Cambridge International A Level
Economics
1
Table of Contents
The price system and the microeconomy .............................................................................. 3
Government microeconomic intervention ............................................................................45
The macroeconomy ................................................................................................................55
Government macroeconomic intervention ...........................................................................61
International economic issues ...............................................................................................74
2
The price system and the microeconomy
Economic efficiency occurs where scarce resources are used in the most efficient way to produce
maximum output.
→ Productive efficiency is producing products with the optimal combination of inputs to
produce maximum output at the lowest cost. To be productively efficient, an economy must
be producing on their production possibility curve e.g. point Y is productively efficient
while point X is productively inefficient. However, a firm is said to be productively efficient
when it is producing at the lowest point on its average total cost curve e.g. point C is
productively efficient
→ Allocative efficiency occurs when firms produces and distributes the optimal level of
goods and services taking into account consumer preferences. It is a situation where
resources are distributed in a way that consumer and producer surplus is maximized
Allocative efficiency occurs where MC = MB or Price equals marginal (P = MC).
→ Dynamic efficiency is concerned with the productive efficiency of a firm over a period of
time. Resources are reallocated in such a way that output increases relative to the increase
in resources. A firm which is dynamically efficient will be reducing its costs by implementing
new production processes e.g. investment in new machines may enable an increase in
labor productivity. As a result, the average cost curve shifts downwards from AC1 to AC2
and per unit cost of production falls from C1 to C2.
3
Pareto optimality occurs when it is impossible to make someone better off without making
someone else worse off
It is an optimal situation, with resources allocated in the most efficient way. On a PPC, any point
on the PPC is Pareto efficient e.g. Y
Utility is the satisfaction (benefit) received from the consumption of a good or service by
consumers. Economists use two approaches to explain utility.
→ Cardinal approach according to classical economists, utility is a quantitative concept that
can be measured in terms of a number called Utils.
→ Ordinal approach states that utility cannot be measured, but it can be compared.
Cardinal approach to see how a consumer maximizes utility using the cardinal approach the
following terms must be understood
→ Total utility is the overall satisfaction that is derived from the consumption of all units of a
good over a given time period
→ Marginal utility is the additional utility derived from the consumption of one more unit of
a particular good
Mu = change in TU / change in quantity
→ Average utility is the total utility expressed with respect to the number of units consumed
Au = TU / quantity
4
Utility maximization using cardinal approach
Assume that a consumer is thirsty and is offered free cups of Pepsi. The table below shows the
total, marginal and average utility gained from the consumption of 6 cups of pepsi.
Cups of
pepsi
0
1
2
3
4
5
6
→
→
→
→
→
→
Total utility
(TU)
0
8
14
18
20
20
18
Marginal utility
(MU)
8
6
4
2
0
-2
Average utility
(AU)
8
7
6
5
4
3
As MU falls, TU increases (positive marginal utility)
TU is maximized when MU equals 0 (zero marginal utility)
When MU is negative then TU begins to decline (negative marginal utility)
Marginal utility falls as more cups of pepsi are consumed
This is due to the law of diminishing marginal utility
A rational consumer will consume up till the point where MU = 0
5
The law of diminishing marginal utility states that as individuals consume more units of a good,
the utility gained from the additional units of consumption declines
Utility maximization when price is involved
→ Economist believe that the price a person is willing to pay reflects the utility they gain
from the consumption of a good
→ Assume the price of pepsi is $4. a rational consumer should buy the 1st cup as it gives
them $8 of utility while they are paying $4
→ The consumer should buy the 2nd cup as it gives a utility of $6 while they are paying $4
→ The consumer should buy the 3rd cup as it gives a utility of $4 while they are paying $4
→ The consumer should not buy the 4th cup as it gives a utility of $2 while they are paying
$4
→ Therefore, if price is involved, a consumer will maximize utility at a point where P = MU
Marginal utility and the demand curve
→ Assume the price of is $4 at which the quantity of cups consumed is 3
→ If price rises to $6, the consumer will buy fewer cups i.e. 2 (as MU = P)
→ But If price falls to $2, the consumer will buy more cups i.e. 4
→ This reflects the law of demand
→ This means the mu curve is the demand curve
→ The (horizontal) sum of all individuals’ demand curves (MU curves) gives us the market
demand
6
Marginal utility of money is the utility that a consumer expects to gain from a good which they
can buy e.g. if $1 can buy 50g of sugar and 80g of rice and if the total utility from these goods
is 4 utils, marginal utility of money = 4 utils.
Utility maximization when two or more goods are involved
→ To understand how consumers make choices among different combinations of goods within
a budget, the Equimarginal principle can be used
→ Equimarginal principle a consumers is said to maximize their utility when the last dollar
spent on every good provided the same marginal utility as the last dollar spent on every
other good
MUA/PA = MUB/PB = MUC/PC…
Where MU is marginal utility
P is price
A, B, C are different products
Assumptions
→ Consumers are rational
→ Utility can be described in monetary units
→ Prices and incomes are constant
Explanation
→ Suppose the two goods are good A and good B
→ The rational consumer will purchase such quantities of good A and good B which satisfy
the Equimarginal principle
→ Assume the consumer purchase both goods where MUA/PA > MUB/PB, then the last dollar
spent on good A gives more satisfaction than the last dollar spent on good B
→ The consumer will increase the consumption of good A and reduce the consumption of
good B
→ As consumption of good A rises, the MUA will fall due to diminishing marginal utility
→ Similarly, as consumption of good B falls, the MUB will rise
→ The consumer equilibrium is formed at those quantities of good A and good B where the
equi-marginal principle is satisfied
Quantity of
pizza
1
2
3
4
5
TU of
pizza
12
22
30
36
40
MU of
pizza
12
10
8
6
4
MU /
P
12
10
8
6
4
Quantity of
cake
1
2
3
4
5
TU of
cake
10
18
24
28
30
MU of
cake
10
8
6
4
2
MU /
P
10
8
6
4
2
→ A consumer has a budget of $5 and can spend it on buying slices of pizza or cake
→ Assume the price of pizza is $1 per slice and cake also costs $1 per slice
→ According to the equi-marginal principle, to maximize utility, a rational consumer will
consume the good that offers the greatest MU/P
→ When selecting among the 1st slice of pizza and 1st slice of cake, the consumer will buy the
1st pizza as its MU/P is 12. For this, the consumer will pay $1
7
→ The consumer is now left with $4 of budget to spend
→ Then the consumer will buy the 2nd pizza and 1st cake as the MU/P is the same for both
goods and the consumer can afford both. This will cost $2 in total
→ The consumer will now be left with a budget of $2
→ Then the consumer will buy the 3rd slice of pizza and 2nd slice of cake as both have the
same MU/P and are within the consumer’s budget. This will cost another $2
→ The consumer has used the entire budget
→ The consumer has maximized utility by consuming 3 slices of pizza and 2 slices of cake
which provide a total utility of 24 utils (2 slices of pizza provide TU of 30 utils and 2 slices
of cake provide TU of 18 utils)
Derivation of the demand curve
Continuing with the above pizza example, we can derive a demand curve for pizza. Let’s assume
the price of pizza has increased to $2 per slice. The MU/P can be calculated at the new price,
Quantity of
pizza
1
2
3
4
5
→
→
→
→
MU of
pizza
12
10
8
6
4
MU /
P
6
4
5
3
2
Quantity of
cake
1
2
3
4
5
MU of
cake
10
8
6
4
2
MU /
P
10
8
6
4
2
The consumer will buy the 1st cake costing $1
Then the consumer will buy the 2nd cake, costing $1
The consumer will buy the 3rd cake and 1st pizza, costing $3
The consumer’s budget is exhausted
Now assume the price of pizza has fallen to $0.75
Quantity of
pizza
1
2
3
4
5
→
→
→
→
→
→
MU of
pizza
12
10
8
6
4
MU /
P
16
13.3
10.6
8
5.3
Quantity of
cake
1
2
3
4
5
MU of
cake
10
8
6
4
2
MU /
P
10
8
6
4
2
The consumer will buy the 1st pizza, costing $0.75
Then the consumer will buy the 2nd pizza, costing $0.75
The consumer will buy the 3rd pizza, costing $0.75
The consumer buys the 1st cake, costing $1
The consumer now buys the 4th pizza and the 2nd cake, costing 1.75
The consumer’s budget is exhausted
8
Demand schedule
Based on the above data we can construct a demand schedule for pizza as follows. A demand
curve is also plotted based on the demand schedule.
Price of
pizza
0.75
1
2
Quantity demanded of
pizza
4
3
1
A budget line shows different combinations of two products obtainable with given income and
prices.
Example: If an apple costs £1 and a banana £2, and an individual has an income of £40, then
the budget line shows all the combinations of the apples and bananas which can be bought with
the given income e.g.
→ 20 apples at £1 and 10 bananas at £2
→ 10 apples at £1 and 15 bananas at £2
→ A change in the price of one good, with income remaining unchanged, leads to a pivot of
the budget line e.g. if the price of bananas falls to £1, then more of bananas purchased
at all levels of income
→ In this case the budget line pivots outwards
→ However, in case the price of a good rises, the budget line will pivot inwards
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A change in income of an individual, with price of both products remaining same, leads to a shift
of the budget line e.g. if the income of an individual increases from £40 to £60, then more of
bananas and Apples can be purchased, the budget line will shift outwards. The budget space will
also increase If income falls, the budget line will shift inwards and the budget space will reduce.
We will now understand how consumers maximize utility by using the ordinal approach which
states that utility cannot be measured, but it can be compared. For this we must understand
consumer preferences and constraints using diagrams.
An indifference curve shows the different combinations of two goods that give a consumer equal
satisfaction. An indifference curves show consumer preferences.
→ Assume a consumer buys a bundle X1 and Y1, providing a certain level of utility (point A).
→ If the consumer reduces quantity of X, then the total utility will decline and this this can be
compensated by consuming more units of good Y till total utility is maximized at point B.
→ If the consumer consumes more of X, the total utility will increase. This can be compensated
by consuming fewer units of good Y till total utility is maximized again at point C.
→ Therefore, points A, B and C represent the same total utility irrespective of the bundle of
goods consumed by an individual.
→ Joining points A, B and C gives us the indifference curve IC1.
10
Assumptions of indifference curve
→ The consumer are assumed to be rational
→ Consumers have preferences and cannot be unsure about their choice (completeness)
→ If a consumer prefers good Apples to Oranges and Oranges to Bananas, then by logic,
they prefer good Apples to Bananas (transitivity)
→ Consumers always prefer more (non-satiation)
Properties of indifference curve
Indifference curves have four properties:
→ Higher indifference curves represents higher level of satisfaction e.g. IC2 offers more total
utility than IC1
→ Indifference curves are downward slopping
→ Indifference curves do not intersect each other (as it defies transitivity)
→ Indifference curves are convex to the origin (due to law of diminishing marginal utility)
Slope of the indifference curve
The slope of a curve is different at each point. To find the slope at any point, a line is drawn
tangent to the point
The slope of this (dotted) line can be calculated similar to that of a linear line and is called the
marginal rate of substitution.
Marginal rate of substitution is the rate at which a consumer is willing to substitute one good for
another
MRS = – (change in Y / change in X)
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Utility maximization using indifference curves
By drawing a budget line (budget constraint) BL1 and indifference curve (consumer preferences)
on the same graph, we can determine the point where total utility is maximized. A consumer will
maximize utility at a point where the budget line is tangent to the indifference curve. Consumer
equilibrium refers to the optimal bundle of two goods a consumer can buy given their budget. This
means the consumer will maximize utility by buying A1 Apples and B1 Bananas Equilibrium means
there is no tendency to change.
Rise in income (normal goods)
Assume a consumer is at equilibrium at E1 and both X and Y are normal goods. As income rises,
the budget line shifts outwards. Assuming there is no change prices of either good, the consumer
moves to the higher indifference curve I2
With the rise in income, the consumer will buy more of both goods as the normal goods If income
falls, the opposite situation may occur.
Rise in income (normal and inferior good)
Assume a consumer’s income rises and the budget line shifts outwards. Assume X is a normal good
while Y is an inferior goods. If there is no change in prices of either good, the consumer will move
to a higher indifference curve I2.
With the increase in income, the consumer will buy more of good X and fewer quantity of good Y.
If income falls, the opposite situation may occur.
12
Income and substitution effects of a price change
As the price of a good decreases, consumers demand fewer quantity, ceteris paribus and vice
versa. There are two main reasons for this i.e. the income effect and the substitution effect.
→ The substitution effect is determined by the gradient of the new budget line
→ The income effect causes a shift to a higher indifference curve
→ A rational consumer will buy A1 and B1 quantity of both goods at E1. Assume the price of
good B (normal good) falls
→ The budget line pivots outwards and the consumer will move to a higher indifference curve
IC2. The new equilibrium will occur at E2 where IC2 is tangent to the new budget line. The
quantity purchased will be A2 and B2
→ The total change can be represented by the distance to E2.
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Indifference analysis (normal good)
A normal good is a good whose demand increases as people’s income increases. In this case, the
substitution effect can be found by holding the consumer constant at IC1, but using the new
budget line. A line is drawn parallel to the new budget line but tangent to IC1. The movement
along IC1 from E1 to E3 represents the quantity of good A substituted by good B i.e. the
substitution effect.
The consumer will experience an increase in real income as price of good B falls. As good B is a
normal good, the consumer will buy more of it. Therefore, the remaining distance from E3 to E2
represents the income effect. With normal goods, both the substitution and income effect are
positive and the overall impact is positive.
14
Indifference analysis (inferior good)
An inferior good is a good whose demand falls as people’s income increases. Assume a consumer
is at equilibrium at A1 and B1. Let’s suppose the price of good b (inferior good) falls, the budget
line will pivot outwards. The consumer will move to a higher indifference curve IC2. Equilibrium will
occur E2 where IC2 is tangent to the new budget line
The quantity purchased will be A2 and B2. The total change can be seen from E1 to E2.
The substitution effect can be found by holding the consumer constant at IC1, but using the new
budget line. A line is drawn parallel to the new budget line but tangent to IC1 the movement
along IC1 from E1 to E1 represents the quantity of good A substituted by good B. The substitution
effect is positive.
15
The consumer will experience an increase in real income as price of good B falls. As good B is an
inferior good, the consumer will buy more of good A. Therefore, the income effect is negative
from E3 to E2. With inferior goods, the substitution effect is positive but the income effect is
negative and the overall impact is positive.
16
Indifference analysis (giffen good)
A giffen good is a product that people consume more of as the price rises and vice versa. Assume
that a consumer can purchase the following bundle of lentils and rice at given prices. Assume the
price of rice rises to $6. The consumer must alter their consumption bundle to remain within the
budget. The consumer now buys more rice even though its price is higher than before.
Assume consumer equilibrium is at E1 where X1 and Y1 quantities are bought. The price of good
B (giffen good) falls and budget line pivots outwards. The consumer will move to a higher
indifference curve. The equilibrium shifts to E2 where X2 and Y2 quantities are purchased. The
total change is the distance between E1 and E2.
The substitution effect can be found by holding the consumer constant at IC1. Using the new
budget line. A parallel line is drawn tangent to IC1. The movement along IC1 from E1 to E3
represents the quantity of good X substituted by Y. The substitution effect is positive. As there is
an increase in real income as price of Y falls and the consumer will buy more of good X. The
income effect is negative from E3 to E2. With giffen goods, the substitution effect is positive but
the income effect is negative and large enough to overcome the substitution effect so the overall
impact is negative.
