to
more
would
not
be
be
the
of
an
units
and
the
a
Z
(combination
F).
Greater
greater
will
Advances
it
now
to
produce
not
of
Figure
of
good
An
in
and
since
have
of
combination
and
use
run
X
and
Z2
produced
units
while
of
the
good
Z.
Since
production
with
more
of
(AB),
actual
growth
has
been
services
in
have
potential
been
output
past
two
for
centuries.
to
and
further
communication
increase
potential
technologies
output .
help
in
X2
units
both
possibilities
which
achieve
a
more
in
the
framework
economic
growth
exible
product
supply
potential
in
the
labour
to
rules
long
can
the
place)
Less
and
also
right
and
takes
term.
market
markets
(LRAS)
(the
activity
more
shif t
and
long-
lead
to
an
output .
of
long-term
growth
growth
can
be
illustrated
through
a
shif t
to
the
of
of
the
Keynesian
AS
curve
or
the
Monetarist/New
goods
remain
LRAS
curve
so
that
full
employment
real
output
the
output)
increases
(see
Figure
3.3.3).
achieved.
G row t h
Good
growth
resources
(potential
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ax
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to
measure
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baskets
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young
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old
also
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and
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the
and
cost
urban
of
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published
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rate
of
total
devotes
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thus
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the
+
by
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to
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should
more
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services
it
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and
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that
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the
cost
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than
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goods
and
services
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lot
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other
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ice
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products
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more
expensive,
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cream.
may
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much
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goods
price
product .
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pensions,
of
cheaper
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buyer.
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of
car
tyres.
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new
each
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is,
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average.
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we
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average
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consumer
few
prices
miles.
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and
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households
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others
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99
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bit
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as
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rate
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n
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=
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total
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purchasing
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statistical
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expenditures
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people
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groceries
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goods
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electronics,
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month
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to
much
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retail
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true
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ination.
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rate
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low
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interest
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rate
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year
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saver
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$100.00
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households
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the
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expensive
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assets
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as
houses
expected
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or
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art
or
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gold,
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ination.
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way,
Recap
ination
Limitations
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measuring
poor
to
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national
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income
income
away
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ination
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CPI
consumers
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only
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prices
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e-shops
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though
time
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its
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good
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price
stability
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will
for
creates
many
Ination
hurts
Ination
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increases
even
signicant
explained,
for
investment
or
not.
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increase?
of
fast
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produced
prices
project
two
will
will
what
or
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it
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rates
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on
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money
power
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incomes
incomes
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How
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good
adjust
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economic
income)
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well
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others.
than
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buy
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competitive
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to
import
widen
Decreasing
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trade
export
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be
to
depreciate
explained
in
and
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sections
lead
may
3.5
to
exert
and
more
It
distorts
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signalling
4.5.
power
that
market
If
a
price
to
prices
signal
cannot
be
responsible
economy.
signal
all
is
are
is
sure
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producers
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price
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as
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want
ination,
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demand
result .
may
induce
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debt .
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families
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to
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face.
whether
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economic
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proving
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•
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higher
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proves
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borrowers
worth
•
T I N U
to
tend
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online
again
S C I M O N O C E O R C A M
from
ination
in
the
economy.
savings,
95
chasing
that
af ter
too
“ination
is
few
goods”.
always
and
Monetarists
everywhere
consider
a
monetary
Recap
phenomenon”.
Costs
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high
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Uncertainty
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growth.
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purchasing
pensioners
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power
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inequality
an
of
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widens
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against
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can
whereas
fast
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thus
then
follow.
quantitative
too
this
much
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easing,
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be
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the
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supply
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prices
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aggregate
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lose;
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it
is
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policymakers
negative.
are
credible
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price
stability
will
be
maintained.
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AS
price
Causes
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level
ination
(APL)
Analytically,
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to
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APL2
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cost-push
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once
latter
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is
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inationary
AD2
process
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it
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difcult
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two.
Demand-pull
ination
Y1 Y2 Yfe
Any
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Real
may
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Figure
risk
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in
the
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chance
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Figure
level.
demand
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Unfortunately,
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it
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be
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Aggregate
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demand
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in
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clear
The
3.3.9,
ination.
result
aggregate
Demand-pull
deationary
pull
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3.3.9
an
In
economy
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the
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Figure
3.3.9
that
the
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increase
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output
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government
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worth
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the
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equipped
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money
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is
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2020
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Friedman
considered
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as
addition,
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at
rate
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sidelines”)
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impose
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welfare
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grade,
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debt .
governments
pressure
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it
forced
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lead
pay
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literature
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how
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indicators
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important .
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interest
reveals
rates
how
and
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rate
country ’s
of
the
income
debt
repayment
obligations
ability
are
is
rising
compared
to
how
fast
its
rising.
condition
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important .
If
debt
“primary
its
balance,
rising
budget ”
and
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government
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country ’s
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it
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expenditures
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“risk
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default .
that
rate
to
even
The
capital.
Debt
that
accumulates
as
a
result
of
budget
risk
from
tax
cuts
is
also
risky
since
the
literature
shows
higher
that
premiums
a
roughly
and
decits
premiums
GDP
.
when
debt
help.
nation’s
premium”
its
on
to
prospect
there
downgrade
condence
borrowed
rates
of
defaulted
low.
country
agency
lose
30%
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speculative
lowest
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whereas
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clearly
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easy
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debt
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to
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recovering
the
rates,
activity
if
also
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income
on
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of
be
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potential
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austerity
the
debt
levels
debt
As
are
that
may
reductions
vulnerable
further
and
is
than
hurt
sector
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include
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population
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3.5
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Credit
Efforts
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default .
increase
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investments
painful
economic
even
not
decreases
foreigners
tax
as
level
and
to
excluding
domestic
to
A
slowly
are
infrastructure
indirect
which
the
least
as
unsustainable
noting
ratio,
growth
ination
taxes
wages
the
is
nature
disproportionately
government
“monetizing”
refers
face.
service
money.
existing
decides
This
residents
The
taxation
is
adopt
of
painful
Infrastructure
impacting
regressive
and
debt
be
Increasing
When
Governments
is
decreasing
unemployment
groups.
also
Such
government
risk
Resources
servicing
ability
in
buyers
increased
to
necessary
is,
debt
by
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can
and
population
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most .
(explained
the
a
spending.
country
(that
lend
and
Governments
infrastructure,
suffer
nance
the
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pensions
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diverted
recession.
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the
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must
discretionary
policy
severe
back
ratio
costs
deny
scal
expenditures.
not
paying
servicing.
have
also
in
opportunity
invested
health
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is,
high
debt-servicing
ability
could
a
debt–to–GDP
expenditures
Rising
(that
that
which
expenditures
debt
servicing
carries
so
decits
and
surplus,
government
policies.
Spending
Cost
budget ”
costs,
budget
expenditures
austerity
Costs
“primary
exceeding
T I N U
is
: 3
it
S C I M O N O C E O R C A M
Why
corporate
tax
cuts
lead
to
small,
if
any,
additional
private
economy
investment .
becomes
trapped
in
a
debt
crisis.
Lastly,
Impact
on
future
taxation
and
explosive
country ’s
spending
If
to
the
cut
debt
to
the
GDP
spending
ratio
and
is
raise
high,
tax
governments
revenues.
debt
problems
are
less
likely
if
most
of
a
government
They
will
will
be
forced
need
to
case
of
Countries
currency
national
Japan,
heavily
face
debt
and
is
held
domestic
denominated
depending
greater
by
on
in
its
external
debt-related
investors,
domestic
borrowing
as
in
currency.
in
foreign
risks.
101
Policymakers’
However,
perspective
if
unchecked,
debt–to–GDP
Historically,
it
has
become
painfully
clear
to
a
countries
that
the
debt–to–GDP
ratio
is
an
lead
to
a
requiring
very
close
monitoring.
Debt
increased
government
expenditures
may
help
a
grow
a
from
and
it
natural
a
recession
will
be
(as
will
necessary
if
be
a
explained
country
and
rising
unsustainable.
debt
crisis
that
will
require
very
It
painful
for
jeopardize
the
the
population
country ’s
of
the
growth
country
and
prospects
for
it
may
a
country
long
recover
high
nancing
also
of
a
become
economic
adjustments
variable
then
may
number
may
of
ratio
later)
suddenly
time.
and
faces
disaster.
HL
The
Phillips
Trade-off
Why
curve
between
unemployment
the
shif ts
and
Phillips
in
curve
aggregate
is
compatible
demand
(a)
ination
Average
The
original
Phillips
the
relied
on
early
1960s
AS
curve
price
Since
with
and
until
the
mid-1970s
level
economists
(APL)
a
New
an
empirical
Zealand
result
economist
that
at
the
Alban
W
London
Phillips,
School
of
APL2
Economics,
curve,
published
became
one
in
of
1958.
the
His
most
work,
famous
the
Phillips
relationships
APL1
in
macroeconomics.
APL3
His
original
annual
statistical
percentage
work
change
examined
in
money
UK
data
wages
on
and
the
the
annual
AD2
unemployment
rate
over
a
period
of
96
years
(from
1861
AD1
to
1957).
He
found
that
the
percentage
changes
in
money
AD3
wages
and
the
unemployment
rate
were
inversely
related.
Y3
•
If
unemployment
market)
then
employers
was
money
were
low
(which
wages
forced
to
implied
increased
offer
a
higher
a
lot
“ tight ”
Y1
Y2
Real
output
labour
(Yr)
because
wages
to
nd
(b)
workers.
Ination
•
If
unemployment
was
high
(a
“slack”
labour
market),
then
rate
money
even
wages
decrease
workers
would
increase
because
without
rms
having
to
but
only
could
offer
by
nd
more
a
little,
and
than
hire
last
or
(π)
could
additional
A2
year ’s
π2
prevailing
Moving
money
from
wage.
wage
ination
to
price
ination
was
the
A1
π1
next
of
step.
Since
production
of ten
set
wages
costs
prices
by
typically
and
since
adding
a
form
rms
a
in
big
the
percentage
proportion
real
world
mark-up
A3
on
Phillips
π3
their
average
decreasing
in
the
cost ,
it
seemed
unemployment
average
price
level.
sensible
would
The
to
lead
expect
to
empirical
an
curve
that
increase
results
showed
U2
that
there
was
indeed
a
trade-off
between
the
U1
U3
Unemployment
ination
rate
rate
the
and
the
unemployment
unemployment
businesses
rate
compete
rate
of
decreases,
for
fewer
an
economy.
ination
worker s
and
increases
this
drives
as
Figure
3.3.12
which
leads
to
an
increase
in
inverse
and
it
is
relationship
compatible
is
with
referred
our
to
simple
as
the
AD/AS
Phillips
model.
curve
Now
real
on
Figure
output
look
at
on
the
Phillips
3.3.1
2a,
equal
shown
point
at
economic
Y1
Figure
economy
Equilibrium
102
effect
curve
of
shif ts
in
aggregate
demand
assume
the
economy
at
equilibrium
prices.
with
This
The
up
Focusing
wages,
(U)
When
to
and
Let
will
average
There
some
will
is
level
some
demand
increase
decrease
price
at
to
Y2.
APL1
.
ination
unemployment
aggregate
output
activity
the
3.3.1
2b.
π1
A1
.
real
and
increase
The
unemployment
in
equal
to
higher
to
U2.
this
to
U1
,
AD2.
level
The
of
level
rises
though,
so
ination
is
now
higher
at
T I N U
price
LRPC
Ination
π2.
We
have
moved
from
point
A1
to
point
A2.
Following
the
rate
increase
from
in
U1
aggregate
to
U2,
demand,
while
ination
unemployment
has
increased
has
to
(π)
decreased
π2.
A7
7%
If
A6
real
demand
output
would
had
instead
have
decreased
decreased
from
from
Y1
to
AD1
Y3.
to
The
AD3,
lower
: 3
aggregate
A5
level
U1
of
to
economic
U3.
The
activity
decrease
will
in
increase
the
unemployment
average
price
level
4%
from
implies
A4
that
SRPC
ination
decreases
from
π1
to
π3.
We
have
moved
from
point
(4%)
A3
2%
A1
to
point
A3
on
Figure
3.3.1
2b.
Following
the
decrease
in
A2
A1
AD,
unemployment
inverse
increased
relationship
between
and
ination
decreased.
unemployment
and
This
ination
1%
SRPC
SRPC
exactly
the
If
what
original
this
the
inverse
as
to
lower
It
could
using
the
rate
and
then
many
to
years,
but
The
by
the
considered
a
at
issue
“menu
the
at
for
many
aggregate
many
could
of
considered
the
(by
achieve
it .
the
1970s,
not
only
did
this
stable
most
used
equal
1%.
to
by
and
unemployment
break
down
but
It
the
most
prominent
Monetarist
short
that
in
the
long
run
there
is
no
ination
and
will
the
long
run,
what
aimed
to
also
that
any
such
they
such
to
at
the
cannot
decrease
inverse
exist ,
called
the
increase
attempt
cost
relationship
but
in
the
natural
rate
by
only
aggregate
natural
rate.
accelerate
are
assumed
rms
will
decrease
to
real
3.5%
GDP
higher
to
2%.
xed,
want
now
to
beyond
aggregate
Since
the
real
produce
in
the
wage
hire
more
workers.
more
Unemployment
to
3.5%
and
A2
the
along
economy
the
has
short-run
moved
Phillips
on
Figure
curve
reects
workers
expecting
1%
ination.
SRPC
This
could
only
of
higher
between
long
run
ination
and
unemployment
According
to
Friedman,
the
a
result
negatively
of
workers
sloped
being
short-run
temporarily
Phillips
fooled.
curve
They
In
ination
at
1%
but
it
increased
to
2%.
Workers
He
temporarily
ination.
along
the
pursuing
demand.
slow
to
the
realize
that
ination
is
higher
than
they
had
lower
short
and
that
consequently
their
real
wage
is
lower.
If
run,
refer
back
to
the
Monetarist
AD/SRAS
diagram
we
have
unemployment
would
return
long-run
along
the
economy ’s
SRAS
curve:
at
a
higher
average
to
price
its
and
the
time
expansionary
expand
of
with
the
year.
to
rate
(using
to
some
next
attempts
natural
result
now
wages
will
point
that
moved
did
trying
a
for
ination
demand
As
will
4.5%
A1
unemployment
we
an
the
point
trade-off
expected
unemployment
ination
1%
at
unemployment ,
Milton
are
showed
Yp.
of
government
essentially
level
and
expect
initially
rate
unemployment .
policymakers
Friedman
that
4.5%,
the
decrease,
so
expected
policies
(U)
economist ,
is
below
economy
aggregate
money
movement
In
rate
between
(1%)
between
Unemployment
curve
natural
below
ination
run
3.3.13
showed
is
potential
decreases
Friedman,
being
that
increasing
output
ination
Phillips
an
the
Workers
now
demand,
and
at
unemployment
its
desirable.
relationship
NRU
(4.5%)
long-run
shows
example
rate
In
The
3.3.1
3
policies).
were
ination
Figure
Assume
two
demand
countries
combination
of
government
of
3.3.13
unemployment
a
ination,
cost
Figure
U’
(3.5%)
years
inviting
achieve
higher
the
(1%)
is
perhaps
choices”
the
policymakers
government
for
combination
manipulating
in
could
could
of
but
3.3.1
2b
Phillips.
and
of
cost
was
desired
whichever
AW
ination
ination
policies),
Figure
of
policymakers
policymakers
achieve
unemployment
was
lower
so
work
governments
with
politically
demand-side
trying
curve
unemployment .
variables
then
seemed
achieve
the
between
stable,
Phillips
described
from
policymakers
intervene.
determine
For
was
unemployment
they
higher
to
The
presenting
them
or
it .
curve
resulting
relationship
unemployment
exploit
Phillips
curve
(2%)
is
S C I M O N O C E O R C A M
average
level,
real
output
is
greater
and
so
unemployment
is
Phillips
lower.
curve
is
vertical
at
the
natural
rate
of
unemployment ,
which
is
In
also
the
The
The
a
equilibrium
logic
distinction
long-run
Friedman
Phelps.
and,
or
According
ination
year ’s
to
Workers
became
theory,
money
rate
by
short
was
illusion.
to
be
the
as
slow
to
realize
uses
demand.
run
only
long
run,
that
or
as
the
is
of
workers
previous
ination
Ed
wages
though,
They
realize
expect
ination
next
rates
when
increase
are
will
be
to
its
Real
workers’
that
back
run
expectations
ination
will
in
its
real
equilibrium
output
is
will
at
adjusted
Phillips
workers
curve
now
to
is
now
original
is
natural
they
expect
money
rate
at
about
higher
Figure
expect
to
higher
2%
to
shift
are
level,
ination
(at
2%)
run
increase.
and
its
(see
to
right
to
the
real
We
left.
that
at
2%.
adjust
will
in
will
the
return
3.3.1
3).
level
Workers’
AD/
Firms
to
wage
say
Figure
SRPC
As
assumed
potential
3.3.1
3.
money
Monetarist
the
level.
long
Unemployment
ination
the
the
the
wages
4.5%
to
in
and
price
return
in
start
equilibrium
in
shifted
will
curve
“restored”.
also
A3
Since
decrease
average
wage
and
they
SRAS
Since
the
thus
has
the
start
point
wages.
exible,
workers.
to
the
money
increase,
changes
economy
have
assumed
wages
ring
to
long
higher
diagram
return
expectations).
to
demand
fully
workers
increasing
policies
will
SRAS
between
result
adjust.
money
curve.
trade-off
the
and
Milton
Phelps-Friedman
Phillips
adaptive
(expansionary)
(SRPC)
by
will
curve
economist ,
Specically,
same
curve
introduced
another
known
any
Phillips
Phillips
was
backward-looking
government
aggregate
short-run
(LRPC)
unemployment
as
are
a
long-run
expectations-augmented
this
from
to
curve
the
unemployment .
independently,
ination
(referred
of
ver tical
between
theory
the
and
suffering
the
Phillips
Their
critique
the
of
rate
Yp.
The
expectations
The
(2%)
short-run
because
ination.
103
If
the
government
below
it
its
would
workers
natural
need
to
would
insists
4.5%
on
rate
engineer
again
be
trying
by
to
decrease
increasing
even
higher
temporarily
unemployment
aggregate
ination
fooled
and
so
demand,
that
potential
to
now
accept
without
realizing
immediately
that
their
real
expect
wage
In
Figure
3.3.1
3,
ination
would
have
to
follows
rise
for
The
movement
unemployment
to
drop
again
to
3.5%
(point
point
A3
to
point
A4
along
the
that
so
was
because
2%
but
workers
ination
were
fooled
increased
to
again.
They
has
in
been
the
NRU.
the
long
will
run,
adjust
since
and
money
wages
increase
so
are
that
economy
would
assumed
the
real
move
back
at
its
to
point
4.5%
is
A5
on
natural
SRPC
rate
(4%)
and
at
the
long-run
Phillips
In
the
short
run
there
is
a
run,
when
wage
expectations
has
increased
have
and
restored,
the
Phillips
curve
will
be
the
real
vertical
is
no
and
trade-off
in
the
long
run
between
ination.
is
symmetric
trade-off
gap
will
to
the
earlier
automatically
analysis
close
of
why
according
to
any
the
is
model.
vertical
Remember,
at
the
the
potential
long-run
level
of
aggregate
real
output
supply
(Yp)
unemployment
is
at
its
equilibrium
natural
rate.
The
problem
what
is
the
that
NRU
policymakers
of
the
do
country
not
is
know
equal
for
to.
curve
•
•
long
money
its
sure
and
they
period.
with
output
•
short-run
shif ted
and
restored.
Recap
The
have
exible,
wage
where
unemployment
the
the
There
analysis
(LRAS)
The
will
adjusted
expected
Monetarist
they
next
curve
have
4%.
inationary
In
Phillips
expectations
SRPC
This
ination
ination
that
unemployment
(2%)
short-run
A4).
at
from
4%
The
workers’
to
wage
4%
Yp.
as
has
adjusted
decreased.
level
(4%)
job
It
offers
SRPC
The
NRU
is
not
the
same
across
time
or
for
all
between
countries.
unemployment
and
ination.
•
•
In
the
long
run,
there
is
no
It
follows
growth
•
In
the
the
•
Any
by
long
natural
run
attempt
to
increasing
lead
to
there
rate
of
only
one
rate
unemployment
lower
of
demand
unemployment ,
more
below
will
be
the
futile
may
NRU
and
policy
workers
not
growth
only
or
perspective
implication
of
this
analysis
is
in
and,
should
not
adopt
policies
aggregate
demand
its
potential
its
natural
level
rate.
and
in
and
Any
order
to
to
increase
decrease
attempt
to
real
output
unemployment
do
this
what
in
this
monitoring
the
long
means
how
whether
run
prove
that
much
it
is
natural
will
very
decrease
have
result ,
even
found
brakes
soon
allow
a
more
job.
In
enough
ination
unemployment
If
low
levels,
probably
time
ination
to
is
is
what
is
must
and
thousands
contrast ,
to
to
slow
they
down
rise.
down
around
sloped
short-run
the
is
for
this
In
though,
was
going
to
rise.
be
the
Many
NRU
for
questioned
the
USA .
whether
curve
relationship
still
holds.
Articles
the
were
or,
whether
perhaps,
just
the
Phillips
curve
“hibernating”.
was
One
dead
or
explanation
observed
precisely
suggest
They
corner.
Phillips
phenomenon
how
much
is
that
it
is
impossible
unemployment
is
to
structural
much
curve
is
cyclical.
Since
structural
and
unemployment—the
the
that
type
will
The
fear
idea
time,
of
unemployment
the
NRU
is
not
in
the
constant
NRU—can
either.
The
change
NRU
is
it
a
xed
percentage
through
time
or
across
countries.
that
of
addition,
relationship
as
we
have
mentioned
earlier,
discouraged
a
rejoining
the
labour
market
and
nding
a
job
may
is
obscure
the
issue
as
this
causes
the
unemployment
fear.
rate
USA ,
decreased
decreasing
also
responsible
not
wondering
workers
negatively
had
decreasing
may
growth.
the
rate
keep
considered
unemployment
policymakers
slow
just
unemployment
believed
did
written
In
104
down
when
below
not
strange
slowing
increase
through
the
of
reached
futile.
policymakers
approaching
rate.
The
Phillips
dominant
higher
a
inverse
how
is
could
the
as
was
ination
know
to
risk
been
above
of
Practically,
fast
the
has
increase
attening
country ’s
run
NRU
clear.
to
Still,
and
the
could
apply
ination.
below
Governments
ination
that
unemployment
(NRU).
unemployment
aggregate
policymakers
fearing
ination.
Policymakers’
The
is
that
trade-off.
during
on.
falling
unemployment
global
nancial
crisis
The
the
last
country
since
the
without
decade
had
end
an
of
something
been
the
increase
experiencing
2008−09
in
money
wages
it
to
decrease
could
be
remaining
wages
the
very
and
without
result
low
rms
of
so
do
wages
that
not
or
prices
expectations
workers
start
of
do
asking
rising.
future
not
for
Lastly,
ination
demand
higher
higher
prices.
The
ideas
versus
of
distribution
same
of
as
what
equality
of
extreme
inequality
Economic
The
and
equity
Equity
Different
equitable.
of ten
means
societies
Although
is
unfair,
have
there
there
arise
is
in
fairness,
is
a
relation
which
different
general
the
not
the
perceptions
consensus
little
to
is
that
on
the
sake
desirability
or
on
what
Nonetheless,
the
share
of
of
inequality
equity
economic
relates
to
the
unequal
distribution
of
and
are
Organisation
the
are
same.
of ten
A
used
interchangeably
pensioner
living
in
a
$500,000
pension
as
pays
might
her
having
understand
Household
per
period
include
a
the
be
just
low
considered
$100
a
time
rent,
income.
difference
income
of
wealthy,
week,
most
but
if
would
is
This
is
why
between
generated
from
wages,
households
time—minus
the
use
interest
from
of
and
it
is
income
the
factors
prot.
important
bank
and
their
own—the
what
they
deposits,
can
or
typically
the
a
may
wealth.
use
value
owe
shares,
wealth
but
Wealth
is
consume
Given
higher
average
year
and
so
on
that
of
their
(that
is,
bonds,
to
consists
assets
their
at
debt).
houses,
consume
less
household
than
wealth
average
average
is
than
income
household
distributed
inequalities
to
cars
more
in
more
wealth
inequalities.
Measuring
The
income
graphically
Economic
is
an
Co-operation
and
intergovernmental
their
income
income.
in
OECD
net
than
In
tend
fact ,
to
be
across
more
economic
distribution
using
a
in
Lorenz
an
the
and
The
economic
OECD
shape
policies
and
that
well-being
foster
for
prosperity,
equality,
all.
is
twice
the
level
because
of
income
wealth
inequality
can
itself
on
average.
generate
as
wealth
inequality
widens,
it
fuels
income
income
inequality.
Wealth
inequality
the
10%
top
in
is
highest
terms
of
in
their
the
USA
wealth
where
own
households
80%
of
total
in
wealth
those
in
the
bottom
40%
own
just
over
2%
of
total
wealth.
point
next
two
countries
on
the
scale
of
high
wealth
inequality
the
Netherlands
and
Denmark.
Wealth
inequality
is
lowest
boats.
add
time
Japan,
Poland,
Greece
and
Belgium
where
households
in
was
it
is
2016,
$25,908
that
10%
prominent
own
a
little
over
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income,
OECD
countries.
their
instance,
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member
Assets
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over
countries
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For
37
of
some
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accumulated
with
important
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Interestingly
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as
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the
though,
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very
with
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countries
Netherlands
bottom
with
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where
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Also,
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households
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to
income
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say
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production
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payments
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in
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to
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own
her
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in
as
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income.
consider
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valued
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opportunity
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equality
distribution
wealth.
wealth
not
fair
of
works
they
income
a
inequality
organization
Income
greater
is
income
Development
and
of
constitutes
agreement
The
income
poverty
inequality
meaning
Economic
and
equity
income.
equality.
is
inequality
: 3
Equality
of
T I N U
Economics
S C I M O N O C E O R C A M
3.4
countries,
with
high
levels
of
debt .
wealth
inequality
economy
can
be
represented
curve.
Population
in
is
represented
cumulative
income
on
percentages,
households.
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the
from
the
horizontal
the
vertical
lowest
axis,
axis
to
the
of
the
the
graph,
highest
percentage
100%
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national
income
population
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B
the
diagonal
right
and
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earns
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of
receives
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and
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to
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0%
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20%
40%
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Population
Figure
3.4.1
The
Lorenz
(cumulatively
degree
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can
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coefcient .
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inequality.
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Constructing
a
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1
1
.6%
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able
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Third
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20%
20%
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3.2
8.4
14.3
23.0
51
.1
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able
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3.4.2).
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3.2%
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the
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and
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100%
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is
each
the
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lowest
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year
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second
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rst
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of
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then
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share
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curve
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households.
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100%
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of
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Both
poverty
refers
to
the
inability
to
cover
minimal
absolute
material
There
is
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distinction
between
absolute
and
as
Absolute
it
of
can
life,
poverty
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to
the
case
where
a
not
to
have
sufcient
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meet
basic
Absolute
poverty
is
of ten
discussed
in
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which
people
cannot
afford
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basket
of
poverty
society
unequal
with
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population,
poverty.
may
still
when
be
median
distribution
the
The
they
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more
idea
poor,
the
income
national
of
income
signicant
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thought
such
services
and
and
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as
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terms
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or
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that
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being
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of
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afford
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of
within
the
afford
typical
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the
degree
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households
income.
is
total
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in
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improve
care;
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to
free
possessing
food;
lives,
of
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of
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people
necessities,
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Measuring
poverty
Poverty
be
of
the
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poverty
gauges
where
people
is,
poverty
income
the
having
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such
as
threat
to
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of
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community.
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impact
will
of
is
increasingly
recognized.
to
everyone
else
in
their
to
keep
measured
of
the
poor
measures
are
in
order
problem,
people
on
needed
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to
to
and
provide
raise
policy
target
its
estimates
visibility
agenda).
appropriate
Also,
policy
interventions.
their
is
usually
measured
in
terms
of
income.
stand
To
compared
should
magnitude
Poverty
society—relative
measure
absolute
poverty,
a
minimum
income
level
called
society.
the
106
people’s
dimensions,
services.
Relative
a
to
more
goods
these
•
relate
has
income
shape
and
poverty
Poverty
needs.
violence;
below
relative
household
education
does
and
conditions.
follows.
access
•
100%
relative
basics
poverty,
80%
consumption
though:
needs.
60%
Lorenz
and
Poverty
40%
3.4.2
“pover ty
line”
is
identied.
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is
the
basic
minimum
need
in
order
amount
of
to
get
poverty
by.
can
Once
be
the
poverty
measured
by
line
is
Difculties
percentage
of
the
population,
who
earn
an
the
poverty
line.
These
poverty
lines
can
be
set
of
poverty
poverty,
a
national
and
an
international
level.
The
World
international
poverty
line
at
periodic
intervals.
It
was
in
1990
at
$1
.00
a
day.
Some
years
ago,
it
However,
Issues
was
arise
meant
from
by
the
$1
.25
and,
in
2015,
it
was
revised
again—to
$1
.90
At
that
in
time,
absolute
households
poverty.
living
Note
that
on
less
these
than
$1
.90
thresholds
a
are
in
“real ”
US
dollars
but
rather
in
(PPP)
dollars
in
order
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take
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account
of
living
between
in
Household
poverty
differing
of
can
be
measured
by
specifying
be
the
median
earning
considered
less
income,
than
usually
50%
of
set
the
at
relatively
examine
In
can
the
poor.
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the
the
lowest
top
median
of
annual
Taking
an
the
to
half
full
range
of
highest—and
of
income.
annual
poor
median
household
50%
in
of
earner s
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incomes
identify
from
poverty
income.
income
this,
income
relative
measures
in
the
we
the
bottom
line
is
then
For
instance,
say
an
economy
is
in
have
that
falls
absolute
provide
poverty
already
explained,
be
described
single
estimates
in
a
indicator.
Index
(MPI)—a
well
Poverty
as
the
developed
$10,000.
below
and
on
poverty
single
For
this
is
beyond
over
most
the
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half.
basis
of
nor
the
is
MPI
faces
in
that
the
the
•
described
that
be
been
Yet ,
can
with
which
as
who
•
nutrition
2010
are
in
order
based
by
a
Poverty
constructed.
the
determine
on
helps
poor
(OPHI)
Programme
to
solely
and
among
the
to
acute
income.
to
in
deprivations
education,
dimensions
are
health
assessed
mortality
are
There
not
years
of
•
school
schooling
attendance
•
cooking
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individuals
still
intensity
are
the
deprived
in
index
their
deprivations
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in
It
covers
determine
that
and
each
living
by
ten
sanitation
•
drinking
the
societies
to
they
are
the
MPI,
education
than
also
to
as
an
the
in
source
many
irregular
household
survey
in
the
may
poverty
who
of
of
As
the
most
countries
basis.
survey
be
the
Even
in
if
place,
the
insufcient .
surveys
frequently
may
likely
households.
homeless,
who
all
be
This
drug
face
represented
limits
gender,
data
and
There
in
to
to
omit
be
includes
users,
acute
poor
a
range
sex
workers
deprivations
the
surveys
disaggregation
enable
impact
women
the
disability
would
its
is
evidence
underestimate
as
poverty
cut-off
the
for
to
the
lines
points
poor.
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create
albeit
and
in
but
turn
in
on
and
a
age.
better
different
of
More
data
in
disaggregated
understanding
groups
of
of
people,
example.
of
suggest
actual
tend
that
Poverty
poor
a
income
sense
to
have
lines
that
no
poverty
and
no
specic
of ten
people’s
the
severity
provide
lines
intensity
more
than
relevance
produce
an
of
poverty,
arbitrary
to
overly
the
lives
of
simplistic
lives.
very
all
their
standards
that
small,
unpredictable
person
income.
and
money
people
once
be
in
or
misleading
poverty
However,
sporadic .
just
can
living
in
Farmers,
twice
a
reality,
for
year
and
have
a
can
reliable,
incomes
instance,
af ter
can
may
harvest
be
earn
time.
