Undergraduate study in Economics,
Management, Finance and the Social Sciences
Introduction to
economics
O. Birchall with D. Verry,
M. Bray and D. Petropoulou
EC1002
2022
Introduction to economics
O. Birchall with D. Verry, M. Bray and
D. Petropoulou
EC1002
2022
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 100 course offered as part of the University of London
undergraduate study in Economics, Management, Finance and the Social
Sciences. This is equivalent to Level 4 within the Framework for Higher Education
Qualifications in England, Wales and Northern Ireland (FHEQ). For more information,
see: www.london.ac.uk
This guide was prepared for the University of London by:
O. Birchall with D. Verry, M. Bray and D. Petropoulou, The London School of
Economics and Political Science.
This is one of a series of subject guides published by the University. We regret that
due to pressure of work the authors are unable to enter into any correspondence
relating to, or arising from, the guide. If you have any comments on this subject
guide please communicate these through the discussion forum on the virtual
learning environment.
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Contents
Contents
Introduction............................................................................................................. 1
Introduction to the subject area...................................................................................... 1
Aims of the course.......................................................................................................... 1
Learning outcomes......................................................................................................... 2
Overview of learning resources....................................................................................... 2
Route map to the guide.................................................................................................. 4
Study advice................................................................................................................... 5
Use of mathematics........................................................................................................ 6
Block 1: Economics, the economy and tools of economic analysis......................... 7
Introduction................................................................................................................... 7
Scarcity........................................................................................................................ 10
Rationality.................................................................................................................... 11
The production possibility frontier (PPF)......................................................................... 11
Opportunity cost and absolute and comparative advantage........................................... 12
Markets........................................................................................................................ 14
Microeconomics and macroeconomics.......................................................................... 15
A note on mathematics................................................................................................ 15
Models and theory........................................................................................................ 16
Criticisms of economics ............................................................................................... 19
Overview...................................................................................................................... 19
Reminder of learning outcomes.................................................................................... 20
Sample questions......................................................................................................... 20
Block 2: Demand, supply and the market.............................................................. 23
Introduction................................................................................................................. 23
Equilibrium................................................................................................................... 24
Demand and supply curves........................................................................................... 25
Shifts in the demand and supply curves......................................................................... 26
Consumer and producer surplus.................................................................................... 27
Overview...................................................................................................................... 28
Reminder of learning outcomes.................................................................................... 29
Sample questions......................................................................................................... 29
Block 3: Elasticity.................................................................................................. 31
Introduction................................................................................................................. 31
Price elasticity of demand ............................................................................................ 32
Cross-price elasticity of demand.................................................................................... 36
Income elasticity of demand......................................................................................... 36
Price elasticity of supply................................................................................................ 37
Incidence of a tax ........................................................................................................ 37
Overview...................................................................................................................... 38
Reminder of learning outcomes.................................................................................... 39
Sample questions......................................................................................................... 39
Block 4: Consumer choice...................................................................................... 41
Introduction................................................................................................................. 41
Consumer choice and demand decisions....................................................................... 42
Utility maximisation and choice..................................................................................... 45
i
EC1002 Introduction to economics
Income and price changes............................................................................................ 47
Deriving demand: ‘The individual demand curve’........................................................... 48
Deriving demand: ‘The market demand curve’............................................................... 50
Complements and substitutes....................................................................................... 50
Overview...................................................................................................................... 51
Reminder of learning outcomes.................................................................................... 52
Sample questions......................................................................................................... 52
Block 5: The firm.................................................................................................... 55
Introduction................................................................................................................. 55
Introduction to the firm................................................................................................ 56
The firm’s supply decision............................................................................................. 56
Profit = Total revenue – Total cost................................................................................. 62
Cost, production and output......................................................................................... 65
Overview...................................................................................................................... 70
Reminder of learning outcomes.................................................................................... 71
Sample questions......................................................................................................... 71
Block 6: Perfect competition ................................................................................ 73
Introduction................................................................................................................. 73
Assumptions and implications....................................................................................... 74
The firm’s supply decision............................................................................................. 75
Industry supply curves................................................................................................... 78
Comparative statics ..................................................................................................... 78
Perfect competition and efficiency................................................................................. 79
Overview...................................................................................................................... 80
Reminder of learning outcomes.................................................................................... 81
Sample questions......................................................................................................... 81
Block 7: Pure monopoly......................................................................................... 83
Introduction................................................................................................................. 83
Perfect competition and perfect monopoly..................................................................... 84
Monopoly analysis........................................................................................................ 84
Social cost of monopoly................................................................................................ 88
Price discrimination...................................................................................................... 89
When can monopolies be justified?............................................................................... 90
Overview...................................................................................................................... 90
Reminder of learning outcomes.................................................................................... 91
Sample questions......................................................................................................... 91
Block 8: Market structure and imperfect competition.......................................... 93
Introduction................................................................................................................. 93
A theory of market structure......................................................................................... 94
Monopolistic competition............................................................................................. 95
Oligopoly..................................................................................................................... 96
Game theory................................................................................................................ 96
Models of oligopoly...................................................................................................... 97
Reminder of learning outcomes.................................................................................. 100
Sample questions....................................................................................................... 100
Block 9: The labour market.................................................................................. 105
Introduction............................................................................................................... 105
The factors of production............................................................................................ 107
Analysis of the labour market...................................................................................... 107
Labour supply............................................................................................................. 110
ii
Contents
Labour market equilibrium ......................................................................................... 111
Disequilibrium in the labour market............................................................................ 112
Overview.................................................................................................................... 113
Reminder of learning outcomes.................................................................................. 114
Sample questions....................................................................................................... 114
Block 10: Welfare economics and the role of government................................. 117
Introduction............................................................................................................... 117
Equity and efficiency................................................................................................... 120
Distortion of the market.............................................................................................. 123
Sources of market failure............................................................................................ 124
Taxes and externalities................................................................................................ 126
Public goods............................................................................................................... 126
Overview.................................................................................................................... 128
Reminder of learning outcomes.................................................................................. 128
Sample questions....................................................................................................... 128
Block 11: Introduction to macroeconomics......................................................... 131
Introduction............................................................................................................... 131
Macroeconomic analysis............................................................................................. 132
The circular flow of income......................................................................................... 132
Measuring GDP.......................................................................................................... 134
Overview.................................................................................................................... 137
Reminder of learning outcomes.................................................................................. 137
Sample questions ...................................................................................................... 138
Block 12: Supply-side economics and economic growth.................................... 141
Introduction............................................................................................................... 141
Supply-side economics................................................................................................ 142
Economic growth....................................................................................................... 143
Inputs to production................................................................................................... 144
Solow growth model.................................................................................................. 144
Romer’s model of endogenous growth........................................................................ 149
Costs of growth.......................................................................................................... 150
Overview.................................................................................................................... 151
Reminder of learning outcomes.................................................................................. 151
Sample questions....................................................................................................... 152
Block 13: Output and aggregate demand........................................................... 153
Introduction............................................................................................................... 153
Components of aggregate demand: consumption and investment............................... 154
Equilibrium output...................................................................................................... 155
The multiplier............................................................................................................. 156
Foreign trade: exports and imports.............................................................................. 159
Overview.................................................................................................................... 160
Reminder of learning outcomes.................................................................................. 161
Sample questions ...................................................................................................... 161
Block 14: Money and banking; interest rates and monetary transmission......... 163
Introduction............................................................................................................... 163
Money and banking.................................................................................................... 164
Financial crises........................................................................................................... 164
Demand for money..................................................................................................... 164
Money market equilibrium and monetary control......................................................... 165
Monetary policy: targets, instruments and the transmission mechanisms...................... 165
iii
EC1002 Introduction to economics
Overview.................................................................................................................... 166
Reminder of learning outcomes.................................................................................. 167
Sample questions ...................................................................................................... 167
Block 15: Monetary and fiscal policy.................................................................. 169
Introduction............................................................................................................... 169
Monetary policy.......................................................................................................... 170
The IS-MP model........................................................................................................ 170
Deriving the IS curve................................................................................................... 171
The MP curve............................................................................................................. 172
The IS-MP in action.................................................................................................... 173
Overview.................................................................................................................... 174
Reminder of learning outcomes.................................................................................. 174
Sample questions....................................................................................................... 174
Block 16: Aggregate demand and aggregate supply.......................................... 177
Introduction............................................................................................................... 177
Aggregate demand..................................................................................................... 178
Aggregate supply....................................................................................................... 179
Equilibrium inflation................................................................................................... 180
Wage rigidity.............................................................................................................. 181
Short-run aggregate supply......................................................................................... 181
Adjustment to demand shocks.................................................................................... 182
Overview.................................................................................................................... 184
Reminder of learning outcomes.................................................................................. 185
Sample questions ...................................................................................................... 185
Block 17: Inflation............................................................................................... 187
Introduction............................................................................................................... 187
Money and inflation................................................................................................... 187
The Phillips curve and inflation expectations................................................................ 188
The costs of inflation.................................................................................................. 191
Controlling inflation.................................................................................................... 192
Overview.................................................................................................................... 192
Reminder of learning outcomes.................................................................................. 193
Sample questions....................................................................................................... 193
Block 18: Unemployment.................................................................................... 195
Introduction............................................................................................................... 195
Rates of unemployment.............................................................................................. 196
Analysis of unemployment ......................................................................................... 197
Changes in unemployment......................................................................................... 199
Cyclical unemployment............................................................................................... 200
Cost of unemployment............................................................................................... 201
Overview.................................................................................................................... 201
Reminder of learning outcomes.................................................................................. 202
Sample questions....................................................................................................... 202
Block 19: Exchange rates and the balance of payments..................................... 205
Introduction............................................................................................................... 205
The exchange rate...................................................................................................... 206
The balance of payments............................................................................................ 208
Real and PPP exchange rates...................................................................................... 208
The current and financial accounts.............................................................................. 210
Long-run equilibrium.................................................................................................. 211
iv
Contents
Overview.................................................................................................................... 211
Reminder of learning outcomes.................................................................................. 212
Sample questions....................................................................................................... 212
Block 20: Open economy macroeconomics......................................................... 215
Introduction............................................................................................................... 215
The macroeconomy under fixed exchange rates........................................................... 215
Devalution of a fixed exchange rate............................................................................ 216
The macroeconomy under floating exchange rates....................................................... 217
Overview.................................................................................................................... 219
Reminder of learning outcomes.................................................................................. 219
Sample questions....................................................................................................... 219
v
EC1002 Introduction to economics
Notes
vi
Introduction
Introduction
Introduction to the subject area
Every day people make decisions that belong within the realm of
economics. What to buy? What to make and sell? How many hours to
work? We have all participated in the economy as consumers, many of us
as workers, some of us also as producers. We have paid taxes. We have
saved our earnings in a bank account. All of these activities (and many
more) belong to the realm of economics. Households and firms are the
basic units of an economy and are concerned with the economic problem:
how best to satisfy unlimited wants using the limited resources that are
available? As such, economics is the study of how society uses its scarce
resources. Its aim is to provide insight into the processes governing the
production, distribution and consumption of goods and services in an
exchange economy.
The previous paragraph could be taken to imply that the ‘realm of
economics’ is limited and clearly defined. However, if we view economics
as a way of thinking, or a set of tools that can be applied to analyse human
behaviour and the world around us, then you will find that the principles
of economics can be applied to many different areas of life. The scope is
thus very broad, but the principles of analysis are well defined, and these
are what you will become familiar with through undertaking this course.
Although the course provides some information that is descriptive, its
main focus is on introducing models and concepts which are used as tools
of economic analysis. Concepts such as opportunity cost and approaches
such as marginal analysis can be widely applied and prove very useful in
understanding various aspects of society and people’s lives.
The study of economics does not just impart knowledge; it also develops
skills such as logical and analytical thinking and problem-solving
capabilities, which are useful beyond the formal study of economics. For
some of you, economics is not the main area of study, and you may not be
intending to pursue a career as an economist. However, we are sure that
an understanding of fundamental economic concepts will prove useful to
you in whatever direction your studies and subsequent career may take.
Aims of the course
The course aims to:
•
introduce you to an understanding of the domain of economics as a
social theory
•
introduce you to the main analytical tools and reasoning used in
economic analysis
•
introduce you to the main conclusions derived from economic analysis
and to develop your understanding of their organisational and policy
implications
•
enable you to participate in debates on economic matters.
1
EC1002 Introduction to economics
Learning outcomes
At the end of the course and having completed the essential reading and
activities, you should be able to:
•
define key concepts and describe the models and methods used in
economic analysis
•
formulate real world issues in the language of economic modelling
•
apply and use economic models to analyse these issues
•
assess the potential and limitations of the models and methods used in
economic analysis.
Overview of learning resources
Textbooks
This subject guide follows the structure of the essential textbook and
works through the parts of the textbook included in the syllabus section
by section, providing commentary, additional questions and extending the
material in some parts.
Begg, D., G. Vernasca, S. Fischer and R. Dornbusch Economics. (London: McGraw
Hill, 2020) 12th edition [ISBN 9781526847393]. Referred to as BVFD.
Earlier editions are also useful but you will find differences. In particular,
this course covers the IS-MP model as a key framework of macroeconomic
analysis, whereas earlier editions focus on the IS-LM model.
How to use the subject guide
Each of the 20 blocks of the subject guide covers one or two chapters
from the primary textbook. The guide works through the textbook section
by section and you will find additional explanations and questions to
aid and test your understanding. The subject guide has been designed to
accompany the textbook, so you should use them jointly and follow the
reading instructions listed throughout.
One key aim of the guide is to encourage active engagement with the
material, as this is how you will gain a good understanding. For example,
many of the models which will be covered in this course are expressed
graphically and the subject guide contains empty boxes where you can
practise drawing these graphs. It is very difficult to understand and
remember graphs just by looking at them, so you will need to practise
drawing them for yourself. For more complex graphs in later chapters,
you could even practise using blank paper and then, when you are
confident, draw the graph in the empty box in the subject guide. You are
also encouraged to actively undertake the other activities and questions
in the subject guide. Answers to these are available on the virtual learning
environment (VLE).
The subject guide and the primary textbook must be used together. The
guide will not make much sense without the textbook. Equally, do not be
tempted to neglect the guide and just focus on the textbook. You need to
be aware that the subject guide not only seeks to complement and clarify
the contents of the textbook, but also to extend it in certain places. For the
final examination, you will need to be familiar with the material in both
the textbook and the subject guide. Textbook chapters that are not referred
to in the guide and are not examinable. We hope that this guide will help
you as you work through the textbook and that you will find it useful in
your studies.
2
Introduction
Online study resources (VLE, Online Library)
In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at: https://my.london.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave
on your application form. You have probably already logged in to the
Student Portal in order to register! As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and
your fully functional University of London email account.
If you have forgotten these login details, please click on the ‘Forgotten
your password’ link on the login page.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
•
Course materials: Subject guides and other course materials
available for download. In some courses, the content of the subject
guide is transferred into the VLE and additional resources and
activities are integrated within the text.
•
Readings: Direct links, wherever possible, to essential readings in the
Online Library, including journal articles and ebooks.
•
Video content: Including introductions to courses and topics within
courses, interviews, lessons and debates.
•
Screencasts: Videos of PowerPoint presentations, animated podcasts
and on-screen worked examples.
•
External material: Links out to carefully selected third-party
resources.
•
Self-test activities: Multiple-choice, numerical and algebraic
quizzes to check your understanding.
•
Collaborative activities: Work with fellow students to build a body
of knowledge.
•
Discussion forums: A space where you can share your thoughts and
questions with fellow students. Many forums will be supported by a
‘course moderator’, a subject expert employed by LSE to facilitate the
discussion and clarify difficult topics.
•
Past examination papers: We provide up to three years of past
examinations alongside Examiners’ commentaries that provide
guidance on how to approach the questions.
•
Study skills: Expert advice on getting started with your studies,
preparing for examinations and developing your digital literacy skills.
Note: Students registered for Laws courses also receive access to the
dedicated Laws VLE.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time, and you should check the VLE
regularly for updates.
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EC1002 Introduction to economics
Answers on the VLE
Answers to the subject guide exercises can be found on the VLE. By far
the most beneficial approach is to attempt the questions and activities
yourself before you look at the answers. If, when you do look at them, you
discover that your own answer is incorrect, try to work out what led you to
that answer (to clear away your misconceptions) and furthermore, try to
understand why the given answer is in fact correct. This will help you to
gain a solid understanding.
Making use of the Online Library
The Online Library (http://onlinelibrary.london.ac.uk) contains a huge
array of journal articles and other resources to help you read widely and
extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login.
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please use the online help pages (http://onlinelibrary.
london.ac.uk/resources/summon) or contact the Online Library team:
onlinelibrary@shl.london.ac.uk
Route map to the guide
The subject guide consists of 20 blocks – an introductory block, and then
9 for microeconomics and macroeconomics, respectively. Throughout the
guide, ‘chapter’ refers to the sections of the textbook, while ‘block’ refers to
the sections of the subject guide. This is to avoid confusion – for example,
when the guide says ‘this concept will be explored further in Chapter
12’, it should be clear to the reader that this refers to Chapter 12 of the
textbook (BVFD).
Introduction and Microeconomics
4
Block Title
BVFD Chapter
1
Economics, the economy and tools of
economic analysis
1,2
2
Demand, supply and the market
3
3
Elasticity
4, 15.3, Maths 15.1
4
Consumer choice
5 (except 5.6)
5
The firm
7, 8
6
Perfect competition
9.1–9.4
7
Pure monopoly
9.5–9.10
8
Market structure and imperfect competition
10 (except 10.6 and A10.2)
9
The labour market
11 (except 11.8)
10
Welfare economics and the role of
government
14 (except 14.7 and 14.8);
15.2–15.3, Maths 15.3
Introduction
Macroeconomics
Block
Title
BVFD Chapter
11
Introduction to macroeconomics
17
12
Supply-side economics and economic growth 18
13
Output and aggregate demand
19, 20
14
Money and banking; interest rates and
monetary transmission
21 (except Maths 21.2, 22
(except Maths 22.1)
15
Monetary and fiscal policy
23 (except 23.6 and the
appendix)
16
Aggregate demand and aggregate supply
24
17
Inflation
25 (except 25.1)
18
Unemployment
26 (except Maths 26.1)
19
Exchange rates and the balance of
payments
27(except Maths A27.1)
20
Open economy macroeconomics
28 (except Maths 28.1)
Study advice
The British education system, possibly more than others, and economics as
a subject, possibly more than others, both emphasise understanding above
rote learning (learning by heart). It is very difficult (if not impossible)
to do well in economics examinations simply by rote learning. A much
better strategy is to try to gain a good understanding of the concepts and
the models. Although this may involve more work in the short term, the
final outcome will be much better, and the examination much easier. For
example, many of the models we will cover can be summarised in a single
graph or set of equations. You will need to be able to use these graphs to
demonstrate the effects of changes in the economic environment to which
the model relates. This is very difficult to do well through memorisation,
but if you understand why the different lines of the graph are drawn
in that particular way or what a particular equation represents, then
adjusting the graph or modifying the equations will become a relatively
simple and straightforward exercise.
The textbook, which the subject guide accompanies, assumes that you
haven’t done any economics before and starts from the basics. It gives a
good explanation of all concepts and uses examples to make these new
concepts intuitive. It also includes material to stretch you, including
Maths boxes. You are required to really master this textbook, including
the Maths boxes and more challenging elements. If there are sections
which are difficult to understand at first, you may find that reading these
through several times is very helpful. In certain places, the subject guide
will also seek to extend the textbook if there are areas where it does not
go far enough. Although you will find the textbook approach of starting
at a fairly basic level very useful, you should expect the examination to be
quite rigorous.
At the end of each block, you will find (i) two to three multiple choice
questions for you to check your basic understanding, (ii) two to three
True/False/Uncertain questions similar in style to Section A of the
examination, and (iii) one long question similar in style to Section B
of the examination. Working through these end of block questions and
then attempt past examination questions is an important part of your
preparation for the course. In this way, we hope to help you really lay
a firm foundation of understanding in economics, and at the same time
5
EC1002 Introduction to economics
demonstrate the high standard that is expected of you as University of
London students.
In the subject guide you will find six ‘food for thought’ boxes. These
are designed to help you engage with the material by relating some of
the theoretical ideas to real world issues and point you towards further
reading you may find interesting. There will be occasional opportunities
to bring in ideas from the boxes into examination answers but note the
further materials accessible through the links are not directly examinable.
Box 1: Why do consumers experience regret? (Block 4)
Box 2: Should wages be fair? (Block 8)
Box 3: Why is climate change such a challenge? (Block 10)
Box 4: How should we measure the wellbeing of nations? (Block 11)
Box 5: Is Bitcoin money? (Block 14)
Box 6: What will the future of work look like? (Block 18)
Use of mathematics
Economic models can be expressed in various ways, in words, in diagrams
and in equations. Although this course mainly uses diagrammatic
representations accompanied by words, simple equations can also be
a concise way of expressing an economic model, and you will need to
become familiar with this approach. At this stage, the maths involved
will be limited to simple algebra and elementary calculus. Some basic
mathematical techniques and ideas will be also introduced in the first
block. It is important to work through the Maths boxes in each chapter,
as these often provide a step-by-step explanation of the mathematical
approach to the models covered. The subject guide will also provide
further explanations where we think this will be helpful. Economics is
becoming an increasingly technical subject and, although the level of
mathematics required for this course is quite basic, we hope that you
will become confident in taking a mathematical approach to analysing
economic issues.
6
Block 1: Economics, the economy and tools of economic analysis
Block 1: Economics, the economy and
tools of economic analysis
Introduction
Block 1 is an introduction to the course. It contains a brief discussion of
several ideas which you will study in more detail later this course. You do
not need to study this block in detail, but you will need to take note of
certain specific issues. These are indicated with the label Important.
This block covers the first two chapters of the textbook and is designed to
give you an introduction to economics and some help in starting to use
the tools of economic analysis. The concepts introduced in this block, such
as scarcity, opportunity cost and ceteris paribus (more on these below),
are absolutely essential to your understanding of economics. The more
thoroughly you work through the material in this block, the better your
foundation will be for all the material that follows.
So what is economics? The word ‘economy’ comes from two Greek words
– oikos (meaning house) and nemein (meaning manage) – its original
meaning was ‘household management’. Households have limited resources
and managing these resources requires many decisions and a certain
organisational system. The meaning of the word economics has developed
over time. Today, economics can be defined as the study of how societies
make choices on what, how and for whom to produce, given the limited
resources available to them. Furthermore, the key economic problem can
be defined as being to reconcile the conflict between people’s virtually
unlimited desires and the scarcity of available resources and means of
production.
These are the definitions provided in the core textbook (BVFD) and indeed
in many other textbooks. They are traditional definitions and have their
origins in an essay by Lionel Robbins (of the London School of Economics
and Political Science) written in 19321 in which he defined economics as
‘the science which studies human behaviour as a relationship between
ends and scarce means which have alternative uses’.
It is important to realise that this definition is not without its critics.
The textbook does not pretend to discuss in any depth the definition
of economics or the legitimate domain of economic investigation.
Those wishing to pursue the philosophical foundations of the nature of
economics could consult the collection of papers edited by Frank Cowell
and Amos Witztum,2 especially papers by Atkinson, Witztum, Backhouse
and Medema.
On a less philosophical note, if we were to follow the definition attributed
to Jacob Viner (an early member of the ‘Chicago School’ and a teacher of
Nobel laureate Milton Friedman) that ‘economics is what economists do’,
the Robbins definition stated above would fall short of describing the way
in which the subject has evolved, in particular in its failure to reflect the
time and effort devoted today to empirical analysis.
Arguably, the definitions provided in the textbook apply more directly to
microeconomics than macroeconomics, the latter being more concerned
with the structure and performance of the aggregate economy and
such issues as growth, cycles, unemployment and inflation. However,
Lionel Robbins An
essay on the nature and
significance of economic
science. (London:
Macmillan, 1932, 2nd
edition 2014) p.16.
1
Cowell, Frank and
Amos Witztum (eds)
Lionel Robbins’s essay
on the nature and
significance of economic
science: 75th anniversary
conference proceedings.
(London: Suntory and
Toyota International
Centres for Economics
and Related Disciplines,
2009) pp.1–500.
Available at http://darp.
lse.ac.uk/papersdb/
LionelRobbinsConference
ProveedingsVolume.pdf
2
7
EC1002 Introduction to economics
underlying these ‘big’ issues is the behaviour of individual agents such as
consumers and firms. Recent developments in macroeconomics have been
concerned with establishing microeconomic foundations. So scarcity and
the rational responses to it are not absent from macroeconomics.
Although the definitions above may appear abstract, economics deals with
phenomena you will be very familiar with from your daily activities, and
provides tools and a language to analyse these. While it is not the only
language available, we hope it will prove useful to you.
Economics and the real world
One of the main reasons that BVFD was chosen as the textbook for the
course is that it combines the exposition of economic theory with liberal
use of actual data on many economic issues. Modern economics is a
subject which, at its best, does not theorise in a vacuum but addresses
issues of real world importance and attempts to make its concepts
and theories consistent with the facts. When economists make policy
recommendations these address issues of current importance and
concern. Furthermore, the effectiveness of economic policy is increasingly
subject to empirical evaluation. Sometimes this happens by piloting
a policy on a restricted scale before it is rolled out nationally. Almost
always government departments, private sector analysts and academic
economists attempt to evaluate the consequences of policy in the months
or years after implementation. If you pursue your study of economics to
a more advanced level you will learn how applied economists attempt
to test the relevance and accuracy of their theories and the success or
failure of economic policy using statistical techniques broadly known as
econometrics. However, even at this early stage of your study you should
attempt to familiarise yourself with actual facts about the economy and
think about what these imply for economic theory and the formation and
evaluation of economic policy. The statistics and policy discussions in
BVFD often (but not always) relate to the UK economy; we encourage you
to look for comparable examples wherever you live.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
8
•
recognise economics as the study of how society addresses the conflict
between unlimited desires and scarce resources
•
describe ways in which society decides what, how and for whom to
produce
•
identify the opportunity cost of a decision or action
•
explain the difference between positive and normative economics
•
define microeconomics and macroeconomics
•
explain why theories deliberately simplify reality
•
recognise time-series, cross section and panel data
•
construct index numbers
•
explain the difference between real and nominal variables
•
build a simple theoretical model
•
plot data and interpret scatter diagrams
•
use ‘other things equal’ to ignore, but not forget, some aspects of a
problem in order to focus on core issues.
Block 1: Economics, the economy and tools of economic analysis
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapters 1 and 2.
Synopsis of this block
This block introduces some of the key concepts in economics. First,
scarcity – the idea that the means available to society (its labour force, its
capital stock, its natural resources, its technology) are insufficient to meet
all the wants (or the desired goods and services) of the people making up
that society. Related to scarcity is the concept of opportunity cost – which
is the value of the best alternative that must be sacrificed. The concept of
scarcity gives rise to the production possibility frontier (PPF), which
shows the maximum amount of one good that can be produced given the
output of another good. The slope of the PPF is the opportunity cost. The
fact that different individuals and countries have different opportunity
costs of producing various goods gives rise to comparative advantage and
creates the possibilities for gains from trade.