17
Deriving the demand curve
An indifference analysis can also be used to derive a demand curve for an individual consumer.
Assume that a consumer is at equilibrium at E1 buying Y1 units of good Y. Suppose the price of
good Y is P1. The demand curve of good Y can be plotted. The quantity demanded of good Y is
Y1 at a price of P1. As price of good Y falls to P2, the budget line pivots outwards and the
consumer moves to the higher indifference curve with equilibrium at E2 buying Y2 units the
quantity demanded of good Y is Y2 at a price of P2. Joining the points gives us the demand
curve for good Y.
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Costs and benefits
→ Marginal private benefit (MPB) is the benefit to individuals from the consumption of an
extra unit of a good.
→ Marginal private cost (MPC) is the expense borne by firms due to production of an extra
unit of good.
→ Marginal social benefit (MSB) is the benefit to society from the consumption of an
additional unit of a good.
→ Marginal social cost (MSC) is the expense to society from the production of additional
units of a good.
Market failure occurs when there is inefficient allocation of resources in market i.e. a divergence
between private costs/benefits and social costs/benefits.
→ Goods can be over-produced or under-produced
→ Goods may be over-consumed or under-consumed
A cost-benefit analysis is a method for assessing the desirability of a project considering the costs
and benefits involved.
→ If there are no externalities MPB (demand) = MSB and MPC (supply) = MSC
→ If externalities do exist in a market then either MSB = MPB + MEB (or) MSC = MPC +
MEC
A shadow price is a price that is applied where there is no recognized market price available
Cost–benefit analysis a technique that is used to aid decision making, particularly in situations
where a conventional financial appraisal would not be entirely appropriate. In all types of
economy there are numerous examples of environmental pollution that result in external costs
being imposed on the local community. CBA is also widely used in the appraisal of major
transport projects such as London’s Cross-rail extension, High Speed 2. The cost–benefit approach
differs from private sector methods of appraisal in two main respects:
→ It seeks to include all of the costs and benefits, not just private ones.
→ It often has to impute a shadow price on costs and benefits where no market price is
available e.g. in the case of transport projects there is a need to value travel time savings.
Externalities are external costs or benefits of an economic transaction, causing the market to fail
to achieve the socially optimal level of production or consumption.
Negative externality of production is the negative spillover impact of an economic transaction on
a third party owing to the production of a good e.g. air pollution caused by factories, water
pollution.
Market failure can be visualized using a marginal analysis. The market equilibrium exists at the
intersection of MPC and MSB, whereby price is P1 and quantity traded is Q1. The MSC exceeds
the MPC, meaning the social cost exceeds the private costs. At market equilibrium, MSC > MSB
i.e. the cost borne by society exceeds the social benefit
The good is over-produced (market failure) and the shaded area shows the deadweight loss.
19
Negative externality of consumption is the negative spillover impact of an economic transaction
on a third party due to the consumption of a good e.g. smoking, gambling, obesity due junk food,
littering in public places.
o Demerit goods are products that create negative spillover effects on society when
produced or consumed and are deemed socially less desirable e.g. alcohol,
gambling, plastic bags, junk food, tobacco products
o Deadweight loss is the welfare loss when due to market failure desirable
consumption and production does not take place
Market failure can be visualized using a demand/supply diagram with a marginal analysis. The
market equilibrium exists at the intersection of MSC and MPB, whereby price is P2 and quantity is
Q2. The MSB is less than the MPB, meaning the social benefits are less than private benefits. At
market equilibrium, MSC > MSB i.e. the cost borne by society exceeds the social benefit. The
good is over consumed causing market failure and the shaded area shows the deadweight loss.
Positive production externality
Market failure can be understood through a marginal analysis. The market equilibrium exists at
the intersection of MPC and MSB, whereby price is P3 and quantity traded is Q3. The MPC
exceeds the MSC, meaning the private cost exceeds the social costs. At market equilibrium, MSB
> MSC i.e. the benefit to society exceeds the social cost. The good is under-produced while the
shaded area represents the potential welfare gain to society.
20
Positive externality of consumption
Market failure can be understood through a marginal analysis. The market equilibrium exists at
the intersection of MSC and MPB, whereby price is P4 and quantity is Q4. The MSB exceeds the
MPB, meaning the social benefits exceed the private benefits. At market equilibrium, MSB > MSC
i.e. the benefit to society exceeds the social cost
The good is under-consumed and the potential welfare gain is shown by the shaded area.
Asymmetric information refers to when one part in a transaction has lesser information than the
other and this can lead to opportunistic behavior causing market failure.
→ Adverse selection is a form of opportunistic behavior that refers to the undesired
decisions that occur when buyers and sellers have access to asymmetric information. This
distorts the process by which the price and of quantity of goods and services are
determined e.g. second hand car markets.
→ Moral hazard is a situation where a party protected from the risk behaves differently
than if they were fully exposed to the risk. This potentially imposes costs on the part that
has inferior information e.g. driving insured company cars.
21
Information withheld by producers
If producers withhold information, consumers may buy greater quantities. A marginal analysis can
help visualize the market failure. The equilibrium exists at the intersection of MSC and MPB,
whereby price is P1 and market quantity is Q1. At the equilibrium, MSC > MSB, the cost borne by
society exceeds the benefit. The good is over-consumed causing market failure.
Information withheld by buyers
If consumers withhold information, firms may sell greater quantities e.g. insurance policies. A
marginal analysis can help visualize the market failure. The equilibrium exists at the intersection of
MPC and MSB, whereby price is P2 and market quantity is Q2. At market equilibrium, MSC >
MSB, the cost borne by society exceeds the social benefit and the good is over-produced leading
to market failure.
Government responses to externalities
→ Indirect taxes may be imposed by the government to tackle negative externalities e.g.
carbon taxes
→ Regulations are a wide range of legal requirements that are imposed by governments.
→ Awareness though educating the public about costs of consuming demerit goods and the
benefits of consuming merits goods.
→ Subsidies may be given by the government to local firms to lower their production costs to
help increase supply.
22
→ Provision of information directly by governments helps reduce information asymmetry e.g.
public broadcasting.
→ Pollution permits may be given by governments allowing firms to pollute up to a certain
level.
→ Government responses to asymmetric information may include legislation e.g. cigarette
manufacturers are required to have health warnings on packets and provision of
information e.g. public broadcasts about the hazards of drink driving
→ Private responses to asymmetric information may include firms offering warranties or
refunds.
Pollution permits
→ The supply of permits is perfectly inelastic as it is controlled by the government.
→ An increase in demand from Do to D1 leads to an increase in price from Po to P1 while
the quantity of permits remains unchanged at Qo
→ As the government reduces supply overtime from So to S1, permit prices rise to P2 and the
quantity traded falls to Q1.
→ Firms may be forced to consider using greener production techniques, thereby cutting
greenhouse gas emissions.
Using taxes to tackle negative production externality
Because of the external costs, MPC is below MSC. The market equilibrium, however, is at Po and
Qo where MSB = MPC. Market failure can be corrected by imposing an indirect tax on firms
causing the negative externality. The tax is added to the cost of producing the product; the
supply curve shifts leftwards, if the tax is the same as the external cost, then the quantity traded
will fall to Qt while price will rise to Pt. Allocative efficiency will now be achieved.
23
Using taxes to tackle negative consumption externality
Due to the external costs, MSB is below MPB. The market equilibrium is at P1 and Q1. Market
failure can be corrected by imposing an indirect tax on those who have caused the negative
consumption externality. The supply curve shifts to the left; if the tax is the same as the external
cost, then the quantity traded will fall to Qo while the price will rise to Po. Allocative efficiency
will be achieved.
Subsidies to address positive production externality
The MSC is below MPC. The market equilibrium is at P1 and Q1; the market under allocates
resources at this point.
The government may provide subsidies to firms equal to the external benefit. The subsidy will
lower the production cost and increase market supply. As a result, there will be an increase in the
quantity produced to Q2 and a lower price at P2. Allocative efficiency is now being achieved.
Subsidies to address positive consumption externality
The equilibrium is where MPC = MPB at which price is Po and quantity is Qo. The marginal
external benefit is added to the MPB curve to give the MSB. If the government subsidizes
production of this product, then the supply curve shifts rightwards to MPC+sub. The marginal cost
of supplying the good is reduced by the amount of subsidy. Resultantly, there is increase in the
quantity produced to Q1 and a lower price at P1. Market failure is eliminated.
24
Types of cost, revenue and profit, short-run and long-run production
A firm seeks to combines factors of production in an effective way to be efficient and profitable.
A firm must find the least cost or most efficient combination of labor and capital for the
production of a given quantity of output.
→ The short run is a time period in which at least one of the firm’s factors of production is
fixed such as capital and other factors of production are variable e.g. labor.
→ The long run is a period of time in which all the firm’s factors of production are variable.
The short-run production function
To determine how a firm’s costs change as it varies its level of production in the short run, let’s
examine the effect that a change in the quantity of labor has on its output given that land and
capital resources remain fixed. The table shows the quantity of doughnuts produced based on the
number of labor employed.
25
Up till the 3rd labor, the marginal product increases which represents increasing marginal returns.
The factors of production are being efficiently used. Beyond this, additional labor increase total
product, but at a decreasing rate i.e. marginal product of labor declines. The begins to
experience diminishing marginal returns Beyond 6th labor, additional labor adds nothing to TP
The 8th labor causes the TP of doughnuts to fall.
The law of diminishing returns states that as additional units of a variable resource are added
to fixed resources, beyond a certain point the marginal product will decline.
The relationship between marginal and total product
→ As long as the MP is positive, additional workers are adding to TP and output continues to
increase
→ Beyond the seventh worker, MP becomes negative as additional workers lead to a fall in
TP
The relationship between marginal and average product
→ The AP curve shows us the output per worker at each level of employment
→ Whenever MP is greater than AP, AP increases.
→ If MP is less than AP, AP falls
26
The firm’s costs of production
→ Fixed costs are expenses that do not change with the level of output e.g. rent, salaries.
→ Variable costs are expenses that are directly linked to the level of output and rise
continually e.g. wages, raw material cost
TC = TFC + TVC
→ Average total cost is the per unit cost of production
ATC = TC / Q
→ Average fixed costs refers to fixed cost per unit of output
AFC = TFC / Q
→ Average Variable costs refers to the direct production cost incurred for each unit of
output
AVC = TVC / Q
→ Marginal cost is the additional cost of producing an extra unit of output
MC = Change in TC / change in Q
Assume the wage rate is $5, so as the firm hires more labor its total variable cost increases. Fixed
costs remain at $100 since the quantity of land and capital does not change in the short run.
Total costs: fixed and variable
→ When output is 0, the firm’s TC equals its TFC.
→ As the firm begins production, it must hire labor. This causes TVC to increase.
→ The rate at which TVC increases varies with the changing productivity of labor.
→ TFC remains at $100 in the short run as the firm is not increasing its land and capital
inputs.
→ TC increases at the same rate as TVC and is a parallel line $100 above TVC.
→ At each level of output, the firm’s TC equals the sum of its TFC and its TVC.
27
Average and marginal costs
→ AFC decreases as output increases as TFC is constant
→ MC decreases and then increases as output increases
→ ATC lies above AVC as a firm’s TC is equal to the sum of variable and fixed costs.
→ At any level of output, the distance between the ATC curve and the AVC curve equals the
firm’s AFC
→ MC intersects ATC and AVC at their lowest points
→ If the last unit produced costs the firm less than the average per-unit cost, then average
cost falls. If the last unit produced costs more than the average cost, then the average rises
From short-run to long-run
All factors of production are variable in the long run, giving the firm greater scope to vary the
mix of its inputs so to achieve efficiency. The law of diminishing returns no longer applies as
quantity of resources is no longer fixed
Firms should aim to be in a position where:
MP(factor a) / price(a) = MP(factor b) / price(a)...
Costs in the long run
→ As output increases so too does the scale of the firm’s operations
→ The shape of the LRAC is derived from a series of short run situations
→ The LRAC curve is a curve that is tangential to each of these short-run cost curves
→ It is the lowest possible average cost for each level of output where the all factors of
production are variable
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→ Increasing returns to scale means that an increase in inputs leads to a larger proportional
increase in output
→ Constant returns to scale occur when an increase in inputs leads to a proportionally
identical increase in output
→ Decreasing returns to scale means that an increase in the quantity of inputs leads to a
proportionally smaller increase in the quantity of output
Economies of scale are benefits gained from falling long run average costs as the scale of
output increases.
Technical/technological economies.
→ Financial economies
→ Purchasing economies
→ Risk bearing economies
→ Marketing economies
→ Managerial economies
Diseconomies of scale are where long-run average costs increase as the scale of output
increases.
Communication inefficiencies.
→ Increased regulation
→ Managerial costs
External economies of scale are cost savings received by all firms as an industry’s scale
increases.
Minimum efficient scale is the lowest level of output at which costs are minimized.
→ A firm that is producing at its optimum output in the short run and the lowest unit cost in the
long run has maximized its efficiency
→ In industries where the minimum efficient scale is low there will be a large number of firms.
Where it is high, competition will tend to be between a few large players
The firm’s revenue
→ Total Revenue is the total amount of money received by a firm from selling its output
TR = price x quantity
→ Average revenue is the average price received from the sale of a good or service
AR = TR / Q
→ Marginal revenue is the additional revenue received from the sales of an extra unit of
output
MR = Change in (TR) / change in (Q)
Profit is the positive difference between a firm’s total revenue and total costs
TP = TR – TC
→ Normal profit is when a firm earns just enough revenue to cover its total production costs
including implicit costs (TR = TC)
→ Abnormal (supernormal) profit is the profit that a firm earns above its normal profit (TR >
TC)
→ Loss (subnormal profit) occurs when a firm’s production cost exceed its revenue (TR < TC)
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Firms and industries
A firm is a business organization that acquires factors of production in order to produce goods
and services that can be sold at a profit
→ Sole traders or one-person businesses
→ Partnerships
→ Cooperatives
→ Private or public limited companies
→ State-owned firms
Multinational corporations are firms that operate in different countries.
An industry includes firms making the same product or in the same line of business.
Market structures
A market structure is the way in which a market is organized in terms of the number of firms and
the barriers to the entry of new firms.
→ Perfect competition
→ Monopoly
→ Oligopoly
→ Monopolistic competition
Barriers to entry refers to any restrictions that prevent new firms from entering an industry.
Perfect competition is an ideal market structure that has many buyers and sellers, identical
products, no barriers to entry
→ Many firms
→ No barriers to entry
→ Homogeneous product
→ Price takers
→ Perfect information
Demand curve - perfectly competitive firm
No perfectly competitive firm is large enough to influence either the market price or output.
Therefore, the demand curve is perfect elastic for an individual firm, P=AR=MR. Choosing the
output is the only decision the firm has to make and this is done by considering the costs of
production.
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Profit maximization occurs when the marginal cost of production equals the marginal revenue
from selling that unit of output (MR = MC).