Recap
electricity
•
housing
is
least
and
their
the
roughly
or
them
more
as
to
be
living
in
difculties
dening
•
having
poverty
in:
poverty
insufcient
collect
poverty
•
sampling;
•
having
limited
of
these
people
•
relying
on
and
irregular
household
surveys
data
in
acute
poverty
disaggregation
of
may
be
omitted
data
“MPI
by
the
poor ”,
1
.57
billion
representing
and
percentage
of
people
are
This
is
million
people
absolute
severity
of
lines,
which
may
underestimate
poverty
the
of
•
relying
on
minimum
income
standards,
which
can
misleading.
living
deprivations
living.
poverty
ten
be
standard
800
are
•
experiencing.
at
measuring
assets.
measured
poverty,
in
indicators,
in
Causes
of
economic
inequality
and
poverty
much
is
a
whole
range
of
factors—economic ,
social
and
the
worldwide
role
estimated
on
people
live
not
poverty
There
higher
because
standards.
water
•
three
identies
poverty
multidimensional
health,
measure
as
(UNDP)
poverty
different
•
•
fuel
of
the
poverty.
statistics.
are
the
indicators,
However,
the
children,
poverty
to
•
measure
denition.
regular
by
such
street
There
child
to
currently
household
do
people
relation
•
neither
are:
•
and
above
captured
Initiative
Development
countries
people
respect
three
dene
median
Multidimensional
Development
a
sampling
Difculties
These
what
in
globe.
captures
with
dening
at
considered
income.
accurately
indicator—has
Nations
developing
the
is
differences
This
calculated
household
poverty
phenomenon
reason
Human
index
vulnerable
around
The
&
measures
100
are
that
$20,000.
$10,000
relative
a
word
composite
United
this
a
are
conducted
provided
portrait
Oxford
which
a
point
terms.
of
step,
There
difcult
data.
have
including
The
who
agreeing
are
poverty
50%
rst
pover ty.
specically,
who
is
very
be
surveys
addition,
and
separates
the
term
income
of
country—from
task .
50%.
median
but
statisticians
simple
a
from
will
a
countries.
•
Households
not
cost
data
percentage
is
power
countries
Relative
the
their
day
surveys
of
measurement
those
poverty-related
parity
assessing
not
•
actually
of
poverty
difculty
were
in
evaluating
per
such,
day.
and
revised
perceptions
to
important
rst
is
set
is
policies
Banksets
•
the
accurately
formulating
both
effectiveness.
at
pover ty
income
scale
below
measuring
taking
Measuring
the
in
T I N U
the
: 3
families
dened,
S C I M O N O C E O R C A M
that
of
the
state—driving
economic
inequality
and
poverty.
poverty.
Examples
are
explored
below.
107
Inequality
This
occurs
of
oppor tunity
when
people
living
in
the
same
society
do
Over
the
level
skills
access
to
the
same
opportunities.
Parental
from
the
key
circumstance
inuencing
inequality
by
gender
is
and
strongly
place
of
birth.
correlated
Inequality
with
income
tend
to
that
with
have
people’s
background,
or
their
gender
ultimately,
have
In
cases
households
at
higher
these
in
were
rates
earnings
disparities
over
in
a
type
as
degree
of
job
The
reason
the
is
parental
their
they
days
longer.
to
seek
poorer
of
At
ethnicity
educational
get
and,
2020
within
and
lower
working
life.
the
is
time,
Yet ,
skilled
factor
plays
distributed;
the
income
lose
as
level
a
but
place
where
these
children
were
because
will
the
born
of
of
trillion
of
the
not
the
in
the
this
may
set
them
back
over
their
there
are
no
cases
where
as
tend
of
inequality
of
opportunity
they
are
cases
of
income
instances
inequality.
where
In
of
will
but
income
inequality
income
of
inequality
opportunity
inequality
but
is
is
not
still
an
the
with
moderate
there
This
important
only
racial
Income
levels
depends
offering
the
on
factors
of
resource
the
of
payments
production
and
payments
take
the
form
of
interest
(for
capital)
highly
power
unequal
lead
to
a
ownership
highly
of
or
are
a
been
is
that
the
the
past
few
share
of
decades
national
own.
(for
prots
suggests
entrepreneurship
is
rising
is
falling.
This
decline
in
and
For
instance,
on
G20
a
report
countries
and
in
labour ’s
share
of
income
very
more
for
time,
certain
and
what
0.1%
to
receive
in
higher
receive
or
experienced
working
may
higher
in
they
and
the
have
are
same
less
more
they
job.
of
of
poverty
involved
are
in
work
Similarly,
minority
less
or
evidence
employment ,
chance
earning
security
risk
paid
when
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according
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in
more
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of
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different
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•
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it .
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inequality
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growth
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low
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of
slower
lower
savings
resources
of
capital
→
low
labour
productivity
higher
of
living
and
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criminality
growth
inequality
lack
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standards
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encourages
from
investment
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role
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taxation
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proportional
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axes
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distinguished
into
direct
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are
directly
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tax
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income
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income
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then
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is
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income
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tax
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>
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dividends
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yearly
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imposed
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imposed
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and
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of
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all
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they
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total
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able
3.4.2
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ax
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3.4.3
22
(20,001
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29
a
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Nikos
As
earns
€35,000
per
year.
earned.
rates.
How
much
tax
MTR
=
ΔY
3.4.3
us
turn
shown,
€9,150
does
(MTR)
ΔT
=
Y
(30,001
– 40,000)
MTR
income
(%)
Average
(0–20,000)
wealth
as
2019.
T
able
Income
paid
Greek
earned:
individuals
prots,
tax
: 3
the
in
again
Nikos
to
the
earns
case
of
Nikos
€35,000
per
and
year
Soa.
and
pays
tax:
€9,150
he
have
to
pay?
Most
will
answer
€12.950
(35,000
×
ATR
=
=
0.26
=
26%
€35,000
0.37)
and
they
are
wrong.
The
calculation
is
a
bit
more
For
the
last
euro
earned
Nikos
paid
37%
in
tax ,
which
is
complicated.
the
Using
the
information
in
T
able
3.4.2,
the
tax
paid
for
MTR.
the
Soa
rst
will
€20,000
be
29%;
earned
and
for
will
the
be
22%;
next
for
the
€5,000
next
Nikos
€10,000
earns
he
earns
€70,000
taxed
37%.
(0.22
×
is
total
€20,000)
tax
+
paid
pays
€24,500
in
tax:
=
0.35
=
35%
€70,000
+
(0.29
×
€5,000)
The
and
=
So:
€4,400
year
€24,500
will
ATR
be
per
it
€2,900
by
Nikos
+
€10,000)
(0.37
For
×
the
the
=
€1
,850
on
+
the
=
last
euro
earned
Soa
€9,150
€35,000
he
paid
45%
in
tax ,
ATR
earns
which
is
MTR.
Nikos
(income
=
€35,000)
MTR
26%
37%
35%
45%
S C I M O N O C E O R C A M
Calculating
T I N U
HL
€9,150.
Soa
Now
consider
Soa,
who
earns
€70,000
per
year
the
amount
Nikos
earns).
To
calculate
how
she
has
to
pay
the
same
steps
will
be
3.4.4
the
information
in
T
able
3.4.2,
the
tax
paid
for
€20,000
earned
will
be
22%;
for
the
next
the
€10,000
ATR
be
29%;
for
the
next
€10,000
it
will
inferred
be
37%;
also
and
for
both
in
this
€30,000
that
Soa
has
above
€40,000
she
will
45%.
a
is
(see
is
T
able
progressive,
more
proportional
×
€20,000)
+
(0.29
×
€10,000)
income
as
income
greater
3.4.4).
than
The
with
Soa
tax
paying
than
Niko.
(0.37
×
€10,000)
+
(0.45
×
€30,000)
tax
tax
€2,900
paid
by
+
€3,700
Soa
on
+
€13,500
the
€70,000
=
so
system
the
MTR
the
is
ATR
equal
remains
to
the
constant
ATR.
tax
system
the
ATR
decreases
as
In
income
a
rises
=
so
+
rises
+
regressive
total
that
So:
(0.22
The
is
MTR
for
as
€4,400
case
the
be
In
taxed
this
while
individuals
case
proportionately
the
from
rises,
it
system
will
be
ATR
the
the
rst
can
followed.
rises
Using
€70,000)
much
What
tax
=
(so
T
able
double
(income
the
MTR
is
less
than
the
ATR.
€24,500
she
earns
Recap
is
€24,500.
Effect
Average
and
marginal
tax
•
To
explain
the
proportional
difference
and
between
regressive
taxes
progressive,
the
average
tax
rate
(ATR)
further
and
we
the
If
the
the
need
tax
tax
ATR
marginal
If
the
tax
it
is
ATR
and
MTR
is
and
progressive
MTR
>
then
as
income
rises
ATR.
system
as
is
income
proportional
rises
and
then
MTR
=
ATR
remains
ATR.
(MTR).
ATR
is
the
proportion
of
income
paid
in
taxes;
that
If
the
tax
ratio
the
of
tax
the
tax
paid
as
collected
a
over
proportion
income.
of
the
More
tax
system
is
regressive
then
ATR
decreases
as
is,
income
the
on
tax
•
The
system
rises
constant
rate
systems
to
•
dene
of
rates
rises
and
MTR
<
ATR.
generally
base,
which
1
1
1
In
Figure
(say,
3.4.3
income)
proportional
through
the
line
slope
tax
the
is
of
the
and
horizontal
the
system
origin.
In
increasing
the
line
is
axis
vertical
is
a
the
measures
amount
illustrated
progressive
while
in
a
by
tax
the
of
any
tax
the
There
base
paid.
straight
system
regressive
tax
tax
many
line
slope
system
may
property
A
of
the
also
in
countries.
most
property
to
raise
which
However,
is
too.
tend
to
more
while
the
property,
regressive
the
income
of
off
many
is,
taxed
tend
there
(that
of
residential
lightly
better
Nevertheless,
be
of
taxation
relatively
residential
owners
taxes
proportionally
T
ax
scope
expensive
middle-class
the
decreasing.
be
particular,
are
in
to
own
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existing
they
poorer
take
households).
paid
Reform
Progressive
make
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the
income
Lastly,
Proportional
would
burden
groups,
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consumption
property
tax
reliance
reducing
regressive
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rendering
reducing
towards
make
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taxes
and
more
heavily
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taxes
poverty.
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and
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most
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and
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also
Indirect
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on
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help
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they
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up
will
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are
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the
larger
Regressive
share
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households.
make
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indirect
tax
base
3.4.3
Progressive,
proportional
and
regressive
at
can
wealth
taxation
reduce
more
as
VAT
spending.
households
reliance
on
regressive.
may
be
However,
On
the
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than
indirect
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only
some
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other
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countries
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How
such
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Figure
of
greater
system
taxes
government
T
ax
budgets
Hence,
pover ty,
income
a
be
a
case
lower
for
rate,
if
differentiating
at
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rates
to
tax
necessities
all.
and
inequalities?
Recap
T
axation
income
crucial
can
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In
and
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the
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T
axation
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expenditure
education
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Progressive
redistribute
incomes.
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income
require
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those
total
on
higher
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A
wealth
incomes.
Increasing
can
lead
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can
be
less
achieved
However,
in
incomes
taxes
development
investment
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to
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compared
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by
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larger
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on
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raising
selective
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tax
Also,
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rates
income
rates
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the
distribution
marginal
marginal
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avoidance
on
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paying
through
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tax
Property
lead
can
to
the
exploitation
of
with
those
on
high
•
This
an
Less
distortions,
approach
including
through
economists,
Piketty,
have
inequality
initiated
2018
1%
was
tax
of
the
cut .
triple
to
in
would
closing
other
types
USA
Their
their
key
as
of
Emmanuel
documenting
1980
Americans
grounds,
way
such
been
af ter
that
and
has
held
share
19.3%
from
be
tax
wealth
that
Policies
to
reduce
care
as
economic
pay
taxes
money
and
another
loopholes,
and
to
more
taxes
can
promote
equity.
to
reduce
pover ty,
income
and
a
government
include
may
the
also
resort
to
the
use
of
following.
reduce
in
inequalities
taxation
and
Saez
and
tax
fuelled
culminated
of
that
all
decades
inequality
by
top
in
On
wealth
forcing
the
and
of
on
everything
they
own
to
public
services
such
as
education
way
of
for
using
all.
The
wealth
taxation
of
opportunities—
Reducing
ensuring
inequalities
individuals’
circumstances—such
as
own
gender,
That
as
turn,
a
they
their
the
services
with
increase
labour
capacity
of
wealth
can
level
improving
health
the
not
for
better
allowed
obtain,
of
to
the
income.
quality
lower
deprived,
so
type
This
and
and
they
the
of
ethnicity
or
the
be
to
groups.
training
educational
job
can
access
income
education,
productivity
limit
they
can
get
achieved
education
A
and
healthier
skills
will
income-earning
decrease
income
and
inequality.
richest
Transfer
payments .
These
usually
include
pensions,
and
and
disability
benets
as
well
as
child
and
improved
tax
towards
implies
status—are
population
these
tax
in
through
recent
tenth
2018.
earlier.
a
and,
cuts
the
or
qualications
economic
tax
af ter
the
wealth
proposing
by
in
capital.
reforms.
Thomas
rise
human
achieve
may
allowances.
These
payments
are
made
to
the
most
thus
groups
of
the
population
using
a
part
of
the
narrowing
revenue
collected
from
the
inequality.
decrease
1
12
indirect
These
opportunities
tax
economic
made
tax-
vulnerable
serve
and
inequality.
inequality
policies.
other
health
increased
on
taxation,
unemployment
diverting
wealth
ending
•
to
redistribute
and
incomes
to
massive
show
four
are
a
been
which
estimates
economists
reduce
Americans
to
extensive
parental
Key
used
taxes.
appropriate
equity
be
improve
policies
background
greater
if
can
reliance
Fur ther
of
induced
income
earners.
the
distort
legal
higher
can
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income.
encourage
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may
of
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up
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lower
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income
equally.
progressive
a
inequality
taxes
•
of
reduce
equally.
more
will
to
for
•
governments
tool
households.
more
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a
to
•
favour
as
poverty
income
inequality.
working
population,
so
they
on
them—but
improves.
reduced
transfers
is
may
the
Gini
are
to
only
is
a
of
risk
become
the
years
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from
ago
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that
overly
necessitate
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many
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example,
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note
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For
have
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of
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transfers
0.62
Familia
to
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design
in
0.49.
a
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cash
welfare
are
of
children
more
their
have
likely
than
children)
to
attend
fathers
under
school
to
three
on
conditions:
regularly,
they
can
be
for
regular
medical
check-ups
and
the
a
neighbourhood
nutrition
and
health
care
huge
its
or
June
managed
to
decrease
the
of
Minimum
wage
increase
the
T
argeted
the
spending
can
as
education
to
make
on
goods
subsidize
and
them
health
available
to
incomes
of
mother
has
classes.
end
urban
fringe
nutritional
poor
it
or
and
services .
directly
care,
to
and
the
public
low
3.3,
services
or
voter s
affordable
rejected
such
government
in
order
to
can
set
or
support
the
workers.
policy
will
The
result
benet
those
is
that
the
higher
wage.
workers,
a
job
at
a
It
may
who
create
However,
research
has
as
mentioned
shown
that
in
sections
reasonable
2.7
increases
in
may
wage
even
have
prompt
deprived
projects
in
areas,
school
lunches
clean
water
and
programmes,
greater
to
higher
in
effort
on
unemployment
the
part
of
workers.
order
perspective
income
inequality
is
the
dening
challenge
villages
our
time.
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is
no
“one-size-ts-all ”
approach
to
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and
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led
groups.
rural
and
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to
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on
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remote
policy
and
policy
to
is
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sufcient
that
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is
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of
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when
to
families
help
in
may
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generating
to
keep
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their
so
a
children
cash
out .
to
induce
them
to
send
children
to
may
not
be
sufcient
remote
to
villages.
offer
free
Esther
(Nobel
using
showed
bringing
that
the
their
likelihood
children
to
of
be
mothers
in
vaccinated
to
to
lentils
camp
was
increased
also
by
six
times
if
that
a
basic
providing
all
a
given
wealth
or
identical
which
higher
sum
periodic
are
of
of
funded
incomes.
(UBI).
a
through
UBI
or
a
1
areas
many
people
as
opportunities
possible
to
learn.
enjoy
The
care,
where
again
policymakers
same
must
as
many
people
services.
The
as
role
possible
of
taxes
have
and
access
to
transfers
redistributing
income
Increasing
and
the
wealth
must
progressivity
of
also
be
income
kilogram
In
are
the
amount
its
of
most
made
taxes
of
is
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model
geographic
regardless
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payments
The
The
country
money,
employment
of
key—policymakers
reducing
reliance
on
indirect
taxes,
decreasing
offered.
income
citizens
are
free
loopholes
Universal
skills
Udaipur,
in
a
as
quality
health
quality
taxes,
of
that
high
considered.
immunization
and
for
in
India
number
Prize,
high
2019)
a
school;
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Duo
Education
ensure
ensure
in
inequality,
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income
at
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access
necessary
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charge;
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with
The
wage
skilled
with
minimum
and
The
provide
infrastructure
most
health
supplementation
of
rural
home
•
hospitals
This
stand
bag
which
areas.
Of ten
it
funds,
infrastructure
intergenerational
depends
or
of
Switzerland’s
policy.
minimum
wage
up
tackling
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of
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such
needs
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be
Widening
include
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priorities,
2016
Policymakers’
and
on
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Examples
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have
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draw
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and
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mothers
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T I N U
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well-designed
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to
tax
all
Therefore,
increase
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human
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with
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be
1
13
3.5
Demand
management
policies):
Money,
In
order
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to
monetary,
each
type
achieve
scal
of
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achieving
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policy
and
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will
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policy
policy
policymakers
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explained,
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other
monetary
supply-side
satisfactory
and
and
monetary
(demand-side
include
conducted
changes
and
in
conducted
in
of
price
3.5.1
provides
a
“bird’s
eye
by
the
by
view“
of
macroeconomic
focus
on
money
at
affecting
aggregate
demand.
also
at
referred
to
stabilizing
as
short-run
aggregate
stabilization
demand,
and
policies
so
the
as
aim
at
production
but
policy.
the
interest
and
rates.
involves
and/or
Monetary
country
and
policy
involves
Fiscal
changes
policy
is
in
level
the
taxes.
into
increasing
side
of
the
market-based
policies.
Fiscal
aggregate
economy.
supply-side
and
supply.
They
are
policies
monetary
policy
They
of ten
and
may
sometimes
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to
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to
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Supply-side
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or
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interventionist
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government
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the
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policy
central
evaluated.
policies.
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the
the
government
Supply-side
Figure
monetary
policies
aim
aggregate
supply.
economy.
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Fiscal
in
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3.5.1
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policies
Monetary
policy
Changes
Figure
Demand-side
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G
(or,
T
Macroeconomic
in
r
Market-based
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HL
she
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,900.
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Us
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reserves
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,810
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to
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Third
National
Bank.
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,000
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Avinash’s
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National
Bank
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money
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Us
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reserves.
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out
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Fourth
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rates.
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its
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day
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bank s
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,000
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amount
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to
$900
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reserve
bank s
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central
bank s
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as
money
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cellphone
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$100
$900
Carla,
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reserves.
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resort ”.
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banks
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set
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•
deposits
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country.
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electronic
bank s.
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Excess
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out .
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into
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reserves
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rst
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required
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money
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services.
bank
•
of
value)
T I N U
is
express
: 3
Money
S C I M O N O C E O R C A M
•
take
place
out
of
Avinash’s
original
$1
,000
deposit .
that
Commercial
bank s
“stroke
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pen”
Money
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to
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one
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loan
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15
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and
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bank
T
able
uses
3.5.1
most
shows
of
the
this
deposit
to
The
The
Deposit
10%
required
Reserve
Loans
issued
ratio
$100
$100
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$72.90
million
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would
be
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demand
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$65.61
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…
…
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instead
time
your
3.5.1
The
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money
required
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$100
loans
reserves
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$1
,000
$9,000
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term
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have
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money
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in
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earned
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that ,
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we
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you
you
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must
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be
go
meaning.
liquid
to
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enough
to
supermarket
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as
with
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transactions
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This
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of ten
holding
money.
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the
nominal
income
in
a
country,
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money
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referred
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able
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claim
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,000
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process.
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currency
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bank s.
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public
holds
will
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purposes.
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demand
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money
for
transactions
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increase
if
real
currency.
GDP
•
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lend
out
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cash
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or
if
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reserves,
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reserve
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average
price
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money
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inject
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examine
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later.
economy
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mathematics
the
“ fresh”
required
reveals
funds
how
money
convenience
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demand
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have
by
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interest ,
interest .
is
to
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take
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Sammy
is
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interest
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r
much
the
“ fresh”
Note
money
reserves
that
M
supply
(so
ΔR
below
can
=
increase
+1000)
denotes
the
from
entering
money
a
$1
,000
the
of
economy.
supply
and
earned
asset
D
such
money
as
a
placing
bond.
decreases
if
his
It
funds
follows
interest
in
an
that
rates
interest-earning
the
demand
for
increase.
s
denotes
deposits
while
the
Greek
letter
Δ
denotes
change,
Figure
which
in
this
case
is
an
3.5.2
demand
interest
ΔM
=
ΔD
=
shows
what
the
above
suggests—that
the
increase.
1000
+
900
+
810
+
729
+
for
rate
money
(r)
and
is
negatively
that
this
sloped
money
if
drawn
demand
against
function
the
will
…
s
shift
2
ΔM
=
ΔD
=
ΔR
+
(1
−
r ) ΔR
s
+
(1
−
r )
r
3
ΔR
+
(1
−
r )
r
ΔR
+
at
to
the
each
right
interest
if
nominal
rate
people
income
will
(money
want
to
GDP)
hold
increases
more
as
money.
r
4
(1
−
r )
ΔR
+
…
r
Interest
2
ΔM
=
ΔD
=
ΔR
×
[1
+
(1
−
r )
s
+
(1
−
r )
r
+
(1
−
=
ΔD
=
ΔR
=
(1
(r)
…]
1
×
−
+
r
ΔR
×
x
s
1
r )
r
1
ΔM
rate
3
−
r )
c
r
r
r
r2
So, if the r
is 10% then an increase by $1
,000 in the banking
r
reserves (the ΔR above) can increase demand deposits and the
money supply by $10,000. The money multiplier m is equal to
r1
the inverse of the required reserve ratio r .
r
It
follows
permits
that
the
a
fractional
money
supply
reserve
to
grow
banking
many
system
times
more
Md
than
the
reserves
in
the
banking
system.
This
is
the
Md
result
of
lending
loans
to
generated,
central
or
take
and
bank
place
so
can
decreasing
have
converted
the
available.
on.
into
and
It
affect
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thus
should
the
amount
more
also
money
of
which
allow
deposits
be
clear
supply
reserves
by
to
M2
Quantity
M2
money
Figure
3.5.2
The
demand
for
Given
If
a
level
of
interest
nominal
rates
money
income
increase
(Y),
from
r1
demand
to
r2
for
then
money
demand
of
(M)
bank s
Md.
1
16
M1
the
increasing
commercial
Y>Y>)
more
be
that
(when
is
will
decrease
holding
movement
on
along
from
M1
to
M2
to
money
balances
the
money
demand
as
is
the
opportunity
higher.
function
There
is
a
Determination
central
if
the
increases
each
then
level
more
average
of
money
interest
be
has
increased
The
supply
central
bank
rates,
We
the
choose
to
to
will
at
The
the
real
increase
people
So,
or
Y
need
demand
money
right
GDP
from
now
r2,
Md
to
for
to
market
to
demand
from
is
have
lend
bank
Y ’.
At
set
simplicity
consider
by
af ter
the
the
the
by
the
money
interest
rate
interaction
of
is
determined
the
money
in
the
demand
money
curve
and
supply.
hold
money
function
Ms
Interest
rate
(r)
M’d.
determined
that
reserves
though
supply
out
requirement
and
established
Even
money
by
r2
affected
changes
rates
bank
equilibrium
money
change.
affect
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bank .
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as
T I N U
g ove r n m e n t
Recap
Tools
of
of
monetary
monetary
policy
policy
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changes
in
the
required
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changes
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discount
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open
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quantitative
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market
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ratio
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purchases
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S C I M O N O C E O R C A M
Tools
central
off
then
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decrease
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to
imminent
expansionary
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interest
will
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and
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as
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bank
Figures
the
to
is
slow
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then
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show
decrease
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monetary
3.5.6
to
pressures,
increase
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increase)
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order
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Md
rates.
how
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aggregate
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change
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bank
M1
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interest
rate
achieve
its
3.5.5
that
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central
bank
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from
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to
to
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assume
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pur sue
expansionary
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it
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interest
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if
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or
perhaps
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the
central
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decided
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and
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interest
rate?
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its
thus
tools
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money
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required
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reserve
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looser)
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supply
contractionary
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money
interest
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rates
of
goals.
money
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Quantity
and
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thus
M2
discount
rate.
or
increase
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discount
rate.
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probably
though
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r
will
probably
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outstanding
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bonds.
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increase
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money
supply
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increase
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the
original
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rate
r1
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money
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demand
for
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money
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in
the
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so
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Figure
the
3.5.6.
equilibrium
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rate
r1
the
public
will
At
want
hold
more
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excess
demand
for
money
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excess
increase
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of
supply
to
of
sales
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the
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market
reserves
money
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open
of
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1
19
•
Ms2
Even
rate
if
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and
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then
decreases,
need
the
to
borrow
from
opportunity
which
will
tend
cost
to
bank s,
of
increase
spending.
r2
Lower
interest
rates
can
also
increase
net
exports
(NX),
as
follows.
•
A
decrease
in
a
country ’s
interest
rates
implies
a
lower
r1
rate
of
have
to
return
deposits
switch
interest
Md
to
currencies
M1
Quantity
of
money
3.5.6
Increasing
the
equilibrium
interest
rate
by
decreasing
will
Effect
of
assets
higher.
other
currency
its
of
They
countries.
in
value.
exports
of
expansionary
monetary
policy
aggregate
will
shif t
the
other
will
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foreign
bonds
They
will
countries
sell
the
where
currency
increased
exchange
or
want
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supply
market
of
buy
that
However,
depreciation
of
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will
currency
cheaper
to
and
if
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growth
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down
abroad
fear
a
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or
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economy
is
follows
and
recession?
The
central
bank
may
thus
monetary
policy,
also
referred
to
as
more
competitive.
monetary
The
thus
central
policy,
aiming
at
increasing
net
the
closing
a
recessionary
(or,
of
a
change
demand
in
exchange
rate
on
net
interest
exports
is
very
bank
money
will
decrease
supply,
interest
typically
bonds.
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exports,
resulting
and
rates
through
lower
investment
be
fully
and
leading
Keynesian
explained
monetary
later.
policy
investment
will
tend
expenditures
to
as
to
an
increase
in
aggregate
well
demand.
as
a
AD/AS
result
of
diagram
a
shown
decrease
in
as
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aggregate
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123
3.6
Demand
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Fiscal
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of
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stability
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is
expenditures—which
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jobs
airports,
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expenditures
monetary
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it
are
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•
policy
real
•
output
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f iscal
policy
policy
the
policies):
the
future
to
raise
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rates
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included.
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26).
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include
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•
benets
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the
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policy
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business
a
contribution
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explained
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help
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ports
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government
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the
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country
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date
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124
126),
are
economy
from
have.
built-
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short-term
cycle.
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capital
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increase
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only
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or
not
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aggregate
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demand
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in
in
accelerate.
the
taxes
to
can
increase
may
also
support
also
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through
the
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short
is
short
term
claimed
but
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incentive
accelerate
this
used
that
long-term
to
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work
growth,
but
income
and
to
there
is
claim.
to
narrow
cash
transfers
term
and
and
through
income
more
inequality
progressive
and
health
in
the
long
investments
in
term.
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policy
public
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lower
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especially
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adopted
goal
taxes
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environment
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growth
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cycle
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trade
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inequality
imbalances.
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close
of
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The
economy
policy
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and/or
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macroeconomic
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intervention
expenditures
employment.
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also
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from
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page
nances
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needs
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HL
that
investments)
GDP
will
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the
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of
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how
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demand
3.6.1
.
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households
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pressures
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curve.
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1
26.
taxes
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increasing
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the
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note
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T I N U
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: 3
also
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S C I M O N O C E O R C A M
can
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expenditures
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aggregate
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taxes
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)
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AS
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LRAS
APL
SRAS
APL1
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Real
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APL2
Figure
3.6.1
Keynesian
Expansionary
scal
policy
closing
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deationary
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using
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diagram
AD1
In
the
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demand
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increased
shown
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to
and/or
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Figure
AD2
3.6.1
because
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direct
AD2
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Figure
(cyclical)
in
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also
3.6.2
Monetarist
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close.
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Unemployment
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/New
Classical
diagram
Figure
3.6.2,
decreases.
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that
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could
also
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an
125
inationary
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austerity,
increase
contractionary
economists
decreasing
taxes)
increase
points.
applied,
Recap
T↑
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more
(but
budget
foster
→
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C↓
→
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not
decits
investment
HL
The
The
Keynesian
term
student
multiplier
RF
Kahn.
It
bottles,
multiplier
was
is
introduced
of ten
by
referred
JM
to
as
Keynes
the
and
and
policy
(G)
is
in
and
the
it
helps
form
considered
of
a
explain
why
increased
National
the
income
of
a
deep
very
recession.
powerful
The
tool
to
Keynesian
a
an
increase
greater
in
increase
government
in
national
ΔY
where
ΔG
is
that
ΔY
is
the
the
change
the
resulting
change
change
in
in
in
=
change
national
kΔG
lif t
an
if
for
example
government
income
namely
in
is
G
national
Y
the
government
expenditures
increases
k,
the
would
by
be
equal
240
Why
is
that
the
by
$240
will
be
case?
to
the
fact
that
one
will
lead
The
is
and
a
2nd
else’s
idea
additional
a
workers
by
the
activity
3rd
will
goods
process
will
in
each
round
to
additional
income
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“ k”
and
means
times
the
all
workers
additional
and
they
and
earned
for
government
will
not
nth
round
an
spend
and
part
services
continue.
creates
million
to
the
million,
service
is
income
they
for
stop
there,
the
though.
that
follow.
There
Why?
of
this
that
additional
others
income
produce,
and
on
the
Note
that
the
additional
additional
demand,
spending
which
×
of
hired
milk
the
on
been
in
on
spend
haircuts,
and
produced.
government
earned
producers
increased
have
by
(GDP)
for
spend
domestically
part
then
the
addition
produced.
If,
leads
of
the
example,
part
Remember
the
additional
economy ’s
more
of
produced
milk
that
income
and
more
income
milk
income
will
haircuts
and
increase
and
the
output
income
earned
have
multiplier.
then
all
production
are
The
the
identically
equal.
national
multiplier,
the
size
of
additional
multiplier
income
goods
and
services.
goods
and
services
depends
earned
The
on
that
additional
is
the
proportion
spent
on
spending
of
domestic
on
domestic
100
the
multiplier
spending
is
income,
which
resulting
from
additional
income
rests
has
a
name—it
is
called
marginal
propensity
to
automatically
consume
someone
workers
to
2.4:
2.4
person’s
Spending
Economic
earned
on
these
states
or:
decides
$100
million
=
that
workers.
will
So,
bottles
$100
Y:
expenditures,
k
the
by
economy
multiplier
expenditures.
income
where
dig
ΔG
government
government
ΔY
>
to
increased
expenditures
expenditures
income
workers
directly
scal
domestic
that
has
his
These
out
unemployed
income
Keynesian
expansionary
government
other
up.
produced.
multiplier
in
turn
leads
(MPC).
to
ΔC
d
MPC
additional
spending
and
Economic
so
on.
that
generates
activity
takes
additional
as
clearly
illustrated
by
place
the
in
ΔY
successive
circular
ow
for
example,
section
1
.1
,
page
example
will
help
spends
spend
$80
$100
of
on
these
to
clarify
the
point.