In economics, people are assumed to behave rationally – only taking a
course of action if its benefits outweigh its costs. Furthermore, people are
assumed to be motivated by self-interest. The idea of the ‘invisible hand’
describes how market forces allocate resources efficiently despite the
self-interested motivations of individuals. Markets resolve production and
consumption decisions via the adjustment of prices.
Economics can be divided into different sub groups and approaches.
Positive economics deals with ‘facts’ about how the economy behaves
and with empirically testable propositions, while normative economics
involves subjective judgements. Microeconomics studies particular markets
and activities in detail, while macroeconomics deals with aggregates and
studies the economy as a whole system.
The interplay of data and theory/models in economics is very important.
Models are deliberate simplifications of reality which help organise how
we think about a problem. A key approach of economic analysis is to
abstract from various factors by holding them constant – this is known
as ceteris paribus or ‘other things equal’. The second half of this block
examines the relationship between data and theory and also provides
guidance and instruction regarding key practical concepts and skills
such as index numbers, nominal and real variables, measuring change,
diagrams, lines and equations. Chapter 2 concludes by briefly addressing
some popular criticisms of economics and economists.
► BVFD: read Chapter 1.
Important: This reading introduces the concept of opportunity cost. You will meet
opportunity cost in the context of the firm in Block 5.
Sections 1.1 and 1.3 introduce the concepts of scarcity, opportunity cost, and efficiency.
These are not separate concepts but are all interrelated and can be demonstrated using
the production possibility frontier introduced in section 1.3.
Read section 1.1, concept 1.1 and case 1.1.
9
EC1002 Introduction to economics
Scarcity
BVFD defines scarcity by saying: ‘a resource is scarce if the demand for
that resource at a zero price would exceed the available supply’. Since the
concepts of demand and supply have not yet been introduced to you, we
can also define scarcity by stating that the means available to society (its
labour force, its capital stock, its natural resources, its technology) are
insufficient to meet all the wants (or the desired goods and services) of the
people making up that society. This implies that for any one person to have
more of something, they or someone else must have less of something
else. In turn, this requires choice, both at the level of the individual agent
but also at the societal or collective level. How individuals and societies
cope with scarcity in relation to wants is central to economics. This course
concentrates on the market economy as the basic organisational principle
for coping with scarcity, but modified by governments to rectify market
shortcomings and to achieve distributional ends.
Opportunity cost
Related to scarcity is the concept of opportunity cost – one of the key
concepts in economic analysis.
To cement your understanding of opportunity cost, complete the following
activity on this concept.
Activity SG1.1
a. Let us change the details of the problem in concept box 1.1. Suppose that there
were no jobs in the campus shop. The only job available, and this is the alternative
to going to the beach with your friends, is to work at the local fast food restaurant
clearing tables and washing dishes. This job also pays £70, but because of its general
unpleasantness you wouldn’t do it unless you were paid at least £55. Should you go
to the beach or work at the fast food restaurant?
b. A high-end ladies fashion boutique purchases winter coats from a manufacturer at
a price of £300 per coat. During the winter the boutique will try to sell the coats at
a price higher than £300 but may not be able to sell all of the coats. Since they are
the latest fashion, no customers would be interested in buying the coats next season.
However, at the end of the winter, the manufacturer will pay the boutique 20% of the
original price for any unsold coats (and re-use the expensive fabrics they are made
from for the next year’s designs).
i. At the beginning of the year, before the boutique has purchased any coats,
what is the opportunity cost of these coats?
ii. After the boutique has purchased the coats, what is the opportunity cost
associated with selling a coat to a prospective customer? (You can assume the
coat will be unsold at the end of the winter if that customer doesn’t buy the
coat).
iii. Suppose towards the end of the winter the boutique still has a large inventory
of unsold coats. The boutique has set a retail price of £950 per coat. The
marketing manager argues that the boutique should cut the price to £199 to
try to sell the remaining coats before they become unfashionable at the end
of the winter. However, the general manager disagrees, arguing that would
mean a loss of £101 on each coat. Which makes more economic sense – the
marketing manager’s suggestion or the general manager’s argument?
► BVFD: read section 1.2.
This section raises various economic issues which you may be familiar with through the
news or other sources. It demonstrates what kinds of issues economics deals with.
10
Block 1: Economics, the economy and tools of economic analysis
In each case, the authors demonstrate the impact on the three key questions of what to
produce, how to produce it and for whom.
The global financial crisis of 2007–09 was a time of great disruption to
economies around the world and indeed to the world economy. As can be
seen in Figure 1.1 of the textbook, the US economy shrank at a faster rate
than had been seen since before the 1980s.
Rationality
► BVFD: read concept box 1.2.
This concept box comes back to the idea of rationality, introduced in
section 1.1 of the textbook. In much of economic analysis people are
assumed to act rationally, using all available information to maximise
their satisfaction. In the real world, human behaviour is complex. The
field of behavioural economics examines human behaviour, especially
when it appears to depart from the assumption of rationality. Chapter
2.10 concludes with some criticisms of economics, including the criticisms
that ‘people are not as mercenary as economists think’. In fact, depending
on the task at hand, behaviour can be modelled very simply, or in a more
complex way to include various other factors, including altruism. In some
cases, even very simple models can go a long way in explaining human
behaviours. When these fail, more complex elements can be included to
make the model more realistic. Behavioural economics indicates some
ways that the simple assumption of rationality can be extended to provide
further insights into human behaviour.
The production possibility frontier (PPF)
► BVFD: read section 1.3.
The production possibility frontier is one of the most fundamental and
important concepts in economics. It shows all the combinations of goods
that can be produced if the means of production are fully employed. It will
come up again in Block 6 when we discuss the perfect competition model
of market structure, Block 10 when we discuss welfare economics and also
in Block 12 when we discuss economic growth.
The PPF: scarcity and desirability
The PPF is a boundary. It demonstrates scarcity in that any point beyond
the frontier is unattainable. Society cannot produce combinations that
lie outside the PPF because there are insufficient resources to do so. The
economic problem has been defined as reconciling scarcity with people’s
virtually limitless desires. These desires mean that people wish to have
more of everything – as such, points above and to the right of the origin
are seen as better than points closer to the origin. If society produces at a
point on the frontier rather than inside it, society will be better off.
The PPF and efficiency
The statements above relate to the idea of efficiency. Points on the PPF
are productive efficient, while points within the curve are inefficient.
An efficient allocation of means of production is one which yields a
combination of outputs where it is not possible to increase the output of
one good without reducing the output of the other.3 Societies must also
choose not just any point on the PPF but a specific point. This relates to
allocative efficiency and will be discussed further in Block 10.
For simplicity, we
assume all goods in the
economy are grouped
into two groups, or
that it is a two-good
economy.
3
11
EC1002 Introduction to economics
The PPF and opportunity cost
Society has a given amount of resources at its disposal and when the
economy is using these efficiently, using more resources to increase the
production of one good necessarily implies decreasing the production of
the other. This trade-off helps demonstrate the idea of opportunity cost.
The amount by which good B is reduced to increase the production of
good A is the opportunity cost of increasing the production of good A.
Moving along the PPF from one point on the curve to another shows how
much of one good must be given up to increase the production of the other
– thus the slope of the PPF is the opportunity cost. The opportunity cost
can also be described as the real price of a good, since it represents the
amount of one good that must be sacrificed in order to attain more of the
other.
The shape of the PPF and marginal analysis
In economics, marginal analysis is very important. ‘Marginal’ simply means
‘extra’ or ‘additional’ and marginal analysis has to do with decision making
at the margin. Economists often analyse the effects of a one unit change
in something – for example: how much better off will a consumer be if
they can purchase one additional unit of a good? How much extra profit
will a company earn by producing one additional unit of a good? How
much more can a company produce if they hire one additional worker?
Asking such questions helps to find the optimal level of (for example)
consumption and production, and you will come across this again and
again throughout the course. For example, Block 4 introduces the idea of
diminishing marginal utility: the first glass of lemonade you drink on a
hot day is very refreshing, the second is less so, and by the time you finish
the third, you may not want to drink any more lemonade for a while. In
this block, the shape of the PPF is linked to diminishing marginal returns:
in the example given in section 1.3, the first worker employed in the film
industry produces 9 units of output, the second produces 8 units, the third
produces 7 units and the fourth produces only 6 units. The fact that the
extra output each additional input can produce diminishes is one reason
why the PPF is concave toward the origin.
Activity SG1.2
Draw a production possibility frontier, clearly marking the regions of inefficient
production, efficient production and unattainable production. Illustrate how the slope of
the PPF represents opportunity cost. Why is the frontier concave to the origin?
Opportunity cost and absolute and comparative
advantage
Important: The ideas of absolute and comparative advantage are
fundamental to our understanding of international trade and you should
study them carefully at this stage.
The concept of opportunity cost can also help us to understand why people
(and countries) specialise in the production of certain goods and then
trade.
Let us expand a bit on the treatment of PPFs in the second part of section
1.3, dealing with the two individuals, Jennifer and John, making the two
goods, T-shirts (T) and cakes (C).
We can write, for Jennifer:
Number of T-shirts produced = (T-shirts produced per hour) * hours spent
on T-shirt production (LT).
12
Block 1: Economics, the economy and tools of economic analysis
Or
Τ = 4LT
T
∴ LT =
4
Similarly for Jennifer cake production can be written as:
C = 2LC
C
∴ LC =
2
Now, we are also told that Jennifer can work up to 10 hours, in T-shirt
and/or cake production. When she does work 10 hours:
LT + LC = 10
C
T
+
= 10
4
2
T + 2 C = 40
Be sure that you understand that for John we have the equation:
2C + T = 10
These equations will show the production possibilities for Jennifer and
John. They will help you in Activity SG1.3 which you should now attempt.
Activity SG1.3
a. Putting cakes on the horizontal axis and T-shirts on the vertical axis draw Jennifer and
John’s production possibility frontiers for a 10-hour working day.
b. In what way do these PPFs differ from that drawn in Figure 1.2? Why?
c. Write down the equations of these production possibility frontiers, making T (T-shirts)
a function of C (cakes).
d. What is the interpretation of the slope of these PPFs?
e. In your diagram what represents Jennifer’s absolute advantage in producing both
goods?
f. In your diagram what represents John’s comparative advantage in making cakes?
To cement your understanding of comparative advantage, complete the
following.
Activity SG1.4
Suppose there are two countries (M and W) and two goods (shoes and hats). The table
gives the labour requirements to produce a unit of each output in each country.
Country M
Country W
Shoes
10 labour hrs/unit of output
12
Hats
2
5
a. Which country has an absolute advantage in shoes? In hats?
b. Which country has a comparative advantage in shoes? In hats?
c. Assuming each country has 100 labour hours available, what will the total production
of shoes and hats be if each country specialises fully in the production of the good in
which it has a comparative advantage (presumably they would then engage in trade
with each other) compared to what they could produce in a situation with no trade if
they spent half their available labour on each good?
13
EC1002 Introduction to economics
If you are interested in exploring these concepts in more detail you can
read Chapter 30 on International Trade (which is optional and will not be
covered in this subject guide or examined).
Markets
► BVFD: read section 1.4 and case 1.2 and complete activity 1.1.
As noted above, economics can be defined as the study of how societies
make choices on what, how and for whom to produce. As such, economics
is concerned with the organisation of economic activities in a society and
the institutional arrangements that will provide optimal answers to the
questions above. These institutional arrangements can be thought of as
existing along a continuum from, on the one hand, ‘command economies’,
where decisions are made centrally by the government planning office, to,
on the other hand, ‘free market economies’, where decisions are taken by
individual agents driven by self-interest but organised by market forces as
by an ‘invisible hand’.
This section begins to explain how free markets can often bring about
efficient outcomes. In subsequent blocks we will discuss in much greater
detail, and with more rigour, how market forces guide resource allocation.
Although it is true that centrally planned economies (command economies)
were riddled with inefficiencies, it would be incorrect to believe that all
non-planned economies are pure market economies. Today we all live in
mixed economies, in which governments play a major role. Subsequent
chapters (15 and 16) will analyse some of the reasons why markets fail
to allocate resources ideally, creating a potential role for the state to step
in. The actual extent of state intervention does, of course, differ quite
significantly across countries and how large the role of the state should be
is a highly contentious issue. Broadly speaking, governments can intervene
in the economy either to promote efficient resource allocation where
markets fail to achieve this end or to achieve more equitable outcomes
than markets generate if left to operate unhindered.
Positive and normative economics
► BVFD: read section 1.5.
This short section distinguishes in a quite traditional way between positive
and normative economics and you should be clear about the distinction.
There have been some quite eminent economists, such as the Swedish
Nobel Prize winner Gunnar Myrdal who rejected the positive-normative
dichotomy, claiming that normative values are inextricably intertwined
with so called ‘objective’ or value-free economic analysis. Myrdal argued
that economists would be much better advised to state their values openly
and explicitly rather than pretend that they could be put to one side while
conducting positive analysis. Though this is not the orthodox view in the
profession! Returning to the treatment in BVFD, complete the following
activity.
14
Block 1: Economics, the economy and tools of economic analysis
Activity SG1.5
Classify the following statements as positive or normative:
• Inflation is more harmful than unemployment.
• An increase in the minimum wage to £11 per hour would reduce employment by 0.5
percentage points.
• The government should raise the national minimum wage to £11 per hour to help
reduce poverty in society.
• An increase in the price of crude oil on world markets will lead to an increase in
cycling to work.
• A reduction in personal income tax will improve the incentives of unemployed people
to find paid employment.
• Discounts on alcohol have increased the demand for alcohol among teenagers.
• The retirement age should be raised to 75 to combat the effects of our ageing
population.
Microeconomics and macroeconomics
Microeconomics takes a bottom-up approach to studying the economy
– focusing on individual consumers, households and firms; while
macroeconomics takes a top-down approach, studying the economy as
a whole system and focusing on aggregates. One analogy that can be used
to describe the difference between macroeconomics and microeconomics
is the study of a rainforest. Macroeconomics studies the ecology of the
rainforest as a whole, while microeconomics studies individual plants and
animals that live there. Most professional economists tend to specialise in
either microeconomics or macroeconomics (indeed, they will specialise on
sub-fields within this broad dichotomy), though modern macroeconomics
builds more heavily on microeconomics, and is what can be called ‘microfounded’. As you work through the textbook and the subject guide you
may find yourself drawn either to micro or to macro ahead of the other.
That is natural. What you should not do at this stage of your study of
economics is unbalance your commitment of time to the two halves; that
is not a good strategy, either in terms of doing well in examinations or
of building a solid foundation for further study of the subject. Blocks 10
and 11 cover welfare economics and the role of the government. Welfare
economics employs microeconomic techniques to analyse welfare at an
aggregate (economy-wide) level, and the role of the government is both
micro and macro – as governments are involved in specific markets but
also attempt to manage the aggregate level of demand and encourage
economic stability and growth. For simplicity, therefore, Blocks 10 and 11
are included in the first half of the course on microeconomics.
A note on mathematics
In discussing the tools of economic analysis, this chapter, perhaps
surprisingly, has little to say in general terms about the role of
mathematics in economics. In its methods and approaches, if not its
subject matter, economics today is almost unrecognisable from the subject
taught under the same name 70 or 80 years ago. The transformation
has indeed been dramatic. Today, top universities require a high level of
mathematical competence of their students, even at undergraduate level
(and higher still at postgraduate level), while a cursory scan of the top
economics journals might give the impression that the subject is a branch
15
EC1002 Introduction to economics
of mathematics. It isn’t. Correctly used, mathematics in economics is a
tool – a means to an end not an end in itself. Nevertheless, some have
argued that the pervasiveness of mathematics in modern economics has
had damaging consequences both on the development of the subject (with
concentration on topics that lend themselves to mathematical analysis and
relative neglect of those that don’t) and on the ability of economists to
communicate with non-economists, often including those responsible for
formulating economic policy.
Whether or not these criticisms are correct, it is highly unlikely that the
trend towards greater reliance on mathematical tools is likely to be reversed
in the near future. For those of you pursuing the subject beyond the
introductory level you will need to be prepared to use considerably more
mathematics. That said, the mathematical requirements of this particular
course are fairly limited. You need to be able to do basic arithmetic and
algebra, (including solving simultaneous equations) and you need to be
able to read and use graphs. Some of the Maths boxes in BVFD use calculus,
including partial differentiation and you should certainly try to understand
this material. Do not regard the mathematics boxes as optional extras.
Models and theory
► BVFD: read the introduction to Chapter 2.
The introduction provides a brief but useful argument explaining why
models and theory are so important in economics. Sometimes students
of introductory economics complain that there is too much theory/too
many models. Why can’t the subject just stick to the facts? But which
facts? And what can they tell us without guiding principles? On their own
the facts are silent. Teamed with appropriate models, however, they can
be eloquent. Broadly speaking, two key tools of economic analysis are
models/theory and data and they are best deployed in tandem. Someone
may notice a certain relationship expressed in economic data and develop
a theory to explain this relationship. That theory will then be tested by
other data, from different time periods and different contexts – these
data will either corroborate the theory, or lead to it being modified or
abandoned in favour of a theory that better fits the evidence.
In the last 20 years or so, the emphasis has been on identifying and
quantifying causal relationships amongst economics variables predicted by
theory. Economists do this using a range of empirical techniques, but also
heavily through the design and implementation of experiments.
Sections 2.1 to 2.5 lay out some important issues relating to economic
data, while later sections of the chapter introduce economic models and
discuss how models and data are used together in economics.
► BVFD: read sections 2.1, 2.2 and 2.3, as well as concept 2.1.
16
Block 1: Economics, the economy and tools of economic analysis
Activity SG1.6
Index numbers: work through the following example to help you understand how index
numbers are calculated. Suppose we want to calculate inflation for four specific goods.
The index for each good is set at 100 for the first year. Work out the percentage price
change in each good (the first one is completed for you).
Product
Price – year 1
Index – year 1 Price – year 2
Index – year 2
Bread
80p
100
120p
150
Cheese
260p
100
312p
Sausages
300p
100
390p
Toothpaste
100p
100
80p
TOTAL
400/4
Overall index
100
The change in the overall index is the average rate of inflation. What was the rate of
inflation for these four products between years 1 and 2?
However, the products in the price index are not equally important and should not be
given an equal weighting in the calculation of the index. That is why Weighted Index
Numbers are often used.
Of the four products above, which do you think represents the lowest proportion of a
family’s total spending? Which represents the highest?
If toothpaste represents a small proportion of each family’s total spending, then we
should make the price change for toothpaste have a much smaller overall effect on the
price index. To do this we weight each price change to give it more or less importance in
the overall index.
This has been done in the table below – see if you can complete the last column:
Product
Weights Price –
year 1
Index –
year 1
Weighted Price –
index –
year 2
year 1
Index –
year 2
Weighted
index –
year 2
Bread
4
80p
100
400
120p
150
600
Cheese
2
260p
100
200
312p
Sausages
3
300p
100
300
390p
Toothpaste
1
100p
100
100
80p
TOTAL
10
Overall
index
1,000/10
100
What is the rate of inflation between year 1 and 2 once weights are factored in?
This figure is considerably higher than the original inflation figure. This is because the
products with the highest weights went up in price the most. The effect of the falling
price of toothpaste on the overall index was reduced because this item had a very small
weight. A weighted index gives a much better estimate of inflation, since it reflects which
items are most important to family’s expenditure.
► BVFD: read sections 2.4, 2.5 and concept 2.2.
17
EC1002 Introduction to economics
Activity SG1.7
You got a job in the year 2020 with a salary of £35,000. In 2022, you receive a £5,000
increase in your salary. CPI in 2022 with base year 2020 is 108. Calculate your real
income in 2020 and 2022 as well as the percentage changes in your nominal income and
your real income.
► BVFD: read section 2.6.
Economic models are a deliberate simplification of reality. In the same way
that an architectural drawing shows all the important features of a house
without necessarily looking ‘realistic’, economic models abstract from
reality to clarify important features. This helps to simplify and clarify the
analysis of the problem at hand.
Economic models often use mathematics as the system of logic which ties
various parts of the model together.
Two terms which you should be familiar with are exogeneity and
endogeneity: Following the definitions provided in L&C (glossary),
an endogenous variable is a variable that is explained within a model or
theory. An exogenous variable influences endogenous variables, but is
itself determined by forces outside the model/theory. In the example of
a model of London Underground revenue, the number of passengers is
an endogenous variable, while factors such as bus fares and passenger
incomes are exogenous.
Important: If you are not already familiar with section 2.8 on reading
diagrams you must study it closely at this stage.
► BVFD: read sections 2.7, 2.8, 2.9 and complete activity 2.1.
These sections, and 2.9 below, turn to the use of empirical evidence in
economics. They begin to give an intuitive feel for econometrics, the
application of statistical and mathematical techniques, often with the help
of computers, to economic data, in order to test hypotheses and/or forecast
the effects of changes in the economic environment on outcomes of interest
(quantity demanded, hours worked, inflation, unemployment, etc.).
Econometrics is a central and well developed aspect of the subject, which is
generally a required component of an undergraduate degree in economics.
However, it is not usually introduced at elementary level.
Fitting lines through scatter diagrams – although the term is not provided
explicitly in this section, the description of how a computer, programmed
to apply defined statistical criteria, quantifies the influences of various
factors in a single model is describing multiple regression analysis.
The subsection ‘Reading diagrams’ is very basic mathematics, not
econometrics. You need to be competent (and confident) in these basic
techniques to follow subsequent chapters of the textbook and this subject
guide. The following activity enables you to practise basic graphical
techniques.
Note: Figures 2.4 and 2.5 plot quantity on the vertical axis and price on
the horizontal axis. These are simply exercises to teach you techniques
for interpreting diagrams and finding the slope and intercept of a line. In
the following chapter, demand and supply diagrams will be introduced
– typical demand and supply diagrams put price on the vertical axis and
quantity on the horizontal axis. Of course, the basic techniques of finding
the slope and intercept of the line remain the same.
18
Block 1: Economics, the economy and tools of economic analysis
Activity SG1.8
Sketch the following functions, finding the slope and intercept.
a. Q=50+20P
b. Q=150–10P
Criticisms of economics
► BVFD: read section 2.10 and case 2.1.
One criticism levied against economics which is mentioned briefly in this
section is that ‘the actions of human beings cannot be reduced to scientific
laws’. However, if we look at human behaviour in general, we can see
stable patterns on average even though the behaviour of individuals is
unpredictable. This has to do with the ‘law of large numbers’, a statistical
concept or ‘law’ which states that as the number of individual cases
increases, random movements tend to offset each other, such that the
difference between the expected value and the actual value tends to zero.
That means the behaviour of a group of people is much more predictable
than the behaviour of certain individuals, because the odd things one
individual does tend to be cancelled out by the odd things that some other
individual does.
Economics has been criticised for failing to predict the financial crisis and
associated recession beginning in 2007–08.4 This led to some damage
to the reputation of the subject and to the status of the profession.
It is too early to say just how damaging this has been (there doesn’t
seem to be any major decrease in the demand to study economics at
university or, broadly speaking, in the longer-term employment prospects
of economics graduates in either the private or public sectors). One
consequence of the crisis has been considerable self-examination of the
way in which the subject has been taught in the past and the emergence
of updated pedagogical approaches can be detected in the design of some
introductory courses.
Overview
Economics analyses what, how and for whom society produces. The key
economic problem is to reconcile the conflict between people’s virtually
unlimited desires and the scarcity of available resources and means
of production. The PPF shows the maximum amount of one good that
can be produced given the output of another. The slope of the PPF is
the opportunity cost (of the good on the horizontal axis in terms of the
other). More generally, opportunity cost is the value of the best alternative
that must be sacrificed. The fact that different individuals and countries
have different opportunity costs of producing various goods gives rise to
comparative advantage and creates the possibilities for gains from trade.
Some economists
were prescient. Nouriel
Roubini (NYU. Stern
School of Business)
as early as 2006 was
predicting that the
US housing bubble
would burst, leading
to damaging loss of
consumer confidence
and ultimately to
recession. Widely
criticised for being too
pessimistic at the time
Roubini’s forecasts were,
if anything, exceeded by
actual events. The link
provides some thoughts
of the Chairman of the
US Federal Reserve,
Ben Bernanke on the
implications of the crisis
for economics:
www.federalreserve.
gov/newsevents/speech/
bernanke20100924a.
htm
4
In economics, people are assumed to behave rationally – only taking an
action if its benefits outweigh its costs. Furthermore, people are assumed
to be motivated by self-interest. The idea of the ‘invisible hand’ describes
how, under certain conditions, market forces allocate resources efficiently
despite the self-interested motivations of individuals. Markets resolve
production and consumption decisions via the adjustment of prices.
There is a spectrum of government involvement in the economy – from a
command economy to a free market economy. Most industrialised nations
have mixed economies.
19
EC1002 Introduction to economics
Economics has many dimensions. Positive economics deals with ‘facts’
about how the economy behaves, while normative economics involves
subjective judgements. Microeconomics studies particular markets and
activities in details, while macroeconomics deals with aggregates and
studies the economy as a whole system.
The second half of this block examined the relationship between data
and theory and provided guidance and instruction regarding key practical
concepts and skills such as index numbers, nominal and real variables,
measuring change, diagrams, lines and equations. The interplay of data
and theory/models in economics is very important. Models are deliberate
simplifications of reality which help organise how we think about a
problem. Data can indicate a relationship that can be theorised about,
and can also be used to quantify relationships and test existing theories.
A key approach of economic analysis is to abstract from various factors by
holding them constant – this is known as ceteris paribus or ‘other things
equal’. Chapter 2 concludes by briefly addressing some popular criticisms
of economics and economists, such as the extent of disagreement in
the discipline (which in fact often relates more to normative than to
positive economics) and assumptions about human behaviour, which are
sometimes seen as oversimplified.
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. Every summer, New York City puts on free performances of Shakespeare
in Central Park. Tickets are distributed on a first-come-first-served basis
at 13.00 on the day of the show, but people begin lining up before
dawn. Most of the people in the lines appear to be young students,
but at the performances most of the audience appears to be made
up of older working adults (tickets can be transferred, so the person
picking up the tickets does not have to be the person watching the
performance). Which of the following concepts best explains this fact?
a. Ceteris paribus.
b. Opportunity cost.
c. Marginal analysis.
d. Absolute advantage.
2. The output produced by Samuel and Roberto in 20 labour hours is
given below for wine and cheese. Choose the option with the correct
statement below.
Wine
Cheese
Samuel
6
4
Roberto
2
3
a. Samuel has an absolute advantage in both products and a
comparative advantage in cheese.
b. Roberto has an absolute advantage in both products and a
comparative advantage in cheese.
20
Block 1: Economics, the economy and tools of economic analysis
c. Roberto has an absolute advantage in cheese and a comparative
advantage in wine, while the opposite is true for Samuel.
d. Samuel has an absolute advantage in both products and a
comparative advantage in wine.
e. Roberto has an absolute advantage in both products and a
comparative advantage in wine.
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. Some people dislike Marmite (a food spread made from yeast extract,
quite popular in the UK), which means that scarcity is not an issue for
this good and there is no reason to expand the PPF for Marmite.
2. Sami buys more sweets than olive oil, while Mete buys more olive oil
than sweets. If Sami is better than Mete at producing sweets and Mete
is better than Sami at producing olive oil, then there are no possible
gains from trade between Sami and Mete.