→ If MR > MC – additional revenue exceeds additional cost, so the firm should increase
output
→ If MR < MC – additional cost exceeds additional revenue, so the firm should reduce
output
→ If MR = MC – additional cost equals additional revenue, there is no change in profit, so
the firm should produce at this output
Short run loss
→ The demand (AR) curve is perfectly elastic owing to high level of competition
→ The supply curve (MC) slopes downwards and then slopes upward in the short run
→ A profit maximizing firm will produce at a level of output where MC = MR i.e. Q1
→ The total revenue at this output is P1 Q1
→ The ATC curve exists above the AR curve
→ At Q1, the total cost is Pc Q1, meaning that total cost exceeds total revenue the firm is
incurring loss
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Long run Loss to normal profit
→ In the long run all factors of production are variable
→ Some loss incurring firms may leave the market as there are no barriers to exit
→ Market supply decreases (supply curve shifts leftwards to S2)
→ Market price increases to P2
→ Remaining firms now sell at the new higher price as they are price takers (AR curve shifts
upwards AR2)
→ The new profit maximization output is Q2 and total revenue equals total cost i.e. P2Q2
→ Losses are eliminated and normal profit is achieved in the long run
Short run abnormal profit
→ The AR curve is perfectly elastic owing to the large number for firms
→ The MC curve slopes downwards and then slopes upward due to diminishing returns
→ A profit maximizing firm will produce at a output where MC = MR i.e. Q2
→ The total revenue at this output is P2Q2
→ The ATC curve exists below the AR curve meaning the total cost is PcQ2
→ Total revenue exceeds total cost i.e. the firm is earning abnormal profit
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Long run abnormal profit to normal profit
→ In the long run all factors of production are variable
→ New firms enter the market owing to no barriers to entry
→ Market supply increases (supply curve shifts rightwards)
→ Market price falls
→ Remaining firms now sell at the new lower price (AR curve shifts downwards)
→ Profits are eliminated and normal profit is achieved in the long run
Allocative and productive efficiency allocative efficiency is achieved when P = MC. Productive
(technical) efficiency occurs when production takes place at lowest possible cost where P = min
ATC. In the long-run, perfectly competitive firms achieve both allocative and productive efficiency.
At the profit-maximizing level of output Q1, P = MC, and ATC is minimum.
Monopoly is a market structure where there is a single dominant supplier of a particular good or
service, thus having the power to influence market supply and price e.g. UK railways.
→ Single dominant firm
→ High barriers to entry (branding, economies of scale domination of resources, legal
barriers, anti-competitive practices)
→ No close substitutes (unique product)
→ Price maker
→ Asymmetric information
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Demand curve - monopoly
Compared with other market structures, demand under monopoly will be relatively inelastic at
each price.
The demand curve for a monopoly is downward slopping as the monopolist must drop prices to
increase quantity demanded. The data for a monopolist is given below:
→ As the monopolist drops prices, the quantity demanded increases, but additional units are
sold a t lower price, therefore, the MR decreases
Monopoly (short run) loss
A monopoly can earn abnormal profit or incur loss in the short run depending on the product
demand.
→ The AR curve is downward slopping.
→ The MC slopes downwards and then slopes upward.
→ The monopolist will produce at a level of output where MC = MR i.e. Q1
→ The total revenue PoQ1
→ The ATC curve exists above the AR curve, meaning total cost exceeds total revenue, the
firm is incurring loss
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Monopoly (short run) economic profit
A monopoly can earn abnormal profit or incur loss in the short run depending on the product
demand.
→ The AR curve is downward slopping while the MC slopes downwards and then slopes
upward.
→ The monopolist will produce at a level of output where MC = MR i.e. Q1, and the total
revenue PoQ1
→ The ATC curve is below the AR curve representing that the firm earning abnormal profit.
Abnormal profit (long run)
As the monopolist is the single dominant firms, it will not face much competition In the long run.
High Barriers to entry make it difficult for new firms to enter the market. Losses (if any) will be
eliminated and the monopolist will earn abnormal profit in the long run. If the monopolist is
earning abnormal profit in the short run, it will continue to do so in the long run as well.
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Barriers to entry
→ Economies of scale such as bulk buying allows firm to lower average costs.
→ Marketing allows firms to sell more which reduces per unit cost of output.
→ Managerial economies are achieved when firms are able hire skilled or more experienced
managers.
→ Advancement in technology may make the production process more efficient.
→ Banks may offer lower interest rates to larger firms, leading financial economies of scale.
→ Legal barriers such as patents and copyrights may make it expensive for new firms to
compete.
→ Ownership of essential resources buy large firms allows them to produce at lower unit
cost.
→ Monopolies may adopt aggressive tactics such as buying out smaller firms or using
predatory pricing.
Allocative and productive efficiency a monopoly produces less output and chargers’ higher
price, allocating economic resources less efficiently. A monopolist does not operate at the lowest
point of its AC curve, but at a higher point. Therefore, a monopolist is productively inefficient.
Moreover, the monopolist produces where MC = MR, but price does not equal MR. At equilibrium
output Q1, price exceeds MC, showing allocatively inefficient.
Price discrimination occurs when different prices are charged to different consumers for the same
good by the producer.
→ First degree (by customer) involves charging consumers the maximum price they are
willing to pay e.g., car salesmen have discretion of over the price of any single car.
→ Second degree (by quantity) occurs when a firm charges a different price for different
quantities consumed, such as quantity discounts on bulk purchases.
→ Third degree (by consumer groups) occurs when a firm charges a different price to
different consumer groups e.g., a theater may divide moviegoers into seniors, adults and
children, each paying a different price when seeing the same movie.
A natural monopoly is a firm that has economies of scale so large that it is possible for the single
firm alone to supply the entire market at a lower average cost than two or more firms. For a
natural monopoly the long-run average cost curve (LRAC) falls continuously over a large range of
output. There are two factors at work making for a natural monopoly: costs and market demand.
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In fig. at the point where market demand, D, intersects the LRATC curve, LRATC is still declining,
meaning that economies of scale have not yet been fully exhausted and the minimum efficient
scale occurs at a higher level of output. As output increases, average costs fall, and keep on
falling even beyond the point where the entire market demand for the product is satisfied. A
market like this cannot support more than one firm. In fact, natural monopoly acts as a strong
barrier to entry of new firms into the industry because potential entrants realize that it would be
extremely difficult to attain the low costs of the already existing firm. Examples of natural
monopolies include water, gas and electricity distribution and postal services.
Monopolistic competition is a market structure in which many firms but with a small degree of
market power e.g. local hair dressers, restaurants, cloth retailers, fast-food outlets.
→ Many firms
→ Low barriers to entry
→ Differentiated product
→ Price makers
→ Asymmetric (imperfect) information
A monopolistic competitor faces a downward-sloping demand curve due to product
differentiation. As a monopolistic competitor raises its price, consumers may choose purchase
substitute goods, resulting in fall in quantity demanded. The demand curve is more elastic than a
monopoly but not perfectly elastic. As a monopolistic competitor must drop prices to increase
output, its MR curve lies below the demand curve.
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Monopolistic competition (short run) loss
A monopolistic competitor may incur loss even when producing at the profit maximization level of
output Q1, at which Price is less than ATC, indicating the firm is making a loss. The firm’s total loss
is represented by the shaded area.
Long run normal profit
→ In the long run, loss incurring firms may leave the market
→ Market supply decreases, but monopolistically competitive firms are not price takers
→ The existing market demand is split among the remaining firms
→ The demand curve of Individual firms increases (AR curve shifts upwards)
→ Losses are eliminated and normal profit is achieved in the long run
Monopolistic competition (short run) abnormal profit
Abnormal profit occurs when the price at the profit maximization output is P1. Since price exceeds
ATC, the firm is making supernormal profit, shown by the shaded area.
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Abnormal to normal profit (long run) adjustment
→ In the long run, firm enter the market seeking profits
→ Market supply increases
→ The market demand is split among the firms
→ The demand curve of Individual firms decreases (AR curve shifts downwards)
→ Profits are eliminated and normal profit is achieved in the long run
Productive and allocative inefficiency monopolistically competitive firms achieve neither
productive nor allocative efficiency. Comparing price with marginal cost at the profit
maximization level of output, Q1shows that Price > MC, meaning that resources are underallocated; allocatively inefficient. Furthermore, the firm is not producing where P = min ATC;
therefore, it is productively inefficient.
Oligopoly is a market structure where a few large firms dominate the industry with high barriers
to entry e.g. smartphone market, aircraft manufacturers
→ A few dominant firms
→ Their decisions are interdependent
→ The products may be differentiated or undifferentiated
→ The uncertainty and risks associated with price competition may lead to price rigidity
Collusive oligopoly is an agreement between two or more firms to limit competition through
strategies such as price fixing or limiting output.
→ A cartel is an anti-competitive agreement between firms to collude by fixing prices or
reducing output, thereby effectively acting as a monopoly.
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Non-collusive oligopoly refers to competing firms with mutual interdependence. This means they
consider the possible actions and reactions of each other when determining pricing and nonpricing strategies.
Assume that a firm only knows one point on its demand curve, the one that it holds at present. This
is shown as point “a”. Now, consider what reactions the firm would expect from its competitors if it
were to change its price. If the firm raises its price then it is unlikely that its competitors would
raise theirs and so a lot of demand would be lost to the other firms. This implies that demand
would be relatively elastic above the point “a”, since a small increase in price would lead to a
large fall in quantity demanded.
If the firm were to lower its price then it is likely that competitors would follow. More to the point,
it is likely that they would undercut the price of the first firm in order to regain any lost sales. This
implies that demand would be less elastic below the point “a”, since a decrease in price is unlikely
to lead to a noticeable increase in quantity demanded. Because of these expectations, the
demand curve will be kinked around the point “a”. It will also possess an MR curve that has the
vertical section bc, since each part of the MR curve will be twice as steeply sloping as the two
parts of the demand curve. The kinked demand curve offers an explanation of why there tends to
be price rigidity in non-collusive oligopoly.
Price and non-price competition
→ Price competition is a strategies to compete in an industry e.g. going-rate pricing, loss
leader pricing or penetrating pricing.
→ Price rigidity refers to the tendency of prices to remain unchanged in non-collusive
oligopoly owing to interdependence.
→ Non-Price competition refers to all other forms of competition e.g. advertising, branding
and packaging
Contestable market in recent years, economists have developed the theory of contestable
markets. This theory argues that what is crucial in determining price and output is not whether an
industry is actually a monopoly or competitive, but whether there is the real threat of competition.
→ There will be low sunk costs (costs which can’t be recovered when leaving the market)
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→ Due to freedom of entry and exit – existing firms always face the threat of new firms
entering the market.
→ This threat of entry is sufficient to keep prices close to a competitive equilibrium and
profits low – otherwise, new firms enter.
→ In a contestable market, it is not the number of firms that is important, but the ease by
which new firms can enter the market.
A market is perfectly contestable when the costs of entry and exit by potential rivals are zero,
and when such entry can be made very rapidly. In such cases, the moment it becomes possible to
earn supernormal profits, new firms will enter, thus driving profits down to a normal level. The
sheer threat of this happening, so the theory goes, will ensure that the firm already in the market
will (a) keep its prices down, so that it just makes normal profits, and (b) produce as efficiently as
possible, taking advantage of any economies of scale and any new technology.
Business objectives
→ Profit satisficing aims for a satisfactory or adequate level of profit, rather than profit
maximization, to help the interest of other stakeholders such as employees
→ Corporate social responsibility CSR is about businesses considering the impact of their
operations on the society as a whole welfare in a positive and ethical way. A business
may consider actions such as reducing its carbon footprint, improving well-being of
workers, minimizing waste, engaging fair trade
→ Revenue maximization firms might maximize sales revenue rather than profits. This might
be done by the firm. This might be done by the firm to either achieve economies of scale
or increase their market share and acquire monopoly power. Managers may also wish to
maximize sales revenue if their salaries and bonuses are linked to sales revenue or to the
size of the firm in relation to other firms in the industry. When firms maximize sales
revenue, they produce the quantity where MR= 0 (Point B).
→ Sales growth maximization firms may try to maximize the volume of sales rather than
sales revenues. Here the firm can follow the average cost pricing (P = AC) and make
normal profits, yet at the same time maximize sales. The average cost pricing may also be
followed in the case where firms face regulatory pressure or are natural monopolies (Point
C).
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→ Loss minimization in some situations firms may have a short-term objective of minimizing
losses. This is likely to be where a firm is facing serious external threats such as loss of its
customer.
The game theory
Game theory attempts to explain the nature of interdependence when making decisions in
oligopolistic markets by considering the actions of competitors based on possible outcomes
Prisoners’ dilemma a situation where two prisoners are being questioned over their guilt or
innocence of a crime. They have a simple choice, either to confess to the crime (thereby
implicating their accomplice) and accept the consequences, or to deny all involvement and hope
that their partner does likewise. The “pay-off” is measured in terms of time spent in prison and is
summarized: The best option for both prisoners is to remain silent face 6 months in prison for the
crime. But because neither can be guaranteed that the other won't confess, the most likely outcome
is that both prisoners will hedge their bets and betray the other - effectively taking the 10-year
sentence off the table and replacing it with the 5-year sentence.
Types of business organization
→ Sole traders
→ Partnerships
→ Private limited companies
→ Public limited companies
→ Multinationals
A sole trader is a business owned by a single person, also known as a sole proprietorship.
This person can employ as many people as needed, but remains the only owner of the
business. Examples of sole proprietors are market traders, hairdressers, physiotherapists, and
owners of small shops such as a bakery, café or stationery shop.
A partnership is a business organization owned by more than one person. In an ordinary
partnership, there are between 2 and 20 owners, known as partners (the co- owners of the
partnership). At least one of these partners will have unlimited liability, although it is usual
practice for all the partners to share responsibility for any losses made by the business.
The government does allow some businesses, such as law and accountancy firms and health
clinics, to operate with more than 20 partners.
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Limited liability companies are owned by shareholders. The owners have the benefit of
limited liability, which means that in the event of the company going bankrupt they would
not lose more than the amount they had invested in the company.
Private limited company is an incorporated business that is owned by shareholders who are often
family members or close friends, unable to sell shares to the general public.
Public limited company is a company, often a large business, with the legal right to sell shares to
the general public on the stock exchange.
A multinational corporation (MNC) is an organisation that operates in two or more countries.
→ MNCs operate on a very large scale, so they are able to exploit economies of scale.
This means that the MNC can pass on cost savings to customers in the form of lower
prices, thereby enhancing its international competitiveness.
→ Through job creation, MNCs are able to help improve standards of living in the
countries where they operate.
→ By operating in overseas markets, MNCs are able to generate more profit by
selling to a larger customer base.
Public corporations (or public-sector organisations) are wholly owned by the government
and are therefore funded through tax revenues. Examples of public-sector organisations are:
water suppliers, sewerage providers, utilities (electricity and gas boards) etc.
Types of growth
→ Internal growth organic growth involves the uses of existing business resources to increase
its scale of operations by selling new products, opening new outlets, or effective promotion.
→ External growth involves the integration of a business with other businesses to increase
market share e.g. Uber’s acquisition of Careem.
Types of external growth
→ Horizontal integration involves a business integrating with another business in the same
industry and same stage of production e.g., Nike bought Umbro in 2007.
→ Vertical integration involves a business integrating with another business in the same industry
but at a different stage of production e.g., a coffee manufacturer acquires a chain of cafes.