Assume
that
cheese,
then
the
MPC
is:
the
+80
government
decides
to
increase
expenditures
by
=
$100
+100
million
126
and
hires
unemployed
workers
to
dig
holes
a
haircut
dollars
5).
produced
An
you
and
the
model
hairdresser
(see
=
income
If
“rounds”,
it,
exist.
an
diagrams
decrease
spending
deation.
interesting
proposed
two
decrease
G↓
was
doesn’t
as
criticize
to
Contractionary
debt
fairy ”
whenever
reason
G↑
in
to
its
Expansionary
severe
“condence
referred
economist
unemployment .
interpreted
average
from
is
most
framework,
regarding
relieve
alleged
but
Classical
because
contractionary
became
or
More
natural
idea
from
Contractionary
APL1
This
contraction”
aggregate
It
demand
accelerate
“expansionary
and
bury
0.8
on
domestically
useful
We
of
to
have
spent
remind
dened
on
these
additional
services,
$20
goods
$8)
taxes
were
spent
of
the
services.
saved,
$7)
on
remaining
(leakages)
and
(say
were
the
again
withdrawals
(say
as
did
ourselves
domestic
government
dollars
where
circular
as
It
go?
income
follows
was
paid
part
was
spent
to
the
the
goods
and
services;
that
is,
on
imports
(say
are
the
withdrawals,
namely
savings
(S),
error
import
Some
expenditures
denitions
of
Any
the
marginal
taxes
In
if
terms
used
to
additional
below
save
are:
(MPS)—the
income
the
marginal
propensity
the
marginal
rate
of
the
marginal
in
any
other
this
easily
can
these
of
the
recession
IMF ’s
chief
acknowledged
estimate.
initiate
will
a
change
multiplier
more
(G)
change,
not
but
be
to
tax
tax)—the
(I)
or
visualized
illustration.
exports
using
Remember
the
that
(X)
also
change.
if
circular
Again,
ow
injections,
of
which
additional
considered
(MPT,
also
referred
to
additional
taxes
paid
on
autonomous
domestic
expenditures
income,
include
G,
as
but
they
also
do
I
not
and
X.
as
The
formulas
to
remember
for
simple
exercises
related
from
the
multiplier
are
these
two:
earned
propensity
to
import
ΔY
=
kΔJ,
where
spending
on
imports
denitions
and
the
J
symbolizes
injections
(MPM)—the
from
additional
numbers
in
the
can
be
G
or
I
or
X
income.
(this
Using
will
GDP
expenditures
and
additional
The
Blanchard,
revised
injection
words,
expenditures
(a)
•
a
investment
to
income
ensuing
one
size
earned
•
additional
the
expected.
Olivier
published
government
depend
•
so
IMF
,
the
(M).
propensity
from
than
time,
the
(T)
are
savings
Interestingly,
underestimated
multiplier,
deeper
the
and
change
income
•
at
had
$5).
only
and
multiplier.
on
process.
These
the
creditors,
much
economist
•
foreign
of
expenditure
proved
part
but
result
Greece’s
Greek
not
that
a
of
It
ow.
part
and
as
domestic
$20
relationship
has
three
elements,
ΔY,
k
and
ΔJ,
so
if
example
any
two
are
given,
you
can
solve
for
the
third)
above:
ΔS
+8
1
MPS
=
=
=
+100
ΔT
+7
1
0.08
(b)
ΔY
k
=
or
MPW
(1
–
MPC
)
d
(here,
MPT
=
=
=
ΔY
each
ΔM
the
be
shown
multiplier
k
(see
is
=
=
•
0.05
material ”,
page
If
131)
that
in
an
as
no
to:
a
can
solve
exercise
“closed”
taxes
will
1
for
the
other).
elements
so
if
either
is
there
is
no
be
economy,
government
and/or
greater
no
(the
it
means
or,
imports
as
that
if
this
it
is
referred
withdrawals
denominator,
MPW,
will
economy
so
its
be
has
multiplier
smaller).
1
To
k
you
+100
“Optional
equal
two
0.07
to
can
has
+5
=
ΔY
It
relationship
+100
given,
MPM
T I N U
is
80
and
: 3
though,
goods
S C I M O N O C E O R C A M
If,
=
illustrate
the
multiplier,
it
is
probably
preferable
to
choose
or
(MPS
+
MPT
+
MPM)
MPW
a
1
which
is
equal
is
Keynesian
indeed
AS
curve
Keynesian.
as
It
the
is
idea
also
of
the
multiplier
preferable
to
effect
assume
an
to
(1
–
MPC
economy
)
in
equilibrium
at
a
level
of
income
(of
GDP)
way
d
below
where
MPW
is
the
marginal
propensity
to
withdraw,
equal
to
the
sum
of
the
MPS,
the
MPT
and
the
there
is
also
found
by
subtracting
from
each
earned
all
that
is
spent
on
domestic
goods
that
is,
MPW
=
(1
–
MPC
sizable
(at
Y1
in
Figure
3.6.3)
a
deationary
gap
(equal
to
so
Y1Yf).
To
the
increase
expansionary
in
scal
government
policy
chosen
spending
to
close
reecting
this
gap,
draw
and
a
services;
is
level
additional
the
dollar
employment
MPM.
illustrate
MPW
full
which
that
is
the
new
aggregate
demand
curve
(AD2)
somewhat
to
the
).
d
right
It
should
be
realized
that
the
multiplier
k
is
of
the
multiplier,
(a)
the
greater
the
MPC
and
(b)
the
initial
one
and
then,
to
illustrate
the
idea
of
the
greater:
smaller
the
draw
a
third
AD3
even
further
to
the
right
at
AD3.
marginal
d
propensity
to
AS
withdraw.
APL
This
makes
sense
in
government
of
income
income)
many
but
if
you
check
expenditures
times
each
(as
time
a
the
will
your
circular
go
spending
fraction
ow:
around
is
the
an
increase
circular
someone
of
the
income
some
will
be
ow
else’s
generated
AD1
leaks
out
taxes
or
that
smaller
There
•
The
the
spent
national
part
of
ow
but
income
is
the
are
a
few
multiplier
on
that
spent
part
because
on
that
imports.
will
result
domestic
is
points
also
The
is
size
of
the
greater,
output
or,
saved,
the
paid
increase
bigger
AD2
'K'
in
the
equivalently,
the
withdrawn.
to
keep
works
expenditures
decrease,
will
by
in
in
mind.
reverse:
then
if
national
the
government
income
(GDP)
Y1
decrease
AD3
in
more.
This
was
the
case
in
Greece
Y2
Y3
Yf
Yr
a
(real
number
of
years
expenditures
necessary
(G)
ago
when
drastically
bailout
loans.
it
agreed
in
order
Greece’s
to
to
GDP
cut
GDP)
government
receive
Figure
the
decreased
by
more
3.6.3
expenditures
The
multiplier
effect
following
an
increase
in
government
(G)
127
Expansionary
government
the
scal
policy,
expenditures
recessionary
approaching
namely
by
ΔG,
(deationary)
full
employment
the
increase
managed
gap
real
from
GDP
to
Y1Yf
at
in
If an economy is entering recession, economic activity starts to
decrease
to
Y3Yf,
decrease as some rms shrink in size while others shut down.
People will be made redundant. Automatic stabilizers decrease
Yf.
the nancial pain to households because they will owe less
in taxes and they will be eligible to collect unemployment
A
2020
paper
by
C
Bayer
and
others
estimated
that
benets. All this is accomplished automatically, without the
following
the
massive
March
2020
$2
trillion
US
stimulus
need for the government to design and enact new laws. Their
response
to
the
Covid-19
pandemic ,
the
multiplier
could
incomes (that is, wage earnings) may drop to zero as they lose
be
as
high
as
2.
Following
the
2009
Obama
Stimulus
their jobs but their disposable incomes (Yd) do not, because
Plan,
which
increased
government
expenditures
in
unemployment benets automatically start and their tax
the
USA
by
$787
billion
to
lif t
the
US
economy
from
burden will also be lower. Automatic stabilizers do not only
recession,
Christina
Romer,
then
Economic
Advisers,
estimated
Chair
the
Council
of
help households in distress but also the economy as they
the
US
multiplier
at
1
.6,
stimulate aggregate demand when the economy is in great
which
meant
that
the
US
real
GDP
was
expected
to
need for a boost. Consumption expenditures will decrease
increase
as
a
result
by
roughly
$1
.26
trillion.
The
size
of
certain
characteristics
by less due to the effect on disposable income of automatic
the
Keynesian
multiplier
depends
on
stabilizers and so will aggregate demand. The downturn will
of
an
economy,
for
example
on
the
degree
of
openness
to
not be as severe. It will be milder.
international
“open”
trade
economy
Characteristics
making
it
or
on
the
imports,
vary
difcult
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across
to
debt–GDP
ratio.
withdrawal,
countries
estimate
the
will
and
In
be
a
greater.
through
expenditure
more
In
time,
contrast,
fast
multiplier.
and
disposable
incomes
rising
if
the
there
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economy
increased
incomes
because
faster
will
of
than
and
risk
rise
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income
incomes.
incomes
of
at
taxes
So,
are
growing
overheating
a
slower
being
and
rate
than
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consumption
too
ination,
and
thus
expenditures
will
Recap
increase
Keynesian
A
a
change
greater
in
any
injection
change
in
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national
I
or
X)
will
income
lead
boom
This
is
because
income,
income
which
one’s
leads
spending
to
more
is
business
(GDP).
someone
spending
The
and
Beyond
more
have
generation.
size
of
the
multiplier
effect
depends
on
of
any
additional
income
spent
a
output .
on
proportion
Or,
equivalently,
saved,
paid
in
it
taxes
depends
or
spent
the
multiplier
is
equal
to
it
the
smaller
the
withdrawals
in
cycle
useful
greater
the
explained
the
expenditures
move
earlier,
mitigate
by
of
enough
the
are
af ter
of
the
cut
scal
of
equipped
country,
benets
and
ups
downs
and
of
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However,
taxes
or
of
of
offering
year ’s
as
low
tax
is
a
start
by
action.
respond
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the
They
are
quickly.
stabilizers
economy.
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enacted
of
the
automatic
of
the
US
in
US
also
example,
February
the
2019,
recession—but
stabilizers
potential
are
automatic
lump-sum
increases
or
had
by
already
GDP
.
proposing
stabilizers.
payments
by
more
For
to
increase
example,
to
than
households
0.5%
when
compared
need
for
are
action
such
as
the
the
features
taxes,
cycle
progressive
tax
if
may
not
more
but
the
start
schools
of
a
that
would
recession
without
government .
stabilizers
most
built
into
Automatic
stabilizers,
of
are
which
exist
institutionally
in
most
built-in
characteristics
the
mitigate
the
short-term
uctuations
of
GDP
.
unemployment
that
reduce
the
•
incomes
not
Automatic
benets
stabilizers
and
include
progressive
unemployment
taxes.
As soon as an economy enters recession, tax burdens
only
pay proportionately
more,
so
that
as
•
income
rises,
progressive
taxes
rise
faster.
For
Without
any
Brody
earns
$10,000
per
year
and
pays
$2,000
pays
128
while
$5,000
taxes
a
tax
full
but
Carrie
then
Carrie
Brody
pays
explanation
earns
pays
25%
see
of
section
$20,000
20%
her
3.4,
of
per
his
income
page
year
in
taxes.
105.)
the
and
government
consumption
to
act ,
decrease
less
and
the
downturn
is
milder.
and
income
in
for
incomes
in
by
income
need
example,
disposable
if
to
projects
Recap
automatically.
higher
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existence
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business
additional
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expenditures
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of
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decrease and unemployment benets are claimed.
pay
the
they
involves
politicians
automatic
introducing
construction
automatically
•
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decrease.
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recession.
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progressive
of
they
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economy,
policy
government
taxes.
to
effects
stabilizers
a
the
economists
scope
that
budget
and
legislative
as
was
several
and
economies,
Automatic
pressures
ups
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•
economies
on
package
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Automatic
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demand.
follows
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discretionary
change
and/or
quickly
aggregate
multiplier.
automatic
deliberate
quickly,
2%
the
As
recession
impact
Stimulus
time,
such
are
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propose
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size
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so
on
imports.
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and
but
1
•
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quarters
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to
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incomes
aggregate
growth
need
for
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and
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rises
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slower;
risk
of
this
to
act,
slows
increased
down
inationary
government
pressures.
aggregate
decrease,
expected
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is
the
“crowding-out ”
the
government
increases
will
need
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government
nance
these
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expenditures
that
taxes
would
but
if
the
defeat
goal
the
is
increase
expenditures.
resort
to
“decit
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to
purpose.
and
increase
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it.
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borrow
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money
funds
borrow
market,
money
the
(rms
government
market
and
will
where
households)
turn
those
and
in
willing
to
to
lend
money
determines
(the
the
savers)
interest
get
rate
out .
who
those
Figure
3.6.4a,
demand
sloping
for
because
loanable
at
lower
also
The
as
to
AD3.
borrow
projects
more.
will
be
Supply
of
protable
loanable
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rates
interest
make
rate
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a
for
loanable
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D(LF)1
is
equal
you
funds
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in
Figure
3.6.4a
is
the
loanable
funds
market .
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is
at
now
that
the
government
but
scal
policy
in
order
the
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interest
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that
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above,
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to
low
to
3.6.4a,
the
borrow
the
demand
necessary
for
will
the
of
rates
then
aggregate
investment
demand,
that
aggregate
demand
will
may
expected,
all
the
way
to
AD2,
not
but
Real
GDP
scal
will
policy
perhaps
is
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as
rise,
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effective
only
as
to
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expected
(deationary)
was
crowded
gap,
as
private
out .
have
guessed,
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this
is
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effectiveness
of
criticism
of
Keynesian-inspired
scal
only
if
policy
the
and
decit
economy
is
spending.
booming
and
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makes
approaching
with
In
such
private
a
case
rms
the
for
government
funds,
which
will
could
be
drive
What
if
the
economy
is
in
a
deep
up
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crowding
out
is
unlikely
as
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condence
In
will
and
As
funds
rms
will
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be
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of
crowding
the
out
occurs
deationary
gap.
or
not
crucially
The
risk
is
depends
smaller,
the
on
the
deeper
expenditures.
need
loanable
funds.
loanable
interest
aggregate
to
recession.
policy
in
the
in
a
form
deep
of
recession
increased
it
is
expansionary
government
spending
funds
shown
will
Also,
nance
that
market
of
needs
employ
increase
government
enter
borrowing
r1
.
government
will
is
as
against
rates.
case
scal
these
increased
in
the
As
absence
of
size
demand
increase
result
employment.
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expansionary
increase
the
the
be
Assume
in
and
this
the
the
component
spending
might
interest
loanable
would
AD2
want
which
to
a
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competing
demand
to
upward
saving
at
spending
AD1
is
full
lending
as
3.6.4b.
more
sense,
sloping
Figure
may
funds.
expansionary
to
in
(I)
much
Their
loanable
interest
from
though,
much
Monetarists
investment
shown
as
want
As
downward
increase
who
together.
for
If,
government
investment
In
not
increase
the
to
interaction
is
government
demand
Expansionary
are
will
to
investment
from
only
to
This
intended
private
from
increasing
prefer
increase
loanable
demand
all.
was
resulting
goal
aggregate
Instead,
decrease.
anyone
at
(G)
since
rates
the
It
spending,
to
then,
If
(G)
of
demand
even
interest
spending.
expenditures
aggregate
crowding
could
increased
demand
aggregate
it
the
effect?
The
If
by
government
T I N U
any
S C I M O N O C E O R C A M
Without
: 3
crowded-out
•
in
can
help
an
economy
grow
again.
Figure
increase
and
Recap
shif t
on
to
the
right
loanable
The
from
funds
resulting
will
higher
D(LF)1
to
increase
borrowing
D(LF)2.
from
cost
r1
The
to
will
interest
rate
r2.
Crowding
dissuade
many
If
out
G↑→
D
↑→
r↑→
I↓
→
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LF
rms
from
plans.
borrowing
Private
to
nance
investment
will
their
own
decrease.
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investment
will
have
(I)
been
(a)
(b)
S(LF)
APL
Interest
rate
AS
(r)
r2
AD1
AD3
AD2
r1
D(LF)2
D(LF)1
F1
F2
Y1
Loanable
Y3
Y2
Yf
Figure
3.6.4a
Crowding
out:
the
loanable
funds
market
Real
output
funds
Figure
3.6.4b
Crowding
out:
the
impact
on
the
economy
129
Effectiveness
of
scal
policy
economy
Advantages
it
•
Perhaps
the
biggest
advantage
of
expansionary
is
not
in
the
form
of
increased
government
that
it
is
direct .
Government
spending
is
raising
a
In
taxes
aggregate
demand.
in
automatically
If
it
increases,
a
deep
recession
ineffective
of
the
as
zero
section
increase.
lower
3.5,
when
condence
bound
page
This
easy
aggregate
especially
monetary
levels
(ZLB)
is
are
low
(HL)
An
increase
may
also
be
•
explained
On
the
policy
in
government
an
in
economic
even
greater
increase
(that
in
is,
expenditures
aggregate
on
GDP)
of
the
multiplier
will
Fiscal
policy
can
be
even
if
demand
because
of
can
specic
in
green
Increased
specic
sectors
infrastructure,
technologies,
appeal
much
policy,
to
the
scal
median
policy
political
agenda
of
the
is
ruling
not
party.
has
an
“expansionary
bias”.
in
many
is
the
direly
that
parliamentary
of ten
try
to
needed.
debt
democracies,
expansionary
Typically,
increasing
national
stall
government
to
scal
opposition
expenditures
unsustainable
will
“become
like
Greece”
was
the
levels
typical
and
Other
opposition
claims
are
that
increasing
the
that
expenditures
will
lead
to
rampant
of
it
education
the
R&D,
or
will
lead
to
increased
interest
rates.
ination
The
result
is
government
economy,
discretionary
the
health
scal
policy
is
of ten
caught
in
endless
such
and
this
explains
why
there
are
many
economists
development
who
of
policy,
effect .
targeted.
target
needs
it
claim
country
debates
as
the
hand,
increase
that
spending
scal
expenditures
lead
or
•
not
monetary
therefore
government
operation
to
politicians
argument).
activity
of
other
politicians
(the
to
policy
opposition
because
1
10.
in
cutting
demand
will
•
contractionary
important
policy
but
constraint
for
because
component
Fiscal
will
do
contrast
independent
of
need
expenditures
voter.
is
the
adopted
scal
and
policy
indicate
of ten
care.
It
can
argue
in
favour
of
an
increased
role
for
automatic
also
stabilizers.
target
specic
regions
of
a
country
that
are
growing
much
•
slower
than
average
or
are
in
Fiscal
lags.
•
T
ax
cuts
can
also
target
the
policy
poor,
who
are
not
only
Time
need
for
a
boost
in
their
disposable
to
an
spend
income
economic
the
crisis
resulting
households,
but
who
additional
signicantly
are
also
income
more
scal
•
In
decrease
income
An
as
increase
on
also
If
in
an
its
the
debt
is
long
early
than
to
can
clearly
trillion,
In
the
(capital)
enacted
poor
its
own
owned,
The
long
trillion
of
can
help
A
then
this.
spending
alone,
March
package
huge
the
was
advantage
existence
stabilizers
do
output ,
longer.
the
potential
for
its
a
need
stimulus
political
debates
increase
expenditures,
$2
and
will
to
the
June
2020
and
if
most
can
Covid-19
it .
may
For
1
1%
of
by
and
of
about ,
being
taxes
the
crisis
•
more
the
package
if
Not
for
only
will
lag
opposition
expansionary
risk s
plan
for
but
it
can
even
get
example,
if
time
the
the
if
stuck
how
expenditures
and
by
economy
in
order
gap,
to
an
unexpectedly
how
scal
there
in
much
decides
deal
to
is
further
to
of
to
with
before
Long
time
stabilizing
increase
a
inationary
rise
increase
much.
instead
government
deationary
recession
gap
the
full
may
impact
of
stimulus.
Expansionary
economy
2019
a
if
which
decrease
spending
exports
scal
to
destabilize
example,
close
result
be
economies
2020
trillion
an
which
lags
shif ting
policy
Advanced
by
such
care
government
and
scal
roughly
a
health
is
lags
scal
already
prove
policy
may
operating
longer
than
prove
close
inationary
to
full
if
the
employment
or
expected.
had
(HL)
Expansionary
scal
policy
may
lead
to
private
additional
discussed
at
the
being
crowded
out
if
the
economy
is
close
to
time
to
economies
entering
a
employment .
If
it
succeeds
of
automatic
stabilizers.
not
require
legislative
economic
so
they
are
able
to
by
quickly
to
in
the
widen
economy,
a
higher
incomes
lead
to
more
trade
decit
imports.
Expansionary
scal
under
conditions
certain
policy
increases
this
may
the
national
prove
debt
and
unsustainable.
downturn.
Discretionary
politicians.
scal
This
maximize
for
as
may
an
•
well
incomes
policy
the
Disadvantages
elections
raising
scal
Automatic
action
respond
in
downturn
•
government
130
much
stress
because
as
is
question
and
expansionary
to
also
administrative
to
•
•
the
writing.
(HL)
is
but
policy
full
•
policy
politicians
investment
$2
time-
122),
aggregate
run.
currency
response
showed
USA
and
potential
the
representing
the
by
long
higher
•
been
very
(page
likely
are
expenditures,
education
right
issue
government
GDP
.
for
increase
the
signicantly.
$7.6
world
term
supply
2020
increased
R&D,
domestically
up
cuts
government
economy
scaled
in
in
tax
by
earlier
inequality.
infrastructure,
aggregate
•
addition,
monetary
policy
agreement
demand.
characterized
explained
incomes
than
increasing
as
in
in
during
also
lags,
characterize
greater
is
decline.
prove
policy
presents
their
tax
is
the
some
re-election
sizable
for
Expansionary
Even
issues.
chances
increases
cuts.
responsibility
if
in
Politicians
of ten
push
government
the
incomes
of
aiming
before
spending
fundamentals
of
the
to
if
because
propensity
lead
scal
effective
to
is
tax
those
consume.
increased
condence
policy
the
very
that
cuts
with
low.
if
on
tax
mostly
higher
More
spending
relies
are
cuts
geared
incomes
generally,
tax
consumer
and
may
to
have
cuts
not
higher
a
lower
may
business
not
T I N U
Recap
and
disadvantages
of
scal
policy
•
Fiscal
policy
affects
aggregate
•
Fiscal
policy
can
targeted.
•
Certain
•
Under
be
expenditures
certain
may
also
conditions
demand
increase
scal
policy
directly.
potential
can
be
output .
scaled
up
•
Politicians
are
•
Fiscal
•
It
may
lead
to
unsustainable
•
It
may
lead
to
ination.
•
It
may
widen
•
T
ax
•
(HL)
policy
responsible
is
for
characterized
scal
by
: 3
Disadvantages
Advantages
policy.
long
time
lags.
debt .
signicantly.
•
(HL)
The
ght
•
(HL)
a
multiplier
renders
scal
policy
powerful
cuts
may
Automatic
stabilizers
can
be
quick
and
should
be
stressed
that
the
role
economic
stabilization
is
of
becoming
Fiscal
directed
perspective
scal
policy
more
to
policymakers
to
are
ght
afraid
off
a
that
have
widened
not
be
able
to
mitigate
zero
lower
bound
recessions
as
a
rates.
(ZLB)
constraint
Research
has
typically
decrease
nominal
it
faces
shown
that
ve
In
recent
percentage
points
this
is
in
not
interest
response
possible
in
to
rates
by
On
the
nominal
other
interest
hand,
expansionary
may
even
why
policymakers
automatic
Policymakers
rates
long
discretionary
and
on
the
worsen
are
are
time
scal
seriously
below
that
macroeconomic
consider
policy
Spending
can
to
has
scal
may
be
a
problem
uctuations.
considering
policy
rising
policies.
may
be
targeted
suffering
Optional
more
better
relying
This
is
more
equipped
income
towards
than
the
following
The
=
ΔG
+
bΔG
+
b
and
3
ΔG
(2)
ΔY
=
(1
+
b
+
b
+
3
+
b
bank s
stock
must
be
have
market
mindful
expansionary
national
also
and
prove
is
not
debt
debt
bias
may
much
of
pumped
the
into
booms.
of
of
the
risks
discretionary
increase
levels.
inationary
Of
very
are
discretionary
scal
economy
result
to
Discretionary
or
it
may
crowd
scal
out
course,
with
real
interest
rates
so
costly.
of
aware
cyclical
though
policy
experiences
is
manifested
saw
with
economic
at
that
the
the
the
outset
but
potency
of
the
for
when
shock s
conditions
Its
need
greatest
extraordinary
circumstances.
was
and
tax
in
an
not
as
a
such
Covid-19
as
a
result
of
conditions
the
example
given
earlier,
when
crisis,
as
we
governments
extraordinary
emergency
scal
measures
to
industries
cuts
can
economies.
be
example,
if
I
for
a
window
xing
b
0.8
earned
from
in
a
the
government
government
£100
building
pounds
and
then
I
will
spend
£80
pounds,
say
on
my
luxury
MPC
cakes
4
ΔG
+
b
ΔG
+
…
→
that
2
considered
holds:
2
ΔY
central
fuelling
decits
Policymakers
is
(1)
is
because
than
material
Algebraically
inequality
inequality.
regions
others
the
investment .
debt
support
are
that
been
with
implemented
that
income
policymakers
exceptional
prevent
Monetary
5%.
characterize
stabilizers.
monetary
poor.
easing,
countries
already
policy
the
contractions.
many
lags
of
three
low,
because
plight
quantitative
with
private
years
investment .
central
policy
to
the
funding
unsustainable
bank s
private
result
scal
interest
out
policy
associated
the
crowd
are
Monetary
However,
may
nominal
spending.
important .
economies
downturn.
may
specically
economies
ill-prepared
policy
improve
and
additional
of
more
in
to
alone
decit .
induce
sizable.
policy,
Many
trade
not
recession.
Policymakers’
It
a
to
S C I M O N O C E O R C A M
Advantages
the
baker
Roxanne
across
the
street
baked.
Now,
4
+
b
+
…)
ΔG
→
income
has
increased
by
180
and
represents
the
service
1
(window
(3)
ΔY
=
x
(4)
ΔY
=
ΔG
c
1
k
−
point .
is
the
good
(cakes)
produced
up
If
Roxanne
in
turn
spends
0.8
of
her
extra
to
this
income
ΔG,
say,
will
k
and
→
b
on
where
xing)
the
cheddar
have
cheese
increased
by
that
£64
Bob
produces,
pounds
(this
then
the
his
third
income
term,
multiplier
2
b
Since
b
is
the
marginal
propensity
to
consume
ΔG)
point ,
domestic
goods
and
services
the
multiplier
k
representing
the
extra
cheddar
produced.
Up
to
this
(MPC)
can
national
income
has
increased
by
100
+
80
+
64
or,
be
2
generalizing,
rewritten
by
ΔG
+
bΔG
+
b
ΔG.
income
b
Bob
2
portion
1
the
change
and
is
in
the
equation.
change
in
income
government
direct ,
The
MPC)
is
spending
rst-round
second
−
ΔY
term
goods,
equal
(ΔG)
effect
(bΔG)
and
is
to
the
which
the
the
rst
In
initial
workers
term
proportion
b
earned
in
of
the
(2)
that
workers
that
and
was
spent
which
is
b
of
on
other
income
to
domestic
others
in
goods
the
by
these
economy.
and
his
the
a
extra
3
ΔG
or,
b
ΔG
on
some
other
of
on.
term
inside
terms
so
a
the
ΔG
is
factored
parentheses
geometric
this
out
we
and
have
progression
it
the
that
should
sum
of
be
realized
innite
converges
1
(as
income
spend
=
(1
(1)
then
as:
k
In
will
0
<
b
<
1)
to
(1
−
b)
For
131
3.7
Supply-side
Supply-side
economy.
within
policies
They
which
quantity
increase
supply
The
improve
as
well
potential
(LRAS)
Goals
•
economic
and
production
of
•
as
on
to
activity
the
to
to
primary
goal
of
shif ting
of
side
place,
the
the
of
the
institutional
to
The
long-run
Supply-side
framework
increase
available
incentives.
the
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giants
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power
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deregulated.
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argued
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unions
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workplace
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sexual
Privatization
and
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many
refers
to
enterprises,
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logic
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owned
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minimum
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their
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133
Incentive-related
economic
policies
as
T
ax
cuts
are
closely
associated
with
a
group
of
it
is
high
tax
discourage
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rates
on
hard
as
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personal
work
income
and
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and
on
investments
believed
they
who
do
increase
mostly
own
income
such
inequality,
assets
and
so
they
disproportionately.
that
corporate
by
but
wealthy
1980s
benet
economists
growth,
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individuals
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and
respectively.
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personal
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Reducing
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expected
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result
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lower
personal
market
income
tax
individuals
may
decide
to
join
the
labour
related
policies
include:
increasing
force;
competition
in
product
markets
that
rates,
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policies
increase
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labour
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taxes
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prices,
increase
output
and
spur
the
innovation
unemployed
may
be
less
willing
to
remain
unemployed
given
•
a
job
offer;
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workers
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incentivized
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work
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production
hours.
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increase
curve
to
income
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economy ’s
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ax
to
longer
corporate
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labour
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suggests
that
in
most,
if
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all,
cases
investment
spending
•
did
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in
fact
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following
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cut
in
corporate
unemployment
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Capital
gains
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prots
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to
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will
and
conclude,
price
of
gains
stock s,
tax ,
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large
that
policies
education
and
health
development
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referred
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argued
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to
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purchased.
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goal
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of
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available
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improved
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private
and
benets
external
134
growth.
training
services,
documented
productivity
for
benets
Education
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for
generates
and
educated
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but
economy
as
not
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quality
and
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gains
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tax ,
East
also
female
have
education
so
to
the
incentive
to
increase
the
increased
enrollments
paid
are
Asia
improved
off
also
and
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public
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force
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of
human
quality
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in
overall
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economic
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form
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capital
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productivity
technology
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physical
capital
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workers
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that
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public
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productivity
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achieve
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economies
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productivity
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technology
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3.7.2).
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(Figure
either
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3.7.1)
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market-
either
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135
shif t
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AS
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term
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Figure
3.7.1
Impact
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AS
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that
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budget
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price
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interest
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short
term,
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Supply-side
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professional
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large
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and
have
in
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countries
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138
interventionist
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: 3
Fiscal
T I N U
stability
S C I M O N O C E O R C A M
Price
in
such
policy
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competitiveness.
case
response.
141
Key
side
issues
policies
economy
Policymakers
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Low
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term
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below
research
examining
to
more
again,
specialized
as
a
internet
sites
to
with
are
extremely
and
so
is
sites.
result
explained
not
than
The
realized
is
all
in
sectors
of
“bottleneck s”
section
and
Capacity
for
as
it
3.2,
as
industries
constraints
reach
(the
any
inationary
pressures
grows.
operating
output ,
growth
that
will
the
will
they
they
do
lead
to
more
not
to
potential
inationary
prove.
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know
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encourage
before
the
country ’s
there
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NRU
can
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beforehand
what
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accelerate
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in
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growth
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and
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will
policymakers
only
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level
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know
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hand,
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permit
inationary
target)
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very
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supply-side
economy
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for
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capacity
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of
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succeed
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productive
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aggregate
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to
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demand
level.
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decreased
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monetary
the
it
is
worth
noting
that
ination
has
not
been
a
NRU
issue
for
most
economies
for
more
than
a
decade.
therefore
example,
since
2000,
the
ination
rate
in
the
USA
has
vigilant .
never
been
struggling
High
As
rises
condence.
For
remain
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NRU.
to
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is
and
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responsible
growth
much
Lastly,
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quickly
availabilities
upwards
economy
economic
accelerating,
USA
Whenever
Some
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that
is
Government
of
economy
employment)
further
On
in
explanations
unemployment
accelerate.
ensure
crisis
historically
is
inverse
unemployment .
suggests
point
In
to
only
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the
without
several
there
In
natural
country
are
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activity
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at
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So,
middle
nancial
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4%,
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becomes
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accelerating.
considered
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and
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to
simultaneously.
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(HL).
global
decreasing,
typically
ination
economy
the
(NRU)
that
this
fallen
ination.
is
At
ination
had
section
consensus
2008– 09
been
economists
unemployment
in
not .
had
unemployment
the
is
such
slope
employment
too
economies
better
information
and
economy.
“bottleneck s”)
to
Is
a
sloping
demand
ination).
Phillips
in
frictional
other
to
the
policymakers
economic
but
of
and/
achieve
upward
AS
aggregate
unemployment
type
they
(cyclical)
seems
operating
increase
live
done
vacancies
begins
prices
apparent
This
constantly
and/or
risk
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Keynesian
be
reducing
unemployment
upward
people
objectives
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Monetarist
of
increase
objectives.
facing
a
a
any
Assuming
to
participants.
curve
ination.
difcult
ination.
hardly
lower
higher
monetary
then
or
market
full
easy
is
a
ination
scal
this
the
macroeconomic
expansionary
job
labour
aggregate
aggregate
so
adjust
usually
policymakers
result
related
arising
It
year,
unemployment?
the
market
LinkedIn
Potential
is
labour
useful
water
the
that
listings
snow
of
clearly
thing
not
rest
because
nd
of
the
unemployment .
June
unemployment
unemployment
for
the
•
meantime
gym
T I N U
rural
: 3
in
S C I M O N O C E O R C A M
collecting
economic
Perhaps
the
between
ination
easiest
achieving
is
to
use
a
growth
way
to
higher
and
illustrate
growth
Keynesian
AS
low
the
and
to
than
increase
4%.