Long response question
1. Use the production possibility frontier to illustrate the following
concepts:
a. scarcity
b. opportunity cost
c. productive efficiency
d. diminishing marginal returns.
21
EC1002 Introduction to economics
Notes
22
Block 2: Demand, supply and the market
Block 2: Demand, supply and the market
Introduction
The previous block introduced economics as ‘the study of how societies
make choices on what, how and for whom to produce, given the limited
resources available to them’ and described how societies adopt various
institutional arrangements to answer these questions as best they can. In
the societies we all live in, the role of the market is very important as a
means of answering these questions. Markets bring together buyers and
sellers and the mechanism of prices operates to coordinate the quantities
sellers wish to sell with the quantities buyers wish to buy. This chapter
examines demand and supply and the way they interact within markets to
determine quantities and prices.
The focus of this chapter, the demand and supply model, is perhaps the
‘iconic’ model of economics. Like all models it has its shortcomings and
knowing when it is appropriate to the analysis of a particular problem,
and when it is not, is something of an art. Some of the strengths and
weaknesses of this basic model will become clearer in subsequent chapters
of the text and blocks in this guide, but first you need to become familiar
with the basic workings of the model. Also postponed until later is the
analysis of the behaviour of individual consumers and individual firms that
lie behind demand and supply curves. It would also be possible to start
with the behaviour of these individual agents and then derive the market
demand and supply curves, however, experience suggests that the power
of supply and demand analysis in showing how prices and quantities
respond to changes in the economic environment can also be experienced
without all the detailed foundations being in place (as long as they are
discussed subsequently) and that this approach is often more motivating
than the reverse sequencing. The blocks of the subject guide therefore
follow the order of the textbook in firstly presenting the demand and
supply model and then showing later how demand and supply curves are
derived from the behaviour of individual consumers and firms.
Demand is the quantity of a product that buyers wish to purchase at any
given price, while supply is the quantity of a product that suppliers are
willing to sell at any given price. Demand and supply come together in a
market and this determines the price and quantity of goods sold. Since we
have all bought (and maybe also sold) goods before, many of these ideas
are quite intuitive. Nonetheless, it is important to become familiar with the
language economists use to explain these ideas and the way that economics
deals with them. Graphical analysis is very important in economics and
you will need to become very comfortable with drawing demand and
supply curves and using them to demonstrate changes in various influential
factors. You will hopefully find this a very useful tool of analysis.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
define the concept of a market
•
draw demand and supply curves (and inverse demand and supply
curves)
•
find equilibrium price and equilibrium quantity
23
EC1002 Introduction to economics
•
describe how price adjustment reconciles demand and supply in a
market
•
analyse what shifts demand and supply curves
•
define reservation prices
•
describe consumer and producer surplus
•
analyse excess supply and excess demand
•
discuss the consequences of imposing price controls
•
discuss how markets answer what, how and for whom to produce
•
describe the functions of prices (to ration, to allocate).
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 3.
Synopsis of this block
This chapter introduces demand and supply and how these come together
in a market to determine equilibrium price and quantity. The factors that
underlie demand curves and supply curves are outlined, as is the way that
a change in one of these factors will lead to a shift in the relevant curve.
The concepts of consumer and producer surplus will also be introduced.
These exist because there are consumers who would be happy to pay
more than the market price, and suppliers who would be happy to sell for
less that the market price. The chapter will also show that allowing the
market to determine price (rather than having the government impose a
price) results in the maximum amount of consumer and producer surplus.
Through the readings and the exercises below, these ideas will now be
examined in further detail.
Equilibrium
► BVFD: read sections 3.1–3.3.
Before turning to some activities which will help to consolidate your
understanding of the material in these sections it is worth elaborating
a little on the concept of equilibrium in economics. You will find that
this concept is central in economic theory (whether it is observable in
practice raises further issues which we do not address here) although
it has many interpretations; even in a basic course such as this you will
encounter more than one version. In microeconomics we are about to
look at the concept of equilibrium market price, later when we introduce
game theory we will encounter the concept of a Nash equilibrium and in
macroeconomics we will define equilibrium in terms of aggregate supply
and demand (as opposed to the supply and demand in the market for a
particular good or service), and in terms of the so-called ‘steady state’
(where capital, investment and output per worker are constant) in growth
theory. What is common in all these examples is that the system being
analysed is in some sense ‘at rest’ – there are no forces at work generating
further changes to the system. In the demand and supply model, an
equilibrium price is one where, simultaneously, consumers want to buy
just the amount that firms want to sell. At any other price one or other of
these groups would want to change the amount they buy or sell. Usually
when an economic system is not in equilibrium, there will be incentives for
the actors or agents in the model to change their behaviour in ways that
move the system towards equilibrium.1
24
In more advanced
analysis, questions can
arise as to whether an
equilibrium exists in
the first place and, if it
does, whether it is stable
in the sense that, out
of equilibrium, forces
arise driving the model
being analysed back to
equilibrium. We do not
examine these issues
further on this course.
1
Block 2: Demand, supply and the market
Demand and supply curves
Activity SG2.1
Use the data in the following table to sketch for yourself a demand curve, a supply curve, and
the whole market – where demand and supply interact. Be careful to put price on the vertical
axis and quantity on the horizontal axis. What are the equilibrium price and quantity?
Price of a
Small Table (£)
Quantity Demanded
(thousands)
Quantity Supplied
(thousands)
0
90
0
10
75
15
20
60
30
30
45
45
40
30
60
50
15
75
60
0
90
(Note: Although these lines are straight, they are still called demand and supply curves).
► BVFD: read Maths box 3.1.
Maths box 3.1 introduces a simple mathematical way of describing the
demand and supply curves and finding equilibrium price and quantity. You
need to be familiar with this algebraic approach where the constants in
the supply and demand curves are given letters (here a, b, c, d) and where
they are expressed as numbers, as in the following activity.
Activity SG2.2
The direct demand function and direct supply function can be used to easily find the
equilibrium quantity and price. Use the following curves to find the equilibrium price and
quantity for noodles:
QD= 30 – 3/4P
QS= 5 + 1/2P
Although people generally talk about quantity as a function of price, when
it comes to drawing the graph, price is always drawn on the vertical axis,
so it is easier to work with the inverse demand function, where price is
expressed as a function of quantity demanded. For example:
Inverse Demand:
P = 20 – QD
Inverse Supply:
P = –6 + QS
These equations are very useful for us to graph the demand and supply
curves, because we can easily read the key characteristics of the curves
straight off the relevant function. To graph the inverse demand function
P = a/b – 1/b*QD (using the notation from Maths box 3.1), we can use
the fact that the intercept on the price axis is a/b and the gradient is 1/b.
Similarly, for the inverse supply function P = c/d + 1/dQS, the intercept is
c/d and the gradient is 1/d.
For example, if the inverse demand curve is P = 12 – 4QD, the demand
curve touches the vertical axis at P = 12 and slopes downward with a
slope of –4.
25
EC1002 Introduction to economics
Activity SG2.3
Find the inverse demand and supply functions using the direct demand and supply
functions in the table below and sketch them in a graph.
Demand/Supply Function
Demand
Q = 30 – ¾*P
Supply
QS= 5 + ½*P
Inverse Demand/Supply Function
D
Shifts in the demand and supply curves
Economics is full of diagrams and curves. For every curve in every diagram
you study you must understand what causes a movement along a curve
and what shifts a curve. Start now with supply and demand curves.
The first step with any curve is to note what is on the axes. With supply
and demand curves it is price and quantity, with price on the vertical axis
and quantity on the horizontal axis. This is awkward because it is not the
usual way of using graphs, where we think of the variable on the vertical
axis as a function of the variable on the horizontal axis, whereas we think
of quantity as a function of price. The reason it is done this way is that this
is how Alfred Marshall (1842–1924) introduced the supply and demand
diagram. Marshall had good reason for drawing the axes as he did given
the way he derived supply and demand from marginal cost and marginal
utility (both concepts you will cover in this course).
Movements along the demand curve represent the changes in the quantity
demanded when the price of a good changes but the prices of other goods
and income do not change. Shifts in the demand curve are due to changes
in the prices of other goods as discussed briefly in BVFD section 3.4. We
will explore this in mode detail in Block 4 (BVFD Chapter 5).
26
Block 2: Demand, supply and the market
Activity SG2.4
For each event in the following table, identify whether this relates to demand or supply, in
what direction the curve would shift, and the effect on price and quantity. If you draw a
graph for each example, you will also see the movement along the other curve, resulting
in the new equilibrium price and quantity. The first line has been completed for you.
The market for sushi
Event
Which curve
shifts? Supply
or demand?
Direction? Effect on
price?
Effect on
quantity?
Movement along
the other curve –
which direction?
The price of salmon
increases
Supply
Left
Lower
Demand, left
Higher
Sushi becomes more
popular in Europe
The price of similar
alternatives rises
Sushi sellers expect
the price of sushi to
rise in the future
New evidence reveals
sushi is not as healthy
as people had thought
New sushi machines
make production
more efficient
Consumer and producer surplus
► BVFD: read section 3.8 and concept 3.2 on consumer and producer
surplus.
Imagine the following scenario:
The current price for a two-litre carton of orange juice in my local grocery
store is £1.50. That’s good news to me, because I was prepared to pay
£2. The store manager is happy to see me loading some cartons into my
trolley, because she knows the store would have been happy to sell them
for just £1.10.
I’m thinking: ‘This is great! I’m coming out 50p ahead on each carton!’
She’s thinking: ‘Fantastic! I’m coming out 40p ahead on each carton!’
So we are both enjoying a surplus.
The equilibrium price is set by the marginal consumer and producer who
were only willing to buy/sell for exactly £1.50. Consumers who would
have been willing to pay more still just pay the equilibrium price and
enjoy a surplus. Producers who would have been willing to sell it for less
can still ask the equilibrium (market) price and also enjoy a surplus. The
efficient market outcome occurs where consumer and producer surplus are
maximised. We will come back to this later.
27
EC1002 Introduction to economics
► BVFD: read sections 3.9 and 3.10 as well as cases 3.3 and 3.4.
These sections will further develop your understanding of demand, supply and
equilibrium. You should read them carefully and try to think each point through. Can
you think of another market where price floors or ceilings have been imposed?
Activity SG2.5
Price floors and ceilings result in a loss of consumer and producer surplus, this is called a
deadweight loss. Can you calculate how much consumer and producer surplus is lost
due to the price ceiling in the diagram below? Has there also been a transfer of surplus
between consumers and producers?
Price
£120
£100
Supply Curve
£80
Free Market Equilibrium
£60
£40
Excess demand
Demand Curve
£20
0
Price Ceiling
50
100
Quantity
Figure 2.3: Loss of producer and consumer surplus due to a price ceiling.
► BVFD: read the summary and work through the review questions.
Overview
Buyers and sellers come together in a market and exchange goods and
services. Demand (from buyers) and supply (from sellers) are key concepts
of economic analysis. Demand curves display the quantity that buyers
wish to buy at each price and generally slope downwards – demand is
higher when the price is lower. Supply curves display the quantity that
sellers wish to sell at each price and generally slope upwards – sellers
are prepared to sell more when the price is higher. The market clears
(and equilibrium is achieved) at the point where the demand and supply
curves intersect. Understanding what demand and supply curves represent
and what makes them shift is the most fundamental lesson from this
block. Price changes are represented by a movement along a curve,
shifts in the curves indicate changes in other factors, such as the price of
complements or substitutes or changes in consumers income (for demand
curves) and changes in technology and input prices (for supply curves).
Shifts in the demand or supply curves change the equilibrium price and
quantity. Inverse demand and supply curves (where price is expressed as
a function of quantity) can be useful for graphing the curves. The block
also introduces consumer and producer surplus and the fact that price
controls lead to a reduction in consumer and producer surplus, whereas
free markets optimise consumer and producer surplus. You need to be able
to calculate consumer and producer surplus and the loss involved due to
price controls.
28
Block 2: Demand, supply and the market
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. From the diagram below, the loss in consumer surplus due to the price
floor is:
a. £50
b. £100
c. £150
d. £200.
Price
£50
Supply Curve
Excess supply
£40
Price Floor
£30
Free Market Equilibrium
£20
Demand Curve
£10
0
10
20
30
Quantity
Figure 2.4: Loss of consumer surplus due to a price floor.
2. Given the following inverse demand and supply curves:
P = 8 – QD/2
P = 2 + QS
and assuming that price is fixed below the equilibrium price at £5, the
loss in producer surplus due to the price ceiling is:
a. £3.50
b. £4.50
c. £8
d. £9.
3. The demand curve for good A is given by:
Q AD = a – bPA + cPB
Where PA is the price of good A, PB is the price of good B, and a, b, c
are positive constants. The supply curve for good A is also linear and is
upward sloping:
a. Goods A and B are complements.
b. Goods A and B are substitutes.
29
EC1002 Introduction to economics
c. Goods A and B are unrelated in consumption.
d. The demand curve for good A is upward sloping.
7. Suppose that the price of Porto wine was £20 per litre in 2010 and £25
per litre in 2011. Ingrid observes that Margaret’s consumption of wine
rose from 1 litre per month in 2010 to 1.2 litres per month in 2011.
Ingrid concludes that Margaret’s demand for Porto wine has to be
upward sloping:
a. Ingrid is wrong: given the above information Margaret’s demand
for Porto wine has to be downward sloping.
b. Ingrid is right: given the above information Margaret’s demand for
Porto wine has to be upward sloping.
c. Ingrid is wrong: the above information is not enough to conclude
that Margaret’s demand for Porto is necessarily upward sloping.
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. People consume chilli and tortillas. This means that an increase in the
price of chilli would lead to a decrease in the consumption of tortillas.
2. Suppose that the price of port wine was £20 per litre in 2010 and £25
per litre in 2011. Ingrid observes that Margaret’s consumption of port
wine rose from 1 litre per month in 2010 to 1.2 litres per month in
2011. Ingrid concludes that Margaret’s demand for port wine has to be
upward sloping.
3. The market for theatre tickets has a downward sloping demand
curve. Ragvir is the last person to buy a ticket and he pays exactly his
willingness to pay. If this is true, there is no consumer surplus in the
market.
Long response question
1. Suppose that the inverse demand and supply schedules for rental
apartments in the city of Auckland are as given by the following
equations:
Demand: P = 2700 – 0.12QD
Supply: P = –300 + 0.12QS
a. What is the market equilibrium rental price per month and
the market equilibrium number of apartments demanded and
supplied?
b. If the local authority can enforce a rent-control law that sets
the maximum monthly rent at $900, will there be a surplus or a
shortage? Of how many units will this be? And how many units
will actually be rented each month?
c. Suppose that the government wishes to decrease the market
equilibrium monthly rent to $900 by increasing the supply of
housing. Assuming that demand remains unchanged, find the new
equilibrium quantity and the new inverse supply curve.
30
Block 3: Elasticity
Block 3: Elasticity
Introduction
The concept of elasticity is very important in microeconomics – here we
devote a whole block to it! Elasticity has to do with responsiveness, for
example: how much does the quantity demanded of a good respond to
a change in the price of that good? For some goods, such as life-saving
medicine, people’s demand will not fall much even if the price increases
substantially, while for other goods, such as a particular chocolate bar,
the demand will respond to price much more, since if the price of one
chocolate bar goes up, people will generally be quite happy to purchase
another one (or a different kind of snack) instead. This chapter uses many
examples to make the concepts more intuitive, and also relies on graphs
and simple equations. Make use of the exercises in this block and in the
textbook to really master this concept and its applications.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
describe how elasticities measure the responsiveness of demand and
supply
•
define and calculate price elasticity of demand
•
indicate the determinants of price elasticity
•
describe the relationship between demand elasticity and revenue
•
recognise the fallacy of composition
•
describe how cross-price elasticity relates to complements and
substitutes
•
define and calculate income elasticity of demand
•
use income elasticity to identify inferior, normal and luxury goods
•
define and calculate elasticity of supply
•
describe how supply and demand elasticities affect tax incidence.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 4.
Synopsis of this block
This block will explore the reasons why demand for certain goods
responds more or less to a change in price. Furthermore, we will also
explore how demand for a good changes in response to a change in the
price of another good, and also how it responds to a change in consumers’
income. As well as the elasticity of demand, we will also examine the
elasticity of supply (i.e. how much producers’ supply decisions change in
response to a change in price). The implications of elasticity for a firm’s
total revenue, and for the effects of taxation shall also be examined.
31
EC1002 Introduction to economics
Price elasticity of demand
►BVFD: Maths 4.1 and Maths 4.2.
These sections are particularly important. You must know the definition
of price elasticity of demand, cross-price elasticity of demand and income
elasticity of demand.
The formula for calculating price elasticity of demand (PED) is important
and also quite intuitive:
Price elasticity of demand = [% change in quantity] /
[% change in price]
As explained in Maths 4.1 this can be expressed using delta notation as:
PED =
∆QD P
∆P QD
where QD refers to quantity demanded and P to price. ∆ always means
‘change in’, such that ∆QD means ‘change in demanded’.
If the quantity demanded changes a lot in response to a change in price,
we say demand is responsive (or sensitive) to the price change,
and the demand is elastic. If the price can change a lot without really
affecting the quantity demanded, we say that demand is unresponsive
(or insensitive) to the change in price and demand for that product is
inelastic.
•
Demand is elastic if the elasticity is more negative than –1.
•
Demand is inelastic if the price elasticity lies between –1 and 0.
This is represented in the sketch below:
When PED=0 demand is said to be perfectly inelastic and when PED=–∞
we say demand is perfectly elastic.
While economists often discuss the absolute value of the elasticity (so
if this is between zero and 1, demand is said to be inelastic, and if it is
greater than 1, demand is said to be elastic) we recommend you not to
lose track of the sign of the elasticity. As we shall see below for other
elasticities (cross-price elasticity, income elasticity), the sign has important
implications. Nonetheless, you will often see positive numbers for ownprice demand elasticities – this is a shorthand and does not necessarily
imply that the law of demand (i.e. that the demand curve for a good is
downward sloping) has been violated.
The Greek letter eta (ε) is often used to denote elasticity. For example,
ε = 0 means that the price elasticity of demand is equal to zero and
quantity demanded will not change at all in response to a change in price.
Activity SG3.1
Consider your own buying habits. Rank the items below in terms of how responsive your
demand for these goods is to a change in their price:
• a nice pair of trousers
• rice
• bananas
• medicine
• holidays abroad.
32
Block 3: Elasticity
► BVFD: read Maths A4.1.
There are various ways of calculating elasticity. Arc elasticity (Maths 4.1)
is used to find the elasticity between two different points of a demand
curve, in such a way that it is equal whether you analyse the change in
price as an increase or a decrease.
Point elasticity, on the other hand, describes the elasticity at a certain
point on the demand curve. Maths A4.1 on point elasticity uses calculus,
however, it also explains that the derivative of the direct demand
function gives the slope of the direct demand function at a given point.
If the function is linear, the slope is constant for the whole curve, and
∆Q
corresponds to ∆P in the PED formula above (dropping the D superscript
for simplicity). The slope of a curve is straightforward and something you
can easily use without any knowledge of calculus.
One thing to be careful of is whether you are using the direct or the
inverse demand function (remember Block 2). For an inverse demand
function, use the inverse of the slope. For a direct demand function, you
can use the slope directly. That should be easy to remember!
That means that for an indirect demand function, the point elasticity is:
PED = 1/s * (P/Q), where s is the slope. For example: P = 20 – Q/2 is an
indirect (or inverse) demand function. The slope of this is dP/dQ = –1/2.
In this case, you would use PED = (1/–0.5) *(P/Q) = –2*(P/Q).
On the other hand, Q = 40 – 2P is a direct demand function. The slope of
this is dQ/dP = –2. In this case you would use PED = –2*(P/Q). (To check
∆Q
that the slope of the direct demand function is equal ∆P note that if P =
∆Q
-10
5, Q = 30, whereas if P = 10, Q = 20. Therefore ∆P = 5 = –2).
If you want to express the elasticity as a positive number, you will need to
use the absolute value (or just multiply the negative number by the minus
one, which is the same thing).
Activity SG3.2
Part A: Calculating an arc elasticity
Given the following information, calculate the elasticity of demand for the following
goods, expressing the elasticities as positive numbers.
Initial Price and Quantity
New Price and Quantity
Good A
Good B
Good C
Good D
P0 = 4
P0 = 4
P0 = 5
P0 = 12
Q0 = 10
Q0 = 10
Q0 = 4
Q0 = 13
P1 = 5
P1 = 5
P1 = 2
P1 = 11
Q1 = 7
Q1 = 9
Q1 = 10
Q1 = 15
PED: value
PED: category
Part B: Calculating a point elasticity
Given the following diagram, calculate the price elasticity of demand at X, Y and Z,
expressing the elasticities as positive numbers, where PED = 1/s * (P/Q).
33
EC1002 Introduction to economics
Price
£20
At X, PED =
At Y, PED =
X
£16
At Z, PED =
Y
£10
Z
£5
8
20
30
40
Quantity
Figure 3.1: Calculating point elasticities on a demand curve.
► BVFD: read sections 4.2 – 4.4 and cases 4.1 and 4.2.
Activity SG3.3
The following table identifies some factors which act as determinants of demand
elasticity. Fill in the fourth column, which has been left blank, with a concrete example.
Factor
Example
Effect on demand elasticity
Necessity
People depend on
this
Demand is inelastic
Substitutes
There are many
similar products
available
Demand is elastic
Definition
Good defined very
narrowly
More elastic (because
there are more possible
substitutes)
Time-span
Tastes change/more
drastic adjustments
become feasible
Demand becomes more
elastic
The share of
your budget
Small items
Demand is inelastic
Good/Service
Activity SG3.4
Sketch a perfectly inelastic demand curve and a perfectly elastic demand curve in separate
diagrams.
34
Block 3: Elasticity
Activity SG3.5
Total spending is the same as the firm’s revenue. Use the data below to decide, if you
were a manager, whether or not to make the price change in the following cases (you can
ignore costs for the purposes of this activity and just assume that an increase in revenue
is a good thing and a decrease in revenue is bad). For each case, calculate the demand
elasticity (using the arc method), decide whether or not to make the change, and then
check your answer by calculating total revenue before and after the price change.
a. Increasing the price from £6 to £7 will lead to a fall in sales from 10,000 to 8,000.
b. Increasing the price from £8 to £10 will lead to a fall in sales from 15,000 to 12,500.
c. Decreasing the price from £20 to £18 will lead to an increase in sales from 6,000 to
8,000.
This activity emphasises the relationship between elasticity and total
revenue. This is clearly explained in the textbook, but if you are not afraid
of a bit of algebra we can derive a useful formula linking the two:
TR = P * Q
∆TR ≈ Q∆P + P∆Q
(This approximation depends on ∆P and ∆Q being small so that the
product ∆P∆P is very small, or what is know as ‘second order small’)
Dividing by ∆P:
∆TR
∆P
but the second term is Q times PED so:
∆TR
∆P
=Q+P
∆Q
∆P
= Q (1 + PED)
Remember that PED is negative and ∆P is positive for a price increase and
negative for a price decrease. So, for example if demand is elastic, say –2,
and price falls, then the sign of ∆TR is positive. If it is inelastic, say –0.3,
and price falls, then the sign of ∆TR is negative.
You may find it helpful to look at this in a more arithmetic way. Suppose
that price starts at P and quantity at Q. Then there is a 1% increase in
price so P changes to P (1 + 0.01). If the elasticity PED is –2 this implies
that Q falls to Q(1 – 0.02). Revenue TR then changes from PQ to
PQ(1 + 0.01)(1 − 0.02) = PQ(1 + 0.01 − 0.02 − 0.0002)
The term 0.0002 is the product of 0.01 and –0.02 and is very small so the
revenue after the price change is to a good approximation PQ(1 + 0.01 –
0.02) so the change in revenue is
ΔTR≈TR(0.01−0.02) < 0
Another way of looking at this is that:
ΔTR≈0.01PQ(1−2) = QΔP(1 + PED)
This is negative because the price elasticity of demand –2 is less than –1.
Another way of saying this is that the absolute value of the price elasticity
of demand which is 2 is greater than 1. If the price elasticity of demand
is less than 1 in absolute value then demand is said to be inelastic and
revenue increases when the price increases. If the price elasticity of
demand is greater than 1 in absolute value then demand is said to be
elastic and revenue decreases when the price increases.
35
EC1002 Introduction to economics
Cross-price elasticity of demand
► BVFD: read section 4.5.
In Block 2, we discussed how a change in own-price leads to a movement
along the demand curve, while a change in the price of a related good
leads to a shift in the demand curve. An increase in the price of a
substitute good will shift the demand curve to the right; an increase in
the price of a complement will shift the demand curve to the left. Section
4.5 discusses the responsiveness of quantity demanded of a good (let’s
call this good i) to a change in the price of a related good (which we can
call good j) – this is known as cross-price elasticity of demand. The
formulas for calculating this are the same as for own-price elasticities,
except that you will use the original and new price of good j, and the
original and new quantity of good i. For example, using delta notation the
cross-price elasticity for good i with respect to the price of good j is:
∆Qi
Pj
∆Pj
Qi
Unlike the case of a downward sloping demand curve where PED was always
negative, the cross-price elasticity can be positive or negative depending on
how the goods are related in consumption (whether they are substitutes
or complements). The cross-price elasticity of demand is negative for
complements and positive for substitutes. If the price of good i increases,
people will demand less of good j if it is a complement to good i, and more
of good j if it is a substitute for good i. What would be the value of the crossprice elasticity between two goods if they were completely unrelated?
Activity SG3.6
Multiple choice question
A Bordurian lawyer explains: ‘Smoking is a Bordurian tradition. If you had coffee, you had
cigarettes; if you had cigarettes, you had coffee’. According to this statement, the cross-price
elasticity of the demand for coffee with respect to the price of cigarettes in Borduria is:
a. positive
b. negative
c. zero.
Income elasticity of demand
► BVFD: read section 4.6 and case 4.4.
Activity SG3.7
Classify the following goods, based on their (hypothetical) income elasticity:
36
Good
Income elasticity
Car
2.98
Food
0.5
Margarine
–0.37
Vegetables
0.9
Public transportation
–0.36
Books
1.44
Type of good
Block 3: Elasticity
Would you expect income elasticities for given goods to be broadly similar in different
countries? For example, would you expect the income elasticity of demand for public
transport to be similar in the USA and in Mali? Think about why or why not.
The income elasticity of demand measures the responsiveness of quantity
demanded to a change in income and is measured by the percentage
change in quantity demanded of good X divided by the percentage change
in real consumers’ income.
Using the delta notation and letting Q represent quantity of the good
demanded and M represent real consumer income, income elasticity of
demand (IED) is given by the formula:
∆Q
M
∆M
Q
Price elasticity of supply
► BVFD: read sections 4.8.
Activity SG3.8
For the following direct supply function QS = 5 + 2P calculate and interpret the PES when
Q = 10 and P = 2.5.
Activity SG3.9
Initially, the price of a tennis racket is £20. Demand is 30 and supply is 50. If the price
falls by £5, the quantity demanded rises to 40, the quantity supplied rises to 40, and the
quantity demanded of white cotton t-shirts rises from 70 to 100. Using the arc method,
calculate the own-price demand elasticity and the elasticity of supply for tennis racquets;
and the cross-price demand elasticity for white cotton t-shirts. Are white cotton t-shirts a
complement or substitute to tennis racquets?
