IB HL Economics – Core Notes
1.
2.
3.
4.
5.
6.
7.
Introduction to Economics (Chapter 1) ...........................................................................................................................................7
1.1.
Factors of Production ..........................................................................................................................................................................................................................................................7
1.2.
Production Possibilities Curve (PPE)...........................................................................................................................................................................................................................7
1.3.
PPC and Economics Concepts ........................................................................................................................................................................................................................................7
1.4.
Why isn’t the PPC Straight Line? ..................................................................................................................................................................................................................................7
1.5.
Circular Flow of Income Model..................................................................................................................................................................................................................................... 8
1.6.
Rationing Systems ............................................................................................................................................................................................................................................................... 9
The Evolution of Economic Thinking – Introduction (Chapter 2) .................................................................................... 9
2.1.
Classical Economics – 18th Century............................................................................................................................................................................................................................ 9
2.2.
Development of Classical Economics in the 19th Century ...............................................................................................................................................................................10
2.3.
Neoclassical School of Economics................................................................................................................................................................................................................................10
2.4.
Keynesian Macroeconomics ............................................................................................................................................................................................................................................10
2.5.
Monetarism (New Classical Economics) ................................................................................................................................................................................................................... 11
2.6.
Economics and the 21st Century – Behavioural Economics ............................................................................................................................................................................. 11
2.7.
Circular Economy ............................................................................................................................................................................................................................................................... 12
Demand – Microeconomics (Chapter 3)........................................................................................................................................... 12
3.1.
The Law of Demand ........................................................................................................................................................................................................................................................... 12
3.2.
The Determinants of Demand – Ceteris Paribus.................................................................................................................................................................................................. 12
3.3.
..................................................................................................................................................................................................................................................................................................... 12
3.4.
The Distinction Between Movement Along Demand Curve & Shift of Demand Curve .................................................................................................................... 13
3.5.
Relationship between Individual Consumer Demand and Market Demand ........................................................................................................................................... 13
3.6.
Explaining the Law of Demand ..................................................................................................................................................................................................................................... 13
3.7.
How can the ‘Dual System Model’ Explain how Humans actually Act? .....................................................................................................................................................14
3.8.
Cognitive Biases and Decision–making ....................................................................................................................................................................................................................14
3.9.
How can Behavioural Economics help consumers make better Choices? ..................................................................................................................................................14
3.10.
Nudge Theory and making Better Decisions .......................................................................................................................................................................................................... 15
Elasticity of Demand – Microeconomics (Chapter 4) .............................................................................................................. 15
4.1.
Price Elasticity of Demand .............................................................................................................................................................................................................................................. 15
4.2.
Determinants of Price Elasticity of Demand ..........................................................................................................................................................................................................16
4.3.
Importance of Understanding Price Elasticity of Demand ..............................................................................................................................................................................16
4.4.
Income Elasticity of Demand [YED] ...........................................................................................................................................................................................................................16
4.5.
Importance of Knowledge of YED............................................................................................................................................................................................................................... 17
Supply – Microeconomics (Chapter 5) ............................................................................................................................................. 17
5.1.
The Law of Supply .............................................................................................................................................................................................................................................................. 17
5.2.
Non–price Determinants of Supply ............................................................................................................................................................................................................................ 17
5.3.
Individual Producers’ Supply and Market Supply ................................................................................................................................................................................................18
5.4.
Explaining the Law of Supply ........................................................................................................................................................................................................................................18
Price Elasticity of Supply – Microeconomics (Chapter 6) .................................................................................................... 19
6.1.
Determinants of Price Elasticity of Supply............................................................................................................................................................................................................. 20
6.2.
Differences between PES for Primary Commodities and Manufactured Products .............................................................................................................................. 20
Market Equilibrium, Price Mechanism & Market Efficiency – Microeconomics (Chapter 7) .............................. 20
7.1.
The System of Equilibrium and Changes to Supply & Demand .................................................................................................................................................................... 21
7.2.
Price Mechanism & its Determinants ........................................................................................................................................................................................................................ 21
1
8.
9.
7.3.
Market Efficiency ................................................................................................................................................................................................................................................................ 21
7.4.
Community Surplus & Efficiency ................................................................................................................................................................................................................................ 21
Methods of Government Intervention in Markets – Microeconomics (Chapter 8) ..................................................22
8.1.
Effect of Indirect Taxes on Supply & Demand ......................................................................................................................................................................................................22
8.2.
The Case of PED being higher than PES ..................................................................................................................................................................................................................22
8.3.
The Case of PES being higher than PED ..................................................................................................................................................................................................................22
8.4.
Effects of indirect Taxes on Producers and Consumers.....................................................................................................................................................................................23
8.5.
Effect of a Producer Subsidy on Supply & Demand ............................................................................................................................................................................................23
8.6.
Impact of Subsidies on Normal Supply & Demand Curve ...............................................................................................................................................................................23
8.7.
Price Ceilings [Max] and Their Effects on Markets ............................................................................................................................................................................................ 24
8.8.
Price Floors [Min] and Their Effects on Markets................................................................................................................................................................................................. 24
Market Failure – Microeconomics (Chapter 9).......................................................................................................................... 25
9.1.
Positive Externalities of Consumption ......................................................................................................................................................................................................................25
9.2.
Achieving Potential Welfare Gain for Positive Externalities of Consumption.......................................................................................................................................25
9.3.
Positive Externalities of Production .......................................................................................................................................................................................................................... 26
9.4.
Achieving Potential Welfare Gain for Positive Externalities of Production ........................................................................................................................................... 26
9.5.
Negative Externalities of Consumption ................................................................................................................................................................................................................... 26
9.6.
Reduction in Negative Externalities of Consumption ...................................................................................................................................................................................... 26
9.7.
Common Pool Resources ................................................................................................................................................................................................................................................ 27
9.8.
Tradable Permits in Reducing Negative Externalities of Production ........................................................................................................................................................ 27
9.9.
Legislation and Regulations in Reducing Negative Externalities of Production................................................................................................................................... 27
9.10.
Why is a Lack of Public Goods a Market Failure? ............................................................................................................................................................................................... 28
9.11.
Why is Asymmetric Information a Market Failure?........................................................................................................................................................................................... 28
10. Rational Producer Behaviour – Microeconomics (Chapter 10) ........................................................................................ 28
10.1.
Classifying Cost .................................................................................................................................................................................................................................................................. 28
10.2.
Measuring Costs in the Short Run ............................................................................................................................................................................................................................. 28
10.3.
Measuring Revenue ........................................................................................................................................................................................................................................................... 29
10.4.
Impact of Increasing Output on Revenue............................................................................................................................................................................................................... 29
10.5.
Measuring Profit ................................................................................................................................................................................................................................................................. 30
10.6.
Maximizing Profit .............................................................................................................................................................................................................................................................. 30
10.7.
Profit Maximization for a Normal Demand Curve ............................................................................................................................................................................................. 30
11. Market Power: Perfect Competition and Monopolistic Competition – Microeconomics (Chapter 11) ............ 31
11.1.
Perfect Competition .......................................................................................................................................................................................................................................................... 31
11.2.
Market Power in Perfect Competition ...................................................................................................................................................................................................................... 31
11.3.
Maximizing Profits in the Short Run ......................................................................................................................................................................................................................... 31
11.4.
Profit Situations in the Long Run in Perfect Competition .............................................................................................................................................................................32
11.5.
Long–Run Equilibrium in Perfect Competition ...................................................................................................................................................................................................32
11.6.
Firms’ Efficiency in Perfect Competition .................................................................................................................................................................................................................32
11.7.
Market Failure in Perfect Competition ....................................................................................................................................................................................................................33
11.8.
Imperfect Competition.....................................................................................................................................................................................................................................................33
11.9.
Monopolistic Competition .............................................................................................................................................................................................................................................33
11.10. Maximizing Profits for Monopolistic Competitive Markets ...........................................................................................................................................................................33
11.11. What happens to Short–Run Profits/Losses in the Long–Run? ................................................................................................................................................................... 34
11.12. Efficiency in Monopolistic Competition ................................................................................................................................................................................................................. 34
11.13. Need for Rectification of Market Failure................................................................................................................................................................................................................ 34
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12. Market Power: Monopoly and Oligopoly – Microeconomics (Chapter 12) ................................................................... 34
12.1.
How can Monopolies Maintain their Market Power?........................................................................................................................................................................................ 34
12.2.
The Scale of Monopolistic Market Power ................................................................................................................................................................................................................35
12.3.
Monopolies and Profit Situations ................................................................................................................................................................................................................................35
12.4.
Efficiency of Monopolies ................................................................................................................................................................................................................................................ 36
12.5.
Monopolies and Market Failures................................................................................................................................................................................................................................. 36
12.6.
Oligopolies – What are their Assumptions? .......................................................................................................................................................................................................... 36
12.7.
Collusive vs. Non–Collusive Oligopoly .....................................................................................................................................................................................................................37
12.8.
Competition in Oligopolies............................................................................................................................................................................................................................................37
12.9.
Oligopolies & Market Failure ....................................................................................................................................................................................................................................... 38
12.10. Government Intervention in Oligopolies ................................................................................................................................................................................................................ 38
13. The level of Overall Economic Activity – Macroeconomics (Chapter 13) .................................................................. 38
13.1.
Measuring National Income .......................................................................................................................................................................................................................................... 38
13.2.
Gross National Product vs. Gross National Income ........................................................................................................................................................................................... 39
13.3.
Difference between Nominal/Real GDP, Nominal/Real GNI ....................................................................................................................................................................... 39
13.4.
Why Gather National Statistics? ................................................................................................................................................................................................................................. 39
13.5.
Limitations of National Statistics ............................................................................................................................................................................................................................... 39
13.6.
The Business Cycle ............................................................................................................................................................................................................................................................ 40
13.7.
Other Measurements of Economic Well–being.................................................................................................................................................................................................... 40
14. Aggregate Demand – Macroeconomics (Chapter 14) ............................................................................................................... 40
14.1.
Components of Aggregate Demand............................................................................................................................................................................................................................41
14.2.
The Aggregate Demand Curve......................................................................................................................................................................................................................................41
14.3.
Changes to Consumption & Impact on Aggregate Demand ...........................................................................................................................................................................41
14.4.
Changes to Investment .................................................................................................................................................................................................................................................... 42
14.5.
Changes in Government Spending............................................................................................................................................................................................................................. 42
14.6.
Causes of Changes in Net Exports.............................................................................................................................................................................................................................. 42
15. Aggregate Supply – Macroeconomics (Chapter 15).................................................................................................................. 43
15.1.
Short–run Aggregate Supply......................................................................................................................................................................................................................................... 43
15.2.
Long–run Aggregate Supply.......................................................................................................................................................................................................................................... 43
15.3.
The Neoclassical LRAS ................................................................................................................................................................................................................................................... 44
15.4.
Keynesian AS ....................................................................................................................................................................................................................................................................... 44
15.5.
Shifting the LRAS and AS Curves ............................................................................................................................................................................................................................. 44
16. Macroeconomic Equilibrium – Macroeconomics (Chapter 16) ........................................................................................... 44
16.1.
Short and Long Run Equilibrium ............................................................................................................................................................................................................................... 44
17. Demand Management – Demand–side Policies – Macroeconomics (Chapter 17) ..........................................................45
17.1.
Fiscal Policy .......................................................................................................................................................................................................................................................................... 46
17.2.
Effectiveness of Fiscal Policy ......................................................................................................................................................................................................................................... 46
17.3.
Sustainable Amounts of National Debt ................................................................................................................................................................................................................... 47
17.4.
The Multiplier Effect ........................................................................................................................................................................................................................................................ 47
17.5.
Monetary Policy .................................................................................................................................................................................................................................................................. 48
17.6.
Expansionary Monetary Policy ..................................................................................................................................................................................................................................... 48
17.7.
Commercial Banks and Supply of Money ............................................................................................................................................................................................................... 48
17.8.
Government Control over Money Supply............................................................................................................................................................................................................... 49
17.9.
Equilibrium Nominal Interest Rate ........................................................................................................................................................................................................................... 50
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18. Supply–side Policies – Macroeconomics (Chapter 18) ............................................................................................................ 50
18.1.
Market–Based Supply–side Policies........................................................................................................................................................................................................................... 50
18.2.
Limitations of Market–based Supply–side Policies ............................................................................................................................................................................................. 51
18.3.
Interventionist Supply–side Policies .......................................................................................................................................................................................................................... 51
18.4.
Limitations of Interventionist Supply–side Policies ........................................................................................................................................................................................... 51
18.5.
Connecting Supply and Demand–side Policies ..................................................................................................................................................................................................... 51
19. Macroeconomic Objectives: Low Unemployment – Macroeconomics (Chapter 19) .................................................... 52
19.1.
Hidden Unemployment....................................................................................................................................................................................................................................................52
19.2.
Limitations of Unemployment Rate due to Distribution of Unemployment ..........................................................................................................................................52
19.3.
Costs of Unemployment ..................................................................................................................................................................................................................................................52
19.4.
Factors Affecting Level of Unemployment ..............................................................................................................................................................................................................53
19.5.
The Labour Market ............................................................................................................................................................................................................................................................53
19.6.
Causes of Unemployment ................................................................................................................................................................................................................................................53
19.7.
Cyclical Unemployment ...................................................................................................................................................................................................................................................53
19.8.
Structural Unemployment ............................................................................................................................................................................................................................................. 54
19.9.
Frictional Unemployment ...............................................................................................................................................................................................................................................55
19.10. Seasonal Unemployment ..................................................................................................................................................................................................................................................55
19.11. Natural Rate of Unemployment ...................................................................................................................................................................................................................................55
19.12. Are Demand–side or Supply–side Policies more Effective at reducing Unemployment? ..................................................................................................................55
19.13. Crowding Out ......................................................................................................................................................................................................................................................................55
20. Macroeconomic Objectives: Low and Stable Inflation – Macroeconomics (Chapter 20) ..................................... 56
20.1.
Who are the Winners during Inflation? ................................................................................................................................................................................................................... 56
20.2.
Who are the Losers during Inflation? ........................................................................................................................................................................................................................ 56
20.3.
Measuring Inflation ........................................................................................................................................................................................................................................................... 56
20.4.
Causes of Inflation ............................................................................................................................................................................................................................................................. 57
20.5.
Combining Demand–pull & Cost–push .................................................................................................................................................................................................................. 57
20.6. Deflation................................................................................................................................................................................................................................................................................. 58
20.7.
Is there a Trade–0ff Between Inflation and Unemployment? ........................................................................................................................................................................ 58
20.8. Long–run Philips Curve .................................................................................................................................................................................................................................................. 58
21. Macroeconomic Objectives: Economic Growth – Macroeconomics (Chapter 21) ...................................................... 59
21.1.
Measuring Economic Growth ....................................................................................................................................................................................................................................... 59
21.2.
Consequences of Economic Growth .......................................................................................................................................................................................................................... 59
22. Economics of Inequality and Poverty – Macroeconomics (Chapter 22)......................................................................... 60
22.1.
Measuring Income Inequality ....................................................................................................................................................................................................................................... 60
22.2.
Constructing a Lorenz Curve ....................................................................................................................................................................................................................................... 60
22.3.
Inequality of Wealth and Poverty ................................................................................................................................................................................................................................61
22.4.
Multidimensional Poverty Index (MPI) ....................................................................................................................................................................................................................61
22.5.
Causes of Inequality and Poverty ................................................................................................................................................................................................................................ 62
22.6.
Consequences of Inequality & Poverty ..................................................................................................................................................................................................................... 62
22.7.
Taxation in Reducing Poverty, Income and Wealth Inequality .................................................................................................................................................................... 62
22.8.
Progressive Tax.................................................................................................................................................................................................................................................................... 63
22.9.
Regressive Taxes ................................................................................................................................................................................................................................................................. 63
22.10. Transfer Payments ............................................................................................................................................................................................................................................................. 63
22.11. Investing in Human Capital .......................................................................................................................................................................................................................................... 63
22.12. Policy–driven Reduction in Discrimination .......................................................................................................................................................................................................... 63
22.13. Minimum Wages................................................................................................................................................................................................................................................................. 64
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22.14. Universal Basic Income (UBI)....................................................................................................................................................................................................................................... 64
23. Why do Countries Trade? – The Global Economy (Chapter 23) ........................................................................................ 64
23.1.
Gains from International Trade .................................................................................................................................................................................................................................. 64
23.2.
Comparative Advantage Theory ................................................................................................................................................................................................................................. 65
23.3.
Illustrating Gains from Specializations and Trad ............................................................................................................................................................................................... 65
23.4.
Gaining a Comparative Advantage ............................................................................................................................................................................................................................ 66
24. Free Trade and Protectionism – The Global Economy (Chapter 24)............................................................................... 66
24.1.
Arguments against Trade Protection ........................................................................................................................................................................................................................ 67
24.2.
Free Trade.............................................................................................................................................................................................................................................................................. 67
24.3.
Tariffs ...................................................................................................................................................................................................................................................................................... 67
24.4.
International Trade Subsidies ......................................................................................................................................................................................................................................68
24.5.
Quotas .....................................................................................................................................................................................................................................................................................68
24.6.
Administrative Barriers...................................................................................................................................................................................................................................................68
25. Economic Integration – The Global Economy (Chapter 25) ................................................................................................ 69
25.1.
Trading Blocs and their Economic Integration .................................................................................................................................................................................................... 69
25.2.
Membership of Monetary Unions ............................................................................................................................................................................................................................... 69
25.3.
Membership of Trading Blocs ...................................................................................................................................................................................................................................... 70
25.4.
Trade Creation .................................................................................................................................................................................................................................................................... 70
25.5.
Trade Diversion .................................................................................................................................................................................................................................................................. 70
25.6.
The World Trade Organization (WTO) .................................................................................................................................................................................................................. 71
25.7.
Factors limiting Effectiveness of WTO ..................................................................................................................................................................................................................... 71
26. Exchange Rates – The Global Economy (Chapter 26) ............................................................................................................. 71
26.1.
Fixed Exchange Rate System .......................................................................................................................................................................................................................................... 71
26.2.
Floating Exchange Rate System ................................................................................................................................................................................................................................... 72
26.3.
Factors Affecting Exchange Rates ...............................................................................................................................................................................................................................73
26.4.
Managed Exchange Rate System ..................................................................................................................................................................................................................................73
26.5.
Evaluation of High Exchange Rates ............................................................................................................................................................................................................................73
26.6. Evaluation of Low Exchange Rates............................................................................................................................................................................................................................. 74
26.7.
Government Intervention in Forex Markets.......................................................................................................................................................................................................... 74
27. The Balance of Payments – The Global Economy (Chapter 27) ......................................................................................... 74
27.1.
The Balance of Payments Account ............................................................................................................................................................................................................................. 74
27.2.
Elements of Current Accounts..................................................................................................................................................................................................................................... 74
27.3.
Elements of Capital Accounts ...................................................................................................................................................................................................................................... 75
27.4.
Elements of Financial Accounts .................................................................................................................................................................................................................................. 75
27.5.
Balancing Balance of Payments .................................................................................................................................................................................................................................... 75
27.6.
Relationship between Current Account and Exchange Rates ....................................................................................................................................................................... 76
27.7.
Consequences of Current Account Deficit............................................................................................................................................................................................................. 76
27.8. Consequences of Current Account Surplus ........................................................................................................................................................................................................... 77
27.9.
Rectifying Current Account Deficits ........................................................................................................................................................................................................................ 77
27.10. The Marshall–Lerner Condition ................................................................................................................................................................................................................................. 78
27.11. The J–Curve.......................................................................................................................................................................................................................................................................... 78
28. Economic and Sustainable Development – The Global Economy (Chapter 28) .......................................................... 78
28.1.
Does Economic Growth lead to Economic Development? .............................................................................................................................................................................. 78
28.2.
Sustainable Development ............................................................................................................................................................................................................................................... 79
28.3.
Sustainable Development Goals and Global Goals ............................................................................................................................................................................................. 79
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28.4. Relationship Between Sustainability and Poverty............................................................................................................................................................................................... 79
28.5.
Common Characteristics of Developing Countries ............................................................................................................................................................................................ 79
28.6. Diversity Amongst Developing Nations ..................................................................................................................................................................................................................80
29. Measuring Economic Progress – The Global Economy (Chapter 29)...............................................................................80
29.1.
Single Indicators .................................................................................................................................................................................................................................................................80
29.2.
Composite Indicators ........................................................................................................................................................................................................................................................81
29.3.
Gender Inequality Index (GII) ......................................................................................................................................................................................................................................81
29.4.
Inequality Adjusted Human Development Index (IHDI) .................................................................................................................................................................................81
29.5.
Happy Planet Index (HPI) ............................................................................................................................................................................................................................................. 82
29.6. Multidimensional Poverty Index (MPI) ................................................................................................................................................................................................................... 82
29.7.
The Inclusive Development Index .............................................................................................................................................................................................................................. 82
30. Barriers to Development – The Global Economy (Chapter 30) ......................................................................................... 82
30.1.
Economic Barriers to Development ........................................................................................................................................................................................................................... 82
30.2.
Political and Social Barriers to Development ........................................................................................................................................................................................................ 84
30.3.
Good Governance and Economic Progress ............................................................................................................................................................................................................. 84
31. Strategies to Promote Economic Growth & Development – The Global Economy (Chapter 31)........................ 85
31.1.
Trade Strategies use in Achieving Economic Growth/Development ......................................................................................................................................................... 85
31.2.
Diversification in Achieving Economic Growth/Development ....................................................................................................................................................................86
31.3.
Market-based Supply-side Policies’ Impact on Economic Growth/Development ................................................................................................................................ 87
31.4.
Foreign Direct Investment and Economic Growth/Development ............................................................................................................................................................... 87
31.5.
Social Enterprises and Economic Development ...................................................................................................................................................................................................88
31.6.
Institutional Change and Economic Growth/Development ...........................................................................................................................................................................88
31.7.
Interventionist Strategies to Promote Economic Growth/Development .................................................................................................................................................89
31.8.
Transfer Payments and Economic Development ................................................................................................................................................................................................. 90
31.9.
Minimum Wages and Economic Development..................................................................................................................................................................................................... 90
31.10. Provision of Merit Goods and Economic Growth/Development ................................................................................................................................................................. 90
31.11. Foreign Aid and Economic Growth/Development ............................................................................................................................................................................................. 90
31.12. Non-Governmental Organizations..............................................................................................................................................................................................................................91
31.13. Contribution of Multilateral Assistance to Economic Growth/Development ........................................................................................................................................91
31.14. Debt Relief and Economic Growth/Development .............................................................................................................................................................................................. 92
6
Introduction to Economics (Chapter 1)
Factors of Production
•
•
•
•
Land – resources provided by nature (also called natural capital)
Labour – human capital in the form of workforce
Capital (Physical or Intangible) – E.g buildings, factories, tools, infrastructure etc.
o Anything that is man–made and assists in production is capital
Entrepreneurship – expertise, management skills and risk–taking since risk is ever–present
Approach to Economics
•
•
Positive Economics – Empirical approach based around evidence, testing hypotheses, similar to the Scientific Method
Normative Economics – consists of economic arguments in the form of value judgements
One of the main debates in Economics today is the extent to which the government should interfere with markets.
Production Possibilities Curve (PPE)
•
•
Economic model depicting the concepts of scarcity, choice, opportunity, cost and
efficiency
Line showing the maximum combination of two types of output that can be produced
in an economy in which all resources are used efficiently and technology remains fixed
•
With the current amount of scarce resources, it can produce a limited amount of
manufactured goods and agricultural products. The PPC shows the maximum amount
of both products that can be produced, called potential output
•
PPC Makes assumptions
o Assumes Economy can only produce 2 goods
o Assumes resources and technology are fixed
o Assumes all resources are used
PPC and Economics Concepts
•
•
•
•
Scarcity – shows the limitations in production, constrained by the amount of resources available
Choice – Shows that a clear choice has to be made between the two outputs competing for resources
Opportunity Cost – By making a choice of one output you must accept the opportunity cost of the output of the
other output
Efficiency – If the economy is using all of its resources to the fullest extent and operating on the PPC, they say there
is productive efficiency.
o Point H on the graph shows inefficiency within the economy, in the form of unemployment (not using all of
their labour) and inefficient use of resources.
The move from point H closer to the PPC is known as Actual Economic Growth
Why isn’t the PPC Straight Line?
•
The graph is a concave shape due to the fact that opportunity cost increases at an unequal rate
o The increase in opportunity cost is unequal because not all of the factors of
production used to produce the other output are suitable. This disparity in the
7
•
•
•
allocation of and redistribution of factors of production increases opportunity cost as more units are
produced.
If the line were to be straight, then it would mean that resources would be allocated between different outputs
instantaneously, which in this case could be oranges and lemons, since they require the same factors of production
o This would therefore mean constant opportunity cost
In the case that there is an increase in quality of the factors of production, or improvements
to technology, then the PPC would shift outwards from PPC1 to PPC2 as such. This is called
increase in production possibilities Examples of such increases may be:
o Improvement of skilled workforce through better education
o Immigration schemes to improve quality and amount of labourers
Conversely, if the factors of production decrease then the PPC may move inwards and the
economy would experience a reduction in production possibilities.
Circular Flow of Income Model
•
•
•
There are two sectors, being the household and firms.
Households have 2 roles:
o They own all factors of production
o They purchase the nation’s output of goods/services
The households provide firms their factors of production in
exchange for: Wages, Rent, Interest, Profit
The model suggests that all income earned is spent on
domestically produced goods/services, which is untrue.
o We can expand on the model by also including 3
more sectors: The Government, the Financial Sector
and the Foreign Sector
o Consumers don’t spend all of their income on domestically–produced goods and producers don’t pass all of
their income to domestic households. The income that leaves as a result is called leakage. There are 3 types of
leakages:
Taxes
Savings – could be in the form of stocks, bank accounts or pension funds
Imports – Foreign goods are bought by both
Households and Producers
o These 3 leakages may also be responsible for introducing
income to the circular flow, and they are called injections.
There are 3 types of injections:
Government Spending – Governments spend
taxed money on utilities and other necessities.
They may even spend more money than they earn
to influence the rate of leakages and affect the
national income.
• There is a category of Government
spending called transfer payments that are
payments to individuals that are not the
result of an increase in output. Examples of this are unemployment benefits, pensions etc.
These do not counted as injections. This is the case as these payments transfer income from
one household into another, and do not relate to output.
Investment – Financial sector lends money to firms, which they may use to finance ventures or
acquire capital. The spending of money by firms on capital is called investment
Exports – Foreign households and firms buy exports, injecting money into the economy. This is
essentially a different type of output.
o Each sector has 1 leakage and 1 injection, but it shouldn’t be assumed that their injection will be equal to their
leakage. Governments spend more money than they earn through borrowing – called running a budget deficit
8
•
•
•
The amount of income flowing into the circular flow is referred to as Gross National Income (GNI).
o When National income is rising, we can say that the Economy is growing, the opposite is called recession
An economy is in equilibrium when leakages are equal to injections
o If injections rise without an increase in leakages, then the economy will grow by having a higher GNI. This is
the case since a new equilibrium will be reached.
The model also demonstrates the interdependence of the sectors.