Very
ination
to
many
meet
countries
the
are
common
even
2%
ination
possible
The
target .
The
and
very
world
is
more
concerned
with
the
risk
of
deation
conict
maintaining
curve.
higher
of
slow
long-term
growth.
low
Keynesian
AS
143
High
economic
growth
and
environmental
sustainability
Economic
growth
effects
the
The
on
possible
basic
idea
increase,
level
of
is
can
benets
economic
that
as
capita
growth
improvement
have
can
Kuznets
pollution
per
in
both
positive
and
negative
understood
(see
countries
can
and
be
it
and
and
lead
become
3.3,
per
then,
decreases.
eventually
thereby
through
section
grow
rises
income,
income
issue
is
that
economic
capita
af ter
This
to
the
page
Growth
87).
The
incomes
some
implies
critical
that
environmental
natural
resources
and
establishing
such
as
growth
not
only
indirect ,
poverty.
requires
the
of
that
may
but
therefore
curve
local
such
be
the
for
In
depletion
stop
of
common
well
growth.
to
as
avoid
the
Lastly,
and
capacity.
but
many
it
may
goods
production
use
a
hold
a
for
externalities
reduction
and
may
Kuznets
can
or
of
turn
technologies
in
the
towards
may
allow
with
pool
or
also
regulations.
of
cap
green
subsidies
activities
and
Carbon
and
in
no
many
trade
that
direct ,
and
They
as
the
worsen
through
and
income
also
on
may
it
to
permits
the
a
social
benets,
programmes
seek
improve
a
poor.
governments
expanding
spending
may
as
wealthy
unemployment
well
as
capital
taxes
schemes
are
adopt
clean
In
industries,
only
on
health
and
and
labour
the
an
If
if
growth
it
is
how
to
welfare
but
to
increase
sanitation
education
it
can
net
also
alleviate
agricultural
and
basic
facilities
that
productivity.
not
not
skills
is
or
driven
if
the
it
is
by
in
benets
from
enough
support
shared.
may
and
a
its
policies
since
be
is
fairly
handful
of
regions,
many
if
it
will
relies
be
lef t
widen.
less
the
income
increasing
there
will
then
growth
whether
necessary
uniformly
only
certain
be
higher
been
because
jobless,
will
to
has
growth
country
growth
determine
is
of
non-inclusive
then
leads
This
benets
is
in
society
gain
be
of ten
inequality
concentrated
the
ultimately
unequal
may
is
growth
wealthiest
it
the
inequality
if
growth
income
economies.
that
certain
and
Lastly,
fact ,
growing
distributed.
will
also
economic
guarantee
will
economic
rms
be
inequality
from
programmes
human
inequality.
that
adopt
technologies
to
such
resources
sustainable
in
governments
fuels
should
adoption
more
growth,
fossil
income
improving
through
These
However,
out
common
investments
and
wastes
only
dispersed
Nevertheless,
environmental
towards
improve
access
Growth
environmental
view
for
Governments
together
technologies.
The
“ futureless”
broader
equity
use
growth.
deplete
2.8).
help
necessary,
144
emissions.
subsidizing
stricter
also
not
emissions
carrying
pollution-intensive
that
section
enforce
may
and
sustainable
shing
(see
as
of
addition,
more
optimistic
pollution-intensive
should
as
an
carbon
more
to
Earth’s
unsustainable.
provides
as
leads
the
externalities
production
less
also
exceed
both
income
pensions
increase
resources
can
alleviate
Redistribution
be
sustainable.
can
redistribution
infrastructure,
of
and
distribution
growth
productivity.
The
growth
distribution.
curve
initially
economic
Economic
environment .
environmental
High
benets
resilient .
are
the
This
will
revive
last .
the
long-term
with
means
distributed
growth
to
remain
that
In
economy
benets
and
country
sells
The
goods
the
countries
of
trade
decades.
Free
of
a
other
and
Examining
trade
to
the
free
will
a
as
has
permits
country
the
buying
borders.
services
world
of
to
countries
referred
the
Benets
•
to
are
in
refers
across
The
are
referred
country
imports
grown
ratio
and
selling
goods
buys
(M).
to
the
The
sum
as
from
of
of
services
exports
a
(X).
other
over
the
exports
imports
over
27%
1970
in
important
free
importance
dramatically
of
and
ow
trade)
past
to
of
world
about
reason
for
goods
have
benets
GDP
,
trade
60%
this
and
decreased
for
T I N U
trade
services
trade
countries
has
in
increased
2018.
growth
services
is
that
dramatically.
in
most
countries
What
free
about
the
restrictions
between
engaging
from
Perhaps
are
the
to
the
(free
possible
trade?
and
trade
specialization.
specialize
in
The
the
scarce
resources
production
of
a
Recap
range
of
goods
and
services,
leading
to
higher
levels
Benets
of
output
country
and
higher
engaging
combinations
of
in
possible
levels
international
goods
and
of
consumption.
trade
services
can
outside
consume
its
curve
Free
trade
scarce
•
and
Free
trade
that
domestic
—
More
within
an
automatically
increased
rms
competition
possess.
will
Free
trade:
permits
specialization
the
and
any
All
allocation
in
the
•
improves
•
increases
of
the
Increased
benets
power
competition
to
output
cut
of
resources
lowering
domestic
monopoly
•
leads
•
forces
to
•
may
lower
to
lower
prices
for
buyers
rms
to
prices
cut
and
waste
improved
and
quality
become
more
efcient
and
induce
domestic
rms
to
grow
and
achieve
quality.
efciency
forced
increasing
of
in
as
the
a
result
use
of
of
free
trade
resources
as
leads
rms
costs.
Firms
cannot
afford
to
of
scale
to
permits
domestic
rms
to
import
capital
goods
that
will
meet
be
resources
power
•
greater
allocation
competition,
economies
—
of
consumption
world.
monopoly
the
of
levels
follow.
leads
product
improve
economy
decreases
may
competition
improved
trade
(PPC).
specialization
resources
free
production
and
•
of
A
•
possibilities
: 4
goods
international
L A B O L G
International
of
E H T
Benets
exactly
their
specications
Y M O N O C E
4.1
waste
•
presents
•
permits
•
permits
consumers
with
greater
variety
resources.
—
Firms
will
also
competition
be
forced
from
to
imports
innovate
or
to
to
and
export
penetrate
Free
trade
which
allows
they
exporting
sell
rms
their
from
from
countries
not
to
grow
in
size
since
expands.
countries
with
the
This
small
market
endowed
allows
markets
importantly,
Free
trade
economies
allows
rms
(machinery,
of
that
to
import
equipment ,
meet
and
tools
use
and
This
much
more
closely
their
free
imports
further
increases
from
4.1
.1a
their
of
trade.
trade
stimulates
faster
Consumers
choose
and
free
the
welfare
Free
enjoy
from
trade
a
due
greater
to
enables
to
4.4.1c
imports
illustrate
and
the
the
quantity
increased
of
welfare
We
assume
the
market
for
corn,
a
variety
of
goods
and
services
the
sold
in
perfectly
free
country
is
competitive
“small”.
In
the
exports,
that
the
results
from
homogeneous
markets.
context
of
We
further
assume
international
traded
across
capital
Natural
means
that
the
country
can
buy
or
sell
as
much
of
the
trade.
faster
transfer
and
diffusion
as
it
wants
without
the
world
price
changing.
borders
as
technology
is
of
embodied
Sd
in
goods.
resources
trade
trade,
to
Price/unit
technology
Free
increase
trade
productivity
product
•
growth.
protability.
“small”
•
they
exact
that
•
resources
capital
product
and
natural
intermediate
free
specications.
acquire
scale.
quantity
products)
to
with.
rms
Figures
goods
faster
to
resulting
•
spread
in
Exports,
benet
to
more.
products
small
ideas
foreign
Most
•
and
withstand
are
markets
technology
allows
are
not
distributed
countries
to
import
equally
and
across
use
countries.
natural
Pd
resources,
•
The
the
such
benets
faster
all
of
oil,
of
scale
allow
that
they
may
specialization
diffusion
economies
enjoys
as
of
and
technology,
and
faster
not
the
of
have.
more
the
increased
growth.
This
is
competition,
possibility
exports
why
a
trade
of
country
D
is
Q
referred
to
as
an
engine
of
economic
Quantity/
growth.
period
Figure
4.1
.1a
Closed
economy—no
trade;
“autarky ”
case
145
Sd
Price/unit
In
F i g u re
open
4.1
.1b
e c o n o my
ma r ke t
is
we
assume
and
higher
t hat
t hat
the
the
price
at
P w.
At
the
can
sell
as
much
of
country
corn
world
in
price
is
n ow
the
Pw
an
world
domestic
Sw
Pw
corn
p ro d u c e r s
affecting
it
( re m e m b e r
this
is
a
as
t h ey
“ s ma l l ”
wa n t
without
country).
T h ey
face
Pd
the
Q2
world
price
units.
only
be
At
Q1
Q2
t hat
willing
p ro d u c e r s
D
Pw
will
the
re ma i n i n g
a re
e qu a l
to
at
which
price,
to
buy
sell
though,
Q1
Q1
Q1Q2
t h ey
units
units
units
in
in
will
be
willing
domestic
of
corn.
the
the
to
consumer s
Domestic
domestic
world
of f e r
ma r ke t
ma r ke t .
will
corn
and
Exports
Q1Q2.
Quantity/
In
this
case,
where
the
world
price
is
higher
than
the
period
domestic
Figure
4.1
.1b
Open
economy—Pw
>
Pd:
country
exports
corn
price
decreases
by
area
area
by
(A
(C).
resulting
area
+
B
+
(A
C).
Producer s
+
A
in
B)
exports,
and
producer
welfare
could
in
consumer
gain
surplus
thus
principle
surplus
increases
results
fully
equal
to
compensate
Sd
Price/unit
consumer s
Free
a
trade
for
their
has
loss
of
increased
income
social
and
welfare
still
be
but
better
not
off.
everyone
is
winner.
In
Figure
4.1
.1c
we
assume
that
the
country
is
again
an
Pd
open
A
B
Sw
economy
market
is
but
lower
at
that
Pw.
the
price
Domestic
of
corn
in
the
consumer s
world
can
buy
as
Pw
much
corn
as
(remember,
be
willing
they
this
to
is
buy
want
a
at
that
“small ”
Q4
units
price
country).
while
without
affecting
At
Pw
price
domestic
corn
they
it
will
producer s
D
Q3
0
Q4
Quantity/
period
Figure
4.1
.1c
Open
economy—Pw
<
Pd:
country
imports
will
only
be
willing
will
thus
be
purchased
of
corn.
In
this
4.1
.1a
illustrates
the
closed
economy
case
when
no
imports
or
exports
of
corn.
This
is
also
referred
resulting
to
(A
“autarky ”
case.
Domestic
demand
and
domestic
corn
will
lead
to
an
equilibrium
price
of
Pd
per
unit
equilibrium
quantity
of
Q
units
per
and
Absolute
and
of
advantage;
trade
generates
many
benets
B)
social
welfare
even
better
for
an
economy.
It
a
off.
The
country
next
step
specialize
is
to
in
not
all
determine
and
it
import .
We
consider
a
export ,
world
parties
producing
Absolute
two
surplus
results
equal
compensate
still
be
rst
which
and
with
decreases
by
area
(B).
the
advantage :
advantage.
production
of
of
can
of
just
one
of
not
relies
A
Adam
on
domestic
off.
producers
Free
trade
if
it
export
that
T
able4.1
.1
a
good
if
more
can
146
resources.
good
and
in
their
everyone
is
a
winner.
countries,
two
goods,
called
apples
Red
and
and
Green,
bananas.
both
countries
have
the
same
We
amount
are
capital
or,
to
simplify
matters,
each
of
country
unit
of
labour.
good
that
The
numbers
each
country
are
can
the
maximum
produce
if
it
countries
all
of
its
Smith’s
theory
resources
in
the
production
of
that
has
an
absolute
Red
good.
Country
of
production:
30
10
10
20
advantage
compared
units
with
to
the
its
trading
same
resources
produce
a
unit
of
the
good
maximum
fewer
for
increases
Smith
Adam
country
produce
equivalently,
using
A
could
HL
two
each
production:
or,
by
(A).
goods
Banana
it
area
Consumers
maximum
partner,
domestic
goods
which
two
but
that
and
Apple
in
the
increases
goods.
explanation
absolute
to
better
Country
The
than
surplus
involved
uses
each
consumer
producer
and
producing
amount
should
lower
Q3Q4
imports
also
has
should
fully
welfare
labour
are
imports,
thus
prots
possibilities
advantage
though
in
and
gain
assuming
increases
reect
specialization
each
Free
is
and
Units
period.
comparative
comparative
+
principle
social
Absolute
price
corn.
and
loss
an
world
abroad
of
supply
in
of
from
units
as
welfare
the
the
Q3
there
area
are
where
offer
corn
price
Figure
case
to
A
country
which
Figure
it
4.1
.2
has
should
an
show
specialize
absolute
the
in
and
advantage.
production
T
able
4.1
.1
Green
advantage :
David
T I N U
Comparative
Apples
Ricardo
30
In
181
7
David
in
T
able
4.1
.3
Ricardo
there
is
showed
still
that
room
for
even
in
the
mutually
case
shown
benecial
25
specialization
comparative
and
and
exchange.
not
He
absolute
showed
that
advantage.
what
Relative,
matters
and
is
not
cost
look
of
at
production
the
is
important.
opportunity
cost
of
This
means
producing
that
each
we
good
for
15
each
country.
production
A
of
country
a
good
has
that
a
it
comparative
can
produce
advantage
at
a
lower
in
the
opportunity
10
cost
Green
0
5
10
15
its
trading
partner.
country
sacrices
fewer
bananas
country
sacrices
fewer
apples
20
on
be
advantage
of
clear
in
from
apples,
labour)
it
T
able
as
can
4.1
.1
with
the
produce
that
same
30
Red
has
the
resources
apples
absolute
(say,
whereas
one
only
10
apples.
Green
has
the
absolute
Green
or
20
as
produce
10
cheaper
and
apple
and
which
on
Red
It
follows
that:
it
can
produce
20
bananas
while
bananas.
should
So,
Red
can
specialize
in
produce
and
Red
apples
export
should
specialize
in
and
export
if
the
one
of
the
production
countries
of
both
has
the
goods?
are
as
in
T
able
4.1
.2
can
in
Figure
4.1
.3,
in
this
90
Green
produce
at
bananas.
it
bananas
90
it
bananas
will
sacrice
What
if
the
needs
apple
60
apples:
Red
opportunity
cost
20
40
bananas
of
=
90
60
apples
case
Green
(with
whereas
must
bananas
apples.
=
Green
apples.
has
by
Dividing
20:
by
90:
advantage
the
opportunity
cost
cost
in
same
1
banana
of
=
1
banana
producing
=
bananas:
2
Red
Country
of
apples
an
it
production:
40
should
apple
Green
specialize
Apple
a
comparative
of
Country
sacrice
cost
production
4.1
.3?
cost:
to
apples:
whereas
advantage
Figure
banana
it
2
and
a
lower
sacrice
bananas.
absolute
a
produces
absolutely
apples
can
produce
apples
only
opportunity
shown
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produces
Dividing
possibilities
or
bananas.
can
60
it
of
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either
apples
opportunity
Green
Green
produce
40
opportunity
it
40
As
an
which
banana.
can
will
in
a
advantage
20
bananas
can
either
If
produce
in
produce
produce
on
4.1
.2
should
unit
focuses
Green
Red
It
4.1
.3
to
to
Focusing
Focusing
Bananas
Figure
T
able
export
60
in
and
bananas.
Y M O N O C E
5
than
E H T
should
L A B O L G
absolute,
Red
: 4
20
maximum
Red
Banana
production:
20
90
maximum
T
able
Green
can
produce
Red
can
produce
either
an
either
40
apples
or
60
apples
20
bananas.
90
bananas.
can
produce
apple
at
opportunity
or
needs
to
a
lower
cost:
it
sacrice
4.1
.2
½
If
it
If
produces
it
of
a
banana
produces
whereas
40
apples
60
it
apples
Green
it
Bananas
must
will
will
sacrice
sacrice
sacrice
100
1
.5bananas.
20
90
bananas:
bananas:
90
Green
consumes
20
apples
Red
opportunity
opportunity
cost
has
a
cost
80
and
70
comparative
bananas
of
40
apples
of
=
60
apples
=
70
advantage
20
90
bananas.
apple
60
Dividing
by
Dividing
40:
by
it
opportunity
cost
production:
60:
50
opportunity
should
cost
specialize
40
Red
of
consumes
1
apple
=
½
of
of
1
apple
20
apples
and
a
20
1
.5
banana
in
and
=
export
30
in
bananas.
apples.
bananas
bananas
20
T
able
4.1
.3
10
0
10
20
30
40
50
60
Apples
Figure
We
have
and
trade
versus
So
should
which
produce
country
should
bananas.
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produce
can
they
apples
now
4.1
.3
resources)
the
established
which
40)
can
and
absolute
according
benecial
produce
more
both
bananas
advantage
to
more
Adam
in
the
Smith,
specialization
and
(90
apples
versus
than
20).
production
there
is
no
exchange.
of
Red
Green
both
room
(60
for
has
goods.
mutually
and
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thirds
which
of
willing
increase
an
to
sell
opportunity
of
an
will
apple
to
to
Red
consumption
specialize
in
produce
(export)
cost
apple).
their
one
will
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if
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banana
produce
bundles?
to
it
is,
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more
buy
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two-
will
more
than
(import)
be
than
the
two-thirds
one
banana
147
if
it
can
cost
pay
Red
less
than
experiences
two
of
apples,
which
producing
one
is
the
opportunity
Limitations
Despite
A
mutually
banana
Green
benecial
for
will
one
sell
exchange
can
occur
if
they
trade
one
apple.
in
one
banana
to
buy
(import)
one
apple.
the
model
determining
which
(export)
goods
that
same
looking
conclusion:
apple
if
it
earns
opportunity
one
an
apple
apple
one,
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if
will
is
sell
of
the
will
half
(export)
of
it .
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than
and
a
the
half
one
way
willing
producing
less
one
other
be
than
acceptable.
pays
which
it
more
cost
is
at
Red
a
around
to
sell
leads
earning
be
which
one
willing
opportunity
to
(export)
banana,
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will
actual
to
trade
to
cost
is
•
to
The
are
the
banana
buy
one
ows.
these
two
countries
trade
they
will
of
theory
goods,
for
of
of
the
two
goods
that
be
but
produce,
produce
•
banana.
able
are
to
It
is
it
no
apples
possibilities.
for
20
For
bananas.
example,
It
could
Red
can
and
20
can
sell
sell
and
(export)
70
20
bananas
bananas
for
and
20
20
apples.
apples.
consume
that
there
exchange
It
It
is
outside
their
is
room
only
if
for
the
mutually
PPCs
of
benecial
the
two
because
in
this
case
of
Ultimately,
comparative
the
opportunity
comparative
factor
endowments
Differences
in
endowments
and
costs
services
Italy
because
goods
or
and
cars
for
Germany
are
highly
of
costs
a
are
good
is
constant
produced
so
the
of
producing
the
PPCs
one
are
more
linear.
In
unit
the
remains
real
the
world,
are
of ten
economies
are
of
commonly
scale
as
increased
associated
with
lower
costs.
that
easily
factors
switching
of
production
from
are
producing
perfectly
one
another
other.
Is
labour
both
good
to
geographically
occupationally
the
mobile,
necessary
skills
though?
to
switch
A
worker
jobs
or
may
may
not
not
be
able
are
It
move
is
location.
assumed
despite
advantage
advantage
and
in
depends
on
the
•
technology.
quantity
result
from
and
quality
differences
of
in
its
productivity,
capital
and
its
productivity
in
and
stock
of
physical
capital
and
its
It
is
stock
the
of
may
in
and
is
technology
affects
embodied
are
the
in
differences
productivity
of
in
in
the
assumed
of
should
trade
increases
result
ows
in
the
can
rate.
foreign
shrinking
also
For
be
physical
human
indirectly
capital
price
of
in
relative
ination
in
an
a
by
they
become
of
the
relatively
a
country
a
and
has
should
countries
also
pay
also
services
because
and
devastated.
aggregate
af ter
currency
good
affect
the
no
trade
trade
barriers,
ows
in
but
the
there
are
world.
is
risky
complete
range
specialization
is
very
risky
in
one
according
good
to
the
theory
of
comparative
a
advantage.
signicant
comparative
specialize
only
in
advantage
exporting
in
tourism
may
the
trade
if
it
over
subsidies
something
Export
demand
outbreak
exclusively
on
so
it
and
of
and
real
A
minimizes
in
risks.
a
This
This
was
must
wide
is
its
economy
collapse,
countries
country
exporting
wrong,
would
GDP
.
Covid-19
tourism.
in
went
revenues
try
painfully
relying
to
range
realized
almost
diversify,
of
especially
would
decreasing
products.
true
for
By
certain
ows.
nations
that
of ten
specialize
in
and
export
a
international
services
expensive
export
of
not
exports
range
of
mostly
primary
products.
as
time.
Comparative
Many
that
narrow
a
it
specializing
worsens
goods
more
in
tourism
narrow
competitiveness
trade.
as
movements
stronger
exported
rates
country
which,
container
available
markets.
ination
a
are
restrict
specialization
noted
or
developing
Higher
there
that
interpretation
doing
Changes
costs
of
capital.
affected
example,
export
that
barriers
be
service,
be
exchange
impede
because
the
addition:
Actual
transportation
low
productivity.
manifested
the
sometimes
no
very
of
If
technology
are
being
natural
stock
strict
Differences
there
of ten
factor
the
differences
that
these
differences
or
•
cars
for
both
that
agricultural
are
It
human
•
much
production
Complete
capital
•
import
opportunity
how
cost
assumed
plenty
In
that
there
of
shipping,
•
case
example,
for
same.
Sources
•
the
assumes
case
specialization
countries
•
in
not
For
the
PPCs.
to
the
be
could
have
parallel
and
advantage
may
Both
and
and
underlying
products.
thus
producing
Note
the
20
mobile,
can
from
and
explain
bananas.
consume
countries
arise
fully
(export)
consume
•
therefore
This
denitely
export
average
Green
not
helpful
export
their
levels
apples
does
being
should
consume
outside
therefore
it
limitations
goods.
matter
though,
20
is
assumed
same
production
advantage
country
model.
comparative
manufactured
(import)
additional
combinations
a
import ,
The
the
homogeneous.
that
If
goods
should
differentiated
buy
model
comparative
the
one
bananas.
apple
the
of
which
it
assumptions
Note
of
banana.
to
lower
the
advantage
is
a
dynamic
cost
concept
of
producing
a
good
or
a
service
articially
and
therefore
It
increase
its
competitiveness
should
dynamic
•
Lastly,
non-price
factors
can
also
lead
to
the
creation
or
concept
of
comparative
advantage
and
of
These
factors
include
product
may
or
quality
of
af ter-sales
support .
For
of
German
by
an
capital
goods
appreciating
euro
are
not
in
foreign
of
their
does
advantage
change
over
is
a
time.
in
import
education,
technology
raising
by
labour
attracting
productivity.
foreign
investment
a
(FDI)
variety
in
of
high-tech
industrial
sectors.
policies
In
in
addition,
the
hope
they
of
a
comparative
advantage
over
the
very
long
term,
good
many
countries
have.
For
example,
South
Korea’s
exports
markets.
of
electronic
ships
and
industrial
148
comparative
and
signicantly
because
as
reputation
invest
also
pursue
creating
affected
that
can
example,
may
exports
it
design,
direct
reliability
as
international
They
competitiveness.
noted
the
Governments
loss
be
abroad.
and
cars,
integrated
are
policies.
to
a
circuits,
large
degree
as
well
a
result
as
of
of
cargo
successful
many
restrict
benets
trade
derived
ows
and
from
free
employ
trade,
various
T I N U
protection
many
of
degrees
trade
quotas,
protection.
subsidies
The
and
most
common
administrative
forms
are
tariff s,
: 4
the
countries
trade
barriers.
E H T
Despite
of
T
ariff s
Analysis
of
a
Given
tariff
the
domestic
A
tariff
is
dened
as
a
tax
imposed
on
imports
restricting
their
ow
into
the
country
and
domestic
producers.
It
has
been
the
most
common
form
in
May
of
Chinese
price
the
the
and
the
domestic
specic
refers
to
tariff
can
without
buy
the
corn
or
in
sell
world
on
of
to
the
For
about
raise
good
at
for
the
while
Pw.
the
this
as
billion
•
lowering
total
P’
domestic
some
Assuming
domestic
context ,
much
price
in
of
•
×
to
consumption
volume
per
of
period.
free
total
a
small
means
product
as
×
of
trade,
in
•
that
it
revenues
Q3
=
in
Q3
drops
imports
In
the
domestic
units
of
corn
market ,
per
to
Q4
units
of
period
corn
shrink s
to
Q4
–
Q3
=
per
Q3Q4
of
addition:
collected
area
(H
+
expenditures
Q4
they
country.
market
“small ”
the
The
units
P’
corn
rise
example,
$250
imported.
be
in
valorem.
tend
market
prevail
that ,
ad
25%
will
and
the
of
will
Remember
country
A
production
price
price
or
imposed
consumed
world
world
wants
be
USA
products.
4.2.1
country.
the
may
the
amounts
Figure
Let
It
2019
established
will
of
corn
protection.
P’
protecting
period.
domestic
price
aimed
while
at
new
production
=
area
increased
demand
on
(H
or
F
+
domestic
+
+
J
by
+
corn
farmers
=
1)
3
decreased
domestic
consumers
+
note
2
+
1);
depends
on
that
the
=
whether
price
elasticity
(PED).
expenditures
“t ”
unit
foreigners
2
corn
F
import
per
by
+
is
=
Pw
collected
(exporters)
×
by
still
Q3Q4
the
=
area
domestic
earn
Pw
(J)
as
the
tariff
government
dollars
per
unit
so
of
corn
changing.
•
tariff
or,
revenues
P ’Pw
×
collected
Q3Q4
=
by
area
the
government
=
“t ”
×
Q3Q4
(3).
Sd
P/unit
A
welfare
•
Consumer
surplus
a
the
result
analysis
of
enjoyed.
•
(Pw+t)
=
reveals
surplus
following.
decreases
higher
Domestic
Producer
the
price
buyers
by
area
paid
of
increases
corn
by
(1
and
are
area
+
the
2
+
clearly
(1)
3
lower
as
L A B O L G
Types
+
4)
as
quantity
worse
Y M O N O C E
4.2
off.
domestic
S'w
P'
producers
=
1
tariff
sell
more
corn
and
earn
a
higher
price
't'
Pw
(remember
Sw
units
of
that
the
tariff
is
collected
from
the
imported
corn).
D
•
Q1
Q3
Q4
Q2
Q /period
Area
on
put
Figure
4.2.1
Effects
of
a
tariff
on
the
market
for
(3)
•
the
price
at
Pw,
domestic
rms
back
will
offer
Q1
units
per
corn
period
per
while
period.
domestic
The
consumption
difference
Q2
–
Q1
will
=
be
Q1Q2
Q2
is
(volume)
of
corn
imported.
In
It
follows
total
(2)
costs
revenues
×
Q1
=
collected
area
by
total
Pw
•
expenditures
×
Q2
import
=
area
domestic
corn
farmers
on
(H
+
expenditures
now
that
corn
unit
of
corn
F
the
=
+
J
Pw
by
+
×
domestic
consumers
=
=
unit
a
(Pw
on
result
the
+
t).
The
The
Figure
of
the
country
decisions
is
are
tariff
referred
have
as
to
it
cannot
be
is
be
spent
money
considered
a
leads
to
a
welfare
loss
equal
to
(4).
to
as
production
produce
cost
Pw.
Q1Q2
imposes
tariff
will
tariff
4.2.1
.
tariff,
“t ”
The
in
a
raise
the
small—its
is
thus
world
=
area
order
tariff
the
equal
price
country
(F
to
units
inefciency
Q1Q3
because
domestically
the
country
to
import
these
than
units
at
it
the
Analytically,
+
J
+
area
G).
(F),
at
and
Pw
to
domestic
to
is
do
and
not
P ’Pw
not
less
“t ”
which
supply
good.
area
(F
the
curve
is
The
product
they
cost
of
could
+
cost
2),
of
also
of
units
have
the
producing
the
area
marginal
importing
Q1Q3
been
under
Q1Q3
these
times
the
bought
the
cost
units
world
under
supply
of
is
only
price
price
the
represents
net
value
lost
by
free
society
trade.
Q1Q3
domestically
produced
even
from
though
have
been
imported
they
instead.
per
if,
as
because
world
being
to
dollars
affected
corn
therefore
dollars
Area
units
(4)
is
price.
are
referred
Q4Q2
consumed
consumption
affect
a
the
is
protect
equal
demands
production
insignicant
the
producing
should
P’
is
price
curve,
G)
government
producers
corn.
a
area
domestically
units
per
that
and
more
Area(2)
domestic
and
may
it
=
Pw
Assume
economy
so
(H)
units
•
and
addition:
world
Pw
government
infrastructure
units
would
•
the
the
or
the
it
quantity
into
by
care
of
Area
of
health
loss.
area(2)
corn
collected
corn
welfare
With
is
schools,
valued
are
by
by
to
now,
as
as
domestic
consumption
a
result
of
consumer s
consumer s
more
the
inefciency
tariff,
even
than
not
though
what
it
because
being
these
would
units
have
149
cost
to
to
import
consumer s
demand
them.
area
curve,
Analytically,
(G
and
+
is
4),
the
units
which
sum
of
is
Q4Q2
the
how
area
much
are
worth
under
Recap
the
consumer s
Effects
would
have
been
would
have
cost
(G),
at
the
Area
they
(4)
units
of
not
to
import
units
could
therefore
Q4Q2
have
to
product
which
willing
pay
and
Q4Q2
have
been
represents
being
to
consume
enjoy
these
times
the
bought
net
units
world
under
value
consumed
these
even
lost
only
price
free
by
units.
Pw
trade.
they
tariff s
A
tariff:
•
increases
the
•
increases
domestic
•
decreases
•
decreases
the
•
decreases
consumer
•
increases
•
creates
•
leads
area
society
though
of
It
domestic
price
of
the
production
of
protected
the
good
good
from
consumption
of
the
good
should
volume
of
imports
been.
producer
tariff
to
surplus
surplus
revenues
production
equal
to
area
inefciency
(3)
and
on
Figure
4.2.1
.
resource
misallocation
•
leads
•
is
to
consumption
responsible
for
a
inefciency
welfare
loss.
Quotas
Analysis
of
a
The
quota
At
A
quota
is
a
quantitative
restriction
on
the
volume
of
supply
the
example,
in
2018
the
USA
imposed
a
quota
on
Q1
units
imports
equal
to
2.68
million
tons
per
year,
that
the
USA
restricted
annual
steel
imports
of
Korea
to
that
specic
amount .
This
was
a
the
effect
of
2017
such
volume
a
quota,
of
imports.
using
Figure
21%
corn
as
an
4.2.2
of
as
a
corn
result
demand
market
farmers
is
are
now
still
restricted.
willing
but
only
ab
units
are
allowed
to
to
be
for
of
the
corn
quota.
equal
to
So,
bf.
at
Pw,
Total
there
is
quantity
an
supplied
both
domestic
and
foreign
producers
is
equal
to
line
decrease
segment
from
domestic
domestic
steel
by
from
the
which
excess
meant
in
Pw,
Korean
imported
steel
corn
price
imports.
offer
For
of
world
shows
Pwb
while
quantity
demanded
is
line
segment
Pwf.
the
There
is
pressure
for
the
What
is
the
effective
price,
it
will
be
domestic
price
of
corn
to
rise.
example.
supply
of
corn
in
this
market?
At
each
Sd
P/unit
S'
=
(Sd
+
equal
to
whatever
domestic
producers
are
quota)
willing
to
offer
plus
the
xed
quota
amount
of
corn
ab.
We
a
b
therefore
draw
from
point
b
a
line
parallel
and
to
the
right
Quota
=
of
(ab)
Sd
all
at
market
P'
S’
prices
so
to
has
that
the
distance
horizontal
ab.
decreased
Note
from
rightward
that
Sw
to
supply
S’.
The
shif t
of
is
corn
world
equal
in
at
this
supply
Sw
1
pivoted
Pw
toS’.
Sw
a
D
Q1
Q3
Q4
Q2
Q /period
The
new
will
be
at
P’
supply
S’.