Make sure that you also understand section 4.7 which brings together own-price, crossprice and income elasticities with reference to inflation.
► BVFD: Examine Table 4.11 – this provides a simple but helpful summary
of the chapter.
Incidence of a tax
► BVFD: read section 15.3 and Maths 15.1.
We now jump forward to a later BVFD capture that examines the effect
of a specific tax in a market and explores the incidence of the tax (i.e.
who bears the burden of the tax). It is important to realise that a sales tax
drives a wedge between the price paid by consumers (sometimes called
the demand price) and the price received by producers (the supply price).
In a simple supply and demand diagram in the absence of taxes these two
prices are, of course, the same.
The key point of this section is that the incidence of the tax is not related
to the person who physically pays the money to the government. Rather,
whichever party (consumers or producers) is less price sensitive (either in
demand or supply) will bear the greater share of the burden of the tax.1
This is summed up by an expression, which we do not prove here, but
which holds for small taxes:
This is summed up in an
expression which holds
for small taxes, but which
we do not prove here:
1
In words, the ratio of
the change in the price
the consumer pays (the
demand price) to the
change in the price that
the producer receives
(the supply price) is
equal to the ratio of the
price elasticity of supply
to the price elasticity of
demand.
37
EC1002 Introduction to economics
PES
∆D
=
∆S
PED
In words, the ratio of the change in the price the consumer pays (the
demand price) to the change in the price that the producer receives (the
supply price) is equal to the ratio of the price elasticity of supply to the
price elasticity of demand. Suppose demand were perfectly inelastic,
how would the burden of a sales tax be shared between consumers and
producers?
Another point to consider is why goods such as cigarettes and fuel are
taxed so heavily. This isn’t only a question of improving health or reducing
pollution – consider the PED of these goods and the implications for
government tax revenues of taxing goods such as these.
Activity SG3.10
Let’s put Maths box 15.1 into practice using a numerical example. If:
QD = 30 – 4P
QS = –6 + 8P
t = 0.375 where t is a specific tax that has to be paid by suppliers.
Calculate
a. the equilibrium quantities with and without the tax
b. the increase in the price paid by consumers and the fall in consumer surplus
c. the fall in the price received by suppliers and the fall in producer surplus
d. the tax revenue received by the government
e. the deadweight loss of the tax.
► BVFD: read the summary and work through the Sample questions.
Overview
This block describes the concept of elasticity, explores how to calculate
elasticities and discusses the implications. Conceptually, elasticity has to
do with responsiveness, usually how much demand or supply responds to
a change in price or income. You need to know how to calculate arc and
point elasticities. The type of elasticities you need to be familiar with are
as follows: own-price demand elasticity (elastic if more negative than –1,
unit elastic if –1, inelastic if between –1 and 0; though in practice these
are often expressed as positive numbers using the absolute value), crossprice demand elasticity (generally positive for substitutes and negative for
complements), income elasticity of demand (negative for inferior goods,
larger than 1 for luxury goods) and supply elasticity (positive since the
supply curve slopes upwards). Elasticity has implications for total spending
on a product (which from the company’s perspective is simply revenue):
If demand is elastic, a fall in price leads to an increase in revenue. It also
has implications for tax incidence – the more price insensitive side of the
market (be it buyers or sellers) will bear a greater burden of the tax.
38
Block 3: Elasticity
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
1. Let the demand for jerk chicken be: QD = 200 – 6P + 2Y, where the
price of jerk chicken is P and Y is consumer income. When the price
of jerk chicken is £8, a rise in consumers’ income from £100 to £150
leads to:
a. a fall in demand and an income elasticity of –0.14, jerk chicken is
an inferior good
b. a rise in demand and an income elasticity of 0.14, jerk chicken is a
normal good and a necessity
c. a rise in demand and an income elasticity of 7.08, jerk chicken is a
luxury good
d. a fall in demand and an income elasticity of –7.08, jerk chicken is
an inferior good.
2. When price elasticity of demand is greater than unity (in absolute
value), revenue will:
a. increase with an increase in price
b. decrease with a fall in price.
c. decrease with an increase in price.
d. remain unchanged with any change in price.
3. Market research about the demand faced by a particular firm
producing good x reveals the following information:
Own price elasticity: –2
Income elasticity: 1.5
Cross price elasticity with respect to y: 0.8
Cross price elasticity with respect to z: –3
Where x, y and z are goods and M is income. Therefore:
a. Commodities x and z are complements while x and y are gross
substitutes.
b. Commodities x and z are complements and so are x and y.
c. Commodities x and z are gross substitutes and so are x and y.
d. Commodities x and z are gross substitutes but x and y are
complements.
True/False/Uncertain
For each of the following indicate whether the statements are true, false or
uncertain, supporting your answer with a brief explanation.
1. If the cross-price elasticity of a good is negative, the income elasticity
must also be negative.
2. If the demand for pizza drops whenever sushi becomes cheaper, pizza
must be an inferior good.
39
EC1002 Introduction to economics
3. Football finals tickets are typically much more expensive than other
football tickets, yet these events are typically sold out. Hence, football
fans must have an inelastic demand for these tickets.
Long response question
1. a.Define the different types of elasticity. What determines the price
elasticity of demand for a certain good? Who can benefit from this
information?
b. Assume that the market demand for barley is given by:
Q=1,900 – 4PB + 0.1M + 2PW
Where Q is the quantity of barley demanded, PB is the price of
barley, M is income (say per capita income of consumers) and
PW is the price of wheat. The prices of wheat and barley are each
200 (say £s per tonne) and M is 1,000. The slopes for barley
demand, wheat demand and income are –4, 2 and 0.1 respectively.
Calculate the own price elasticity of demand, the income elasticity
of demand and the cross-price elasticity of the demand for barley
with respect to the price of wheat.
c. Calculate and illustrate graphically the impact on welfare of a
specific tax of 37.5p per unit to be paid by suppliers when QD = 30
– 4P and QS = –6 + 8P. How do the welfare implications change if
the tax is paid by consumers instead of suppliers?
40
Block 4: Consumer choice
Block 4: Consumer choice
Introduction
This block introduces another two fundamental concepts in
microeconomics: indifference curves and the budget constraint. Indifference
curves illustrate a consumer’s preferences, while the budget constraint
shows what it is possible for them to consume, given a limited budget and
the prices they face. Put together, these concepts are used to determine the
consumer’s consumption decisions. In this way, we can see how the demand
curves you learned about in Block 2 are derived.
After studying the demand curve in Block 2, it is important to realise that
this curve is the direct result of the assumptions of rationality and individual
decision making as discussed in Block 1. This block, on consumer choice,
draws on the idea of opportunity cost as well as individual preferences to
derive the demand curve.
You will need a good understanding of the intuition behind the models
in this block. It is important that you gain a good grasp of them, because
we use an equivalent set of concepts in analysing how firms make their
production decisions (Block 5), and they are also used to determine
household’s labour supply (Block 9). As well as this, you will also need
to practise drawing the graphs in this chapter, since they will help to
understand the concepts, and since you may need to be able to reproduce
them for your exam. In particular, practise drawing the income and
substitution effects for normal and inferior goods, since many of the key
concepts are summarised in these graphs.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
define the relationship between utility and tastes for a consumer
•
describe the concept of diminishing marginal utility
•
describe the concept of diminishing marginal rate of substitution and
calculate the marginal rate of substitution (MRS)
•
represent tastes as indifference curves
•
derive a budget line
•
explain how indifference curves and budget constraints explain
consumer choice
•
describe how changes in consumer income affect quantity demanded
•
describe how a price change affects quantity demanded
•
define income and substitution effects
•
show how the market demand curve relates to the demand curves of
individual consumers.
Note, that cash versus transfers in kind are not covered by the subject guide
and are not examinable. In case of interest this it covered in Chapter 5.6 of
BVFD.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 5 (except 5.6) including
the appendix.
41
EC1002 Introduction to economics
Synopsis of this block
The chapter starts by introducing the concept of utility, and the
assumptions that are commonly made by economists about utility. It then
explains indifference curves and the budget constraint and shows how
these are combined to determine the consumer’s choices. The impact of
changes in the consumer’s income and changes in price are examined in
detail, including the decomposition of the effects of price changes into
income and substitution effects. The chapter also demonstrates how these
ideas are used to derive the individual demand curve, and then the market
demand curve. The relationship to elasticity, particularly cross-price
elasticity, is also discussed.
Consumer choice and demand decisions
►BVFD: read section 5.1 and concepts 5.1 and 5.2.
Utility
The concept of ‘utility’ was introduced by Jeremy Bentham, in his 1789
book Principles of morals and legislation. He defined it as follows: ‘By utility
is meant that property in any object, whereby it tends to produce benefit,
advantage, pleasure, good, or happiness, (all this in the present case comes
to the same thing) or (what comes again to the same thing) to prevent the
happening of mischief, pain, evil, or unhappiness to the party whose interest
is considered.’ The philosophy of ‘utilitarianism’ (the ‘greatest happiness
principle’) was invented by Bentham and has been very influential. The
textbook defines utility much more simply as ‘the satisfaction consumers
get from consuming goods’ (p.74). In the 19th century, economists believed
that utility levels could be measured, and used a unit of measurement called
‘utils’. Nowadays, economists assume that utility is not measurable in this
way, but is still a useful concept that underlies much of microeconomics.
Marginal utility
As discussed in Block 1, consumers and firms make decisions at the
margin. This idea is very important in relation to utility. The marginal
utility of a good or service is the extra utility a person gains from
consuming one more unit of that good or service.
Activity SG4.1
Linking the shape of the indifference curves to the assumptions regarding consumer tastes.
The various assumptions that lie behind indifference curves are reflected in certain
aspects of the shape of the curve. Match the assumption to the characteristic of the curve
and explain why.
42
Diminishing marginal rate of substitution
Lines never cross
Consumers prefer more to less
(non-satiation)
Any bundle is on some
indifference curve
Completeness
Indifference curves convex to the
origin (ICs look like ‘smiles’ when
seen from the origin)
Transitivity
Downward sloping
Block 4: Consumer choice
The slope of the indifference curve is the marginal rate of
substitution
The marginal rate of substitution (MRS) between two goods, as you know
from the definition on p.76, measures the quantity of a good the consumer
must sacrifice to increase the quantity of the other good by one unit
without changing total utility. On pXX, in the paragraph discussing how
the slope of a typical indifference curve gets steadily flatter as we move to
the right, there is an important gem of information: ‘The marginal rate of
substitution … is simply the slope of the indifference curve’. On the graph
below, the tangent T shows the slope of the indifference curve and the
MRS at point b.1
Consider the indifference curve depicted in Figure 4.1 showing all
combinations of Clothing and Food that give the consumer the same
level of utility. The MRS is the absolute value of the ratio of the change
in clothing to the change in food. Since these two changes always have
opposite signs, the MRS (slope of an indifference curve) is obtained by
multiplying ΔC/ΔF by –1.
Some textbooks define
the MRS as the slope of
the indifference curve,
that is as a negative
quantity, others as the
‘absolute value’ of the
slope (i.e. as a positive
quantity). This is simply
a matter of convention
and it doesn’t matter
which convention is
followed, as long as one
is consistent.
1
35
a
Clothing
30
25
20
b
15
c
10
e
f
T
5
0
d
5
10 15 20 25 30 35
Food
Figure 4.1: The marginal rate of substitution is the slope of the indifference
curve.
Movement Change in clothing Change in food Marginal rate of substitution
From a to b
–12
5
(–12/5)*–1 = 2.4
From b to c
–5
5
(–5/5)*–1 = 1.0
From c to d
–3
5
(–3/5)*–1 = 0.6
From d to e
–2
5
(–2/5) * –1 = 0.4
From e to f
–1
5
(–1/5) * –1 = 0.2
Table 4.1
You should remember from Block 3 that Δ (delta) means change.
Examining the movement from a to b and b to c etc. gives us a good
approximation of the slope of various sections of the curve. An even
more accurate way is to examine the change in utility due to a one unit
change in either of the goods: this gives us the marginal utility of each
good at a point on the curve. In fact, the MRS is given by –MUF/MUC, (i.e.
the marginal utility of food at a certain point on the indifference curve,
divided by the marginal utility of clothing at that point, multiplied by –1).
We will come back to this again at the end of the block (as it is covered in
more detail in Maths A5.1).
43
EC1002 Introduction to economics
Figure 5.5 of BVFD also helps to illustrate this idea, showing indifference
curves for people with different tastes. The glutton is more willing to
substitute films for food than the weight-watching film buff and has a
higher MRS. Drawing a tangent to any part of their indifference curves
shows that the slope of the gluttons indifference curve is steeper –
reflecting his higher MRS between meals and films.
The slope of a typical indifference curve gets steadily flatter as we move to
the right, reflecting a diminishing marginal rate of substitution.
Clothing
For example:
a
A
b
B
Food
Figure 4.2: Changes in the slope of an indifference curve reflect a diminishing
marginal rate of substitution.
The slope of the tangent A shows the MRS of food for clothing at point a.
Similarly, the slope of the tangent B shows the MRS at point b. We can see
that the slope flattens as we move from a to b, reflecting a diminishing
MRS. At point a, the person has quite a lot of clothing and is willing to
substitute a fair bit of this for a certain amount of food. At point b, the
person has much less clothing but quite a lot of food and is only willing
to substitute a very small amount of clothing to gain the extra amount of
food. Going back to Table 4.1, you can also see the diminishing MRS, as
the amount of clothing the person is willing to substitute for 5 additional
units of food continues to fall.
Budget constraint
Activity SG4.2
The slope depends only on the relative prices of the two goods. Draw budget constraints
for the following three price combinations, assuming a total income of £120.
a. PX=£12,PY=£20
b. PX=£10,PY=£20
c. PX=£12,PY=£15
What is the interpretation of the slope of the budget constraint? It
represents the rate at which the consumer can substitute good X for good
Y in the market, or the opportunity cost of X in terms of Y. To see this,
suppose the consumer wishes to consume a little more X, ∆X. This will
cost her ∆XPX. Assuming she was spending all her income on X and Y (on
her budget line) then she will have to reduce her expenditure on Y by the
same amount. So ∆XPX=–∆YPY , (i.e. the slope ∆Y/∆X=–PX/PY).
44
Block 4: Consumer choice
► BVFD: read Maths 5.1.
You should be familiar with the general form of the budget constraint
used in this section, (i.e. where Px is the price of good X, Py the price of
good Y, x the quantity of good X, y the quantity of good Y and M the
money income available to the consumer). Note that the first term on the
left-hand side of this equation is the consumer’s expenditure on good X
and the second term is expenditure on good Y. Since we assume that the
consumer spends all her income on these two goods, the amount spent
on the two goods sums up to M which is her income. One important point
from this Maths box is that the slope of the budget constraint is given by
–Px/Py i.e. the price ratio.
The figure in this Maths box shows how you can represent a general case,
where you don’t have specific quantities and prices. The intercepts will
then be M/PY and M/PX respectively. This is likely to be how you will draw
a budget constraint most often.
Utility maximisation and choice
Indifference curves and the budget constraint together indicate the
choice a consumer will make to maximise their satisfaction. This can be
represented by the following diagram:
Step 1
Preferences
(What the individual wants to do)
Step 2
Budget Constraint
(What the individual can do)
Step 3
Decision
(Taking constraints into account, the individual attempts
to reach the highest level of satisfaction)
Figure 4.3: Consumer choice and the decision rule.
Decision rule
The point which maximises utility is the point at which the consumer
reaches the highest indifference curve that the budget constraint allows.
For the ‘standard’ indifference curves we have been looking at, this
decision rule says that the consumer should choose the consumption
bundle where the slope of the budget line and the slope of the indifference
curve coincide. In other words, it is the point at which the indifference
curve is tangent to the budget constraint.
► B
VFD: read appendix A1 of Chapter 5 of, which applies whether or not
utility can actually be measured.
We can describe the consumer’s optimal decision using equations as
follows: At the chosen bundle, the marginal rate of substitution between
the two goods must equal their relative price, i.e. MRS =–MUx/MUy =–Px/
Py. Rearranging this gives MUX/PX= MUY/PY .
45
EC1002 Introduction to economics
Good Y
We can also describe their decision graphically, as follows: The consumer
choses the bundle where the indifference curve is tangent to their budget
constraint. The slope of the indifference curve (MRS = –MUx/MUy) and
the slope of the budget constraint (–Px/Py)must be equal. The tangency
thus implies –MUx/MUy = –Px/Py. Rearranging this gives MUX/PX=MUY/PY.
M/Py
b
u0
M/Px Good X
Figure 4.4: A budget constraint and an indifference curve.
MUX/PX=MUY/PY has the intuitive interpretation that the marginal utility
derived from the last pound spent on X must be equal to the marginal
utility of the last pound spent on Y. Otherwise the consumer would adjust
their consumption pattern and increase their utility.
Imagine that MUX/PX > MUY/PY. This implies that the consumer derives
more utility from the last pound spent on good X than the last pound spent
on good Y. In this case, by consuming one pound more of good X and one
pound less of good Y, they can increase their utility level without spending
any more money. The consumer should continue to adjust their spending
in this way until MUX/PX=MUY/PY.
It is important to understand the intuitive explanation of the consumer’s
decision, as well as being familiar with the relevant equations and graphs.
► BVFD: read section 5.2 and case 5.1
Activity SG4.3
Draw budget constraints and possible indifference curves for the following scenario:
Susan buys cabbages and carrots. Cabbages cost £1 per kilo and carrots cost £0.80 per
kilo. Her income falls from £20 to £16. Carrots are a normal good, but cabbages are an
inferior good.
► BVFD: read section 5.3 and case 5.2.
Activity SG4.4
Figure 5.13 shows the effect of an increase in the price of meals in a diagram with meals
and films on the axes. Subsequent diagrams explore the effect on consumer choice.
Draw a diagram to check your understanding of the following two cases:
a. a fall in the price of meals
b. an increase in the price of films.
46
Block 4: Consumer choice
Income and price changes
Substitution and income effects
Decomposing the effects of a price change into income and substitution
effects is an important piece of economic analysis with many real world
applications. Case 5.1 shows one such application; others relate to the
effects of changes in wages on labour supply and changes in interest rates
on savings decisions. Remember:
•
The substitution effect is always negative.
•
The income effect is negative for normal goods and positive for inferior
goods.
•
For normal goods, the income and substitution effects reinforce each
other.
•
For inferior goods, the income and substitution effects work in
opposite directions.
•
For inferior goods, if the income effect dominates the substitution
effect, the good is called a Giffen good (in practice, these are very
rare).
Activity SG4.5
For a choice between Good X and Good Y, analyse the following cases, clearly indicating
the income and substitution effects in each case.
a. The price of good X rises and it is a normal good.
b. The price of good X rises and it is an inferior good.
c. The price of good X falls and it is a normal good
d. The price of good X falls and it is an inferior good.
Advice in tackling this activity: You will find Figures 5.16, 5.17 and 5.18 helpful for this
activity, and you might want to repeat it a few times on a separate sheet of paper until
you are really comfortable with these concepts. The following order is generally best:
STEP 1.Draw the original budget line and indifference curve.
STEP 2.Draw the new budget line.
STEP 3.Draw the hypothetical budget line parallel to the new budget line and tangent
to the original indifference curve. This gives you the substitution effect.
STEP 4.Draw the new indifference curve (where you place this depends on what type of
good it is). This gives you the income effect.
47
EC1002 Introduction to economics
Deriving demand: ‘The individual demand curve’
In Block 2 we introduced demand and supply and learned about the
demand curve. Now we are able to derive the individual demand curve
from the choices of consumers.
Activity SG4.6
Derive the individual demand curve from the information in figure A and sketch it in B.
Can you now explain why the demand curve is downward sloping?
Sunglasses
A
(Price per sandwich = p1)
(Price per sandwich = p2)
e1
e2
e3
e4
Price-consumption curve
(Price per sandwich = p3)
(Price per sandwich = p4)
x1 x2 x3 x4
0
Sandwiches
Price per Sandwich
B
Sandwiches
0
Figure 4.5: Deriving the individual demand curve.
► BVFD: read the second part of the appendix: deriving demand curves.
This explains why, for normal goods, a fall in price leads to an increase in quantity
demanded, due to both substitution and income effects.
Demand curves and consumer surplus
We have now shown the theoretical underpinnings of a downward sloping
demand curve. In particular, we have gone beyond general statements
such as ‘at lower prices existing consumers want to purchase more and
new consumers enter the market’ and shown that at each point on the
demand curve consumers are maximising their utility by equating their
P
MU
MRS ( MU ) with the relative price ( P ) where x is the good on the horizontal
axis and y the good on the vertical axis. This enables us to give further
intuition to the price at any given quantity and to the whole demand
curve.
48
x
x
y
y
Block 4: Consumer choice
To do this, we can put some numbers on a given utility maximising point
corresponding to a set of prices for x and y and a given income. For
example, let Px = £4, Py = £2 and income = 40. This is shown on the
diagram below. This diagram shows the consumer’s utility maximising
combination of x and y (x1, y1) at A in the upper panel and the demand
for x at Px = £4, Py = £2, M = £40 in the lower panel. How much is an
extra unit of x worth to the consumer at A’? At A, due to the tangency,
MRS = –2. This means our consumer would give up 2 units of y in order
to have another unit of x – that is the meaning of MRS = –2; one unit
of x has the same value to her as 2 units of y. Since y costs £2 per unit,
two units of y are worth £4, an extra unit of x must also be worth £4 as
an extra unit of x is worth the same as two units of y at A. Another way
of saying this is that at A and A’ the consumer’s willingness to pay for
another unit of x is £4. So price can be interpreted as the willingness to
pay for an extra unit of the good, given income and prices of other goods.
Similarly, the demand curve can be interpreted as a willingness to pay
curve (its downward slope implying that the more x the consumer has, the
lower her willingness to pay for an extra unit). Although we do not do the
mathematics here, you can see intuitively that because price at a given x
represents the willingness to pay for a marginal unit of x, the area under
the demand curve up to that level of x shows the total willingness to
pay for that amount (the sum of the willingness to pay for each separate
unit). This also makes it easier to see that the consumer surplus (a concept
introduced in Block 2) at any given price and quantity is the difference
between the total willingness to pay for that amount minus what is
actually paid – the prevailing price times the quantity.
y
20
y1
At A, MRS = −Px/Py = −4/2 = −2
A
Indifference curve
x1
10
x
Px
4
A/
Demand curve for x
x1
x
Figure 4.6: Willingness to pay and consumer surplus.
49
EC1002 Introduction to economics
Deriving demand: ‘The market demand curve’
► BVFD: read section 5.4.
The market demand curve is the horizontal addition of the demand curves
of all the individuals in that market. In the following activity we assume
that there are only three consumers, but the method can be applied to
much larger numbers; in such cases kinks in the market demand curve
would tend to be smoothed out.
Activity SG4.7
Consumer 3
12
12
12
12
8
8
8
8
4
4
4
4
0
7
2 4 6
5 10
Figure 4.7: Deriving the market demand curve.
Complements and substitutes
► BVFD: read section 5.5 of and the part of 5.3 which addresses cross-price
elasticities of demand.
Section 5.5 on complements and substitutes introduces the fact that goods
are not always substitutes for each other, but may in fact be complements.
This means that if the demand for a good rises, then the demand for other
complementary goods will rise as well.
You will remember from Block 3 that cross-price elasticities are negative
when two goods are complements and positive when two goods are
substitutes. The section on cross-price elasticities (in section 5.3) details
three factors which impact on income and substitution effects and can
make the cross-price elasticity for good Y either positive or negative
(responding to a change in the price of good X). These are: whether the
two goods are good substitutes for each other; the income elasticity of
demand of good Y; and good Y’s share of the consumer’s total budget.
Section 5.5 also shows that not all indifference curves are convex to the
origin as in Figures 5.2 and 5.3 of BVFD. How well the two goods can
be substituted for each other is reflected in the shape of the indifference
curves as follows:
50
PRICE
Consumer 2
PRICE
Consumer 1
PRICE
PRICE
Complete the fourth graph, showing the market demand curve. Why might the three
consumers have different demand curves?
•
Figure 5.20, left hand side depicts perfect substitutes. This is where
indifference curves are straight lines – full substitution from one to the
other if the price of one good falls below the price of the other good.
•
Figure 5.20, right hand side depicts perfect complements. This is
where ndifference curves are perpendicular lines – no substitution
effect of a price change, the consumer will consume more (or less) of
both in the same proportion.
Market demand
Block 4: Consumer choice
•
Figure 5.18 depicts good substitutes – indifference curves are quite flat
– large substitution effect of a price change.
•
Figure 5.17 depicts poor substitutes – indifference curves are very
curved – small substitution effect of a price change.
Activity SG4.8
Draw the indifference curves for perfect complements together with a budget line. Now
draw a new budget line for a change in the price of one of the goods. Indicate the income
and substitution effects (if any) of the price change.
Activity SG4.9
Barbara likes peanut butter and jam together on her sandwiches. However, Barbara is very
particular about the proportions of peanut butter and jam. Specifically, Barbara likes 2
scoops of jam with each scoop of peanut butter. The cost of ‘scoops’ of peanut butter and
jam are 50p and 20p, respectively. Barbara has £9 each week to spend on peanut butter
and jam. (You can assume that Barbara’s mother provides the bread for the sandwiches.)
If Barbara is maximising her utility subject to her budget constraint, how many scoops of
peanut butter and jam should she buy?
Activity SG4.10
Suppose that a consumer considers coffee and tea to be perfect substitutes, but he
requires two cups of tea to give up one cup of coffee. This consumer’s budget constraint
can be written as 3C + T = 10. What is this consumer’s optimal consumption bundle?
► BVFD: read appendix A2 and Maths A5.1.
The section of the appendix introduces utility functions. As is written,
although no one really knows anyone’s utility function for any good,
expressing utility numerically through a utility function can be very useful.
The maths box shows how marginal utility can be found using the delta
notation or calculus. If you are familiar with calculus, you may find this
makes marginal analysis much easier. However, it is also possible to use
the delta notation to find marginal utility, or else this will be given to you,
as per the activity below.
Activity SG4.11
Calculate the optimal quantity of each of two goods (x and y) and the consumer’s total
utility given px = 1, py = 2, M = 80, and U(x,y) = xy, where MUx = y and MUy = x. How
would you represent this graphically?
► BVFD: read the summary and work through the review questions in
Chapter 5.
Overview
This block started by introducing utility and indifference curves, as
well as the budget constraint. Indifference curves represent consumer
tastes, while the budget constraint shows the possibilities open to the
consumer, given their limited budget. Putting these together, we learned
the decision rule that determines consumer choice, under the assumption
that consumers maximise utility. In particular, we saw that consumers
will chose the bundle of goods such that MUX/PX = MUY/PY. Expressed
graphically, this means that the highest reachable indifference curve is
tangent to the budget constraint. We then explored how their choices are
affected by changes in income and prices, looking in particular at income
and substitution effects of a price change. This helped us identify normal
51
EC1002 Introduction to economics
and inferior (and Giffen) goods. We also further examined complements
and substitutes. Understanding how consumers make choices lets us see
what lies behind the – individual and market – demand curves. Finally, the
analysis of budget constraints and indifference curves also made it possible
to evaluate the relative benefits of cash transfers versus transfers in kind.