Rationing Systems
•
•
Planned Economy/Command Economy – decisions on how to produce, what to produce and for whom to produce is
made by a central governmental authority and all resources are collectively owned. There are disadvantages to a
Planned Economy:
o Inevitable misallocation of resources because planning all aspects of economy on a micro scale is too difficult
logistically
o Resources will not be allocated efficiently because prices will be set superficially
o Few incentives and little motivation – output may be hindered
o Consumer goods may be restricted
Free Market Economy – all production are privatized, and laws of supply & demand should regulate the market such
that shortages and excess surpluses aren’t commonplace. However, there are some disadvantages to a pure Free Market
Economy:
o Demerit Goods will be overproduced as a result of excessive demand and strive towards profits
o Merit Goods may be underproduced since they’d only be provided for people who can afford them
o Resources would be used up quickly as profiteering may take priority
o There would not be social security, so the unemployed, sick and orphans would not have supporting systems
o Formation of Monopolies/Oligopolies would lead to high prices, loss of efficiency and excessive power
The Evolution of Economic Thinking – Introduction (Chapter 2)
Classical Economics – 18th Century
•
•
•
•
•
Before the rise of capitalism, the wealth of a nation was measured simply by how much gold and silver they had, and
this was called mercantilism
o Rulers aimed to accumulate wealth by acquiring more Silver and Gold, and placed high tariffs to prevent
them from leaving the Economy
Adam Smith reinvented the school of thought of Economics with the book The Wealth of Nations
o He proposed that instead of Gold and Silver, the wealth of nations is actually measured by the amount of
goods and services it produces – This is now called Gross National Product (GNP)
o He argued that priority for Governments should be to maximise outputs
o One of his greatest contributions was also identifying and explaining the benefits of Division of Labour and
Specialization
Smith introduced the theory of Labour Theory of Value, and according to this theory, the value/price of a good is the
sum of the value of the labour used to produce that good
Smith also contributed to Economics through his idea of the Invisible Hand, which suggested that firms are not
compelled by any authority to operate in a certain way, but by consumer demand.
o He also suggested that this force would lead to better products, since competition would incentivize better
production techniques
o Therefore, when producers seek to maximize profits, they also maximize consumer satisfaction
The satisfaction that consumers receive from goods/services is called utility
• When producers supply goods that give consumers the most utility, they create jobs and
wealth for the Nation as a whole
Smith argued for free trade, because in his view countries could export excess product for revenue, and for optimum
efficiency, could import products other countries produce more efficiently – this was contrary to mercantilism,
whereby countries restricted imports to protect the domestic economy
9
Development of Classical Economics in the 19th Century
•
•
•
David Ricardo expanded on International Trade and agreed with Smith on many such issues:
o He agreed countries should specialize in the production of different goods and trade freely to increase global
output
Classical Economics was later developed heavily by Jean–Baptiste’s Law of Markets, and he was influenced by the
works of Smith
o According to Say’s Law, the source of all demand in an economy is the production of goods
o Economic activity of production creates incomes equivalent to the value of the output
These incomes are then used to consume other goods and services
o By supplying goods, producers are effectively creating the purchasing power for consumers to demand other
goods – therefore, total demand in the economy comes about as a result of production
Say’s Theory is used to argue that there can’t be any overproduction of goods within the economy and that economic
growth is achieved through generating more demand for products through production
Neoclassical School of Economics
•
•
•
•
•
•
•
Neoclassical Economics brought the discipline from a subjective and qualitative study of Economies into a
quantitative one, based around mathematical models
Difference between Neoclassical and Classical economics relates to the determination of the value/price of goods
o Neoclassical Economics rejected Labour Theory of Value – Neoclassical Economics argues that the value of a
product comes from the value that consumers place on it, and the amount of utility it brings them
Neoclassical economics emphasizes demand as value of products rather than production
The work of the above economists is known as the marginal Revolution – derived from the concept of ‘marginal
decision–making’
o This practically means consumers decide whether to consume the next ‘unit’ of product depending on the
amount of utility that extra unit would bring them – producers produce that extra unit depending on its cost
Law of Marginal Utility – the more units a consumer consumes, the less utility is gained from it.
Though the Classical School of Economics considered both supply and demand, it
placed much more emphasis on the supply side since it believed in the Labour Theory
of Value – Neoclassical economics puts more emphasis on the demand side as it rejects
Labour Theory of Value
Alfred Marshall depicted the principles of Supply and Demand in a visual way, to
demonstrate how prices are determined in a market, and how changes affect it.
o Neoclassical economics assumes that consumers and producers are optimizers,
in seeking the best outcome for themselves. The assumptions made in
Neoclassical Economics are called Rational Choice Theory
Customers want the most utility
• Consumers are thought to be self–interested in getting most
utility
• It’s assumed that customers have full information about the
product and all substitutes, and that they make good
judgements in terms of the marginal utility of consuming extra units
Producers want the most profit
• Producers are assumed to be able to calculate the marginal cost of producing an extra unit of
a product
For Economics in the 20th century the general consensus was to not intervene in Economies too much, and faith in
markets reaching equilibriums, whereby resources would be used up efficiently, was high.
Keynesian Macroeconomics
•
John M Keynes was responsible for the next evolution in Economics and was the father of Macroeconomics
10
•
•
•
•
Keynes put forward the radical idea that it was the level of demand, rather than supply, that determined the level of
National Income – referred to as demand–side theory
o He also suggested that governments had a key role in managing the level of total demand (known as aggregate
demand)
Keynes, who at the time witnessed the Great Depression, and how Laissez–faire failed to eliminate mass
unemployment, argued that during the Great Depression there was insufficient demand in the economy
o Demand from consumers and businesses was not enough to buy up the total output of goods and services
being produced
Consequently, with excess supplies, workers would be laid off and since their incomes would be
eliminated, they would no longer have purchasing power to purchase any more output, lowering
aggregate demand, and also demand for labour, since the level of aggregate demand is already low,
Keynes’ theories countered Neoclassical economics in 2 ways:
o It countered the idea that markets would reach equilibrium automatically, and advocated for governments to
intervene – Keynes argued that market forces could restore the economy eventually, but that this would take
too long
o In Economics until Keynes it was widely believed that you should operate within your budget constraints,
and not spend more than you had. Keynes argued that to increase aggregate demand, governments can go
into debt and run budget deficits (spending more money than they earn in tax revenue by borrowing)
The assumption here was that when the Government and the economy performed well, they would
spend less so that this debt could be paid off
Seeing that Economies went through the entire Business cycle frequently, he proposed ‘counter–cyclical’ government
policies
o During a recession, Governments should increase aggregate demand by expansionary fiscal policy (increasing
gov spending and decreasing taxes) and expansionary monetary policy (interest rates and supply of money)
o During a booming economy, where an economy risks high inflation, Governments should decrease aggregate
demand by contractionary fiscal policy and contractionary monetary policy
Monetarism (New Classical Economics)
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•
•
•
This focuses on the amount of money in an economy as a main determinant of economic growth – Monetary factors
determine economic growth
Monetarists were most concerned with the issue of inflation in an economy, and they believed that Central Banks
should not use monetary policy to try to deliberately increase aggregate demand in the economy by increasing the
supply of money as this would lead to higher inflation
They believed that Central Banks should increase money supply, but by a strictly controlled rate with the rate of
growth of National Income
Monetarists believe that the best way to achieve economic growth is through supply-side policies instead of demandside ones, and for the Central Bank to control the growth of money supply – Expansionary policy would lead to
inflation – Monetarists view government intervention as a negative force in an economy
Monetarists (like Neoclassical economists) argue that the economy will move automatically to a level of national
income where all resources are fully employed
Utilises the theory of Rational Expectations – when governments employ expansionary policies, households and
businesses will anticipate that inflation will occur, and acting in a rational manner, will behave in a way that will
actually cause wages and prices to rise
Economics and the 21st Century – Behavioural Economics
•
Neoclassical Economics assumes that consumers behave rationally –they calculate the utility to them with relation to
the price of the product in an intelligent, logical and selfish way
o However, people usually do not behave this way – psychology often contradicts rational behaviours
This led to the rise of a new branch of Economics, called Behavioural Economics – this branch
incorporates principles of Psychology rather than the broad rationalist assumptions of Neoclassical
Economics
11
•
Richard Thaler and Cass Sunstein argue that consumers can be ‘nudged’ to make choices voluntarily that are better for
them and one which brings more utility
o This however may be problematic when a Government does not know what is best for people, and nudges
them to make the incorrect decisions or one which may simply benefit them
Circular Economy
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Linear economies create environmental issues.
o The idea is that products are manufactured, used, and then disposed of in landfills as if they were disposable
A circular economy, products are ideally designed to be durable, long–lasting and recyclable, such that old products
are not completely disposed of, but re–used
o There is a particular focus on repairing and using products for as long as possible
Demand – Microeconomics (Chapter 3)
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•
Market – environment where goods/services are exchanged for money or other items. There are a few types of
markets:
o Product Markets – Goods/Services
o Factor Markets – Where Factors of Production are exchanged
o Stock Markets
o International Financial Markets – E.g Currency Exchanges
Demand is the quantity of a good/service that consumers are willing and able to purchase at different prices in a
given time period – emphasis on ability to purchase products
The Law of Demand
•
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The Law states: “as the price of a good falls, the quantity of demanded product will usually increase,
ceteris paribus” – ceteris paribus refers to all other factors being the same, like control
variables
The graph curves because of the laws of marginal utility – customers get less utility from
repeat purchases, so prices have to be lower to entice demand (drawn straight for simplicity)
The Determinants of Demand – Ceteris Paribus
•
Income – there are 2 types of products to keep in mind when considering how income
affects the demand for a product
• Normal Goods
o Generally, for most goods, as income rises, demand for it will rise as well.
With higher incomes, more goods can be afforded, and more luxury goods
will be in demand. With rising incomes, demand for normal goods will shift
to the right. See shift to D1 from D
• Inferior Goods
o If a product is deemed to be an ‘inferior good’, then demand for it should start to
fall with rising income. Inferior goods may be products such as cheap wine or
own brand supermarket products. With better substitutes, customers should
start to acquire better products.
•
Other Price of Related Goods
• Substitutes
o If products are substitutes for each other, then a change in price of one product
will affect the demand of the other.
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•
•
•
•
In the example we see that a decrease in the price of chicken will lead to extra demand for it, and
will shift the demand curve to the left and will subsequently decrease demand
Complements
o These are products that are purchased together, such as printers and ink
cartridges. If products are complements to each other, then a change in the price
of one product will lead to change in demand for the other
See example – reduction in price of consoles will lead to increased
demand for games and the curve will shift right
• Unrelated Goods – change in price of one good will have no effect on demand of other
ones
Tastes and Preferences
• Usually, if a product is highly preferred, whether by shifts in consumer tastes or other
factors, it will generally be demanded at most price points – the curve will shift to the
right subsequently and opposite if an item falls out of ‘fashion’
Future Price Expectations
• If consumers believe that the price of a product will increase in the future, then they may demand it more of the
product now, when the price is lower. This would shift the curve to the right – e.g if more taxes are announced on
cigarettes, then demand for it will increase as people would stockpile them at a lower price
o Likewise, if they expect the price to fall, demand may fall as they would anticipate purchasing the
product at a later date – before Black Friday demand for electronics falls for this reason
Number of Consumers
• If there is an increase in the number of consumers, then the demand curve would shift to the right. Demographic
changes affect demand in numerous ways
o An ageing population may mean that increased demand is directed towards more senior–oriented
activities such as holidays and mobility products such as scooters
The Distinction Between Movement Along Demand Curve & Shift of Demand Curve
•
•
A change in price leads to changes in the demand along the curve
A change in non–price factors leads to changes in shifts in the curve to the left or right
Relationship between Individual Consumer Demand and Market Demand
•
•
It’s possible to construct demand curves for the entire market through a process of horizontal summing.
This is done through: 𝐓𝐨𝐭𝐚𝐥 𝐌𝐚𝐫𝐤𝐞𝐭 𝐃𝐞𝐦𝐚𝐧𝐝 𝐚𝐭 𝐏𝒙 = ∑ 𝐀𝐥𝐥 𝐂𝐨𝐧𝐬𝐮𝐦𝐞𝐫 𝐃𝐞𝐦𝐚𝐧𝐝 𝐚𝐭 𝐏𝒙
Explaining the Law of Demand
•
People do not have perfect information – the assumption that all economic agents have access to all the same
information at the same time – so the Law of Demand cannot apply universally
13
•
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With consumers not being able to make rational decisions often, the term bounded rationality is used to explain that
rationality is limited by the amount of information they have available
o Could also be used to describe when people do not have the cognitive ability to weigh up all of their options
Bounded selfishness – people do not always act selfishly, as the standard model assumes
Additionally, consumers often act impulsively and do not demonstrate perfect willpower, which is assumed by the
standard economic model – this is called bounded self–control
How can the ‘Dual System Model’ Explain how Humans actually Act?
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According to the model, humans have 2 different systems of thinking, with one being faster than
the other
System 1 is called the ‘automatic system’, and they are essentially decisions that are made
reflexively or subconsciously
System 2 involves ‘reflective thinking’ and involves less emotional, and more analytical type of
thinking
Neoclassical economics assumes that consumers use Reflective thinking to make all of their
financial decisions, however we often use System 1, which can result in poor decision–making
Cognitive Biases and Decision–making
•
We have cognitive biases that affect our decision–making, and these may lead to poor decisions based on harmful
presumptions. There are several different types of cognitive biases:
o Availability Bias – the availability of recent information and examples tend to over–influence people’s
decision making. People are not good at assessing probability, so events that stick out to them make a large
impact – e.g thinking smoking is fine when they see healthy old smokers
o Anchoring bias – this occurs when we are given the value of something and we anchor this value as a future
reference point – e.g when you see a discount at a supermarket and relative to the price of a quality brand
good, believe that you are getting a good deal
o Framing Bias – this is essentially how information is conveyed to us. Information may be conveyed positively
or negatively, which would then likely make the target audience believe so as well.
o Social Conformity – Bandwagon–ing and ‘going with the flow’
o Status Quo/Inertia bias – sometimes when faced with difficult choices or a very large number of choices,
consumers stick with what they know or are comfortable with
o Loss Aversion Bias – people feel that losses are more significant than gains, which may lead them to make a
poor decision on the ground that they wouldn’t be losing something, even if the potential utility would be
higher if they did – e.g BOGOF
o Hyperbolic Discounting – preference of short–term reward over a greater long–term benefit
How can Behavioural Economics help consumers make better Choices?
•
Choice Architecture – the theory that the decisions that we make are heavily influenced by the way that they are
presented to us – businesses often take advantage of this by encouraging you to buy something impulsively, even if it
by the theory of rationality it isn’t of utility
o Default Choice – pre–set option that is effectively selected if the decision–maker does nothing – e.g being
given Google to search on or getting a coffee every day
Consumers often do not have the time, cognitive ability or resources needed to research alternatives,
which may result in them always sticking with their default choice
o Choice architects can also influence consumer choice by mandated choice – effectively when people are
required by law to make a decision in advance – e.g putting a choice whether to donate organs when people
renew driving license
14
Nudge Theory and making Better Decisions
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The key to nudge theory is to maintain consumer sovereignty – consumers’ right to choose – but to encourage them to
make better, more utilitarian decisions
o Example is positioning healthy food nearer students to encourage them to pick it out
When designing positive choice architecture, architects must override certain cognitive biases and System 1 thinking
which makes poor decisions
o Though there is always the opposition that criticizes Nudge theory on the grounds that it is excessive
government intervention and that Governments do not always know what’s best for people
Elasticity of Demand – Microeconomics (Chapter 4)
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The concept of elasticity measures how much something changes when there is a change in one of the determinants. It
is the measure of responsiveness
Price Elasticity of Demand is the measure of how much the demand for a product changes when there is a change in
one of the factors that determine demand. There are 2 Elasticities of Demand:
o Price Elasticity of Demand (PED)
o Income Elasticity of Demand (YED)
Price Elasticity of Demand
•
PED is a measure of how much of a demanded product changes when there is a change in a
price of a product
PED =
•
•
% Change in Quantity of Product Demanded
% Change in Price of Product
There are 2 extrema on the PED ranges, but these are only theoretical:
o If PED = 0, then a change in the price of a product will have no effect on the
demand. With this, a product is deemed ‘perfectly inelastic’
o If PED = ∞, then the quantity demanded at a price point is infinitely big. This is
said to be ‘perfectly elastic’, and is best represented by a graph
More typical ranges of PED are as such:
o Inelastic Demand – 0 < PED < 1, if the value is between 0 and 1, and it means that a
change in price leads to a proportionally smaller change in demand. As such,
increases in price will lead to higher revenues, even if demand falls slightly:
o Elastic Demand – 1 < PED < ∞, a change in the price of the product will lead to a greater than
proportionate change in demand, so increasing the price of the good will lead to a loss in sales revenue
o Unit Elastic Demand – PED = 1, A change in the price of the product leads to a proportionate, opposite
change in the quantity demanded – e.g, if price is raised by a certain percentage, demand will fall by the same
percentage
Inelastic
Demand
Elastic
Demand
Unit
Elastic
Demand
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•
It is important to note that PED is NOT equal Across the Curve! – The curve is not straight, so the gradient differs
as you go lower on the graph
o Low priced products usually have a more price inelastic demand as changes in their prices are not as
impactful to customers as changes in price to more expensive products.
Determinants of Price Elasticity of Demand
1.
Number and Closeness to Substitutes
o This is the most important determinant of PED. The more substitutes for a product there are available, the
more elastic the demand will be. The closer the substitutes, the more elastic the demand.
o Products with few substitutes, such as oil, tend to have inelastic demand as consumers do not have other
choices
2.
The necessity of the Product and how Widely the product is Defined
o Clearly, products such as food are necessary to survive, and it is when products are needed rather than wanted,
that demand will be inelastic. However, if we go further and narrow the product group into meats, then the
demand will be more elastic since there are several substitutes for that product group
3.
Proportion of Income spent on the Good
o If the good constitutes a small part of one’s income, then its demand will be relatively inelastic as there are
few financial consequences of purchasing that good – status quo bias may explain this
4. Time Period Considered
o As the price of a product changes, it takes time for consumers to change their buying habits, and people like
to stick with what they know initially. In the short term demand for a good which has changed prices may be
inelastic, but over a period of time consumers may change their consumption habits and the demand may be
more elastic.
Importance of Understanding Price Elasticity of Demand
•
Governments must know the financial consequences of imposing taxes or other forms of add–ons, which may increase
or decrease price of goods. Too low of a demand as a result of Government action which increased prices may lead to
unemployment as the product may no longer be financially sustainable.
o Governments usually place taxes on products that have relatively inelastic demand to this effect
•
Primary Commodities refer to raw materials – these products tend to have relatively inelastic demand as they are often
necessary to their consumers and have little to no substitutes available.
Manufactured Goods tend to have elastic demand since there are more substitutes available, and they often aren’t
‘necessary’ per se.
•
Income Elasticity of Demand [YED]
•
Change of demand for a product changes when there is a change in a consumer’s income
YED =
•
•
% Change in Quantity of Product Demanded
% Change in Consumer′ s Income
The sign of YED is very important in distinguishing whether a product is a normal good or an inferior good
o Demand for a normal good rises as income rises
o Demand for an inferior good falls as income rises
For Normal Goods, the YED is Positive – if the % demanded is less than the % increase in income, then you get a YED
value 0 < YED < 1 and the product is said to be income–elastic
o If the % increase in demanded is greater than the % increase in income, then the product is said to be income–
elastic
16
•
•
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Necessity Goods are products that have low income elasticity – demand for them will not change much if income rises
– e.g demand for bread won’t increase with income as people have enough bread.
Superior Goods are products that have high income elasticity – demand for them will increase with income as they are
more desired to satisfy needs. This can only be achieved
once basic necessities are achieved.
For inferior goods the YED is Negative because demand
decreases as income increases – People stop purchasing
inferior goods and start purchasing more superior goods
Importance of Knowledge of YED
•
•
For Firms – when they plan to enter a market – if incomes in the target country increase, then firms that have
products with a YED are more inclined to enter it.
o If a country is going to enter a recession, where GNP decreases, then firms may want to consider
manufacturing more inferior goods, as demand for those goods will rise when income falls.
To explain sectoral changes
o As an economy grows, and incomes increase, demand for primary goods, such as agricultural products does
not greatly increase because they have income–inelastic demand. When incomes grow, people do not tend to
buy more agricultural goods – extra income tends to be spent on manufactured goods
Output in secondary sector will increase at a faster rate than Primary
As an economy grows further, YED can explain the growth in the Tertiary Sector – services tend to
have a high YED – this means more growth for non–essential services
Supply – Microeconomics (Chapter 5)
•
Supply – the quantity of a good/service that producers are willing and able to supply at different prices in a given
period of time. There is emphasis on the ability to produce, or called effective supply, as producers must have the
financial capabilities to supply.
The Law of Supply
•
•
•
As the price of a product rises, the quantity supplied of the product will usually increase ceteris paribus
It is important to note that there is a movement along the upwards sloping curve when prices change, but when other
determinants change, the entire curve shifts left or right
In neoclassical economics, producers are seen to be rational, so when prices rise they produce more to take advantage
of extra potential sales to increase profits
Non–price Determinants of Supply
•
Change in these factors leads to the shift of the curve left or right
•
Cost of Factors of Production
o If there is an increase in the cost of a factor of production, such as wage increases,
then costs will increase. This means that they will be able to supply less and will shift
the curve left (S→S1)
•
Price of Related Goods – Competitive & Joint Supply
o Competitive Supply – producers have a choice of what to produce
because their factors of production are able to produce more than
one product, and if prices for one type of good rises, then the
producer may opt to utilize their factors of production to produce
more of the good that has a higher price.
17
o
When one of the products is in higher demand, they are effectively competing for the factors of production
and are said to be in competitive supply.
o
Joint Supply – sometimes when one good is produced, another good is produced at the same time, perhaps as a
by–product – e.g sugar and molasses. So, naturally, when the prices of one of those goods rises, then the
supply of the by–product will increase, as they are in joint supply.
•
Government Intervention – Indirect taxes & Subsidies
o Governments often interfere in markets in a way which alters supply. The two most common ways are
through taxes and subsidies
o Indirect Taxes – taxes on goods/services that are added to the price of the product – producers are the ones
who pay this tax, which increases the cost of production. They will therefore have the effect of shifting the
curve left at every price point.
o Subsidies – payments made by Governments to firms, which reduces their cost of production temporarily.
This would shift the curve to the right as more supply can be produced.
•
Expectations about Future Prices
o If producers expect prices to increase in the future, they are more likely to increase supply to take advantage
of the potential increase in demand
•
Changes in Technology
o Improvements to the state of technology allow producers to manufacture more goods more efficiently, which
would shift the supply curve to the right – catastrophic events that hinder production would shift the curve
to the left as production possibilities are reduced.
Individual Producers’ Supply and Market Supply
•
We are able to construct a supply curve for the entire market through the process of horizontal summing
o Supply quantities are summed across a certain price point between all producers and this process is repeated
for different price points to acquire the entire curve.
Explaining the Law of Supply
•
There are a number of factors to consider when attempting to explain the Law of Supply
•
The Short Term
o Short run is defined as the period of time in which at least one factor of production is fixed – long run is
defined as the period of time in which all factors of production are variable but state of technology is fixed.
All production takes place in the short run
o Firms will not be able to increase their factors of production in the short–term quickly so the only way
supply can increase is if they can allocate more of their variable factors of production to the fixed ones.
•
The Law of Diminishing Returns
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o
o
o
If a firm increases its output in the short term by allocating more variable factors of production to fixed ones,
output from each unit added will fall. But first:
Total Product – total output of a firm using its fixed and variable factors in a given time period
Average Product – Output produced on average by each unit of the variable factor
AP =
o
In this case, V = Number of Units of Variable Factor Employed
Marginal Product – the extra output that is produced by using an extra unit of the variable factor.
MP =
o
•
Total Product
V
∆Total Product
∆V
From the above, we can deduce the following definitions:
The Hypothesis of Eventually Diminishing Marginal Returns – as extra units of a variable factor are
added to a given quantity of a fixed factor, output from each additional unit will eventually diminish
The hypothesis of Eventually Diminishing Average Returns – as extra units of a variable factor are added
to given quantity of a fixed factor, the output per unit of the variable factor will eventually diminish
Increasing Marginal Costs
o Marginal Cost – increase in total cost of producing an extra unit of output
MC =
∆Total Cost
∆ Quantity
If output produced by each additional worker (MP) begins to fall, yet each worker costs the same,
then the cost of producing an extra unit (MC) begins to increase – because of the law of diminishing
return, as output increases, marginal costs will increase as well.
Therefore, firms will only supply more and increase output if prices that they will receive for the
products also increase with output. This way they can cover their MC. This is why the supply curve
slopes upwards.
Price Elasticity of Supply – Microeconomics (Chapter 6)
•
PES is the measure of how much of the supply of a product changes when there is a change in price of the product.
PES =
•
% Change in Quantity Supplied
% Change in Price of Product
There are 2 extrema for the PES value, and unlike PED, they can indeed occur.
o If PES = 0, then a change in the price of a product will have no effect on the
quantity supplied at all – Numerator will equal zero. This is said to be perfectly
inelastic
Firms cannot respond to price changes rapidly and will continue to
product the same quantity of the good, regardless of the price. This is
when it is possible to have perfectly inelastic supply.
19
o
If PES = ∞, then supply is perfectly elastic, meaning that any change to price will reduce supply to zero. At
this point, at price point P1, there is infinite supply.
In international trade, supplies of commodities such as wheat are
assumed to be infinite as long as consumers pay the market price
•
More typical ranges of values for PES are:
o Inelastic Supply – 0 < PES < 1 – a change in price of product leads to a less than
proportionate change in supply
o Elastic Supply – 1 < PES < ∞ – a change in price leads to a more than
proportionate change in supply
o Unit Elastic Supply – PES = 1 – Change in price of product leads to a proportionate
change in quantity supplied
•
The different PES values are shown on the graph to the left.
o S1 = [PES = 1]
o S2 = [PES = 1]
o S3 = [PES < 1]
o S4 = [PES > 1]
Determinants of Price Elasticity of Supply
•
•
•
How much Production costs rise with Increasing output – producers are unlikely to increase supply if cost of
production increases significantly, even if the prices rise. It is when the price increase makes up for the extra cost that
extra supply can be produced. There are a number of factors which prevent significant rises in costs:
o Existence of Unused Capacity – if not all factors of production/resources are being used efficiently, then
firms can increase supply without much cost by increasing their resource use efficiency
o Mobility of Factors of Production – if the factors of production can be moved from one production into
another, then it will not add significant cost to increasing supply. This is likely to yield elastic supply.
Time Period Considered – generally, the longer the time period, the more elastic supply will be because initially,
firms may not be able to change their production methods/factors of production in time to respond to price changes,
however, in the longer–term, it may be more profitable to adjust supply.
Ability to store Stock – if firms are able to store high levels of stock/inventory, then reserves of products can be used,
and more can be produced as they have the ability to store the product. This will lead to price elastic supply
Differences between PES for Primary Commodities and Manufactured Products
•
•
Commodities tend to have inelastic supply as it is often difficult to adjust supplies/production methods to take
advantage of price increases – e.g, if demand for cocoa rose, then it would be difficult to increase supply of cocoa in
the short–term as it takes time to grow the cocoa.
Manufactured Products tend to have elastic supply as it is easier to adjust their supply. It is easier to resolve
bottlenecks from the determinants of PES with manufactured goods and therefore, easier to increase supply.
Market Equilibrium, Price Mechanism & Market Efficiency – Microeconomics (Chapter 7)
•
•
•
Due to the interdependence of Producers and consumers, the concepts
of supply and demand must be joined.
Market Clearing price – the price at the equilibrium point, where all of
the supply should be sold.
The system of equilibrium should be self–correcting, in that it will
return to a state of equilibrium if a factor is adjusted:
o In diagram a, producers increased prices to P1, but consumers
responded by lowering demand to quantity Q1, whereas
suppliers produced quantity Q2, leaving an excess supply of Q2 − Q1
20
o
To eliminate their surplus, producers will need to lower their prices to increase demand and this
process will continue until Quantity demanded equals quantity supplied.
In diagram b, producers attempted to lower the price to point P2, however, at that price point, suppliers have
excess demand, in which case their supply levels, quantity Q3, is insufficient. To eliminate this shortage,
producers increase their costs, and the equilibrium is eventually reached again
The System of Equilibrium and Changes to Supply & Demand
•
The supply and demand curves shift according to the behaviours they exhibit when their
determinants are changed, in which case they shift left/right
o E.g, when income increases, normal products such as holidays experience
increased demand, so the demand curve shifts right ceteris paribus.
In this case, there is insufficient supply, therefore, excess demand, so prices
have to shift to point Pe1 to reach a new equilibrium
Price Mechanism & its Determinants
•
Price has 3 significant functions in a market:
o Signal Information to Consumers & Producers – this is an important piece of knowledge, because they
trigger a behavioural response to act in a way which works in accordance with market mechanisms based on
something which each of these groups values: cost
o To ration scarce resources – resources are rationed as demand is inherently linked with supply and prices. As
a resource gets more scarce, prices increase, and the attainability of the product will decrease as a new, higher
equilibrium price point will occur.
o Give Consumers and Producers Incentives – prices affect behaviours, since demand is linked with price..
Usually, high prices mean a disincentive to consumers and vice versa.
Market Efficiency
•
•
Consumer Surplus – extra utility gained by consumers from paying a price lower than
which they were prepared to pay. This is shown below for a consumer who was willing
to pay 19$ for a product, but only had to pay the equilibrium price. This consumer
surplus is depicted by the triangle ABC
Producer Surplus – excess of actual earning that a producer makes from a given quantity
of output, over and above the amount the producer would be prepared to accept for
that output
Community Surplus & Efficiency
•
•
•
In a market equilibrium, with no external influences and no external effects, it’s said to
be socially efficient, or in a state of allocative efficiency – resources are allocated in the
most efficient way socially viewed
In terms of community utility, we can take supply as being Marginal Social Cost, and
demand as being Marginal Social Benefit.
o At the equilibrium point of these curves, consumer and producer surplus is
at the highest point possible, and when we take sum of consumer and producer
surplus, we get community surplus
This is seen to be the most efficient way of allocating resources in
this community
It’s very simple to calculate Producer and Consumer surpluses. Since it’s a triangle,
1
you simply find the area of a triangle, with the 𝑎 being opposite of the hypotenuse (𝐴𝑆𝑢𝑟𝑝𝑙𝑢𝑠 = 2 (𝑎 × 𝑏))
21
Methods of Government Intervention in Markets – Microeconomics (Chapter 8)
Effect of Indirect Taxes on Supply & Demand
•
•
•
•
•
•
Indirect taxes are imposed is to increase Governmental revenue and supplement direct tax, and also to discourage the
consumption of a certain good.