At
Q3
Figure
4.2.2
Effects
of
a
quota
on
the
market
for
units
Figure
domestic
period
4.2.2,
farmers
while
volume
the
of
world
are
willing
domestic
corn
price
for
to
corn
offer
consumption
imports
will
be
Q2
–
is
Q1
at
Pw.
units
will
Q1
be
=
of
Q2
At
price
corn
units.
Q1Q2
=
Pw,
per
per
Before
units
now
decides
to
limit
the
quantity
of
corn
more
than
•
of
from
af
to
only
ab
units
per
period.
No
imported
corn
the
is
corn
supplied
may
in
enter
this
the
domestic
market .
Sw.
corn
of
corn
At
as
world
quota
corn
150
that
was
faced
price,
domestic
price
were
offered
the
are
domestic
the
farmers
willing
are
to
market
effective
willing
purchase
corn
to
offer
Q4
The
quota
difference
is,
of
Q4–Q3
course,
equal
=
Q3Q4
to
the
is
the
quantity
amount
of
the
ab.
quota
was
imposed:
imposed,
by
at
domestic
by
Pw,
foreign
the
world
buyers
producers
consumers
given
offered
foreign
by
the
price
was
would
demanded.
demand
domestic
exporters.
Q1
=
collected
area
by
domestic
corn
farmers
=
(H)
expenditures
×
Q2
=
area
on
(H
+
corn
F
+
by
J
+
domestic
consumers
=
G)
How
import
Pw,
expenditures
=
Pw
×
Q1Q2
=
area
(F
+
J
+
G).
innitely
for
as
Therefore,
corn
farmers
offer
and
D,
Q1
at
quota
was
imposed:
total
revenues
collected
by
domestic
corn
farmers
=
elastic
×
Q3
=
area
(H
+
F
+
2
+
1)
much
the
units
Q1Q2
the
the
P’
at
domestic
buyers
in
intersects
market?
•
supply
and
which
revenues
×
total
Af ter
Before
price,
corn
D
ab
•
much
corn.
the
total
Pw
units
corn
of
period.
government
imports
that
price
demand
of
Pw
The
of
imports
imposed
The
af
of
•
corn
of
where
corn
units
In
equilibrium
of
units
were
•
total
P’
×
they
expenditures
Q4
=
have
elasticity
area
(H
on
+
increased
of
demand
F
corn
+
or
J
by
+
3
domestic
consumers
+
note
2
decreased
(PED).
+
1);
depends
that
on
the
=
whether
price
following
they
points.
usually
rms
•
Consumer
surplus
decreases
by
area
(1
+
2
+
3
+
4)
result
of
the
higher
price
paid
and
the
lower
Domestic
buyers
of
corn
are
clearly
Producer
surplus
increases
by
area
(1)
as
worse
sell
more
corn
and
earn
a
Area
higher
(3),
the
shaded
represents
area
money
is
known
typically
as
”quota
earned
by
are
rms
price
as
that
a
can
result
now
of
export
the
the
restricted
the
bigger
Their
would
import
expenditures
revenues
of
the
than
if
an
equivalent
tariff
importing
had
export
revenues
may
even
be
been
greater
have
been
under
free
trade.
With
free
than
trade
revenues
(and,
import
expenditures)
were
equal
their
to
(F
+
J
+
G)—whereas
with
a
quota
appropriated
by
foreign
product
at
foreign
supply.
exporter
they
are
equal
to
area
(J
+
3),
which
a
could
higher
exporting
export
rents”
the
the
exporting
foreign
price.
area
and
the
their
domestic
export
•
If
then
off.
they
producers
rents.
rent ,
quantity
imposed.
•
these
quota
equivalently,
country)
enjoyed.
the
as
(and
a
collect
collect
The
be
greater.
This
possibility
minimizes
the
probability
of
money
retaliation.
represented
by
governments.
received
case
only
quota
refers
The
if
also
(3)
the
domestic
government
Note
that
earned
the
as
a
term
This
to
foreign
of
in
is
would
auctioned
rents
result
go
represents
rarely
be
off
Recap
the
the
Effects
of
quotas
economics
some
A
quota:
•
increases
the
•
increases
domestic
•
decreases
•
decreases
the
•
decreases
consumer
•
increases
•
creates
favourable
domestic
price
of
the
protected
good
decision.
effects
of
a
quota
tariff
domestic
usually
(3)
collected
follows
to
by
a
the
is,
P ’)
now
welfare
that
are
(that
price
area
additional
It
may
area
government .
income
revenues
•
(3)
that
domestic
”equivalent ”
the
area
money
the
licences.
to
policy
•
by
shaded
The
a
same
tariff
with
foreigners,
those
that
one
represents
as
of
would
so
they
the
rents
production
of
the
good
an
also
exception:
quota
raise
consumption
of
the
good
tariff
that
represent
volume
of
imports
are
surplus
an
producer
surplus
loss.
quota
typically
leads
to
a
“quota
rents”,
which
are
usually
collected
by
greater
foreigners
welfare
loss
resulting
plus
equal
area
(4),
inefciency
quota
The
of
imposed
welfare
which
also
area
(2),
which
inefciency
reects
explained
the
reects
explained
resulting
earlier,
plus
the
•
earlier,
(3),
to
production
inefciency
and
resource
misallocation
consumption
area
leads
the
•
leads
•
is
to
consumption
inefciency
rents.
existence
of ten
to
production
loss
is
quota
instead
usually
rents
of
helps
tariff s
bigger.
explain
even
why
though
Foreigners
T I N U
the
are
: 4
reveals
quotas
the
are
off
responsible
an
associated
better
E H T
analysis
equivalent
are
collected
for
a
tariff
by
L A B O L G
welfare
welfare
loss
(assuming
greater
that
than
the
that
quota
of
rents
Y M O N O C E
A
foreigners).
as
Subsidies
Analysis
of
production
subsidies
and
of
Sd
g
P/unit
export
subsidies
Ss
A
production
government
subsidy
on
all
is
a
units
per
of
unit
the
payment
good
by
the
produced
by
a
rm.
An
j
export
subsidy
on
units
the
the
is
a
per
exported
assumption
that
unit
by
the
a
payment
rm.
In
country
by
both
is
the
government
analyses
small
in
the
we
only
Pp
keep
context
n
of
F
H
Pw
economics.
Sw
m
Production
subsidy
A
A
production
subsidy
is
a
per
unit
payment
by
D
the
Q1
government
leads
to
a
to
rms
decrease
on
in
all
their
units
of
output
production
produced,
costs.
The
price
so
cost
that
production
permits
imports
subsidy
of
are
rms
the
to
produce
good
illustrated
more
decrease.
in
Figure
at
The
which
Q /
period
4.2.3
Effects
of
a
production
subsidy
on
the
market
for
corn
each
effects
4.2.3.
Q2
lower
Figure
production
Q3
of
a
In
Figure
domestic
period
4.2.3
the
farmers
while
world
are
price
willing
domestic
to
of
corn
offer
consumption
is
Q1
of
at
Pw.
units
corn
At
of
will
that
corn
be
at
price
per
Q2
151
units
free,
per
will
period.
thus
The
be
period.
In
•
revenues
quantity
equal
to
Q2
of
–
corn
Q1
=
imported,
Q1Q2
if
units
trade
of
is
corn
per
Recap
addition:
Effects
total
Pw
•
×
Q1
total
=
collected
area
by
domestic
producers
of
production
subsidies
=
A
production
•
does
subsidy:
(A)
expenditures
by
domestic
consumers
=
Pw
×
Q2
not
affect
the
domestic
price
of
the
protected
=
good
area
(A
•
import
If
the
jg
+
C)
expenditures
dollars
right
B
government
costs
of
+
per
will
or,
the
now
unit
of
increase
better
marginal
cost
jg
Pw
×
output ,
Ss.
(MC)
a
and
the
area
shif t
so
(B
+
the
supply
the
marginal
by
supply
cost
in
equal
does
not
affect
consumption
•
does
not
affect
consumer
•
increases
domestic
•
increases
producers’
•
increases
producer
•
decreases
the
•
decreases
import
to
the
curve
is
world
to
At
offer
price
the
Q3
units
production
Pp,
which
subsidy
will
world
per
costs.
is
mn
not
paid
to
by
affected
Pw
period
Now,
equal
be
price
decreases
because
though,
what
the
(given
domestic
per
of
consumers
small
will
their
unit
government .
a
rms
pay
be
now
sold
by
imports
•
total
Pw
at
Q2.
It
decreased
revenues
×
Q3
=
follows
from
Q1Q2
collected
area
(A
+
that
B
by
+
the
(Pw)
•
willing
to
Q3Q2.
H
+
In
leads
•
total
expenditures
the
•
equal
to
by
quantity
import
area
+
consumed
expenditures
B
+
addition:
is
do
not
decrease
since
the
export
increase
remain
price
to
Pw
×
Q3Q2
=
that
import
expenditures
are
area
equal
export
revenues
foreigners
analysis
reveals
Consumer
surplus
•
price
Producer
and
surplus
thus
export
an
spending
opportunity
inefciency
and
and
cost
resource
to
for
a
welfare
loss.
are
than
goal
is
illegal
are
to
to
sell
under
still
it
in
the
stimulate
World
granted
domestic
exports.
Trade
by
market.
Technically,
Organization
many
countries
in
The
export
(WTO)
different
(See
section
4.4,
page
162
for
information
on
the
WTO.)
effects
world
of
an
price
export
is
subsidy
assumed
at
are
Pw
illustrated
so
that
in
Figure4.2.4.
quantity
demanded
(C);
equal
to
Q1
units
of
corn
per
period
while
rms
offer
Q2
the
per
period.
Units
Q1Q2
are
thus
exported.
collect).
the
remains
consume
government
imposes
production
they
The
a
subsidy
the
the
increases
is
paid
to
domestic
rms
equal
to
hj
for
each
unit
following.
same
as
consumers
pay
same
by
area
export ,
then
the
domestic
price
of
corn
will
increase
to
P ’.
the
This
same
and
good
The
they
•
(and
collect)
and
If
welfare
the
but
units
A
to
government ’s
is
(remember
imports
the
paid
change
to
of
expenditures
increased
responsible
subsidies
consumers
C)
volume
of
F).
domestic
(A
revenues
misallocation
forms.
same
good
remains
(volume)
producers
to
leads
the
rules
•
the
surplus
foreigners
nancing,
earn
plus
Consumption
domestic
of
country
lower
they
quantity
surplus
production
jg
•
unchanged
good
the
revenues
case).
the
amount
dollars.
The
of
to
production
curve
the
•
C).
subsidy
decrease
downwards
Remember
curve
=
production
then
vertically
to
Q1Q2
grants
supply
yet ,
subsidy
=
is
because
rms
earn
P’
by
selling
abroad
so
they
will
not
quantity.
(F)
because
the
price
Sd
P/unit
earned
per
unit
by
producers
Pp
is
equal
to
the
world
price
h
r
P'
Pw
plus
equal
the
to
jg,
subsidy
the
mn
vertical
paid
by
the
distance
government ,
between
the
which
two
is
supply
Sw
Pw
curves.
•
The
cost
subsidy
area
be
(F
of
the
per
+
H).
nanced
subsidy
unit
mn
This
by
to
times
cost
higher
the
the
must
government
quantity
somehow
taxes
now,
by
is
equal
produced
be
to
Q3
nanced.
increased
It
the
or,
can
borrowing
D
now
and
other
higher
taxes
government
therefore
later
or
by
expenditure.
cutting
An
back
on
opportunity
some
cost
is
It
follows
that
a
production
subsidy
leads
to
a
equal
to
area
(H).
This
represents
the
because
units
Q1Q3
are
now
even
though
it
would
have
4.2.4
willing
P’
in
been
cheaper
subsidy
is
a
per
unit
payment
by
the
export
subsidy
on
the
market
for
corn
sell
any
home
quantity
market .
domestically
The
difference
unless
they
P ’—Pw
is
also
equal
subsidy
paid
hj.
At
P ’,
domestic
consumption
to
will
to
Q3
exports
while
rms
increases
will
from
offer
Q1Q2
Q4
(=
units.
gz)
to
The
Q3Q4
quantity
(=
jw)
of
units
based
only
means
on
that
a
the
units
rm
will
of
output
nd
it
exported.
more
period.
In
addition:
government
•
152
an
subsidy
per
payment
of
them.
export
rms
to
the
export
corn
to
Effects
to
decrease
An
Q /period
produced
the
domestically
Expor t
Q4
production
earn
inefciency
import
Q2
welfare
be
loss
Q1
involved.
Figure
•
Q3
0
total
revenues
from
area
collected
by
domestic
producers
This
protable
to
(0Q2zPw)
to
area
(0Q4rP ’)
increase
total
expenditures
area
(0Q1gPw)
increased
or
by
to
domestic
area
consumers
(0Q3hP ’);
decreased
depends
change
whether
on
they
from
have
Recap
PED
Effects
•
export
revenues
increase
from
area
T I N U
•
(Q1Q2zg)
to
of
export
subsidies
area
An
export
subsidy:
(Q3Q4rh).
the
higher
Domestic
•
Producer
The
to
cost
surplus
the
jw
(=
sell
to
a
the
subsidy
Q3Q4),
paid
of
greater
or
area
area
quantity
hj
(B
of
+
C
+
and
B)
a
•
decreases
consumption
+
enjoyed.
•
decreases
consumer
B
+
C)
a
as
•
increases
domestic
•
increases
the
revenues
higher
subsidy
now
other
•
(B)
is
by
therefore
becomes
areas
plus
cost
(A
+
areas
areas
increasing
increasing
government
There
This
this
and
B
•
increases
the
quantity
•
increases
producer
•
leads
(B
a
volume
C)
+
while
C
cancel
+
F).
out,
regulatory
or
protection.
other wise
trade
legal
standards,
the
of
Areas
are
by
(A),
the
good
surplus
production
of
of
the
domestic
good
rms
of
exports
to
increased
surplus
government
spending
and
must
as
it
imposes
an
opportunity
cost
back
on
•
some
leads
to
production
inefciency
and
resource
are
were
(C)
area
+
to
one
F)
(B
equal
equal
and
(B
also
are
that
prohibited.
to
were
as
+
F).
to
areas
of
the
the
(A
+
•
leads
•
is
to
consumption
responsible
for
a
inefciency
welfare
loss.
B)
two
welfare
loss.
barriers
and
set
environmental
of
borrowing
cutting
equal
areas
trade
are
good
exports
government
now,
by
gains
losses
barriers
Standards
they
or
loss
the
barriers
the
misallocation
leaving
Administrative
Administrative
taxes
later
welfare
since
of
equal
project .
clear
+
taxes
price
price.
is
nancing
nance
domestic
result
off.
earn
the
as
quantity
export
the
F);
+
worse
(A
the
times
(A
lower
clearly
by
government
unit
area
the
are
increases
per
by
and
corn
the
following.
decreases
price
buyers
producers
•
surplus
the
: 4
Consumer
reveals
E H T
•
of
analysis
L A B O L G
welfare
increases
referred
a
imports
These
standards
to
common
may
or
must
be
as
with
form
of
trade
satisfy
health-related
safety
each
only
a
and
few
every
ofcers
truck.
who
You
were
can
ordered
imagine
seemingly
innocent
requirement
effectively
reducing
the
volume
created
of
to
the
and
imports
fully
delays
that
inspect
that
this
resulted
entering
in
Y M O N O C E
A
•
France.
standards.
Calculations
For
example,
the
EU
and
the
UK
do
not
permit
imports
of
1
.
chlorine-washed
the
at
USA .
The
blocking
USA
US
for
and
of
imports
that
these
chicken
regulations
car
hormone-treated
maintains
exports
environmental
standards
chicken
such
to
and
as
beef.
the
T
ariff
exercise
from
restrictions
Assume
aim
Countries
specied
protect
beef
that
following
set
a
tariff
questions
is
imposed
using
the
on
some
good
information
in
X.
Answer
Figure
the
4.2.5.
emissions
domestic
S
P/unit
population
(euros)
and
combat
regulations”
standards
change
may
used
are
regulations
or
climate
may
exporting
set
to
or
rms
protectionism.
set
to
protect
for
protecting
set
to
just
to
issue
domestic
consumers,
make
and
is
to
it
or
so
they
costly
that
equipment ,
standards,
for
amount
and
Safety
example
electrical
Some
ensure
“green
imports.
for
more
consumers
domestic
so-called
impede
products.
comply
The
some
to
automobile
children’s
be
but
only
protect
concerning
chemicals
though,
be
the
are
to
S'
4000
Sw
disguised
standards
not
4400
foreign
just
an
A
are
D
excuse
producers.
18
0
32
51
75
Q/period
(thousand
In
addition
to
such
standards,
the
importing
country
may
of
add
more
“red
tape“
to
the
necessary
bureaucracy
Figure
when
importing
paper work
lengthen
in
for
Perhaps
the
barriers
France.
The
The
country
exporters
valuation,
administrative
Poitiers
good.
required
the
processes.
a
to
inspection
most
is
a
French
old
increase
complete
and
absurd
very
may
example
one
or
customs
of
related
government
had
the
it
Japanese
at
video
Poitiers
imports
were
instead
of
at
to
a
be
such
the
city
ordered
inspected
major
and
harbour
is
located
inland,
is
far
from
ports
and
small
What
country
case
or
was
is
the
size
of
the
b.
Calculate
the
pre-tariff
c.
Calculate
the
import
tariff
imposed?
volume
of
imports.
of
expenditures
(or
the
export
revenues
that
the
foreign
rms)
under
free
trade.
pass
Calculate
the
revenues
earned
by
domestic
producers
airport .
under
Poitiers
diagram:
a.
d.
customs
T
ariff
may
of
all
4.2.5
typical
clearance
to
units)
involved
free
trade.
staffed
153
e.
Calculate
consumer
expenditures
on
the
good
under
free
k.
Calculate
l.
What
the
resulting
increase
in
the
producer
surplus.
trade.
f.
Calculate
the
post-tariff
volume
of
imports
and
is
the
resulting
production
inefciency
equal
to?
their
m. Calculate
the
resulting
consumption
inefciency.
change.
3.
g.
Calculate
import
expenditures
af ter
the
tariff
was
Production
Assume
and
the
change
that
occurred
as
a
result
of
the
How
much
did
consumers
spend
on
the
good
that
af ter
good
X.
i.
The
was
exercise
is
granted
Answer
the
to
following
the
producers
questions
of
using
in
Figure
the
4.2.7.
imposed?
money
imposed
subsidy
the
information
tariff
a
tariff.
some
h.
subsidy
imposed
spent
was
by
consumers
collected
by
af ter
foreign
the
tariff
exporters,
P/unit
was
(dollars)
domestic
s
s'
producers
group
and
the
government .
Calculate
how
much
each
collected.
j.
What
is
the
resulting
production
inefciency
k.
Calculate
the
resulting
consumption
l.
Calculate
the
resulting
decrease
2.
Quota
equal
to?
inefciency.
h
165
in
the
consumer
surplus.
g
150
Assume
Answer
Figure
Sw
exercise
that
the
a
j
quota
is
following
imposed
questions
on
imports
using
the
of
some
good
information
f
X.
in
4.2.6.
D
0
250
450
1000
Sd
P/unit
Q /year
(thousand
of
units)
(euros)
Figure
4.2.7
Production
subsidy
diagram:
small
country
case
S'=(Sd+Quota)
a.
What
is
the
b.
Calculate
revenues
c.
7500
1
3
Sw
2
the
of
Calculate
of
the
annual
the
the
producers
4
size
subsidy
import
foreign
annual
under
free
granted
(on
a
expenditures
rms)
under
revenues
free
earned
per
(or
unit
basis)?
export
trade.
by
domestic
trade.
6000
d.
Calculate
under
C
annual
free
consumer
expenditures
on
the
good
trade.
D
e.
0
450
700
1400
1750
f.
Figure
4.2.6
Quota
diagram:
small
country
Calculate
a
Q /month
result
Calculate
What
b.
Calculate
the
c.
is
Calculate
of
the
import
rms)
the
free
Calculate
size
the
foreign
under
d.
the
quota
revenues
free
the
imposed?
expenditures
under
(or
export
revenues
of
g.
by
domestic
producers
h.
expenditures
on
the
good
under
free
i.
Calculate
of
f.
the
volume
of
imports
as
import
and
the
expenditures
change
that
af ter
occurred
the
as
subsidy
a
result
of
How
much
the
did
consumers
subsidy
Calculate
the
annual
af ter
Calculate
the
was
the
annually
total
subsidy
annual
spend
on
the
good
granted?
cost
revenues
was
of
domestic
rms
granted.
the
subsidy
to
the
government .
trade.
e.
in
subsidy.
collected
trade.
consumer
change
subsidy.
annual
granted
af ter
trade.
earned
annual
the
case
was
a.
the
of
the
the
change
in
the
volume
of
imports
as
a
result
j.
Calculate
the
change
k.
Calculate
the
resulting
in
l.
What
the
consumer
surplus.
quota.
Calculate
imposed
import
and
the
expenditures
change
that
af ter
the
occurred
quota
as
a
increase
in
the
producer
surplus.
was
result
of
is
the
resulting
production
inefciency
equal
to?
the
m. Calculate
the
resulting
consumption
inefciency.
quota.
4.
g.
How
much
quota
was
did
consumers
spend
on
the
good
af ter
Export
Assume
imposed?
good
h.
What
can
you
infer
about
the
price
elasticity
of
X
that
on
i.
for
Calculate
the
the
good
size
given
of
the
the
price
quota
change
rents.
Who
in
the
154
the
resulting
decrease
in
the
subsidy
earns
using
unit
of
is
granted
X
to
exported.
the
producers
Answer
the
of
some
following
the
information
in
Figure
4.2.8.
a.
What
b.
Calculate
is
the
size
of
the
subsidy
granted
(on
a
per
unit
basis)?
these
producers
Calculate
a
each
market?
rents?
j.
exercise
demand
questions
(PED)
subsidy
the
consumer
surplus.
the
annual
earned
export
before
the
revenues
export
that
domestic
subsidy
was
granted.
Calculate
before
annual
the
consumer
export
subsidy
expenditures
was
on
the
good
granted.
(dollars)
e.
Calculate
a
7
.00
f.
result
the
of
Calculate
annual
the
change
export
annual
in
the
volume
of
exports
as
subsidy.
export
revenues
af ter
the
export
T I N U
d.
S
P/unit
subsidy
granted
earned
g.
How
a
much
af ter
h.
as
the
Calculate
collected
as
well
result
did
of
the
subsidy
annual
af ter
the
the
change
export
consumers
export
the
as
total
export
revenues
subsidy.
annually
was
export
in
spend
on
the
good
E H T
was
granted?
revenues
subsidy
domestic
was
: 4
Sw
5.00
rms
granted.
D
30
38
Calculate
the
annual
cost
of
the
export
subsidy
to
the
Q /year
government .
(thousand
Figure
c.
4.2.8
Export
Calculate
the
subsidy
total
of
units)
diagram
annual
revenues
earned
by
j.
Calculate
the
change
k.
Calculate
the
resulting
l.
What
is
the
before
the
export
subsidy
was
the
consumer
increase
in
production
the
surplus.
producer
inefciency
surplus.
equal
domestic
m. Calculate
producers
resulting
in
granted.
the
resulting
consumption
inefciency.
to?
L A B O L G
21
Y M O N O C E
i.
14
155
4.3
Arguments
control
If
in
the
benets
Figures
country
so
free
to
increases,
employing
trade
from
4.1
.1a
why
various
trade
4.1
.1c
are
and
so
(section
do
so
degrees
many
of
restrict
Why
is
in
shown
welfare
countries
protection?
and
against
a
has
the
imports
“managed”
common?
specic
a
big
demand
simple
from
free
trade
creates
losers
from
pressure
when
answer
trade.
that
winners
free
the
free
is
There
trade
all
groups
and
losers.
are
government
trade
not
are
the
parties
that
When
signicant
for
increases
are
the
then
protection.
import
involved
worse
off.
losses
they
This
may
is
penetration
a
because
shrinking
or
in
though
on
Figure
4.1
.1c
(page
146)
it
is
try
the
case
increase
is
small
in
cheaper
consumer
surplus
few
that
surplus
of
producers
revenues
dismiss
exceeds
resulting
the
import-competing
affected
loss
imports
from
and
workers.
Arguments
Common
In
then
prots
rms
each
and
addition,
in
decrease
may
these
favour
suffer.
one
non-economic
If
also
be
may
the
Governments
of ten
erect
are
active
Below
only
forced
of
of
a
conict
crucial
goods
a
country
for
is
strategic
in
industries
as
well
These
of
in
this
as
being
argument
wide
strategic
of
is
to
ensure
self-sufcient
reasons.
such
the
The
food
strategic
doubtful,
and/or
at
Trade
barriers
are
that
in
the
to
other
harmful
substances.
for
pressurize
in
and
these
weaken
cases
are
industry
for
are
The
countries
Some
If
the
countries
or
their
resort
cultural
to
Trade
to
imports
of
barriers
as
For
example,
the
restrict
the
part
of
also
other
lms
and
Trade
barriers
also
and
protect
health
the
preserve
of
a
a
broader
which
why
consumer
the
fewer
governments
or
indirectly,
their
are
export-
common
arguments
divided
into
used
in
non-economic
arguments.
evaluated.
necessarily
labour
are
higher
labour
therefore
imply
First ,
higher
higher
productivity
because
costs
there
domestic
is
wages
then
the
disadvantage.
may
no
of
be
is
labour
important .
higher
even
reason
are
not
a
domestic
Theory
should
Workers
regions,
way
resist
labour
lower
to
fear
than
imports.
reection
industry
suggests
of
has
that
higher
a
be
channelled
to
labour
other,
and
owners
of
capital,
and
more
perhaps
will
stations
in
these
face
real
broadcast
changes.
adjustment
They
will
try
costs
to
and,
blame
of
course,
foreigners
of
their
plight
and
will
demand
protection.
of
protection,
which
will
reduce
the
incentive
to
many
hours
of
and
adjust ,
other
policies
could
be
adopted
to
foreign
to
ensure
that
certain
the
adjustment ,
especially
for
displaced
workers.
standards
are
met.
The
that
in
but
often
such
domestic
producers
goal
standards
are
is
another
may
be
cases
shif ting
almost
resources
impossible
from
without
one
use
signicant
purportedly
are
a
assistance,
which
itself
is
costly
to
implement .
pretence
such
cases,
trade
liberalization
should
proceed
gradually.
protected.
if
employment
distressed
economic
many
minimum
Also,
Common
of
social
In
through
each
each
the
exports
programmes.
exist
public
directly
carefully
because
then
uses.
government
to
promote
from
by
Even
when
countries
to
safety
to
off
used
Note
•
aim
explains
are
not
resources
smoothen
language
exports.
worse
embargoes.
to
television
number
be
suffered
This
most
be
do
productivity,
restructure
countries
increase
may
enjoyed
They
wages
and
Instead
strategy.
to
drugs
are
unfriendly
as
protection
identity
the
must
rms
higher
labour
for
life
consequent
validity
belonging
will
•
these
rms
of ten
alliances.
restrict
politically
referred
large.
economic
wages
domestic
whole
and
the
to
of
and
efcient
to
and
cost
in
and
and
succumb
production
weapons
importance.
least
political
employed
area
that
income
promoting,
and
comparative
•
of
are
claims
abroad
classied
to
political
protection
barriers
as
aim
whole
benets
examine
productivity,
aerospace
a
policies
protection.
arguments
to
If
of
an
rms
and
concentrated
costs
case
in
these
rms.
we
favour
arguments
trade
also
as
loss
the
rms
domestic
•
likely
visible
of
government
trade
signicant
be
down
are
each
the
producer
there
a
very
Clearly,
lobby
that
free
the
suffers
rms
of
in
may
pursues
while
oriented
and
the
shutting
trade
articially,
of ten
the
to
unemployment .
government
to
market .
realized
country.
Politicians
of
consumers
exporting
Focusing
the
incentive
protection.
Managed
the
of ten
in
of
gain
Free
of
area
nancial
pressures
increase
The
trade
protection
and—as
4.1—net
many
of
for
arguments
in
industry
in
a
with
whole
few
or
region
no
relies
on
employment
the
alternatives
favour
for
the
local
population,
then
the
trade
liberalization
process
ofprotection
must
•
A
most
protect
common
domestic
employment
ood
the
down.
jobs.
and
market ,
foreign
higher
rates
in
Many
cheaper
domestic
Cheap
resulting
156
as
argument
is
of
that
higher
forcing
labour
of
favour
claim
restricting
free
quality
trade
foreign
domestic
typically
rms
blamed
unemployment .
trade
is
to
decreases
products
to
for
shut
the
and
be
gradual
workers
people
have
do
no
job.
economists
Prize,
to
not
give
adjust .
move
sufcient
Recent
easily
Financial
had
2019).
to
research
another
incentives
thought ,
This
to
time
do
according
signicantly
for
has
owners
found
location
not
to
complicates
as
if
they
much
Duo
the
capital
that
even
matter
Esther
of
as
(Nobel
issue.
imports
of
argument
decit .
goods
A
and
in
favour
trade
of
decit
services
is
protection
exists
greater
if
the
than
is
its
to
government
“anti-dumping
value
The
idea
is
that
protection
will
render
expensive
and
less
attractive.
Spending
WTO
on
any
launches
dumping
then
decrease,
shrinking
and
correcting
a
tariff,
minimize
referred
the
to
as
injury.
an
investigation
the
taking
place.
It
is
to
determine
not
always
the
easy
extent
to
imports
determine
will
to
imports
of
more
impose
export
The
revenues.
may
duty ”,
the
“normal
price”
of
the
good
as
the
price
may
trade
vary
depending
on
the
region
at
which
the
good
is
sold,
imbalance.
the
There
First ,
are
it
several
invites
improvement
expense.
country
their
a
to
a
problems
from
country ’s
buy
such
the
a
widening
does
trade
and
exports.
not
decit
as
comes
into
make
the
the
and
in
most
decit
may
be
the
result
of
problem.
The
products
expensive
and
therefore
uncompetitive:
and
T
ariffs
services
(so
that
may
be
exports
unable
to
decrease)
penetrate
and
they
preferred
choice
for
domestic
also
to
buy
High
imported
ination,
products
rigid
labour
instead
markets
who
(so
that
nd
labour
as
costs,
poor
uncompetitive
quality,
lack
of
domestic
reliability,
that
or
poor
growing
marketing
trade
decit .
may
In
be
these
markets,
delivery
the
real
cases,
nance
a
helpful
and
possibly
may
prove
the
adoption
of
appropriate
Governments
may
decide
to
erect
reasons
trade
trying
growth
of
certain
development .
The
industries
idea
is
in
that
their
once
the
necessary
know-how
and
achieving
economies
of
scale,
initial
these
they
will
competition.
At
that
point ,
as
it
of
should
industry ”
be
removed.
argument
This
and
is
is
to
This
collect
sufcient
it
revenue
activities.
taxing
Since
imports
may
points
be
a
of
last
entry
resort
cannot
be
given
up.
be
gradual
If
this
is
the
to
case
must
services
is
to
ensure
not
that
the
interrupted.
necessary
its
when
production
a
developing
and
export
country
base.
refers
and
to
the
process
services
of
increasing
produced
and
the
exported
to
decrease
risks
(see
section
4.10,
page
198).
in
Many
countries
still
produce
and
export
a
limited
assist
of
products
according
to
the
principle
of
comparative
stages
their
unit
(an
HL
concept).
If
these
countries
are
to
risks,
be
able
they
need
to
develop,
through
appropriate
costs
to
a
comparative
advantage
in
new
areas.
Also,
meet
the
meantime
they
need
to
keep
out
imports
from
more
dictates,
foreign
producers.
This
is
accomplished
through
well-known
essentially
a
form
of
the
new
industries
being
established.
It
is
of
again
industrial
systems
making
industries
theory
the
be
goods
protection
“infant
T
ax
ineffective,
will
efcient
protection
more
not
in
international
become
revenues.
are
to
government
diversify
investments,
by
their
policies.
barriers
lower
to
ood
reached
behind
decrease
acquire
which
basic
may
to
advantage
of
few,
liberalization
of
Protection
range
the
hope)
is
poor
will
detrimental
import
governments
are
revenue,
developing
•
imports
verdict
industries
as
issues,
protection
remedial
a
is
many
in
order
delay
when
with
countries
pro-development
country
variety
prove
government
their
Diversication
a
(they
dumping
lengthy,
until
which
imports
result
is
design
and
during
anti-dumping
it
•
well
a
developing
for
provision
high
time
when
is
dumping
As
not
then
rise).
of
gain
restructure
provide
collect
cheaper
imposed
investigation
to
period
place.
foreign
are
households
market
certain
into
the
the
time
domestic
to
markets
and
the
taking
automatically
to
difcult
goods
or
ballooning
in
being
good
allegedly
efcient .
fundamental
domestic
order
the
accusation
domestic
•
trade
are
an
of
was
suspected
their
consequently
Third,
treat
duties
any
at
buyers
dumping
argument .
partners
products
incomes
country ’s
policy
this
balance
foreign
foreign
with
trading
trade
restricting
decrease
ability
of
retaliation
in
Second,
will
importantly,
cause
potential
T I N U
trade
: 4
of
a
E H T
common
improve
L A B O L G
Another
Y M O N O C E
•
a
form
of
necessary
industrial
policy.
policy.
argument
also
needs
to
be
carefully
evaluated.