In this case the coffee manufacturer is involved in forward vertical integration while the café
is involved in backward vertical integration. Furthermore, lateral integration involves
mergers and acquisitions in which have similar operations but do not directly compete with
each other e.g., Tata Motor’s acquisition of Land Rover.
→ Conglomerate integration refers to integration of businesses involved in completely
different industries and stages of production e.g., Berkshire Hathaway owns businesses in a
range of industries including insurance, clothing and beverages.
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Types of integration
→ Merger a type of integration in which two companies form a single new company under
one common board of directors whereby their original entities ceases to exist e.g. both
Daimler-Benz and Chrysler ceased to exist when the two firms merged, creating Daimler
Chrysler.
→ Acquisition a type of integration whereby one company buys another company by
paying cash, stock or a combination of the two, becoming the controlling owner e.g. Apple
buys Shazam.
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Government microeconomic intervention
Labor market – demand and supply
The wage rate is determined by the demand for and supply of labor in a market. Firms demand
labor while individuals supply their labor services. When demand for labor equals its supply, we
get an equilibrium wage rate and quantity of labor employed. The demand for labor is a
derived demand which means its demand depended on the demand for goods and services.
Demand for labor
→ The demand curve for labor of an individual firm shows how many workers will be hired
at any given wage rate over a given time period
→ To derive the demand curve for labor of an individual firm, we use the marginal revenue
product of labor MRP or MRPL
→ Assuming that a firm is a profit maximizer
→ There is a link between the quantity of labor that a firm employs and the quantity of
output that it plans to produce
Marginal revenue product of labor is the extra revenue generated when an additional worker is
hired
MRP = MPP x MR
Demand for labor for an individual firm
Assume, in the short run, a firm is operating in perfectly competitive market, meaning it is a wage
taker. As workers are hired, the total physical product TPP rises.
→ Plotting these values gives us the MRP of labor for the firm
→ The MPP marginal physical product initially rises and beyond the 3rd worker, it declines
similar to the marginal revenue product MRP because labor is being added to other
factors of production which are fixed e.g. capital
→ Therefore, the MRP curve slopes upwards, peaks and then slopes downwards
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Changes in the demand of labor
→ The price of product may affect labor demand e.g. if the price is high, meaning the profits
are higher, firms will demand more workers
→ Changes in productivity may affect labor demand e.g. an increase in worker productivity
will increase the marginal revenue product MRP and firms will demand more workers
→ Change in demand for the product may also influence demand for labor e.g. the entry of
a new product may reduce demand for an existing product, reducing demand for labor
→ Change in price of capital also influence demand for labor as capital and labor are
considered substitutes e.g. a rise in labor wages relative to capital may influence firms to
adopt capital intensive production reducing demand for workers
Market demand for labor
The market demand or labor is a composite of all individual demand curves. There is an inverse
relation between the wage rate and the quantity of labor demanded. In the short run, this is due
to the law of diminishing returns. In the long run, labor can be substituted with capital based on
the wage rate.
Individual supply of labor
→ The supply of labor is the total number of hours that a worker is able and willing to work
at a given wage rate
→ There is a trade-off between leisure and work
→ People have a target income which they seek to achieve, and beyond that, they may seek
leisure over work
→ There are two components to how much hours a person is will to work given the wage rate,
namely the income effect and the substitution effect
→ At lower wages, a person is more willing to work more, therefore, the substitution and
income effects are positive, meaning the wage effect is also positive
→ Therefore, the individual supply curve is upward slopping
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→ As wages rise, the substitution effect remains positive, but the income effect becomes
negative, however, the wage effect remains positive
→ The supply curve is still upward slopping but becomes steeper
→ Once a person achieves their target income, even though the substitution effect remains
positive, but the income effect becomes negative and is strong enough to override the
substitution effect, however, the wage effect remains positive
→ As a result, the supply curve bends backwards
Market supply of labor
The market supply of labor is upward slopping i.e. at higher wages, the quantity of labor
supplied increases and vice versa, ceteris paribus. As the wage rate rises more workers enter the
market seeking higher wages while many inactive workers also begin to seek work. This over rides
the negative income effect.
Shifts in market supply of labor
→ Wages in substitute jobs affects labor supply e.g. higher wages for nurses may attract
people from other professions to, possibly switch over
→ Entry requirements such as skills, education and qualifications may also influence labor
supply e.g. becoming a doctor requires excessive training and education which may be
difficult for many, therefore, the labor supply may be limited
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→ Non-monetary benefits such as working h0urs, perks and growth opportunity may affect
labor supply e.g. better perks may attract more people increasing the supply of labor in
a profession
→ Improvement in occupational mobility such as education and training may allow people
to switch from one profession to another
→ Value for leisure time may influence whether or not people chose to join a profession
Wage determination in a perfectly competitive market
→ The data below is of a firm operating in a perfectively completive markets
→ All calculations have been explained previously
→ Assume the labor wage is $60, as the firm is a wage taker, the wage will remain the
same for any additional workers hired
→ At a wage rate of $60, the cost of hiring each worker is the same i.e. $60. therefore, the
MCL marginal cost of labor is perfectly elastic
→ The MRP curve increases and them slopes down in the short run
→ To maximize profits, the firm will hire labor at a point where MC = MRP i.e. 5 workers
→ If the firm hires 6 workers, the MCL exceeds the MRP, meaning the cost of hiring the 6th
worker exceeds the revenue gained
→ If the firm hires 4 workers, the MRP exceeds the MCL i.e. the revenue gained by hiring the
6th worker exceeds the cost
A firm operating in a perfectly competition market has the following features
→ A larger number of buyers and seller of labor
→ Labor is homogeneous
→ Firms are wage takers
→ No barriers to entry and exit for labor
→ Perfect information is available to both labor and firms
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The above diagram on the left shows the market for labor while the diagram on the right shows a
perfectly competitive firm in this market. The market equilibrium wage rate is W1 and Q1 labor
are employed. The individual firm will hire workers at a point where (MCL) supply equals MRP
(demand), meaning the individual firm will pay W1 wage while hiring Q1 workers.
A trade union is an associations that represent the interest of groups of workers. Trade unions
may control labor supply and use collective bargaining to pressurize firms. If they succeed, wages
may be raised from We to Wu. The quantity demand of labor falls to Qu. Unemployment may
rise in the labor market as supply of labor exceeds its demand at wage Wu. Beyond Q1, the
labor supply curve is upward slopping as firms must offer higher wages to attract extra workers.
A monopsony is a single buyer of labor in an industry and is a wage setter.
→ A monopsonist can hire extra workers by offering higher wages, but in doing so, all
previously hired workers must also be paid the new higher wage e.g. if the 1st worker is
hired at $10 the second must be hired at a higher wage such as $15
→ Therefore, the (MCL) marginal cost of hiring an extra worker will exceed the average cost
of labor (ACL) and the MCL will be above the ACL
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→ A monopsony will maximize profits by hiring workers till the point where MCL equals MRP
→ This means Q1 workers will be hired, but the wage it sets is W1 because the wage is on
the supply curve (ACL)
→ However, the competitive wage rate should We and Qe workers should be hired
→ Therefore, fewer workers are employed in a monopsony while the wage rate is also lower
than that in competitive markets
Monopsony and trade unions
If a trade union pressurizes the monopsony to raise wages from W1 to Wu. The supply curve will
become perfectly elastic, meaning MCL equals ACL. The firm will hire workers at Wu up till the
point where the wage Wu touches the ACL. Beyond this, to hire extra workers, the firm must offer
higher wages, but all previously hired workers must also be paid the new higher wage. Now the
MCL will diverge from the ACL. The firm will maximize profits by hiring workers where MCL =
MRP. This means Qu labor is employed at a wage rate of We. This means employment in the
industry may rise from Q1 to Qu.
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Wage differentials and labor market imperfections
→ Labor is not homogeneous as labor may vary in terms of productivity (MRP), firms may
be able to discriminate among different worker categories such as men and women and
different professions may have different supplies of labor.
→ Labor is not perfectly mobile as occupational and geographical mobility is less likely due
to education and training needs of different professions along with the lack of information
about various job opportunities
→ Presence of trade unions and supply restrictions may improve bargaining power of
workers helping to drive up wages
→ Monopsonies have wage setting ability which may limit the rise in wage rates
→ Non-monetary benefits may differ in different professions which may attract fewer or
more workers e.g. if a profession offers better perks, more people may seek work,
increasing the labor supply, driving down wages
Economic rent and transfer earnings
→ The total income of a factor of production is made up of its economic rent and its transfer
earnings
→ Transfer earnings are the minimum income a worker needs in order to supply their labor
→ Economic rent is the extra income a worker receives – above the minimum level they need
in order to work e.g. a footballer may earn more economic rent than an office clerk
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Poverty it refers to the inability to satisfy minimal consumption needs.
▪ Absolute poverty when a household does not have sufficient income to sustain even a
basic acceptable standard of living (meet basic needs).
▪ Relative poverty is a comparison between income of individuals or households in a society
with average incomes. It is closely related to how equally or unequally society’s income is
distributed among its total population.
The poverty trap is a vicious cycle of poverty and deprivation causing even greater poverty, from
one generation to the next
The savings ratio is the amount of savings expressed as a proportion of total disposable income
in an economy
Economic causes of income inequality
→ Differences in tax structures
→ Lack of human capital
→ Discrimination in society and work
→ Lack of access to financial markets
→ Bargaining power of people when seeking work
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Consequences of poverty
▪ Low living standards are associated with greater levels of psychological stress, and poor
levels of health, all leading to poorer job and income-earning prospects.
▪ Poverty results in a lower ability to access health care and education, leading to lower
productivity and lower incomes.
▪ Social issues such as higher crime rates, drug use, family breakdowns and homelessness
are possible consequences of poverty.
Policies to redistribute income/wealth
By providing benefits
→ Universal benefits are paid out to everyone in certain categories, oft en age related,
regardless of their income or wealth e.g. pensions and child benefits
→ Means-tested benefits are only paid to those on low incomes. They are targeted directly
at those who are seen to be most in need e.g. unemployment benefits
By imposing taxes
→ Progressive tax is where the rate rises as income increases
→ Regressive tax is where the percentage of tax falls as income rises
Other policies
→ The government may provide certain services free to people e.g. healthcare and
education
Rational consumer choice
→ Consumer rationality is assumed that individuals use rationale considerations to make
sensible choices that align with their best interests
→ Perfect information to act rationally, economic agents must have access to full information
such as prices, product specifications, and information about alternative products
available on the market
→ Utility maximization economic theory assumes that people decide on the option that
gives them maximum utility
Limitations the assumptions of rational consumer choice
→ Availability bias refers to the ease with which an idea or event can be recalled from
memory e.g. shark attacks or aircraft accidents
→ Biases when making decisions, people’s cognitive responses are influenced by biases
including common sense, intuition, emotions, and social norms
→ Bounded rationality refers to the fact that people’s cognitive decision making capacity is
limited owing to barriers such as information failure, time and choice
→ Imperfect information occurs when people have inaccurate, incomplete or unreliable
information, so decision making is not optimal
→ Anchoring is a cognitive bias that influences how people view a product by comparing it
to something else e.g. a sale with 70% discount may become an anchor for a customer
→ Framing is about presenting information in such a way that it creates a bias in favor of a
particular decision e.g. choices can be presented to highlight the benefits and limitations of
a choice
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Behavioral economics is the study of actual economic decision-making with emphasis on human
behavior being less rational than traditional economic theory suggests. The limitations of
assumptions of rational consumer choice include
→ Choice architecture refers to the way choices are presented to people and how different
designs affect the choices made e.g. a restaurant menu may be designed to create
nudges for customers to choose certain items
Choice architecture
→ A Default choice occurs when a person is automatically signed up into a system e.g.
employees being enrolled on a pension scheme to make financial contributions to their
retirement saving. Employees must choose to opt out if they do not intend to seek the
pension
→ Restricted choices limit the choices available to people such as placing healthier food
items in school cafeteria, restricting the consumption of unhealthy food items
→ Mandated choices is when people are required to make advanced decisions and declare
whether they wish to participate in a particular activity e.g. some governments give a
mandated choice to people who must register to vote in person
Nudge theory is the practice of influencing the choices that people make. Nudges are created by
choice architecture using small prompts or tweaks to alter social behavior, but without taking
away the power for people to choose
→ Providing information about social norms e.g. socially acceptable behavior on public
transport
→ High visible speed cameras may prompt motorists to drive slower
→ Healthy food items displayed in cafeteria
→ Different colored bin to encourage recycling
→ In many countries, cigarettes are hidden from view
→ Packaging including details about caloric intake
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The macroeconomy
Circular flow of income an economy is divided into two sectors households and firms. The
households provide resources namely land, labour, capital and enterprise to firms who in return
pay wages, rent, interest and profit. Firms produce goods and services which are consumed by
household, and these households spend money on purchasing goods and services produced by the
firms. The flow of goods and services through these markets are balanced by counter flows of
payments. Households make payments for things they buy in product markets, while firms make
factor payments—wages, interest payments, rents, royalties in exchange for resources they buy.
→ Government sector households pay taxes to the government which is spent on building
roads, transfer payments, defense etc. In this model taxes are considered leakages while
government spending is considered an injection into the economy.
→ Foreign sector it is a portion of economy that includes exports and imports, exports bring
in revenue which considered an injection in the economy, but imports result in leakages as
money leaves the economy.
→ Financial sector it consists of financial institutions engaged in borrowing and lending with
firms. Financial institutions help individuals and firms invest money for interest payments or
borrow money to invest in capital goods. Financial institutions perform the function of
mobilizing savings for investment, savings are considered leakages and investments are
considered injections in the economy.
Business cycle is a graph that represents the fluctuations in the GDP in an economy over time.
▪ Expansion occurs when there is positive growth in real GDP, shown by those parts of the
curve in fig. that slope upward. During periods of real GDP growth, employment of
resources increases, and general price level of the economy usually begins to rise more
rapidly (inflation).
▪ Peak represents the cycle’s maximum real GDP, and marks the end of the expansion.
When the economy reaches a peak, unemployment of resources has fallen substantially,
and the general price level may be rising quite rapidly; the economy is likely to be
experiencing inflation.
▪ Contraction following the peak, an economy begins to experience falling real GDP shown
by the downward-sloping parts of the curve. If the contraction lasts six months (two
quarters) or more, it is termed a recession, characterized by falling real GDP and growing
unemployment of resources. Increases in the price level may slow down a lot, and it is even
possible that prices in some sectors may begin to fall.
▪ Trough represents the cycle’s minimum level of GDP, or the end of the contraction. There
may now be widespread unemployment. A trough is followed by a new period of
expansion (also known as a recovery), marking the beginning of a new cycle.
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Unemployment refers to the situation when people are willing and able to work and actively
seeking employment but are unable to find work
Unemployment rate = number of unemployed people x 100
labor force
The labor force refers to people of working age who are in employment, self-employment and
the unemployed
→ A healthy economy has an unemployment rate of 4% to 5%
Claimant count is a measurement of all those who receive unemployment benefits. Claimant
statistics have the advantage of being very easy to collect. However, they exclude all those of
working age who are available for work at current wage rates, but who are not eligible for
benefits. If the government changes the eligibility conditions so that fewer people are now
eligible, it will reduce the number of claimants and hence the official number unemployed, even if
there has been no change in the numbers with or without work. The claimant statistics therefore
understate the true level of unemployment.