Imposing an indirect tax raises the firm’s costs and shifts the supply curve for the product
vertically upwards by the amount of the tax
o Therefore, less of the product can be supplied at every price point
There are 2 different types of taxes to consider:
o Specific Tax – fixed value of VAT – shifts supply curve upwards vertically by the
amount imposed
o Percentage Tax – tax is a percentage of the selling price, so the curve will shift upwards
by a variable rate
If the market is in Equilibrium, after a tax of X is imposed per unit, the supply curve shifts
upwards by S1 + tax. At that point, producers want to increase the price to P2 to mitigate the
cost, but we can see that there is excess supply, and a lack of demand at that price brings the
price down to a new equilibrium.
We see that Governmental tax revenue now increases to CP1 XY and the market falls from
producing Qe units to Q1 units – this may lead to more unemployment as a lower quantity of
goods would be produced – this has implications on the market
In graph c, we can see that half of the tax is paid by the consumers, and half by the producers.
Producers do not pay all of the tax. However, the share of the tax burden is usually uneven
since this supply & demand curve is unit elastic – it varies with different elasticities
The Case of PED being higher than PES
•
•
•
In the graph shown, we see that a tax is imposed and the supply curve shifts to S1 + tax and
producers want to increase prices to shift the burden onto customers, but since there is
excess supply at that price, low demand brings the price down to P e.
Producers have to bear the burden of the tax, because demand is very elastic, meaning that
they will not purchase much of the supply at that higher price. So, the producer must take
in some of the tax cost as a loss.
o Ultimately, due to the total cost of the tax, indicated by the blue areas, the producer now earns $C per unit.
The market also shrinks in size from producing Qe units to Q1. This has implications in terms of employment
The Case of PES being higher than PED
•
•
•
After raising prices to respond to taxes, a new equilibrium at Pe is established.
In this case, producers can pass on most of the financial burden from the tax, because
consumers are not very responsive to price changes, so they are able to pay more for the
good – they contribute P1Pe to the tax.
The income of the producers falls by a little bit down to $C per unit.
22
Effects of indirect Taxes on Producers and Consumers
•
•
•
If PED = PES, then the burden of any tax imposed will be shared equally between the consumers and producers
If PED > PES, then the burden of any tax imposed will be greater on the producers than the consumers
If PED < PES then the burden of any tax imposed will be greater on the consumers than the producers
•
This is why governments often place higher indirect taxes on items with a relatively low elasticity of demand, since it
will not lead to a significantly lower supply, therefore potentially higher unemployment
Effect of a Producer Subsidy on Supply & Demand
•
•
•
Subsidies – money paid by a government to a firm, per unit of output. The reasons for
governments giving subsidies may be:
o To lower the price of essential goods such as rice – Government hopes that this will
lower the products’ prices and therefore increase demand for them.
o To guarantee the supply of certain products that Government believes is essential
and to maintain employment in large sectors
o To enable producers to compete with overseas trade and protect domestic economy
If a subsidy is granted to a firm, then the supply curve for the product will shift down by the amount of the subsidy
since its costs of production will be lowered, allowing for more supply at every price point
o The amount of the subsidy which is passed onto consumers will be determined by the relative elasticities of
demand, similar to indirect taxes.
Specific Subsidies – specific amounts of subsidies given per unit, not a percentage.
Impact of Subsidies on Normal Supply & Demand Curve
•
•
•
•
•
•
After the subsidy is granted and the supply curve shifts downwards, producers lower their prices and produce more
supply until a new equilibrium, point P1 is reached.
We see that prices fall to P1, rather than the whole amount of the subsidy, which would be P2
The income of producers rises to point D from Pe and they are given amount P𝑒 DWZ as a subsidy while consumers
only pay P1
Diagram 𝑏 shows that consumers pay less, saving on expenditure P1 P𝑒 XY, however, they purchase more units, Q1, since
the prices are lower
Diagram c shows the opportunity cost to the government, since the money for the subsidy could have been used
elsewhere
There are a number of things to consider before granting a subsidy:
o Opportunity cost – what else could the government have spent the money on?
o Whether the producers feel that they will not have to compete and become more efficient due to the cash
o Subsidies may lead to overproduction and inequity as some producers will be able to charge lower prices
while others cannot afford to do so
Governmental Price Controls: How & Why?
•
The Free Market does not always lead to the best outcome for producers and consumers or for society. This often
leads to intervention by the Government in the form of price controls. They can do this in 2 ways:
23
o
o
Maximum Prices
Minimum Prices
Price Ceilings [Max] and Their Effects on Markets
•
•
•
•
This is when the Government sets a price, below the Equilibrium price, which
producers cannot go below
These are normally imposed when the product in question is a necessity or a merit
good (product which may be unprovided given the Free Market)
In the example, if a government set a Maximum price PMax, then we demand for the
product would increase significantly, which would then mean that producers would
have to produce Q2 quantities of products, but they cannot do that at this price.
Hence, we have excess demand, and the Quantity that is able to be supplied is Q1
o Excess demand may be problematic, because it may lead to black markets where these products, sometimes of
a dubious quality/safety, are sold at a higher price point, but would receive demand due to their higher
supply
The Government would then have to fix the excess demand issue. They may do one of two things:
o They could attempt to shift the demand curve to the left until Equilibrium is reached at PMax, but this would
limit the consumption of the product, which may defeat the purpose of imposing a P max
o They could try to shift the supply curve to the right to reach a new Equilibrium point with PMaxQ2. There are
a number of ways to do this:
Government could offer subsidies to firms to encourage them to produce more
Government could start to produce the product themselves to increase supply – this is known as
direct provision
If the Government had any reserves, they could release their supply of the product
Price Floors [Min] and Their Effects on Markets
•
•
•
•
•
This is where the Government sets a price below which producers cannot go. These
may be set for one of two reasons:
o To attempt to raise the income of producers for essential products such as
agricultural ones – could be due to large fluctuations in price or lots of
foreign competition
o Protect workers by setting a minimum amount which the supplier earns,
which is meant to prevent the redundancy of some who could be
terminated.
The PMin would be above the Equilibrium and would mean that prices are increased, leading to excess supply since
there is only demand for Q1 quantity of products at that price, whereas a quantity of Q2 exists. If the government does
not interfere further, then the consumption of the product will fall to Quantity Q 1.
o This is problematic, because producers will try to get around Price controls by setting the Price between P Min
and Pe
o The Government would typically respond to this situation by buying up a lot of
the supply such that the demand curve shifts to the right
Then they could sell the products abroad, destroy them or store them
There are some ways that the minimum price could be maintained:
o Producers could be limited by quotas, restricting supply such that supply doesn’t
exceed Q1
o Government could try to increase demand for the product by advertising or
restricting supply of incoming products if they are imported
If the government Guarantees the minimum price, then firms may become reluctant to be efficient and may waste
more resources and produce more products than they do not need, rather than ones they do.
Governments may also implement these price controls to restrict the consumption of some demerit goods such as
alcohol or cigarettes by making them less attainable
24
Market Failure – Microeconomics (Chapter 9)
•
•
•
•
•
•
Market failure occurs when community surplus is not achieved and in these moments, we expect the Government to
intervene by allocating resources more efficiently
Externality – this occurs when the production/consumption of a good/service has an effect on a third party
o If the effect is harmful, then it is a negative externality
o If the effect is beneficial, then it is a positive externality – this means that there are external benefits in
addition to the private benefits to consumers and producers
If there are externalities, then we have a market failure
Where there are externalities:
o Social Benefits = Private Benefit + External Benefit
o Social Costs = Private Cost + External Costs
Where there aren’t externalities:
o Social Benefits = Private Benefits
o Social Costs = Private Costs
There are 4 types of Externalities:
o Negative Externality of Consumption – use of a product causes spillover costs to third parties
o Negative Externality of Production – production causes spillover costs to third parties
o Positive Externalities of Consumption – use of a product causes spillover benefits to third parties
o Positive Externalities of Production – production causes spillover benefits to third parties
Positive Externalities of Consumption
•
•
•
•
Certain goods/services are beneficial to the consumer, but may also be beneficial to a
third party such as a society
o Consequently, the marginal social benefit is greater than the marginal private
benefit enjoyed by consumers
E.g. in a market for Healthcare, people would consume where the marginal social cost
(effectively the supply curve) meets the Marginal Private Benefit curve (effectively
demand curve) at Quantity Q1 and Price P1
o The socially optimum level is at P* and at Quantity Q*, and the welfare is in
the shaded blue area, – with the Quantity increase, there is a greater Marginal Social Benefit rather than a
Marginal Private Benefit
Hence, the market fails because the optimum has not been achieved through producing extra units to get Quantity
Q* – society would have benefitted from an increase in demand in education
o The extra welfare that could have been achieved is known as welfare loss, since it was not achieved due to the
market failure
Improvements to the factors of production will make the PPC shift outwards, increasing the economy’s production
capabilities – by this, we can see that increases to Marginal Social Benefit may improve the quality of the factors of
production, allowing the economy to grow
Achieving Potential Welfare Gain for Positive Externalities of Consumption
•
If the government wishes to increase the consumption of merit goods that create positive externalities of
consumption, then they may do the following:
o Subsidies – Supply of merit goods such as healthcare could be subsidized to
increase their consumption
This would shift the MSC curve downwards which would make it
such that the cost of healthcare would be decreased, and it be
demanded at quantity Q*, a more socially efficient quantity.
25
o
o
The shift brings the cost levels down to optimum levels, and achieves perfect social optimum levels
by offering healthcare at Price P*
Public Awareness Campaigns/Ads – people may not have correct information on the benefits of a product, or
may need to be made aware of another merit good
This would shift the Marginal Private Benefit curve to the right, towards the MSB curve, thereby
increasing social welfare
Legislation – mandating that people undertake a certain action that will increase positive externalities would
have the desired effect of increasing Marginal Private Benefit, granted that the action does not infringe on
liberties or take too much effort
Positive Externalities of Production
•
•
•
•
These are when Social costs are reduced by creating favourable effect for third parties –
this makes it such that Marginal Social Costs are lower than the Marginal Private cost
The firm has not benefited from this, and their costs stay the same.
Hence, the new socially optimum levels would now become the increased quantity Q *
at a lower price of P*
The highlighted blue area is the potential welfare gain – therefore, this is a market failure
Achieving Potential Welfare Gain for Positive Externalities of Production
•
•
Subsidies – granting firms subsidies to reduce their costs would shift the Marginal Private Cost curve downwards
towards the socially optimum levels – however, it is difficult to gauge how much each firm needs in subsidies to reach
such an optimum
Direct Provision – Government could provide merit goods themselves
Negative Externalities of Consumption
•
•
•
•
Demerit goods such as cigarettes cause harm to society as a whole, even if they are a
third party to the consumer of the good.
Here, the consumers gets their Marginal Private Benefit from the good, and due to
market forces the consumers reach a equilibrium of P1Q1, and currently, since
MPB = MSB, there is overconsumption of the good.
The difference between the potential Marginal Social Benefit loss and the actual
Marginal Private Benefit is the welfare loss
Hence, we can conclude that this particular good is overproduced by the difference
of Q* and Q1 quantities and that there is overproduction
Reduction in Negative Externalities of Consumption
•
•
Market Based Approach – Indirect taxes – a ‘sin tax’ could be imposed on demerit goods to reduce their consumption
o This would shift the Marginal Social Cost curve upwards as the price of the good must increase. Doing so
shifts the Equilibrium point towards the socially optimum quantity, being Q *, albeit, at price P 2
However, the relatively inelastic demand for many demerit goods
means that their demand can’t be reduced too significantly
Exorbitant taxes on such goods may create a black market
Legislation – changing consumer behaviour through punishments and mandating that
they act a certain way that is socially beneficial This can be done through methods
such as making it very difficult to obtain.
26
•
Education/Raising Awareness – more passive approach and relies on consumers changing their behaviours based on
rational information and lowering their demand based on non–financial reasons. However, consumer biases may
render education futile.
o Nudge Theory & Demerit Goods – These actions are a direct form of nudges, and we see examples of such in
things such as graphic images on cigarette packets to nudge consumers from consuming demerit goods, and
bringing the demand (Marginal Private Benefit) down.
Common Pool Resources
•
•
•
•
•
Common Pool resources are typically natural resources such as fishing grounds, pastures etc. They are very difficult to
restrict people from using, so they are considered to be non–excludable.
If even one person uses the resource, its value decreases, so it is rivalrous
o Since they are non–excludable and rivalrous, they inevitably degrade if not under proper management
One example is fishermen overfishing and endangering fish populations, to the point of total extermination. Such
profit seeking by producers result in large negative externalities, increasing the Marginal Social Cost
The atmosphere is threatened by industry and pollution
Controlling such damage to the environment is vital not only to the health of the planet, but also in terms of economics,
because quality factors of production, such as land and healthy workers are needed for a strong economy
Tradable Permits in Reducing Negative Externalities of Production
•
•
•
•
Tradable Permits are economic tools that are meant to reduce producers’ ability to degrade common pool resources
At its core, tradable permits are ‘licenses’ for businesses to conduct
economic/production activities in an area with a common pool resource. They
effectively set limits as to how much the business can degrade the resources
o These permits are tradable between different businesses, so there is a
whole market for these.
Carbon taxes are taxes imposed when fossil fuels are burned. This is a way for
producers to essentially ‘pay’ for the negative externalities they are responsible for
o As shown, a Carbon tax would increase the Marginal Private Costs,
thereby increasing the price of the good, ultimately bringing down the
Quantity produced down to level Q2, which is closer to the socially optimum level of Q*
The Carbon tax in this case is meant to be beneficial:
o To increase profitability and efficiency, it is expected that businesses will change their production
methods/operations and invest in cleaner technologies that emit less carbon
o At higher prices consumers are disincentivized from consuming harmful goods such as electricity, thereby
affecting consumer perceptions
o Generates governmental revenue which can be used to subsidize cleaner energy sources
Legislation and Regulations in Reducing Negative Externalities of Production
•
•
•
These are known as command and control methods, as they require direct, and forceful action rather than a market–
based approach that is seen in tradable permits
This would have the same effect on Marginal Private Costs as the Carbon tax, as the cost of production increases to
meet strict demands, thereby bringing the Marginal Private Cost closer to the socially optimum levels
However, they may have some consequences:
o It is a logistical impossibility for Governments to have enough environmental data to establish fully informed
regulations
o Micromanagement is not an option, so regulations may over–regulate, and under–regulate in some economic
sectors which were not considered
o This will raise prices and cause firms to be less competitive against foreign producers without such costs
27
o
Lobbying may prevent effective market–based legislation
Why is a Lack of Public Goods a Market Failure?
•
•
Public goods are ones which would not be provided in a Free Market as they are not worth pursuing financially.
These products have large benefits to society, so their absence is a case of Market Failure as there is significant welfare
loss without it.
Public Goods are not provided in Free Markets because they are non–rivalrous, and non–excludable
o Public Goods are often beneficial to whole communities, not single consumers, so for producers, there is a
free–rider problem where non–payers enjoy the benefits of the Public good
Why is Asymmetric Information a Market Failure?
•
•
Perfect information is needed for markets to function at maximum efficiency but most consumers have imperfect
information due to several reasons such as misinformation.
Asymmetric Information occurs when one party in the economic transaction has more, or better quality information
than the other party. There are 2 types of asymmetric information:
o Adverse Selection – When one party has better quality information than the other, resulting in economic
decisions that are not always optimal
Screening is a process through which the less informed party can acquire better information to aid in
their decision–making
o Moral Hazard – this occurs when people have an incentive to alter their behavior and take more risk when
they know that their actions’ negative consequences will be borne by others
Example of this is if an insured driver purposefully destroys their car, knowing that they will be
refunded for it
Rational Producer Behaviour – Microeconomics (Chapter 10)
•
In the Neoclassical school of thought, it is thought that Producers want to maximize their profits
Classifying Cost
•
Economic Cost – this is the opportunity cost of the firm’s production – the opportunity cost of the factors of
production. To understand this, we have to split economic cost into two categories:
o Factors purchased from others and not already owned by the firm – the opportunity cost in this case is
simply the cost of purchasing those factors of production, as other things could have been bought
Explicit Cost – any costs to the firm that involve direct payment of money
o Factors already owned by the firm – this involves the concept of implicit cost – situation in which factors of
production could have been hired out to others, or used elsewhere in the firm
Measuring Costs in the Short Run
•
Total Costs – complete costs of producing output. These are split into 3 different measures:
o Total Fixed Cost (TFC) – total cost of the fixed asset the firm used – this is a constant amount and does not
change with differing outputs
o Total Variable Cost (TVC) – TVC increases as output increases, and are direct costs associated with
production
o Total Cost (TC) – Total cost of all fixed and variable factors (TC = TVC + TFC)
•
Average Costs – these are split into 3 categories as well:
28
TFC
)
q
o
Average Fixed Cost (AFC) – fixed cost per unit of output (TC =
o
As this is constant, as outputs increase, average fixed costs fall
AVC
Average Variable Cost (AVC) – variable cost per unit (AVC = q )
o
AVC tends to fall as output increases, and then increase again. This is
explained by the hypothesis of diminishing returns – as more of the variable
factors are applied to fixed ones, costs tend to increase
ATC
Average Total Cost (ATC) – total cost per unit (ATC = q )
Initially falls with increasing output, then increase again.
•
Marginal Cost (MC) – Marginal Cost is the increase in total cost of producing an extra unit. It is calculated by:
MC =
o
∆TC
∆q
MC tends to decrease as output increases, but then increases due to the hypothesis of diminishing marginal
returns. As more of the variable factors are applied to the fixed factors, the extra output from each additional
unit of variable factor added falls, so the cost per unit increases
Measuring Revenue
•
•
Total Revenue – 𝐓𝐑 = 𝐩 × 𝐪
𝐓𝐑
𝐩×𝐪
Average Revenue – average revenue received per unit of output: 𝐀𝐑 = 𝐪 = 𝐪
•
Marginal Revenue – extra revenue gained upon sale of additional unit of output: 𝐌𝐑 =
∆𝐓𝐑
∆𝐪
Impact of Increasing Output on Revenue
•
If a firm does not have to lower prices as output increases, then it has a perfectly elastic
demand curve, but this largely happens in theory. In this case, the firm has to be small, as
they can increase their output without affecting total industry supply, therefore, price.
o Therefore, when MR = ∞, then D = AR = MR
•
Revenue when price falls with increasing output – Downwards sloping demand curve
o If a firm has control of their prices, then to increase demand they would have to
decrease those prices – this is the case with relatively elastic demand
o AR is equal to price, so as the price falls with increasing output, AR falls
o MR falls with increasing output, but at a larger rate than AR, and if the AR
curve slopes downwards, the MR curve always slopes down with a larger
gradient
MR < AR, because to sell more products, price has to be lowered, which
results in lost revenue. Hence, the marginal revenue decreases
o TR increases initially, but will eventually fall with increasing output as extra
revenue because the extra revenue gained from selling the product at a lower
price is outweighed by the revenue lost by not selling the products at a higher
price.
•
The changes in PED value on a demand curve as summarized below:
o Total Revenue is maximized when PED = 1 and MR = 0
o ∴ PED = 1 where MR = 0
o PED decreases as the price decreases on the demand curve – demand becomes less elastic with increasing
price
o To the left of the point where PED = 1, PED will be greater than 1
29
o
•
To the right of the point where PED = 1, PED will be less than 1
Granted that a firm knows whether their demand is elastic or inelastic, there are several pricing policies:
o When PED is elastic, firms wishing to increase revenue should lower its price
o When PED is inelastic, any firm wishing to increase revenue should raise prices
o When PED is unity, then firms wishing to maximize revenue should leave price unchanged, since TR is at its
maximum
Measuring Profit
•
•
There is a major distinction between profit per definitions of Accountants and per Economists
o Accountants believe that Profit = Total Revenue − Total Cost
o Economists believe that 𝐏𝐫𝐨𝐟𝐢𝐭 = 𝐓𝐨𝐭𝐚𝐥 𝐑𝐞𝐯𝐞𝐧𝐮𝐞 − 𝐄𝐜𝐨𝐧𝐨𝐦𝐢𝐜 𝐂𝐨𝐬𝐭
Economic cost – this takes into account both explicit and implicit costs such as opportunity cost,
which accountants do not
Per the definition of profit by economists, there are 3 different types of profit scenarios:
o Normal Profit – If Total Revenue = Total Cost, then it is said that you make normal profit, and have zero
economic profit
o Abnormal Profit – If Total Revenue is greater than total costs (inc. economic cost), then firms are said to be
making an economic profit
o Losses – If Total Revenue is less than total costs (inc. economic cost) then negative economic profit are made.
Maximizing Profit
•
•
•
•
If a firm sees that their Marginal Costs are lower than Marginal Revenue, then clearly the firm needs to produce
greater quantities of goods. Therefore, when MR > MC, increase production
In the graph, we can see that the Demand curve (D=AR=MR), intersects the Marginal Cost curve at two points, q 1
and q2
o At point q1, the firm experiences profit minimization, whereby the firm has made
losses until that point, since the Marginal Costs have been higher than their
Marginal Revenue
From point q1 to q2, the firm makes an economic profit on every extra unit produced,
because the MR is higher than the MC. As long as the losses from quantity 0 to q1 aren’t
greater than the revenue from point q1 to q2, then the firm has made abnormal profit
Therefore: if a firm wishes to maximize their profits, it should produce at the level of output where Marginal Cost
cuts Marginal Revenue from below
Profit Maximization for a Normal Demand Curve
•
Profit here is maximized by producing at output levels where MC = MR. We can see what
price point this would be, and we see that consumers are willing to pay Price P for quantity
q of the product.
•
To illustrate where Abnormal profit would be made, the Average Cost curve must be
added.
The profit per unit of producing at q levels id the difference between AR and AC
o Hence, profit per unit is a–b
o Since q units are produced, the total abnormal profit is ab × 0q
•
•
The position of the AC curve determines what type of profit is made:
o At AC1, normal profit is made, because 𝑝 = 𝑐1 , so no abnormal profit
rectangle can be made
30
o
At AC2, a loss is made as the AC is higher than the AR. The amount of loss made is represented by rectangle
ADC1C2’s area
Market Power: Perfect Competition and Monopolistic Competition – Microeconomics
(Chapter 11)
•
•
•
•
Market Power – this is the ability of a firm to raise the market price of a good/service above marginal cost – firms
increase price by restricting output
o In a perfectly competitive market, no firms can do this and therefore have no individual market power
If they raise their prices, their demand falls significantly, so they are price takers
Firms that have some degree of control over market prices of goods are called price makers or price setters
Reducing the general supply of goods to increase prices is harmful to society, and moves away from the socially
optimum MSC = MSB, reducing community surplus and causing market failure
Demand no longer is the same as Marginal Revenue
Perfect Competition
•
Theoretical model based on some specific assumptions – this should be the ideal economy. Perfect competition makes
the following assumptions:
o The industry is comprised of a very large number of firms
o Each firm is so small that they are not able to alter their output to shift overall market prices. So all firms in
this market are price takers
o Firms all produce exactly identical products and the goods are homogenous – no marketing to distinguish
goods, no branding, impossible to distinguish different products
o Firms are free to enter or leave the market and there are no barriers to any of these
o All producers and consumers have perfect knowledge of the market, including all prices, costs and its inner
workings.
Market Power in Perfect Competition
•
•
•
Since all firms are price takers, we can make certain assumptions about the demand curves for
the firms and industry.
In this market there would be a normal demand curve, whereby all firms must sell at the
equilibrium price or lose their customers
For firms, they can only sell at price P, and at that price, demand is stable, so they have a
perfectly elastic demand. It doesn’t matter if they produce more output, it will not affect
market prices since they are small, so they can sell as many as they want.
Maximizing Profits in the Short Run
•
To maximize profits, firms must produce at a level of output where their
Marginal Costs equal their Marginal Revenue. We therefore add the MC
curve to the graph with the perfectly elastic demand.
•
In short Run competition, there are possibilities for 2 different profit
scenarios:
o Short–run abnormal profits – the firms in the industry are generating revenue above
their economic costs
We can see that the firm’s Average Revenue is higher than their average
cost, so the firm is generating P − C amounts of profit.
o Short–run losses – if their average costs are higher than their AR then they are
making a loss. The amount of loss they are making is determined by the area of the
rectangle PCACMC
31
Profit Situations in the Long Run in Perfect Competition
•
Short–run abnormal profits to long–run normal profits
• With perfect knowledge, more producers will enter the market in order to make large
amounts of abnormal profits, and in the long–run, as many more firms enter the
market, the supply in this industry will increase, shifting the supply curve to the right,
establishing a new equilibrium price and quantity
• As the demand for the new levels of supply decreases, individual
firms experience this as well, and a new Price is taken by them. At
this demand level, they are making normal profits since their
average costs are equal to their average revenue.
•
Short–run losses to long–run normal profits
• If the firm is making losses, then eventually they will leave the
market and join another industry, which will mean that the overall
market supply levels decrease to levels of S1Q1 – this increases
market prices from P to P1
o Therefore, the firms’ losses become smaller and eventually
they are able to generate normal profits as their increased
demand at the higher price will lead to AR = AC
Long–Run Equilibrium in Perfect Competition
•
•
In the long–run, firms will make normal profits
As they make abnormal profits, the supply levels will adjust accordingly to lower the profits, and if they are making
losses, then the supply will also adjust accordingly – at the equilibrium point there is no incentive for firms to enter
or leave the market, so the Equilibrium levels will persist unless there are changes to firms’ costs, or outside factors
affect the market
Firms’ Efficiency in Perfect Competition
•
There are 2 ways of measuring efficiency:
•
Productive Efficiency – a firm is said to be productively efficient if it produces its products at the lowest possible
unit cost – AC
o i.e if the firm produces products at quantity q, which is at the minimum point of the AC curve, then they
are fully efficient.
o Therefore, the productively efficient levels are where MC = AC
This is an important measure, as it signals that firms are using their resources as efficiently as they
can, and that there is little to no waste
•
Allocative Efficiency – This occurs where suppliers are producing the optimum mix of goods and services required by
consumers
o Allocative Efficiency occurs where marginal cost is equal to the average revenue
o This is important as if a firm is producing at the allocatively efficient levels of
output, there is a situation of ‘pareto optimality’, where it is impossible to make
someone better off without making someone else worse off
32
•
•
•
o
In the diagram, we can see that while the firm is producing at profit–maximizing levels of output, they are
not fully allocatively efficient, as they do not produce at MC = AR quantities.
o
In a similar way, if the firm is making losses in the short–run, though they are
producing at profit maximizing (minimizing in this case) levels, they aren’t
producing at the most efficient levels of MC = AR
Market Failure in Perfect Competition
As you can see, profit–maximizing firms in the long run, in perfect competition, all
produce at the lowest point on their AC curves and since there is perfect knowledge, they
all sell at the same price and minimize their costs by producing at MC=AC
In perfect competition, firms all are allocatively efficient, because they also produce at
quantities where MC = AR – this means that there is no market failure as market failure
is the failure to produce at allocatively efficient quantities
Hence, no government intervention is needed.
Imperfect Competition
•
•
•
•
•
A market is considered to be imperfect when it fails to equate Marginal Social Cost
with Marginal Social Benefit
Because profits are maximized where the Marginal Cost is the same as Marginal
Revenue, and since Q1 quantities of supply are available, price is at P1, meaning that
there is a loss of consumer surplus of the difference between P1 and MSC = MSB, in the
dark blue triangle
Producer surplus is also reduced, shown in the pale blue triangle – therefore, community surplus is not maximized,
causing market failure
Even though the Marginal Social Benefit is higher than the Market Social Cost, the required quantity of goods are
not produced
The more imperfect a market is, the more market power available to firms
Monopolistic Competition
•
•
•
•
•
•
A monopolistic competitive market is one with many competing firms, where each
firm has a little bit of market power
There are several assumptions for a monopolistic competition market:
o Industry is made of a large number of firms
o Firms are small relative to the size of industry, so they can act independently
and their actions will not impact others highly
o Firms produce slightly differentiated products meaning that consumers can
tell between different firms’ products
o Firms are completely free to enter and leave the market
The only difference between monopolistic competition and perfect competition is that there are product
differentiation.