Recap
It
is
indeed
theoretically
sensible,
and
the
policy
has
Non-economic
been
adopted
by
all
developed
economies
in
the
of
including
in
the
varying
previously
USA ,
as
degrees.
well
as
However,
discussed
by
it
all
also
drawback s
of
Asian
export
suffers
from
industrial
a
government
policies.
a
mistake
to
reverse
the
which
pick
a
is
made,
its
will
course
protection
stakeholders.
dictates,
industry
“ winner ”?
could
If
then
it
and
be
qualies
It
be
possible
withdraw
ercely
protectionism
we
have
for
may
the
such
be
for
These
difcult
its
include
ensure
is
not
of
by
lif ted
the
on
•
is
state
The
inherent
support ,
World
impose
is
an
Trade
tariff s
suspected.
abroad
own
at
a
because
making
and
Organization
(taxes
on
Dumping
or
of
sluggish
price
country,
risk
below
below
exporters
are
said
the
(WTO)
to
on
the
as
as
with
government .
the
WTO
(see
The
industry
industry
good
if
a
price
cost .
subsidized
injured
section
if
a
to:
or
food
block
imports
•
protect
a
•
protect
the
of
drugs
of
life
and
illegal
substances
way
Economic
health
(cultural
and
arguments
safety
issues)
in
of
the
favour
population.
of
protection
infant ”.
include
arguments
that
protection
is
needed
to:
over-reliant
it
is
sells
this
or
country
•
protect
jobs
•
correct
•
protect
•
enhance
•
protect
•
help
from
foreign
competition
may
page
le
162)
trade
against
decit
possible
dumping
selling
at
in
could
indirectly
a
a
to
dumping
rm
Of ten
directly
rm
4.4,
weapons
•
government
revenues
its
infant
industries
be
a
developing
country
diversify
its
produce
and
by
export
their
needed
industries
to
theory
permits
a
exist
normal
average
is
crucial
inefcient .
imports)
is
protection
certain
Removing
“perpetual
the
that
in
If
These
There
arguments
self-sufciency
government
support?
resisted
case
treatment .
the
favour
How
such
determine
in
protection
achievers
the
•
does
arguments
past
base.
complaint
and
157
Arguments
•
Protection
less
against
breeds
competition
Less
inefciency
and
competition
protection
are
as
faced
implies
domestic
with
greater
rms
captive
domestic
are
exposed
domestic
monopoly
to
markets.
power.
benecial
only
positive
•
Greater
monopoly
power
for
domestic
rms
implies
for
lower
the
buyers.
Higher
prices
decrease
consumer
surplus
opinion
power
for
households.
Their
ability
demand
for
all
other
goods
and
services
in
the
from
visible
therefore
constrained.
output
and
This
could
employment
have
levels.
negative
effects
Unfortunately,
are
not
conspicuous
and
may
be
ignored
by
Higher
prices
for
domestic
rms
that
import
(inputs
in
their
own
production
production
costs,
so
higher
for
lost
his
supply
may
may
even
decrease,
and
If
these
these
domestic
on
cost-push
rms
happen
in
their
levels
more
to
be
or
Protectionism
may
governments.
If
markets
will
and
adversely
affecting
result ,
in
the
than
economy.
it
Protectionism
preserves
or
induce
the
the
and
from.
one
trade
long
rms
The
as
of
or
retaliation
frictions
term
are
(“tit
for
escalate
hurting
faced
reduction
well
while
•
third-best
in
are
that
losers.
may
such
how
even
Most
people
shrunk
know
or
can
shut
someone
circumstances.
much
because
cheaper
of
free
trade
free
leads
assumption,
This
down
who
Most
our
of
us,
clothes,
trade.
to
a
namely
compensation
government
workers
with
all
with
as
in
rms)
tat ”)
then
parties
limited
variety
have
to
choice.
competitiveness
Utility
is
a
by
a
net
welfare
that
gain
winners
can
be
fully
accomplished
policies.
for
retrain
and
Governments
move
to
can
industries
to
jobs.
start
Governments
new
businesses
can
that
help
can
effectively
in
world
markets.
Too
often
compete
though,
especially
labour,
has
have
never
been
neglected
materialized.
This
and
may
this
help
foreign
trade
why,
in
the
past
few
years,
protection
has
increased
war
why
there
has
been
a
backlash
against
globalization.
involved.
options
cost
settle
decreases
decreases
to
plentiful
capital
since
best
for
their
example
for
of
this
new
and
dangerous
trend
is
clear
to
the
tariffs
imposed
by
the
USA
on
many
goods
ranging
buyers
solar
panels
and
washing
machines
to
steel
and
secondaluminum.
best
and
job
crucial
targeted
areas
from
(consumers
has
usually
in
choose
costs.
create.
The
Consumers
the
that
overall
and
may
The
not
be
explain
•
as
industry
aware
cars
compensation
•
are
export-oriented
international
sales
in
jobs
her
displaced
losers,
destroys
earlier.
size,
inationary
more
employment
an
trade
not
conclusion
owners
hurting
in
arise.
competitiveness
eroded,
greater
rms.
and
their
though
imply
help
•
that
similar
intermediate
through
pressures
even
layperson
or
or
are
compensate
Aggregate
explained
a
politicians.
process)
prices
reasons
have
on
rests
higher
for
suggest
public
these
The
products
the
free
appliances
•
trade,
rm
of
though,
effects
free,
surveys
general
economy
has
overall
to
a
because
is
However,
the
to
identify
express
on
of
and
as
purchasing
economies.
one-third
higher
benets
prices
to
about
These
tariffs
have
led
to
retaliatory
tariffs
by
the
households
USA
’s
trading
partners.
•
companies,
Studies
have
found
the
following.
rms.
US
as
a
result
of
the
recent
tariff s,
lost
Domestic rms will not be exposed to the technological
more
than
$1
.7
trillion
in
the
price
of
their
stock s
advancements embodied in imported machinery (capital goods).
(www.nber.org).
•
Recap
Overall,
Arguments
against
protectionism
•
These
were
•
It
breeds
inefciency
as
a
result
of
less
greater
monopoly
misallocation
of
power,
leading
It
leads
to
to
waste
prices
In
for
consumers
month
addition,
decreasing
power
and
their
ability
to
express
other
It
limits
tariff s
by
exporters
in
lost
exports
as
our
earlier
consumers
the
USA
’s
trading
partners
approximately
$2.6
billion
(www.princeton.edu).
and
tariff
analysis
rms
have
suggests,
borne
cost
of
the
tariff s
almost
imposed.
growth
in
the
USA ,
China
and
other
major
products.
economies
•
US
demand
Slower
for
almost
their
entirely
purchasing
by
and
resources.
higher
decreased
(www.brookings.edu).
retaliatory
costing
American
•
employment
jobs
competition
per
and
US
300 000
choice
for
consumers
and
for
rms
as
will
decrease
demand
for
commodities,
variety
affecting
commodity
exporters
in
Africa,
South
America
decreases.
•
It
increases
the
intermediate
production
goods
costs
(inputs),
of
rms
forcing
and
Australia.
and
services
It
may
rms
•
It
also
reduce
relying
deprives
on
It
export
more
domestic
technological
•
also
slow
down
exports
of
them
to
from
the
rest
of
the
world
with
all
goods
potentially
increase
consequences
for
their
economies.
prices.
The
•
will
importing
devastating
their
It
increases
the
expensive
rms
progress
competitiveness
of
taking
embodied
possibility
of
imported
in
of
inputs.
advantage
imported
retaliation
by
domestic
of
the
goods
pandemic
especially
advanced
including
the
trading
worse,
of
capital
Covid-19
world
World
Bank,
return
to
for
only
developing
economies
is
organizations
agree
free
has
that
made
crucial.
such
perhaps
these
countries.
trade—accompanied
Most
as
the
the
only
this
matters
The
response
policymakers,
IMF
and
solution
time
with
the
is
the
policies
partners.
that
compensate
the
vulnerable
in
each
economy.
References
Policymakers’
perspective
www.brookings.edu/podcast-episode/how-have-trumps-
Free
Just
Free
a
158
few
trade
rising
few
trade
versus
years
has
incomes
decades.
ago
been
most
trade
there
protection
would
responsible
countries
Almost
all
have
for
have
economists
been
much
of
trade-wars-affected-rust-belt-jobs/
no
the
witnessed
agree
growth
over
that
www.nber.org/system/les/working_papers/w271
14/
dilemma.
free
the
and
last
trade
is
w271
14.pdf;
page
33
www.princeton.edu/~reddings/papers/CEPR-DP1
3564.
pdf;
page
15
in
the
world.
expressed
become
the
in
the
more
imports
as
volume
implies
This
a
and
past
area
open,
decades
more
on
a
of
as
Preferential
or
trade
or
international
of
a
that
GDP
annual
of
been
ows
trade
are
eliminate
wider
has
size
is
of
countries
also
even
Economies
of
exports
been
have
and
increasing.
has
Trade
T I N U
preferential
the
The
rising
World
has
in
liberalization,
eliminating
164
the
agreement
is
as
a
bilateral
agreements
Organization
member
a
countries
process
may
or,
be
of
reducing
achieved
multilaterally
(WTO)
which
representing
or
through
through
currently
roughly
98%
of
liberalization.
range
of
agreements
trade
barriers
goods
and
between
between
two
them
services.
agreement
countries
between
two
countries
it
is
to
as
a
agreement .
If
it
is
between
(a
regional
that
may
plurilateral
here).
trading
not
be
in
agreement
Lastly,
if
it
bloc).
the
is
If
it
same
(but
is
between
region
this
between
it
is
distinction
all
many
referred
is
countries
not
who
referred
are
to
as
barrier s,
worldtrade.
necessary
If
trade
Trade
dened
trade
agreements
agreements
to
trade.
the
trade
result
trade
countries
narrow
of
interconnectedness
interconnectedness
meaning
proportion
value
Preferential
greater
greater
many,
members
of
the
WTO
it
is
referred
to
as
: 4
Globalization
integration
a
multilateral
usually
E H T
Economic
L A B O L G
4.4
agreement .
Trading
countries,
it
is
referred
to
as
a
regional
blocs
Regional
trading
blocs
or
tax
agreements
and
government
regulatory
According
to
the
WTO,
in
2020
there
were
320
policies
agreements
in
force
up
from
294
in
2019.
There
a
proliferation
are
of
faster
regional
to
trading
achieve
and
blocs
because
because
of
for
deeper
integration
between
of
trading
Free
trade
area
(FTA):
this
is
formed
when
a
group
agrees
them
Free
of
a
and
to
phase
while
toward
of
out
each
or
eliminate
maintains
non-members.
origin”
of
trade
Trade
its
own
the
area
For
Free
trade
areas
into
new
to
prevent
through
example,
components
to
it
of
qualify
non-members
shipping
Customs
union:
the
may
country
be
with
required
the
that
lowest
at
in
80%
addition,
more
union
common
adopt ,
central
in
addition,
a
common
bank .
trading
blocs
Area
a
for
laptop
0%
are
manufactured
an
FTA
to
a
The
prime
example
is
the
Agreement ,
USMCA ,
which
force
on
1
(the
July
2020.
1994
It
North
is
referred
American
to
as
Free
as
it
incorporates
some
minor
Trade
changes.
the
USMCA
changed
the
“country
of
For
origin”
for
automobiles
within
must
be
so
that
75%
manufactured
of
components,
inside
the
area;
it
up
from
also
the
somewhat
greater
protection
of
workers,
so
in
tariff.
may
members
generally,
(FTA).
States–Mexico–Canada
of
evolve
into
a
customs
agree
to
common
a
common
trade
external
policy
making
cars,
workers
must
earn
at
least
$16
an
union
by
2023;
US
farmers
have
greater
access
to
Canada’s
tariff
dairy
or,
climate,
external
least
hour
if,
on
migration.
goods
factories
•
a
regional
NAFTA
stipulates
group
as
and
require
62.5%,
the
such
justice
(trade
rule
tariff.
policies
security,
barriers
tariff
example,
into
other
monetary
Agreement)
“rules
as
health,
share
United
the
barriers)
well
of
came
between
common
bank
bloc
the
countries
or
countries.
•
•
share
issues
such
Examples
Types
They
growing
currency
demand
as
environment ,
Members
agreements
policies.
competition
has
the
been
say,
regional
supervision),
trade
spending
(on,
Y M O N O C E
neighbouring
toward
market;
it
strengthens
intellectual
property
rights,
nonextending
copyright
protection
of
an
author ’s
work
by
members.
20
•
Common
market:
a
customs
union
may
evolve
into
years,
market
if,
in
addition,
to
the
free
ow
of
services
within
the
bloc
there
is
also
free
ow
capital
(cross-border
investments
within
the
the
US–Israel
the
ASEAN
labour
(no
work
permits
are
required
for
a
citizen
of
6
Free
member
country
an
form
economic
and
of
to
work
in
integration
any
monetary
is
for
other
union.
the
member
bloc
Members
to
harmonize
certain
economic
policies,
of
an
into
Viet
and
regulatory
policies.
force
in
1985
Area,
established
Darussalam,
by
Indonesia,
the
original
Malaysia,
Singapore
and
Thailand)
in
1992
and
the
by
had
added
Cambodia,
Laos,
Myanmar
and
Nam.
economic
Customs
union.
The
Southern
African
Customs
Union
particularly
(SACU)
macroeconomic
into
country).
evolve
•
union
entered
any
1999
highest
which
Trade
(Brunei
Philippines,
The
FTA ,
bloc)
ASEAN
—
include:
of:
—
—
examples
goods
—
and
example.
a
Other
common
for
They
which
includes
Botswana,
Lesotho,
Namibia,
coordinate
159
South
the
Africa
world’s
The
the
EU
six
and
Eswatini
oldest
was
initially
member
Community
was
Customs
a
established
customs
countries
in
1910.
It
central,
is
of
union
the
(EEC)—Belgium,
when
European
Germany,
in
July
France,
duties
and
between
the
and
adopted
a
all
common
•
external
A
The
Southern
Common
trading
free
trade
agree
but
market.
to
each
Brazil,
associate
Guyana,
Peru
(COMESA)
•
has
27
states
are
big
a
21
in
and
is
liberalization
also
was
when
joined
•
as
A
Southern
states
The
since
the
and
was
19
union
of
preferential
a
through
“building
the
members
of
WTO.
at
trade
block”
least
one
into
a
area
is
phase
•
a
are
their
formed
formed
out
if
trade
country
An
members
barriers
eliminate
between
maintains
its
them,
trade
policy
•
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member
all
and
WTO
preferential
is
if
free
trade
common
formed
agree
union
market
monetary
to
a
area
trade
policy
to
if
members
permit
the
of
free
a
customs
ow
of
labour.
economic
and
trading
multilateral
almost
market
additionally
economic
common
formed
adopt
non-members.
common
now
is
to
macroeconomic
agreements
to
union
agree
common
capital
freedoms
of
customs
union
2018.
Union
these
with
Since
July
four
disadvantages
or
A
money.
European
Currently,
monetary
as
non-members.
towards
Africa
transformed
people
blocs
member
members
Ecuador,
membership
adopting
union.
whether
block”
African
services,
a
and
euro
Argentina,
Colombia,
Venezuela’s
Union
countries.
joined
question
are
by
subsequently
Chile,
Eastern
1993
goods,
member
members
and
•
for
monetary
“stumbling
trade
in
of
Advantages
The
Surinam.
Customs
and
have
Bolivia,
included
market
Economic
by
Market
has
movement
established
Uruguay,
2016.
European
common
of
and
in
Common
The
initially
and
members
suspended
The
was
Paraguay
the
Market
towards
(MERCOSUR)
and
customs
or
Common
Bank,
Recap
tariff.
•
Central
Italy,
Netherlands—eliminated
them
European
currency.
1968
Economic
How
Luxembourg
the
common
union.
is
formed
additionally
and
union
union
regulatory
is
formed
agree
establish
a
if
to
if
of
a
certain
policies.
members
adopt
common
members
harmonize
a
of
an
common
central
currency
bank .
blocs
agreement
but ,
agreements,
blocs
at
the
becomes
the
same
time,
signicance
of
non-members
evaluating
the
of
most
role
of
trading
apparent .
trade
HL
Static
non-member
effects
is
The
static
analysis
of
trading
blocs
rests
on
the
work
inefcient
Viner
in
1950
who
introduced
the
terms
trade
trade
creation
refers
to
an
increase
in
imports
that
efcient
domestic
production.
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elimination
of
trade
import
barriers
from
in
a
trading
bloc
will
lead
one
another
produced
goods
domestically.
and
services
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replaced
by
imports
from
that
domestic
another
the
a
20%
being
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efciency
producer
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since
with
lower
diversion
production
member.
shif ts
away
dictate.
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welfare
as
it
both
is
still
consumers
high
costs
to
a
foreign
costs,
leading
to
fewer
within
true
the
world
importing
price
levels.
country
For
face
example,
prices
and
South
Korea.
Assume
that
consider
the
tariff
on
shoes
imported
from
both
USA
Mexico
South
Korea.
Korea
as
Initially
this
the
country
USA
is
the
is
importing
cheapest ,
shoes
more
from
efcient
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from
despite
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tariff.
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though,
the
USA
and
Mexico
a
to
sign
a
customs
union
then
shoe
tariff s
will
be
member
scarce
for
Mexican
shoe
exporters,
but
will
still
be
in
resources
place
for
to
arises
a
when
less
imports
efcient
shif t
member
from
due
to
an
efcient
away
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because
South
Korean
manufacturers.
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USA
may
switch
the
latter
enjoys.
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external
tariff
for
may
render
some
member
articially
relative
from
switch
production
importing
of
a
from
good.
the
Another
truly
member
efcient
and
size
case
efcient
shoes
will
South
now
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Korean
shoe
articially
imports
cheaper.
of
to
trade
case
creation
and
it
will
and
trade
determine
diversion
whether
cheaper
agreement
the
more
will
will
nonvary
members
the
Mexican
the
The
preferences
160
would
improves
wasted.
non-member
in
effect
were
scrapped
producer
what
production
agree
domestic
the
Mexico
producer,
increases
This
against
members
South
be
to
USA ,
and
previously
will
advantage
that
producers
has
to
member.
the
the
internal
cheaper
production
displace
closer
less
implies
diversion.
and
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articially
it
creation
possible
and
the
of
comparative
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to
since
then
lowest
cost
enhances
or
diminishes
static
efciency.
the
the
•
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trading
rms
of
so
bloc
investment
signicant
a
expands
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the
investment
will
accelerate
argument
bloc ,
size
they
for
of
rates
the
will
growth.
developing
could
market
follow.
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for
accelerate
the
rates
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countries.
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process
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out
exposes
turn
in
rms
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production,
allocation
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and
tariff s
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prices
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waste;
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competition
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in
also
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products
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movement
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employment
opportunities
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less
overall
•
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they
borders
also
permit
power
greater
had
of
faster
members
economic
acted
technology
increases:
leverage
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countries
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but
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large
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criticism
163
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monetary
adopt
monetary
subset
the
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of
euro,
deeper
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for
and
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and
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have
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labour
is
to
so
the
with
movement ,
than
countries
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deal
the
much.
smaller
member
the
why
increased
countries
permit
they
have
has
than
within
in
to
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areas
intellectual
property
rights,
competition
e-commerce
efforts
that
a
country
alone
cannot
and
deal
anti-
with.
(HL)
Since
may
grow
all
rms
and
that
the
a
why
as
in
a
bigger
of
market
scale.
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they
may
to
lower
prices
and
increased
competitiveness
in
markets.
countries
are
in
a
weaker
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position
agreements
to
may
defend
prove
their
trade
discriminatory
smaller,
the
of ten
powerful
developing,
to
use
their
countries
huge
as
they
bargaining
achieve
their
preferred
outcomes.
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may
power
explain
the
countries
but
WTO
considered
many
selling
economies
trade
deadlocked
world
be
agreements
latest
may
potential
will
achieve
their
agreement
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agreements
risk
arises
China,
with
union
a
India
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have
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many
resulted
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to
some
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business
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block s”
proliferation
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EU)
individual
policy
a
of
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and
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countries
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EU
economies
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a
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result
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likely
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bank .
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countries
and
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of
economic
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responsibility
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has
currency,
Bank
of
a
is
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since
monetary
the
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to
mostly
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microeconomic
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be
will
to
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either
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a
its
sovereignty,
compromise
or
will
be
country.
that
trading
lobbying
who
efforts
hope
to
blocs
of
are
of ten
formed
self-interested
benet
from
any
as
member
resulting
trade
effects.
lower
transaction
necessary.
exchange
paid
to
transactions
(ECB).
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one
the
an
currency
bank .
within
costs
time
a
This
as
for
cost
monetary
currency
individual
another,
is
conversions
or
a
a
business
fee
eliminated
has
for
any
union.
November
There
is
greater
price
transparency,
which
makes
ECB.
comparisons
of
much
Buyers
easier.
prices
of
goods,
(consumers
services
and
and
rms)
resources
are
able
to
union
spot
nature.
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quickly
the
lowest
price
available
in
the
market
for
include
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the
than
countries
for
•
These
member
agreement
countries
union
eurozone
2019
other
an
other
liberalization.
additional
union
of
agreements
reach
say,
blocs
multilateral
trading
each
explains
trade
agreements
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local
than
•
•
prosperity,
and
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true
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achieve.
negotiations
extent
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follow,
transfer.
especially
agreements
WTO.
regional
difcult
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trade
to
trade
the
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country
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agreements
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advantage
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proliferation
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integrate
to
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to
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country
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allow
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proliferation
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interests.
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with
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161
increases
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countries
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and
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union
their
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union
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•
lower
volume
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member
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monetary
include:
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costs
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This
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exchange
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market .
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comparisons
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trade
exchange
rate
risk s
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costs
cross-border
investments.
•
•
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group
of
countries
with
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common
market
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loss
members.
things
very
cycles
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when
one
another
country
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of
to
enter
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monetary
latter
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room
rates.
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members
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World
is
WTO
steam
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probably
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country
Members
was
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are
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bank
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policy,
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to
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rate
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alone
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a
•
value
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WTO
limited
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expenditures
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promote
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trade
trade
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barrier s.
are
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requires
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most-favoured
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treat
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functions
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goods,
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WTO
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tariff s
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and
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countries
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independent
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policies
members
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enforce
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imposing
trade
are
sanctions
independent
or
manipulate
its
somehow
162
to
tariff s
anchored
effectively
promotes
parties
as
countries
agreements
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and
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Appellate
not
23
that
member
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and
bank .
is
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principle
WTO
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central
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and
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out
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to
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rate
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in
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union,
•
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1995.
conducting
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demand
pressures
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of
possibility
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country
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and
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monetary
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all
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policy
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most
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rate
“asynchronous”.
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union
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monetary
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affairs.
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assistance
technical
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and
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is
countries
trade
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capacity.
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is
Doha
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WTO,
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barriers
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years
and
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has
resulted
According
to
in
world
OECD
and
trade
World
to
them
accused
trade
(sum
world
output
of
exports
and
imports)
as
(gross
world
product)
25%
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to
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in
a
The
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force
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argue
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governments).
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WTO,
recession.
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quotas
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appease
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few
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world
disagree
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protection
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governments
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policies,
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WTO
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policies
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body
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WTO
trade
will
estimates
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volume
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compared
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to
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year
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enforced
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because
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set
December
2019
the
1995
164
of
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resort
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consuming
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needs
the
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of
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US
with
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subsidies
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“supreme
whose
164
Organization
the
world
court ”
Trade
activity.
The
•
T I N U
additional
their
: 4
build
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163
4.5
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exchange
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Exchange
2
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exchange
rate
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the
2019:
•
16
£1
.00
2019:
=
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.2037.
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.00
=
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managed
value
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say
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central
The
currencies
decides
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increase
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say
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a
revaluation
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the
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system.
depreciation
value)
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and
value)
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change
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changes
in
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xed
the
change
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exchange
terms
central
bank,
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the
krone
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xed
Bank,
against
the
a
at
what
is
known
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central
rate
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.00
=
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permits
it
to
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hand,
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reason
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central
bank
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set
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when
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whenever
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“managed
revaluation
be
exchange
and
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the
central
rate
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the
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at
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the
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have
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is
devaluation
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specically,
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term
appreciation
refers
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price
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rate
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refers
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demand
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Denmark
More
)
in
exchange
has
164
the
following.
bank
The
British
then
bank .
by
speed
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rate
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e
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to
buy
Stock
acquire
a
to
UK
make
in
the
UK .
If
Americans
the
will
also
which
US.
of
are
Think
higher
have
dollars
is
by
those
expect
when
price
its
it
price
to
to
sell
make
reects
of
US
British
interest
their
the
UK
deposit .
cross-border
referred
to
as
nancial
who
to
is
fall
want
in
high
to
sell
value.
and
a
They
buy
may
pounds
lower.
of
of
be
she
Dhaka.
sold
to
coats
an
to
will
made
their
American
have
for
(Burberry ’s
be
•
and
to
For
to
bonds
bank
Swiss
make
rm
or
to
wants
to
make
bank
UK
of
for
the
4.5.1
pound
ows
are
exchange
markets.
or
two
is
of
a
the
demanded
However,
selling
origin
of
the
them
of
back
to
pounds
there
currency
currency
in
the
may
demand
for
illustrates
will
Swiss
as
the
buy
to
the
demand
exchange
which
francs
of
send
remittances.
affect
Bank,
have
currency
migrants
thus
to
will
the
in
in
is
euros
will
the
by
rate.
central
selling
increase
euros).
the
in
decide
of
families
which
to
market
working
their
that
and
National
supply
exchange
taka,
referred
intervention
a
expressed
foreign
Bangladesh
money
are
Swiss
The
the
say,
Bangladeshi
Switzerland,
francs.
will
Figure
shares
send
bank
supply
example,
pounds
or
of
in
money
Amounts
central
the
coats)
the
will
country
buying
from,
sending
They
foreign
exchange
for
supplied
exchanged
Lastly,
She
into
be
and
(capital)
why
market .
workers
Bangladesh.
buy
foreign
reasons
may
migrant
nancial
reasons
exchange
equilibrium
terms
of
US
exchange
rate
for
the
dollars.
deposits
establish
a
new
S
Price
rm
in
therefore
UK ,
they
and
in
other
London
department
investments
Exchange,
the
supplied
now
its
supplied
also
by
(that
Economics.
government
British
be
important
(as
pounds
They
necessary
pounds
because
ows
Pounds
buying
to
need
demand
goods
•
services
Americans
Consider
its
groups.
and
dollars
Burberry.
the
need
trade
British
(education).
will
pounds,
UK
Burberry.
dollars
meaning
sold
in
her
to
reects
Investors
UK ,
to
attend
pounds
of
following
pounds.
services,
add
the
buy
bought .
to
order
to
to
demand
be
by
the
rm
advantage
outows.
may
when
new
take
deposits.
into
pounds
later
a
to
system.
rate
buy
and
of
capital)
foreign
manufacturer
pounds
and
to
and
supply
want
and
planning
needs
will
buy
supply
currency
for?
who
goods
UK
exchange
demanded
exports)
pounds
the
demand
Who
what
may
British
on
would
Individuals
is,
•
focus
for?
and
Pounds
•
let ’s
dollar
to
Pounds
the
So,
For
wishing
investments
(or
initially
and
in
currency
why?
simplicity
pounds
participants
are
a
on
pounds
forces.
The
Who
establishing
investors
whereas
T I N U
changes
revaluation
in
: 4
depreciation
and
changes
E H T
ofcial
L A B O L G
devaluation
deliberate
Y M O N O C E
Therefore,
deposits
of
of
£
pound
in
$
British
pounds,
they
will
have
to
buy
pounds
with
their
US
£
dollars.
or
The
shares,
same
a
applies
British
Manchester,
UK .
if
they
company
The
or
demand
want
to
for
set
to
up
buy
a
pounds
UK
bonds
factory
in
therefore
also
e1
reects
cross-border
referred
•
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to
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because
pounds
price
make
as
nancial
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investments
it
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those
rise
price
Buying
from
capital)
by
to
into
is
and
in
who
in
buy
value.
low
and
its
UK
which
are
inows.
selling
change
the
a
a
currency
They
sell
may
it
later
currency
value
is
buy
when
hoping
referred
its
D
to
Quantity
(traded
•
UK
A
are
supplied
importers
British
shirts
will
dollars
exchange
The
of
the
New
goods
to
the
sell
for
and
UK
these
Christmas
pounds
for
US
(Abercrombie
and
to
buy
shirts.
with
dollars
therefore
supply
pounds.
Abercrombie
pounds
of
his
to
the
An
shirts)
and
pounds
period)
Figure
necessary
for
UK
will
the
US
need
Since
UK
to
holiday.
imports
and
4.5.1
The
market
for
UK
pounds
Fitch
Englishman
family
pay
reects
Fitch
of
per
groups.
services
(importing)
pounds
of
following
goods
purchase
York
his
supply
US
buying
have
for
visiting
of
rm
by
£
as
speculation.
Pounds
for
to
is
Figure
pound
the
of
price
pounds
the
4.5.1
with
of
the
traded
pound
is
focuses
respect
to
pound
per
on
and
period.
expressed
the
the
in
US
the
On
US
exchange
dollar,
rate
the
horizontal
the
vertical
dollars,
so
it
is
of
the
vertical
is
the
axis,
US
axis
quantity
the
price
dollars
of
per
$
services
one
UK
pound
or
£
(vacations
in
New
York).
To
•
British
investors
in
the
USA
supply
pounds.
include
buying
US
government
a
bonds
on
the
sold
in
the
New
York
Stock
error,
denominator
Exchange,
of
remember
this
that
fraction
is
whatever
also
on
currency
the
or
horizontal
shares
common
Such
is
investments
avoid
buying
a
axis
of
your
diagram.
In
Figure
4.5.1
,
demand
US
for
pounds
D1
is
equal
to
the
supply
of
pounds
S1
at
the
165
exchange
factor
lead
rate
e1
,
affecting
to
say,
$1
.31
demand
appreciation
or
for
per
pound.
pounds
or
depreciation
Any
change
supply
of
the
of
in
any
pounds
will
pound.
So,
the
quantity
exchange
upward
is
the
demand
for
pounds
negatively
sloped?
is
that
if
the
exchange
rate
decreases
and
buy
a
US
becomes
cheaper
then
fewer
dollar s
will
be
buy
a
pound.
and
British
more
imported
competitive
goods
for
will
will
also
be
Changes
The
cheaper
in
exchange
for
Americans
demand
rate
will
or
to
to
invest
supply
appreciate
or
symmetrical
UK
at
supply
buy
reason.
residents
will
excess
demand
or
in
the
for
depreciate
excess
supply
If
the
need
US
imported
goods
will
in
the
UK .
for
Investing
British
in
the
residents.
USA
They
fewer
pound
pounds
in
exchange
pound
is
pound
more
pounds
become
more
will
will
also
become
therefore
the
foreign
exchange
market
at
rate.
UK .
a
currency
depending
S1
whether
lower
pounds
and
Price
on
the
of
become
Americans
lower
it
dollar.
expensive
supply
cheaper
the
then
The
needed
more
to
demanded
the
expensive
pound
for
cheaper
pounds
increase.
The
to
reason
of
will
sloping
becomes
Why
rate
arises
of
of
£
pound
in
$
the
foreign
exchange
market .
A
currency
will
appreciate
£
if
there
is
excess
demand.
It
will
depreciate
if
there
is
e2
excess
supply.
Excess
demand
for
currency
decreased.
the
demand
currency
will
result
increased
or
either
because
because
supply
of
the
e1
b
a
the
currency
increased.
Excess
decreased
More
or
specic
supply
will
because
examples
result
supply
are
of
given
if
demand
the
for
currency
below.
D2
Currency
appreciation:
Excess
D1
If
for
whatever
reason
the
demand
for
pounds
shif ts
to
the
right
from
D1
to
D2
then
excess
pounds
rate
to
equal
increase
appreciated
to
to
from
ab
e2
e1
will
in
to
put
pressure
Figure
4.5.2.
on
The
the
whatever
reason
per
period)
pound
will
have
Figure
4.5.2
Impact
of
an
increase
in
the
demand
for
UK
pounds
e2.