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. Judith spends all her money buying wine and cheese and wants to
maximise her utility from consuming these two goods. The marginal
utility of the last bottle of wine is 60, and the marginal utility of the
last block of cheese is 30. The price of wine is £3, and the price of
cheese is £2. Judith:
a. is buying wine and cheese in the utility-maximising amounts
b. should buy more wine and less cheese
c. should buy more cheese and less wine
d. is spending too much money on wine and cheese.
2. Harry considers coffee and tea to be perfect substitutes, but he requires
two cups of tea to give up one cup of coffee. His budget constraint
can be written as 3C + T = 10. How should Harry pick his optimal
consumption bundle?
a. Harry should only consume tea and demand T=10.
b. Harry should only consume coffee and demand C =
10
3
c. Harry should pick a bundle at the tangency between his
indifference curve and his budget constraint, where his MRS
equals the price ratio.
d. Harry can consume any affordable bundle containing both tea and
coffee.
3. The price of an inferior good goes down. As a result consumption:
a. increases as income and substitution effects enhance each other
b. decreases as income and substitution effects enhance each other
c. increases if the good is not Giffen
d. is unchanged as income and substitution effects offset each other.
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. If Daniel’s rent went up by 10% this year, but his income increased by
15% he cannot be worse off than last year.
2. Carla’s income increased by 20% last year and she bought 10% more
audiobooks. This means that audiobooks are inferior goods for Carla.
3. Mark likes jeans and cowboy boots. He experiences diminishing
marginal utility over these two goods. He is indifferent between
52
Block 4: Consumer choice
a bundle with three pairs of jeans and two pairs of cowboy boots
(bundle A) and a bundle with two pairs of jeans and four pairs of
cowboy boots (bundle B). Given this information we infer that he
would prefer a bundle with three pairs of jeans and three pairs of
cowboy boots.
Long response questions
1. Ivan earns £80 per week and needs to decide how many cans of Coke
and sandwiches to buy. Each sandwich costs £4 and every can of Coke
costs £2. His utility function is U(s,c) = sc, where s stands for sandwich
and c for can of Coke.
a. Find an equation for Ivan’s budget constraint and show the budget
constraint in a diagram.
b. Calculate the optimal weekly amounts of sandwiches and cans of
Coke for Ivan and show the optimal bundle on a graph.
c. Ivan has worked hard this year and his boss decides to give him a
raise. He now earns £100 per week. Show the increase in income
on a graph and discuss how it affects his demand for sandwiches
and Coke.
d. Explain what would happen if the price of sandwiches went up
by £5 and income remained at £100 per week. Show Ivan’s new
budget line on a graph. Would Ivan still demand the same amounts
of sandwiches and cans of Coke?
e. Explain the difference between normal, inferior, and Giffen goods
and what sign the income and substitution effects are in each of
these cases. Are sandwiches a normal good in this case?
2. Susan buys bagels and falafels. The price of a falafel is £1 and the
price of a bagel is £3. Susan has £12 to spend on bagels and falafels.
a. Draw Susan’s budget constraint and a possible indifference curve.
Explain the assumptions behind the shape of the indifference curve
you have drawn.
b. If the price of falafels falls to £0.80 each, how will this affect her
purchases? Answer in words and graphically, clearly indicating
income and substitution effects of the price change.
c. If Susan only enjoys bagels and falafels when she has two falafels
for every bagel that she eats, draw her indifference curves. How
many bagels and falafels should she buy to maximise her utility?
Assume Susan has £12, one falafel costs £0.80 and bagels cost £3
each.
d. Susan’s friend Declan grows 100 potatoes each year and all of his
income comes from selling them. He spends all of his income each
year consuming potatoes and other goods. For Declan, potatoes
are a Giffen good, in that for a given income his consumption of
potatoes will rise when their price rises. The price of potatoes falls,
and he consumes more potatoes. Taking into account the fact that
his income actually comes from selling potatoes, explain how the
last statement can be consistent with those that precede it.
53
EC1002 Introduction to economics
Food for thought – Box 1: Why do consumers experience regret?
We’ve spent quite some time thinking about how consumers optimise
their decisions based on their preferences, given prices and their income.
Classical consumer theory assumes consumers are rational decision
makers who know their own preferences and that these preferences are
stable, at least for the period of analysis. And yet, if consumers are always
optimising, then their decisions should always be the best possible and so
they should never regret their choices!
But how realistic is this? There are areas of life or circumstances in which
many of us make poor choices and then come to regret our decisions. For
example, consuming food that is high in fat or sugar and then regretting
not going for healthier options; or overspending in the present rather than
saving for the future; or not exercising enough (despite having a gym
membership!). How can we square consumer regret with consumer
theory?
Behavioural economics draws insights from the psychology literature to
refine our understanding of consumer decision making. In fact, several
Nobel prizes in Economics have been awarded in this area for the study of
different aspects of behaviour and an investigation into rationality (Daniel
Kahneman in 2002 and Richard Thaler in 2017). We now understand that
decision makers are subject to a range of cognitive biases, which can lead
to feelings of regret, especially in areas where we struggle with self-control.
For example, we may be biased by our current emotions and fail to
anticipate correctly how we will feel in the future about our current
choices. We might also be influenced by how choices are presented to us
(or ‘framed’), realising this only later.
One way to conceptualise what is going on is that the utility function
consumers perceive at the time of decision making (known as decision
utility) is different from the utility that is actually experienced when the
consumption bundle is actually consumed (experienced utility). To read
more about decision and experience utility, visit Decision Utility, The
Decision Lab.
54
Block 5: The firm
Block 5: The firm
Introduction
The two most important concepts in microeconomics are demand and
supply. In the previous block, we saw what lies behind the demand curve
and how this is driven by consumer preferences and the constraints
imposed by their budgets. In this and the following blocks, we will explore
what lies behind the supply curve. Basically, supply depends on the
technology available to firms, the cost of inputs, and the market structure
the firm operates in (e.g. the number of other sellers, which affects price
and revenue at each level of output). This block provides an introduction
to the analysis of the firm.
We assume that firms attempt to maximise profit and profit is equal to
revenue minus cost. A large part of the block analyses firm costs – from total
cost to fixed and variable costs, average costs as well as marginal costs, and
the relationships between all of these.
The early material in Chapter 7 of BVFD is quite straightforward. Although
you will need to be familiar with this to have a context for the more detailed
analysis, you should concentrate your attention on the material from Chapter
8 (especially the appendix). Numerical examples are provided in the block to
help you calculate the firm’s optimal level of output. You should also practise
representing these concepts graphically.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
distinguish between economic and accounting definitions of cost
•
describe the relationship between revenue, cost and profit
•
describe the production function
•
identify the point of diminishing marginal returns
•
demonstrate how the choice of production technique depends on input
price
•
use isoquants and isocost curves to derive the firm’s total cost curve
•
calculate marginal cost and marginal revenue
•
find the profit maximising level of output, given the firm’s demand
curve and total cost curve.
•
identify fixed and variable factors in the short run
•
analyse total, average and marginal cost, in the short run and long run
•
draw the relevant cost curves and explain why they have certain
shapes
•
define returns to scale and their relation to average cost curves
•
describe how a firm choses output, in the short run and the long run
•
describe the relationship between short-run cost and long-run cost.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 6; Chapter 7 sections
7.1, 7.2 and appendix.
55
EC1002 Introduction to economics
Synopsis of this block
This block introduces the firm including types of firms, the concept of
economic costs and how this differs from accounting cost, and the arguments
in favour of and against the frequently made assumption that firms intend
to maximise their profits. It examines why firms chose a certain level of
output by first introducing the production function, as well as isoquants
and isocost curves and uses them to derive the firm’s total cost curve. It
also shows how the demand curve facing the firm can be used to derive the
firm’s total revenue curve. Profit is equal to revenue minus cost, thus through
understanding the firm’s revenue and costs, we can find the profit function.
The concepts of marginal cost and marginal revenue are introduced, to show
that provided that it is profitable for the firm to operate at all, it will choose
its level of production such that marginal cost and marginal revenue are
equal. Production, costs and the output decision in the short run (where at
least one factor of production is fixed) is discussed, followed by a discussion
of the long run (where all inputs are variable). There is also a more detailed
discussion of returns to scale. The block concludes by discussing the
relationship between short-run and long-run costs.
► BVFD: read section 7.1–7.3, including concept 7.1.
Introduction to the firm
Section 7.1 outlines the most common forms of business enterprises: sole
traders, partnerships and limited liability companies. Section 7.2 discusses
a firm’s accounts. If you have taken any accounting courses, you will be
familiar with these concepts, though here they are approached from an
economic perspective. In particular, the discussion of accounting profit
versus economic profit and the concepts of zero economic profit and
supernormal profit are especially important to understand. Section 7.3
introduces the principal agent problem. These sections provide useful
background knowledge to the economic analysis of the firm.
Activity SG5.1
What is the economic cost of studying for an undergraduate degree?
► BVFD: read section 7.4.
After this point, the subject guide moves on to BVFD Chapter 8, returning
to Chapter 7 later in the block.
The firm’s supply decision
This discusses the fundamental idea that firms maximise profits, and
profits are the difference between total revenue (the amount of money
the firm gets by selling what it produces) and the total economic cost of
production. The notation is π for profits, TR for total revenue and TC for
total cost. Total revenue TR = PQ where P is the price of the good and Q is
the quantity sold.
For simplicity, we assume that a firm produces only one type of good.
Profits, total revenue and total cost all depend on output Q, so we can write
π(Q) = TR(Q) − TC(Q)
Thus, the firm’s problem is to maximise profits as a function of Q.
Note, that BVFD Chapter 7.5 starts with a discussion in which firms
can only producer integer quantities of output and works with tables of
56
Block 5: The firm
marginal revenue and marginal cost. However, it is essential that you
study the calculus treatment (Maths A7.1 and Maths A7.2).
You should also supplement this by reading an introductory maths
textbook on calculus that covers maximisation and minimisation for
functions of a single variable. In particular this is discussed in Chapter
3 of the subject guide for Mathematics 1 (MA105a), which includes a
discussion of marginals and profit maximisation, and in Chapter 8 of
the textbook for MA105a (Anthony, M. and N. Biggs, Mathematics for
economics and finance, Cambridge University Press, 1996). If you have
already studied this material go back and review it now; if you have
not yet studied this material, make sure that you study it as part of your
revision for this course.
It is important to understand the difference between a local and a global
maximum. The mathematical treatment focuses largely on first- and
second-order conditions for a local maximum. Economists are interested
in finding a global maximum. We do this by looking at the relative sizes
of marginal revenue and marginal cost. The diagrams and functions you
see in BVFD Chapter 7 all have the property that marginal revenue is at
first greater than marginal cost, so profits are increasing in Q. Then there
is a value of Q at which marginal revenue is equal to marginal cost. Above
this value of Q marginal revenue is less than marginal cost, so profits
are decreasing in Q. This ensures that the level of Q at which marginal
revenue is equal to marginal cost gives a profit maximum.
Section 7.4 of the textbook looks at these three elements quite briefly, but
using some of the material in Chapter 8 and some additional graphs, we
will explore them in somewhat greater detail. At the end of the paragraph
on cost minimisation is a footnote pointing to the appendix of Chapter 7.
We will work through the appendix in detail, as this will allow us to derive
the firm’s total cost function. However, first we need an introduction to
the production function – this can be found in sections 8.1 and 8.2. After
working through some parts of Chapter 8 relating to cost, we will come
back to Chapter 7 to examine revenue and then use these two concepts
(cost and revenue) to find the firm’s profit function.
The production function
► BVFD: read section 8.1.
Logically, the fundamental concept in producer theory is the production
function, which gives output as a function of inputs. To make things simple
we assume at this level that there are two inputs, capital and labour. This
course treats in detail the short run in which capital is fixed, and the
only decision is how much labour to use. In the long run, both labour
and capital are variable and the theory needed to analyse this properly
is more complicated than that needed for the short run. It is outlined in
the appendix to Chapter 8, which you should read. However, detailed
discussion of production functions and their relationship to cost functions
is deferred until the EC2066 Microeconomics course.
We begin with production. The hill-shaped structure depicted in Figure
5.1 is the production set, the set of technically feasible combinations of
output Q, measured vertically, and inputs, K and L on the horizontal plane.
It includes all the area on the surface and in the interior of the hill. A
technically efficient production decision will be a point ‘on’ the hill, while
points ‘in’ the hill represent technically inefficient production decisions
in the sense that the input combination corresponding to the point is
57
EC1002 Introduction to economics
Output
capable of producing more output. The production function Q= f(K,L)
is only the surface (and not the interior) of the hill, and denotes the set
of technologically efficient points of the production set (i.e. for a given
combination of inputs, K and L, output Q is the maximum feasible output).
The contours of the hill (i.e. the cross-sections of the ‘hill’) are comparable
to the isoquants in the appendix of Chapter 8, showing combinations
of capital and labour that generate a given output. Note that the
production function as used by economists is a very simplified summary
of the relationship between inputs and output; an engineer setting up a
production process for mobile phones or motor cars (to use two examples
from the textbook) would have a much more detailed blueprint of the
production process.
Q=f (K,L)
K
L
Figure 5.1: The production set.
The production and cost functions take technology as given. Many firms of
course are developing new technologies, either new products or new ways
of making products. There is some discussion of this in BVFD Chapter 18
on economic growth, but a proper analysis of the microeconomic issues
requires the tools developed in EC3099 Industrial economics.
► BVFD: read section 8.2.
The total output curve (also known as the total product curve), shown in
Figure 8.2 of the textbook, is a reduced form of the production function
for the short-run, when only one input is allowed to vary and the other
is held fixed. We can find this curve by ‘slicing’ the hill in Figure 5.1
above vertically at a particular level of capital K0. The reduced production
function Q = ƒ (L, K0), is thus a vertical section of the hill.
Activity SG5.2
Describe how the phrase ‘too many cooks spoil the broth’ can demonstrate the law of
diminishing returns.
58
Block 5: The firm
► BVFD: read case 8.1 and Maths 8.1.
Activity SG5.3
Define the following terms and give a formula for b. and c.
a. total product
b. average product
c. marginal product.
Activity SG5.4
Complete the following table:
Quantity of
Labour (L)
Total Product
(TP)
1
129
2
480
3
1,053
4
1,800
5
2,625
6
3,456
7
4,116
8
4,608
9
4,968
10
5,250
11
5,445
12
5,580
Average Product
(AP)
Marginal Product
(MP)
The point where marginal product reaches a maximum is called the point of diminishing
marginal returns. At what quantity of labour does diminishing marginal returns set in?
Graph the Total Product curve in a diagram and the marginal and average product curves
in a separate graph.
Isoquants and isocost lines
►BVFD: read the appendix A2 of Chapter 8.
Appendix A2 introduces isoquants. ‘iso’ (or ‘ίσο’ using Greek letters) is a
Greek word which means equal. Isoquant means equal quantity, isocost
means equal cost. An isoquant is very similar to an indifference curve –
while an indifference curve shows different combinations of goods which
generate a certain level of utility, an isoquant shows different combinations
of inputs which generate a certain output. Read about isoquants on
pp.166–67.
To find the optimal combination of labour and capital, the second tool we
need to use is called the isocost line, the line showing all combinations of
labour and capital (these being our two inputs in the current example)
which generate the same total cost, given the prices of the two inputs –
read about the isocost line on pp.167–68. It is worth pointing out that
on p.167, the textbook uses the term ‘cost function’ for the C=wL+rK.
However, this term is usually reserved for the equation showing cost as a
function of output, not input. Given that there are only two inputs, L and K
with prices w and r respectively C=wL+rK is an identity (something that is
always true) – this is how we define total cost.
59
EC1002 Introduction to economics
To find the optimal combination of labour and capital, the second tool we
need to use is called the isocost line, the line showing all combinations of
labour and capital (these being our two inputs in the current example)
which generate the same total cost, given the prices of the two inputs–
read about the isocost line on pp.167–68. It is worth pointing out that
on p.167, the textbook uses the term ‘cost function’ for the C=wL+rK.
However, this term is usually reserved for the equation showing cost as a
function of output, not input. Given that there are only two inputs, L and K
with prices w and r respectively C=wL+rK is an identity (something that is
always true) – this is how we define total cost.
Activity SG5.5
Let r = £2/hr and w = £12.50/hr. Draw a diagram with three isocost lines for when cost is
equal to £50; to £100; and to £150.
In the case of consumer choice, the budget line was fixed at the
consumer’s budget, and the consumer maximised their utility by choosing
the combination of goods which put them on the highest possible
indifference curve. For the firm, for a given level of output, the firm
minimises cost by choosing the combination of inputs that puts them on
the lowest possible isocost line. As such, the isoquants together with the
isocost curve can be used to derive the optimal combination of labour and
capital that minimises the cost of producing a particular level output. In
turn we can find the firm’s total cost function at different levels of output.
Read about this on p.168.
The optimal combination of labour is at a tangency between the (lowest)
iscocost and isoquant i.e. where the slope of the isocost line is equal to
the slope of the isoquant. This is where the Marginal Rate of Technical
Substitution (MRTS) – a concept analogous to the MRS for indifference
curves – is equal to the ratio of the price of capital and wage (the relative
factor price). That is:
MPK r
MRTS =
=
MPL w
Or else: Slope of the isocost line =
-
MPK
r
=slope of isoquant.
=
w MPL
This result has an intuitive explanation; namely, that the firm must buy
resources such that the last pound spent on K adds the same amount of
output as the last pound spent on L. This can be easily seen by further
rearranging the equations above to give:
r
w
=
MP
MPk
L
60
Block 5: The firm
Activity SG5.6
Use the information below to draw isoquants and isocost lines and find four points on the
firm’s total cost curve.
Rental rate of capital = £2 per hour
Wage = £2 per hour
Cost levels: £12, £16, £20 and £24.
Output combinations:
Qx = 25
Qx = 50
Qx = 75
Qx = 100
Capital
Labour
Capital
Labour
Capital
Labour
Capital
Labour
A
1
8
2
10
3
10
4
10
B
2
5
3
6
4
7
5
8
C
3
3
4
4
5
5
6
6
D
5
2
6
3
7
4
8
5
E
8
1
10
2
10
3
11
4
What is the slope of the isocost lines?
What is the MRS at the points where the isoquants are tangent to the isocost lines?
What does this imply about the firm’s total cost curve?
Productive efficiency
The fact that the total cost curve shows the least-cost method of producing
each output level implies that the points on the long-run total cost curve
are productive efficient. It is important to note that every point on a firm’s
average total cost curve is, by definition, productive efficient – not just the
minimum point. Productive efficiency occurs when a certain quantity of a
good is produced at the lowest possible input cost. Saying the same thing
in a different way – productive efficiency means that the firm is obtaining
the maximum possible output from its inputs.
Activity SG5.7
A firm Sam’s Lamps has the production function Q(L, K) = L*K. Given labour of 5
and capital of 7, are they producing efficiently by producing 12 units? What level
of production is the productive efficient level? What reasons might there be for not
producing efficiently? Now suppose that Sam’s Lamps has decided to produce 100 lamps
and the price of labour is £5 per unit and the price of capital is also £5 per unit. The firm
decides to employ 50 units of capital and 10 units of labour. Is this efficient? Hint: with
this production function the marginal product of labour is equal to K and the marginal
product of capital is equal to L.
Input price changes and input substitutability
The discussion of the effects of changes in the price of inputs (the wage
level or the rental price of capital) on p.169 is equivalent to the discussion
of the change in the price of goods for consumer choice. In that case, we
identified income and substitution effects of a price change – here, we
identify output and substitution effects.
The shape of the isoquants reflects how easy or difficult it is to
substitute between inputs such as labour and capital. This is called the
‘substitutability of inputs’. The two figures below display isoquants for
different production functions. Figure (a) reflects a production function
where there are only limited opportunities for input substitution. If labour
61
EC1002 Introduction to economics
is increased significantly (in this example, eight-fold), capital can still
only be reduced by a small amount (5 units) for the level of production
to be maintained. On the other hand, figure (b) reflects a production
function with more abundant opportunities for input substitution – if the
firm increases its employment of labour from 25 to 200, it can reduce its
employment of capital substantially, from 80 to 35.
K
K
a
80
a
40
35
b
25
Q = 50
b
35
200 L
Q = 50
200 L
25
(b) Production function with abundant
input substitution opportunities
(a) Production function with limited
input substitution opportunities
Figure 5.2: The shape of isoquants and opportunities for substitution.
Activity SG5.8
To produce a subject guide, one author and one computer are perfect complements in
production. One author and two computers would not be more productive. Two authors
would be more productive (i.e. produce two subject guides) – but only if they each have a
computer. Draw the relevant isoquants for this case.
Profit = Total revenue – Total cost
► Now come back to section 7.5 and 7.6 of BVFD.
The focus of BVFD section 7.5 is the relationship between marginal
revenue, marginal cost and output choice to maximise profits. The section
7.6 discussion on the relative size of marginal cost and marginal revenue,
used to identify when increasing output increases or decreases profits, is
very important. It is very helpful to understand this when you are working
with whole numbers. However, you must also study the calculus treatment
of marginal revenue and marginal cost in Maths A7.1 and Maths A7.2.
Pounds
Having used isoquants and isocost lines to derive the total cost curve, we
return to section 7.4. Table 7.3 on p.128, which contains data for a certain
firm. We can use this to graph the firm’s total cost function, as follows:
140
120
100
80
60
40
20
0
TC
0
1
2
3
4
5
Output
Figure 5.3: Total cost.
62
6
7
8
9
10
Block 5: The firm
This curve shows how much it costs the firm to produce any output level
for given technology. It represents the total economic cost of production at
various levels of output.
The firm knows its total cost curve. We also assume it knows the demand
curve it faces. Knowing the demand curve, the firm can calculate the
revenue it would receive at various output levels and derive its total
revenue curve.
25
Price
20
15
10
5
0
0
1
2
3
4
5
6
7
8
9
10
Quantity
Figure 5.4: Demand curve.
140
120
TR
X
Pounds
100
80
60
40
20
0
0
1
2
3
4
5 6
Output
7
8
9
10
Figure 5.5: Total revenue.
For example, point X on the demand curve shows the firm will sell 7 units
of output at £15, generating revenue of £105. Point X on the total revenue
curve therefore shows the combination of 7 units of output and revenue of
£105.
Putting the total cost and total revenue curves together allows us to find
the profit function (profit as a function of output). For example, when
total cost and total revenue are equal, profit is zero. At 6 units of output,
the gap between the two curves is greatest, and this is the highest point on
the profit curve, showing a profit of £27.
63
Pounds
EC1002 Introduction to economics
140
120
100
80
60
40
20
0
TC
TR
0
2
4
12
Output
6
8
10
6
8
Output
10 Profit 12
Profit
Pounds
140
120
100
80
60
40
20
0
–20 0
2
4
Figure 5.6: Total cost, total revenue and profit.
► BVFD: read section 7.5, section 7.6, Maths A7.1 and Maths A7.2.
Marginal analysis
Marginal analysis is one of the key analytical tools in economics. We
have already covered marginal utility in the previous block. This section
introduces marginal cost and marginal revenue. ‘Marginal cost’ (MC) is the
change in total economic cost due to the production of one more unit of
output. ‘Marginal revenue’ (MR) is the change in total revenue due to the
sale of one more unit of output. At the profit maximising level of output,
marginal cost and marginal revenue are equal.
Both maths boxes involve calculus, which helps to simplify the analysis.
You should work through these maths boxes to understand the principles
they are expounding.
Activity SG5.9
If the firm faces the demand curve: P = 25 – 2Q:
a. fill in the blanks in the table below
b. draw the marginal cost and marginal revenue curves
c. find the profit maximising output level for this firm. How much profit is the firm
earning at that point? Assume output must be in integers.
Output
64
Price
Total
revenue
Total
cost
0
8
1
23
2
34
3
42
4
49
Marginal
Revenue
Marginal
cost
Profit
Block 5: The firm
5
55
6
65
7
78
8
93
9
110
10
130
Cost, production and output
► BVFD: read section 8.3.
TP
increasing
marginal
returns
Output
Output
This section explores firm costs in the short run. The first few sentences
of this section state that the firm’s production function can be translated
into a relationship between cost of production and output. In the jargon of
economic theory there is a ‘duality’ between cost and production. We do
not explore this duality rigorously; however, you should appreciate that
when the costs of inputs are given to the firm, then how much it costs to
produce some level of output will depend on the amount of inputs needed
to produce that output and that the latter will reflect the firm’s production
function. The following diagram shows how total and marginal product
are related to total and marginal cost:
decreasing
marginal
returns
increasing
marginal
returns
costs
increase
at a
decreasing
rate
TC
costs
increase
at an
increasing
rate
Q
MP
L
Cost
Cost
L
decreasing
marginal
returns
costs
increase
at a
decreasing
rate
MC
costs
increase
at an
increasing
rate
Q
Figure 5.7: Relationships between total and marginal product and total and
marginal cost.
The top left figure shows the total product curve, which is initially
displaying increasing marginal returns and then displays decreasing
marginal returns after the dotted line. This is a mirror image of the total
cost curve depicted in the figure below it. When marginal returns are
increasing, costs are increasing at a decreasing rate, and vice versa. The
slope of the TP curve gives the marginal product, while the slope of the
TC curve gives marginal cost. The total product curve is also related to
the marginal product curve (top left figure). The marginal product curve
65
EC1002 Introduction to economics
displays increasing marginal returns by increasing up to a maximum point,
and then falling when marginal returns are decreasing. The marginal
cost curve below is the mirror image of the marginal product curve
and demonstrates the rate of change of costs more explicitly – it falls
when costs are increasing at a decreasing rate and rises when costs are
increasing at an increasing rate.
In this section you are introduced to fixed costs for the first time. These
are costs that have to be paid even if the firm produces a very small
amount greater than zero. However, at zero, the total cost is zero. Thus,
there is a jump in costs at zero. For this reason, you must compare profits
at some positive number with zero to see whether the firm should produce
or would prefer to shut down. This is done by requiring that, in addition to
the MC = MR condition (profit maximisation), that total revenue ≥ total
cost or equivalently average revenue ≥ average cost (profit is not negative
i.e. losses). If the best the firm can achieve by producing is losses, then it
will prefer not to produce.
Remember that the relevant cost is economic cost. This depends on the
timescale over which you are looking.
This section introduces various short run cost curves. It is important to
understand what they represent, but also to practice sketching them.
Activity SG5.10
Why does the SMC curve cut the SAVC and SATC curves at their minimum points?
Provide an intuitive answer.
► BVFD: read Maths A8.2.
This maths box provides formulas for the various short-run costs based on
a short-run total cost function. You need to remember that:
•
Total cost = Fixed cost + Variable cost
•
Marginal cost is the change in total cost as quantity produced changes
•
Average costs are calculated by dividing the cost by the quantity
produced; this applies to average fixed cost, average variable cost and
average total cost.
The relationship between marginal cost MC and average costs AC is very
important. You need to remember that AC is increasing if MC > AC, and
decreasing if MC < AC, and have some understanding of why this is so.