As there is differentiation, there will be some brand loyalty – this gives firms some power in being price makers as
they will retain some of their demand even if their prices are adjusted.
o However, demand will still be elastic as there are still many different substitutes that only slightly differ
The diagram shows that firms product at quantity levels MR = MC, to maximize profits.
Firms still hold a relatively small amount of market power since adjustments to their price will lead to significant
drops in demand, even with brand loyalty, as their demand is relatively elastic.
Maximizing Profits for Monopolistic Competitive Markets
33
•
•
•
•
•
It’s possible for firms to make abnormal profit in the short run – the firm in this case is
producing at levels of MC = MR and the AC, at its lowest point (denoted C on 𝑦 axis), is
less than the selling Price of P
It is also possible for firms to be making losses in the short run – the firm produces at
quantities MC = MR, but the AC at quantity q represents a cost higher than that of the
price.
What happens to Short–Run Profits/Losses in the Long–Run?
Because of the freedom to enter or exit the market, an equilibrium point will be reached,
and firms will start making normal profit.
If firms make abnormal profit, other firms will be attracted to the market and will start
producing more quantity of goods to make such profits themselves
o This will lead to oversupply so the demand, and price, will decrease to levels
where AC = AR
If losses are made, firms will leave the market, which will reduce supply, thereby
increasing demand, and increasing price, where AC = AR
o At the Equilibrium levels, firms still produce at profit maximizing levels of
MR = MC, and the AC = AR, so they are not making abnormal profits or any
losses.
Efficiency in Monopolistic Competition
•
•
•
•
Productive efficiency is reached where the quantity produced
intersects the AC curve at its lowest point
Allocative efficiency is where the quantity produced where MC =
AR
The first graph in the diagram shows that in this market firms
produce at profit maximizing levels of MC = MR, rather than most allocatively efficient levels of output at MC = AR
However, in the long run, in graph 2, we see that the situation still occurs as the firm still produces at profit
maximizing levels.
Need for Rectification of Market Failure
•
•
Firms in monopolistic competitive markets are, in the long run, maximize profits, but are neither productively nor
allocatively efficient – this is a market failure
The market failure is not due to the firm’s inability to produce at correct levels, but due to consumers’ desire to have a
variety of products – the monopolistic competitive markets give consumers a variety of choice, benefitting society
Market Power: Monopoly and Oligopoly – Microeconomics (Chapter 12)
•
•
We make several assumptions in the theory of monopolies:
o There is only one firm producing the product, so the firm is the industry
o Barriers to entry exist, which stops new firms from entering the market and maintains the monopoly
o Due to the barriers to entry, the monopoly can maintain abnormal profits
Judging whether a business is a monopoly or not depends on the amount of market power that they have – market
power itself depends on how many competing substitutes are available
How can Monopolies Maintain their Market Power?
•
Monopolies can maintain their market power by maintaining barriers to entry to the market. Several types of such
barriers exist:
34
o
Economies of Scale – businesses’ unit costs of production fall as they produce more units. This is defined as
the fall in average costs that come when a firm alters all of its factors of production to increase its output. A
large firm can benefit from economies of scale in numerous ways:
Specialization – larger firms can hire more specialized personnel, who’d likely make the business run
more efficiently
Division of Labour – Larger firms can use this to reduce their average costs and decrease the time
needed to fully produce a good, increasing their output
Bulk Buying – buying items in larger quantities can yield a bulk discount, which would reduce the
business’s costs of production/sales
Financial Economies – large firms can raise capital much more cheaply as they are considered a safer
investment by financial institutions – lower bank interest rates for example
Transport Economies – large firms may be charged less for deliveries and they may create their own
delivery system to improve their distribution
Technical Economies – Larger, more expensive machinery that can increase output and decrease time
of production can be purchased by larger firms with more capital
Promotional Economies – marketing is more available to larger firms due to their capital reserves
• Businesses wishing to compete with the monopoly would be at a massive disadvantage, as
they would not have the many economies of scale available to them to decrease their average
costs, and therefore, reduce prices to levels that will create demand
o
Natural Monopoly – an industry is a natural monopoly if there are only enough
economies of scale available to support one firm.
The monopolist has the Demand curve D1, and average costs of LRAC
(long–run average cost). The monopolist can make abnormal profits by
producing quantities between q1 and q2, such that their AR is greater than
their LRAC
If another firm were to enter this market, then they would claim some of
the monopolist’s demand, and the curve would therefore shift to the left (D2). However, now both
firms are in a very poor position, because at every level of quantity produced, their LRAC would be
significantly greater than their AR
o
Legal Barriers – some firms are given the legal right to be a monopoly, and so, entering the market would be
illegal – examples include patents, because the right to produce the product is protected by intellectual rights
Brand Loyalty – in some markets, customers may simply have too much faith in the brand, and may not
accept any others who attempt to compete with the status quo.
Anti–competitive Behaviour – unfaithful manner, such as waging a price war, whereby they lower their
prices to extremely low, loss–making levels to drive the other business out of the market through forcing
them into insolvency.
o
o
The Scale of Monopolistic Market Power
•
•
Since the monopolist is the industry, they have a downwards sloping demand curve.
They can control the price or quantity of goods available in the market, but not both.
The monopolistic firm maximizes their profits by producing at levels where their
Marginal Revenue is equal to their Marginal Cost. The quantity at which this is achieved
is shows the price level that the firm must sell at.
Monopolies and Profit Situations
35
•
This is one of the few cases where a firm can make abnormal profits in the long run –
since other firms cannot introduce new supply into the market, the monopoly can
continue producing at quantity q, where their MC = MR
•
However, it is not always the case that a monopoly will always make abnormal profits.
If the monopolist produces a product for which there is little demand, then they will
not earn abnormal profit.
o In this case, their AC would be higher than their AR. This means that they would be making losses, which, in
the long run, will lead to the firm becoming insolvent.
Efficiency of Monopolies
•
•
•
Monopolies produce at levels where they achieve neither productive nor allocative
efficiency. They simply produce at the profit maximizing levels of MC = MR
Output is restricted for maximum revenue generation, so the socially optimum levels of
output, at allocative efficiency levels of MC = MR, is not met
Maximum amount of output is not met, as a lower quantity of goods is traded for a
higher price, therefore higher revenue. So productive efficiency, where MC = MR is
not met.
Monopolies and Market Failures
•
Allocative efficiency is not achieved, so there will obviously be a market
failure unless the firm ceases to produce at profit maximizing levels of
output.
•
Monopolies can have some advantages over perfect competition:
o The first advantage is that monopolies have monumental
amounts of economies of scale, which means that they are more
likely to be able to produce at levels where the price would be
lower than the same situation in a perfect competition market
o The high economies of scale decreases the Marginal Cost, which
therefore means that they can increase output and decrease
prices.
o There is also likely going to be increased expenditure on R&D,
which may yield consumers with greater choice, and better
quality products than in a perfectly competitive market, where
smaller firms have less capital.
•
However, a monopoly obviously has several drawbacks compared to perfect competition
o If significant economies of scale do not exist for a monopolist, then they’d decrease their output and increase
prices to maximize profits.
o Firms in a perfectly competitive market will produce at equilibrium levels, where Industry supply meets
industry demand (MC = MR to maximize social benefit) but the monopoly only needs to produce at levels
where profit is maximized.
Oligopolies – What are their Assumptions?
•
An oligopoly consists of a few number of firms dominating the market – the assumption is that a few key firms
control a large portion of the industry’s output
36
•
Concentration Ratio – ratio of firms’ control over the market – this is expressed in the form CR𝑥 , where x represents
the number of the largest firms.
o The most common ratio used is CR4, where the output (% of total market output) of the 4 largest firms is
expressed.
•
The products and markets of oligopolies vary - in some industries like oil, the top firms may produce the same
product, or in other markets such as the automotive industry, the top firms may produce differentiated products
whilst claiming most of the market output.
The difference here is that firms are interdependent on each other, so they have to take careful note of other business’s
actions to make sure that they can operate efficiently – this can lead to collusion, as firms want to avoid surprises and
want to maximize profits
In oligopolies firms tend to have stable prices, even in events of economic instability, as they fear how rivals may react
•
•
Collusive vs. Non–Collusive Oligopoly
•
•
There are 2 types of collusion:
o Formal Collusion (Or Cartel) – when firms openly and transparently agree on prices. Sometimes this is illegal,
as anti–trust laws may be invoked. Higher prices lead to less output for consumers, so this may cause negative
externalities.
o Tacit Collusion – this happens when firms charge the same prices without any
formal collusion. This leads to the same outcome as monopolies and formal
collusion, as the market would have one price and a large quantity of supply
from several producers.
o The desire to make abnormal profit is an incentive to maintain collusion.
o There is a large incentive for firms to try to cheat. If a firm is in a duopoly, for
example, and believes that lowering their prices can yield them a larger market
share until others respond, they may do that and temporarily increase their
abnormal profit. This may however lead to a price war.
A non–collusive oligopoly exists when firms in an oligopoly do not collude and have to be aware of the reactions of
other firms when making pricing decisions. The behaviuor of firms
in this situation must be strategic and calculated, and this is
referred to as game theory
o In game theory, if firms are in a position where they must
make a pricing decision against other rival firms, they may
opt to use the max–min strategy, whereby they choose the
option which minimizes their loss and maximizes their
profit.
o Game theory is useful when there are a few firms in the
industry, because it is very difficult to predict the behaviour
of a large number of firms compared to a select few.
Competition in Oligopolies
•
•
When firms cannot compete in terms of price, the concept of non–price competition becomes very important. Types of
non–price competition include promotion, advertising, personal selling, branding etc.
Competition in these markets are characterized by large amounts of promotional expenditures to try to make their
demand less elastic.
o Many firms do this to increase barriers to entry to other firms, to maintain their position in the oligopoly
37
Oligopolies & Market Failure
•
•
•
If firms in the oligopoly produce at profit maximizing levels of MC = MR, they will not
be allocatively efficient, as they will not be producing at the socially optimum levels of
D
MC = AR
If there is collusion, then the profit situation, and efficiency levels will look exactly like
a monopoly, as they will produce at MC = MR levels.
The same thing will happen in non–collusive oligopolies, as firms will have lower
amounts of market power, so they will likely conform.
Government Intervention in Oligopolies
•
Leaving large oligopolies to their own devices may lead to abuse of the market. There are several ways in which this
may happen:
o Restriction of output, higher prices and inefficient allocation of resources – consumers will receive less of
the product and will pay higher prices. This results in a lower consumer surplus and is therefore a market
failure.
o Lower consumer choice – as fewer brands may exist, the selection of products may be limited
o Productive inefficiency – production does not take place at the lowest possible cost of MC = MR, so there is
a waste of resources
o Allocative inefficiency – under-allocation of resources as value put on it is higher for consumers than its cost
to producers.
•
Governments may intervene in oligopolies in several ways.
o Restriction of firms’ ability to grow through mergers/takeovers – prevents firms from acquiring a larger
market share through inorganic growth.
o Outlaw ‘price fixing’ – this would make collusions illegal. Anti–trust laws exist in almost all countries
o Restrict firms’ ability to fully control their supply
o Set up a Regulatory body to manage Oligopolies:
Such organizations can set price caps
They can fine organizations for anti–competitive behaviour
Ability to break up monopolies/duopolies into smaller businesses, decreasing the original firm’s
market power
o In an extreme case, the government may take the industry into public ownership – this is the most direct
provision that can occur. This would mean that the industry is nationalized.
The level of Overall Economic Activity – Macroeconomics (Chapter 13)
•
Governments are mainly concerned with a few main variables in terms of economics, and have matching economic
objectives:
Variable
Economic Objective
Economic Growth
Steady increase of National Income
Employment
Low Unemployment Rate
Price Stability
Low and Stable Inflation Rate
National Debt
Sustainable Level of National Debt
Income Distribution
Equitable Distribution of Income
Measuring National Income
•
One such measure is Gross Domestic Product (GDP). There are 3 different ways to measure this figure:
38
Output Method – this measures the actual value of goods and services produced. Through this method: GDP =
∑(Value Added by all Firms into Economy).
‘Value Added’ – cost of inputs is deducted at each stage of production
o The income method – this measures the value of all the incomes earned in an economy.
o The Expenditure Method – This measures the value of all spending on goods and services in an economy. This is
calculated by summing up the spending by all sectors of the economy. These include:
Spending by households – this is known as consumption
Spending by firms – this is known as investment
Spending by Governments
Spending by foreigners on exports minus spending on imports – this is know as net exports
A highly accepted definition of GDP is the total value of all final goods and services produced in an economy in a
year.
o
•
•
Therefore, GDP = National Output = National Income = National Expenditure
Gross National Product vs. Gross National Income
•
GDP includes the value of total economic activity, regardless of who owns the national factors of production – e.g
MNCs are included in this count
GNI is the total income that is earned by a country’s factors of production, no matter where they are located
GNI includes GDP but subtracts the earnings from foreign assets operating in the country, and adds income from
assets in foreign countries.
o The income earned from assets abroad is known as property income from abroad and the difference between
income from assets abroad and income paid to foreign assets operating domestically is known as net property
income from abroad
•
•
GNI = GDP − Income from Foreign Assets + Income from Domestic Assets
GNI = GDP − Net Property Income from Abroad
Difference between Nominal/Real GDP, Nominal/Real GNI
•
•
•
•
Nominal GDP/GNI – value of respective economic measurement not adjusted for inflation, and with current prices.
Real GDP = Nominal GDP Adjusted for inflation
Real GNI = Nominal GNI Adjusted for inflation
To measure respective values per capita, we have to simply divide their values by the size of their populations.
Why Gather National Statistics?
•
The United Nations provides some guidelines on collecting National Statistics, and they call it the System of National
Accounts
o These statistics can be seen as a way of appraising the economy and how successful the markets are. They are
also used to assess whether economic objectives have been reached or not.
o Economists use these statistics to develop models and make forecasts
o Businesses use information to predict future demand
o Assessing quality of life since many people associate high GDP/GNI with high standards of living
o Comparing countries on the world stage
Limitations of National Statistics
•
•
Inaccuracies – there are a vast number of sources for these statistics, and there will always be discrepancies in the data
gathered.
Unrecorded/Under–recorded economic activity – informal markets – National Income includes economic activity that is
recorded, so illicit market activity, or informal markets are not included within these figures.
o Statisticians try to estimate this value and include it in statistics, but they are obviously not accurate.
39
Generally, countries with higher tax burdens tend to have a larger percentage of informal/hidden markets
respective to their GDP – consumers are more likely to turn to illicit markets if prices for their desired goods
are absurdly high.
External Costs – Externalities are not measured in GDP figures. Cutting down trees leads to an increase in GDP, but
the negative economic impact of fewer trees is not included.
Quality of Life Concerns – GDP may increase due to longer working hours and a more depleted and demoralized
society, but other factors are important to assess standards of living.
Composition of Output – Significant portion of output can be in the form of capital or defense goods, which do not
benefit consumers.
o
•
•
•
The Business Cycle
•
•
The business cycle consists of changes in the economy with respect to Real GDP, as
it goes through several stages of development
o In the Recovery stage, Real GDP increases, and we can largely attribute this
to increasing aggregate demand as households/firms increase their spending.
The increased demand leads to increased output for goods, and
more demand for employment, increasing employment rates.
• Newly employed workers spend newly acquired income on
more goods/services, driving up aggregate demand even
more.
o In the Boom stage, the economy goes into decline as it reaches its potential
output
o When a recession occurs, aggregate demand falls significantly, decreasing
Real GDP, as total spending decreases
Fall in demand leads to less demand for labour, leading to increased unemployment
o The economy will not fall eternally into a pit of recession, because there is a minimal amount of production
and spending that must take place – some level of aggregate demand will be maintained.
Governments will also try to decrease interest rates to increase demand for cash for investment.
Government will also run budget deficits to finance basic services and economic recovery, injecting
cash into the economy.
Though economies go through the business cycle, economic growth can still be achieved in the long term, because
output can increase with each complete cycle. This is shown in the diagram, where the boom of the next period is
higher than the one before.
Other Measurements of Economic Well–being
•
•
•
OECD Better Life Index – based on 11 factors that OECD identified as essential for comparison of well being. These
relate to the core themes of material living conditions and quality of life
The Happiness Index – variables for this are GDP per capita, social support, life expectancy, freedoms, perceptions of
corruption and generosity
Happy Planet Index (HPI)
Aggregate Demand – Macroeconomics (Chapter 14)
•
•
Aggregate demand is the total spending on goods and services in a given period of time at a given price level
The diagram for Aggregate demand is the same as the one for Demand in microeconomics, however, on the y axis it is
labelled Average Price Levels
40
•
On the x axis, there is National Output, which is the total quantity of goods/services
o National Output is the same as National Income, which is GDP. This is converted to real figures to get Real
Output
Components of Aggregate Demand
•
Consumption (C) – this is the total spending by consumers on domestic products/services. There are 2 types of goods:
• Durable Goods – Goods used by consumers over a long period of time – over 1 year
• Non–Durable Goods – short term goods used for less than a year
• Investment (I) – addition of capital stock to the economy. This is done by firms, and there are 2 types of
investments:
• Replacement Investment – when firms spend on capital in order to maintain the productivity of existing
capital
• Induced Investment – when firms spend capital on increasing output to respond to higher demand in
economy
• Capital Stock are all goods made by people and are used to produce other goods such as computers
• Government Spending (G) – Capital spent by the government on a federal and provincial level
• Net Exports (X–M) – Net exports are the export revenues minus import expenditure
• If this figure is positive then it will increase aggregate demand and if it is negative then it will decrease it.
• Therefore, we can define aggregate demand as:
AD = Consumption + Investment + Government Spending + Net Exports or
AD = C + I + G + (X − M)
•
If we consider the expenditure definition of GDP, then we can define aggregate demand as: AD = GDP
The Aggregate Demand Curve
•
Looking at the AD curve, we can see that a decrease in prices reduces level of output
demanded by C, I, G and net foreign sector increases from Y1 to Y2
o We typically use the label of Y for the x axis, rather than Q, which is for
microeconomics
Changes to Consumption & Impact on Aggregate Demand
•
There are several factors that can change the aggregate demand, and therefore shift
the entire curve left or right:
o Change in income taxes – As incomes rise, people have more money to spend
on goods, so consumption increases. If taxes on income increases, then people
have less disposable income, meaning that consumption decreases.
o Changes in interest rates – if interest rates are increased, then AD is likely to
fall, because acquiring durable goods will become more expensive, and will
therefore fall in demand.
Increased interest rates also encourage people to save rather than spend as they can earn passive
income through payments by banks. It is the opposite way around if interest rates are decreased.
o Changes in Wealth – There is an important distinction to be made – income is what people earn, and wealth
is the value of the total assets people have. The level of wealth in an economy is influenced by 2 main factors:
Change in house prices – houses are consumers’ main asset, so if its price changes, then the vast
portion of their wealth changes as well.
Changes in value of stocks and shares – this is the other type of asset most people have, so its prices
influence personal wealth.
People are more likely to spend more, and therefore increase consumption, if they have assets to sell
to buy other durable goods. Hence, increased wealth increases AD
41
o
o
Changes in consumer confidence/expectations – increased optimism and confidence in the future stability
or growth of wealth/income is an incentive for people to increase spending now, as they see no reason to save
significant sums of cash. This is likely to increase consumption.
If the opposite is true, then people are more likely to save money in hopes of getting through an
economic crisis, so aggregate demand is likely to fall.
If consumers expect increased inflation, then they are also likely to spend more now to get the most
out of their money – opposite is true for deflation – especially true for durable goods
Level of household indebtedness – The extent to which households are in debt, and are able to borrow
influences consumption. Increased ability to borrow is likely to increase spending on durable goods –
increased AD.
Increasing interest rates likely mean that people will have to dedicate more portion of their income
on paying back mortgages and other debts, rather than on consuming goods, so in this case, AD will
fall.
Changes to Investment
•
•
•
•
•
Changes in interest rates
o To invest, firms need money, which they can either acquire through their retained
profits or through borrowing. If they borrow, then increases to interest rates are
likely to decrease investment as they become more expensive and therefore induce
cost–saving measures.
o Increasing interest rates increases firms’ reliance on their retained profits, as it is
the other main source of income. So there is an inversely proportional relationship between Borrowing and
Retained Profit
Changes in Business Taxes
o Increases to business taxes will decrease net profit after tax, so businesses will end up with less retained
profit. We’d expect for AD to fall in this case or increase if the opposite is true. This would shift the level of
investment.
Technological Changes
o This will be a long-term change, but with increasing technological capabilities, businesses will invest more
into better technology to improve efficiency, so long term AD will increase.
Changes in business confidence/expectations
o With increased confidence in the future of demand and the economic climate, businesses will increase
investment to be prepared to meet increased demand, and if the opposite is true, then they will implement
cost saving measures and decrease investment to make up for it.
Level of corporate indebtedness
o Works the same as consumer indebtedness, if businesses have the capacity and ability to borrow easily, and
cheaply, then they are likely to increase debts and increase investments and vice versa.
Changes in Government Spending
•
Government spending often rises when they feel that there is a need to correct failures in markets. Increasing
governmental spending should increase AD, as it encourages and directly increases the level of spending in an
economy
Causes of Changes in Net Exports
•
A positive value of Net Exports = X − M means that there is a trade surplus, and a negative value means that there is a
trade deficit.
•
Changes in level of exports
o If the level of foreign income rises, then they are likely to increase their imports and consumption of foreign
goods. For a country that the goods are bought from, their export revenue will increase. Growing economies
may also use foreign capital to do so, which may increase a country’s GNI as well.
42
o
o
o
•
Changes to exchange rates also influence level of exports – a more valuable currency for the exporter means
that the level of exports may decrease, as it will become more expensive for foreign firms operating with a
lesser valued currency.
Trade policy – a more liberal, and freer policy is likely to mean that tariffs are reduced, which is likely to
increase exports as firms will strive to find new markets for their products. A Protectionist policy will
decrease exports, as they will become much more expensive and they will fall.
Inflation rates – if inflation rates in a producer’s country increase, then those goods are less likely to be in
high demand, as their prices would be higher.
Changes in level of imports
o National Income – if the level of national income (GDP) rises, then there is likely to be an increase in
consumption of goods/services. If there is a shortage of such goods, or the desired goods are not available,
then consumers may opt to import them. Foreign capital may also be imported to increase production and
output in a domestic economy as well. So as GDP rises, Imports rise as well.
o Exchange rates – stronger currency in importer’s country means that they will have cheaper imports, and if
opposite is true, then imports will decrease and they’ll increase in price.
o Trade policy – a more open trade policy would increase level of imports, as tariffs would be lower and vice
versa.
o Inflation Rates – see explanation for exports.
Aggregate Supply – Macroeconomics (Chapter 15)
•
Aggregate Supply – this is the total supply of goods and services in an economy
Short–run Aggregate Supply
•
•
•
•
The SRAS curve looks like a microeconomics supply curve that slopes upwards, and
per the Law of Supply, the gradient increases as you go up the curve. This is the same
for macroeconomics SRAS curve, since it is simply the product of horizontal
summing of all supply from firms.
The short run is defined as the period of time when prices of factors of production do
not change – price of labour is fixed
A change in factors other than price will lead to the entire curve shifting left or right.
Factors responsible for this are referred to as supply side shocks
Factors that may change the position of the SRAS curve are, at their simplest, factors
that lead to changes in costs of production. Some typical examples include:
o Change in wage rates → increased cost of production → decrease in AS
o Change in cost of Primary Commodities → Increased cost of production →
decreased AC
o Change in tariffs → if capital used is imported and tariffs increase, then cost
of production will increase → decrease in AS
Long–run Aggregate Supply
•
There are two major interpretations of the LRAS, and the one from neoclassical economics is the more broadly
accepted form.
43
The Neoclassical LRAS
•
•
Neoclassical economists often believe that there should be minimal governmental
intervention in markets, and with this idea, the LRAS curve is perfectly inelastic,
meaning that there is the same demand at any price level.
o The LRAS curve depicts what the economy operating at full capacity and
efficiency would look like.
The LRAS considers output to be entirely based on the quality and quantity of
factors of production, and not price levels, so price levels do not affect LRAS.
Keynesian AS
•
The Keynesian AS has 3 different stages and does not distinguish between long
and short runs.
o Phase 1
AS curve is perfectly elastic at low levels of economic activity –
producers can produce more without increasing their average
costs due to extra unused factors of production
o Phase 2
As the factors of production get used up and the economy creeps towards its ‘capacity’, at point Yf,
and this will increase producers’ average costs because they will have to spend more on scarce factors
of production, increasing the average price levels for consumers.
o Phase 3
The economy reaches its full capacity of a Yf and at this point, it is impossible to increase output
because all factors of production are fully employed. This would make the AS perfectly inelastic.
• Stage 3 corresponds to the New neoclassical economics LRAS, because it demonstrates that
there can be no more output in the economy unless the quantity and quality of the factors of
production are increased.
Shifting the LRAS and AS Curves
•
•
•
An outwards, or shift to the right, of either curve means that the
productive capability of a nation has increased. This can be compared
to, and correlates with the outwards shift of the PPC
The increase in full employment level of output is equivalent to the
outwards shift of PPC.
Decrease in quality or quality of factors of production will have the
opposite effect.
Macroeconomic Equilibrium – Macroeconomics (Chapter 16)
•
The equilibrium for a market on a macro scale is when aggregate supply meets aggregate demand. However, there is a
short run and a long run equilibrium in macroeconomics.
Short and Long Run Equilibrium
•
Here, the SRAS meets the AD. The level produced is equivalent to the amount demanded,
so there is no reason to produce more. Therefore, the economy is in equilibrium.
44
•
This is where AD is equal to AS, however, there are 2 types of AS depending on the
economic school of thought used:
o
New Classical Perspective – the economy will always move towards its long–run
equilibrium at full–employment level of output. The only impact on demand will be
prices.
Long-term equilibrium level of output is equal to the full employment level of
national income, and the economy will move towards this point without
government intervention.
Combining the SRAS and LRAS, we can see that there may be a short run
increase in demand, which will result in the economy producing quantity Y1, and
this is called an inflationary gap, where the level of output is greater than the
equilibrium quantity.
However, it is only possible to have increased output in the short–run. As the
economy is originally at full employment of resources, there can be no
underemployment, or new resources to use. To produce more, firms compete
with additional resources, and the scarcity of the factors of production increase
the firm’s costs, forcing them to increase prices to level P 2.
• Referring back to the Short run, the consequence of the increase in the
price of factors of production shifts the SRAS curve to the left, which
brings the equilibrium point of the Short run back to the LRAS equilibrium point, but at price level
P3
o
•
However, if AD falls, then the economy will experience a deflationary gap, where the
level of national income is lower than the equilibrium point at which resources are
fully employed. This will decrease average price levels down to P2, a lower level.
This means that firms’ costs are also decreased, which means that they are
able to supply at a higher quantity, increasing national income to level Yf.
This therefore shifts the SRAS curve to the right, where it meets the LRAS
curve at income level Yf.
The Keynesian Perspective – per this perspective, the equilibrium level of income may occur at different levels.
o Per this, an economy can be in equilibrium even at levels which do not fully
employ resources
o This depends more on AD rather than movements in LRAS.
o In the example, the equilibrium level is at output Y, rather than Y f, whereby there
is full employment. This is possible because there can be an under–allocation,
misuse or simply spare resources available, meaning that more output is possible.
In this case, we have a deflationary gap as the equilibrium is not equal to full
employment.
o Keynes believes that there can be increases in demand such that prices do not
increase, as the economy would be in stage 1–2, where they have spare, unused
resources which they can take advantage of to produce at the same price levels. At
this point, the demand is perfectly elastic.
However, as an economy moves from phase 2 to 3, increases in demand
increase prices, as there is inflationary pressure from resources becoming
less available, and thus leading firms to compete for resources.
If the economy is at phase 3, then they would already be operating at
full employment, and thus, increases to AD would only have a purely
inflationary effect and increase prices without having a corresponding
change in output.
Demand Management – Demand–side Policies – Macroeconomics (Chapter 17)
45
Fiscal Policy
•
Fiscal policy pertains to government expenditure and taxation rate. There are 3 different type of public spending;
o Capital Expenditure – any spending that adds to the capital stock of the economy – such as improving roads
o Current Expenditure – ongoing payments by the governments, such as wages or school textbooks
o Transfer Payments – benefits paid to individuals with no production of goods/services in exchange for the
payment – e.g social security
•
Fiscal policy has several aims:
o Maintain low and stable rate of inflation
o Low unemployment rate
o Stable economic environment for long–term growth
o Reduce fluctuations in the business cycle
o Equitable distribution of income
o Favourable Balance of Payment
Expansionary Fiscal Policy
•
•
Expansionary Fiscal Policy – this is a form of Keynesian demand management. Several
actions can be taken to influence levels of aggregate demand:
o Lower taxes to increase disposable income, therefore, aggregate demand
o To encourage greater investment, it can reduce corporate tax, which will increase
national income
o Increase spending on public goods/services to increase aggregate demand
If the government succeeds in implementing its expansionary policy, then they should
shift the AD curve to the right.
o This will create inflationary pressure as average price levels rise, but in exchange there will be a increase in
output in the short run to Y2.
o Increased AD should also increase employment rates, as more demand for factors of production would exist.