Difficulties in measuring unemployment
→ Underemployment exists when people are inadequately employed e.g. part-time
workers
→ Hidden unemployment is when people are unemployed, but are not included in the
official statistics e.g. discouraged workers
→ Voluntary unemployed people who chose not to work full-time e.g. people who have
retired early
→ Regional disparities different regions have face different unemployment rates e.g. in
2019, unemployment in the US was 3.6%, but in Alaska the rate was 6.1%
→ Gender disparities females tend to experience higher rates of unemployment than males
e.g. in nations such as Africa
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Causes of unemployment
Frictional unemployment exists when people are temporarily unemployed while in between jobs
or seeking to enter the job market for the first time. Such unemployment always exits in an
economy at any given time. It can be addressed using the following measures:
→ Improve information symmetry between employers and job seekers
→ Reduce unemployment benefits
Seasonal unemployment is caused regular and periodic changes in the derived demand for
labor at different times of the year e.g. Ski instructors are less in demand during summers. Such
unemployment always exits in an economy at any given time and can be addressed using the
following measures:
→ Improve information symmetry between employers and job seekers
→ Reduce unemployment benefits
→ Vocational trainings programmes
Structural unemployment arises when labor skills mismatch with the jobs available in a specific
industry e.g. changes in technology, relocation of industry etc. It exists when the demand for labor
is less than the supply of labor.
→ As demand for labor falls, from ADL1 to ADL2, a new equilibrium is formed.
→ Therefore, the wage rate falls from W1 to W2 while the number of unemployed workers
is (Q1-Q2)
Changing market trends mean that new jobs are created but workers may lack the skills needed
for such jobs. Such unemployment can be addressed by:
→ Improve training and education programs
→ Facilitate mobility of labor force to encourage relocation as demands for labor change in
regional areas
Cyclical (demand-deficient) unemployment is unemployment caused by a lack of aggregate
demand in the economy e.g. the Covid-19 pandemic. It is the most severe cause of unemployment
and is caused by a fall in one or more components of aggregate demand, a decline in business
cycle. Derived demand for labor falls at output falls and workers are made redundant.
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→ As demand for labor falls, from ADL1 to ADL2, the wage rate remains the same due to
contractual obligations and government regulation.
→ Therefore, the number of unemployed workers is greater, (Q1-Q2)
Cyclical unemployment can be addressed by the government through the use of:
→ Expansionary fiscal policy which includes lowering taxes and increasing government
spending
→ Expansionary monetary policy which includes lowering interest rates to spur consumption
and investment in the economy
Natural rate of unemployment NRU is the sum of structural, frictional and seasonal
unemployment in a nation
NRU = structural UE + frictional UE + seasonal UE.
Consequences of unemployment
→ A loss of real GDP as fewer people work, the amount of output produced is less than the
level the economy is capable of producing, meaning an economy finds itself somewhere
inside its production possibility curve.
→ Loss of income for unemployed workers people who are unemployed do not have an
income, they are likely to be worse off financially.
→ Loss of tax revenue since unemployed people do not pay income taxes, reducing tax
revenue for the government.
→ Unemployment benefits the greater the unemployment, the larger the unemployment
benefits that must be paid, and the less tax revenue left over to pay for important
government-provided goods and services such as public goods and merit goods.
→ Unequal distribution of income unemployed people become poorer while employed
people are able to maintain their income levels, leading to disparity in the levels of
income in the country.
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Economic growth refers to a sustained increase in a nation’s real GDP over time
→ It is expressed as the annual percentage change in real national output
→ Economic growth is an increase in real GDP for 2 consecutive quarters
→ Recession (negative economic growth) is a fall in real GDP for 2 consecutive quarters
Reason for economic growth
→ Factor endowments refers to the quality and quantity of resources of a nation e.g. Saudi
Arabia is well endowed in oil supply while France has arable land
→ Size and skill of the labor force impacts economic growth e.g. China huge labor force
and Germany’s skilled labor force
→ Investment expenditure in capital and human resources is vital for long-term growth as it
boosts the nation’s productive capacity. This can also encourage foreign direct investment
→ Discovery of raw materials such as gas reserves will increase a nation’s productive
capacity helping to increase its production potential
→ Labor productivity is determined by many factors e.g. qualification, experience, training
and motivation. Higher productivity leads to greater economic growth
→ Mobility of labor refers to the extent to which workers are willing and able to change
jobs (occupational mobility) and move to different locations for work (geographical
mobility)
Types of growth
Actual growth occurs in the short-term when an economy operate below its full-employment level
of national income but moves towards its potential level of GDP by using resource more efficiently
Growth rate = GDP (new) – GDP (old) x 100
GDP (old)
Actual growth due to an increase in aggregate demand. In a PPC diagram, actual growth can be
shown by movement from a point ‘A’ within the PPC to a point ‘B’ closer to the PPC.
Potential growth occurs due to an increase in the quantity and/or quality of factors of production
in the long run e.g. land, labor, capital, enterprise and technology. This can be shown by a
rightward shift of the LRAS curve. Furthermore, using the PPC model, potential growth can be
demonstrated by an outward shift of the PPC curve.
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Consequences of economic growth
→ Reduction or elimination of poverty owing to higher income per person
→ Creation of new jobs and lower unemployment
→ Increased tax revenue enable the government to fund public and merit goods
→ Increased consumer spending leads to higher revenues for firms which may be reinvested
into buying capital stock, improving the production potential
→ With rising income the amount spent on demerit goods tends to increase
→ There is a risk of inflation if the economy continues to grow owing to excessive aggregate
demand in the country
→ Higher rates of growth can cause negative externalities that damage the environment e.g.
air pollution, road congestion, land erosion
→ It may cause other forms of market failure e.g. depletion of natural resources such as
deforestation and overfishing
→ Economic growth often creates greater disparities in income distribution and wealth
→ Growth also leads to greater tax revenue collection enabling the government to
redistribute income and wealth in the economy
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Government macroeconomic intervention
Macroeconomic objectives of the government
→ Economic growth (steady rise in national income)
→ Low unemployment
→ Low and stable inflation rate
→ Sustainable level of government debt
→ Balance of payment equilibrium
→ Equality in income distribution
Aggregate expenditure it is the total amount that will be spent at different levels of GDP in a
given time period. It is made up of the following:
→ Consumption it refers to consumer expenditure is spending by households on goods and
services to satisfy current wants, for example, spending on food, clothes, travel and
entertainment. However, as income increases, total spending increases, but the proportion
of disposable income spent falls. This is referred to as average propensity to consume and
can be expressed as:
APC = C/Y (consumption/income)
This implies that a rich person has a lower marginal propensity to consume (mpc) and a higher
propensity to save (mps)
→ Investment It is the spending by firms on capital goods, such as factories, offices, and
machinery and delivery vehicles. The amount of investment undertaken is influenced by
changes in consumer demand, the rate of interest, technology, the cost of capital goods,
expectations and government policy.
→ Government spending this covers spending on items such as medicines used in state
hospitals, equipment used in state schools and government investment in new roads. The
amount of government spending that is undertaken in any period is influenced by
government policy, tax revenue and demographic changes. If a government wants to raise
economic activity it may decide to raise its spending.
→ Net exports the level of net exports is influenced by the country’s GDP, other countries’
GDPs, the relative price and quality competitiveness of the country’s products and its
exchange rate. When a country’s GDP rises, demand for imports usually increases. Some
products may also be diverted from the export market to the domestic market. When
incomes rise abroad, demand for the country’s exports is likely to increase. The level of
the exchange rate can be a key influence on net exports. If the exchange rate falls in
value, the country’s exports will become cheaper and imports will become more
expensive. If demand for exports and imports is elastic, export revenue will rise while
import expenditure will fall, causing net exports to fall.
Income determination
→ Changes in income the level of income in an economy is determined where aggregate
expenditure is equal to output. If aggregate expenditure exceeds current output, firms will
seek to produce more. They will employ more factors of production and GDP will rise.
Whereas if aggregate expenditure is below current output, firms will reduce production.
So output will change until it matches expenditure as shown in Figure. The diagram is often
referred to as the Keynesian 45° diagram. It measures money GDP on the horizontal axis
and aggregate expenditure equals national income (GDP). Output is determined where
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the C + I + G + (X − M) line cuts the 45 degree line. If aggregate expenditure rises,
perhaps because consumption and investment increase due to greater optimism, output will
increase.
→ Withdrawals and leakages for income to be unchanged it is also necessary for injections
of extra spending into the circular flow of income to equal withdrawals from the circular
flow. If injections were greater than leakages, there would be extra spending in the
economy, causing income to rise.
Inflationary and deflationary gaps in the short run, and Keynesians argue also possibly in the
long run, an economy may not achieve full employment. An inflationary gap will occur if
aggregate expenditure exceeds the potential output of the economy. In such a situation, not all
demand can be met, as there are not enough resources to do so. As a result the excess demand
drives up the price level. The fig. below shows that an economy is in equilibrium at a GDP of Y,
which is above the level of output, X, that could be achieved with the full employment of
resources. The distance ab represents the inflationary gap.
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A government may seek to reduce an inflationary gap by cutting its own spending and/or raising
taxation in order to reduce aggregate expenditure. The fig. shows a reduction in government
spending moving the economy back to the full employment level.
The equilibrium level of GDP may also be below the full employment level. In this case there is
said to be a deflationary gap. The fig. shows that the lack of aggregate expenditure results in an
equilibrium level of GDP of Y, below the full employment level of X. There is a deflationary gap
of vw.
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The Keynesian solution to a deflationary gap is increased government spending financed by
borrowing. The fig. shows an in increase in government spending eliminating a deflationary gap.
Autonomous investment is investment that is undertaken independently of changes in income e.g.
a firm may buy more capital goods because it is more optimistic about the future or because the
rate of interest has fallen.
The accelerator the accelerator theory focuses on induced investment (investment made in
response to changes in income) emphasizing on the volatility of investment. It states that investment
depends on the rate of changes in income (and hence consumer demand), and that a change in
GDP will cause a greater proportionate change in investment. If a £1 million increase in GDP
causes induced investment to rise by £3 million, the accelerator coefficient is said to be 3. If GDP
is rising, but at a constant rate, induced investment will not change. This is because firms can
continue to buy the same number of machines each year to expand capacity.
Capital-output ratio a measure of the amount of capital used to produce a given amount, or
value, of output.
Types of government revenue
→ Taxes comprise of both direct and indirect taxes and are a major source of revenue.
→ Direct sale of goods may provide many goods and services free of charge to their users
such as public goods and even electricity, water etc.
→ Sale of state-owned businesses to the private sector may bring in government revenue.
→ Borrowing from national and international financial institutions such as central bank or IMF
may bring in revenue.
Types of government expenditure
→ Current expenditure includes government spending on recurring items including wages,
maintenance of public schools and public health care services, subsidies etc.
→ Capital expenditure includes public investment on roads, school hospitals, etc.
→ Transfer payments are made to low-income groups for the purposes of income
redistribution e.g., unemployment benefits, child allowances, etc.
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Budget is a record of a country’s tax revenues and expenditures over time.
→ Balanced budget exists when tax revenues equal government expenditures.
→ Balanced surplus exists when tax revenues exceed government expenditures.
→ Balanced deficit exists when government expenditures exceed tax revenues. The
accumulation of deficits leads to public (government) debt.
Automatic stabilizers are factors that automatically work toward stabilizing the economy by
reducing the short-term fluctuations of the business cycle.
→ High growth in a period of high economic growth, automatic stabilizers will help to
reduce the growth rate. As aggregate demand will increase, firms will hire more labour,
reducing unemployment, and increasing income levels in the economy. The government will
receive more tax revenues – people earn more and so pay more income tax (the tax rate
doesn’t change, the amount received just becomes higher). Fall in unemployment will
require the government to spend less on unemployment benefits. As a result, government
spending will fall whereas tax revenues will rise, leading to a fall in aggregate demand
back to full employment level of output. In a period of high growth – ceteris paribus
government borrowing will fall.
→ Recessions in a recession, aggregate demand will fall, firms will fire labour in the shortrun due to sticky wages, increasing unemployment. This will lead to a fall in income levels
in the economy. The government will receive less tax revenues – people earn less and so
pay less income tax. Rise in unemployment will require the government to spend more on
unemployment benefits. Resultantly, government spending will increase while tax revenues
will fall, leading to an increase in aggregate demand back to full employment level of
output. In a period of recession – ceteris paribus government borrowing will increase.
Fiscal policy is the use of taxation and government spending to manage aggregate demand in
order to achieve the government’s macroeconomic aims.
→ The level of the government’s own spending, G, can be changed.
→ Consumption spending C, can be influenced if the government changes personal taxes on
consumers, changing their level of disposable income.
→ The level of investment I, can also be influenced if the government changes taxes on
business profits.
Expansionary fiscal policy if an economy is experiencing a recessionary (deflationary) gap
caused by insufficient aggregate demand. Fiscal policy undertaken to eliminate a recessionary
gap is called expansionary fiscal policy, because it works to expand aggregate demand and the
level of economic activity. Expansionary fiscal policy may consist of:
▪ Increasing government spending
▪ Decreasing personal income taxes
An increase in government spending impacts directly on aggregate demand, which increases. If
the government decreases taxes, aggregate demand is affected in a two-step process. If
personal income taxes are cut, the result is a rise in disposable income, which is then likely to lead
to an increase in consumption spending, causing the AD curve to shift to the right. If business taxes
are cut, after-tax business profits increase, which in turn is likely to lead to higher investment
spending and therefore higher AD. In all three cases, AD is intended to shift to the right from AD1
to AD2, allowing the economy to achieve full employment or potential output Yp. Finally, the
government may decide to pursue a policy of increasing government spending and lowering
taxes simultaneously.
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Contractionary fiscal policy if an economy is experiencing an inflationary gap caused by
excessive aggregate demand. Fiscal policy undertaken to close an inflationary gap is called
contractionary fiscal policy, because it works to contract aggregate demand and the level of
economic activity. A decrease in government spending has a direct influence on the aggregate
demand curve, causing it to shift to the left. An increase in personal income taxes or business taxes
is intended to affect aggregate demand in a two-step process. As personal income taxes
increase, after-tax income falls, causing consumption spending and aggregate demand to fall. As
taxes on profits increase, after-tax profits fall, leading businesses to spend less on investment and
causing aggregate demand to fall. In all three cases, the aggregate demand curve is meant to
shift to the left. The government can also pursue a combination of decreases in government
spending with increases in personal income and business taxes.
Keynesian spending multiplier measures changes in GDP due an injection of government
spending, investment, or exports spending. The total income of individuals can be expressed as:
MPC + MPS + MRT + MPM = 1 …. (1)
Taxes, savings and imports are leakages, denoted by MRL (marginal rate of leakage):
MRL = MPS + MRT + MPM
Equation (1) can be written as:
MPC + MRL= 1
MRL = 1 - MPC
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The Keynesian spending multiplier:
K = 1 / (1 - MPC) or K = 1 / MRL
Example: in country A, 50% change in income goes to consumption, while in country B, 80%
change in income is consumed. Both countries want to determine the effect of an increase in
government spending by $10 million.