To see why average cost must rise if marginal cost is above the average
and fall if marginal is below average, imagine you calculate the average
age of people in a room full of university students – if the next person to
walk into the room (the marginal person) is an old lady, the average age
in the room will rise. Similarly, if a baby crawls into the room, the average
age will fall. You can get the relationship between average and marginal
cost by noting that:
AC(q) =
MC(q) =
66
TC(q)
q
dTC(q)
dq
Block 5: The firm
If your calculus and algebra are good enough, you can move beyond what
you are expected to know for EC1002: use the quotient rule to find the
derivative of AC, then do some algebra:
daC(q)
dq
q
=
=
=
dTC(q)
dq
–
dq
dq
TC(q)
q2
qMC(q) – TC(q)
q2
1
q
(MC(q) – AC(q))
Hence dAC(q)/dq is positive if MC (q) > AC (q), in which case AC (q)
is increasing; it is negative if MC (q) < AC (q), in which case AC (q) is
decreasing.
Activity SG5.11
Find the short-run fixed cost, variable cost, marginal cost, average fixed cost, average
variable cost and average total cost for the short-run total cost function STC = M + aQ2,
for which the first derivative is 2aQ.
• short-run fixed cost
• short-run variable cost
• short-run marginal cost
• short-run average fixed cost
• short-run average variable cost
• short-run average total cost..
The output decision
► BVFD: read section 8.4 and complete activity 8.1.
This section discusses how the firm chooses its level of output in the short
run. Two points are important: firstly, the output level at which profit is
maximised is where marginal cost is equal to marginal revenue. Secondly,
the firm must check whether the price it receives at this output level
enables it to (a) cover all of its costs, (b) cover only its variable costs and
perhaps contribute a little towards the fixed costs, or (c) not even cover its
variable costs.
Note, price received is not necessarily equal to marginal revenue. In fact,
this will depend on the demand curve the firm faces. If the demand curve
is horizontal, marginal revenue will always equal price. If the demand
curve is downward sloping, the marginal revenue curve will also be
downward sloping, as in Figure 8.7, and price will be higher than marginal
revenue. Whether the demand curve is horizontal or downward sloping
depends on whether or not the firm is a price taker, passively accepting
the market price. We will come back to this in detail in the next blocks
where we examine perfect competition and pure monopoly – two market
structures where the demand curves facing the firm are quite different.
The key point to note is that: The firm’s short-run supply curve is
its marginal cost curve above the average variable cost curve.
The firm will supply the output at which SMC is equal to MR, provided
that price is not less than the firm’s SAVC.
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EC1002 Introduction to economics
Production, costs and output in the long run
► BVFD: read section 8.5 and 8.6
We now move on to the long run, and examine production, costs and the
output decision as we did for the short run. The contents of this section
should be familiar as this material is a descriptive version of what is in
the appendix of Chapter 8. Read through carefully and make sure you are
familiar with these ideas, including the concept of factor intensity.
The U-shaped average cost curve is important to understand and is
discussed further in the following section. The relationship between
average and marginal costs (already demonstrated algebraically) is also
important and applies both in the short run and in the long run.
► BVFD: read section 8.7, cases 8.3 and 8.4 and Maths 8.3.
If five workers and five machines can produce 1,000 soft toys, how many soft
toys could be produced if we employed 10 workers and 10 machines? This
question has to do with returns to scale in production. Does doubling inputs
result in more than double, less than double or exactly double the original
output? This will tell us if there are increasing, decreasing or constant
returns to scale.
Some textbooks, but not BVFD, make a distinction between returns to scale
in production and economies of scale in costs. Thus, on the production side
if there are constant returns to scale then a doubling of all inputs leads to
a doubling of output; and with increasing (decreasing) returns to scale a
doubling of all inputs more (less) than doubles output (see Maths 8.3). As
long as input prices are held constant then the relationship between returns
to scale in production and economies of scale in costs is straightforward: if
doubling inputs more than doubles output then cost per unit of output is
smaller at higher output. However, if input prices change as output increases
or decreases then the effect of these changes, as well as underlying scale
effects in production, will affect average costs. The fact that BVFD equates
the two concepts implies an underlying assumption that input prices are not
changing as output increases or decreases.
Figure 5.8 demonstrates varying returns to an increase in inputs at different
levels of input. First let us describe what is meant by the ‘composite
input’ on the x-axis. This is a combination of labour and capital where the
proportions of each are held constant. Thus, for example, if we double
labour, we also double capital and the capital–labour ratio remains the
same. A change in scale does not have to do with changing the composition
of inputs, but rather with changing the amount that is employed.
68
Output
Block 5: The firm
Long-run production function
Composite Input
Figure 5.8: Long-run production function.
We can now see how this curve demonstrates initially increasing, then
constant, and finally decreasing returns to scale. The vertical bars rising
up from the x-axis are evenly spaced. However, the quantity of output
generated from these input levels varies greatly. At low levels of input,
increasing the units of input increases the level of output more than
proportionally, representing increasing returns to scale. At high levels of
inputs and outputs, the opposite is the case, since increasing the level of
inputs increases the level of outputs less than proportionally, representing
decreasing returns to scale.
Section 8.7 discusses some real-world reasons behind returns to scale and
discusses why firms may face a U-shaped long-run average cost curve. You
should understand the reasons why LRAC may fall initially, be constant for
some time, and then increase.
► BVFD: read section 8.8.
The only difference to the analysis of the output decision in the short run
is that there are no fixed costs, since all inputs are variable in the long
run. For this reason, the concept of it being worthwhile to produce as long
as variable costs are more than covered has no relevance and the firm
simply chooses its output level where MR = LMC, and then checks if this is
profitable using the LRAC curve.
The firm’s long-run supply curve is its marginal cost curve
above the average cost curve. The firm will supply the output at
which LMC is equal to MR, provided that price is not less than the firm’s
LRAC.
► BVFD: read section 8.9.
The short-run cost curve shows the costs for when one input is fixed at a
certain level. If it were fixed at a different level, the short-run cost curves
would also be different. For example, if the level of capital was fixed at a
higher level, short-run costs for producing a given level of output may be
lower, if each worker is more productive with more capital to work with.
There is a different short-run cost curve for each quantity of the fixed
input. This is sometimes described as a family of short-run cost curves. In
the long run the firm chooses the plant size with the lowest average cost
for any given level of output. The LAC includes one point (assuming there
are a large number of feasible plant sizes) from each SAC (not necessarily
69
EC1002 Introduction to economics
the minimum point of the short-run curve, as the text explains). The longrun average cost curve can be described as an envelope of these short-run
curves.
Activity SG5.12
Draw six short-run average cost curves, each with a single point of tangency to a long-run
average cost curve showing increasing, constant and then decreasing returns to scale.
► BVFD: read the summary and work through the review questions.
Overview
This block has demonstrated what lies behind the firm’s production
decisions. Using isoquants and isocost curves, the firm can determine the
least-cost combination of inputs to produce a given quantity of output.
From there, the firm’s total cost curve can be derived. It is assumed that
firms pursue a goal of profit maximisation, where Profit = Revenue – Cost.
Knowing the demand curve it faces, the firm can derive its revenue curve,
and since it knows both revenue and cost, the profit-maximising level of
output can easily be found, which is where marginal cost and marginal
revenue are equal. Marginal analysis is a very useful tool in economic
analysis, as we have seen here in the case of the firm.
The distinction between the short run (when one factor of production is
fixed) and the long run (where all inputs are variable) is important. The
production function, which summarises the technical possibilities faced
by the firm, can be used to derive the firm’s total cost curve. Short-run
total cost is equal to short-run fixed cost plus short-run variable cost.
Average costs are found by dividing cost by quantity produced. Average
cost is falling if marginal cost is below average cost and rising if marginal
cost is above average cost. The short-run marginal cost curve reflects the
marginal product of the variable factor (usually labour). It cuts the SATC
and SAVC curves at their minimum points. In the short run, the firm choses
its output level where MC = MR, but only produces at all if the price
received at this level of output at least covers all variable costs and makes
some contribution to fixed costs. The long-run total cost curve represents
the economically efficient (least-cost) production method for each level of
output when all inputs can be varied. The long-run average cost curve is
usually U-shaped, representing increasing, constant and then decreasing
returns to scale as output rises. In the long-run, the firm supplies the output
at which MR = LMC as long as the price is no less than LAC at that level
of output. The LAC curve is an envelope of many SAC curves which all
touch the LAC at just one point. This block showed how the short-run and
long-run supply curves of an individual firm can be found. You need to be
able to reproduce the output curves and cost curves covered in this block.
Since there are quite a few, the best way to do this is to understand what
they mean, why they have certain shapes, and how they are related to each
other. The examination will test your understanding of these cost concepts
(rather than just your capacity for memorisation).
► BVFD: read the summary and work through the review questions.
70
Block 5: The firm
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. Anita owns a grocery shop. These are her annual revenues and costs:
Revenues: £250,000
Supplies: £25,000
Electricity and heating: £6,000
Employees’ salaries: £75,000
In addition to the above, Anita pays herself a salary of £80,000 and
accumulates any remaining profits. If she closed her shop, she could
rent out the land and building for £100,000. Due to her experience at
running her own shop the local supermarket would offer her a job and
pay her £95,000.
a. Anita’s revenue exceeds her economic costs so she should continue
running her business.
b. Anita’s economic costs exceed her accounting costs so she should
shut down her business.
c. Anita’s economic costs exceed her revenue so she should shut
down her business.
d. Anita’s salary is less than what the supermarket would pay so she
should shut down her business.
2. Suppose the short-run total cost of producing T-shirts can be
represented as STC = 50 + 2q where q is the level of output. The
average and marginal costs of the 5th T-shirt are:
a. £50 and £2.
b. £12 and £2.
c. £50 and £10.
d. £12 and £10.
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. A publishing company is selling books. To do so they need to employ
proofreaders and assign them computers. Hiring more proofreaders
without assigning them computers cannot increase the number of
books produced.
2. When long-run costs for a firm are at a minimum the extra output
we get from the last dollar spent on an input must be the same for all
inputs.
3. A car manufacturer invests in a factory and machinery (capital), which
they cannot modify in the short run. They also employ workers on a
yearly contract. If the rent needed for the factory and machinery, the
wages paid to the employees and prices do not change, the long-run
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EC1002 Introduction to economics
cost of producing a good must be lower than the short-run cost of
producing the same good, as no inputs are fixed in the long run.
Long response questions
1. Bob Smith manages a branch office of a large financial services firm.
He uses computers (capital, K) and people (labour, L) to produce
consulting advice Q, according to the production function: Q =
KL. The marginal product of labour is equal to K and the marginal
product of capital is equal to L. Employing people costs the wage
rate w = 1 while renting computers costs the rental rate r. Suppose
computers cost twice what people do (i.e., r = 2w = 2). The number
of computers in the branch is fixed at K = K.
a. How much labour does Mr Smith employ if he needs to produce
output Q? Show that total cost is C(Q)= 2K +Q/K .
b. Given that the first derivative of the total cost function above
is 1/K, derive average and marginal cost. How do average and
marginal cost vary with output? Explain using a graph.
c. Corporate headquarters has just authorised Mr Smith to upgrade
the branch office by varying the quantity of computers. What is the
optimal (cost-minimising) mix of capital and labour?
2. A car manufacturer invests in a factory and machinery (capital), which
they cannot modify in the short run. They also employ workers on a
yearly contract. If the rent needed for the factory and machinery, the
wages paid to the employees and prices do not change, the long run
cost of producing a good must be lower.
72
Block 6: Perfect competition
Block 6: Perfect competition
Introduction
Our study of microeconomics now looks in greater depth at different types
of market structure, which refers to the economic environment in which
buyers and sellers in an industry operate. It is generally defined according
to four characteristics: the size and number of buyers and sellers, the
extent of substitutability of different sellers’ products, the extent to
which buyers are informed about prices and available alternatives and
the conditions of entry/exit. Although BVFD covers the two extremes of
market structure (perfect competition and pure monopoly) in one chapter,
this subject guide devotes a block to each, enabling some issues to be
covered in a bit more depth.
In perfect competition (Block 6), there is a very large number of firms
and free entry and exit, whereas in monopoly (Block 7), there is a single
firm which supplies the whole market, and very large barriers to entry
into the market. While many real-world firms do not fit neatly into these
two extremes, it is nonetheless worthwhile to study them first, partly
because they do approximate some real-world markets (see below for
examples), but also because they provide a benchmark that is very useful
for comparison with other market structures which are more commonly
encountered in the real world. Perfect competition is a desirable market
structure in terms of maximising the welfare of market participants and
for this reason is often used by economists as a kind of first-best standard
in order to evaluate the welfare losses caused by deviations from the
competitive ideal. The subsequent block (Block 8) will introduce other
market structures (monopolistic competition and oligopoly), which sit on
the continuum in between these two extremes.
The study of both perfect competition and monopoly relies on knowledge
from Blocks 4 and 5, so make sure you are familiar with that material
first. In particular, you need to fully understand why choice of the profit
maximising output requires firms to equate marginal cost and marginal
revenue. You should also recall that the return needed to keep a firm from
leaving the industry is already included in its cost curves, which include all
opportunity costs – including the next best alternative return to operating
in the current market. In the long run if a firm is earning a price above
average cost it is earning abnormal, supernormal, or economic profits
(these three terms tend to be used synonymously in economic texts).
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
define perfect competition
•
describe why a perfectly competitive firm equates marginal cost and
price
•
demonstrate how profits and losses lead to entry and exit
•
draw the industry supply curve
•
carry out comparative static analysis of a competitive industry.
73
EC1002 Introduction to economics
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 9, sections 1 to 4.
Synopsis of this block
This block introduces the market structure perfect competition. It starts
by outlining the underlying assumptions and the implications of these,
notably that firms in a perfectly competitive market face a horizontal
demand curve and act as price takers, with no ability to influence the
market price. This also means that MR = P for perfectly competitive firms.
The block then describes the firm’s short-run supply decision and shortrun supply curves. In the short run, firms will stay in business if P > AVC,
even if they are making a loss, however, in the long run, they will exit the
market unless P ≥ AC. The firm’s long-run supply curve is flatter than the
short-run supply curve since it can adjust all inputs in the long run. The
industry supply curve is the horizontal summation of all the individual
firms’ supply curves. In the long run, firms can exit and enter the market.
This provides a further reason why the long-run industry supply curve is
flatter than the short-run industry supply curve. The chapter also discusses
how firm and industry supply curves are affected by an increase in costs or
a change in the market demand curve.
Assumptions and implications
► BVFD: read the introduction to Chapter 9, section 9.1 and concept 9.1.
Perfect competition is a model of market structure. It rests on the
following assumptions:
1. Many firms, each negligible in size relative to the entire industry.
2. All firms produce homogenous goods.
3. Perfect information regarding prices and available alternatives.
4. Free entry and exit.
From these assumptions, the key implication is that the individual firms in
this market face a horizontal demand curve. All act as price-takers, with
no ability to influence the market price.
The textbook mentions the market for corn as a market which closely
resembles a perfectly competitive market. Other examples of markets
which may approximate perfect competition – at least along certain
dimensions – include forex (foreign exchange) and agricultural
commodities such as cocoa.
Activity SG6.1
For the forex market (e.g. selling US dollars), note down how and to what extent each of
the four assumptions above are met.
In reality, there are not many markets which are truly perfectly
competitive. Nonetheless, for the reasons described in concept 9.1, it is
still a very useful model to study.
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Block 6: Perfect competition
The firm’s supply decision
► BVFD: read section 9.2.
In the previous section, it was established that the negligible size of
individual firms in a competitive market means that each firm faces a
horizontal demand curve. At the beginning of this section, it is shown that
this means, for price taking firms, that price equals marginal revenue. Be
sure you understand this; if you do you will also understand why MR < P
for a firm facing a downward sloping demand curve. We will return to this
point when we discuss monopoly.
For an individual firm, we can write its revenue as TR = P*Q. Dividing by
Q we have
TR
= AR = P
Q
Because the firm is a price taker, P is a constant term in this equation.
Therefore, changes in TR come about via changes in Q.
∆TR = P∆Q
or
∆TR
= MR = P
∆Q
Marginal revenue, the increase in total revenue when output increases by
one unit, is just the price received for that output. We can show TR as a
function of Q graphically as follows:
TR
TR
Slope=P
Q
Figure 6.1: Total revenue for a competitive firm.
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EC1002 Introduction to economics
This enables us to provide a diagrammatic treatment of profit maximisation
for a competitive firm.
TC
TR
TR, TC
Panel (a)
Q1
Q2
Q3
Q (output)
Q4
Profit, π
Profit, π, (TR–TC)
Panel (b)
Q1
Q2
Q3
Q (output)
Q4
£
MC
AC
D=AR=MR
Profit, π
Panel (c)
Q1
Q2
Q3
Q4
Q (output)
Figure 6.2: Profit maximisation for a competitive firm.
In panel (a), a total cost curve (with fixed costs in the short run and increasing
marginal cost) is superimposed on the TR curve. Profit, which we denote by
π, is the vertical distance between total revenue and total cost. It is positive
between Q1 and Q4. For output lower than Q1 or greater than Q4 the firm makes
a loss. Geometrically, profit is maximised when the vertical distance TR–TC is
greatest (between Q1 and Q4). This occurs at Q3, where the slope of TR is equal
to the slope of TC. These two slopes are MR and MC respectively, so profit is
maximised when output is chosen such that MR = MC (or P = MC, as MR = P).
Panel (b) simply graphs profit, π, against output. Profit maximisation means
getting to the top of the ‘profit hill’, again at Q3, of course.
Panel (c) shows the same process in a third equivalent way, using the firm’s
demand and cost curves (the MC and AC curves corresponding to the TC
curve in panel (a)). Profit maximising output is at Q3 where MC = MR. The
shaded area shows the firm’s actual profit; it is AR – AC, which is profit per
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Block 6: Perfect competition
unit at Q3 multiplied by the number of units this is earned on, namely Q3.
Equivalently it is TR (= AR*Q3) minus TC (= AC*Q3).
Thinking of the economic intuition rather than the geometry of the MC =
MR (or MC = P) requirement, we can examine the firm’s position when
MC and MR are not equal, say at Q2 in Figure 6.2. Clearly in panel (b) this
is not at the summit of the ‘profit hill’. Panel (c) shows why. At output Q2,
MR>MC. What does this mean? It signifies that at Q2 increasing output by
one unit adds more to revenue than to cost, so increasing output increases
profit. The marginal benefit of increasing output exceeds the marginal cost.
You should be able to see, by the same reasoning, that if output is greater
than Q3, the marginal benefit of contraction exceeds the marginal cost.
You also need to revise, from section 8.4 of BVFD, the so-called shut down
condition (if price falls below short-run variable cost the firm should not
produce any output). It may initially seem counterintuitive for a firm to
produce output in the short run even if it is making a loss. How can this
be? Think about a firm’s short-run fixed costs, rentals on building and
machines, insurance premiums, contractual management fees, etc. These
are unavoidable even if the firm produces zero output. But losses never
have to be greater than these fixed costs. Any variable costs, costs that
vary with the level of output, can be avoided by not producing. If these
variable costs can be more than covered by producing some output then
the ‘profit’ on the cost of variable inputs can contribute to paying for the
unavoidable fixed costs, even if the firm is making a loss overall.
Short-run supply decision
The firm’s short-run decision can be summarised as follows:
•
The price is determined by the market (by market supply and demand).
•
For a perfectly competitive firm, P = MR.
•
A profit maximising firm produces where MR = MC. Because P = MR,
this means that a perfectly competitive firm operates where P = MC.
•
The optimal quantity to produce is indicated by the SMC curve, which
is the firm’s short-run supply curve – the firm chooses quantity where
P = MR = SMC.
•
The firm will only produce if the price lies above its SAVC curve and
only covers all their costs if it is at least equal to its SATC curve.
Activity SG6.2
Draw the short-run cost curves of a perfectly competitive firm and indicate prices at which
they … and the quantities they will produce at each of these prices:
a. Make supernormal or economic profits
b. Will not produce in the short run.
c. Just cover all their costs.
The marginal firm
If the price level is below the lowest point on the firm’s LAC curve, firms
will exit the market in the long run, as they would otherwise be making
losses. But how do we know which firms will exit? In theory, firms have
access to the same technology and will thus have the same costs curves in
the long run, when enough time has passed for full adjustment of capital
to be made. This assumption is also made in BVFD – that all firms in the
market and the potential entrants have identical cost curves. In this case,
which firms exit and which stay would be quite random. However, in the
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EC1002 Introduction to economics
real world, firms will not all have identical cost curves, since technology is
changing continually and firms have different histories. For example, some
firms will have replaced their capital stock more recently than others.
In a situation where no firms are covering their long-run opportunity
costs, the marginal firm will be the first one whose capital comes up for
replacement. This firm will exit first.
It is very important to understand that the two conditions (price =
marginal cost) and (price = average cost) are there for entirely different
reasons. Price = marginal cost is a consequence of profit maximisation
under perfect competition and must always hold. Price = average cost is a
zero profit condition which is driven by free entry and exit in the situation
in which all firms have the same cost function. BVFD assumes that all the
firms are identical.
Activity SG6.3
Reproduce Figure 9.4 from the textbook, except to show exit, not entry.
Industry supply curves
► BVFD: read section 9.3.
It is crucial to distinguish carefully between supply curves for an individual
competitive firm and supply curves for the industry (the market as a
whole) – the industry supply curves are the horizontal summation of all
the individual firms’ supply curves. In each case it is also important to
distinguish between the short run and the long run. The previous section
showed that the long-run supply curve for a firm is its LRMC curve above
minimum LRAC. Note that this is average total cost not average variable
cost, because while it may be rational to make a loss in the short run (if
variable costs are more than covered and revenues make a contribution to
covering fixed costs), this is not the case in the long run. In the long run,
if a firm cannot cover its costs it should leave the industry. When firms
leave the industry, industry supply shifts inwards and price increases. This
process continues until revenues just cover costs for remaining firms in the
industry. On the other hand, if firms are making abnormal or economic
profits then new firms will enter the industry and drive down the price.
This process continues until firms are just covering all opportunity costs
(i.e. no abnormal profits are being earned). The long-run industry supply
curve is flatter than its short-run counterpart. It is possible that the longrun industry supply curve is horizontal, and this is the ‘pure theory’ result
with perfectly elastic supply of inputs. However, due to the likelihood that
input prices will increase as an industry expands, as well as due to the fact
that, in practice, firms have different cost curves, it is much more likely
that the long-run industry supply curve will be upward sloping.
Comparative statics
► BVFD: read section 9.4.
This section is vital for your understanding of competitive markets. If you
fully understand the consequences, both at the level of individual firms
and the industry as a whole, of shifts in the market (industry) supply or
demand curves then you will have mastered an important building block of
microeconomic analysis. The essential point is that entry or exit from the
industry ensure that individual firms have zero profits (remember this can
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Block 6: Perfect competition
be compatible with a return to management and entrepreneurship – these
are included in the cost function; they are opportunity costs, namely what
managers and entrepreneurs could earn in the next best activity). This
means that in the long run, price must return to the minimum ATC, making
the long-run supply curve horizontal as long as expansion or contraction of
the industry does not change input prices. The two activities are designed
to assist your understanding of this. Note that in this section, at the industry
level, the short-run supply curves hold constant the number of firms in the
industry (at the level of the individual firm the short-run corresponds, as
usual, to one or more of the firm’s inputs being fixed).
The section on shifts in the market demand curve demonstrates that the
short-run industry supply curve is much less elastic than the long-run
industry supply curve. In the short run, firms cannot respond as much to
a change in price and the number of firms is fixed. As such, an increase in
demand has a much greater impact on price in the short run compared to
the long run.
Activity SG6.4
Reproduce both graphs in Figure 8.8 but for an increase in demand, rather than an
increase in costs (the textbook also suggests this activity and already provides the
industry side).
Perfect competition and efficiency
One of the reasons given in concept Box 9.1 for studying competitive
markets is that ‘a perfectly competitive market has some desirable
properties in terms of efficiency of the market outcome’. In this setting
competitive markets are efficient in the sense that they maximise the sum
of consumer and producer surplus (effectively profits in this context).
However, this does not imply that a move to competitive markets is better
for everyone. For example, monopoly is better for the owners of a firm
than perfect competition because profits are higher. However, the sum of
consumer and producer surplus are larger under perfect competition.
Later in the course (Block 10/BVFD Chapter 14) you will encounter
a much more precise statement of the efficiency properties of perfect
competition. Under strong conditions, which you will study in detail in
EC2066 Microeconomics if all markets are perfectly competitive then the
outcome is Pareto efficient, that is it is impossible to make someone better
off without making someone else worse off. However markets may fail to
work in this way. You will learn more about market failure in Block 11.
In particular, externalities imply that the supply curve may not represent
marginal social cost. Another reason why the supply curve may not
represent marginal social cost is if there is imperfect competition in the
market supplying inputs to the industry.
Using the competitive model: a worked example
Assume that the raspberry growing industry in Scotland is perfectly
competitive, and each producer has a long-run total cost curve given by:
TC = 144 + 20Q + Q2
and its marginal cost by
MC = 20 + 2Q.
The market demand curve is:
∼
Q = 2,488 – 2P
∼
(Q is the demand in the market, Q is the output of an individual firm).
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EC1002 Introduction to economics
a. What is the long-run equilibrium price in this industry?
b. How many active producers are in the raspberry growing industry in a
long-run competitive equilibrium?
c. Illustrate diagrammatically the long-run equilibrium of the firm and
the industry. Your diagram does not have to be drawn to scale but
should contain the relevant information.
Solution
a. The first thing we have to realise is that the question is concentrating
on the long-run, so it is the properties of long-run equilibrium that are
going to be relevant in solving this problem. In the competitive model
free entry and exit ensure that firms are earning zero profit (they just
cover all opportunity costs). This is a vital step in solving the problem.
Zero profit means that TR = TC for each firm, i.e.
PQ = 144 + 20Q + Q2
But this is not yet helpful to us because it is one equation with two
unknowns. What can we do? Well our model of the competitive firm
also tells us that it will produce where P = MC. We are given MC so
we can substitute in to the left hand side of the equation above:
(20 + 2Q)Q = 144 + 20Q + Q2
This gives us Q2 = 144, i.e. Q = 12
Now from P = MC we know P = 20 + 2Q, i.e. P = 44.
b. Now turn to the market demand curve and substitute in this price to
estimate market demand:
∼
Q =2488 – 2 * 44 = 2,400
So now we know that market demand is 2,400 and that each profit
maximising competitive firm produces 12 units.
Therefore the number of firms in the market must be
2,400/12 = 200
c. The diagrams are shown below. Make sure that you label the axes and
any curves or lines in the diagram as well the solution values of prices
and quantities.
LRMC
P, AC, MC
P
Market demand
LRAC
Market supply
44
44
12
Q
2400
Figure 6.3: Long-run equilibrium of the firm and the industry.
Overview
A market structure is the economic environment in which buyers and
sellers in an industry operate.
This block covered perfect competition and its underlying assumptions,
including that:
80
Q
Block 6: Perfect competition
•
there is a large number of buyers, all small relative to the whole
market and all producing a homogeneous product
•
buyers and sellers have perfect information regarding prices and
available alternatives
•
there is free entry and exit.