Effectiveness of Fiscal Policy
•
•
•
Fiscal policy is effective in the long run at combating recessions – in the Great Depression, many countries reverted
back to Keynesian demand management to increase employment and AD.
This can also target specific areas of the economy which the government believes needs change – e.g if they can
reduce taxes and increase spending on areas which need it.
However, fiscal policy can have several disadvantages:
o Time lags – changing fiscal policy takes time as factors such as taxes cannot be changed at will. It will also
take time before there is an increase in AD
o Political Pressure – parties may influence government’s decisions, as things such as increased governmental
expenditure could mean increasing taxes and losing voters.
o Sustainable debt – Governments may have to run budget deficits to fund its expansionary activities, and this
may rack up national debt in the long run.
o Effect on net exports – may lead to increases on interest rates – this may increase exchange rates, making
exports less attractive and imports more attractive – this may ultimately lead to a decrease in net exports,
working against government intentions
o Crowding–out effect – if the government decides to increase borrowing, then it effectively reserves large
portions of the money in circulation for its own purposes, making it harder for other firms to acquire loans.
This may decrease Investment. The increased demand for money will influence interest rates, as it may be
increased to discourage borrowing.
46
Sustainable Amounts of National Debt
•
•
National Debt is the accumulation of government budget deficits over a period of time. It represents money owed both
to domestic and foreign parties. It is usually expressed as a percentage of the country’s GDP for the year.
Though running budget deficits has short–term benefits, such as stimulating the economy, in the long run it may
have undesired consequences:
o There will be an increase in debt servicing costs, meaning that they will have to pay back the amount owed
alongside increased amounts of principal and interest. This is consequential:
It may lead to crowding out, whereby the government may monopolize borrowing, decreasing the
ability of firms to borrow and invest.
Increases in interest payments may lead to budget cuts to compensate – real world impact on
citizens – may lead to deflationary fiscal policies such as increased taxes to compensate – this would
decrease output
The Multiplier Effect
•
•
•
•
•
If the government decides to fill in their deflationary gap by increasing its own
spending, then the final increase in AD will be greater than the amount spent.
The Multiplier effect is the principle that any amount of increase in government
spending will lead to a proportionally larger amount of increase in national
income.
Government spending and business investments are injections into the circular
flow of income, and any injections are multiplied through the economy as
people get a share of the income and spend parts of it
o The economic transactions of the Government lead to many different
parties acquiring the injection, and subsequently spending it themselves.
With the injection of cash into the economy, some of it gets withdrawn, through
methods such as direct taxation, payments for imports, or deposits into savings accounts. During each round of
spending in the circular flow of income, some income is withdrawn from the circular flow and some is re–spent
The Marginal Propensity to Consume – this is a decimal point number that describes what percentage of the injected
income is re–spent on domestic goods/services.
o Considering MPC as being the same with each round of spending, the total amount spent, with the initial
spending by the Government as the base, comes out to higher than the initial injection. Dividing the total
spending by the initial investment gives you the multiplier.
MPC =
Multiplier =
•
Amount Withdrawn from Economy
Amount re − circulated in Economy
Total Spending including Initial Government Spending
Initial Government Spending
There are formulas which can be used to find:
o MPC – Marginal Propensity to Consume (Amount Retained in Round)
o MPW – Marginal Propensity to Withdraw (Amount Withdrawn from a Round)
o MPS – Marginal Propensity to Save
o MRT – Marginal Rate of Taxation
o MPM – Marginal Propensity to Import
47
•
The formula goes as such:
Multiplier =
1
1
1
=
=
1 − mpc mps + mpm + mrt mpw
•
•
Any change in the amount of any of the withdrawals will change the value of the multiplier – e.g if the
taxation rate increases, then the multiplier will fall or if the marginal propensity to import falls, then there
will be an increase in the multiplier.
If the government is planning to intervene to try to fill a deflationary gap, then it must try to estimate the gap
between the equilibrium and full employment output – then it must have an estimate of the multiplier so that they
can judge the amount of AD increase needed to fill the gap.
o Both of these things are notoriously difficult to calculate.
Monetary Policy
•
•
•
These are a set of policies that govern the supply of money and levels of interest in the economy.
o Governments use expansionary monetary policy to increase AD, and contractionary, or deflationary monetary
policy to decrease AD
Generally, banks are free to set their own interest rates, but here we will use the base rate (or prime rate) that is set by
the central bank.
o The responsibility of the central bank is maintaining a low inflation rate, and regulating the supply of money
Monetary policy has several aims:
o Maintenance of a low and stable rate of inflation
o Low unemployment rate
o Stable economic environment for long term growth
o Reduce fluctuations in the business cycle
o Achieve Balance of Payments
Expansionary Monetary Policy
•
•
•
•
To increase AD, the interest rate may be lowered to encourage borrowing, and
therefore, increase the amount of spending, increasing the national income through
increased consumption and investment.
They can also increase the supply of money, which would lower its price, therefore, its
interest rate, as the interest rate is simply the value of money.
Monetary policy has several advantages:
o It is relatively quick to put in place as interest rates and supply of cash can be adjusted quickly.
o No political intervention – no political discourse needed, unlike fiscal policy
o No ‘crowding out’, unlike fiscal policy
o More fine–tuning as the interest rate can be adjusted in very small increments
However, monetary policy may be limited:
o Time – it may still take months for the effects of increased AD to be seen
o Method is ineffective when interest rates are very low – you can only decrease interest rates so much before
you approach zero%
Commercial Banks and Supply of Money
•
Commercial banks can actually introduce money into the national supply through the process of credit creation
o This is when money is lent to consumers or businesses based on their amount of deposit
Banks lend out more money that is deposited! The multiplier of the amount of deposit that is lent
out is called the money/banking multiplier
• This multiplier is related to a legal requirement as to the % of the deposits banks must hold
in their reserves to meet cash demands of their depositors.
48
1) An amount let’s say $100,000 is deposited in a bank. The central bank requires 20%
of cash to be held in reserves, so $20,000 is kept in the vault, meaning that the bank
has $80,000 to lend
2) Then a business asks for $100,000 to fund a venture. Given that their credit standing
is good, they are granted $100,000 as the bank sends the money to their virtual bank
account. They now have $100,000 as a liability.
• As a result, $100,000 has now been created out of nothing.
3) However, this new $100,000 must meet the 20% reserve requirement, but the bank
can just deposit 20% of this new $100,000 from the remaining $80,000, leaving them
with $60,000 to spend on more loans.
• This process can be repeated for 3 more loans of $100,000 or other amounts
4) At the end of the process, the bank will have $500,000, so there is a money multiplier of 5.
Money multiplier =
1
Minimum Reserve Requirement
Government Control over Money Supply
•
•
•
•
Minimum reserve requirements
o There is a clear relationship between the minimum reserve requirement and the money multiplier, so
effectively, the larger the minimum reserve requirement, the smaller the money multiplier
o If a government wants to reduce the supply of money, then it should increase the minimum reserve
requirement – this will reduce the banks’ ability to create credit, and will reduce money supply. This will
therefore increase interest rates, and thus, lower AD as consumption and investment fall.
Opposite should occur if government wants to increase supply of money and AD
Open Market Operations
o This involves buying and selling government securities in the open market –
bonds pay back their nominal value, and are very low risk
o If Government wants to reduce money supply, then it will sell more government
securities to institutions, which will have the effect of reducing money that
commercial banks have to lend.
This fall in supply will increase the cost of borrowing and increase the
interest rates. This therefore makes AD fall as consumption and
investments fall.
o If the government wants to increase the money supply, it will buy back its securities and inject cash into the
economy that way.
Changes in the central bank lending rate
o This is known as the base rate – the central bank charges the lowest interest rate, so changing its interest
rates is a way to influence the interest rates of commercial banks.
o If the government wants to reduce money supply, it will raise the minimum lending rate to disincentivize
borrowing and encourage saving – this happen as commercial banks’ interest rates would rise as well.
Opposite is true if Government wants to increase supply of money
Quantitative Easing
o Involves the introducing of money into economy by a central bank – this happens more now as even with low
interest rates many consumers and firms do not have confidence in the banking system to manage the money
supply through their loaning strategies.
o New money is injected into the economy through purchasing assets, mostly securities, from commercial
banks and other financial institutions with newly created electronic cash. This will lead to:
Increase in commercial banks’ reserves as they will sell securities – this encourages them to lend more
as they have more capability to lend, and would therefore increase AD
49
Lower interest rates, as the supply of cash increases – people’s debts will be less expensive now,
which should increase confidence.
Exchange rates will fall, which will make exports less expensive and imports more expensive.
Increases Net Exports, increasing AD
Equilibrium Nominal Interest Rate
•
•
•
•
•
•
Interest rates are more formally defined as the opportunity cost of holding/spending
money
The nominal rate of interest – rate of interest available in the market, discounting inflation
o If adjusted for inflation, it is real rate of interest
If consumers/firms hold/spend money, then they forego the opportunity of saving it or
investing it. If nominal interest rates are high, then they are giving up on a large return on
savings, so they will hold their money and demand less of it.
o If interest rates are low, then the cost of spending money is lower, incentivizing
spending and increasing demand for money. This is why the supply of money is a
downwards sloping curve.
The supply of money is usually fixed at a given time, and as such, it is a perfectly inelastic
supply curve. So even if the interest rates shift from i1 to i2, the supply of cash will stay
constant at quantity QM
The equilibrium point in the market for money is where the Demand for cash meets the
supply of cash, at the nominal interest rate of ie.
If the central bank adopts a contractionary monetary policy, then the supply would shift
from Qe to Q1, increasing nominal interest rates to i1
Real Rate of Interest = Nominal Rate of Interest − Inflation Rate
Supply–side Policies – Macroeconomics (Chapter 18)
•
•
Supply–side policies are meant to increase supply in the long–run, and shift the AS/LRAS curve to the right
These policies have several main aims:
o Achieve long–term growth by increasing the productive capacity of the economy, and shift the PPC
outwards
o Improve competition and efficiency
o Reduce labour costs and unemployment through increased labour market flexibility
o Reduce inflation to improve international competitiveness
o Increase firms’ incentives to invest in innovation by reducing costs
Market–Based Supply–side Policies
•
•
•
•
These are a set of policies a government can following to influence AS, but are meant to have minimum levels of
government intervention.
Reduction in household income taxes – high income taxes discourage people from working at their optimum
productivity levels, as they get taxed more as they earn more – reducing income tax yields them a net increase in
disposable income, which can encourage them to work harder, increasing the production capabilities
Reduction in corporate taxes – If businesses can have more retained profit, they can increase investment – increasing
investment adds to the capital stock in the economy, improving the factors of production
o It is usually an incentive to operate more efficiently, innovate, and compete better, with the knowledge that
you will have more retained profit
Labour Market Reforms
50
Reduction in power of trade unions – Unions raise firms’ costs, as they negotiate higher pay and more
accommodating working environments – preventing such cost–increasing measures will increase retained
profit
o Elimination/Reducing in Minimum Wage – Costs of labour would be decreased, increasing AS
o Reduction in unemployment benefits – Some argue that increased benefits discourage working at maximum
levels of productivity – reduction in benefits would encourage increased number of people to become
employed
Deregulation – Red tape increases firms’ costs, so eliminating them would decrease AC, increasing AS.
Privatization – Profit–maximizing businesses are often more efficient than state–owned ones, and are more likely to
contribute more towards national income and increase AS to levels where profit is at optimum levels
Trade Liberalization – these include reduction of subsidies and quotas to increase the appeal of international trade –
this would increase the efficiency, and likely the AS as exporting firms aim to be more competitive internationally
o
•
•
•
Limitations of Market–based Supply–side Policies
•
•
•
•
•
•
•
Increasing people’s disposable income through reduction in income tax may actually decrease incentive to work
Income inequality may increase with income tax decreases, as higher–earning individuals will accumulate more
wealth than lower–earning ones
Labour market reforms are a dangerous field, as it is very possible to decreased working/living conditions for workers
– pressure from unions as well
Wealth disparity may increase with decreased corporate tax, as firms may dedicate more of their net profit towards
dividends rather than investment
Deregulation is likely to lead to important environmental/social/health conditions deteriorating
Privatization may lead to a monopoly as firms could be in a field with no competition
There will be large time lags before effect is seen.
Interventionist Supply–side Policies
•
•
•
•
Opposite to market–based approach – this involves direct governmental actions in the market
Investment in human capital – Increasing the availability/quality/cost of education, such that the population develops
better skill sets and is more equipped to become efficient workers in the economy
o Training programmes, subsidies to education institutions etc.
Investment in R&D (Research & Development) – Governments can encourage increased investment in the field of R&D,
which is important, as improved technology increased the production capabilities of an economy
o Tax incentives, better intellectual property rights protections, grants etc. can encourage more R&D
Provisions and maintenance of infrastructure – infrastructure may be defined as large–scale capital needed for economic
activity to take place – increasing spending on infrastructure can improve the quality of this capital, which would
then lead to improved efficiency and capability for economic activity – the LRAS would be increased as a result from
this
Limitations of Interventionist Supply–side Policies
•
Interventionist policies are absolutely needed in an economy and are not controversial. They increase positive
externalities, and the quantity of merit goods, increasing consumer surplus. However, there are some limitations:
o Significant monetary cost – opportunity cost for government, and it may also encourage extra borrowing,
adding to the national debt
o Significant time lag
o Implementation is limited by ideology of the country – there may be strong opposition to the idea based on
the parties governing the country
Connecting Supply and Demand–side Policies
51
•
•
Supply–side policies are by definition in the long run, but they may have impacts on short run demand
o E.g reducing income tax will have expansionary fiscal effects – may increase AD at the cost of increased
inflationary pressure
o Increased government spending will have expansionary fiscal effects, which adds onto AD and increased
national income
o Increased borrowing as a result of supply–side policies may lead to crowding out, and may increase interest
rates, decreasing AD
Demand–side policies can have impacts on supply–side
o Lower income tax may increase AS as workers increase their productivity to earn more disposable income
o Any government spending on infrastructure will improve the factors of production, and capital stock,
increasing LRAS
Macroeconomic Objectives: Low Unemployment – Macroeconomics (Chapter 19)
•
The International Labour Organization defines unemployment rate as the number of people who are unemployed, as a
percentage of the total labour force
Unemployment Rate =
Number of Unemployed
× 100
Total Labour force
Hidden Unemployment
•
This consists of several types of people:
o People who have ben unemployed for a long time and have given up their search for work
o Part–time workers, or contractors, who’d prefer full time employment
o People who are over–qualified to work in the job that that work in.
Limitations of Unemployment Rate due to Distribution of Unemployment
•
Unemployment rates are an average for a country, and do not fully indicate what the distribution of employment is
within a country. There may exist disparities which are overshadowed in the statistic. Several types of disparities
exist:
o Geographical Disparities – e.g inner city unemployment may be higher than rural unemployment, due to
population density and the demand for labour
o Age Disparities – Unemployment for younger people is usually higher than the national average
o Ethnic Differences – minorities often experience higher unemployment rates – perhaps due to educational or
prejudicial reasons
o Gender Disparities – Unemployment amongst women are generally higher than men due to a plethora of
reasons, varying from social prejudices to culture.
Costs of Unemployment
•
The costs of unemployment increase with the duration in which people are unemployed. The costs below are
associated with long term unemployment:
o Costs of unemployment to unemployed people themselves – Clearly, unemployed people do not earn
income, and unemployment benefits are likely lower than the income they’d earn. This leads to a lower
quality of life, deterioration in sense of worth, leading to mental health issues, and may even increase suicide
rates
o Costs to Society – May increase criminality, homelessness, vandalism and others. Unemployment causes
many negative externalities.
52
o
Costs to the Economy – as the availability of one of the factors of production, labour, is decreased, the PPC
would shift inwards, and the possible output of the economy would be reduced.
Increase in spending on unemployment benefits drains tax revenue, and increases opportunity cost
to the Government
Factors Affecting Level of Unemployment
•
There is a pool of unemployment, in which
individuals go and in out of employment
constantly. This is illustrated below
•
The movements in this pool affect the supply of
labour in an economy, and this, alongside the
demand for labour, determine the rate of
unemployment in a country.
Governments are concerned with those who are
unemployed in the long term, as they stay in the
pool and decrease the supply of labour
•
The Labour Market
•
•
•
This market is on a macroeconomic scale, and therefore, the demand for labour is
referred to as ASL , or, Aggregate Demand for Labour. The Supply curve is
therefore ASL. The Equilibrium point is We.
The ASL curve slopes downwards, because at lower real wage levels, producers are
more willing to take on workers as their costs are lower
The ASL curve slopes upwards, because at higher real wage levels, more people are
willing to work at the prospects of higher incomes, increasing supply.
Causes of Unemployment
•
There are several types of unemployment;
o Cyclical (demand–deficient) unemployment
o Structural Unemployment
o Frictional Unemployment
o Seasonal Unemployment
Cyclical Unemployment
•
This is associated with cyclical downturns in the economy – by cyclical, we mean
referring to the business cycle
As an economy falls into a state of economic downturn, AD tends to fall, and this is
likely to also lead to a fall in AD, as firms’ outputs decrease and costs increase,
leading to the necessity to lower the costs of factors of production, one of which is
labour.
•
53
•
•
As AD falls, ADL shifts to the left, to ADL , where the new equilibrium wage levels are c, and at which point, the supply
of labour decreases
o However, due to the way labour markets work, it is very difficult to decrease
wages in fear of discontent, strikes, labour union action or otherwise. So the
optimum average wage levels is not reached, but the equilibrium level of We
is.
Cyclical unemployment can be countered by increasing AD through Keynesian
demand management policies. This may call for fiscal policy changes to increase
government spending, therefore AD. Monetary policy can be changed to decrease
interest rates or increasing supply of money.
Structural Unemployment
•
This is the most consequential type of unemployment and occurs as a result of the
changing of the structure of the economy. There are 2 forms of this:
•
Permanent fall in demand for a type of labour – as an economy develops, some
jobs will simply not be needed anymore, and the ADL for that occupation will fall
permanently – e.g, coal mining in an economy powered by nuclear energy. People
who are not able to change their skillsets to change occupations are said to be
occupationally immobile.
o If the barrier to new employment is geography, then they are said to lack
geographic mobility
o Several causes of this exist:
Technological changes
Globalization – labour may be cheaper in other countries, which will reduce domestic demand for
labour
Changes in consumer taste
o It is of note that very long-term demand deficient unemployment could cause structural unemployment
•
Change in the institutional framework of the economy
o These are factors such as legal changes, that force a market to experience
shifts in the demand for labour. Examples include:
Laws governing the labour market – e.g if it is mandated that
workers not be terminated unless they are justified through
submitting lengthy paperwork, then the ADL is less likely to
experience major fluctuations, but it may also lower overall ADL,
because firms would be afraid of taking on new workers in fear of
the costs of associated with terminating said employee.
• There could also be laws relating to minimum wage, so if
the equilibrium wage is lower than the minimum wage,
then employers are forced to increase wages to that level, increasing the supply of labour.
•
Structural unemployment is best dealt with supply–side policies. If the government decides to go the interventionist
route, then they have a few options:
o Education system that trains people to have more labour mobility so that the loss of demand for their job
does not permanently affect them
o Retraining programmes for the already–unemployed to increase their labour mobility
o Subsidies for firms to increase training for workers to increase labour mobility
o Supporting apprenticeship programmes to increase labour mobility in the long term
o Job centres so that unemployed people can have an outlet to enter the workforce more easily
If they decide to use market–based policies:
o Perhaps lowering unemployment benefits may encourage some to workforce, as they see that their situation
is unsustainable, but this is controversial as it’d cause negative externalities to those who genuinely need such
benefits – in theory this should shift the ASL to the right
•
54
o
Deregulation around employment could encourage businesses to take on more workers, as there would not be
the logistical challenge and legal costs of employing workers.
However, this will increase inequity, and lead to worse working conditions as firms try to further
reduce costs.
Frictional Unemployment
•
•
•
•
This occurs when people move in between jobs, have left education, are looking for work, or otherwise. This is not
inherently a negative thing, it only becomes such when it becomes long term. These people are assumed to be
employed in the near future.
Though frictional unemployment is not a problem, it can be reduced through improving the flow of information
about vacancies to unemployed individuals in hopes of them taking up work quicker. This could be done through jobs
websites.
Seasonal Unemployment
Determined by climate or other factors, which affect ADL based on the time of year.
This can be reduced through encouraging and increasing labour mobility, and can be done through promoting outlets
for job vacancies so that they are more visible.
Natural Rate of Unemployment
•
•
Some types of unemployment occur, even if the market is in equilibrium. When it is in equilibrium, the number of
people working is the same as ones looking for vacancies, however, there will be people who do not want to work, or
are unable to accept the job due to a lack of qualification, disability etc.
The Natural Rate of Unemployment includes unemployment caused by structural, frictional and seasonal factors.
Natural Rate of Unemployment = Structural + Frictional + Seasonal Unemploment
Are Demand–side or Supply–side Policies more Effective at reducing Unemployment?
•
•
This depends on the cause of the unemployment. If it is due to an economic downturn, as a stage of the business
cycle, then demand–side policies are more likely to work well.
o Though, for such policies the government may have to run budget deficits, which in the long term may lead
to further changes to fiscal policy to repay their debts.
At full employment of resources, there will still be unemployment in the form of natural unemployment, so
increasing ADL will have little to no effect on the unemployment rate – this is where supply–side policies may be
effective. Using demand–side policies will cause inflationary pressure.
Crowding Out
•
•
To run budget deficits, the government must borrow money – they can do this by selling
securities or treasury bills to consumers. This leads to demand for savings, or loanable funds,
shifting to the right, therefore increasing the supply of loanable funds.
With the government selling securities, the demand for loanable funds increases, which
leads to the interest rates also increasing, discouraging borrowing and encouraging saving.
As more money is saved, the supply of loanable funds increases from QF1 to QF2.
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•
•
The difference between QF1 and QF3 is the increase in the quantity of loanable funds, and can be attributed to the
government policy. Due to this increasing the interest rates, businesses are likely to reduce
their investments and save their cash, which would have crowded them out of the market
for loanable funds.
o This may reduce AD in the short–term, but the long–term effect is dependent on
whether the policy works.
Keynesian economists argue that if the economy is not at full employment, then crowding
out will not occur, but extreme new classical economists argue that the supply of money is
perfectly inelastic, so increases to the demand of the loanable funds will not increase the
total quantity of loanable funds, but will decrease it as it increases interest rates
Macroeconomic Objectives: Low and Stable Inflation – Macroeconomics (Chapter 20)
•
•
Inflation is defined as the persistent increase in the average price levels in the economy, expressed through the
Consumer Price Index
High rates of inflation are quite consequential:
o Loss of purchasing power – there may be falls in real income, if pay rates are not adjusted proportionally.
Many fixed–pay workers do not have protections against inflation
o Effects on savings – If inflation rates are higher than interest rates, then savers would have lost significant
amount of money, and would have been better off spending it. High inflation therefore discourages saving
o Effect on economic growth – with increased savings comes reduced consumption, and perhaps more
incentive to purchase fixed assets – this may reduce the amount of savings available for investment,
decreasing national income
o Effect on interest rate – Commercial banks often gain their revenue from interest rates, and if inflation rates
approach the nominal interest rates, they must increase them so that there is a net positive difference –
otherwise consumers would not save their cash there, reducing their revenue reserves.
o Effect on international competition – if a country has a higher inflation rate then their trading partners,
then their exports would become less attractive, making other lower–inflation countries’ exports better for
them financially
o Uncertainty – Firms may reduce investment in anticipation of economic turmoil and may be discouraged
from investing due to lower real revenues.
o Labour unrest – workers may complain that their pay is not proportional to inflation
Who are the Winners during Inflation?
•
•
•
•
Not necessarily a winner, but people whose incomes are linked to inflation would not have a net decrease in income
Strong Unions and employees with large amounts of power – they may get pay increases even beyond the inflation
Owners of fixed assets, as during inflation, more trust is given to tangible forms of wealth, and with this increased
demand, their prices increase
Importers – demand for imports will increase, as the prices of domestic products increase
Who are the Losers during Inflation?
•
•
•
•
•
People receiving fixed incomes
People with low bargaining power, or restrictive Labour Union laws
Savers/Lenders – demand for loanable funds will decrease, as the real interest rates are ultimately lowered
‘Cash Rich’ individuals who have most of their wealth in the form of liquid cash
Exporters – higher prices reduce the incentive to produce, and higher selling prices would decrease demand aboard
Measuring Inflation
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•
•
•
•
CPI is also known as the Retail Price Index
CPI consists of a ‘basket’ of goods that is meant to cover a broad range of consumer goods bought by the typical
household, ranging from cars to milk. CPI tracks the change in the prices of these goods, and when the average price
of the basket increases, there is said to be inflation
Statistical methods of measuring CPI varies from country to country.
Different products have different ‘weights’ for how much their price changes impact the CPI.
•
However, CPI is not without its difficulties:
o The CPI index uses a range of goods which is not universal and is therefore not always 100% indicative of the
economic climate.
o Clearly, not all transactions can be recorded and taken to calculate the CPI, so samples are taken from
representative locations, but these samples can themselves be outliers, contributing towards the CPI being
inaccurate.
o Some products increase in price due to improvements to them, or have other factors increasing their quality.
Such advancements could be recorded as price increases, and may lead to slight anomalies in CPI
o International standards for CPI are not the same. International comparisons are not infallible.
o Volatile economic/political/social environment could lead to unusual price changes, which could artificially
increase inflation
•
To increase the quality of economic analysis, economists also use CPI – commodity price index, which involves
tracking changes to the average price levels of factors of production
PPI – Producer Price Index – this effectively tracks the MSRP, or manufacturer suggested retail price – price before
shops set their own prices
•
Causes of Inflation
•
•
•
•
•
Causes of inflation can be divided into two categories: demand–pull
inflation, and cost–push inflation
Demand–pull inflation is an increase in average price levels as a
result of increases to AD.
Increases to AD are caused by a plethora of factors
Cost–push inflation occurs when costs of production are increased,
which subsequently increases average price levels, as consumers pay
for that.
Increases to prices because of wage rises are called wage–push inflation
Combining Demand–pull & Cost–push
•
•
Inflation sometimes perpetuates itself, often due to a lack of confidence
First, AD increases initially due to some factor. After, to respond to higher average
prices, workers may demand higher wages, or factors of production may become more
expensive, which may lead to the SRAS curve to shift upwards to SRAS 2, thereby
creating a new equilibrium. However, with increased pay, there may be a further
increase to AD, moving the curve to AD3 , as households have the illusion that their
incomes have increased, when in reality prices have too.
o This is called an inflationary spiral
•
If the initial cause of the inflationary spiral was due to increases to demand, then contractionary policies, fiscal or
monetary, can be used to reduce AD. However, reducing spending, or increasing taxes may be damaging to
governments, as the policies may be unpopular.
If the cause is cost–push in nature, then contractionary policies will be very damaging, as it’d lead to further falls in
GDP and unemployment, and politics would not allow this to occur.
Central banks attempt to stop high inflation from occurring in the first place by setting inflation targets, and
attempting to stay within its bounds. They can often adopt contractionary policies without political consequences, as
they (theoretically) have no political interests.
•
•
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•
Nowadays, the preferred way to manage inflationary crises is through monetary policy, as they are quicker, less
politically consequential, and as they do not change government spending on its financial commitments.
Deflation
•
•
•
•
This is general fall in average price levels and can be either a positive or negative change.
‘Good Deflation’ – this originates from improvements to supply–side of the economy, and
increased productivity, which increases levels of output, and GDP. With lower general
prices due to higher supply, more people can be employed, and more spending can occur.
‘Bad Deflation’ – this occurs on the demand–side. When AD falls, average price levels
decrease, alongside real output – this is negative as it leads to unemployment and lower
GDP
o Lower levels of AD will lead to greater unemployment, and this may spiral into
further deflation, as costs may become too high, which is referred to as a deflationary spiral
o Deferred consumption – if prices are falling, consumers may put off purchasing products in anticipation of
lower prices, and this may further decrease AD
o Decrease in consumer certainty/confidence in the market’s stability – people naturally do not want to take
risks
o Less investment – with reduced retained profit, businesses are less likely to spend on its growth or other
factors.
o Bad deflation makes the use of monetary policy ineffective, as it is not possible to reduce interest rates
enough to increase AD substantially
Disinflation – this is when inflation rates decrease, not when deflation occurs.