S2
for
£
pounds
exchange
Price
If
for
of
demand
(traded
for
£
increases
Quantity
and
for
demand
the
supply
of
pounds
of
of
£
pound
S1
decreases
of
£
$
and
shif ts
to
the
lef t
from
S1
to
S2
then
excess
demand
£
of
pounds
rate
to
equal
increase
to
to
ab
e2
will
in
put
pressure
Figure
4.5.3.
on
The
the
exchange
pound
will
have
e2
appreciated
from
e1
to
e2.
b
a
e1
Currency
If
for
and
of
whatever
shif ts
to
pounds
rate
depreciation:
to
reason
the
equal
to
decrease
depreciated
lef t
to
from
the
from
fh
will
e3
e1
in
to
Excess
demand
D1
to
put
for
D3
pounds
then
pressure
Figure
4.5.4.
supply
decreases
excess
on
The
the
supply
exchange
pound
will
have
D1
Quantity
If
for
and
whatever
shif ts
to
reason
the
the
right
supply
from
S1
to
of
pounds
S3
then
(traded
increases
excess
pounds
rate
to
equal
decrease
depreciated
to
to
from
fh
will
e3
e1
£
in
to
put
pressure
Figure
4.5.5.
on
The
the
of
pounds
per
period)
supply
Figure
of
for
e3.
4.5.3
Impact
of
a
decrease
in
the
supply
of
UK
pounds
exchange
pound
will
have
S1
Price
of
of
£
pound
$
e3.
£
Causes
of
a
of
changes
in
the
exchange
rate
currency
h
f
e1
Changes
in
Remember
that:
then
foreigners
goods
and
foreign
Assume
its
need
when
need
services
in
the
that
a
exports.
more
Demand
166
ows
it
a
to
country
buy
will
its
need
exports
goods
and
currency;
when
to
currency
sell
its
it
e3
services
imports
to
buy
currencies.
Changes
for
trade
of
for
foreign
country
is
Growing
the
the
demand
a
country ’s
experiencing
exports
domestic
currency
of
currency
by
growing
implies
that
D3
exports
demand
foreigners
to
pay
for
foreigners
will
therefore
these
increase
£
(traded
will
exports.
for
Quantity
Figure
4.5.4
Impact
of
a
decrease
in
the
demand
for
D1
for
£
of
pounds
per
period)
UK
pounds
a
of
of
S1
£
Price
pounds
S3
$
of
of
of
Rp
rupiahs
£
S2
$
of
Rp
Rp
£
T I N U
S1
Price
: 4
e1
h
e1
for
£
D
Quantity
(traded
Figure
and
for
4.5.5
the
the
Impact
of
demand
currency
appreciate.
an
curve
will
This
increase
is
will
in
the
shif t
create
supply
to
the
pressure
illustrated
in
for
right .
for
Figure
UK
the
of
pounds
per
period)
Quantity
(traded
Figure
pounds
Excess
demand
currency
In
4.5.6
Figure
4.5.6
expressed
to
growth
4.5.2.
Effect
in
the
other
hand,
This
is
exports
a
decrease
will
illustrated
in
lead
to
in
Figure
a
the
foreign
depreciation
demand
of
the
for
in
the
for
that
domestic
demand
for
imports
increases.
To
foreign
products,
importers
must
sell
the
to
buy
domestic
the
necessary
currency
will
foreign
increase
currency.
and
will
will
shif t
to
the
right .
Excess
The
therefore
supply
for
the
right
to
supply
the
tend
create
pressure
in
on
Figure
the
currency
to
is
a
very
the
decrease
to
a
so
the
the
and
it
in
currency
depreciate.
This
domestic
the
will
follows
imports
for
supply
that
the
are
a
of
if
demand
supply
of
the
appreciate.
currency
its
for
imports
domestic
This
exports
rising
will
reects
currency
currency
currency
will
rise.
is
will
above
rise
will
faster
tend
currency
illustrated
the
reects
faster
tend
than
to
affecting
analysis
are
means
rising.
that
more
imports.
have
to
to
supply
buy
the
more
rupiahs
necessary
in
dollars
the
to
foreign
pay
The
supply
curve
for
the
rupiah
for
will
the
shif t
S2
to
as
imports
depreciate
are
to
now
greater.
The
rupiah
will
e2.
interesting
A
result
growing
that
is
seemingly
economy
may
currency.
It
will
be
shown
witness
that
this
is
a
not
if
the
growing
economy
attracts
more
investments.
to
value
the
than
and
If
ination
goods
in
then,
In
its
of
imports
appreciate.
exports
of
value
in
relative
and
a
country
ination
services
than
they
in
used
less
competitive
will
seem
accelerates
that
to.
abroad
country
Its
products
while
shows
that
means
are
rising
will
imported
that
on
prices
the
become
goods
less
and
of
average
and
services
more
attractive
domestically.
imports
then,
ceteris
contrast ,
if
paribus,
Foreign
so
will
demand
the
demand
for
demand
for
increasing
depreciate.
trade
rates
it
exports
its
ceteris
in
lead
its
for
imported
the
supply
exports
its
goods
of
will
currency.
its
and
decrease
In
and
addition,
services
will
therefore
domestic
increase,
currency.
of
Rp
ows
Price
The
incomes
This
S1
Factors
rupiah
Indonesian
is
faster
demand
the
Indonesians’
If
4.5.5.
4.5.3.
paribus,
the
the
decrease
Figure
If
in
e1
.
currency
Changes
A
at
of
necessary
illustrated
Indonesian
initially
period)
rate
supply
depreciating
will
buy
imports.
counterintuitive.
curve
exchange
domestic
This
the
also
market
in
therefore
currency
the
buy
to
more
then
the
on
impor ts
increase
Assume
of
is
expenditures
will
Indonesians
demand
price
dollars
economy
rupiahs
per
a
4.5.4.
domestic
growing
Rp
currency.
exchange
Changes
a
accelerates
Indonesia
country ’s
the
US
Consumption
On
of
of
for
L A B O L G
D1
E H T
e2
e3
Y M O N O C E
f
any
changes
in
a
of
rupiahs
S2
country ’s
of
Rp
$
trade
ows
will
affect
its
exchange
rate.
Changes
in
growth
Rp
rates
and
changes
in
ination
rates
are
two
factors
country
and
thus
that
will
e1
affect
and
exports
the
and
supply
Changes
in
imports
for
its
of
a
the
demand
currency.
relative
growth
rates
e2
A
higher
are
now
imply
growth
rising
rising
domestic
faster
implies
than
consumption
consumption
on
rate
also
on
incomes
previously.
include
foreign
in
Rising
expenditures
expenditures
but
that
country
incomes
and
household
spending
goods
the
and
not
only
services.
D1
It
D2
follows
that
in
a
growing
economy,
demand
for
for
Quantity
will
rise.
Now
let ’s
focus
on
the
Indonesian
rupiah
assume
that
the
growth
of
the
Indonesian
of
per
rupiahs
period)
economy
Figure
is
Rp
(Rp)
(traded
and
for
Rp
imports
4.5.7
Effect
of
higher
ination
on
the
exchange
rate
accelerating.
167
Figure
on
4.5.7
the
the
dollar
decrease
abroad,
D2
shows
rupiah.
was
its
the
at
e1
.
exports
decreasing
in
Figure
the
same
effect
Initially
the
The
as
higher
higher
they
the
of
rupiah
ination
exchange
ination
will
become
demand
for
the
in
in
rate
Indonesia
Indonesia
less
from
D1
words
becomes
stock
will
competitive
rupiah
other
it
against
country.
More
and
time
imported
goods
and
services
will
more
attractive
to
Indonesians.
Imports
the
interest
tend
foreign
to
increase.
exchange
More
market ,
rupiahs
will
shif ting
the
be
rupiahs
in
from
S1
to
S2.
The
decrease
in
the
and
the
increase
in
the
supply
of
depreciation
demand
the
in
an
Changes
Inows
in
and
in
to
economy
will
tend
cross-border
also
distinguish
rupiahs
will
lead
of
to
depreciate
capital
nancial
a
currency.
tend
affect
the
two
and
and
types
foreign
outward
of
for
rate
investment
direct
assets,
some
refer s
including
reason
in
tend
a
that
to
for
an
then
to
the
stock s,
UK
bonds
rms
UK
nancial
listed
more
and
selling
will
bonds,
or
the
bonds
inows
currency.
deposits
in
the
in
London
attractive
need
or
London
the
to
make
Stock
therefore
and
of
the
in
to
of
For
UK
nancial
example,
pounds
Stock
nancial
buy
the
deposits
UK
in
Exchange.
increase.
inward
Figure
lower.
these
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169
Consequences
Impact
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changes
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France
shows
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Example
Currency
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of
exchange
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exports
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wine.
rate
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exchange
rate
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.00
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the
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170
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page
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wine
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4.5.8
and
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attractive.
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exports
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abroad
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attractive
and
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demand
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However,
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demand
increases
AD
curve
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right
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have
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This
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explains
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tend
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their
exports
remain
cheap,
and
therefore
cyclical
rate
foreign
markets.
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is
the
idea
behind
note
economy
what
is
known
the
net
and
exports
demand)
AD
curve
is
will
expected
shif t
to
to
the
Real
GDP
will
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from
right
Y1
will
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employment
Y1
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originally
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much
to
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smaller
In
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so
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if
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to
Y3
and
cyclical
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the
possibility
of
demand-pull
ination
is
evident
as
the
4.5.8).
contrast ,
an
therefore
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slow
down
will
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net
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exports
will
price
to
Average
level
Impact
on
level
(APL)
will
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demand
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The
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average
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value
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Figure
more
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should
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depreciation
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the
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“export-led
become
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in
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to
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cheaper
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domestically
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Since
: 4
Assume
Figure
shown.
T I N U
In
growth
E H T
economic
price
AS
(APL)
unemployment
depreciation
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in
aggregate
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AD3
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decreasing
of
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will
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contrast ,
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the
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rely
energy)
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if
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domestic
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that
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on
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AD1
cyclical
exible.
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In
in
L A B O L G
on
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Impact
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cost
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In
contrast ,
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aggregate
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demand
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these
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on
food
imported
and
then
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rise.
pressures.
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Note
bigger
pharmaceuticals
avoid
may
or
increase
whereas
deationary
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these
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the
to
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tourism
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effects
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example,
domestic
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particular
rate
will
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foreigner s
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country.
residents
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171
abroad.
but
It
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generally
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import-competing
domestic
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their
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A
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172
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exchange
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Of
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pressures
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devalue
In
reducing
T I N U
may
to
currency
to
: 4
signicant
devalue:
“black
•
the
central
bank
may
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using
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foreign
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in
contrast ,
there
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Note
central
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domestic
of
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in
L A B O L G
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both
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•
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revalue:
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level
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undervalued
to
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This
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decide
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means
on
that
market
rate
they
try
to
equilibrium
something
like
this
level.
and
consequences?
more
currency
competitive
automatically
exports.
This
is
implies
the
cheaper
biggest
and
advantage
D2
such
a
policy.
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increased
export
penetration
and
does
higher
export
revenues
increase
aggregate
demand
bank
that
it
through
the
export
multiplier,
accelerate
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does
currencies
it
bank
will
will
try
to
perform
sterilized
neutralize
any
intervention,
changes
in
spectacular
have
countries,
example,
if
a
central
bank
would
like
export–led
signicantly
including
growth
China,
have
that
contributed
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to
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achieved.
the
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money
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much.
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risk
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countries
Undervalued
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and,
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thus
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rates
oat
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Illustrating
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foreign
options
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Sometimes
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avoid
decrease
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The
intervention
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movements
exibility.
starts
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at
may
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rates
exchange
exchange
managed
try
same
oats
a
and
both
E H T
exchange
could
a
country
keep
its
currency
undervalued
against ,
to
for
example,
the
US
dollar?
Its
central
bank
would
have
to
be
173
purchasing
exchange
way
be
rates
US
dollars
market .
by
The
articially
selling
supply
higher.
its
of
currency
its
in
currency
Alternatively,
it
the
would
must
foreign
industries.
in
the
keep
this
interest
goods
of
low.
The
country
in
the
the
the
are
the
currency
partners.
addition,
less
First ,
country ’s
industries
exports
of
retaliation
and
selling
currency
the
creates
the
trade
trading
its
frictions
partner
risk
price
is
low
be
will
with
trading
suffer.
more
by
by
How
for
import-
rates
there
is
increased
risk
of
cries
for
continuously
maintaining
exchange
way
the
currency
be
countries
try
their
currency
maintain
overvalued.
This
rates
it
at
would
a
level
above
policymakers
the
the
In
exchange
means
free
decide
on
a
tax
the
are
some
of
the
on
developing
that
they
try
currency
case
(see
market
equilibrium
something
like
this
countries
section
have
as
4.10).
trying
of
imports.
They
industries”
by
in
the
past
tried
to
to
part
The
shif t
of
an
basic
out
substituting
erected
and
at
overvalued.
trade
the
This
of
rates
to
lower
of
An
idea
is
that
(that
would
same
price
is,
the
domestic
time
to
Fixed
When
keep
versus
comparing
in
mind
of
because
cheaper.
imported
of
considered
the
their
their
at
a
oating
the
capital
and
goods
and
with
of
costs
of
boost
the
the
xed
the
oating
free
They
economy
lower
exports,
are
interest
a
to
use
can
as
raw
exchange
of
one
currency
of
the
the
will
currency
will
policy
also
lead
trade
goods
for
export
price
in
was
the
currency
expensive
commodities
determined
dollars,
each
acted
abroad.
(for
in
farmers
world
earned
dollar
earned
from
less
their
rate
would
hurt
the
export
country.
of
aggregate
decrease
to
a
that
rate
policy
to
be
part
that
are
of
a
policy
part
to
an
be
the
net
“cooling
off ”
the
of
economy.
is
also
lower
help.
(the
First ,
typical
the
cost
of
consumer ’s
includes
industries
imports).
to
cut
It
their
forces
costs
domestic
increasing
and
of
keeping
their
domestic
own
rms
prices
using
low.
Lastly,
imported
With
ination
contained,
the
country
inputs
can
rates
low,
which
encourages
long-term
keep
investment
growth.
that
HL
the
section
Marshall-Lerner
4.6,
page
become
become
They
adopt
184)
condition
then
cheaper
pricier
follows
in
net
the
is
satised
trade
abroad
and
domestically
can
use
rate
pressures
higher
exports
there
is
less
contractionary
page
1
14)
decrease
Exchange
and
because
costly
3.5,
therefore
to
that
important
section
achieve
increase
demand.
decrease,
systems
systems
can
policy
inationary
in
may
Exports
decit
more
and
(HL ,
will
see
narrow
competitive,
less
attractive.
as
while
This
exchange
depreciation
follows
decrease
overvalued
pressures.
imports
also
costs
low.
that
imports
This
but
slow
also
through
means
speculation:
need
that
there
for
the
demand-side
will
adjustments
continuous.
is
down
risk
policies
growth
increase
time
are
currency
of
government
(see
and
unemployment .
usually
crises
are
destabilizing
smooth
avoided.
speculation
as
for
example,
the
fundamentals
of
an
economy
(inationary
interest
and
so
and
so
on)
point
to
a
weakening
currency.
Speculators
in
then
start
A
(when
trade
M
>
decit
X)
may
implies
be
massively
selling
the
currency,
leading
supplied
than
demanded
in
the
excess
supply
will
depreciate
more
foreign
the
sharper
decrease
in
its
to
an
value.
automatically
that
of
the
is
less
exchange
currency.
need
for
the
central
bank
to
carry
large
currency
exchange
reserves
as
there
is
no
need
to
intervene
market .
constantly
174
of
more
materials)
foreign
The
the
quoted
population
efciency
There
is
this
demand.
decit
narrowed.
became
exchange
will
cheaper
unnecessarily
A
in
interest
new
may
aggregate
and
currency
competing
exports
monetary
lead
to
appreciation
also
keep
goal
rate
system
(exible)
loose
the
of
pressures
rates
overvaluation
primary
which
developing
import
if,
the
would
must
be
exchange
other.
monetary
use
the
rates
component
monetary
the
exports
currency
demand
Concerning
tight
for
basket
to
goals.
it
to
foreign
for
rates
domestic
currency
Alternatively,
have
the
“infant
is
Policymakers
as
inationary
addition,
imports
of
its
in
other
their
exchange
advantages
disadvantages
Advantages
for
dollars
higher
However,
machines
production
oating
that
US
against ,
would
into
production
protect
maintained
absurd
become
price
decrease
selling
overvalued
bank
these
and
and
that
that
overvalued
the
combat
interest
inputs
central
import-substitution
agriculture
barriers
sounds
imports
the
currency
Its
demand
traditional
domestic
of
remain
was
The
markets
production
exchange
growth
to
keep
their
rate
the
policy
level.
living
manufacturing
a
consequences?
overvalued
were
was
of
and
In
countries
its
by
higher.
was
coffee)
aggregate
strategy
permitting
This
out
substitute
to
to
their
keep
dollar?
currency
exports
Maintaining
Many
keep
rate
sector
what
to
high.
exports.
Why
US
market .
downside
units
maintain
country
the
its
commodity
of
buyers,
industries.
used
considered
ination.
overvalued
to
a
articially
example,
Sometimes
domestic
infant
be
be
low
as
Keeping
could
example,
The
interest
would
could
industrialization.
purchasing
In
expensive
increase
that
or
of
that
keeping
that
will
will
caused
Another
keep
from
means
partner
distress
protection.
success
success
trading
The
to
export
export
of
competitive.
the
the
undervalued
One
competing
and
risks?
barriers
goods
eyes
domestic
accelerate
What
trade
any
Assuming
to
maintain
the
exchange
rate
at
a
xed
parity.
a
they
regain
competitive
any
oating
system
domestic
it
or
the
world
exchange
economic
rate
or
goes
political
unpredictably,
exchange
up
and
down
Disadvantages
there
is
a
lot
of
uncertainty
in
market
as
to
its
future
path.
Exporters
as
well
as
investors,
face
signicant
are
domestic
against
exchange
only
which
they
can
only
partially
protect
a
result,
services
are
both
and
the
negatively
fewer
risks,
the
volume
volume
affected.
resources
will
drop
of
of
international
Smaller
available
out
of
cross-border
the
to
rms
protect
trade
portfolio
and
goods
investors,
Even
against
with
the
policy
to
lack
the
either
market.
“policy
discipline”
that
a
system
imposes.
ination.
growth
it
For
A
country
could
means
example,
may
therefore
be
that
more
the
expansionary
xed
be
easily
resulting
adopted
growth
policies
by
will
a
be
more
to
exchange
rates
deprived
of
monetary
activity.
policy
Monetary
as
a
tool
policy
to
may
that
the
exchange
rate
remains
be
xed.
are
also
domestic
deprived
policy
of
exchange
rate
policy
to
objectives.
by
policymaker s
constrained
somehow.
faster
of
the
expansionary
budget
Financing
growth
through
of
because
a
large
money
“printing”
decits
budget
supply
money)
or
(if
scal
need
may
the
higher
to
be
lead
decit
interest
to
is
of
crowding
out
(HL).
Neither
of
these
rates
possibilities
prone
acceptable
under
a
xed
exchange
rate
system.
accelerate
government
even
if
Devaluation
implies
inationary.
Recap
to
rates—advantages
a
avoid
must
exchange
xed
exchange
To
Floating
of
economic
ensure
use
is
nanced
such
is
to
to
and
investments
smaller
themselves
in
with
because
rate
depreciation
rate
nanced
Governments
a
markets.
themselves.
deal
As
for
world
and
Policymakers
risks
hope
in
the
used
importers,
cannot
advantage
development
affect
foreign
They
rates
Policymakers
affecting
have.
be
or
revaluation
sudden
the
change
need
corrected
lower
the
to
in
resort
by
can
prove
the
to
income
value
of
the
devaluation
adopting
national
disruptive
a
trade
contractionary
and
so
as
each
currency.
decit
scal
decrease
policy
import
and
absorption.
The
disadvantages
are
that
this
means
slower
disadvantages
growth,
Advantages
•
achieve
•
Trade
can
freely
domestic
use
monetary
policy
to
The
goals.
imbalances
corrected
are
through
Exchange
rate
central
reserves
in
principle
exchange
rate
market
automatically
adjustments
This
only.
low
•
possibly
even
a
recession,
as
well
as
higher
cyclical
unemployment .
Policymakers
adjustments
are
usually
T I N U
in
any
advantage
: 4
with
(exible)
smooth
to
bank
be
and
no
to
a
high
maintain
intervene
maintain
involves
or
must
able
the
large
in
the
exchange
opportunity
foreign
exchange
foreign
exchange
rate
cost
at
as
the
target
reserves
earn
level.
either
interest .
and
continuous.
E H T
Since
oating
L A B O L G
exchange
of
Y M O N O C E
Disadvantages
Recap
•
There
is
less
exchange
need
for
the
central
bank
to
keep
foreign
reserves.
Fixed
•
At
times,
•
Increased
and
The
there
is
of
rms
and
expansionary
destabilizing
decreases
investment
government
these
risk
uncertainty
cross-border
smaller
•
exchange
rates—advantages
and
disadvantages
Disadvantages
investors
may
policies
accelerate
be
to
volume
and
drop
more
for
the
ows
Advantages
speculation.
it
of
trade
short-term
to
•
uncertainty
Fiscal
of
even
if
ination.
•
trade
discipline
exchange
adopt
gains
Less
volume
out .
prone
•
forces
rate
price
Firms
forced
are
is
exchange
rate
cross-border
imposed
system
maintain
competitive
and
and
may
on
be
risk
increases
investment
governments;
a
policy
the
ows.
a
choice
xed
to
stability.
to
be
efcient
advantage
they
to
maintain
any
have.
Disadvantages
Advantages
of
xed
exchange
rates
•
Less
uncertainty
and
exchange
rate
risk
means
that
Policymakers
domestic
engaged
export
in
exchange
rate
investment .
exports
Since
and
or
risk
Fixed
is
that
that
bill.
could
exchange
as
not
well
can
lower
rates
as
may
cannot
prove
easier
Portfolio
predict
investors
their
return
increase
of
compatible
governments
policy
trade
import
imports
ination
system,
scal
international
revenues
capital
with
easily
a
the
pursue
inationary.
from
avoid
any
volume
•
The
government
•
The
use
of
because
supply
exchange
rate
•
expansionary
impose
scal
discipline
on
Fixed
governments.
of
or
Exchange
rate
has
therefore
of ten
been
a
Fixing
determined
to
curb
high
Trade
In
to
achieve
interest
rate
a
scal
decit
rates,
of
an
policy
may
neither
adjustments
exchange
are
is
affect
of
rate
policy.
constrained
the
which
sudden,
is
so
money
acceptable.
they
are
disruptive.
policy
choice
ination
and
use
are
of
not
automatically
painful
corrected,
contractionary
scal
policy.
for
The
central
bank
may
maintain
large
foreign
maintain
reserves,
which
is
costly.
stability.
addition,
costs
deprived
expansionary
decits
exchange
price
policy
the
•
governments
monetary
exchange
requiring
exchange
is
nancing
potentially
•
rates
use
goals.
their
also
ows.
xed
cannot
rms
and
rms
prices
are
forced
down
to
to
be
efcient
maintain
and
whatever
to
keep
their
competitive
175
Calculations
1
.
To
convert
HL
the
cost
of
good
expressed
in
dollars
($)
into
$
asked
pounds
(£),
just
remember
for
the
dollar
price
of
the
euro
(
)
divide
the
€
that
$
dollar
price
of
the
pound
by
the
euro
price
of
the
£
price
in
£
=
price
in
$
£
×
€
$
pound
:
£
Notice
that
the
dollars
($)
on
the
right-hand
side
cancel
$
out
so
that
the
result
convert
the
cost
of
the
multiplication
is
pounds
(£).
$
£
=
2.
To
into
dollars
($)
just
of
good
expressed
remember
in
pounds
$
£
×
£
€
(£)
=
as
the
pounds
(£)
cancel
out
€
€
£
that
€
If
$
price
in
$
=
price
in
£
you
are
asked
for
the
euro
price
the
pounds
(£)
on
the
right-hand
side
3.
so
that
the
Calculating
a
result
of
the
multiplication
“cross-exchange-rate”
is
is
the
that
you
are
given
the
price
both
in
euros
(
£
dollars
the
pound
($).
the
176
and
in
dollars
(
£
)
then:
if
of
the
pound
by
the
dollar
price
:
€
easy.
of
price
£
pound
you
are
£
£
€
=
(£)
$
)
)
£
$
€
(
$
£
Assume
euro
cancel
of
out
dollar
$
divide
that
the
€
£
Notice
of
×
×
£
€
=
$
as
$
the
pounds
(£)
cancel
out
over
of
payments
transactions
a
period
of
of
a
time,
is
dened
country
usually
as
with
a
a
the
record
rest
of
of
the
the
It
value
is
a
T I N U
credit
payments
world
currency,
year.
so
payments
Transactions
as
credit
that
items
Transactions
to
as
debit
lead
and
that
items
to
an
enter
lead
and
inow
the
to
an
enter
of
currency
account
outow
the
with
of
a
are
plus
currency
account
with
a
two
types
of
transaction
are
shown
in
the
it
for
a
is
with
Mexico
plus
a
a
sign.
debit
and
For
item
minus
enters
the
and
its
USA
it
enters
balance
is
an
the
of
outow
US
of
balance
of
sign.
known
•
sign.
are
If
minus
Mexico’s
a
referred
Turkish
currency
sign.
enter s
The
item
with
largest
steel
steel
company
manufacturing
from
Mexico.
Mexico’s
It
is
balance
a
of
acquires
rm,
debit
this
is
item
payments
for
an
for
with
$1
.2
billion
outow
Mexico
a
of
and
minus
sign.
following
For
Turkey
it
is
an
inow
of
currency
so
it
is
a
credit
item
examples.
and
•
If
Raquel,
who
lives
in
Mexico
City,
buys
a
$250
this
is
an
outow
of
currency
from
Mexico.
it
is
a
debit
item
and
enters
its
balance
If
Arturo,
with
a
minus
sign.
For
Italy
it
is
an
inow
so
payments
•
If
Layla,
it
is
with
an
a
a
credit
plus
American
item
and
enters
Delta
a
her
during
stay,
this
her
Components
college
The
balance
of
student ,
the
the
account .
break
an
current
and
inow
the
payments
components,
nancial
is
of
Italy ’s
balance
current
debit
current
The
goods
(physical
of
visits
is
of
Mazatlan
spends
divided
$1200
currency
balance
account ,
includes
the
for
laptops,
airplanes,
in
includes
tangible
imports;
with
it
into
the
into
of
City,
in
buys
the
$500,000
New
York
worth
Stock
outow
Mexico
of
and
currency
enters
from
Mexico.
Mexico’s
It
balance
is
of
is
a
minus
an
sign.
inow,
so
For
it
is
the
a
USA
’s
credit
balance
item
and
of
enters
of
payments
with
a
plus
its
sign.
on
The
major
account
and
of
difference
services
it
is
is
positive
If
it
between
referred
there
is
the
to
is
as
a
negative
value
the
surplus
there
of
exports
balance
in
is
a
the
of
and
trade
balance
decit
in
imports
in
of
the
services.
trade
in
balance
in
of
value
farm
a
wine
products,
or
medical
includes
imports
and
the
balance
goods
the
of
all
the
country
oil,
Net
goods
exports
machines,
equipment .
exports
services.
components.
or
of
two
of
income
and
nal
products.
in
are
goods
from
combined
and
to
arrive
at
the
services.
abroad
(the
primar y
income
cars,
account
records
differences
between
income
received
More
raw
abroad
(inows)
and
income
payable
abroad
materials,
(outows).
products
accounts
trade
account)
from
it
listed
payments
three
capital
following
merchandise)
example,
intermediate
sign.
Mexico.
This
generally,
plus
in
If
trade
account
or
a
account
account
balance
Mexico
shares
an
for
payments
Of ten
The
this
item
payments
trade
The
with
of
services.
The
payments
sign.
spring
money
of
Airlines
balance
Mexico
resident
of
of
a
currency,
balance
of
Exchange,
payments
Turkey ’s
For
of
Mexico
enter s
Italian
•
jacket ,
: 4
balance
all
payments
E H T
of
of
L A B O L G
The
Balance
Y M O N O C E
4.6
Exports
are
Primary
income
includes
mostly
two
types
of
credits
income.
and
are
recorded
with
a
plus
sign
as
they
lead
to
an
inow
•
of
currency.
Imports
are
debits
and
are
recorded
with
a
It
includes
and
sign
as
they
between
is
referred
there
is
lead
the
a
negative
to
to
value
as
the
surplus
there
is
outow
exports
balance
in
a
an
of
the
of
of
of
trade
balance
decit
in
currency.
goods
the
of
The
and
in
trade
balance
in
If
it
trade
of
is
goods.
of
balance
of
trade
in
it
It
includes
period
is
services
account
exports
tourism,
others.
plus
includes
and
the
the
a
When
plus
sign)
Whitney
export
for
value
for
of
all
the
services
and
of
an
insurance,
architectural,
are
and
debits
visit
India
Germany.
example,
credits
Germans
Museum
Italy
are
imports
sign)
for
for
nancial,
exports
whereas
sign.
so
minus
imports;
education,
Again,
sign
minus
or
and
dividends
from
portfolio
compensation
who
time
work
then
(wages
a
of
paid
and
country
return
residents
compensation
in
home
the
by
(so
South
only
they
country).
a
salaries)
but
An
for
are
of
a
short
not
example
Korean
would
university
to
be
a
services
an
an
American
import
and
India
and
When
are
for
it
are
is
the
in
(a
services
with
export
debit
architect
Boston
USA .
it
delivering
a
series
of
lectures
in
Seoul.
that
“net
GDP
from
GNI
Net
current
income
from
abroad”
is
what
distinguishes
shipping,
recorded
an
import
Italian
Art
legal
recorded
academic
a
Note
country
of
considered
goods.
British
The
interest
investments.
employees
positive
If
in
•
goods
the
The
direct
difference
imports
goods.
prots,
minus
a
This
account
credit
that
it
and
so
a
designed
was
macroeconomics.
and
a
with
(a
in
an
(unilateral)
records
receives.
international
international
as
receipts
and
including
gif ts
that
includes
pension
to
aid
It
food
ows,
aid
to
and
a
country
migrant
cooperation
payments
transfers
donations,
between
EU
makes
workers’
and
transfers
related
governments
institutions),
emergency
aid
gif ts
remittances,
(such
foreign
af ter
natural
177
disasters
the
and
inows
so
on.
If
it
(outows)
is
of
positive
such
(negative)
moneys
it
exceed
means
the
that
outows
in
the
Egyptian
income
(inows).
money
as
Current
account
a
under
current
the
(debit)
will
payment
of
account
current
be
as
a
account .
recorded
investment
in
receipt
The
the
income
of
equal
Turkish
under
investment
outow
current
its
of
account
current
balance
account .
The
sum
of
net
exports
of
goods
and
services,
net
income
Changes
and
net
dened
say
we
current
as
that
say
The
the
there
that
transfers
current
is
a
there
capital
Typically,
the
importance.
is
a
a
account
current
period
balance.
account
current
of
time
If
this
surplus.
account
(a
If
is
it
year)
positive,
is
net
capital
we
negative,
A
decit .
central
bank
acceptable
by
use
to
the
foreign
account
is
small
and
usually
of
minor
transfers
which
assets
between
countries,
such
as
net
is
counted
(goods
(credit)
purchases
as
a
debit
for
the
reserve
foreign
and
nancial
assets)
of
migrants
such
or
and
leave
sales
rights
rights,
to
mineral
trademark s,
The
(debit)
a
of
non-nancial,
natural
rights
franchises,
nancial
nancial
investment
reserve
Direct
as
well
of
as
the
investment
resources
and
leases
so
on),
and
one
direct
or
includes
changes
central
(of ten
FDI)
country
country
(the
is
investment
Building
market
currency
holdings
yen,
dollars,
are
the
short-term
patents,
internet
can
of
and
investment ,
in
ofcial
the
bank
to
of
the
to
as
long-term
source)
host).
the
in
The
intent
includes
new
portfolio
•
gold
•
a
few
international
in
so)
in
operations
reserve
from
the
of
in
foreign
is
signicant
a
decrease
reserves
ofcial
economy.
by
The
The
new
lasting
the
central
facilities
dollars,
dollars
and
pounds,
Swiss
currencies
the
IMF
francs,
as
recognizes)
(such
as
into
a
US
Treasury
reserve
Bills)
currency
enters
until
reserves
in
with
we
a
ofcial
plus
the
that
considered
enters
whereas
account
realize
are
reserves
sign
with
by
a
an
minus
accounting
assets
the
increase
sign.