In a competitive industry, buyers and sellers are price-takers and have
no influence over the market price. Price is equal to marginal revenue
and the firm choses output where P = MR = MC. In the short run, the
firm’s supply curve is its SMC curve above SAVC. In the long run, the
firm’s supply curve is its LMC curve above its LAC curve. The industry
supply curve is obtained by horizontally adding the supply curves of the
individual firms. The long-run industry supply curve is flatter than the
short-run industry supply curve both because firms can fully adjust their
inputs and also because firms can enter or exit the market. Graphical
analysis of short-run and long-run supply curves was carried out for both
the perfectly competitive firm and the perfectly competitive industry. These
are affected by changes in costs and in the market demand curve, leading
to a new equilibrium.
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. An increase in the cost of capital will have the following effect on a
perfectly competitive market:
a. Short-run average and marginal cost will increase which would
lead to a fall in output and an increase in price. In the long run,
firms will leave and price will rise further.
b. Short-run average and marginal cost will not change but there will
be a fall in output and an increase in price. In the long run, firms
will leave and price will rise further.
c. Short-run average cost will increase but there will be no change in
output or price. In the long run, firms will leave and price will rise.
d. Short-run marginal cost will decrease which would lead to an
increase in output and a decrease in price. In the long-run, firms
will enter and price will become stable.
2. The inverse supply function in the market for cherries has equation
Q
3Q
. The inverse demand function has equation pD =12 - 2 .What are
ps =
2
the equilibrium price p and quantity Q?
a. P=6,Q=4
b. P=6,Q=5
c. P=9,Q=6
d. P=10,Q=
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EC1002 Introduction to economics
3. Which of the following statements characterises a perfectly competitive
market:
a. Firms have an incentive to set a price below the marginal cost of
production.
b. Firms produce goods that have a large number of complements.
c. Firms have no incentive to set a price above the marginal cost of
production.
d. Firms produce at the lowest point of their average variable cost
curves.
True/False/Uncertain
For each of the following indicate whether the statements are true, false, or
uncertain, supporting your answer with a brief explanation.
1. The market for mangoes is perfectly competitive. This year, an increase
in the number of storms lowered the productivity of mango trees. Hence,
we should expect both the short-run equilibrium price and the long-run
equilibrium price in the market for mangoes to increase.
2. The market for beer is perfectly competitive. If a tax is imposed on the
production of beer, beer will become more expensive.
3. In the market for tablecloths each firm has the cost function C(q)=5q.
This means that the supply is horizontal in this market.
Long response question
1. Suppose all firms in a perfectly competitive market are initially in both
short-run and long-run equilibrium. Then a lump-sum tax (i.e. a tax that
is unrelated to a firm’s output) is introduced.
a. Draw a diagram to illustrate the effects of the lump-sum tax on an
individual firm and the whole industry.
b. What impact will this have on each firm in the short run?
c. What impact will this have on market price in the long run?
d. What impact will this have on each firm’s output in the long run?
e. What impact will this have on the number of firms in the industry in
the long run?
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Block 7: Pure monopoly
Block 7: Pure monopoly
Introduction
Having examined perfect competition in the previous block, this block
now covers pure monopoly, which is a market structure where only one
firm supplies the whole market, and thus there is no competition between
firms. Utilities (such as gas or water) supplying a particular region
are often monopolies (this will be explored in the section on natural
monopolies). Furthermore, patents allow companies to hold a monopoly
over an invention (for example a pharmaceutical drug) for a limited
period of time. Although finding other real-world examples of companies
that are ‘pure’ monopolists can be as difficult as identifying examples of
markets that are ‘perfectly’ competitive, some companies that come close
include Microsoft, in the market for operating systems, and, a historical
example, de Beers diamonds, which controlled an estimated 80 per cent of
rough diamond supply in the 1980s.1 This block examines the theoretical
aspects of monopoly as a market structure, including how the monopolist
determines its price and output, the social cost of monopoly due to
inefficiency, and price-discrimination by monopolists.
www.economist.com/
node/2921462
1
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
define pure monopoly
•
find the optimal price and output levels for a monopolist using
MC = MR
•
relate PED to monopoly power
•
recognise how output compares under monopoly and perfect
competition
•
describe how price discrimination affects a monopolist’s output and profits.
Note, that the two-part tariff (in Chapter 9.10) is not examinable.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 9 sections 5 to 10
(but not the two-part tariff).
Synopsis of this block
This block introduces the case of pure monopoly, with its own underlying
assumptions – namely that there is only one firm supplying the whole
market and large barriers to entry. The block describes the profitmaximising output for the monopolist as well as the relationship between
the elasticity of demand and the monopolist’s degree of market power
(measured by how far above marginal cost, and revenue, it can set the price
it charges). The allocative inefficiency of monopoly is demonstrated by the
loss of social surplus compared to the case of perfect competition. First,
second and third degree price discrimination are explained, including the
impact on the monopolist’s output, price and profits. Despite the allocative
inefficiency of monopoly, one possible advantage could be that monopoly
profits provide an incentive for firms to innovate. Natural monopolies
display a falling long-run average cost curve over the whole range of
production. Government regulation of monopolies is also discussed.
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EC1002 Introduction to economics
► BVFD: read section 9.5.
Perfect competition and perfect monopoly
We turn now to the case of monopoly, which is at the other end of the
spectrum compared to perfect competition. Like the latter, in its ‘pure’
form it is likely to be rather rare in practice, but studying the pure form
tells us a lot about how firms behave when they have market power (i.e.
when they face a downward sloping demand curve). The table below
summarises how perfect competition and monopoly differ, according to the
four assumptions made to describe perfect competition in section 9.1.
Number of firms
Nature of product Information
Entry and Exit
Perfect competition Very large, infinite
Homogeneous
Perfect
Free
Monopoly
Homogeneous
(One product)
Perfect
Large barriers to
entry
One
Table 7.1: Characteristics of perfect competition and pure monopoly.
In relation to the final column, BVFD in this chapter essentially rule out
by assumption the entry to the industry of new firms (which would erode
monopoly profits). You should think about why this happens in practice.
Some barriers to entry are ‘natural’, for example the unique talents of a
singer or sports star (their monopoly profits are not eroded by the entry of
clones) while others are artificial, such as the monopoly position afforded,
perhaps temporarily, by licences, patents, tariffs and the like. Such
artificial barriers to entry can, in principle and often in reality, be removed
to introduce competition into previously monopolised industries.
► BVFD: read section 9.6 and Maths A9.1 and A9.2
Monopoly analysis
This section shows that profit maximisation for a monopolist, as for
a competitive firm, requires producing where MR = MC. But, unlike
the competitive case, MR is not equal to P – it is less than P (see next
paragraph). This means that in profit maximising equilibrium, where
MR = MC, P > MC and this turns out to be the source of monopoly’s
inefficiency. You need to be sure that you really understand the monopoly
diagram, BVFD Figure 9.11. What follows spells out in a bit more detail
some aspects of the monopoly analysis.
To begin with it is crucial for you to understand why, in the case of
monopoly, MR < P (remember from the previous block that MR = P for
a competitive firm). This is explained in section 8.6, but here it is spelled
out in more detail. The downward sloping demand curve faced by the
monopolist means that if a monopolist wants to sell more output it will
have to lower the price. But the lower price applies to all of its output,
not just the marginal unit. Marginal revenue is the price the monopolist
receives for the marginal unit less the price reduction it must accept on
all the units previously sold at a higher price. This is demonstrated in the
following simple diagrammatic illustration.
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Block 7: Pure monopoly
P
TR11 = 9.5 × 11 = 104.5
TR10 = 10 × 10 = 100
MR = TR11 – TR10 = 4.5 = P11 + 10∆P
(∆P is negative)
10
9.5
D
10
Q
11
Figure 7.1: Marginal revenue when the firm faces a downward sloping
demand curve.
When the price is 10, 10 units are sold and total revenue received by the
firm is 100. To sell an extra unit (the 11th unit) the price must fall to
9.5. This, however is not the firm’s net gain in revenue because it now
sells each of the previously sold 10 units for 9.5 rather than 10. The net
revenue, the marginal revenue, from selling the 11th unit is its price,
9.5, minus the reduced revenue on the first 10 units, i.e. 0.5 * 10 = 5.
Therefore MR = 9.5 – 5 = 4.5. So MR is less than price.
Activity SG7.1
As part of your studies of microeconomics, it is important for you to be able to draw the
cost and revenue curves for a typical monopolist.
a. Reproduce Figure 9.11, making note of the key points (the point where the MC and
MR curves cross, the price level the monopolist chooses, and the average cost at this
quantity) and highlighting the monopolist’s profit.
b. Illustrate a rise in costs (as described in the section ‘comparative statics for a
monopolist’).
c. Illustrate an increase in demand (as described in the section ‘comparative statics for a
monopolist’).
As noted above, cutting the price increases demand but reduces the
revenue on existing units. The effect on a firm’s total revenue depends on
the price elasticity of demand, as you will remember from Blocks 3 and
5. This is described in more detail in this section, and in Maths A9.2. The
formula in equation 7 (or 8) of the maths box is very useful. Although the
derivation in the box uses calculus, the intuition can be seen by using the
delta notation as follows2
TR = P * Q
∴∆TR = P∆Q + Q∆P
Therefore we can write:
MR =
∆P
∆TR
=P+Q
∆Q
∆Q
But PED (price elasticity of demand), ε, can be written as ε =
∆Q P
.
∆P Q
In fact, the expression
in the text is an
approximation. The full
expression for ∆TR is
∆TR = P∆Q + Q∆P
+ ∆P∆Q. For small
changes in P and Q
the final term can be
ignored, giving the
equation in the text.
2
Substituting into the above we get, after a bit of manipulation:
(
1
ε
(
=P 1–
1
|ε|
(
(
MR = P 1 +
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EC1002 Introduction to economics
which is equivalent to equations (3) and (4) in Maths A9.2. Here you can
see straight away that if demand is inelastic, |ε|<1, MR is negative. This
shows concisely what is explained in the text, namely that a monopolist
will never operate on the inelastic portion of the demand curve.
Also, because MR = MC for profit maximisation, some further
straightforward manipulation yields:
1
P – MC
=
|ε|
P
which is the proportionate mark-up of price over marginal cost, is
sometimes used as an index of monopoly power (the Lerner Index). In the
case of perfect competition this index is zero (P = MC, |ε| = ∞ ). What is
the maximum value this could take in the case of monopoly?
The equation:
MR = P + Q
∆P
∆Q
can also be used to show a useful result for MR where the demand curve is
linear. Suppose the (inverse) demand curve is given by P = a – bQ where
∆P
–b is ∆Q
then substituting into the above equation gives MR = a – 2bQ.
(Maths 8.1 shows the same result using calculus). Remember that this
is the case for linear (straight line) demand curves only. The marginal
revenue line has the same intercept on the P-axis as the demand curve but
is twice as steep. Thus, in Figure 9.10, the MR curve crosses the horizontal
axis at exactly half the quantity at which the demand curve crosses the
horizontal axis – this is due to the fact that when P = a – bQ, the DD curve
crosses the horizontal at a/b. The MR curve corresponding to this demand
curve is MR = a – 2bQ. This curve crosses the x-axis at a/2b: exactly half
the quantity at which the demand curve crosses.
The following question requires you to use the result we have just
explained about the slope of the MR curve relative to the slope of the
demand curve in order to solve for the monopoly equilibrium:
Using the monopoly model: a worked example
The (inverse) demand curve faced by a monopolist is given by:
P = 210 – 4Q
a. Suppose the monopolist has constant marginal cost equal to 10 (MC
= 10). Use the method shown above to find the monopolist’s marginal
revenue and, using that, calculate the monopolist’s profit maximising
output, price and total revenue.
b. Now suppose that the monopolist’s MC increases to 20. Calculate the
new monopoly quantity (Q), price (P) and total revenue (TR).
c. Suppose now that the demand curve given above refers to a perfectly
competitive industry in which each firm has a constant marginal cost
of 10. What is the industry price, output and total revenue?
d. Now in this competitive industry suppose that the MC for each firm
increases to 20. What is the new P, Q and TR for the industry.
e. Compare and comment on the change in TR for the monopoly and the
competitive industry when MC increases from 10 to 20.
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Block 7: Pure monopoly
Solution
a. The MR curve has the same vertical intercept but twice the slope of the
demand curve. i.e.:
MR = 210 – 8Q
P, MR
210
D (AR)
26.25
52.5
Q
Figure 7.2
The monopolist maximises profit when MR = MC, 210 – 8Q = 10. So
Q = 25. Put this into the demand curve to calculate P = 110. TR =
P*Q = 2,750.
b. Following a similar procedure, when MC = 20, Q = 23.75, P = 115,
and TR = 2,731.25.
c. When the industry is perfectly competitive, the industry supply curve
is horizontal at P = MC = 10. At this price the demand curve tells us
that Q=50 and therefore TR is 500 (P*Q).
d. By the same method, when MC = 20, industry output is 47.5, P = 20
(from demand curve) and TR = 950.
e. When MC increases from 10 to 20 the monopolist’s TR falls and the
industry TR increases. Why the difference? The monopolist always
operates on the elastic portion of its demand curve, otherwise
MR would be negative and this is never optimal. So an increase
in price reduces TR – a consequence of an elastic demand curve.
At the competitive output, on the other hand, for the industry
as a whole the demand curve is inelastic (you can check this by
calculating the elasticity or by substituting the competitive output into
the MR equation and noting that MR is negative, implying inelastic
demand). Of course, with inelastic demand an increase in MC and
price will increase TR. For each firm in the competitive industry MR is
positive and equal to price.
Activity SG7.2
Consider two monopolists in two industries. One is the sole postal service operating in
a country. The other is the sole producer of a certain type of cheese (no-one else has the
technology to produce this cheese). Which of these do you think faces a more elastic
demand schedule? Draw a rough sketch of the demand, marginal revenue and cost
curves for each industry and examine the gap between the point where MC = MR and
the price chosen by each monopolist. Which firm has greater market power?
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EC1002 Introduction to economics
Social cost of monopoly
► BVFD: read section 9.7.
This section establishes the important result that, compared with a
perfectly competitive industry, a monopolist produces less output and
charges a higher price (given the same cost conditions). This is the source
of the social cost of monopoly – the deadweight loss of monopoly.
The intuition for this is that, with price above MC, consumers place a
higher value on extra output than it costs to produce that extra output –
expanding output would be socially productive under such circumstances.
It is this deadweight loss, rather than the existence of monopoly profits,
that economists see as the rationale for ‘competition policy’. Competition
or antitrust policy works differently in different countries but will seek
some mix of attempting to generate more competition in markets which
are currently uncompetitive and regulating the behaviour of firms with
market power, for example by setting price ceilings. Occasionally, it will
be decided that monopoly is in the ‘public interest’ (not an easy concept to
pin down!) and therefore its existence is allowed to continue unchecked
by policy. Section 9.9 (Monopoly and technical change) returns to the
potential advantages of monopoly.
Our worked example and section 9.7 of the textbook uses a horizontal
long-run marginal cost curve. However, remember that Section 9.3
described how, realistically, industry supply curves are likely to be upward
sloping. The diagram below portrays the social cost of monopoly in
the case where the long-run marginal cost curve slopes upwards. Some
consumer surplus has been lost and has become monopoly profits while
some has become deadweight loss. There is some producer surplus lost
compared to the perfectly competitive model, but this is smaller than the
supernormal profits gained by the monopolist.
P
Perfectly compeve
market
Pure monopoly
P
D
D
PM
MC
S
PC
PC
MR
QC
Consumer surplus
Q
Producer surplus
QM
QC
Deadweight loss
Figure 7.3: Monopoly and (in)efficiency.
The previous block described how the perfectly competitive model results
in outcomes that are both productive and allocative efficient. Productive
efficiency occurs because firms choose a quantity on their cost curves.
This applies to monopoly in the same way. Although monopolists are
not under pressure from competition to choose the cost-minimising mix
88
Q
Block 7: Pure monopoly
of inputs, they are still likely to do this in order to maximise profits. In
terms of allocative efficiency, the perfect competition model is allocative
efficient because the sum of consumer and producer surplus is maximised.
This means it is not possible to make one party better off without making
the other party worse off. By contrast, the monopolist is not allocative
efficient. As there is a deadweight loss, by lowering the price and
increasing the quantity produced, it would be possible to increase the total
surplus available for distribution between the two parties.
Price discrimination
► BVFD: read sections 9.9
When firms have market power (pure monopoly is the extreme case) they
can, under certain circumstances, employ pricing strategies that increase
their profits by ‘raiding’ the consumer surplus of their customers.
We have taken it as given that there can be only one single price
charged for a unit of a homogeneous good. Imagine this were not the
case. There would be possibilities for mutual gains via arbitrage – those
charged a low price could sell the good to those charged a high price; at
intermediate prices both parties gain. Arbitrage would continue until a
single price prevailed. Where such secondary markets are impossible or
can be prevented by simple monitoring strategies, firms with monopoly
power can increase their profits by charging different prices to different
consumers. Can you think of examples where it is difficult or impossible
for secondary markets to erode price differences?
Make sure you understand the rather remarkable result that first-degree
price discrimination eliminates the deadweight loss associated with
a single price monopolist. Whereas in the case of third-degree price
discrimination, by far the most common type in practice,3 BVFD show
that the monopolist must equate MR in both sub-markets (make sure you
understand why) and set these equal to the common value of MC. This
leads to higher prices being charged in the sub-market with the more
inelastic demand. We can show this more rigorously by applying the
formula for MR derived above (and in Maths A9.2).
1
1
=P 1–
=MR2=MC
MR1=P 1–
ε1
ε2
[
[
[
[
Suppose that in market 1 |ε1| = 1.5 and in market 2 |ε2| =3, then
equating MR11 and MR22 gives: P1(1–1/1.5) = P2(1–1/3). This means
P1/P2 = 2. The profit maximising monopolist charges twice as much in the
more inelastic market 1 than in the more elastic market 2. The exact price
levels can then be pinned down by equalising marginal revenues to MC.
Activity SG7.3
Define first-, second- and third-degree price discrimination. For first-degree price
discrimination, draw graphs illustrating producer and consumer surplus compared to a
competitive industry and to a non-discriminating monopolist.
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EC1002 Introduction to economics
When can monopolies be justified?
► BVFD: read sections 9.9. Case 9.3 and 9.10.
The pharmaceuticals industry provides one example of the controversy
regarding monopoly and competition law. In this industry, production
costs are very small and most of the costs involved are fixed costs on R&D
to discover and test new medicines. Firms can patent their discoveries
for a period of 10 years, allowing some time when they can sell these at
a monopoly price and earn profits which help cover the R&D costs for
that and other drugs. After this time, generic versions of the drugs start
to be sold by rival firms and the price generally falls. On the one hand,
people argue that life-saving drugs should be made available immediately,
especially to developing countries. On the other hand, it is argued that
without the monopoly period provided by the patent, firms would have no
incentive to invest in R&D and new drugs would not be discovered.
The case of natural monopoly discussed in section 9.10 and in concept
9.2 is important, so make sure you understand this and the issues of
regulation that arise. In Figure 9.17, little would have been lost if the LMC
curve were simply a horizontal line. This would correspond to a long-run
total cost curve of the form TC = a + bQ where a is the fixed cost and b
the constant marginal cost. Here the falling AC comes about as the fixed
cost a is spread over larger outputs. Take the case of railways where there
are large fixed costs in setting up the track network but the marginal cost
per journey mile (Q) may be quite low in comparison. In this case it would
be very inefficient to have several providers each installing their own
parallel rail networks.
► BVFD: read the summary and work through the review questions.
Overview
This block discussed the case of pure monopoly, where there is only
one firm and large barriers to entry, such that the monopolist faces no
competition from incumbent firms or even from potential entrants.
The profit-maximising output for the monopolist is discussed, with
the monopolist choosing the quantity where MC = MR. Price is higher
than MR for the monopolist. Just how much higher it is depends on the
elasticity of demand and indicates the degree of monopoly power for
that industry. Where a monopolist and a perfectly competitive market
can meaningfully be compared, a monopolist charges a higher price
and supplies a lower quantity of output. The allocative inefficiency of
monopoly is demonstrated by the loss of social surplus (called ‘deadweight
loss’) compared to the case of perfect competition.
90
A discriminating monopolist charges different prices to different
consumers. First-, second- and third-degree price discrimination are
explained, including the impact on output, price and profits. These
strategies transfer surplus from consumers to producers but reduce the
deadweight loss of the monopolist. Despite the allocative inefficiency of
monopoly, one possible advantage could be that monopoly profits provide
an incentive for firms to innovate. Furthermore, there are some industries
which work best as monopolies, these are called natural monopolies
and have a falling long-run average cost curve over the whole range of
production. These are generally industries with very large fixed costs
such as water, electricity and telecommunications, and tend to be heavily
regulated by government or publicly owned.
Block 7: Pure monopoly
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the best response
1. A monopolist faces an (inverse) demand curve given by P = 100 –
2Q. Marginal cost is constant and equal to 16. Profit maximisation is
achieved when price is equal to:
a. 45
b. 21
c. 58
d. 82
2. A profit-maximising monopolist sets an output of 100 per day and a
price of £20. Which of the following statements is true?
a. The firm’s marginal cost and marginal revenue curves intersect at
an output of 100, and the point on its demand curve at this output
is at £20.
b. The firm’s marginal cost and marginal revenue curves intersect at
an output of 100, and the point on its marginal revenue curve at
this output is at £10.
c. The firm’s marginal cost and average revenue curves intersect at
an output of 100, and the point on its marginal revenue curve at
this output is at £20.
d. The firm’s marginal cost and average revenue curves intersect at
an output of 100, and the point on its average revenue curve at
this output is at £20.
3. Assume that the demand for a new software is P(Q)=120–2Q. The cost
of producing it is C(Q)=4Q for a monopolist. What is the deadweight
loss associated with the monopoly in this market?
a. 1,682
b. 1,566
c. 841
d. 775
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. Monopolies always imply deadweight losses in the market.
2. A monopoly is never desirable.
3. Monopolists can find the optimal price without knowing the full
demand schedule.
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EC1002 Introduction to economics
Long response question
1. A monopolist faces a demand curve P = 120 – 54Q. The firm faces a
constant marginal cost MC = 20.
a. Calculate the profit-maximising monopoly quantity and price.
Use the formula linking MR, P and MC to find price elasticity of
demand at this point in the demand curve.
b. Suppose that all firms in a perfectly competitive equilibrium had
a constant marginal cost MC = 20. Find the long-run perfectly
competitive industry price and quantity.
c. Compare consumer surplus under monopoly versus perfect
competition. You may find it useful to draw a diagram.
d. What is the deadweight loss due to monopoly? Is this the same as
the difference between the two consumer surpluses you calculated
in c.?
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Block 8: Market structure and imperfect competition
Block 8: Market structure and imperfect
competition
Introduction
Most firms in the real world do not operate within markets described
by the textbook definitions of perfect competition or pure monopoly.
This block introduces a theory of market structure and some models
of imperfect competition. These models help to explain some of the
phenomena we see in real world markets such as advertising, price
wars and product differentiation. Game theory is introduced as a useful
tool for analysing strategic interactions. The maths boxes show how to
find reaction functions of firms competing with each other in a market
structure called duopoly (where there are two firms). You will need to
practise using these to calculate price, output, profits and consumer and
producer welfare and compare these to the outcomes of other market
structures such as monopoly and perfect competition. Although these look
complicated, in fact, they are all based on the simple equations that:
Profit = Total Revenue – Total Cost and
Total Revenue = Price * Quantity.
The formulas for marginal revenue and marginal cost can be derived from
these using calculus. MR, in the case of linear demand, can also be derived
using the result already seen that MR has the same intercept on the price
axis and is twice as steep as the demand schedule.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
recognise imperfect competition, oligopoly and monopolistic
competition
•
discuss how cost and demand affect market structure
•
interpret an N-firm concentration ratio
•
identify equilibrium in monopolistic competition
•
recognise the tension between collusion and competition in a cartel
•
describe game theory and strategic behaviour
•
identify dominant strategies
•
analyse simultaneous (one shot) games to find Nash equilibria
•
analyse sequential games using backwards induction
•
analyse reaction functions and Nash equilibrium
•
describe Cournot and Bertrand competition and the idea of
Stackelberg leadership
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 10, except 10.6 and
A10.2.
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EC1002 Introduction to economics
Synopsis of this block
This block starts by introducing a theory of market structure, focusing
on how market structure depends on the shape of the industry longrun average cost curve and the position of the market demand curve.
Market structure can be described using an N-firm concentration ratio.
Two specific types of imperfect competition are analysed in this block–
monopolistic competition and oligopoly. One key characteristic of a
monopolistically competitive market is product differentiation. The
long-run equilibrium of this market is described graphically. One key
characteristic of oligopoly is strategic interaction. Firms can either compete
or collude. If they compete, this can be analysed using models from game
theory, such as the prisoner’s dilemma. A specific example of oligopoly
is duopoly, where there are only two firms. They can compete on output
(Cournot behaviour) or price (Bertrand behaviour). If one firm moves
first, it is a Stackelberg leader. The outcomes of these interactions are
described in this block, and you will learn how to find these and how to
compare them with the outcomes that arise under monopoly and under
perfect competition. The behaviour of incumbents is affected not only
by other firms already in the market, but also by the threat of entry of
new firms. Barriers to entry can either be natural (innocent) or strategic
(constructed). Strategic entry deterrence can consist of investing in spare
capacity, in advertising, or in product differentiation, for example. This
can be analysed by use of a decision tree. In all these games, the concept
of Nash equilibrium is important and demonstrates a stable outcome, from
which the players have no incentive to diverge.
A theory of market structure
► BVFD: read the introduction and section 10.1 of Chapter 10.
The crucial determinant of market structure is minimum efficient scale
(the lowest point at which a firm’s LAC curve stops falling) relative to the
size of the total market as shown by the demand curve.
The concentration ratio measures the fraction of total output in an
industry that is produced by some specific number of the industry’s largest
firms. The N-firm concentration ratio leaves this number general. Once it
has been specified, we refer to the five-firm concentration ratio, or threefirm concentration ratio, for example.
The degree of competition in a market is also affected by globalisation –
the closer integration of markets across countries – since this increases the
ability of foreign producers to compete effectively in the domestic market.
As such, the degree of competition does not only depend on the number of
domestic producers alone.
Activity SG8.1
1. Calculate the four-firm concentration ratio of an industry with the following
distribution of sales: 40%, 10%, 10%, 10%, 8%, 8%, 6% 4% 2% 1% 1%.
a. 100%
b. 80%
c. 70%
d. 40%.
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Block 8: Market structure and imperfect competition
Monopolistic competition
► BVFD: read section 10.2.
Monopolistic competition describes a market structure with a large number
of firms, each one selling a product which is an imperfect substitute
for the product of its rivals (this is called product differentiation). Each
firm faces a downward sloping demand curve for its product. Firms in a
monopolistically competitive industry are not price-takers; they have some
market power and can set the price they charge. If they increase price
they will lose some customers, but not all. If they drop their price they
will gain some market share but will not capture the whole market. Since
the number of firms is large, they can ignore any reactions of competitors
when they make their output and pricing decisions. A further important
assumption of this model is that there is free entry and exit. When a new
firm enters the industry, it will take customers from all existing firms,
shifting the demand curve faced by each firm to the left.