Is there a Trade–0ff Between Inflation and Unemployment?
•
•
•
•
•
•
•
Alban William Phillips discovered that there was an inverse relationship between the
rate of change of money wages (nominal) in the economy and the rate of
unemployment.
If there was a high level of unemployment, firms would have to pay higher wages as the
supply of labour would be scarcer, and if unemployment was very low, they would have
to offer lower wages.
When there is an economic expansion, wherein more output is demanded, wages rise
more quickly than they would if there was a contraction in activity
The rate of money wages could even become negative wherein workers would be willing to accept lower wages than
become unemployed.
The subsequent Philips curve now depicts the inverse relationship between inflation rates and unemployment, as pay
consists of a large portion of firms’ costs – change in wages leads directly to changes to price levels
Therefore, in an attempt to decrease unemployment rates, a government may increase inflation, so there is a
compromise.
However, nowadays the Philips curve is not fully valid, as sometimes inflation increases at the same time as
unemployment, which is referred to as stagflation
Long–run Philips Curve
•
•
•
Many monetarists argued the invalidity of the original curve and attempted to explain
that there is no trade-off between unemployment and inflation.
This led to the LRPC, or the long–run Philips curve, which depicts full employment of
all factors of production, similar to LRAS
Increasing AD in the short run, for example, if the government wanted to decrease
unemployment through stimulating AD, leads to the SRPC shifting upwards, as
average wage levels increase
58
This would put the inflation rate to 6%
This temporarily decreases unemployment from levels A to level B, however, nominal wages at that stage have
not risen on par with inflation, so their real incomes have not increased
Realizing this, the workers who were incentivized to work as a result of higher pay now leave their
jobs and the equilibrium unemployment rate is achieved.
If people expect inflation to rise, then at point C they would negotiate higher wages, which would further increase
labour costs, and therefore, wage levels.
o The same effect occurs – temporary unemployment reduction is achieved, but nominal wages are not
increased.
Expansionary policies typically do not work for reducing unemployment, so supply–side policies are more often used.
The effects on the LRPC curve would be the same as the LRAS one, and would correspond to an outwards shift on
the production possibilities curve
o
o
•
•
•
Macroeconomic Objectives: Economic Growth – Macroeconomics (Chapter 21)
•
•
•
•
Economic growth is defined as a period of time in which real GDP increases
Demand–side factors can cause a short–term increase in economic activity and increase in real GDP, which can be
shown through a SRAS/AD diagram and a PPC
o Consider that the economy is at level a, with the depicted deflationary gap. This is
equivalent to point a on the PPC, meaning that all resources/factors of production are
not being used at optimum efficiency
Shifting the AD curve to the right would put the economy at a point where
SRAS=LRAS, which would put them at optimum efficiency, and would close
the deflationary gap.
• However, the economy will never reach point b, because there will
always be inefficiencies in the form of natural unemployment and
other factors.
Deflationary gaps are often caused by periods of economic downturn or other consequential
events that decrease output. In the short term, the deflationary gap can be closed by using
demand–side policies.
Measuring Economic Growth
Economic growth rate can be calculated through a simple percentage change formula:
Growth Rate =
Real GDP of Year 2 − Real GDP of Year 1)
× 100
Real GDP in Year 1
Consequences of Economic Growth
•
There are many advantages to economic growth, hence why it is an objective of
governments. Some of these are:
o Non–inflationary growth can occur when LRAS increases at a faster rate than AD,
keeping prices stable. As populations rise and become more educated members of
society, AD will naturally rise at a ‘normal’ rate.
It is necessary therefore to grow the economy through supply–side policies
in the long run.
o Higher living standards – as AD increases, while prices remain stable, the average person’s real wealth will
increase, and they will be able to afford more consumer goods and luxuries.
o Innovation and advancements – competition and the desire to retain and attract more consumers
incentivizes businesses to innovate more, and invest more in R&D – clearly a positive externality
o Greater tax revenue – more public goods and services will be available for the public, which may further
improve their living standards, and reduce income inequality through wealth more evenly
o Increased demand for exports – more competitiveness on the international markets
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o
•
Social attitudes and greater liberties – as people grow more economically stable, society and their
perceptions can become more oriented on personal freedoms.
However, economic growth can also be negative in its effects:
o Higher income ≠ Better Living standards – many may assume that living standards improve with increasing
income, but it may be the case that people are sacrificing more of their time and personal well–being for
more pay – might lead to discontent based on material gain
o Sectoral Changes – Economic growth often leads to the primary sector being taken over by massive growths
in the tertiary sector, which may ruin the livelihoods and markets of that sector. This calls for better equity
and equality of opportunity
o Economic growth can be environmentally unsustainable – profiteering may lead to actions that cause
negative social externalities
Economics of Inequality and Poverty – Macroeconomics (Chapter 22)
•
•
•
•
•
•
Equity means granting everyone, regardless of background, the same opportunities and being fair, rather than having
everyone have the same amount of wealth
Equality is when the economic outcome for everyone is the same, regardless of socio–economic background
Some form of inequality is inevitable in an economy, as increased wealth is an incentive to be more productive and
get a sense of fulfilment.
Higher national incomes do not necessarily mean that there is better equity or equality, as national policies,
governmental systems may influence where that increased income travels to. It likely is not distributed evenly due to
factors such as corruption.
Inequalities in wealth and income are considered to be inequalities in outcomes – this is when despite opportunities to
increase income, people are not able to acquire extra wealth
Inequalities in opportunity present themselves when people simply do not have the opportunity to earn higher incomes
– these are factors such as education, place of birth, etc.
Measuring Income Inequality
•
The best representation of income inequality comes in the form of a Lorenz curve. It takes
the household income gathered and present them graphically from the following data
•
•
The farther a country is from the absolute line of equality, the more income inequality they have.
The GINI index is essentially the following:
100
∫
(Absolute Line of Equality − Country′ s curve) 𝑑𝑥
0
•
• The higher the GINI index, the less equal the income distribution is
The GINI index does not establish an absolute correlation between development and income distribution; other
factors must be considered
Constructing a Lorenz Curve
•
•
Incomes are compiled onto 5 quintiles, with the first being the ‘poorest’ 20% and the 5th being the 20th richest
Then the cumulative of the % of their shared income is compiled as such:
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Inequality of Wealth and Poverty
•
•
•
While being indicative of wealth, income is not wealth. Wealth is the net worth of a person, being their total assets
subtracted from their liabilities
Wealth is even less evenly distributed than income, as the Credit Suisse Global Wealth Report stated that the bottom
50% of adults owned less than 1% of total wealth
There are 2 types of poverty, being absolute and relative poverty
o Absolute poverty occurs when a person’s income covers practically none of their basics needs such as food,
water, shelter etc. The World Bank sets a poverty line, which indicates whether someone is in absolute
poverty or not
This line is $1.90 USD, however this much will purchase different number of goods depending on the
country, so the figure is converted using purchasing power parity exchange rates, which yield figures
which better represent the purchasing power of a level poverty income
o Relative poverty refers to an individual earning low income relative to others in the country – one way of
having a boundary is setting its definition be incomes less than 50% of the median income
Different countries often set their own poverty lines as well, so there is not a single standard for
relative poverty
Another measure could be the income needed to meet one’s basic needs, however, this is subjective
Multidimensional Poverty Index (MPI)
•
•
•
Income is one factor in poverty, as not being able to meet your basic needs
through purchasing them leads to poverty. However, there are other factors than
simply income that indicate a state of poverty – the UN created MPI to indicate
this
There are 3 main dimensions: health, education and standards of living – each of
these factors has an equal weight in indicating poverty
A person is considered to be multidimensionally poor if they experience
deprivation in at least 1/3 of the indicators [knowing the indicators is not needed
for IB Econ SL/HL]
•
Understanding the composition of poverty allows countries to develop better
policies to reduce levels of poverty – e.g if the indicator shows that most suffer from a lack of nutrition, a food stamp
programme can be implemented.
•
Measuring poverty has numerous problems associated with it, logistically speaking:
o There are many different categories of poverty, and they may vary in definition between NGOs,
Governments etc. This makes international comparisons difficult
o Some factors are impossible to quantify, such as feelings of desperation when one has fears related to poverty,
or other qualitative factors.
o Conducting surveys on poverty requires extensive funding as it is a laborious task
o Many Governments opt to lower the poverty line to ‘lift’ people up from poverty – the core problems may be
covered up due to their difficulty
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Causes of Inequality and Poverty
•
•
•
•
•
•
•
Inequality of opportunities
o Different people are born into different environments and circumstances, which they cannot fully control.
Factors such as education and healthcare affect one’s long–term ability to be equal in economic status as
another person from another location
o Social mobility – one’s circumstances may prevent them from moving up the socioeconomic ‘ladder’, and this
is a long–term goal in reducing poverty
Discrimination
o Gender, age, ethnicity, background amongst other factors can influence how ‘far’ one is able to get.
Differences in Human Capital
o Depending on the occupation, there may be an excess supply of labour alongside a low demand for them,
which would lower real wage levels. As more people move into such occupations, wages would become less
equitable and unfair – desire to lower costs lead to worse working conditions and legal protections as well
Differences in ownership of resources
o It is easier to increase your wealth if you have already started with a significant amount of wealth. May of the
wealthiest people increased their wealth at a rapid pace, while individuals with a lower wealth have had to
work much harder and longer to increase theirs by the same relative amount
Globalization
o Offshoring and extra demand for labour drives businesses to locate their labour–intensive work aborad,
where they can lower the cost of their human capital. With technological improvements, there is increased
structural unemployment, as skilled workers are able to dominate and increase their incomes in the
Quaternary sector, for which there is increased demand and low supply (due to a lack of labour mobility)
Supply–side Market Policies
o Policies such as deregulation, and others which aim to lower costs of production may directly lead to
increasing inequality as these protections may have acted as a safety net for individuals. One example is
‘zero–hour’ contracts, where an employer is not required to employ an individual for a set number of hours.
Tax and Benefits Policies
o The taxation rates may be not be equitable. In many countries, taxes on income from certain assets such as
securities are not taxed as much as income, which allows for the individuals, who already hold vast amounts
of wealth, to increase it at disproportionate rates
o Austerity measures, aimed at reducing Government expenditure to reduce debt, may remove programmes
which prior helped redistribute wealth and implement social security.
Consequences of Inequality & Poverty
•
•
Economic Growth
o While it may have benefits to have a unequal society in the short–term, in the long run, it will lead to lower
productivity, education and skills within the workforce, as fewer people would have access to facilities to
improve those factors, and therefore, improve the quality of the factor of production
o This will also make the PPC shrink inwards in the long run
Living Standards and Social Stability
o Opportunity costs are greater for people in poverty, as they have greater need for basic necessities, while
having a lower amount to spend on such needs. This level of despair may lead to social unrest and perhaps a
change of Government, if people see that their systems do not help
Taxation in Reducing Poverty, Income and Wealth Inequality
•
•
Many governments implement progressive tax systems to tax those earning higher levels of incomes more than those
earning less, as a way of having some level of equality
Few governments have systems in which they tax wealth through taxing assets which are likely to be owned by the
wealthiest, such as large property.
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•
Increasing tax on the wealth of rich individuals would allow the government to take possession of that capital, and
redistribute it or re–invest it into the economy to create greater distribution of income
Progressive Tax
•
•
•
•
Progressive tax systems may also apply to corporate tax, as
the largest firms often pay similar tax rates as smaller ones
despite their size and economies of scale.
Progressive tax brackets are calculated through appraising
what tax rate one’s portion of income belongs to.
Taxes are often more complex than it is shown here, though.
In many countries, some spending is deductible, if the government deems it to be an economic action that should not
be taxed – this could include things such as charity donations
However, progressive tax may create disincentives:
o People may work fewer hours and become less productive, knowing that a disproportionate portion of their
income will be taxed
o This may lead to firms and individuals leaving the country for ones with lower tax rates – this would have a
net negative economic impact
Regressive Taxes
•
•
•
Regressive tax structures tax individuals less as their income increases.
Due to the fact that indirect taxes are fixed, they are a regressive form of tax – someone earning less than another
person will spend a higher portion of their income on indirect tax than someone who earns more
Though it is not designed to do so, such indirect taxes may be a barrier for income deprived individuals in acquiring
their basic needs, for example, petrol.
Transfer Payments
•
•
Transfer payments may be used as another method of increasing equality in terms of income and wealth – these are
essentially social security payments from the Government
Some transfer payments are universal, such as child support, but others may require one to be eligible to receive it –
e.g earning below a certain income to qualify for Medicare
Investing in Human Capital
•
•
It is not as simple as encouraging governments to increase the quantity of their investment in human capital, but also
the quality of such investments – spending on areas not necessary creates opportunity cost
Generally, investments in human capital involve attempting to improve social mobility through increasing the
availability, quality and barrier of education, healthcare etc.
o Examples include apprenticeships, free University education, Universal Basic Income, free School Lunches
Policy–driven Reduction in Discrimination
•
•
•
Greater levels of equality can be reach if forms of discrimination are eliminated. Governments may do this through
enacting laws which prohibit discriminatory behaviour, and punish them
Diversity policies also set a legal mandate for reducing discriminatory behaviour within firms
Other forms of policies aimed at achieving this may include:
o Equal pay laws
o Prohibition of employer discrimination against disabled people
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Minimum Wages
•
•
There are significant advantages to having minimum wages:
o There is no empirical evidence for it damaging employment rates
o Nature of minimum–wage work is such that it is irreplaceable by machinery
o Higher pay levels motivate and increase productivity, so it should offset the cost
o Higher pay encourages people to stay in their occupations and gain more skills and experience, and reduce
firm costs as they do not have to spend as much on re–training employees
o Higher pay encourages more people to join the labour market, which may reduce natural unemployment
rates, and increase AD
o Minimum wage supports people who would have otherwise been reliant on social security or other goodwill –
they can be productive members of society as a result of them being economically active
Some disadvantages could be:
o May reduce the supply of labour, leading to an increase in unemployment
o May encourage firms to find ways of reducing labour costs – may cut corners on safety or invest in machinery
o Higher pay rates could transfer onto the consumer in the form of higher prices, which may create other
economic issues of its own
Universal Basic Income (UBI)
•
•
•
Welfare programmes have many costs associated with them, as it is necessary to check qualifications of candidates to
make sure that its funds are not drained by cheaters. There is also the logistical challenge of managing everyone’s case
In a country with UBI, everyone would receive the same amount of money each time interval with no preconditions
or registration
There are several arguments against UBI:
o People would not want to work as they’d have large amounts of income with no work
However, UBI would be enough to satisfy their basic needs, not fully support people financially. UBI
gives people the extra disposable income they need to become more economically active through
actions such as starting a new business
o It’s too expensive
However, it is within the best interests of society to distribute wealth from the wealthiest to ones
who genuinely need it. There are few economic consequences of increasing taxes on the rich, but
there are many for increasing inequality
It would also allow the government to reduce spending in other areas where they feel that people can
use UBI to assist them. This can free up resources to be put back into the economy
Why do Countries Trade? – The Global Economy (Chapter 23)
Gains from International Trade
•
•
•
•
•
Lower Prices – people usually aim to purchase goods from abroad so that they are cheaper than domestic ones.
Producers can also lower their costs by buying foreign commodities
Greater Choice – variety drives demand for international trade
Differences in resources – some areas of the world have resources which others do not have and need. Trade allows
this exchange to happen and for almost any commodity to be acquired.
o This creates dependencies between countries, which can improve diplomatic relations and allow countries to
support each other
Economies of scale – the size of the market for goods increases when it is exported, so there is potential for increased
economies of scale and a greater AD
o If countries specialize in a certain industrial process, such as chemical manufacturing, then the task can be
delegated to them, which will lower costs as these skills will not need to be learned.
Increased competition – the increased number of firms operating in the industry leads to increased competition, and
all of the advantages that come as a result. This may also decrease prices in the long term and give consumers more
choice
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•
•
More allocative efficiency – resources are more likely to be allocated efficiently given the international demand for
them – especially if they are non–renewable or perishable, as they must maximize profits from a limited supply of the
product
Source of foreign exchange and currency exchange – many countries do not have a convertible currency, or have one
which is in extremely low demand, so being able to exchange goods for more exchangeable currency such as the
United States Dollar is essential – it allows the country to import more goods, as they will be able to exchange the
product for something they are willing to accept – an international accepted currency
Comparative Advantage Theory
•
Absolute advantage – this occurs when a country is said to be able to produce a good using fewer resources to do so
compared to another country
o A country should try to specialize in producing the good for which they can use the least amount of resources
to be optimally efficient.
• Comparative Advantage – a country is said to have comparative advantage if it can produce a product at a lower
opportunity cost than another country.
o Per the theory of comparative advantage theory, a country should specialize in the production of a good for
which they have an absolute advantage, and one for which they have a lower opportunity cost compared to
another good from another country
The other country should produce the good for which they have the lowest opportunity cost, as it
maximize allocative efficiency and allow the other trading country to acquire the other good
o To illustrate the concept, we can say that the country which has the highest production capacity for a good,
and a relatively smaller trade off in the production of the other good should specialize in producing the good
Illustrating
Gains from Specializations
and Trade
•
To do this,
we have
to consider
an
exchange
ratio, in
this case, using the prior example, 1:1 for cheese and wine
o Before specialization, let us assume that Poland produces at level x on its PPC,
producing 600 million kg of cheese for 300 million litres of wine.
It then specializes where it has the comparative advantage, in producing cheese, and produces 1500
million kg of cheese and no wine.
• They then decide to export 600 million kg of cheese to France,
and because the exchange ratio is 1:1 between cheese and wine
(red line), it receives 600 million litres of wine as imports.
o With this, Poland is now consuming quantities of wine
outside of their PPC, which is a 300 million litre gain in
the supply of wine available.
o Before specialization, France produces at level x on their PPC. They then start
producing wine, where they have the comparative advantage, and no cheese.
It then agrees to export 600 million litres of wine to Poland, and due to
the exchange ratio, they gain 600 million kg of cheese which they could
not have produced while also holding a supply of 1400 million litres of
wine. So there is a net gain of 200 million litres of wine for France,
which they can consume.
•
Comparative Advantage Theory works only when the opportunity costs borne by
countries is different – if they have the same opportunity cost, then there is no point in
trading in terms of net gains of products.
•
The theory also has its limitations:
o It assumes perfect knowledge and perfect competition
o Assumes there are no transport costs, which is wholly untrue – they can make or break trade deals
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o
o
o
o
Assumes there are 2 economies producing 2 goods, but economies are much more complex than this
Assumes there is no economies of scale to be gained, however, having economies, or diseconomies of scale
may alter a country’s comparative advantage
Assumes factors of production remain in the country, but many allocate factors such as labour abroad where
it is cheaper and send the finished product back to the origin country
Assumes there is a completely free international trade market, but in reality, tariffs and other barriers exist
Gaining a Comparative Advantage
•
With large amounts of land which can be used for agricultural purposes, and large amounts of unskilled labour force,
a country can develop a comparative advantage for agricultural products. This idea works for other products.
o The idea is that any advantage a country has which lowers the cost of one of its factors of production
compared to another yields them comparative advantage
Free Trade and Protectionism – The Global Economy (Chapter 24)
•
•
Free trade is said to take place if there are no barriers to trade between any and every country
Despite the idea sounding flawless, many still argue for protectionism. Some arguments against Free Trade go as
follows:
o Protects Domestic Employment
Some domestic firms would not be able to compete on the scale that multinational foreign firms,
with vast amounts of capital can, which may lead to them being driven out of their markets, and
hence, leading to unemployment – though the industry may still die out from other factors
o Protecting Economy from Low–cost Labour
Domestic industry may suffer from large amounts of unemployment if enough volume of goods is
imported from countries with lower cost of labour, however, based on the theory of comparative
advantage, we could say that it would lead to inefficiencies as the cost of human capital would
increase – this could lead to fewer exports, therefore, worse output
• Supply–side policies are meant to incentivize the creation of a workforce which is mobile
and can therefore adapt to situations where their industry is threatened. If this is not the
case, then large–scale structural unemployment may take place.
o Protecting an infant industry
Some governments may impose protectionist policies to protect some of their newly developing
industries which may not enjoy the same economies of scale as multinational firms, which would put
them at a major competitive advantage.
• This argument can be somewhat refuted by the fact that most countries have well–
developed capital markets, from which firms which are at a disadvantage can raise the
capital they need to compete better
o However, there is a major time lag between acquiring capital and it having an
immediate impact on competitiveness, not to mention the fact that most forms of
capital acquired from the capital market have interest and are liabilities.
o To avoid over–specialization
If a large–enough MNC acquires enough control of the aggregate supply or production in an
economy, then it may be the case that the national income may come from a select number of
exports, creating major dependencies on them, and therefore, the MNC.
o Political/Strategic Reasons
It may be important for a government to want to maintain the integrity of some of its industries,
such as munitions, as it may be a government policy
o Prevent Dumping
Dumping occurs when a country exports products at below production price to other countries in
large quantities, which cripples domestic production and drives them out of the market
• However, imposing protectionist policies as a response may be seen as provocative, and may
start a trade war
o To protect product standards
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o
o
Tariffs or bans on foreign products may be imposed for health or quality reasons. A country which
has banned hormone–treated beef would not allow it to be imported from elsewhere
• High standards increase costs of production, as certification and adjustments to production
per the standards of a country are expensive. This makes it harder for producing countries to
take advantage of their comparative advantage
To raise government revenue
Some countries may require extra source of revenue, in which case they can impose tariffs, which are
essentially taxes on imports.
• However, this increased cost is transferred onto the consumer, and may result in average
price levels increasing
To correct a balance of payments deficit
Protectionist policies may be implemented to reduce import expenditure and balance out the
amount a country earns on exports and spends on imports
However, this doesn’t correct the core problem that caused a balance of payment deficit, so it is a
short–term ‘fix’
Arguments against Trade Protection
•
•
•
•
•
Protectionist policies raise average price levels of imports and costs for producers
There could possibly be fewer choices for consumers
Domestic markets can become more competitive with an increased number of firms in the competition, which would
incentivize the development of new ways of maximizing profits
Distorts comparative advantage, leading to inefficient use of world’s resources – specialization is reduced, and the
potential global output of certain products are reduced
May lead to ‘trade wars’, which damage both parties’ economies – this involves large tariffs
Free Trade
•
•
•
With free trade, consumers are often able to acquire products at a lower price, as international markets are often
more competitive and therefore, have lower prices.
In the diagram it can be seen that if there was free trade in the country, then
consumers could purchase wheat for average world price level of P W, which is lower
than the domestic equilibrium price of Pe, which would mean that Quantity Q2 of
wheat can be consumed
o At price level PW, domestic producers are willing to supply at level Q1, so if
domestic firms wish to compete with international firms, they must lower
their prices
A country can export goods given that the average world price level for their product
is higher than the domestic price, as firms wish to maximize profits, therefore,
venturing to foreign markets with that aim.
o If World prices are lower than the equilibrium price, then it is better for
consumers to import, so there would be fewer exports
Tariffs
•
Tariffs are taxed placed on imports. They tend to shift the supply curve upwards, as
they increase the per unit and marginal costs of production. The impact of tariffs is
shown on the diagram.
o Considering the tariff to be at rate T, then it would increase the cost of
importing the product to Pw + T, which will decrease domestic demand for
the product from quantity Q2 to Q4
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This means that domestic producers are able to produce ∆Q3 Q1 more units, which would increase their
revenues to ∆0Q3 × 0Pw + T – the area 𝑎, 𝑏, 𝑔, 𝑐, ℎ
o Foreign producers now produce ∆Q4 Q2 fewer units, reducing their revenue from the areas of the triangles
ℎ, 𝑖, 𝑗, 𝑘 to now only 𝑖 and 𝑗
o The government now gains revenue 𝑑 and 𝑒
Tariffs are the most common anti–dumping measure
There can also be 2 more outcomes:
o Consumers do not purchase additional ∆Q4 Q2 units of wheat, but instead use the money they would have
spent on something else, which would create the consumer surplus of 𝑓
o New quantities of ∆Q3 Q1 units would be produced by domestic producers, who are inefficient, as they
require a minimum revenue of areas ℎ, 𝑐, which is 𝑐 levels higher than that of foreign producers, which shows
that domestic producers are less efficient – this represents a loss of welfare in the shaded triangle
o
•
•
International Trade Subsidies
•
•
Subsidies are paid per unit of output to lower costs.
If a government grants a subsidy for a domestic firm, then it’d shift the supply curve
downwards by the amount of the subsidy
o Prior to the subsidy, domestic producers produced at quantity Q1 for price
Pw, and consumers imported ∆Q1 Q2 from abroad.
o With the subsidy, domestic producers now receive Pw + Subsidy per unit, so
they are able to increase the quantity supplied by ∆Q1 Q3 , and a lower
quantity of ∆Q2 Q3 is now imported from abroad to fully meet demand.
o The subsidy results in a welfare loss of area 𝑔, as less efficient domestic firms produce more of the product
for a higher cost of the subsidy, which is a resource which could have been allocated elsewhere in the
country/world.
There is no loss of consumer surplus, as the price does not change, but they will be affected since the
government must acquire revenue for the subsidy from citizens.
Quotas
•
•
Quotas are physical limits on the number or value of goods that can be imported
In the example below, before the quota is imposed, Q2 units of wheat were purchased at world price of P w, domestic
suppliers supplied Q1 units with the foreign producers making up for the rest of the ∆Q1 Q2 units that are demanded
In the example, a quota of ∆Q1 Q3 (maximum units imported) is imposed, and this means that domestic producers
produce at their same level of Q1, but foreign firms produce at only level ∆Q1 Q3 .
o However, with this, there is an excess demand of ∆Q3 Q2 with respect to price Pw, so as a result, prices begin
to price to level PQuota, through which domestic producers are able to increase their revenue by ∆PQuota Pw per
unit
Importers’ revenues fall by areas 𝑐, 𝑑, 𝑒 to 𝑏, 𝑔, ℎ
The possible outcomes are:
o Consumers do not consume ∆Q4 Q2 units of wheat and spend the amount they would have spent on ∆Q4 Q2
units on something else, which represents a consumer surplus of 𝑘
o The ∆Q3 Q4 extra units that domestic firms now produce are done so inefficiently, as they require extra
revenue of 𝑗 to do so, which is less efficient than international firms.
This is another form of dead–weight loss for producers.
•
•
Administrative Barriers
•
There are several types of administrative barriers a government can impose in aim of numerous objectives;
o ‘Red Tape’ – these are often lengthy, complicated and costly bureaucratic procedures which aim to
discourage imports, as it’d mean having to spend extra on resolving documentation or other issues. This
delays the imports reaching the domestic market
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o
o
Health, safety and environmental standards – the primary aim of this is to prevent unsafe and inferior
products from reaching domestic markets and causing negative externalities. It is important that this is used
in this capacity, as increased regulation increases per unit costs and average price levels.
Embargoes – Complete ban on import of goods/services – this is often a political punishment, rather than a
legitimate supply–side policy
Economic Integration – The Global Economy (Chapter 25)
•
•
•
Economic integration is a process through which countries coordinate and link their economic policies and decrease
trade barriers
Bilateral trade agreement – trade agreement between 2 countries – usually to remove quotas/tariffs
Multilateral trade agreement – trade agreement between several countries
Trading Blocs and their Economic Integration
•
•
A trading bloc is defined as a group of countries which join together to increase trade
between them
The economist Bela Balassa identified 6 stages of economic integration:
o Preferential trading areas – this is a special agreement between a group of
countries that grants them special privileges in terms of trade, whether that’s
access to certain goods or reduced duties
A reciprocal trade agreement means that the terms are mutual, and that
both parties gain the same privileges
o Free trade areas – this is an agreement in which countries agree to trade freely
amongst themselves, and be free to trade/not trade amongst countries outside of
the free trade area
o Customs Union – this is when countries agree to trade freely amongst
themselves, but all also agree to have common barriers reducing trade outside of
the customs union
o Common Markets – this is a customs union with common policies on product regulation, and free
movement of goods and services.
o Economic and monetary union – this is a common market but with the same currency and common central
bank – an example is the Eurozone and countries apart of that.
o Complete economic integration – this is where countries have no control over their fiscal, monetary or
otherwise policies. In this case, economies would be harmonized.
Membership of Monetary Unions
•
•
Membership of monetary unions have several advantages:
o Exchange rate fluctuations between countries in the union will disappear, as a common currency will be used.