This
convention
One
way
to
understand
residing
to
gain
over
typically
lasting
and
Portfolio
and
of
bank
of
holding
a
a
country
foreign
Interdependence
distribution
changes
outside
resident
of
Egypt
is
and
an
to
investment)
establish
have
existing
is
also
full
a
bonds,
following
the
over
an
CA
one.
shares
and
acquiring
for
the
is
on
capital
between
necessarily
the
the
holds
being,
or
to
is
that
dividends
a
debit
next
of
outow
account
and
inow
of
item
year
refer
decisions
at
least
investment
to
the
and
money
the
accounts
=
–FA
CA
+
FA
–
KA
+
KA
=
0
balance
on
the
current
account
and
account ,
KA
is
the
FA
is
the
balance
The
capital
account
(KA)
is
very
on
small
insignicant
so
we
will
be
ignoring
it
in
for
the
so
The
of
the
10%
to
of
qualify
acquisition
corporate
For
Turkish
of
and
such
and
when
interest
the
=
–FA
(1)
exert
This
is
an
identity
necessarily
current
holds
account
goods
which
true.
means
It
decit
and
exporting
simply
so
services
(that
is,
that
it
from
selling)
that
is
the
to
it
states
always
that
if
importing
rest
the
of
rest
country
(that
the
of
and
a
is,
world
the
has
than
world,
a
buying)
it
then
companies,
money
is
when
or
an
equal
recorded
inow
of
assets
leads
to
an
is
the
recorded
resident
payments
(credit)
into
from
with
of
the
Egypt
a
in
be
surplus
in
its
nancial
it
account .
Why?
The
reason
There
must
is
that
it
must
nance
this
decit
somehow.
as
be
an
inow
(plus
sign)
of
dollars
from
the
a
nancial
account
decit
the
in
of
equal
magnitude.
For
example,
current
account
is
489
billion
dollars
if
the
(– 489),
the
country
must
have
somehow
found
these
489
in
dollars
to
pay
for
the
excess
of
goods
and
services
it
of
over
what
it
exports.
It
must
be
that
sign.
– 489
receives
investments
will
sized
the
money
minus
equally
buys
outow
Egypt
an
and
bonds
example,
have
imports
funds—it
from
account .
true:
CA
nancial
account .
therefore
more
deposits.
stock s
Buying
entity
savings
the
billion
Turkish
separate
company
investment .
control
management
requires
government
loans
then
nancial
a
is
then
Egyptian
as
exchange
new
control
foreign
direct
complete
investments
buys
visualize
investment
stock s,
in
to
facilities,
interest .
other
other
corporate
is
rm.
over
company ’s
a
this
in
characteristic
must
178
US
British
interest .
(“greeneld”
objective
investment)
control
foreign
Por tfolio
that
(in
following.
country
taking
either
IMF
having
Note
in
exchange
rms
is
the
deposits
bonds
CA
objective
Turkish
the
direct
investment
productive
(factories,
scratch
host
the
or
(“browneld”
as
affect
assets.
strange
the
time
well
to
renminbi,
transformed
payments
the
and
Investing
of
order
and
Canadian
eight
easily
that
of
ofcial
seems
the
sale
in
Chinese
government
be
other
here
balance
country.
distinctive
of
the
facilities
investment .
presence
as
for
intervene
names.
balance
the
to
copyrights,
domain
where
direct
rm.
or
include:
or,
stores
•
needs
generally
available
rights,
The
•
are
non-produced
(shing
direct
referred
refers
(the
investment
Direct
assets
Japanese
economy
another
payments
that
readily
investment
investment
from
are
account
account
assets
Direct
of
assets
they
country
Note
The
balance
so
as
that
land
reserve
lender;
•
assets,
international
debt
these
•
hold
countries,
exchange
Australian
enter
must
all
nance
euros,
they
of
rate.
•
the
holdings
includes:
forgiveness,
and
ofcial
reserves
These
•
in
is
account
capital
It
over
then
recorded
If
you
that
are
its
=
having
income
–(+)489
trouble
from
so
that
with
selling
this,
its
–
489
think
labour
+
of
489
a
=
0
family.
services
in
Assume
2020
was
have
(consider
spent
nanced
assets
the
more
the
(such
and/or
these
a
then
of
goods
it
It
we
are
could
have
may
and/or
If
family).
services
How
must
had.
bank s.
accounts
It
the
and
“imports”).
bicycle)
from
its
its
earned?
decit
used
borrowed
family
it
“exports”
bought
these
than
$3,000
as
the
family
the
family
have
sold
these
central
bank
this
decit .
The
central
bank
$640
the
savings
into
this
nancial
account
includes
buying
and
selling
of
It
bonds,
also
the
deposits
includes
central
holdings
changes
bank .
of
and
Let ’s
reserves
loans
in
well
ofcial
now
of
as
the
direct
holdings
separate
central
as
the
bank
of
to
clarify
an
important
point .
reserves
changes
from
We
the
can
billion
is
the
that
the
economy.
and
central
by
reserves
reserves
recorded
are
bank
bank
Note
also
reserves
it
to
of
now
with
a
nance
the
equal
plus
and
accounting
central
exchange
its
sign
“entered”
convention
are
considered
that
will
if
a
be
the
assets
country
forced
to
has
resort
ofcial
borrowing
to
pay
for
its
nancing
needs.
investments.
in
Returning
of
ofcial
now
to
the
identity
above
(2)
it
should
make
sense:
nancial
CA
account
by
the
$50
“ lef t ”
from
exchange
stock s
to
and
by
decrease
held
foreign
billion
foreign
Remember
outside
insufcient
The
This
amount
reserves
residing
balanced.
$50
decreased
economy.
ofcial
used
ofcial
billion.
because
some
“inows”
The
to
somehow
decreased
add
During
worth
now
+
KA
+
FA
=
Ofcial
reserve
transactions
=
0
rewrite
or
relationship
(1)
above
as:
– 470
CA
+
FA
+
ofcial
reserve
transactions
=
we
now
also
include
the
capital
account
(KA)
can
be
written
CA
+
+
KA
+
FA
+
KA
+
FA
=
0
as
now
a
included
in
ofcial
the
reserve
transactions
=
0
of
a
the
nancial
current
transactions
by
“autonomous”
taken
cars
or
for
or
account ,
the
business
or
excluding
central
bank
transactions
exporting
stock s
account
the
rms.
and
Changes
the
are
capital
they
Examples
investors
in
ofcial
referred
because
purposes.
grain
If
the
to
as
sum
referred
of
to
as
autonomous
balance
For
be
the
an
sign.
An
of
are
FA
as
rms
or
importing
selling
(excluding
Further
equal
will
following
is
help
Further
in
assume
ofcial
the
of
=
KA
(excluding
is
transactions
negative
If
the
referred
=
change
its
in
Assume
payments
–5
to
balance
transaction
– 470
ofcial
that
is
decit .
it
payments
clarify.
balance
CA
FA
positive
accommodating
transaction
assume
=
+228
billion
with
ofcial
that
a
values
billion
dollars
The
all
it
is
sum
has
decit
billion
sum
to
as
of
a
there
the
must
opposite
nancing.
country
for
some
recorded
of
$71
1
sign
account
which
a
combined
totaling
more
could
decit
owed
foreigners
bank .
assets
with
residing
plentiful
other
Again,
be?
was
a
into
=
bank
to
inows
outows.
of
Let:
dollars
=
bank
–205
again
billion
was
dollars .
holding
reserves.
transactions
the
They
This
ofcial
is
now
foreign
held
outside
foreign
increase
increase
“ lef t ”
Remember
by
the
is
the
that
the
+21
billion
exchange
by
$21
billion
recorded
economy
by
with
and
accounting
central
economy.
exchange
referring
CA
+
KA
to
+
the
FA
=
identity
Ofcial
+228
+425
held
billion
690
account
billion.
out
This
This
of
the
dollars .
billion
and
means
country
combined
nanced
surplus
the
bought
of
from
the
$425
country
$425
companies
stock s
or
bank
Note
reserves
may
minus
“entered”
convention
are
that
and
a
considered
a
country
ofcially
lend
above
(2):
reserve
transactions
=
0
dollars
or,
+
the
228
–
2
–
226
=
–
0
2
+
as
(–205
ofcial
–
21)
=
0
reserves
are
included
in
FA .
would
as
owed
more
domestic
in
bonds,
residents
there
are
still
recorded
and
in
is
never
reserves
of
payments
single
the
autonomous
statistical
transaction
authorities
other
nancial
institutions)
but
(customs,
unfortunately
is
costly
the
case.
It
is
never
the
case
because
data
this
collection
For
and
far
from
perfect .
Many
transactions,
especially
billion
the
nancial
account
(which
is
the
hardest
one
to
compile
example,
stock s
accuracy),
bought
are
simply
not
recorded
and
some
even
and
to
be
estimated.
So,
typically
the
sum
of
all
accounts
foreign
$50
billion
missing.
come
into
This
is
play,
changes
in
ofcial
reserves
do
not
add
up,
reserves
that
the
central
the
country
decit
and
were
force
it
used
to
to
as
they
zero.
where
bank
to
should,
the
sum
is
not
zero
but,
say,
–5
billion
dollars,
then
statisticians
namely
nance
balance
the
aptly
named
errors
and
omissions
entry
at
the
holds.
bottom
of
the
balance
of
payments
equal
to
+5
billion
the
dollars
of
by
account ,
very
ofcial
every
companies.
transactions
ofcial
if
properly
capital
include
changes
omissions
good
owed
$425
out .
be
that
and
nancial
and
capital
than
current
billion
than
billion
than
foreign
accommodating
balance
the
the
or
If
The
FA.
countries.
logically
the
the
dollars
nancing)
amount
reserves
including
the
this
ofcial
have
However,
billion
central
country?
central
with
bonds,
where
exceed
billion
ofcial
billion.
the
year:
dollars
current
$475
owed
that
recorded
domestic
in
the
in
more
–2
autonomous
the
because
bank s
How
its
happens
become
was
in.
of
What
reserves
It
$475
in
reserves.
country
account
included
are
dollars
nancing)
central
=
ofcial
that
690billion
Errors
This
are
transactions.
payments
is
of
reserves
bonds
surplus.
balance
0
account
transactions
reserve
transactions
of
transactions
overall
This
balance
payments
example
the
a
=
reserve
to
are
buying
ofcial
“accommodating”
autonomous
50)
(2)
dollars.
referred
+
example
country
KA
and
(425
ofcial
different
exchange
CA
Items
+
as
foreign
CA
5
the
Consider
relationship
–
0
or,
If
T I N U
$28,000
the
: 4
year
E H T
(consider
same
L A B O L G
the
Y M O N O C E
$25,000
and
therefore
articially
force
the
balance
of
payments
overall.
179
to
equal
ofcial
errors
be
zero.
and
minus
the
sum
was
not
omissions
5
payments
same
If
reserves
billion
to
CURRENT
zero.
but
all
that
to
The
the
accounts
but
plus
5
including
billion
statisticians
would
articially
force
balancing
item
opposite
sign
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changes
dollars,
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add
If
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errors
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and
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residents
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has
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large,
would
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in
then
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reporting
known
to
or
the
as
sending
in
drugs
their
their
transaction
capital
entry
illicit
underreporting
investments
error.
omissions
point
to
economy
arms
income
wealth
the
ight—see
an
or
trade
from
their
abroad
authorities
section
4.9,
is
or
relatively
to
off shore
without
(part
page
of
what
is
193).
ACCOUNT
(1)
Net
exports
(2)
Net
(3)
Net
(4)
Net
current
(5)
Balance
CAPITAL
entry
dollars
equal
magnitude
of
zero
of
goods
exports
of
services
income
from
investments
transfers
on
current
account:
(1)
+
(2)
+
(3)
+
(4)
ACCOUNT
(6)
Net
capital
(7)
Net
purchases
(8)
Balance
FINANCIAL
transfers
on
of
non-produced,
capital
account:
non-nancial
(6)
+
assets
(7)
ACCOUNT
(9)
Net
portfolio
(10)
Net
FDI
(1
1)
Changes
(12)
Balance
(13)
(Errors
in
investments
ofcial
on
holdings
nancial
and
of
account:
international
(9)
+
(10)
+
reserves
(1
1)
omissions)
Notes
Items
of
(5),
(5),
(8),
(8),
changes
(9)
in
accounting
(9)
and
and
the
(10)
(10)
ofcial
identity
is
include
negative
holdings
below
of
must
autonomous
then
we
foreign
say
transactions.
there
exchange
is
a
by
the
or,
the
the
T
able
above
sum
opposite
does
sign,
to
not
force
equal
the
(1
1)
of
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is
the
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bank,
the
decit .
balance
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of
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adding
item
payments
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(1
1),
will
the
sum
namely
balance
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because
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hold:
CA
If
Item
balance
zero,
then
balance
of
we
must
payments
+
(5)
+
add
to
KA
+
(8)
item
FA
+
=
(12)
(13),
0
=
0
errors
and
omissions
(the
statistical
discrepancy)
with
balance.
4.6.1
HL
Relationship
between
the
current
reects
account
AUD
and
the
exchange
have
established
that
the
equilibrium
exchange
rate
by
the
interaction
of
the
demand
and
value
of
supply
dollars
Australia’s
exports
products.
The
as
Americans
supply
of
AUD
need
reects
imports
to
of
import
Australia
US
goods
as
and
Australians
services
need
and
to
to
buy
buy
USD
of
they
a
of
Australia’s
is
US
determined
value
buy
rate
the
We
the
to
must
rst
sell
and
offer
AUD
in
the
foreign
exchange
currency.
market .
What
will
happen
to
the
exchange
rate
if,
ceteris
paribus,
a
Initially
country ’s
exports
decrease
and/or
its
imports
increase
and
AUD)
current
account
records
a
decit?
To
answer
we
will
and
assume
that
the
demand
for
and
the
supply
currency
reect
only
trade
ows
(that
is,
only
exports
of
Let ’s
focus
on
with
trade
ows
simplied
180
goods
and
services
Australia
set-up,
only
and
and
the
between
shown
in
no
nancial
Australian
the
Figure
USA
4.6.1
,
the
where
rate
the
for
the
demand
Australian
for
AUD
dollar
(D1)
(USD
per
intersects
supply
of
balanced
AUD
as
the
(S1).
value
At
e1
,
of
Australia’s
exports
(X)
is
current
equal
account
to
imports
(M).
Specically,
at
the
exchange
rate
the
e1
,
value
e1a
ows).
dollar
and
exchange
e1
and
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at
of
is
a
is
simplify
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matters
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(AUD)
Australia.
demand
In
for
this
AUD
Australian
dollars
Australian
products
dollars
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(Australia’s
also
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demanded
(Australia’s
supplied
imports).
by
by
Americans
exports)
Australians
and
to
to
e1a
buy
buy
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US
products
Figure
AUD
imports
M)
We
S2
of
4.6.2
assume
maintains
now
that
focus
on
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the
is
Australian
exhibiting
dollar.
phenomenal
AUD
USD
non-inationary
growth
and
that
it
is
believed
that
this
AUD
'ab'=excess
b
of
performance
are
invest
eager
to
in
the
will
continue—therefore,
Australian
economy.
investors
Demand
for
supply
Australian
AUD
stock s
and
bonds
is
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and
so
are
the
: 4
a
e1
outstanding
f
CAD,
as
M'
>
X
direct
e2
investment
ows
into
its
economy.
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for
E H T
and
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AUD
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exports
Price
X)
of
from
AUD
Australia)
USD
Q
of
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per
period
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Figure
4.6.1
Impact
on
the
Now,
if
whatever
AUD
of
a
current
account
decit
f
e2
for
reason,
perhaps
because
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faster
a
b
e1
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from
Australia
the
with
USA ,
the
starts
the
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importing
supply
curve
of
more
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shif ting
to
the
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dollars
right
to
and
services
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S2.
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D2
for
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the
higher
investment
original
exchange
rate
e1
,
there
is
now
in
the
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D1
for
AUD
inows
exchange
market
an
excess
supply
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it
decit
supply
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exports
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to
e2f
nor
that
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(page
not
164)
only
the
to
again
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but
is
also
the
as
its
both
excess
as
equal
demand
market .
need
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more
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will,
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also
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bottom
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ows.
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is
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for
explained
the
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also
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other
the
exchange
ab,
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a
that
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a
in
into
in
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of
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section
a
4.5
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nancial
do
assets)
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economy
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The
owing
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goods
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dollar
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greater
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on
to
nancial
demand
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investors
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and
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that
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establish
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to
in
will
right
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or
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demand
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e2.
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the
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This
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buy
presence
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clause
supply
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also
trade
services)
between
countries.
ows
The
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Impact
demand
Australia
currency.
trade
4.6.2
demand
of
less
achieved
are
a
The
The
until
imports
exchange
to
Figure
account
narrow
been
led
of
the
exceed
market .
and
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now
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foreign
AU)
current
current
will
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the
decit
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reect
reect
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e1
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e1a
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foreign
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decit
the
At
is
dollar.
exports
of
above
clause
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e1b.
competitive
and
Australian
Australia’s
current
and
dollars
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the
will
exports
distance
depreciates,
exports
supply
at
The
in
trade
Australian
supply
the
e2
of
Australia
more
Australian
the
Note
it
goods
of
excess
ab.
AUD
As
value
greater
paribus,
At
Australia’s
of
is
that
become
value
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by
of
e2.
attractive.
the
e1
,
value
reaches
(its
At
imports
in
account
excess
ab.
into
line
Q
segment
T I N U
of
AUD
L A B O L G
of
Y M O N O C E
S1
(Australia's
Price
bottom
line
between
Does
the
nancial
account
have
a
stronger
effect
on
the
countries.
exchange
Relationship
and
the
What
will
between
exchange
the
nancial
account
Comparing
that
rate
of
happen
to
the
exchange
rate
if,
ceteris
into
a
country ’s
nancial
account
a
the
outows
decrease
and
the
nancial
increase
account
Figures
current
in
ofcial
reserve
transactions
by
a
surplus?
In
order
to
simplify
the
a
the
demand
portfolio
and
and
the
supply
direct
of
a
analysis,
currency
investment
ows
and
decit
whether
4.6.2
may
it
it
should
lead
does
or
to
a
not
be
clear
depreciation
of
the
country.
It
depends
could
well
on
be
account
decit ,
the
currency
may
that
be
For
example,
for
the
period
1994–2002
the
bank s)
was
recording
now
a
rising
trade
decit
but
the
dollar
was
assume
How
could
that
be?
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USA
was
attracting
only
more
reect
but
account
current
appreciating.
that
4.6.1
account?
(excluding
central
USA
records
current
and/
appreciating.
changes
the
account
currency,
nancial
despite
or
than
paribus,
the
inows
rate
than
sufcient
cross-border
nancial
capital
inows
to
between
off set
the
downward
pressure
on
the
dollar
from
the
current
countries.
181
account
even
(a
decit .
In
appreciate
negative
positive
item
and
terms
even
5)
if
if
greater
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T
able
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4.6.1),
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the
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in
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and
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The
decit
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2016
same
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1992
value.
in
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2016
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that
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that
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economy
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depends
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in
the
to
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that
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current
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In
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it
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much
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No
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a
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Why?
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131
appreciation)
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it
Mexican
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demanded
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4.6.2
what
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Current
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decit
182
output ,
4.6.2.
2016
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economy.
size
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exports?
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yuan
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Current
account
data
for
Mexico.
Source:
data.worldbank .org
possible
adverse
described
below.
implications
for
various
different
factors
the
that
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decit
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positive
risk
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international
Moody ’s
downgraded.
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and
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evaluate
they
issue.
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of
it
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countries
decided
and
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assign
risk
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grade
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increasing,
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the
bonds
will
receive
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lower
grade,
which
means
as
investor s
will
only
lend
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country
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even
rates.
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tightens
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squeeze
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country
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credit
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out
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rating
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its
country
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capital
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and
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fear
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cost
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will
not
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typically
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to
rise
and
the
economy
a
avoid
a
recession.
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it
defaults
on
its
loans,
then
sales—but
is
required
to
agree
to
painful
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immediate.
policies.
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rates
Demand
In
order
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inows
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capital
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currency,
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management
and
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central
current
be
forced
to
increase
interest
rates.
Higher
interest
domestic
bonds
and
deposits
more
attractive
to
is
to
narrow
investors,
who
will
want
to
buy
them.
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not
depreciate
but
this
choice
is
costly.
By
selling
foreigners
as
bonds
it
is
promising
them
future
interest
will
debt
for
the
issuer.
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demand
explained
to
be
will
may
diverted
also
prove
from
decrease
costly
as
domestic
domestic
government
purposes.
and
will
lowering
aggregate
demand
and
ownership
of
domestic
rates
assets
requires
willing
buyers.
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the
future
prospects
for
the
below
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shares,
points
Willing
buyers
economy
look
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asset
is
assets
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collect
prots,
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price
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sizeable
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of
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years
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fund
reasons.
necessary
time
for
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investors
to
public
or
make
direct
investments.
return
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higher
income
for
lower
inequality
income
will
have
households,
increased.
dampen
growth
risky
an
for
prospects,
economy
to
as
explained
consume
its
for
a
long
means.
of
the
also
imports
need
of
to
of ten
funds
much
•
the
•
mounting
future
be
rates
to
interest
be
increasing
willing
compensate
rates,
sudden
to
for
worsening
the
though,
country ’s
decit
may
lead
to:
severe
interest
depreciation
rates
to
of
attract
the
currency
lenders
must
sale
of
domestic
foreign
assets
debt
and
at
reduced
prices
downgrading
by
credit
agencies
be
•
painful
demand-side
•
diminished
policies
foreign
growth
for
many
years.
diverted
adverse
lend
imply
account
necessary
the
foreign
and
higher
Correcting
create
will
a
•
current
decit
uses
could
goods.
may
•
education.
abroad
that
persistent
account
of
increased
or
from
part
domestic
These
health
means
will
future,
from
A
current
future
only
effects
at
decit:
surging
debt
a
persistent
Methods
and
current
their
account
effectiveness
higher
additional
are
three
types
of
policies
available
to
policymakers
to
risk
with
a
persistent
current
account
decit:
expenditure-
interest
reducing
costs,
who
income.
of
deal
they
households,
of
and
loss
the
nance
borrowing
exports
Foreigners
interest
loss
be
There
and
will
the
bank s,
of
involves
In
away
infrastructure,
any
debt
income
and
current
prospects
Persistent
borrowing.
government
purchase
foreign
for
forced
airports
threat
forces
this
interest .
diverted
of
exchange,
capital
decit
abroad
plus
be
the
on
painful
may
ratings
account
capital
earnings
from
credit
repayment
foreign
Mounting
an
borrow
repayment
consumer
on
and
investments
in
assets
carries
are
Recap
current
income
exchange
away
to
of
the
been
public
state-owned
development
they
of
it
sovereignty.
National
If
or
a
lower
suggest
usually
It
and
time
large
income
polices
the
case
foreigners
natural
clearly,
for
countries
Growth
earlier.
to
lower
estate
of
the
latter
country
since
These
so
This
both
income
imports.
exist
which
prove
but ,
persistent
costs
investments.
expecting
on
prospects
recording
high.
assets
businesses
national
unemployment
Governments
good
Their
decreasing
recession.
crisis.
if
and
spending
especially
rising
Growth
take
Selling
by
investment
for
Foreign
decit
need
interest
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spending,
account
payments
funds
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consumption
current
interest
suffer
payments
the
decrease
population
represent
of
policies.
bonds
be
to
adoption
currency
levels
may
require
macroeconomic
foreign
aggregate
nancial
decits
demand-side
rates
aim
make
account
bank
contractionary
may
: 4
current
to
of
is
E H T
A
risk
there
T I N U
As
rate
L A B O L G
exchange
Y M O N O C E
The
policies,
expenditure-switching
policies
and
supply-
problem.
side
policies.
183
Expenditure-reducing
If
policies
they
are
resources
These
include
policies
that
decrease
the
level
of
implemented
are
then
misallocated.
inefciency
The
country
also
increases
suffers
the
as
costs
of
aggregate
protectionism.
demand.
They
(decreasing
policy
thus
G
include
and/or
(increasing
contractionary
increasing
interest
rates).
T)
but
By
scal
also
policy
tighter
decreasing
monetary
Supply-side
Policies
demand,
they
reduce
the
level
of
national
income
decreasing
spending
on
imports
(M).
to
help
also
include
imports
are
directly
related
to
the
level
of
income.
rise,
then
spending
on
imports
rises;
if
then
spending
on
imports
decreases.
can
Note
that
will
in
aggregate
benet
the
demand
export
will
sector
also
as
decrease
the
will
increase.
exports
will
All
help
in
all,
shrinking
narrow
the
imports
current
account
cost .
though
Growth
which
that
will
means
are
contract
shut
an
surely
that
Recessions
or
such
the
adjustment
and
account
slow
down
economy
painful.
down
Output
and
or
may
and
policy
may
suffer
a
unemployment
aim
of
this
imports
set
of
regulations
at
turn
a
high
negative,
recession.
decrease,
laws
will
To
induce
is
to
switch
domestically
such
a
on
rises.
that
product
correct
a
so
expensive,
achieved
in
to
make
two
switch,
them
ways:
by
spending
produced
or
by
a
xed
competitiveness,
account .
result
from
Persistent
uncompetitive
by
high
monopoly
may
also
be
power.
responsible,
production
labour
unions,
costs.
protection
may
market-based
may
also
goods
supply-side
help
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most
high
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and
services.
policies
that
to
It
focus
competitiveness
decit .
they
Such
may
and
policies
cause
imports
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less
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of
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external
treat
the
imbalance.
explained
supply-side
earlier).
policies
Within
this
have
major
framework,
drawback s
the
most
become
and
value
this
of
drawback
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difcult
to
implement ,
can
any
benets
will
appear
only
af ter
a
very
long
time
the
Although
these
policies
are
instrumental
and
necessary
protection.
exchange
the
may
uncompetitive,
persistent
rate
system,
the
central
bank
the
long
currency
to
devalue
instead
of
trying
term
to
achieve
and
maintain
competitiveness,
may
persistent
permit
current
and
in
In
also
nature
away
goods
lag.
currency
economy ’s
the
businesses
by
markets
considered
and
be
of
worker
priced,
follows
rms
high
signicant
more
in
increase
dominated
and
higher
(as
services.
(see
long-term
policies
policies
towards
ailing
characterized
regulation
Unfortunately,
from
an
decit
decits
markets
fundamental
The
a
perhaps
are
Expenditure-switching
of
decit .
comes
even
incomes
are
of
markets
Note
policies
ination.
competitiveness
as
rising
restore
persistent
Excessive
exports
account
policies
the
product
This
Supply-side
help
a
current
decrease
current
supply-side
incomes
curing
decrease
persistent
If
and
incomes
a
certain
Remember
section3.7).
that
correct
(Y)
decit
therefore
policies
aggregate
to
current
account
decits
must
be
dealt
with
maintain
immediately.
it
articially
rate
currency
the
at
system,
to
price
of
the
xed
value.
central
slide
domestically.
domestic
its
the
and
bank
even
currency
and
keep
makes
Consumers
goods
In
a
may
will
it
managed
permit
value
undervalued.
imports
switch
services.
exchange
the
to
Import
more
of
the
Decreasing
expensive
relatively
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cheaper
expenditures
Recap
and
supply-side
will
Expenditure-reducing
decrease.
Note
that
exports
will
also
become
cheaper
more
competitive
so
that
export
revenues
will
effects
will
tend
to
correct
the
current
account
potential
is
that
risk
ination
of
a
may
rapid
depreciation
accelerate.
or
Import
devaluation
prices
will
(such
monetary
policies)
a
imports.
recession
and
They
domestic
rms
that
use
imported
raw
intermediate
products
will
experience
an
from
their
will
to
production
immediately
demand
costs.
increase
higher
wages,
In
addition,
and
this
further
the
may
cost
of
compel
increasing
higher
imports
Aggregate
supply
may
therefore
inationary
pressures.
In
They
also
increase,
aggregate
demand
will
curve
demand-pull
Alternatively,
and
the
other
will
to
the
right ,
leading
since
increase
leading
policymakers
barriers
market ,
substitute
lead
so
domestic
import
may
184
and
nations.
In
policies
are
policies
domestically
that
switch
produced
that
the
make
exchange
imports
rate
more
and
expensive.
to
retaliation
and
ination.
policies
more
include
competitive
policies
and
to
labour
make
product
markets
more
exports
and
so
that
costs
and
prices
decrease.
They
are
the
potentially
necessary
but
only
effective
in
the
long
term.
to
could
will
less
resort
make
to
imports
attractive.
protection.
more
T
ariff s
expensive
Households
and
in
The
Marshall-Lerner
J-curve
products
for
imports,
condition
and
the
effect
rms
decreasing
or
a
sharp
depreciation
implies
that
the
foreign
the
of
exports
decreases
and
the
domestic
price
of
imports
expenditures.
increases.
Unfortunately,
frictions
They
possibly
to
price
country ’s
income.
growth,
unemployment .
lowering
They
Devaluation
will
slower
ination.
trade
domestic
shif t
national
to
workers
of ten
demand
include
protection
exible
will
so
production
decrease,
addition,
and
lead
towards
increased
markets
cost-push
decrease
scal
living
Supply-side
costs.
that
increase
goods.
in
policies
materials
away
and/or
are
contractionary
rise,
Expenditure-switching
therefore
as
decit .
decrease
A
demand
increase.
and
Both
policies
abroad
aggregate
and
expenditure-switching
policies
such
invite
protectionist
retaliation
addition,
they
go
policies
from
create
affected
against
WTO
trade
imports
exporting
membership
revenues
rules.
With
less
will
Therefore,
a
exports
attractive
increase
trade
more
competitive
domestically
and
decit
import
will
we
abroad
expect
expenditures
improve.
and
that
will
export
decrease.
crucially
demand
(PED)
rests
for
on
the
exports
size
and
of
the
the
PED
price
The
J-curve
Since
imports.
The
reason
relates
to
the
fact
that
the
behaviour
PEDs
and
of
expenditures
following
a
change
in
are
condition
or
Marshall-Lerner
a
sharp
account
for
condition
depreciation
decit ,
exports
short
run
and
immediately
so
the
satised,
Marshall-
any
in
a
trade
decit
will
take
time
to
be
realized.
PEDs.
In
The
the
not
the
must
Marshall-Lerner
of
sum
be
a
of
states
currency
the
PED
(absolutely)
condition:
that
to
for
for
devaluation
improve
imports
greater
than
a
devaluation
a
trade
(or
a
balance
current
and
the
the
PED
one.
a
Figure
4.6.3,
in
path
goods
through
devaluation
J-curve
time
will
is
and
on
the
horizontal
services
time
trace
of
the
the
(X
–
M)
balance
letter
“J”.
axis
is
on
of
and
the
trade
This
is
the
trade
vertical
axis,
following
referred
to
as
the
E H T
on
in
is
price
improvement
depends
low
of
Lerner
revenues
ef fect
of
effect .
sharp
Trade
depreciation)
will
improve
decit
balance
if
The
proof
needs
following
express
may
the
Fitch
dollar
some
help
to
German
depreciation
&
(ped(x)
of
(A&F)
price
the
ped(M))
>
1
(XM)
elementary
calculus,
explain
condition.
trade
euro
shirts
is
+
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will
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the
in
Let
in
make
but
If
dollar s,
euros
even
=
0
the
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though
so
+
we
then
American
PED(M)
that
their
exactly
the
t1
t2
time

same
quantity
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A&F
shirts
is
bought
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Germany.
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
their
and
in
dollar
price
imported
dollar s
trade
the
the
will
same
same,
will
the
import
necessarily
balance
and
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if
quantity
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export
same.
$250m
demanded
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remain
expressed
Germany ’s
revenues
(expressed
in
Figure
dollar s)
Since
by
if
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will
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the
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New
elasticities
balance,
the
euro
lower,
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of
York
price
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a
so
thus
BMW
cars
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one.
satised
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>
It
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PED(X)
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is
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that
dollar
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proportionately
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1
.
the
The
follows
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of
sum
that
German
the
euro,
improve.
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initially
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is
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A
sharp
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average
US
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the
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PED
especially
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186
growing
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General
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Assembly
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aspects:
environmental
year
2030.
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SDGs
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43).
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T I N U
development
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Environmental
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Y M O N O C E
4.9
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T I N U
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issue
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income
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Recap
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