KA = 1 / (1 - 0.5) = 2
KB = 1 / (1 - 0.8) = 5
The effect of a change in government can be calculated by:
ΔGDP = K x ΔE (ΔGDP: change in GDP, k: Keynesian spending multiplier and E: expenditure)
For country A: ΔGDP = 2 x 10 = $20 million
For country B: ΔGDP = 5 x 10 = $50 million
Example: in UK, for each additional £1 of income earned by people, 10 pence are saved, 20
pence are taken as tax and 10 pence are spent on imported goods. The government wants to
increase its spending in order to increase GDP by £500 million.
KUK = 1 / (1 - 0.60) = 2.5
GDPUK = K x ΔE = 2.5 x 500 = £1.25 billion
Strengths of fiscal policy
→ It can pull an economy out of a deep recession.
→ Fiscal policy can target specific sectors by making changes in the composition of
government spending depending on government priorities e.g., changing the amount of
spending on education.
→ Changes in government spending directly impact aggregate demand, helping policymakers to be certain that changes in spending are likely to change aggregate demand.
→ Fiscal policy can affect potential output and long-term economic growth indirectly.
Weakness of fiscal policy
→ Tax increases are politically unpopular and may be avoided by the government.
→ Changes in government spending and taxation may lead to conflicts in macroeconomic
goals e.g., expansionary fiscal policy may reduce unemployment but lead to inflation.
→ Increase in government expenditure will lead to greater competition for loans for private
investment. This may reduce private sector investments, known as crowding out effect.
→ As fiscal policy requires approval from the parliament, this may lead to delays in
implementation.
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Monetary policy is used by the central bank to influence the price or quantity of money in order
to impact aggregate demand.
→ Interest rates are the cost of borrowing and the profit of lending money
→ The money supply is the amount of money in circulation within an economy at a particular
point in time e.g. banknotes, coins, loans, bank deposits and central bank reserves
The money market is where the demand for money and the supply of money determines
equilibrium interest rates. The demand curve for money Dm is downward-sloping, as interest rate
falls, the quantity of money demanded by consumers, firms, and government increases. The supply
curve of money Sm is perfectly inelastic as it is controlled by the central bank and does not
depend on interest rates. The intersection of Dm and Sm determines the equilibrium interest rate
‘i’. If the central bank increases the money supply, Sm1 shifts to Sm2, and interest rate falls to i2.
If the central bank decreases the money supply, Sm1 shifts to Sm3, and interest rate rises to i3.
The demand of money can also change, this could be due to an increase in income levels of in the
economy, leading to increased spending. When interest rates are low, demand for money is high
as people may prefer to save less and hold on to money. When interest rates are high, investors
may consider saving and demand less money.
Demand for money – liquidity preference theory
Keynesians argue that rate of interest is determined by demand and supply of money. It is
assumed that the supply of money is determined by the monetary authorities and is fixed in the
short-run. The demand for money refers to the desire to hold money: to keep your wealth in the
form of money, rather than spending it on goods and services or using it to purchase financial
assets such as bonds or shares. The opportunity cost of holding any money balance is the extra
interest that could have been earned if the money had been used instead to purchase bonds. It is
usual to distinguish three reasons why people want to hold their assets in the form of money.
→ Transaction motive since money is a medium of exchange, it is required for conducting
transactions. However, people receive money only at intervals (e.g. weekly or monthly)
and not continuously, they need to hold balances of money in cash or in current accounts.
The transaction demand for money relates directly with real GDP. The higher the GDP, the
higher will be the money demand for transaction purposes.
→ Precautionary motive firms and households also demand money to meet any unexpected
expenses and take advantage of any unforeseen bargains. Money held for transaction
and precautionary motives are called active balances – as they are likely to be spent.
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Active balances are relatively interest inelastic, which means a rise in interest rates will not
result in households and firms to significantly alter or cut back on their holdings of money
for transaction and precautionary purposes.
→ Speculative motive certain firms and individuals who wish to purchase financial assets
such as bonds, shares or other securities, may prefer to wait if they feel that their price is
likely to fall. In the meantime, they will hold money balances instead. This speculative
demand can be quite high when the price of securities is considered certain to fall. Money
when used for this purpose is a means of temporarily storing wealth. Therefore, firms and
households will hold money, which are sometimes called idle balances (LP2), when they
believe that the returns from holding financial assets are low. When interest rates are
high, the opportunity cost of holding money is high and idle balances will be low. Vice
versa, when interest rates are low, opportunity cost of holding money is low, idle balances
will be high. The idle balances are therefore interest elastic – very responsive to changes
in interest rates.
How the central bank changes the money supply
→ Open market operations governments may sell bonds and treasury bills through the
central bank to raise capital for public projects or to manage budget deficits. Private
individuals, firms and commercial banks invest in these bonds in order to earn profits,
reducing bank deposits and decreasing the money supply. If central bank wants to
increase the money supply, it can buy government bonds from commercial banks,
individuals and firms. This leads to an increase in the money supply in the economy, putting
downward pressure on interest rates. Commercial banks have excess reserves which can
be lent to borrowers.
→ Reserve requirement are the amount of funds a commercial bank must have on hand as a
reserve at the central bank by the end of each working day. The central bank sets the
percentage rate, called the required reserve ratio. As commercial banks receive
additional deposits from customers, they do not keep all this cash with themselves. A
percentage of the additional funds are kept as reserves (fractional reserve banking). If
the central bank increases this rate, this would decrease the funds that commercial banks
can lend, driving up interest rates.
→ Discount rate is the minimum interest rate set by the central bank for lending to other
commercial banks (discount loan). Since the rate is normally high, banks only use this if they
can't borrow funds from other banks. If central bank lowers this rate, commercial banks
can borrow more at lower rates, leading to an increase in the money supply.
→ Quantitative easing QE is a monetary policy tool that injects money directly into the
economy via the central bank purchasing a wide range of securities such as bonds. This is
needed due to the liquidity trap that exists when discount rate cannot be cut any further,
as it is close to zero, making traditional monetary policy ineffective. QE is a direct
injection of money into the circular flow of income, reducing interest rates, increasing
aggregate demand.
Expansionary monetary policy if an economy is experiencing a recessionary gap due to
insufficient aggregate demand. The central bank decides to increase the money supply, causing a
rightward shift in the supply of money curve from Sm1 to Sm2, the interest rate falls from i1 to i2.
The drop in the rate of interest means a lower cost of borrowing; therefore, consumers and firms
are likely to borrow more and spend more, so that consumption spending (C) and investment
spending (I) increase. The effect is to increase aggregate demand and cause a rightward shift of
the AD curve. This is shown in fig. where the recessionary gap has been closed through the shift
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from AD1 to AD2. An increase in the money supply by the central bank is referred to as an
expansionary monetary policy.
Contractionary monetary policy suppose now that the economy is experiencing an inflationary
gap caused by excess aggregate demand. The central bank reduces the money supply; this
appears in fig. as a leftward shift of the Sm curve, from Sm1 to Sm3, the result is a higher rate of
interest i3, or a higher cost of borrowing, and therefore, reduced borrowing by consumers and
firms. The effect of lower investment spending (I) and lower consumer spending (C) is to decrease
aggregate demand. This is shown in fig. where the inflationary gap has been closed through the
shift from AD1 to AD2. A decrease in the money supply by the central bank is referred to as a
contractionary monetary policy.
Monetary policy and inflation targeting in recent years more and more central banks around the
world use monetary policy to maintain a targeted rate of inflation around 2% e.g., Canada,
Norway, the European Union. If predicted inflation is higher than the target, they use
contractionary monetary policy to increase interest rates and lower aggregate demand, lowering
the inflation rate. If predicted inflation is lower than the target, they use expansionary monetary
policy to lower interest rates and increase aggregate demand.
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Liquidity trap
According to Keynesians, the speculative demand for money is highly responsive to changes in
interest rates. If people believe the rate of interest will rise, and thus the price of bonds and other
securities will fall, few people will want to buy them. Instead there will be a very high demand for
liquid assets (money and near money). The demand for money will therefore be very elastic in
response to changes in interest rates. The demand for money curve will be shallow and may even
be infinitely elastic at some minimum interest rate. This is the point where everyone believes
interest rates will rise, and therefore no one wants to buy bonds. Everyone wants to hold their
assets in liquid form.
With a very shallow LP curve, a rise in money supply from MS to MS′ will lead to only a small fall
in the rate of interest from r1 to r2. Once people believe that the rate of interest will not go any
lower, any further rise in money supply will have no effect on interest rates. The additional money
will be lost in what Keynes called the liquidity trap. People simply hold the additional money as
idle balances.
Quantity theory of money states that money supply and price level in an economy are directly
proportion. When there is a change in the supply of money, there is a proportional change in the
price level.
MV = PY
M: money supply, V: velocity of money
P: price level, Y: output of the economy (GDP)
The theory revolves around the idea that the more money people have, the more they spend,
when more people compete for the same goods, they put upward pressure on price levels. If the
money supply is expanded too much, price levels will increase. If the money supply is held too
tightly, size of the overall economy might contract. Monetarists argue that money supply should be
increased by 3% to 4% annually which allows for stable economic growth and avoids the overmanagement of the economy by the central bank.
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Strengths of monetary policy
→ It is not subject to political pressure and can be implemented more quickly than fiscal
policy.
→ Independence of central bank allows for decisions to be taken in economic interests.
→ Even if a central bank is not independent from government, monetary policy is still not
subject to much political pressures.
→ Interest rates can be adjusted in very small steps, making monetary policy better suited to
‘fine tuning’ of the economy.
Weaknesses of monetary policy
→ If central banks only target inflation, they may be unable to pursue other goals, such as
full employment level of real GDP.
→ It reduces the ability of central bank to respond to supply-side shocks such as increases in
oil prices, leading to cost-push inflation.
→ A financial crisis may also require an expansionary monetary policy, which might also
lead to inflation higher than the target.
→ It is less effective in a deep recession as banks are less willing to lend fearing borrowers
may be unable to repay loans. Moreover, weak consumer and business confidence may
limit spending and investment respectively (liquidity trap).
Supply side policies are policies aimed at increasing the production potential of an economy by
improving the quality and quantity of factors of production, leading to a rightward shift of the
SRAS and/or LRAS curve.
→ Privatization is the selling of state-owned businesses to the private sector. This leads to
increased efficiency as profit-seeking private firms look to improve operations to compete
for customer satisfaction. This leads to the use of improved production techniques coupled
with skilled labor leading to increased productivity, lowering the cost of production. This
puts downward pressure on market prices, firms raise output, increasing the real GDP of
the economy.
→ Deregulation involves eliminating or reducing government regulation on private sector
firms such as lowering license fee, reducing bureaucratic hurdles etc. This reduces barriers
to entry in a market, increasing competition, and putting pressure on firms to become costefficient. This leads to a fall in prices and increased output for the economy.
→ Minimum wage rate reducing or eliminating minimum wage rate may reduce
unemployment as firms will be able to hire more workers at lower wages. Firms will
experience a fall in unit costs, increasing their profit margins, leading to increased
production. This may lead to increased investment in the economy and economic growth.
→ Unemployment benefits if the government reduces expenditure on unemployment
benefits, unemployed workers will be forced to work, increasing the production level of
firms and reducing government expenditures.
→ Trade union power trade unions attempt to keep wages above the market wage level. If
the power of trade unions is limited, wages will be more responsive to the forces of supply
and demand. This may lead to increased employment at lower wages, raising output.
→ Trade liberalization seeks to remove trade barriers such as tariffs and quotas to allow
the free flow of goods and services across borders. This increases pressure on local firms
to compete along-with allowing local firms to export goods to foreign markets.
→ Infrastructure government expenditure on improving information and providing
infrastructure will help reduce the cost of production of firms, increasing profit margins.
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This provides an incentive for firms to increase output, leading to an increase in the
nation’s production potential along-with attracting foreign investment.
→ New technology if a government either increases spending on R&D or facilitates private
sector investment in R&D, this will result in improved or new capital goods, which can lead
to increased productivity. This will lower cost of production and increase output of firms,
causing economic growth.
→ Education and training better training and education lead to an improvement in the
quality of labor resources, increasing the productivity of labor. This results in efficient use
of capital goods by skilled labor, increasing productivity, causing economic growth.
Advantages of supply-side policies
→ Such policies can reduce structural, frictional and real wage unemployment.
→ By making the economy more efficient, supply-side policies can reduce cost push inflation.
→ By making firms more productive and competitive, they will be able to export more.
→ Such policies will increase the sustainable rate of economic growth by increasing LRAS; this
enables a higher rate of economic growth without causing inflation.
Limitations of supply-side policies
→ Policies such as education spending may not influence the economy for 15-20 years.
→ Such policies are costly to implement.
→ In the short run, policies such as reducing business taxes can limit government tax revenue.
→ Many measures have a negative effect on distribution of income, at least in the short-term
e.g., lower taxes rates, reduced union power, and privatization.
→ In a recession, such policies cannot address problems related to weak aggregate demand.
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International economic issues
A country’s balance of payments is a record of all the economic transactions between residents
of that country and residents in other countries.
→ Current account includes; balance of trade in goods; balance of trade in services; net
income flows and net current transfers.
o Trade in goods records exports and imports of tangible goods e.g., cars, clothing.
o Trade in services records exports and imports of services e.g., tourism, banking.
▪ Balance of trade (BOT) = exports – imports
o Income includes all inflows and outflows of wages, rents, interest and profits from
abroad e.g., dividends paid on foreign shares by residents in the country.
o Current transfers include inflows and outflows owing to transfers from abroad such
as gifts and foreign aid.
→ Capital account consists of, firstly, capital transfers which include transactions such as
ownership of capital goods, debt forgiveness, project-aid for development and the sum of
assets, Secondly, transactions related to non-financial assets consisting of natural resources
e.g., forestry rights. Moreover, it also includes intellectual property rights e.g., patents.
→ Financial account measures the flow of funds for investment in real assets (factories or
office building) or financial assets (stocks and bonds) between a nation and the rest of the
world.
• Direct investment includes investments in physical capital such as buildings and
factories usually undertaken by multinational companies.
• Portfolio investment records financial investments such as stocks and bonds.
• Reserve assets records government holdings of gold, foreign exchange reserves.
Current account + (capital account + financial account + errors and omissions) = 0
Interdependence of current and financial account if there is a current account deficit, there must
be a financial account surplus, which provides it with the foreign exchange it needs to pay for the
excess of imports over exports. When there is a surplus on the current account, the country is
accumulating foreign exchange, which it can use to buy assets abroad. Similarly, a surplus in the
current account is matched by a deficit in the financial account.
BOP disequilibria a BOP deficit means there is a deficit in the combined current, capital and
financial accounts (plus errors and omissions). A BOP surplus means there is a surplus in the
combined three accounts (plus errors and omissions).