This will reduce costs and incentivize trade due to reduced volatility
o Currencies used in a significant monetary union will be more stable and less vulnerable to speculation and
fluctuations
o Common currency makes price differences between different areas more apparent, which will help
consumers and producers act more rationally when making decisions
However, it also has several disadvantages:
o Interest rates are decided by a central bank, so individual countries have no control over the interest rates
that are set.
This means that certain tools within monetary policy are not available for the government to
influence inflation, unemployment and economic growth. This is problematic if a member state
experiences economic problems when other member states are not – there will be economic disputes
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•
•
Many argue that without more fiscal integration in the form of uniform treasuries, taxes and
budgets, some member states will act irresponsibly and threaten the unity of the monetary union
Countries are not able to alter exchange rates to influence international trade
Transitioning into a new currency is an incredibly costly and burdensome task – old currency has to
be collected, destroyed, and new ones printed.
In a situation where countries are experiencing economic instability and volatile exchange rates, a monetary union
will serve to stabilize their economies. In this case, membership may be beneficial to both parties.
In a case where their currencies are relatively stable, joining a monetary union may have more disadvantages.
Membership of Trading Blocs
•
•
In terms of economics, there are several benefits to such a membership:
o Greater market size, which allows producers to increase their production and output, potentially benefiting
from increased economies of scale and becoming more efficient.
o Increased firm efficiency leads to greater consumer choice and lower prices for members
o Foreign investors may be attracted to the market as a way of accessing the greater market – this will boost
investment levels
o If the bloc includes free movement of labour, then greater employment opportunities will be present, and
economic growth may be easier to achieve, as human capital would be more accessible, and easier to acquire
in some cases.
o It will help cerate political stability and cooperation, as economic unity creates interdependency
o Trading blocs have more economic and political power, so acquiring new trade deals will be easier for the
group of countries rather than individual states
However, several disadvantages exist for membership of trading blocs
o There is likely to be discriminatory economic policies against states outside of the trade bloc, which can be
damaging in terms of Global efficiency, harmony, and in terms of the goals of the WTO (World Trade
Organization) – this is likely to negatively affect poorer states with less political power as they will not be
able to secure the best trade deals
o Some degree of economic sovereignty will be lost – control over certain aspects of the economy is lost
Trade Creation
•
•
If the trading bloc is a customs union, then trade creation may occur:
o This occurs when entry of a country into a customs union leads to the
production of a good or service transferring from a high–cost producer to a
low–cost producer.
In an example, before the UK joined the EU in 1973, it a comparative advantage over
France in producing lawnmowers, which led France to put tariffs on UK
lawnmowers.
o Upon joining the EU, this tariff was naturally lifted, which meant that there was an increase in the quantity
of lawnmowers imported into France, as their price was lowered – there was ∆Q1 Q4 increase in the quantity
imported.
This leads to an increase in world efficiency, highlighted in the blue triangle, as more units are able
to be produced and consumed at a lower price point
This increases consumer surplus as well, as consumers are able to acquire more units to satisfy their
demands
o Therefore, we see that a high–cost producer, France, being inefficient at producing the good, has now moved
onto importing from a low–cost producer, the UK and therefore, more efficient production can be achieved
o This agreement should be two–way, so products for which France has a comparative advantage will be
imported more into the UK
Trade Diversion
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•
•
This can occur if there is a trade bloc which is also a customs union. This has the
opposite effect, and transfers production from a low–cost producer onto a high–
cost producer
Joining a customs union would mean the placement of quotas or tariffs onto
producers outside of the union, which will shift the foreign supply curve upwards,
and increase prices
o This would increase the quantity produced for domestic producers to
∆0Q1 Q2 units, and the rest of the ∆Q2 Q3 units would be imported from the EU.
This represents a loss of consumer surplus of the shaded area, and a large overall loss in world
efficiency, as fewer goods are purchased at a higher price
The World Trade Organization (WTO)
•
•
•
•
The organization aims to resolve trade and economic disputes on the world stage – they are often attributed to the
fall in global tariffs from an average of 40% to 4%
All WTO members must grant each other ‘most favoured nation’ status, meaning that when concessions are made to
one country by another in the WTO, all must receive the same benefits
WTO has several principles:
o Non–discrimination in terms of economics
o More open trade – reducing barriers to trade
o Predictability and transparency – reduce volatility in global markets and to prevent economic crises
o Encourage fair competition and fight unfair practices such as dumping
WTO’s functions are:
o Administer trade agreements
o Be a forum for trade negotiations
o Monitor national trade policies to regulate
o Cooperate with developing countries to help them increase their trade
Factors limiting Effectiveness of WTO
•
•
•
Unequal bargaining power of countries – all countries are said to have an equal vote, however, the large economic
power of the EU and USA mean that their concerns and propositions are more heard than those of smaller nations
Some agreements of the WTO may prevent smaller developing countries from protecting their infant industries and
achieve diversification
Increasing amount of trade deals outside of WTO – this delegitimizes the WTO and sets a precedent of factionalism
Exchange Rates – The Global Economy (Chapter 26)
•
•
•
Exchange rates are the value of one currency expressed in terms of another currency
Currencies are traded on the foreign exchange markets, called Forex.
o This is usually done by governments, central banks, private commercial banks and other financial
institutions
There are 3 main types of exchange rate systems in the world
Fixed Exchange Rate System
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•
•
•
•
•
•
This is where the value of a currency is fixed, or ‘pegged’ to another currency, average
value of selected currencies or the value of commodities such as gold – value changes as
pegged item’s value changes
If the value of a currency increases in a fixed exchange rate system, it is said to be a
revaluation, and the opposite is a devaluation
Fixed exchange rates are maintained by government intervention in Forex markets
In this example, the supply of Barbados Dollars increases due to factors such as greater
investment or otherwise – this would typically decrease the value of the currency
o The government however, purchases the excess amount of the currency from the Forex market using its
foreign reserves to maintain the balance
If Demand for a currency increases, then governments may also increase the supply of the currency to make sure that
the value does not increase
It is also possible to maintain exchange rates by making it illegal to use non–government rates, but that is hard to
enforce and likely leads to black markets
•
This regime has several advantages:
o Reduction in volatility and increase in business confidence – firms can plan ahead knowing that the exchange
rate will not change rapidly
o Fixed exchange rates ensure sensible fiscal policy, as inflation will be detrimental to demand of imports and
exports
o Should reduce speculation in theory
•
Disadvantages:
o Having a fixed exchange rate means that the central bank is compelled to monitor and manipulate markets to
keep the rate fixed – this could mean increasing/decreasing interest rates, which may have negative
consequences elsewhere in the economy
o Large reserves of foreign currency are required, as they must demonstrate that they are able to defend the
exchange rates by buying/selling foreign currencies
o Finding the exact rate to set the currency is very difficult and doing so incorrectly will have consequences on
imports/exports
o Potential international backlash if rates are set intentionally low to manipulate trade
Floating Exchange Rate System
•
•
•
This is where the value of a currency is determined solely by the supply and demand of it – there is no government
intervention to influence the value of the currency
If the value of a currency increases in this regime, it is said to appreciate and if opposite, depreciate
The impacts of changing currency values are high – e.g if 1 USD = €0.8, and if it changes to 1 USD = €0.7, then the
value of the Dollar is said to have appreciated in terms of Euros – fewer dollars can buy more euros
o The relationship of changing exchange rates are such that if one depreciates, another appreciates. In the
example above, Euros would have been said to depreciated against the Dollar
If $1 = 0.8€, then 1€ =
•
•
1
$
0.8
This has several advantages:
o Government can freely use demand management tools such as monetary policy to alter things such as interest
rates for domestic purposes – they are not bound to control the currency
o In theory, the currency should be balanced – forces of supply & demand control price.
o Reserves are not needed, so this will save money on purchasing foreign currency
Disadvantages:
o Likely to create uncertainty and encourage speculation
o Forces outside of supply & demand affect the exchange rate, so it doesn’t always balance itself
72
o
May worsen inflation, because if they already have high inflation compared to other countries, imports will
be cheaper and exports less competitive, and this may further increase prices, worsening inflation
Factors Affecting Exchange Rates
•
•
•
•
For this we have to consider forces that will affect the supply and demand of foreign currencies.
First, let’s consider what foreign currencies may be used for:
o Buy exports of foreign countries
o Invest in foreign firms in their own currency
o Save their money in foreign banks in the local currency
o Make money on speculating about changes in exchange rates
Demand for a currency will rise when:
o There is an increase in demand for foreign goods/services – this can be caused by:
Foreign inflation rates being lower than domestic inflation – this makes foreign goods less expensive
Increase in domestic incomes, which will increase demand for all
goods/services
Change in consumer taste for foreign goods
o Foreign investment prospects improve due to factors such as economic growth
or business–friendly environment
o Foreign interest rates increase, which will make it more attractive to save in
foreign banks
o Speculators believe that a foreign currency will increase in value
Supply of a currency will increase when:
o Consumers wish to purchase foreign goods/services – increases demand for
foreign currency, which increases the supply of the currency that is exchanged
in the Forex market.
o Invest in foreign firms
o Save their money in foreign banks
o Make money by speculating on another currency and exchanging them
o All the factors in the demand increase section apply here, as they increase the
supply of the currency exchanged
Managed Exchange Rate System
•
•
•
No currency in the world is completely free floating, as it is extremely vulnerable to losing its value drastically in case
of economic crises – governments intervene in Forex markets to control the price of their currency and ensure
stability
With this system, the currency is permitted to float, but in some cases, governments may intervene.
Often, central banks set an upper exchange rate limit, and will intervene if it reaches that level – this isn’t made
public for fear of speculation
Evaluation of High Exchange Rates
•
•
This has several advantages:
o Downward pressure on inflation – the price of imports decreases, as purchasing power for foreign goods
increases. This encourages competition as domestic firm are able to lower costs by saving money
This results in greater efficiency
o More Imports can be purchased
However, it also has several disadvantages:
o Damage to exports – due to the higher prices, it may more difficult to sell goods abroad, and this may result
in a balance of payments deficit
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o
Damage to domestic industries – greater imports may result in decreased AD and therefore, increased
unemployment
Evaluation of Low Exchange Rates
•
•
This has several advantages:
o Greater employment in export industries – cheaper exports encourage more firms to be active in that
industry, leading to greater employment and output exported
o Greater employment domestically – lower exchange rates increase prices of imports, so domestic goods, with
a lower price, are likely to enjoy increased AD
Though, its disadvantages are:
o Inflation – There may be higher prices in the economy if there is a large dependency on imported goods or
commodities, which would transfer onto the consumer, raising aggregate price levels.
Government Intervention in Forex Markets
•
•
Governments may intervene in Forex markets for several reasons:
o Improve balance of payments
o Avoid large fluctuations in exchange rate and curtail speculation
o Improve business confidence through economic stability
There are 2 main methods of intervening in Forex markets:
o Using foreign currency reserves to purchase/sell foreign currencies – The supply and demand of currencies
can be altered by buying or selling certain units of its currency
To raise exchange rates, governments can purchase their currency from the market
To lower exchange rates, they may sell their currency more
o Changing interest rates
Increasing interest rates will make foreign firms more attracted to saving and investing in the
country – to do this, foreign firms must buy the local currency, which will increase its demand and
vice versa.
The Balance of Payments – The Global Economy (Chapter 27)
The Balance of Payments Account
•
•
•
The balance of payments account is a record of the value of all the transactions between residents of one country and
the residents of all other countries in the world at a given period of time, usually a year
There are 3 parts to this account – the current account, the capital account, and the financial account
Any transaction that leads to money entering the country from abroad is known as a credit item and is given as a
positive value – money leaving the country is known as a debit item and has a negative value
Elements of Current Accounts
•
This is a measure of the flow of funds from trade in goods and services and income flows. It is usually sub–divided
into 4 parts:
o The balance of trade in goods – this is a measure of revenue received from the exports of tangible goods
minus expenditure of imports of tangible goods
When export revenue is greater than import expenditure, then there is a surplus in the balance of
trade in goods – opposite is called a deficit on the balance of goods/services
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o
o
o
The balance of trade in services – measure of flow of funds in services and intangible products – things such
as banking, tourism etc.
Income – This is known as net investment income – it’s a measure of net monetary movement of profit,
interest and dividends in and out of the country, as a result of financial investment abroad
Income from dividends from investment abroad is an inflow, and dividends paid to foreign investors
by domestic firms is an outflow
Income from domestic firms abroad is considered to be inflow, and is positive
Profits sent out of the country by foreign firms are outflows, and are negative
Current transfers – measure of net transfers of money – payments made between countries when no
goods/services change hands
These include items such as grants/aid – on an individual level, they include workers giving financial
gifts to their family in the country from abroad.
Current Account Balance = Balance of trade in goods + balance of trade in services + net income flows + net transfers
Any one of these factors may be in surplus or deficit, so the average value determines whether the
current account is in surplus or deficit.
Elements of Capital Accounts
•
This has two small components:
o Capital transfers – net monetary movements gained or lost through actions such as the transfer of goods and
financial assets by migrants entering or leaving the country, debt forgiveness, transfers relating to the sale of
fixed assets, inheritance taxes and death duties
o Transactions in non–produced, non–financial assets – net international sales and purchases of non–
produced assets, such as land, right to resources and intangible assets such as copyright.
Elements of Financial Accounts
•
•
This measures the net change in foreign ownership of domestic financial assets
o If foreign ownership of domestic financial assets increases faster than domestic ownership of foreign financial
assets, then more money is entering the country, which puts the balance in surplus and vice versa.
This has 3 components:
o Direct investment – direct measure of purchase of long–term assets such as purchasing property, businesses
etc. There is an expectation of positive returns, but this is not always the case
Most of the activity in this section is in the form of Foreign Direct Investment (investment by MNCs
in other countries) – the International Monetary Fund states that investment in a firm is FDI if it
counts for at least 10% ownership of the company
There is not always an expectation to get return on investments
o Portfolio investment – stock and bond purchases, which are not direct investments as they do not include a
lasting interest in the company – includes buying/selling of bonds or even savings deposits.
Within this, the investor is spending money to purchase an asset with the expectation that it will be
paid on the investment and that the money will be returned in the future.
o Reserve Assets – reserves of gold and foreign currencies – it is this account that ensures that the balance of
payments will always balance to zero. It is the net changes in the official reserve account over the period of
time, that balances the accounts.
Balancing Balance of Payments
•
In reality, the balance of payments will not balance. There are too many individual transactions taking place for it to
do so – not every transaction gets recorded correctly, if at all.
o To counter this, an item called ‘net errors and omissions’ is placed to make sure that it balances.
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•
•
•
The balance of payments must always equal to zero, because it is a debit and credit–based measurement, meaning
that every transaction involves a receipt and a payment. So when a country purchases domestic products and imports
it, there is an inflow of money in the current account, but an outflow in the financial account as the country uses
foreign reserves to pay for the item.
If the current account is in deficit, then the other accounts will be in surplus and omissions will be added to balance
it, and vice versa.
If the Current Account is in deficit, then by definition, the Financial + Capital Accounts MUST be in surplus to
balance out.
Current Account = Capital Account + Financial Account + Net errors
Current Account + (Financial Account + Capital Account) = 0
•
•
•
•
Current Account
Balance of trade in goods
Balance of trade in services
Income
Current transfers
•
•
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Financial Account
Direct Investment
Portfolio Investment
Reserve Assets
Official Borrowing
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Capital Account
Capital Transfers
Transactions in non–financial,
and non–produced assets
Relationship between Current Account and Exchange Rates
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A deficit in the current account may result in downward pressure on the exchange rate of the currency
o In a fixed exchange rate system, the implication is that the rate is set too high – in the short run, this may be
covered by increases in the capital and financial accounts, but this is unsustainable in the long run due to
reserve assets running out
o In a floating system, the deficit implies that there is an excess supply of currency on the Forex market – this
may be because demand for exports has fallen, as has the demand for the currency and demand for imports
has increased, leading to more demand for foreign currencies
This should decrease the value of the domestic currency, improving the competitiveness of exports
and increasing price of imports.
•
A surplus in the current account may likewise result in upwards pressure on the exchange rate
o For a fixed exchange rate system, the implication is that the exchange rate has been set too low – this can be
offset in the short run by deficits in the financial and capital accounts, or by increases to reserves, but this
may have political consequences as other countries may protest the artificially low exchange rates
o In a floating system, the surplus implies excess demand for the currency on the Forex market – this may mean
demand for exports has risen and imports fallen – this leads to less demand for foreign currencies, so a lower
supply of domestic currency on the foreign exchange markets
The exchange rate should naturally rise, decreasing the competitiveness of the country’s exports and
lowering domestic price of imports
Consequences of Current Account Deficit
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In this case, the capital account will have to be in surplus to balance out the current account. This may have several
consequences:
o Foreign reserves may be used to increase capital accounts, but no country is able to use foreign reserves to
fund long run deficits in current accounts – there are not enough reserves
o In the case of a deficit, it may be required to have more foreign investment into the country, through things
such as acquiring properties, businesses etc. This can be harmful to a country’s economic sovereignty and
could cause political tensions
o The deficit may be funded by high levels of borrowing from abroad, which is unsustainable in the long term,
as it accumulates high costs in the form of interest – it may add onto the deficit in the future
o With levels of debts and the potential for governments to default on some debt, they may get a poorer credit
rating, which may make it more difficult to acquire credit from abroad and finance future deficits
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One response to finance a current account deficit may be to lower interest rates to lower the exchange rate,
but this prevents the Central Bank from using interest rates as a part of monetary policy – this will cause
inflationary pressure in the economy
A current account deficit is a negative component of AD, so it may shift the curve to the left, leading to less
consumption and more unemployment.
Consequences of Current Account Surplus
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There are a number of factors which may lead to a country having a surplus current account – structural factors:
o Countries may have significant amounts of comparative advantage in the long run, which would increase
demand for their exports
o Households in the country may have high savings ratios, and may have less consumption overall as a result
o There may be significant increases to the prices of exports, such as oil, an inelastic–demand product. This
leads to increased export revenue
o A country may have experienced increased technological advances and improvements to productivity,
increasing their national income.
Cyclical Factors:
o Depreciation of a country’s currency increasing international competitiveness
o Increase in foreign consumer demand for country’s main export markets – increase to export supply and
revenue
o Cyclical improvements to the economy and national income, which increases consumption and investment,
shifting AD to the right.
o Increases to net income flows and current transfers, for example, increased profits abroad.
There are positive and negative consequences to having a current account in surplus:
o A current account surplus allows a country to have deficits on its capital account by increasing its official
reserve account or by purchasing assets abroad – this comes with benefits of having larger foreign reserves
o Short run increases to current account represents a shift of AD to the right, as net foreign income increases –
results in increased inflationary pressure and employment
o In the long run, persistent current account surplus may cause appreciation of the currency, making imports
cheaper, decreasing inflationary pressure – though, this may harm exporters as there will be less demand for
them.
o In effect, if additional revenue from increased exports is not spent on imports, then it is used to purchase
assets abroad as a form of saving
o Persistent current account surpluses are indicative of other countries’ deficits, so it may highlight inequalities
in trade
It is easiest for understanding the scale of a current account surplus/deficit to depict it as a portion of GDP
Rectifying Current Account Deficits
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For the most part, in the long run, countries ensure that current accounts do not go into deficit by implementing
effective supply–side policies – the goal is to ensure that exports are competitive and that domestic firms can
compete with importers
However, if the country already has a deficit, there are two ways of mitigating the problem:
o Expenditure–switching policies – these are policies aimed at switching domestic expenditure away from
imports and towards domestically produced goods and services – as import expenditure falls, exports are
more likely to increase current accounts’ value. Examples of this are:
Devaluation of currency by Governments – makes imports less attractive
Protectionist Measures – though this may be against WTO agreements
o Expenditure–reducing policies – these policies attempt to reduce total expenditure in the economy, shifting
AD to the left. The scale of the fall in import expenditure will depend on the level of marginal propensity to
import – though, this is likely to decrease economic growth and national income, and cause unemployment.
Examples of this policy are:
Deflationary fiscal policies – increases to tax, reducing gov. expenditure etc.
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Deflationary monetary policies – increasing interest rate/reducing money supply
• Increasing interest rates could also attract foreign firms to save in domestic banks, which
would increase the balance of the financial account, which helps mitigate a current account
deficit
The Marshall–Lerner Condition
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It is assumed that depreciation to currencies will increase demand for exports, however, this assumes for the product
to have unit elasticity of demand. In reality, the elasticity of demand of the exports will determine the level of output
abroad.
The condition is a rule which indicates how successful a depreciation of an exchange rate will be as a way to improve
current account deficits
The condition states that reducing the value of the currency will only be successful if the total value of the price
elasticity of demand for exports and imports are greater than 1.
PEDexports + PEDimports > 1
The J–Curve
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In the short–run, the current account deficit becomes worse before it actually improves –
the J–curve depicts what happens once the exchange rate decreases to improve current
account deficits
Once the exchange rate changes, it is not realistic to assume that every producer and
consumer will instantaneously know about it – in the short–run, the PED of the product
will become inelastic, and the same quantity of products will be supplied at a higher price,
reducing export expenditure
Moreover, it is difficult to break contracts and sign new ones with the new exchange rate in mind, so the process of
adjusting demand is not fast to respond
Over time, products experience more elasticity, and we see that here, with consumers adjusting their demand
accordingly to the price, as they gain more information about the state of the market.
Economic and Sustainable Development – The Global Economy (Chapter 28)
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Developmental Economics is separate to Economic Growth, which is simply a one–dimensional indicator
The core idea is that economic development is inclusive in the sense that it benefits all people in an economy, not a
rich minority – it must also not have a large cost burden on future generations
Economic Development is also about increasing living standards, equity, freedoms and society as a whole
Economic growth does not always lead to economic development
Does Economic Growth lead to Economic Development?
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Before we analyze this, we have to consider sources of economic growth:
o Natural factors – increase in quantity of a factor of production will shift PPC outwards and improve growth
– this can also involve improving the quality, rather than quantity, of factors of production to increase
production possibilities
o Human Capital Factors – increased immigration, better training, education etc.
o Physical Capital and Technological Factors – this can include improving the quantity or quality of physical
capital – these include items such as buildings, factories, vehicles etc.
Capital widening – This occurs when extra capital is used with an increased amount of labour – this
will not improve productivity, as the ratio of capital to workers increases, which only increases
production possibilities
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Capital deepening – This occurs when there is an increase to physical capital but not to workers, so
the ratio of workers to capital improves and productivity, alongside output is increased
Institutional factors – adequate banking system, legal system, good educational system and political stability.
Sustainable Development
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Economic growth is unsustainable in the long run with current attitudes towards the environment. Economic
development must include sustainable development to ensure that quality of life, and economic growth is sustained.
Economic growth relies on increasing use of factors of production, and of those, commodities, are often non–
renewable, meaning that at some point production will be possible to sustain at high levels due to shortages in
resources, which will lead to supply deficiencies.
The impacts of ‘unsustainable’ development may be:
o Access to water will become scarcer for poorer communities, as global warming reduces supply of water in
deprived areas – this will increase poverty and devastate populations. In an economic sense, there will be a
decrease in the quantity and quality of human capital as a result.
o Diseases may spread more rapidly as a result of poorer living and sanitary conditions
o Droughts are likely to become a bigger problem, which may lead to food shortages
o Rising sea levels will likely lead to increased flooding and bear high social costs
Sustainable Development Goals and Global Goals
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Concept made by the UN – aims for human and economic development by 2030
Key achievements of SDGs:
o More than 1 billion people were lifted out of absolute poverty since 1990
o Child mortality has dropped by more than 50% since 1990
o Number of out–of–school children dropped by more than 50% since 1990
The 17 Goals relate to a wide range of humanitarian and social problems such as education and gender equality
For example, goal for reducing poverty are:
o Reduce the amount of adults and children living under various forms of dimensional poverty by at least 50%
by 2030
o Establish more national social security systems and safety nets to prevent poverty
o Ensure equal rights to capital resources, such as credit, to have increased economic opportunities
Relationship Between Sustainability and Poverty
There is a very strong link between these concepts, as poorer people rely much more on the natural environment for
survival and resources – damaging the environment therefore directly affects resources available for poorer people to
sustain themselves physiologically and economically
Poorer people are much more vulnerable and affected by natural disasters such as floods, and are often unable to
recover because they do not enjoy aid from governments and lack the necessary capital ownership to sustain them
while they replenish their wealth
The destruction of natural resources increases demand for such resources drastically for poorer people, which in turn
degrades the quality of the resource much more, as it is used by more people – e.g soil degrades when it is used for
extremely dense farms
Common Characteristics of Developing Countries
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Low standards of living characterized by low income, inequality, poor health, and inadequate education
Low levels of productivity – low standards of education and poor health leads to reduction in the quality of human
capital within the country – low technological availability also reduces output possibilities
High rates of population growth and dependency burdens – large families have many people to support, and they are
often unable to do so as economic opportunities are limited.
o The crude birth rate is the annual number of live births per 1000 of the population
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Child Dependency Ratio =
% of Population under 15
% of Population 15 − 64
Old Age Dependency Ratio =
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% of Population over 65
% of Population 15 − 64
High and rising levels of unemployment and underemployment – national unemployment statistics often do not
depict the situation clearly. There may be hidden unemployment, in which people work in non–formal settings for a
limited amount of time, and do not register with Labour departments
o People may also be underemployed, in which they would like to work full time but can only do so part–time
informally to sustain themselves
o There are also people who have given up their search for work, and are hidden from employment data.
Substantial dependence on the primary sector – many LEDCs depend on primary sector’s products as exports, and a
select number of products make up much of the export revenue
o A problem with a lack of diversity in exports and reliance on select exports is that primary commodities
often have volatile prices as they have relatively inelastic demand – this can affect their export revenue and
put them in a deficit on their current account balance.
Imperfect markets and limited information – many LEDCs lack factors needed for markets to operate efficiency, and
lack many factors that economics theories have as assumptions – e.g they lack a proper legal system for businesses to
punish others for unfair practices, they lack access to Media/Internet to be informed of market prices and availability
of products to consume, they lack infrastructure to enter new markets and keep prices low
Dominance, dependence and vulnerability in international relations – the political and economic influence of
developed nations dominate over LEDCs’, as they often can use their economic prowess as a leverage to take
advantage of the resources of LEDCs and hinder natural economic development. They may rely on aid or technology
from MEDCs for some level of development, which would make them unable to negotiate fairer deals to benefit them.
Diversity Amongst Developing Nations
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Though many share similarities, LEDCs are all unique in their economic and social issues. Some examples are shown:
o Different amounts of resource endowments – depending on the amount of resources available to them, their
development may vary – e.g a poor country with oil is more likely to be able to use it as leverage to boost
their development. Countries without highly–demanded resources are more likely to have large industries
based on labour–intensive manufacturing or harvesting
o Historical backgrounds – colonization may have affected countries positively or negatively, depending on the
level of exploitation by colonizers – e.g if they took advantage of natural resources and left countries with
little economic opportunity, they are less likely to succeed than a country whose colonizer developed
infrastructure there.
o Geographic and demographic factors
o Ethnic and religious breakdown – political and social unrest will hinder economic development as vital
resources, such as human and other factors of production would be diverted to help either side claim victory
in the conflict.
o Sectors of the Economy – not all LEDCs depend on primary and secondary sectors, some may depend on
tourism, which is a tertiary sector service.
o System of Government – some countries may be monarchies, single–party states, false democracies,
theocracies etc – this makes it difficult to create models and universal systems for countries to lift themselves
out of economic crises. What works for one political system may fail in other ones.
Measuring Economic Progress – The Global Economy (Chapter 29)
Single Indicators
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Single indicators are solitary measurements used to assess development.
o GDP per capita and GNI per capita are common figures used to assess development.
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If a country receives significant FDI (foreign direct investment), then its GDP figures will be higher
than GNI as GDP does not discriminate against who owns assets within the country. However, since
most profit from foreign firms leave the country, GNI is more commonly used
Money sent back home from workers abroad is called worker remittance, and in developed countries
it makes up a very small portion of GDP, but in less developed countries this figure can be
significantly higher.
PPP, or Purchasing Power Parity is another singular indicator used. This accounts for differing purchasing
powers with the ‘same’ amount of money by using exchange rates to equate the price of common goods.
Another form of PPP is the Big Mac Index.
PPP is often used jointly with GNP per capita as a more sensible indicator of individual earnings.
Health measures are also used, and in singular capacity, some of the following are used:
o Life expectancy at birth
o Infant mortality rate
Education Measures used:
o Expected years of schooling
o Mean years of schooling
Other indicators:
o GINI index for economic inequality
o Energy indicators (ability to maintain heating and access to electricity)
o Environmental and pollution indicators
It is important to realize that increasing GNI per capita does not equate to better welfare, as many different factors
determine welfare outside of GNI. These may include factors such as environmental damage, social costs such as
crime and working hours
Composite Indicators
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Singular indicators are often too specific and do not give the full context that is needed.