A current account surplus occurs when the sum of money flowing into a country’s current account
exceeds the money flowing out
A current account deficit occurs when the sum of money flowing out of a country’s current account
exceeds the money flowing in
Relationship between the current account and the exchange rate
→ A current account deficit shows the country is spending more than it is earning, so it must
require more foreign exchange when it faces relatively lower demand for its own currency
as exports are in lower demand. This is automatically resolved in a free floating exchange
rate system because it makes exports relatively cheaper and imports relatively more
expensive. Exports earning should rise and import expenditure should fall
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→ If a currency is overvalued, the quantity supplied is greater than its quantity demanded
resulting in more debits than credits thus causing a BOP deficit
→ If a currency is undervalued, the quantity demanded exceeds its quantity supplied,
resulting in more credits than debits thus leading to BOP surplus
Relationship between the financial account and the exchange rate
→ A surplus in the financial account is likely due to credit items from investments being made
in the domestic economy. To make these investments, investors will need to demand the
domestic currency, causing an appreciation
→ In case of a financial account deficit, this would likely be represented by domestic
investors investing in portfolio investments aboard. To make these investments, investors
will need to supply their currency to purchase the foreign currency, causing a depreciation
of the domestic currency
Implications of a persistent current account deficit
→ Exchange rates a persistent current account deficit will lead to a weaker domestic
currency owing to fewer exports. This impact raise the production cost of domestic
industries reliant on imported raw materials
→ Interest rates a persistent current account deficit can put downward pressure on the
exchange rate, increasing prices of imports. Governments may be tempted raise interest
rates to attract capital inflows. However, this can have contractionary impact on
aggregate demand
→ Foreign ownership of domestic assets a current account deficit is financed by a surplus
on the financial account, often in the form of FDI, meaning domestic assets become owned
by foreign firms. This may boost aggregate demand but may cause leakages in the
circular income as firms remit profits back to their home country
→ Debt if a nation does not have sufficient financial reserves to fund its persistent current
account deficit, it will have to borrow e.g. from the IMF; this would leading to mounting
interest payments
→ Credit ratings a persistent current account deficit tends to reduce the credit rating of a
country as it can signal underlying structural problems in the economy. Such economies
may need to restructure their debt by agreeing to new terms e.g. longer repayment
periods
→ Demand management a rapidly growing economy often experiences a current account
deficit as those with higher incomes purchase more imports. This may require
contractionary demand management policies which may compromise economic growth and
employment in the economy
→ Economic growth in order to close the current account deficit, a government may choose
to use contractionary demand-side policies, which lower aggregate demand and is likely
to limit economic growth
Methods to correct persistent current account deficit
Expenditure switching policies are measures aimed at cutting a current account deficit by
encouraging households and firms to buy domestically produced products rather than imports
→ Export promotion are polices that stimulate the demand for exports through subsidies and
direct spending towards these industries
→ Trade protection are measures that reduce the competitiveness of imports through
protectionist measures e.g. tariffs making domestically produced products more attractive
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→ Currency devaluation the central bank through intervention can devalue its exchange
rate in order to reduce export prices and make imports relatively more expensive. This
may lead to an increase in net exports
Expenditure reducing (dampening) policies are measures designed to cut a current account
deficit by lowering disposable income to limit aggregate demand and import expenditure
→ Contractionary monetary policies are the use of higher interest rates to reduce
aggregate demand in the economy, thereby reducing spending on imports
→ Contractionary fiscal policies are the use of higher taxes and reduced government
spending to reduce consumption and investment and spending on imports
Supply side policies are long term measure that strive to raise the productive capacity of a
nation and to increase its export competitiveness
→ Investment in education and healthcare these measures help to improve the economy’s
human capital thereby raising the quality of exports and improving long term
international competiveness
→ Investment in infrastructure these policies help to support firms, especially those
engaged in exports, owing to improved transportation and communication networks
Implications of a persistent current account surplus
→ Domestic consumption and investment in the short run, a current account surplus means
net exports increase, leading to an increase in aggregate demand. This leads to economic
growth and lower unemployment
→ Exchange rates a current account surplus implies greater demand for domestic currency
(appreciation), meaning exports become expensive (less attractive) and imports cheaper
(more attractive domestically). This can make the economy less attractive for FDI
→ Inflation a persistent current account surplus means net exports increase which will cause
aggregate demand to rise, leading to demand pull inflation. But as imports become
cheaper, there may be fall in the cost of production for firms that rely on import of raw
materials
→ Employment export-led growth enjoyed by an economy with a persistent current account
surplus may also lead to reduction in unemployment. Structural unemployment may fall as
geographical mobility of labor will take place towards such economies
→ Export competitiveness higher demand for exports and higher exchange rate can lead to
higher export prices. A persistent current account surplus can diminish the international
competitiveness of the country over time
A trade weighted index is used to measure the effective value of an exchange rate against a
basket of currencies e.g. in calculating the trade weighted index of the Pound Sterling, the most
important exchange rate would be with the Euro. If the UK exports 60% of total exports to the
EU, the value of £ to Euro would account for 60% of the trade weighted index. A trade weighted
index is useful for measuring the overall performance of a currency.
Example: Australia trades with only two countries, Nigeria and Malaysia. 80% of Australia’s is
with Nigeria while 20% is with Malaysia. The original trade weighted index is 100.
The value of the Australia’s currency against the Nigerian Naira rises by 10% while it rises by
50% against the Malaysian Ringgit.
→ Calculate the new value of Australia’s trade weighted index.
Trade weighted index = (110 x 80) + (150 x 20) / 100 = 118
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Indicators of living standards
Genuine progress indicator (GPI) is a measure of living standards which takes into account a
variety of indicators including income, leisure time, distribution of income and environmental
standards.
→ GDP is adjusted for income distribution. As the poor receive more benefit from a rise in
income than the rich, the GPI rises when the poor receive a higher proportion of income
and it falls when income becomes more unevenly distributed.
→ Deductions and additions are made based on factors that influence standards of living.
→ The items deducted are costs of crime, traffic accidents, carbon dioxide emissions,
depletion of non-renewable resources and the loss of wetlands and forests.
→ Items which are added include the value of housework, volunteer work and increases in
leisure time.
Single indicators of economic development
→ GDP/GNI per capita means expressing the real GDP/GNI of a nation in terms of its
population size to determine the value of national income per person. Purchasing power
parity refers to the exchange rate that enables residents to purchase a common basket of
goods and services in different countries
→ Health indicators are indicators of measuring economic development by using healthrelated determinants of the quality of life e.g. life expectancy, under-five mortality rate,
and expenditure on healthcare as percentage of GDP
→ Education indicators are indicators that use education-related determinants of the quality
of life e.g. literacy rates and the mean years of schooling
Real GDP per capita as an indicator of living standards
→ An increase in real GDP per head means that living standards have risen, but the extra
income may be unevenly spread.
→ Higher output will obviously mean that more goods and services are being produced, but
not all of these may add to people’s living standards e.g. an increase in the consumption
of tobacco may reduce the quality of people’s lives.
→ Increases in real GDP per head figures may not include economic activity in black markets.
Furthermore, if working conditions deteriorate or pollution increases, people may not feel
better off.
→ Another problem is that comparing different countries’ real GDP per head is difficult as
each country measures its output in their own currency. There is a risk that if an unadjusted
currency is used, the comparison may be distorted. This is because the value of a currency
can change e.g. if the real GDP of Kenya was KSh1200bn and the exchange rate was
initially $1 = 100 Kenyan Shillings (KSh), the GDP of Kenya would be valued at $12bn. If
the exchange rate changed to $1 = KSh80 the next day, the value of its output in dollars
would change to $15bn, despite the fact that in that period Kenya would not have
increased its output by 25%.
Composite indicators of economic development
The human development index HDI is a measure of economic development comprising real
income, life expectancy and educational attainment
→ Healthcare measure life expectancy at birth. The greater the healthcare in a nation, the
greater the social and economic well-being tends to be for its citizens
→ Education indicates the mean years of schooling and expected years of schooling in a
country
→ Income levels measure national income of a country i.e. real GNI per capita at PPP
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The value of HDI ranges between 0 and 1. The greater the value, the greater the human
development e.g. Norway has an HDI of 0.953 while Pakistan has an HDI value of 0.557.
However, HDI ignores factors such as gender inequality, income distribution, environmental issues
and sustainable development.
Measure of economic welfare (MEW) is a measure of economic development that considers not
only the real GDP per capita, but also other factors that affect the quality of life e.g. crime rate,
population, inflation, value of leisure time enjoyed by citizens, economic output of the informal
sector, and environmental damage caused by industrial production and consumption.
Multidimensional poverty index MPI is a composite measure of deprivation in terms of the
proportion of households that lack the requirements for a reasonable standard of living. It
measures indicators of living standards (cooking fuel, sanitation, safe drinking water, floor space
and assets), education (years of schooling and school attendance) and health (child mortality and
nourishment). The six indicators of living standards are given a total weighting of 33% and
similarly the two indicators of health also have a weighting of 33%. A household is considered to
be multidimensionally poor if they are deprived in at least 33% of the weighted indicators. This
means that a family would be regarded as poor if it has lost a child and has another who is not
attending school.
Gender inequality index (GII) measures development by calculating gender disparities through
three dimensions i.e. reproductive health, empowerment and labor market participation.
Kuznets curve shows the relationship between economic growth and income inequality. It suggests
that as an economy develops, income becomes more unevenly distributed, and after a certain
income level is reached, income becomes more evenly distributed as shown in the figure. The
thinking behind this initial rise in income inequality is that as an economy develops there will be a
movement of labour from low-paid and low-skilled agricultural jobs to higher paid and more
skilled manufacturing jobs. This suggested trend, however, is not being followed in all developing
economies. The curve also does not explain the rise in income inequality in some developed
economies such as the UK.
The inequality human development index IHDI is a measure of the average level of human
development by accounting for inequalities in societies
→ The difference between HDI and IHDI is the social and economic cost of inequality
→ IHDI value is likely to be below the HDI value as inequalities rise
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Strengths and limitations of approaches to measuring economic development
Advantages
→ These measures can be used for comparisons between countries
→ Such indictors can be used to measures changes in development within a country over time
Disadvantages
→ Measuring economic well-being is a complex process that changes over time
→ Some indicators only portray a particular strength of a country but not necessarily the full
picture
→ Most indicators use qualitative factors
→ Political and social conflicts, corruption, and external shocks make it challenging to access
data
Phillips curve shows the inverse relationship between unemployment rate and inflation rate.
Short-run Phillips curve assume a fixed SRAS curve, and imagine a succession of aggregate
demand increases. As aggregate demand shifts from AD1 to AD2, the price level rises from Pl1 to
Pl2, the level of real GDP increases from Y1 to Y2, and the level of unemployment
correspondingly falls. The same process is repeated as aggregate demand increases from AD2 to
AD3, and then to AD4, and so on. With every increase in aggregate demand, we have an
increase in the price level and a fall in unemployment. It follows that we can simply think of each
point on the Phillips curve (such as a, b, c or d) as corresponding to the point of intersection of
SRAS with a different AD curve (a, b, c or d). The ‘choice’ of where to be on the Phillips curve in
part (a) thus corresponds to a ‘choice’ of AD curve in part (b) of the fig.
The impacts of these events on the Phillips curve and on the SRAS curve are shown in fig a and b.
In part b, as the supply shocks cause the SRAS curve to shift leftward from SRAS1 to SRAS2 and
then to SRAS3, the result is higher price levels (from Pl1 to Pl2 and Pl3) and lower levels of GDP
(from Y1 to Y2 and Y3), signifying increases in unemployment. In other words, decreases in SRAS
result in higher price levels and higher unemployment. This phenomenon is inconsistent with the
logic of the Phillips curve, and was interpreted to involve outward shifts in the Phillips curve, which
until then was thought to be stable and constant. The outward Phillips curve shifts appear in part
a, indicating that higher rates of inflation are associated with higher rates of unemployment; the
moves from point a to b and c in part a correspond to points a, b and c in part b.
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Long run Phillips curve in the long-run, Phillips curve is vertical at the level of ‘full employment’.
Consider fig. and suppose the economy is initially at point a in both parts. In part b, point a
indicates the economy is at a point of long-run equilibrium on AD1, SRAS1 and the LRAS curve,
with real GDP equal to potential GDP shown by Yp. At Yp, unemployment is equal to the natural
rate of unemployment, which we assume to be 5%. In part a, point a indicates that the economy is
on a short-run Phillips curve, SRPC1, where it is experiencing a rate of inflation of 5% and
unemployment of 5%, or the natural rate of unemployment. Suppose there occurs an increase in
aggregate demand, so that the AD curve in part b shifts from AD1 to AD2. In the short run the
economy moves to point b on the SRAS1 curve, corresponding to a higher price level, Pl2,
increased real GDP, Yinfl, and lower unemployment. This corresponds to point b on the SRPC1 in
part a, where there is a higher inflation rate of 7% and lower unemployment at 3%.
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The economy moved to point b in the short run, because in the short run wages are constant; with
the price level increasing, firm profitability increases, output increases and unemployment falls.
But in the long run, point b cannot be a point of equilibrium, because wages will rise to meet the
increases in the price level, causing the SRAS curve to shift leftward from SRAS1 to SRAS2, where
it intersects AD2 at a point on the LRAS curve, or point c. Point c in part b is associated with a
higher price level Pl3, but real GDP has fallen back to Yp, and the rate of unemployment has
returned to the natural rate. In part a, these changes mean the economy has moved to point c,
where the short-run Phillips curve has shifted to the right to SRPC2. At point c, there is a higher
rate of inflation, now standing at 9%, and unemployment has climbed back up to 5%, or the
natural rate.
The vertical line connecting a and c is the long-run Phillips curve (LRPC), situated at the natural
rate of unemployment.
Measuring inequality of income
The lorenz curve is a representation of the income distribution in a country, based on the income
or wealth accounted for by each quintile of the population. It plots the cumulative percentages of
a nation’s income across cumulative percentage of a nation’s population. The line of equality is a
45-degree line representing perfect equality in income distribution. The fig. shows Lorenz curves
of Bolivia and Belarus. In case of Bolivia, the poorest 20% of the population receives 2.7% of
income, shown by point ‘a’. Point ‘b’ on Bolivia’s curve is obtained by adding the 2.7% of income
of the poorest quintile to the 6.5% of income received by the second quintile, giving 9.2%, or the
cumulative income of the bottom 40% of population. Similarly other points can be plotted, giving
Bolivia’s Lorenz curve.
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The distance between the line of equality and the Lorenz curve shows the inequality in the
distribution of income of Bolivia. As seen in fig. the Lorenz curve for Belarus is closer to the line of
equality, meaning there is lesser inequality in the distribution of income as compared to Bolivia.
Gini coefficient it is a measure of the degree of inequality in income in a country.
Gini coefficient = area of A
area of A + B
→ If the income distribution is equal, this coefficient will have a value of 0.
→ If all income accrues to just one person, then the Gini coefficient is 1.
→ A Gini coefficient of 0.3 therefore indicates a more equal distribution of income than say
a coefficient of 0.5. Economist commonly refer to the Gini index (the Gini coefficient
multiplied by 100).
Gross domestic product GDP is a measure of national economic performance and looks at the
total output by the factors of production in a country.
Nominal and real GDP nominal GDP is a measure of all goods and service produced within an
economy over a period of time at current prices while real GDP is a measure of all goods and
service produced within an economy at base year prices.
Gross national income GNI
GNP = GDP + Net property income from abroad
Net property income from abroad is the income which the country’s residents earn on their
physical assets owned abroad and foreign financial assets (such as shares and bank loans) minus
the return on assets held in the country, but owned by foreigners. So, GNP gives a measure of the
income of the country’s residents.
Net national product (NNP)
NNP = GNP – capital consumption
Capital consumption is the depreciation (fall in value) on capital goods in an economy which
occurs due to machines wearing out, breaking down or becoming obsolete due to advances in
technology.
Capital consumption can also be called as depreciation or replacement investment as it covers
investment undertaken to replace worn out and out of date capital. So gross measures include all
investments whilst net measures only include investment which adds to capital stock.
Economic development is an increase in living standards — this could relate to income per head,
levels of education, healthcare, access to housing etc. It is measured in many ways.
Shadow economy it represents the informal (black markets) sector where the output of goods
and services is not included in official national income figures. The size of the hidden economy
varies between economies and is influenced by the marginal rates of taxation, penalties imposed
on tax evasion etc.
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Purchasing power parity it is the amount of a country’s currency that is needed to buy the same
quantity of local goods and services that can be bought with another currency. A PPP exchange
rate is an exchange rate between currencies that makes their buying power equal to the buying
power of US$1, and therefore equal to each other.
National debt it is the total debt a central government or the whole public sector has built up over
time, and is connected to budget deficits and budget surplus. If a government has a budget
deficit in one year it will add to the country’s national debt. In contrast, the extra revenue earned
from a budget surplus can be used to pay off part of the national debt. The national debt tends
to increase during economic downturns as this is when government expenditure tends to rise at a
more rapid rate than tax revenue.
Malthusian theory the Malthusian Trap is a theory that states, as population growth is ahead of
agricultural growth, there must be a stage at which the food supply is inadequate for feeding the
population.
→ Population and food supply Thomas Malthus theorized that populations grew in
geometric progression. A geometric progression is a sequence of numbers where each
term after the first is found by multiplying the previous one by a fixed, non-zero number
called the common ratio e.g. in the sequence 2, 10, 50, 250, 1250, the common ratio is 5.
Additionally, he stated that food production increases in arithmetic progression. An
arithmetic progression is a sequence of numbers such that the difference between the
consecutive terms is constant e.g. in the sequence 2, 5, 8, 11, 14, 17, the common
difference of 3. He derived this conclusion due to the Law of Diminishing Returns. It can be
concluded that populations will grow faster than the supply of food leading to a shortage
of food.
→ Population control Malthus argued that because there will be higher population than the
availability of food, many people will die from the shortage of food. He theorized that
this correction will take place in the form of Positive Checks (or Natural Checks) and
Preventative Checks. These checks would lead to the Malthusian catastrophe, which would
bring the population level back to a ‘sustainable level’.
→ Energy usage the idea of Malthusian Catastrophe has also been extended to energy:
since energy consumption is increasing at a faster rate than population and the majority
energy comes from non-renewable sources, it would appear to be falling into a
Malthusian Trap sooner than food production.
→ Positive checks or natural checks he believed that natural forces will correct the
imbalance between food supply and population growth in the form of natural disasters
such as floods and earthquakes and man-made actions such as wars and famines.
→ Preventative checks to correct the imbalance, Malthus also suggested using preventative
measures to control the growth of the population. These measures include family planning,
late marriages, and celibacy.
Barriers to economic growth and development
→ Rising economic income and wealth inequality can hinder development
→ Low levels of human capital including poor access to healthcare and education
→ Lack of access to international markets owing to trade protection and tough global
competition is detrimental for lesser developed countries (LDCs)
→ Capital flight is the withdrawal of money, assets or resources from a country owing to
economic and political uncertainties. This can hinder economic growth and development
→ Lack of access to infrastructure and appropriate technology e.g. telecommunication and
public utilities
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→ Dependence on primary sector production e.g. mineral extraction can hinder development
as these resources are exhaustible, so cannot be sustained in the long run
→ Economic growth and development can be hindered by the geographic location of a
country e.g. access to sea routes
→ Tropical climates are susceptible to diseases e.g. malaria which may cause deaths and
reduce labor productivity
→ High levels of debt can slow down economic growth and development
→ Activities in the informal economy are not recorded, leading to lower tax collections
→ Unequal political power and status means that millions of women, migrants and ethnic
minorities may be excluded from progress on human development, limiting their
contribution in economic activity
→ Lack of good governance including corruption may make a country unattractive for
investors, encourage informal sector activities and may increase transaction costs
→ Gender inequality limits the quantity and quality of labor resources in the production
process e.g. in some countries women are not allowed to work with men, vote or drive
→ Weak institutional framework may include poor legal systems, unfriendly corporate laws,
poor taxation structures, inability of the banking system to provide micro-credit, and
inability to protect property rights. This can limit economic growth and development
Strategies to promote economic growth and/or development
→ Import substitution is an inward-looking strategy that encourages domestic production
and the purchase of domestic output through protectionist policies e.g. tariffs. This may
help increase domestic employment and lessen the impact of fluctuations in import prices
→ Export promotion is an outward-looking trade strategy that focuses on greater
international trade. This helps domestic firms gain access to larger markets, and allows for
the transfer of skills and technology
→ Economic integration creates economic benefits for trading partners e.g. lower prices,
greater consumer choice and improved political relations along-with easier access to
international markets
→ Diversification is a strategy that involves countries broadening their supply of goods and
services in export markets. This helps overcome overspecialization in LDCs and reduce
their vulnerability to fluctuations in prices of primary sector output
→ Trade liberalization encourages free trade which lowers costs of conducting international
trade
→ Privatization improves competition leading markets efficiencies and lower prices
→ Deregulation limits the level of government intervention by lowering barriers to entry,
allowing for quicker decision making
→ Tax policies are used to redistribute income and wealth to support low-income households
→ Transfer payments are another way of to facilitate greater economic growth and
development by providing financial assistance through pensions, unemployment benefits
and child allowances
→ Minimum wage policies can be enforced by the government to help wage earners
receive a higher amount deemed to provide people with income sufficient to maintain an
acceptable living standard
→ Growth and development strategies also include provision of merit goods such as
education and health programmes to improve the human capital in the nation
→ Government spending on infrastructure such as transportation and telecommunication
networks helps to encourage inward FDI
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→ Green and clean energy sources enable a nation to provide affordable and reliable
energy in the long run, which facilitates economic sustainability and development
→ Investment in transport such as railways, roads, shipping and aviation which help lower
business costs and allow for timely delivery of goods
→ Access to clean water and sanitation help communities to live a healthy life, reducing
infectious diseases that can harm labor productivity
Foreign direct investment FDI is direct investment into production in a country by a company in
another country, either by buying a company in the target country or by expanding operations of
an existing business in that country.
Benefits of FDI
→ It helps in economic development of the country where the investment is being made,
especially in developing economies.
→ Resource transfer, in terms of capital and technical knowledge, is also a key motivator that
encourages inward FDI.
→ FDI allows the transfer of technology—particularly in the form of new varieties of capital
inputs—that cannot be achieved through financial investments or trade in goods and
services.
→ Recipients of FDI often gain employee training in the course of operating the new
businesses, which contributes to human capital development in the host country.
→ Profits generated by FDI contribute to corporate tax revenues in the host country.
Inward foreign direct investment
→ As multinational companies (MNCs) operate at a large scale, they tend to enjoy
economies of scale, which can benefit consumer in the form of lower prices
→ MNCs are keen to expand into LDCs that are well-endowed in natural resources that can
be exploited for production
→ Access to fast-growing economies e.g. Bangladesh present enormous opportunities to
MNCs to generate sales revenue
→ LDCs offer financial incentives e.g. tax rebates or cheaper rents to MNCs to incentivize
them to relocate operations
→ Inward FDI generates national income, which can help domestic growth and development
→ FDI, allows for the transfer of knowledge and technology, helping to improve
productivity of domestic firms
→ Inward FDI helps generate employment opportunities in the domestic country
World Bank is an international financial institution that provides loans to countries of the world for
capital projects.
→ Promote economic development of the world's poorer countries.
→ Assists developing countries through long-term financing of development projects.
→ Provides to the poorest developing countries whose per capita GNP is less than $865 per
year.
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International Monetary Fund IMF is an international organization that aims to promote global
economic growth and financial stability, encourage international trade, and reduce poverty by
providing financial assistance.
→ Provide a forum for cooperation on international monetary problems.
→ Facilitate the growth of international trade, thus promoting job creation, economic growth,
and poverty reduction.
→ Promote exchange rate stability and an open system of international payments.
→ Lend countries foreign exchange when needed, on a temporary basis and under
adequate safeguards, to help them address balance of payments problems.
Foreign aid is financial assistance from donor nations to LDCs for the purpose of development.
Aid is given on concessional and non-commercial terms
→ Humanitarian aid is foreign aid used to help countries to achieve development objectives
and improve standard of living. This may include grants, concession loans, project aid and
conditional aid
→ Economic aid is to LDCs with the interest to build better economic ties e.g. tied aid, which
requires the recipient country to spend the aid on buying products from the donor country
→ Political aid is given to promote specific political objectives e.g. the UK provides aid to its
former colonies seeking to maintain an influence. The US provides aid to support
capitalism in LDCs
Uses of foreign aid
→ Foreign aid can be used to increase production and productivity
→ May help to eradicate extreme poverty
→ As a form of injection into the circular flow of income, it may help reduce inequalities and
unemployment
→ It creates economic dependence on donors
→ Aid in the form of loans incurs interest payments
→ It may be insufficient to help LDCs achieve economic development
Debt relief (debt forgiveness) is the partial or total remission of foreign debt, especially owed
by low-income countries and LDCs
→ Debt rescheduling means renegotiating the length of time to repay the existing loans of
highly indebted nations
→ Internal debt is money borrowed by a country from domestic lenders e.g. commercial
banks
→ External foreign debt is money borrowed by a nation from foreign lenders e.g. foreign
commercial banks, IMF, world bank, foreign governments
Official development assistance ODA is foreign aid from donor governments, rather than NGOs
for development purposes
→ ODA can be provided bilaterally or channeled through a multilateral development
agency e.g. United Nations
Multilateral development assistance MDA is financial support delivered through international
institutions such as World Bank and the IMF
→ The world bank is an international financial institution that lends money to ELDCs for
economic development projects
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→ The IMF is an international multilateral financial institution that’s aims to promote global
monetary cooperation and facilitate economic growth and development
Institutional change
→ Improved access to banking, including microfinance and mobile banking
→ Microfinance (micro-credit) refers to small sums of borrowed funds by individuals in
ELDCs for self-employment purposes so they can generate income
→ Mobile banking is a service provided by financial institutions that allow customers to
conduct financial transactions remotely using a mobile device e.g. smartphone
→ Property rights are the entitlement to both tangible and intangible assets owned by an
individual, organization or government e.g. land rights and intellectual property rights
→ Land rights refer to the ability of individuals to obtain, use and hold land at their will
→ Increasing women empowerment helps to end social and cultural discrimination against
females, which can have a positive impact on their self-esteem and mental well-being.
→ Reducing corruption creates incentives for investors, which can lead to greater capital
formation and economic development
Potential conflicts between macroeconomic objectives
→ Low unemployment and low inflation when an economy grows rapidly people are in
employment, but it is likely that inflationary pressure will occurs. Low unemployment means
people have extra money to spend as the economy reaches full employment. This is likely
to increase aggregate demand and therefore cause demand-pull inflation. Moreover, low
unemployment may also cause cost-push inflation as full employment makes it harder to
attract skilled labor, putting upward pressures on wage rates
→ Tradeoff between unemployment and inflation the short-run Phillips curve shows a
potential trade-off between pursuing low unemployment and low inflation as economic
objectives.
→ High economic growth and low inflation economic growth is usually associated with an
increase in the level of aggregate demand. The risk associated with inflation become
higher as the economy approaches full employment level of national output. If aggregate
demand rise faster than aggregate supply, demand-pull inflation occurs as price levels of
goods and services rises. Cost-push inflation can also occur because high economic growth,
as full employment level of output makes it difficult for firms to attract skilled labor owing
to labor market rigidities, leading to wage inflation and ultimately higher price levels in
the economy
→ High economic growth and environmental sustainability economic growth is also
associated with issues regarding environmental sustainability. As the economy grows,
increased levels of production and consumption can create negative externalities that
cause environmental problems e.g. pollution, land erosion and loss of the eco-system. This
can damage the well-being of individuals and societies long-run standard of living.
However, environmentally sustainable methods of production e.g. use of green technology
and renewable energy sources may benefit the well-being of current and future
generations
→ High economic growth and equality in income distribution rapid economic growth
creates greater disparities in income and wealth distribution within the economy as
everyone may not experience the same benefits. Higher income groups tend to save a
greater proportion of the increased income while low-income groups tend to spend more
on meeting basic needs. The world’s richest had a combined wealth of $743 billion in
2019, an increase of 74% in just two years. By contrast, during the same period, the US
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economy grew by 7.5% while the EU grew by 6.4%. In 2020, the combined wealth of the
top 10 richest people exceeded the nominal GDP of Singapore, Turkey, South Africa, and
Switzerland.
Government failure a situation where government intervention to correct market failure causes
further inefficiencies, there are three main reasons why government failure may occur.
→ Imperfect information it is often very difficult to give an accurate figure for the value of
a negative externality such as pollution. It is difficult both to put an accurate figure to all
of the external costs imposed and to trace the source of the pollution itself. There is a lack
of information about the level of consumer demand for a product. If the government is
providing a product free of charge to the consumer, then some estimation of the level of
consumer demand is required. This could be the case with a public good.
→ Undesirable incentives the imposition of taxes can distort incentives. High marginal rates
of taxation can create disincentives for people to work harder and gain more income. If
this happens, then scarce resources are not being used to their best effect and there is
inefficiency. Politicians are often seen as being motivated principally by the desire to
remain in government. If this is so, then economic policies may be designed by
governments to try to retain power rather than to try to ensure maximum efficiency in the
economy. Those running public services may have inappropriate incentives. Once products
are provided by the government, then the profit motive of the private sector is largely
removed.
→ Policy conflict Government intervention in the running of the economy is often justified by
the need to reduce inequality. However, it is possible that government intervention might
sometimes increase existing inequality. This is simply understood by recognizing that the
imposition of any tax will have a distributional effect. Thus, a tax on energy use that aims
to reduce harmful emissions of greenhouse gases will have different effects on different
groups of people. If the tax is on the use of domestic fuel, then older members of society
may bear the greatest effect as they use proportionately more domestic fuel for heating
than others in society. This could be seen as unfair and increasing inequality in society.
Moreover, subsidies might enhance competitiveness of manufacturing industries and keep
workers in jobs but they are completely inconsistent with the need for more sustainable
development policies.
The Laffer curve theory was developed by supply-side economist Arthur Laffer to show the
relationship between tax rates and the amount of tax revenue collected by governments. The
curve is used to illustrate Laffer’s main premise that the more an activity — such as production —
is taxed, the less of it is generated. Likewise, the less an activity is taxed, the more of it is
generated. The Laffer curve may be considered to be linked to government failure as it provides
an economic justification for the politically popular policy of cutting tax rates.
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It starts from the premise that if tax rates are 0% – then the government gets zero revenue and if
tax rates are 100% – then the government would also get zero revenue – because there is no
point in working. If tax rates are very high, and then they are cut, it can create an incentive for
business to expand and people to work longer. This boost to economic growth will lead to higher
tax revenues – higher income tax, corporation tax and VAT. However, economists disagree on the
level at which higher tax rates actually cause disincentives to work.
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