Composite indicators are a combination of various singular indicators.
One such indicator is HDI or Human Development Index
o This consists of 3 different variables – long, healthy life, quality education and decent standard of living
Long healthy life – life expectancy at birth is used
Education – years (mean) of schooling is used
Standard of Living – GNI per capita converted with PPP with USD
o These 3 indicators give a value between 0 and 1, with higher values meaning better development
o However, HDI is still an average value, so it is prone to discrepancies and false results if the country provides
false statistics. There may also be inequalities within the country, which HDI is unable to measure.
Due to the limitations of just using HDI, several others are available.
Gender Inequality Index (GII)
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This measures gender inequality or equality with
3 components:
o Reproductive Health – measured by
material mortality ratio and adolescent birth
rates
o Empowerment – measured by proportion
of parliamentary seats occupied by females
and proportion of adults 25 years or older
with at least secondary education
o Economic Status – measured by labour market participation and labour force participation rate of female and male
populations aged 15 and older
The indicator measures disparities between men and women, so the higher the value, the worse gender inequality is.
Inequality Adjusted Human Development Index (IHDI)
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This is essentially HDI, but it also takes into account human development costs of inequality
If a country theoretically has perfect equality, then the IHDI value will be the same as HDI, but if there is any level of
inequality, then the IHDI value will be lower than HDI, as inequality decreases the metric.
The difference between IHDI and HDI indicates human development costs of inequality
Happy Planet Index (HPI)
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HPI measures sustainable well-being – measures how countries are doing with achieving long and happy lives, taking
into account sustainability
Multidimensional Poverty Index (MPI)
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This measures deprivations experienced by poor people in 3 different areas: health, education and standards of living
o Health – measured through nutrition and child mortality
o Education – Years of schooling and school attendance
o Standards of living – cooking fuel, sanitation, drinking water, electricity, housing and assets
The Inclusive Development Index
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This is an annual assessment of 103 countries’ economic performance that measures how countries perform on 11
dimensions of economic progress in addition to GDP. This has 3 different components:
o Growth and development – GDP per capita, Labour productivity, employment and life expectancy
o Inclusion – Median household income, GINI index for income and wealth and Poverty rate
o Intergenerational equity and sustainability – Adjusted net savings, dependency ratio, public debt as % of
GDP and Carbon intensity of GDP
Barriers to Development – The Global Economy (Chapter 30)
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Barriers to development often reveal themselves in the form of cyclical
feedback loops, from which it is very difficult to escape from – one
type is a self-perpetuating cycle of poverty. One such cycle is shown:
Economic Barriers to Development
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Economic Inequality
o This usually means that there are low rates of saving, meaning high MPC – this likely means low investment
and therefore, economic growth
o People who control the most capital and wealth likely lead poorer governments, and are not likely to pass
legislation aiming at increasing equality of opportunity and inequity.
o The economic activity of the rich often involve foreign goods and they move their capital abroad, meaning
that their economic activity does not stimulate the domestic economy.
Lack of Access to Infrastructure and Appropriate Technology
o Better access to infrastructure improves equality of opportunity, as larger numbers of people are able to have
the means to undertake economic activity – e.g better public transport leads to better employment
opportunities
o Better access to technology includes both consumption and production
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Encouraging countries to introduce better production equipment is not enough – an abundance of
labour in the labour market encourages firms to keep using labour-intensive production rather than
capital-intensive – ideally, there should be better technology that uses abundance of labour
Better technology in terms of consumption increases quality of life and general wellbeing – e.g solar
cooking means that scavenging for fuel is not needed.
Low levels of Human Capital – low education & healthcare
o Lack of access to education
Increased levels of education results in greater positive externalities as people are able to adapt to
changes and improve their skills, becoming more efficient and productive.
• It can also empower women as societies with greater education tend to have greater gender
equality
• Improved healthcare – this removes heavy focus on personal health as they can be more
reassured that damages to personal health is insured and that good healthcare is available.
Improvements to education require large amounts of funding, and there may be other barriers to it,
such as infrastructure. Gender inequality could also be a barrier, alongside the need for children to
be labourers for subsistence farmers.
HDI correlates directly with economic development – one factor could be portion of GDP spent on
healthcare, the higher, the better the HDI
Dependence on Primary Sector Production
o Similar to dependency on a select number of exports, a country may experience a current account deficit if
the prices of the commodity falls, heavily impacting their GDP and economic growth
A country whose income comes from a few types of exports remain vulnerable to losing economic
growth if they are affected – fixing a current account deficit is difficult for them
• Primary commodities tend to have inelastic demand, meaning that small fluctuations in
demand will lead to proportionally higher prices, lowering export revenue
Lack of Access to International Markets
o It will be more difficult for countries to take advantage of their comparative advantage and engage in Forex
markets if there are barriers to international trade
o Protectionist policies damage international trade – e.g EU subsidizes farmers heavily, which leads to them
exporting more, reducing international prices for certain goods – this in turn reduces the export revenue for
developing countries which rely upon that primary commodity.
o Barriers to international markets come in various forms:
Being landlocked
Insufficient infrastructure for land/sea/air transportation
Requirements to enter foreign markets
Non-convertible currency (can’t be traded on Forex markets)
• These tend to have fixed exchanged rates and tend to be pegged to other currencies –
overvaluation of the currency leads to black markets, impacting the supply of the currency
Existence of Informal Markets
o This is a sector of the economy that is neither taxed nor documented/administered. The economic activity
within informal markets are not recorded, so they do not contribute towards GDP – this is problematic as
more than half of the world’s workers work within informal markets.
o Better education tends to lead directly to decreases in informal economies, as better employment
opportunities present themselves – formal employments have social and legal protections
o Government revenue will obviously be affected as less economic activity is able to be taxed.
Capital Flight
o This is the movement of large sums of capital out of the economy – this could be due to low confidence in
the economy/government. This leads to fewer available resources for economic growth and economic activity.
It may cause devaluation of domestic currencies as the supply on foreign markets would increase as it’s
exchanged more for others.
Indebtness and Gearing
o The repayment of interest on loans is known as debt servicing – the interest paid on the principal is counted
as an outflow of money as the principal is eliminated when it is repaid – the interest paid is a form of
opportunity cost
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Upon the increase in oil export revenues for OPEC countries, banks ventured to foreign countries to provide
credit – they usually provided credit at market rates, rather than central bank rates, and they often
demanded repayment in ‘hard’ currencies such as USD
They did not monitor where the money went, so much of it went to economically damaging wars,
dictatorships, bribes etc, rather than to private firms to stimulate production.
After a recession which followed, many of these countries defaulted on their debt
Geographical Factors
o Landlocked nations – countries with coasts are able to lower transport costs through freighters. This
reduction in costs incentivizes international trade and drastically reduces cost of entry into foreign markets
o Tropical climates – agricultural productivity is lower for tropical countries due to geological reasons, but it
is also more difficult to develop tropical land into usable assets/capital, as making the land usable is costly.
o
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Political and Social Barriers to Development
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Legal system and Property Rights
o Corporate and individual rights are essential, as they increase these parties’ confidence when engaging in
economic activity – people are able to benefit from their assets given that they have exclusive rights to it.
Why make a product when someone else can copy it and profit on it?
o ‘Dead Assets’ are ones which can be used for economic activities, but are not formally owned by anyone – 3rd
world countries often have vast amounts of dead assets, but are unable to use it for these purposes.
o A strong legal system also incentivizes people to increase the value of their asset by developing them, as they
are assured that they are protected under the law.
o Valuable assets such as houses can be used as collateral in acquiring credit, so it can grant many new
economic opportunities
Taxation Structure
o It is notoriously difficult to collect taxes in developing nations, as it is a logistical nightmare. There may also
be corruption and fraud involved, which governments either are not willing to, or have the means to
investigate and prosecute – this just encourages more people to do this.
o Large informal markets directly correlate with the rate at which the Government collects tax revenue –
undocumented transactions cannot be taxed.
o There are obvious consequences to low tax revenue – inability to undertake monetary, fiscal or Foreign
economic activities as they require significant expenditure.
Banking System
o Banks are the source of most ‘money’ in countries, as they are often the provider of credit to firms and
individuals. Credit encourages consumption and production, which increase national income and output.
Interest earned on the principal leads to banks investing in other areas of the economy, further stimulating
economic activity.
o Lack of banking system also means that people and firms do not save money, but rather acquire other forms
of wealth such as assets or take their capital abroad. Saving is necessary for investment by firms and banks,
which drives economic growth as production possibilities, and often, demand, increase.
o Poor individuals often have no access to any form of credit, and black market credit (loan sharks) often
charge exorbitant interest on the principal, which may lead to defaulting on the payment.
Gender Inequality
o Social welfare – empowered women tend to be healthier, have more productive families and improve
education through improved children’s school attendance.
o Improves quality of human capital directly as women can be better educated and more skilled, and it leads ot
future generations becoming better quality human capital as well.
o Increased wealth for women – improves consumption, driving up AD.
Good Governance and Economic Progress
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Corruption
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Election rigging and other forms of corruption lead to Regimes which lack regard for the economic welfare
of citizens, and often implement economic policies designed to benefit major influential stakeholders in the
Government, rather than the general populace.
o Delegitimizes the legal system – if you can ‘buy’ your way out of punishment, why not engage in criminal
activity?
o Unfair allocation of resources – influential stakeholders often are able to acquire the most resources, which
will not be allocated efficiently, as they will not be used with regard to social welfare – leads to catastrophic
market failures.
o Bribes increase costs of production, as they can become a frequent cost of conducting business – higher prices
are set thereafter and this passes onto the consumer.
o Reduced trust in the economy and currency – people are less inclined to engage in economic activity
knowing that they will not be able to be rewarded in doing so due to the above factors.
o Tax revenue will often be allocated towards corrupt initiatives and not be redistributed to the populace.
o Lack of proper legal system is a major deterrent to business activity (and FDI), as they become much riskier.
o Elites of corrupt countries often have capital flight, reducing the country’s wealth, resources and allocative
efficiency.
Political instability
o Politically stable nations are more likely to gain FDI and economic activity domestically and abroad, as there
will be more confidence in its integrity.
o Political stability is likely to lead to better long-run economic policies that are more likely to benefit the
populace and result in improved allocative and productive efficiency.
o The loss of life, welfare, standards of living, resources and quality of human capital all result in devastating
losses to the integrity and functioning of the economy. This would undoubtably reduce or even stop
economic growth.
Unequal Political Power & Status
o Wealth inequality in LEDCs result in an extremely unfair distribution of resources and wealth, reducing the
economic opportunities of the regular citizen. The lack of access to resources for economic activity reduces
economic activity, lowering AD and national income.
o The belief that the government works to simply financially reward their stakeholders incentivizes
engagement in the political process, further perpetuating and enabling corruption in the country
o
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Strategies to Promote Economic Growth & Development – The Global Economy (Chapter 31)
Trade Strategies use in Achieving Economic Growth/Development
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Economic growth only refers to an increase in Real GDP over a time period, but Economic Development is a multidimensional indicator referring to more than simply increase in GDP
•
Import substitution (Import Substitution Industralization) – Inward Approach
o The principle that a country should produce a good domestically rather than import it, if it can – this
increases exports and directly benefits domestic economy. Several factors determine the policy’s success:
Government must select range of goods to produce domestically, but these tend to be labour
intensive tasks
Subsidies must be given to encourage domestic production
Protectionist policies must be enforced to lower imports
o ISI isolates domestic economy, protecting culture, jobs and social habits
o ISI protects domestic economy from powerful foreign firms’ influence
o However, in the long run there may be inefficiencies and losses in community surpluses
o ISI means that the country doesn’t benefit from specialization – lack of allocative efficiency
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Export Promotion – Outward Approach
o This strategy is based upon increasing levels of imports to promote GDP growth and competitiveness in
international markets
o Ideally, the country would increase exports for products for which they have a comparative advantage
o They may even alter their exchange rates to be lower, such that exports become more competitive
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Certain criteria are needed for these outward policies:
Liberalized trade – open participation in world market
Liberalized Capital flows – eliminate barriers to FDI
Floating Exchange Rate
Additional investment to improve infrastructure
Less regulation to lower costs for prospective foreign firms
Developing countries may choose to increase exports for primary commodities or manufactured goods.
Growth with primarily primary commodities are unlikely to achieve massive economic growth, as
global demand for products such as oil is not increasing readily, and its demand is relatively inelastic,
leaving countries vulnerable to price fluctuations
Exporting manufactured goods may be preferable, as it may lead to a more skilled, and trained
workforce as some products require capital-intensive production, rather than labour-intensive ones.
• Improving the educational system is therefore crucial to developing a workforce with the
necessary skills for manufactured-goods-driven exports
Though this seems like an obvious way to achieve economic growth, there are several downfalls:
Increased competition, or even dumping in international markets may lead to trade wars, tariff
escalation and increased protectionism to protect domestic industries – this decreases global
economy’s efficiency and leads to market failures.
It is unclear whether state intervention aids in outwards approaches
MNCs may have too much influence over the economy, and may decrease GNP, alongside political
stability. There may be demands to implement protectionism to curtail MNCs
Economic Integration
o Countries may opt to integrate their economies closer together through trade agreements, customs unions or
common markets.
o This may lead to increased global efficiency, and greater allocative efficiency, and enhanced economies of
scale
o More integrated markets encourage diversification and encourage specialization
o For disadvantaged, or landlocked nations, integration may produce them with resources and the necessary
infrastructure (ports) needed for trade
o Free movement of labour increases remittances sent home, and potentially may improve qualities of life
o Greater political and economic stability
o Increases individual bargaining power in international markets
o Domestic AD may decrease for domestic industries
o Consumers have access to less expensive goods as costs in forms of subsidies, tariffs or quotas. This shifts
production from high-cost producers to low-cost producers, increasing allocative efficiency
o Trade creation will benefit producers as they can import primary commodities cheaper, leading to lower
prices and improving efficiency
o There may be several drawbacks, however:
The role of the WTO may be undermined as it encourages countries to look inwards
Trade may become more complicated with other countries with regard to other trade agreements
Inefficient firms may be driven out of industries
There may be trade diversion, whereby production shifts from a low-cost producer to a high-cost
producer
Diversification in Achieving Economic Growth/Development
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Too many developing countries rely on singular commodities for most of their export revenue, which leaves them
vulnerable to current account deficits if prices fluctuate
Diversification reduces the above risk, and improves the skill of the workforce as diversification into sectors such as
the Quaternary or Tertiary sector will require additional education/training
o A more skilled and educated workforce increases the quality of human capital, increasing production
possibilities and increasing labour mobility, also reducing structural and other types of unemployment.
There are several barriers to diversification:
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Tariff escalation – this is when the rate of import tariffs on goods rises the more goods are processed – this
reduces incentive to diversify into a non-primary commodity export sector, as it will have less demand
More Qualified Workforce – developing countries are less likely to have quality educational systems, which
is a barrier to having a workforce with enough skills to expand economic sectors which require more skill
Primary commodities require no prior skill, so it is a default choice for people
Market-based Supply-side Policies’ Impact on Economic Growth/Development
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Trade liberalization – this is the process of removing or reducing barriers to international trade, such as tariffs,
quotas etc.
o Many developing countries lack the infrastructure needed to gain full benefits of trade liberalization, and
protectionist policies adopted by developed countries would prevent developing countries from accessing
goods at the lowest price possible.
Privatization – selling Public sector companies to private entities to improve their efficiency and profitability – this
may lead to improved allocative efficiency, but may also cause negative externalities as their goods/services may
benefit those in most need of it, even if it’s not profitable.
o This may be problematic for developing nations as they have many dependents on public firms, and since it
requires massive logistical planning and delicate handling.
o The privatized firm is likely to be important services, which may lead to damaging monopolies, as
competition to the Government would not have been established by the time of the privatization.
Deregulation – increased regulations discourage competition as they increase costs. It’s likely to reduce imports.
o High regulation both domestically and in terms of imports/exports, decrease AD and likelihood of firms
willing to fulfil demand unless it can cover the costs of the regulations
o Generally, the easier/cheaper it is to start a business, the more likely there will be increased AD, efficiency
and economic growth, and increased international competitiveness
o However, deregulation may remove vital health & safety protocols or others which are necessary. In the name
of reducing cost, governments may cause major negative externalities
E.g if deregulation for banks is reduced, then more debt-based artificial economic growth may occur,
and standards of living may decrease
Foreign Direct Investment and Economic Growth/Development
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There are 2 ways of having FDI:
o MNCs building new facilities/acquiring new capital or expanding existing ones (Greenfield Investment)
o MNCs merge/acquire with existing firms
MNCs may have interest in developing economies for several reasons:
o Developing countries may have untapped natural resources, which may require foreign capital and expertise
to capitalize on
o Local markets and AD may be growing, which would attract firms as they’d seek abnormal profits
o Labour and other costs may be lower in foreign countries, which would allow the firm to become more
efficient and lower Average Costs, lowering price
o Fewer regulations impose fewer costs on firms, allowing for lower prices and better competition
o Grants – Governments may provide financial incentives for certain firms to reduce their costs and give them
an advantageous start in the country
Potential advantages of FDI:
o FDI provides firms with additional capital which they need to grow and expand. Expanding businesses have
increased investment, increasing GDP
o MNCs provide more employment and training – workforce may become multi-skilled
o MNCs can conduct R&D, potentially improving technologies within the country
o Increased employment and earnings have a multiplier effect, further improving GDP
o More tax revenue from increased consumption, profits and other corporate revenue
o MNCs can improve infrastructure with foreign capital, improving their quality of their factors of
production, potentially improving production possibilities
o Lower prices and better choice for consumers due to MNCs’ better allocative efficiency
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Possible disadvantages:
o MNCs may import labour, reducing opportunities for domestic workers to improve their skills, which may
keep them as labourers, increase inequity and maintain low levels of skills in a feedback loop
o MNCs may have too much power, economically and politically, which could mean that they can influence the
Government to provide them with unfair advantages and reduce their costs (e.g lower tax, reducing
competition)
They could hold massive influence over trade unions, and prevent workers from having proper legal
protections from exploitative firms
o MNCs may have transfer pricing, where they sell goods/services from one division of the company to another
abroad, with lower corporate taxes, to reduce cost. This could mean that the Government may not receive
increased tax revenue
o MNCs’ activities may lead to environmental damage, reducing private costs, but increasing social costs
o MNCs may deplete natural resources of countries unfairly and send it to foreigners, not allowing the country
to benefit from it
o MNCs often use capital-intensive production normally, but in foreign countries the lower labour costs may
encourage firms to use abundant labour for labour-intensive production – this would reduce efficiency
o MNCs often repatriate their profits to the main corporate entity abroad, causing a leakage in the economy
and not impacting GDP
o Potential exploitation of workforce/children to minimize labour costs
MNCs typically publish their CSR, or Corporate Social Responsibility report to ease such concerns.
Social Enterprises and Economic Development
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Social enterprises are organizations with the main objective being social, rather than financial. They may be for-profit
or non-profit. Most aim to undertake activities that have positive externalities and are environmentally responsible
They don’t have profit as a main goal, but it is necessary for them to function, so it is an aim.
Institutional Change and Economic Growth/Development
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Improved access to the banking system
o A lack of access to capital markets and banks means that people are not able to save or acquire credit. This is
a major barrier to economic growth/development, as credit is essential for people to start businesses and
fulfil or create demand for products, increasing consumption.
Credit is also necessary for existing businesses to grow and increase investment, which further
increases GDP
o Microfinance – this service provides the poor with small amounts of low-cost credit, savings accounts and
others.
Microfinance allows people to start small businesses but is insufficient as a solution as it cannot
provide large-scale credit.
Though, there is still an element of risk assessment, so credit will not be provided to those who are
deemed too high of a risk of defaulting
o Mobile phone banking – this allows many to pay for goods/services and transfer money via text, and allows
people to withdraw money at authorized establishments.
Mobile banking is extremely beneficial if people are not able to access physical cash for payments, in
cases where there is a shortage of it. Mobile banking creates some resemblance of stability as people
regain the confidence of being able to transfer money, and fear not being able to access their money
less. This can help re-build or establish a proper banking system.
o Increasing women’s rights – in many areas, women are excluded from the workforce due to discriminatory
reasons
Empowering women increases the quality and supply of human capital, increasing production
possibilities and allowing for social progress to be made.
Increased quality education for women also increases the supply of skilled labour, which allows the
technical sectors of the economy to develop.
Empowerment can occur in the following ways:
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• Increases to accessibility and quality of education
• Legal framework and protections against gender discrimination
• Increasing access to healthcare for women
• Granting women equal rights to men
• Increasing presence of women in decision-making roles
• Implement systems to help women access safe legal assisstance
Reducing Corruption
o Corruption leads to misappropriation of resources and capital, and diverts Governmental focus from social
causes to financial ones.
o Corruption leads to tax avoidance, as confidence in the Government is reduced, and since many pay bribes to
avoid tax payments. This decreases GDP and decreases tax revenue, reducing the capabilities and policy tools
of the Government.
o A number of reforms may help reduce corruption:
Investing in transparency and independent external appraisal – auditing agents can audit
Government expenditure and finances, increasing confidence in the appropriation of Government
funds
Reform institutions – making tax payments easier, reducing bureaucracy, and increasing the
accessibility of tax-related assistance will make people more likely to pay taxes
Technology – more automated computer systems for finances reduces the possibility of corruption,
as discrepancies can be identified more easily and accountability can increase
Promote Secure Property Rights
o ‘Dead Capital’ is detrimental, because people can’t take advantage of the assets that they de facto own to
increase their own economic opportunities. This reduces one’s net worth, and robs them of a source of wealth
o Undocumented assets such as houses can be ‘claimed’ by other entities and effectively stolen off people,
potentially driving them to insolvency
o Granting landowner status to property holders allows them to use it for economic activity, stimulating the
area economically. Agricultural land can also be used for subsistence, or commercial farming.
o Land rights increase people’s confidence, which incentivizes them to use it for economic activities without
fear of losing the asset
o Land rights, especially in urban slums, can reduce homelessness drastically and increase economic
opportunities as a permanent address is necessary to access credit and conduct other administrative tasks
o Land rights may maintain peace, as people are less likely to dispute ownership status of land if the party’s
claim to land is legally protected.
Interventionist Strategies to Promote Economic Growth/Development
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These allow for economically disadvantaged individuals to engage in economic activity easier. These should be aimed
at:
o Sectors of the economy – e.g informal or primary sector
o Geographical area of the poor – e.g slums/villages
Factors of production poor people possess – e.g labour
Products consumed by the poor – e.g food
Redistributive Fiscal Policies – transfer payments can allow for wealth to be redistributed to those who most need it,
and with the multiplier effect, increase economic activity. Though, the fiscal capabilities of the Government (ability to
raise revenue through tax) can be limited by several factors:
o There may be a large informal sector – mitigated by documenting workers and reducing barriers to
employment
o Heavy reliance on indirect taxes – mitigated by imposing higher indirect taxes on luxury goods consumed by
higher-income individuals
o Tax exemptions and loopholes – mitigated by tax reform
o High income tax – implement progressive tax system to ease tax burden of the poor and increase tax on the
rich
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Civil non-compliance – increase transparency, reduce administrative barriers etc.
Transfer Payments and Economic Development
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Many developing countries suffer from low fiscal capabilities, which limits their ability to increase transfer payments
for public/merit goods
One solution could be Conditional Cash Transfers (CCT), whereby receipt of transfer payments occurs upon
fulfilling a certain condition
o This is likely to have a positive impact, as people would perform socially responsible and beneficial tasks such
as being legally employed in exchange for payment, which can improve their economic capabilities,
potentially improving their lives.
o It does not directly increase education, but given the condition of school-attendance, it can lead to new
generations of more skilled and educated workers, improving the quality and supply of human capital.
Minimum Wages and Economic Development
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Though it can have obvious benefits, such as legal protection against below-minimum-wage pay rates, it cannot be
relied upon as a sole strategy:
o Minimum wages cannot be enforced in informal sectors, where 61% of the world’s population works – this
makes up the vast majority of employment in Africa
This puts much more importance on the task of eliminating informal sectors to combat the issue.
o There is still the risk that there will be non-compliance, which can be aided by solid legal frameworks and
punishments, alongside information campaigns to encourage workers to know their rights
o Minimum wages may lead to some unemployment, as some employers will not be able to support some
employees at this pay rate
Provision of Merit Goods and Economic Growth/Development
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The impacts of increased access, quality and quantity of merit goods has incredibly positive externalities, enlarged by
the multiplier effect and indirect benefits.
Key area of development is healthcare and education, as those are one of the main needs of the poor
Infrastructure must also be developed to accommodate economic development – this encourages international trade,
improves labour mobility and improves quality of factors of production, expanding PPC outwards.
Merit goods’ supply can be increased through increased FDI, Governmental investment, Microfinance or aid
Foreign Aid and Economic Growth/Development
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Humanitarian aid is given to help civilians and authorities to cope with emergency situations and recover socially,
politically or economically. This is often short-term but can be prolonged
Development aid – this is long-term financial assistance for a country to stimulate its economy and improve social
and/or political structures as well. It is general aid
Official Development Assistance – defined by OECD as aid that promotes and specifically targets economic
development and welfare of developing countries. This is given by foreign governments or other inter-governmental
institutions
o This can only be aid in the form of a grant (no repayment) or a soft interest-free/below-market-rate interest
loan – the aim is not to treat aid as if it were a capital market
Bilateral aid – when a government directly grants another aid
Multilateral aid – When a government grants an organization aid to provide another country that aid
However, there can be issues with providing foreign aid:
o A corrupt Government is likely to misappropriate aid to areas that do not benefit society
o Aid is often given for political reasons, which leads to misappropriation of funds – those who need it most do
not always get it
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Aid is often implicitly given with the condition of political support – essentially becomes a bribe on a macro
level
Aid can also be in the form of ‘tied aid’ which stipulates that the recipient use the money to purchase
goods/services from the donor – this allows recipient to profit off the aid
Too much aid can create a dependency and discourage economic development. Aid’s main aim should be to
allow a country to become self-sufficient
Aid can be ineffective if the economic policies of the country do not appropriate the aid fairly or in a way
that promotes economic development
Loans in the form of loans must still be repaid, and there is the possibility of defaulting on the debt.
Non-Governmental Organizations
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NGOs carry out two main types of activities:
o Operational activities – planning and undertaking specific projects
o Advocacy activities – aimed at raising awareness for issues or influencing government policy
NGOs can often work directly in the area in need of assistance, which allows them to understand the demographic,
geographic, and social factors barring the area from economic development – aid can be tailored to suit the needs of
the area based upon this
Though, there are select limitations to NGOs:
o They rely on funding, so they must spend time and effort to raise funds which takes away manpower from
aid-work.
o Their funding often is provided by governments, so they can be heavily leveraged based on political
objectives – funds can be withheld.
o NGOs can be uncoordinated whereby they dedicate resources to areas where they are not needed –
cooperation with authorities is needed for the most effective relief.
o NGOs can have religious/political biases
o NGOs are unaccountable – their spending does not have to be justified
Contribution of Multilateral Assistance to Economic Growth/Development
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The World Bank is comprised of two sections:
o The International Bank for Reconstruction and Development (IBRD)
The IBRD grants loans to middle-class individuals through floating bonds on the capital market –
repayment of bonds is guaranteed by a member state
• This often means that loans can be provided to those in need at lower rates than other
sources
o International Development Agency (IDA)
IDA provides zero to low-interest loans to some of the poorest areas – they make loan conditions
extremely favourable to not put undue financial burden
o The World Bank aims include social causes such as eliminating poverty, and their activities focus on
providing economic assistance to stimulate economic development in impoverished areas.
The International Monetary Fund – primary purpose is to ensure the stability of the international monetary system –
exchange rates, international payments etc. They also engage in the following:
o Promoting international monetary cooperation and integration
o Facilitating balance international trade growth
o Promoting stable exchange rates
o Providing aid to countries with balance of payments issues
o The IMF surveys and appraises countries’ economic performance and discusses options for aid if they require
it
o IMF offers technical assistance with banking and other financial areas, and training to countries for free
o IMF is funded by each member state putting in money based on a ‘quota’ – the magnitude of the payment
depends on the country’s economic capabilities
o IMF grants loans under conditions of imposing their demanded policy – support only continues if
obligations by recipient is fulfilled
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The head of the World Bank is typically appointed by the President of the United States, which can present issues if
its activities contradict U.S. policies (thank you Donald, very cool!)
Debt Relief and Economic Growth/Development
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Debt relief frees up the resources of Governments for spending on areas where more positive externalities can be
achieved – focus on not defaulting on payments presents major opportunity
Reducing Debt Service – debt servicing fees are eliminated, putting the recipient at a net positive in terms of the cost
of the loan
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