The key element that makes monopolistic competition different to perfect
competition is that firms face a downward sloping demand curve rather
than a horizontal demand curve (i.e. demand for their products is not
perfectly elastic as it is in perfect competition). Since this is due to product
differentiation (the assumption that the goods are heterogeneous), firms
have a strong incentive to advertise their products – either to inform
customers about what makes their product different, or to create and
enhance customers perceptions of this difference. If advertising is effective,
it can increase the demand for a product and also decrease the elasticity of
that demand, both of which can lead to an increase in revenue for the firm.
Activity SG8.2
Figure 10.2 shows the short-run and long-run equilibria for a firm in a monopolistically
competitive market. Remember that the demand curves DD and DD’ (and the associated
MR curves) refer to a single firm in the market. The market demand curve, of course, lies
further to the right. Practice drawing the diagram yourself, highlighting:
i. the short-run monopoly profits
ii. the tangency of the DD’ curve and the AC curve in long-run equilibrium.
In the long run, the price charged by firms is equal to the average cost and
they are just breaking even. In industries where there are many producers
but of differentiated products, free entry will tend to eliminate profits in
the long run.
Monopolistic competition and efficiency
The long-run equilibrium point is not on the minimum of the LAC curve as
it would be under perfect competition – this implies inefficiency, as firms
are operating with extra capacity, on the downward sloping section of their
average cost curves. Any point on the LAC curve is by definition productive
efficient. Producing on the downward sloping part of the AC curve implies
a loss of allocative efficiency, as price will be higher than marginal cost
(since the LMC curve passes through the lowest point of the LAC curve).
Because the price is set higher than the marginal cost, consumer surplus
is lower than it would be if prices were set equal to marginal cost at the
lowest part of the firm’s AC curve.
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EC1002 Introduction to economics
Oligopoly
► BVFD: read section 10.3 (but not the kinked demand curve)
An oligopoly is a market structure characterised by there being only a few
firms, which interact strategically. Firms are aware that their decisions
affect the actions of other firms and that their own optimal decisions
depend on what the other firms are doing. The basic tension is between
wanting to collaborate to achieve a monopoly outcome, and the incentives
to cheat on any agreement so as to raise one’s own market share and
profits. Examples of oligopolies in the UK include the supermarket industry
(dominated by Tesco, Sainsbury and ASDA) and retail banking (dominated
by Barclays, Lloyds, the Royal Bank of Scotland and HSBC).
Oligopolistic industries tend to be dominated by a few large
firms. One reason for this is that large firms often have a competitive
advantage because their fixed costs (e.g. research and development) can
be spread out over a greater sales volume so the per unit cost is reduced. A
further reason is that large firms can exploit economies of scale and scope,
which creates natural entry barriers. Economies of scale arise because a
large scale facilitates the division of labour, which increases productivity.
Economies of scope apply to firms that produce multiple products and
arise because firms can share resources or functions between different
product areas. In industries where there are large economies of scale or
scope, there is simply not enough room for a large number of firms, all
operating at or near their minimum efficient scales. Hence, it is more
common for a small number of large firms to dominate the market.
Profits under oligopoly
In some oligopolistic industries, firms manage to approach joint profit
maximisation (in this case, the outcome in terms of market price and
output is similar to pure monopoly). In others, firms compete very
intensely and approach the perfectly competitive output. In the long run,
profits will attract entry, unless there are natural entry barriers such as
large economies of scale.
Game theory
► BVFD: read section 10.4.
Considering the extent to which game theory has revolutionised much of
modern industrial organisation theory, and oligopoly theory in particular,
the treatment here in BVFD is relatively brief (although the treatment in this
section is expanded in section 10.7). Game theory is a very useful approach
for analysing strategic interaction. In a game, your best move depends on
what your opponent does. This is helpful for analysing oligopoly, since one
of the key features of this market structure is strategic interaction between
firms. One key concept is a dominant strategy – a player has a dominant
strategy if one strategy is their best response, regardless of what the
other player does. In Figure 10.5, choosing a high output is a dominant
strategy for each firm. Another key concept is Nash equilibrium – this is
a situation where no player has an incentive to change their strategy, since
they are doing as well as they can, given the strategies chosen by the other
players. Note that in Figure 10.5 the Nash equilibrium is, unsurprisingly,
the pair of dominant strategies. However, it is not necessary that both firms
have a dominant strategy for there to be a Nash Equilibrium.
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Block 8: Market structure and imperfect competition
Activity SG8.3
You and your partner were just arrested for the burglary you pulled off last night, and
are being interrogated separately in different rooms. The officer says to you ‘Well, looks
like you’ve got some decisions to make here. You can confess to the burglary or you can
continue to deny any role in it. Your problem is that the consequence for you depends
on what your partner does. If he confesses and you don’t, we’ll throw the book at you
and give him immunity. You get 10 years in jail and he goes free. Of course, the reverse
would be true if you confess and he doesn’t. If you both confess, you’d both get a lighter
sentence, 5 years. If you both insist on denying the charges, we should have enough
evidence to get you both for 1 year for sure.’
Now answer the following questions:
a. What does the payoff matrix for this game look like? (base this on Figure 10.5) (it
is conventional to make the payoff for the player, on the left hand side of the payoff
matrix, the ‘row player’, the first entry in each cell and the payoffs for the player at
the top of the matrix, the ‘column player’ second).
b. Does either player have a dominant strategy?
c. Does this strategy result in the best joint outcome for the prisoners?
d. Does this strategy result in the best outcome for the police?
The game in Figure 10.5, and the traditional prisoner’s dilemma you
have just worked through are one-off games (sometimes called ‘one shot’
games). Many real-world economic decisions, such as firms setting prices
or quantities, relate to repeated actions rather than one off moves. This
can quite dramatically change the expected outcomes. The intuition is
that repeated games provide incentives for cooperation that are absent in
one-off games; in a repeated game, honest behaviour can be rewarded and
cheating can be punished (it is necessary that the threat of punishment is a
credible threat).
Models of oligopoly
► BVFD: read section 10.5 and Maths A10.1.
This section covers models of oligopoly (illustrated in the two-firm
case, a duopoly) that preceded game theory by many years (Cournot
and Bertrand were 19th-century French mathematical economists and
Stackelberg, a German economist, first published his analysis in 1934).
While it is often possible to reformulate the models in game theoretic
terms, it is instructive to understand the structure of such models. We will
cover the Cournot and Bertrand models formally in this subject guide and
the idea behind Stackelberg leadership, but will not cover the mathematics
of the Stackelberg model. The Stackelberg model as described in A10.2 is
not examinable.
Cournot model
The graphical analysis of the Cournot model is useful if you find the
mathematics in Maths A10.1 difficult. If you don’t, the mathematical
treatment is more concise. Note that Maths A10.1 uses calculus in deriving
the reaction functions. But in the last chapter, we showed that for a linear
demand curve the MR curve has the same intercept on the price axis, but
is twice as steep. Let us see how this works out in the example BVFD use in
the maths box.
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EC1002 Introduction to economics
We are given the market demand curve P = a – bQ, which we can write as
P = a – bQA – bQB. Now we want to write firm As MR curve as a function of
its own output, holding its rival’s output constant, so using the result from
the last chapter, MRA= a – 2bQA – bQB .
Although calculus is the most straightforward means, there is an
alternative method of finding MC. Using delta notation as before,
∆TCA = c∆QA. Therefore:
∆TC MC = c
=
A
∆QA
Now setting MRA = MCA gives us A’s reaction function and similarly for
firm B. Solve the two reaction functions simultaneously to get the Nash
equilibrium in quantities.
Firm A’s reaction function can be expressed as:
a–C a–QB
QA =
–
2b
2
Firm B’s reaction function can be similarly derived and is symmetric since
both firms are assumed to have the same marginal cost. Hence:
QB =
a–C
2b
–
a–QB
2
Solving simultaneously (or setting QA=QB and solving, in light of
symmetry) gives the Cournot quantities are:
a–c
QA = Q B =
3b
Total supply is higher than in a monopoly. The corresponding market price
is:
a+2c
P=
3
Activity SG8.4
Consider a market for a homogeneous product with demand given by Q = 37.5 – P/4.
There are two firms, each with a constant marginal cost equal to 40.
a. Determine output and price under a Cournot equilibrium.
b. Compute the deadweight loss as a percentage of the deadweight loss under a nondiscriminating monopolist.
Activity SG8.5
Which model of strategic duopoly interaction (Cournot or Bertrand) would you think
provides a better approximation to each of the following industries, and why?
i. oil refining
ii. insurance.
Sequential games
► BVFD: read section 10.7.
The game discussed in this section is represented again below with an
alternative presentation of the payoffs, for clarity. Sequential games such
as this are often represented with the payoffs at the end of the relevant
path. As stated below the diagram, in each case the first payoff in each
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Block 8: Market structure and imperfect competition
set of brackets is the incumbent’s, the second the potential entrant’s. This
depiction, and that in Figure 10.11, is known as the extensive form of the
game (sometimes also known as a decision tree).
Without strategic
entry deterrence
With strategic
entry deterrence
Entrant
Entrant
In
In
Out
Incumbent
Accept
(1,1)
Accept
Fight
(-1,-2)
(5,0)
Out
Incumbent
(-2,1)
Fight
(-1,-1)
(2,0)
Payoffs are: (Incumbent, Entrant)
Figure 8.1: Strategic entry deterrence.
Let us start with the case where there has been no strategic entry deterrence,
for example there has been no investment in excess capacity which can be
used to quickly flood the market with extra output. This is shown as the
game on the left above, and in the top row in the matrix in Figure 10.11.
Sequential games can be solved by backwards induction, which means
starting from the final step of the game. In this case, only one leg of the
decision tree involves a decision by the incumbent (i.e. the left leg). The
incumbent can either choose between a payoff of 1 (if it accepts the entry
without fighting) or –1 (if it fights). It will choose 1. The threat to fight
entry is not a credible one in this case. Now going back to the first step
of the game, where the entrant has a decision to make. The entrant can
either choose a payoff of 1 (if it enters, since it knows the best move for the
incumbent will be to accept its entry) or 0 (if it does not enter). It chooses 1.
The outcome of the game is thus that the entrant enters and the incumbent
accepts. Both make a profit of 1. Now for the case where the incumbent has
taken steps to deter entry – the game on the right (the second row in Figure
10.11). As described in the textbook, this could be by investing in spare
capacity which is only useful if it chooses to fight a market entrant. Starting
again with the second part of the game, the incumbent chooses between a
payoff of –2 (if it accepts) and –1 (if it fights). It will choose –1. The entrant
thus faces the following choice: a payoff of –1 (if it enters and the incumbent
fights), or a payoff of 0 (if it doesn’t enter). It will choose 0. Thus, the
outcome of the game is that the entrant does not enter and the incumbent
makes a profit of 2. As compared to the first case (no spare capacity) the
incumbent’s threat to fight is credible, it does better by fighting than by
accepting. Sequential games and backward induction are useful tools for
analysing this type of market interaction. However, certain key assumptions
are required, for example that both players have accurate knowledge of the
whole decision tree, including the payoffs of their opponent.
An interesting sequential game is the Stackelberg model (analysed
mathematically in A10.2, but not examinable). Unlike in Cournot
competition where firms choose their output level simultaneously, in the
Stackelberg model they choose their output sequentially. There is a leader
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EC1002 Introduction to economics
who moves first and a follow who sets output section. The key insight
of the Stackelberg model is that there is a first mover advantage – in the
Stackelberg equilibrium the leader reaps higher payoffs than in Cournot
competition, while the follower reaps lower profits than in Cournot
competition.
► BVFD: read section 10.8 and the summary, and work through the review
questions.
Overview
Market structure is partly determined by firms’ minimum efficient scale (the
lowest point at which a firm’s LAC curve stops falling) relative to the size of
the total market as shown by the demand curve. Imperfect competition exists
when firms face a downward sloping demand curve. The most important
forms of imperfect competition are monopolistic competition, oligopoly and
pure monopoly. The key characteristic of a monopolistically competitive
market is product differentiation, which gives each firm some limited
monopoly power in its special brand. There is free entry and exit. In long-run
equilibrium, the demand curve is tangent to the firm’s LAC curve, and price is
equal to average cost but is greater than marginal cost and marginal revenue.
The key characteristic of oligopoly is strategic interaction. Strategic
interaction can be analysed using game theory. The outcome will depend on
whether the game is played once or repeatedly, and if it is possible for firms
to make binding commitments. A specific example of oligopoly is duopoly,
where there are only two firms. In a Cournot duopoly, each firm treats the
other firm’s output as given. Whereas in a Bertrand duopoly, each firm treats
the other firm’s price as given. If instead one firm moves first and sets output,
that firm is a Stackelberg leader and will gain higher payoffs than the firm
which follows.
The outcomes of these forms of interaction can be compared with the
outcomes that arise under monopoly and under perfect competition.
In some oligopolistic industries, firms manage to approach joint profit
maximisation (in this case, the outcome in terms of market price and output
is similar to pure monopoly). In others, firms compete very intensely and
approach the perfectly competitive output. In the long run, profits will
attract new firms into the industry unless there are barriers to entry. The
analysis of imperfect competition helps explain real world phenomena such
as advertising, price wars and product differentiation.
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and be
sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the best response.
1. Refer to the box below. Two bus companies offer a daily service
Two firms, A and B, produce the same product and compete by setting
prices. They are the only firms that produce the product. Both firms
have a marginal and average cost of £2. If both firms set the same price,
they share the market equally. If they charge different prices, the firm
charging the lower price takes the entire market. Which of the following
statements is incorrect?
100
Block 8: Market structure and imperfect competition
a. The equilibrium price is equal to marginal cost.
b. In equilibrium both firms set the same price.
c. In equilibrium the two firms share the market equally.
d. Because the number of firms in the industry is small firms make
profits in equilibrium.
2. An industry is a Cournot duopoly with two firms A and B. Industry
inverse demand is p = 10 – Q, where Q = qA+qB. Both firms produce
with a constant average and marginal cost 4. Which of the following
statements is correct?
qB
a. Firm A has a reaction function QA = 3
2
b. Both firms produce 3.
c. The industry price is 5.
d. Both firms make losses.
3. Suppose both England and Norway fish in the North Sea. Both
countries know that their fish supplies are being depleted and that this
depletion could be slowed down if they both cut their fishing fleets in
half. The matrix below shows the payoff for both countries (England’s
payoff is first entry in each cell) with unchanged and halved fleets.
Norway
England
10 boats
5 boats
10 boats
300,300
550,250
5 boats
250,550
500,500
a. There is no Nash equilibrium.
b. There is a Nash equilibrium where England and Norway both
employ five boats.
c. There are two symmetric Nash equilibria where one country
employs five boats and the other 10 boats.
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. If the market consists of only two producers that compete in prices and
have the same production costs, then equilibrium output is the same as
if the market was perfectly competitive.
2. In a tennis game Serena is playing against Naomi. Serena and Naomi
each choose between two actions: to play more in the front or in the
back. If they both make the same choice, Serena wins. If they make
different choices, Naomi wins. In this game there are no pairs of
actions that are best responses to each other.
3. If two players have a dominant strategy, then there will not be any
other Nash equilibria than the outcome in which both players play
their dominant strategy.
Long response question
1. a.People generally believe that oligopolies (and in particular
duopolies) are always inefficient. Are they correct?
b. Two firms A and B produce the same good. Each sets the price of
the good. If the two firms set the same price, they share the market
equally. The demand for the output of the industry is Q = 90 – p
where p is the price. Both firms have a marginal and average cost
101
EC1002 Introduction to economics
of £10. The two firms observe that they can both increase profits
if they set up a cartel which produces the level of industry output
which maximises industry profits. What is the output of the cartel?
What is the industry price? Assume that the two firms share the
market equally. What profit does each firm make?
c. Suppose firm B believes that firm A will remain at its cartel level of
output. What is the profit maximising level of output for firm B?
d. Under what conditions is it difficult for firms to sustain a cartel?
Food for thought – Box 2: Should wages be fair?
When analysing individual labour market decisions we assume that people
decide how many hours to work based on the wage rate and their preferences
over leisure and consumption. In this model, the wage drives the decision to
work (and the hours of work chosen) by becoming the opportunity cost of
spending time in leisure. Economists have questioned the assumptions behind
this result. Some have picked at the fact that not all people are able to choose
their hours of work – it is much more common for people to say yes or no to
a contract including a fixed amount of hours, or to choose to go full or part
time. Others have pointed to the fact that people derive job satisfaction and so
the notion of work as a source of disutility that needs to be compensated for
through a wage is oversimplified. These critiques, however, do not consider
how the wage could influence the quality of work.
In 1990 George Akerlof and Janet Yellen introduced a new model to try
and explain how workers decide the effort to put in their activity, moving
the discussion forward by thinking about workers’ behaviour after choosing
the hours of work. Their hypothesis, motivated by equity theory in social
psychology and social exchange theory in sociology, states that workers are
motivated by their pay and that the wage influences the effort exerted (i.e.
the quality of work) in a given task. The motivation for the fair wage-effort
hypothesis is the observation that people who feel that they are not getting
what they deserve try to get even! In this model, people form an idea of a
wage they deem ‘fair’ for a given task. If they are paid this fair wage, they
exert maximum effort in their tasks. But if the actual wage falls short of
their perceived fair wage, then workers proportionately withdraw effort.
Unemployment thus occurs when the fair wage exceeds the market-clearing
wage. This hypothesis is consistent with observed data on wage differentials
and unemployment patterns.
Try and think about what you would deem a fair wage for different tasks.
What motivates an increase in your perceived fair wage? Do you think other
people would state the same numbers?
From Akerlof and Yellen (1990) citing Mathewson (1969):
I am working with the feeling
That the company is stealing
Fifty pennies from my pocket every day;
But for ever single pennie [sic]
They will lose ten times as many
By the speed that I’m producing, I dare say.
For it makes one so disgusted
That my speed shall be adjusted
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Block 8: Market structure and imperfect competition
So that nevermore my brow will drip with sweat;
When they’re in an awful hurry
Someone else can rush and worry
Till an increase in my wages do I get.
No malicious thoughts I harbor
For the butcher or the barber
Who get eighty cents an hour from the start.
Nearly three years I’ve been working
Like a fool, but now I’m shirking—
When I get what’s fair, I’ll always do my part.
Someone else can run their races
Till I’m on an equal basis
With the ones who learned the trade by mining coal.
Though I can do the work, it’s funny
New men can get the money
And I cannot get the same to save my soul.
[Mathewson, 1969, p.127].
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EC1002 Introduction to economics
Notes
104
Block 9: The labour market
Block 9: The labour market
Introduction
The previous blocks discussed the theory of the firm and various market
structures. Part of the theory of the firm is the way in which firms aim to
combine inputs in the most cost efficient way possible. This gave us the
first taste of the roles of capital and labour in the production process.
In addition to labour and capital, the factors of production also include
land and raw materials, as well as entrepreneurship. These factors will
be briefly explained below. This block then focuses on the labour market.
Some of what you will learn about the labour market is also relevant for
the analysis of the other factors of production; however, there are also
key differences. We will not explore these further in this block. Interested
students can read BVFD Chapter 11 – otherwise, you will most likely cover
the analysis of markets for the other factors of production in later years as
you continue your studies in economics.
The study of the labour market is important – not least from an individual
point of view, as most of us will allocate a substantial fraction of our
time to the labour market in the future (if you are not already doing
so). Furthermore, many social policy issues concern the labour market
experiences of particular groups of workers. Finally, as we have already
mentioned, labour is a key input in the production process. The overall
productivity of an economy depends on the skills of the labour force and
the quality of management. It also depends on the level and nature of the
capital stock. The approach to this subject matter is similar to the analysis
of markets for consumer goods, and the structure of the textbook chapter
will also be familiar to you (covering demand, supply, equilibrium, and
adjustments). However, in some ways the details are quite different. For
example, labour is human effort, thus the supply of labour depends on
individual preferences.
In this course, the labour that firms buy is modelled in essentially the same
way as renting a machine. Decisions on how much labour households
supply is treated as the other side of the decision about how much time
to spend not working for money, which is referred to as leisure. There are
useful things to be learnt from this simple model, although the idea that
time spent not working for money should be called leisure is nonsense
to anyone with caring responsibilities for children and other family
members. Economists have thought about these things, but they are not
an important part of most introductory and intermediate level courses in
microeconomics.
From moral, political and economic viewpoints, people are in fundamental
ways not the same as machines. The ways in which people working in
organisations do or do not have power and status, and the ways in which
the organisation manages and motivates its people, are fundamentally
important to those involved and the way the organisation works. This
depends partly, but only partly, on how much people are paid. Economists
are increasingly interested in the incentives within organisations, the way
in which pay is related to hours worked, to measurable outcomes, and to
outcomes that cannot easily be measured. Work is also very important for
people’s sense of themselves – losing your job or being unable to find a job
are major risk factors for depression. The course EC3015 Economics of
labour covers some of these issues.
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EC1002 Introduction to economics
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
describe the factors of production
•
analyse a firm’s demand for inputs in the long run and short run
•
recognise marginal value product, marginal revenue product and
marginal cost of a factor
•
define the industry demand for labour
•
analyse labour supply decisions
•
define economic rent
•
define labour market equilibrium and disequilibrium
•
demonstrate how minimum wages affect unemployment.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD) Chapter 11 (except 11.8).
Synopsis of this block
This block first introduces the factors of production and then provides an
analysis of the firm’s demand for factors, building on the analysis from
the Block 5 on the firm, where the firm’s choice of a cost-minimising mix
of inputs was discussed. Having now analysed various market structures
(Blocks 6–8), the impact of the shape of the demand curve the firm faces
for their output on their demand for inputs (which is derived demand)
is now clarified, focusing on labour. The more elastic the firm’s demand
and marginal revenue curves, the more an increase in the price of labour
leads to a fall in the firm’s demand for labour. In the short run, at least
one factor of production is fixed, but the firm can adjust its variable input
which is labour. Labour is subject to diminishing marginal returns when
other factors are fixed and the marginal physical product of labour falls
as more labour is hired. The firm hires labour until the marginal cost
of labour equals its marginal revenue product. The industry’s demand
for labour is less elastic than the horizontal sum of firm’s short-run
demand curves, because higher industry output in response to a wage
reduction also reduces the output price. In terms of the supply of labour,
this depends on the size of the population, the participation rate and
the number of hours people choose to work. For someone already in
the labour force, a rise in the hourly real wage has both a substitution
effect tending to increase the hours worked and an income effect
tending to reduce the supply of hours worked. Four factors increase
the participation rate: higher real wages, lower fixed costs of working,
lower non-labour income and changes in tastes in favour of working.
The industry supply curve of labour depends on the wage paid relative to
wages in other industries using similar skills. People who would like to
work and are actively seeking work but cannot find a job are unemployed.
Unemployment can be defined as voluntary or involuntary. Possible causes
of involuntary unemployment (representing disequilibrium in the labour
market) are minimum wage agreements, trade unions, scale economies,
inside–outsider distinctions and efficiency wages.
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Block 9: The labour market
The factors of production
The production of any good or service requires inputs. These are known as
the factors of production. The three main inputs to the production process
are: land, labour and physical capital.
•
Land comprises all free gifts of nature such as land, forests, minerals
etc. Although its productivity can be improved through fertiliser and
irrigation (for example), its supply is generally considered fixed, even
in the long run.
•
Labour includes the mental and physical effort of people employed in
return for remuneration. Each individual has different skills, qualities
and qualifications. This is known as their human capital.
•
Physical capital is the stock of produced goods that are used in the
production of other goods and services by firms (mostly) and also
households. Physical capital is manufactured, which means that the
stock of capital can be increased. It is not completely consumed in the
production process although it does tend to wear down over time –
this is known as depreciation.
Supplied by
Consumed in production?
Speed of adjustment
Land
Nature
No
Never – fixed supply
Labour
Individual people
No
Fast
Capital
Firms (generally)
Not fully
Medium
Table 9.1: Characteristics of key factors of production.
These are the three main inputs to production described in BVFD.
Other textbooks add further inputs, for example: raw materials and
entrepreneurship.
•
Raw materials are also provided by nature and are included together
with land in many definitions; however one key difference is that
raw materials (such as oil, coal, cotton, etc.) are fully consumed in
the production process. Thus in one sense, there is little difference
between the analysis of markets for raw materials and markets for
final consumption goods.
•
Entrepreneurship is provided by entrepreneurs or innovators and
includes introducing new ideas and business practices as well as
accepting risk to their own resources and possibly also organising the
other factors of production.
Analysis of the labour market
► BVFD: read Chapter 11.
One key difference between our analysis of consumption goods in the
previous blocks and our analysis of labour as an input to production in this
block is that the roles of the key market participants have been reversed.
Previously, when we talked about consumption goods, firms were the
suppliers and individuals were the consumers. In the labour market,
individuals are now supplying their labour, which firms demand. A second
key difference is that the demand for labour is derived demand, in that
the demand for labour depends on the demand for the goods produced by
that labour. Firms’ decisions on how much to produce and how to produce
it imply specific demands for various quantities of inputs.
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EC1002 Introduction to economics
Labour demand in the long run
► BVFD: read section 11.4 and Maths 11.1.
When analysing input markets it is important to distinguish between the
short run, when (by definition) the amount of at least one input cannot
be varied by the firm, and the long run, in which the firm is free to vary
all its inputs. This section deals with the labour market in the long run.
Because both labour and capital can be varied, an increase in the price of
labour (the wage rate) will decrease the demand for labour due both to
the substitution effect (capital becomes relatively cheaper so any given
output is produced more capital-intensively) and the output effect (with
higher costs, the profit maximising output level, where MC = MR, falls).
The point made in Figure 11.1 is returned to below in the discussion of the
short-run demand for labour.
This section (BVFD Section 11.1) goes beyond the analysis in Chapter 8
to demonstrate how the elasticity of demand impacts on the output effect
of a change in one of the factor prices. The (perfectly elastic) horizontal
demand curve DD is much more elastic than the downward sloping
demand curve D’D’. If the firm faces the less elastic curve, the output
effect of an increase in costs is smaller – as can be seen in Figure 11.1.
This shows the importance of recognising that the demand for factors is
derived demand such that the characteristics of the demand for the
output have an impact on the demand for the factors of production.
Activity SG9.1
Use budget constraints and indifference curves to demonstrate the effect on the demand
for labour of a fall in the wage rate – clearly indicate both substitution and output effects
and accompany your graphs with a written explanation.
Activity SG9.2
A fall in the wage rate will:
a. increase the demand for capital but the effect on the demand for labour is uncertain
b. increase the demand for labour but the effect on the demand for capital is uncertain
c. decrease the demand for capital but the effect on the demand for labour is uncertain
d. decrease the demand for labour but the effect on the demand for capital is uncertain.
Short-run demand for labour
► BVFD: read section 11.2 and Maths A11.1 and Case 11.1.
The firm can calculate the optimal amount of capital and labour to use as
inputs in the production process using marginal analysis: the extra value
gained from one more unit of the input must be equal to the unit price of
that input. The extra value gained from one more unit of the input is, in
turn, the marginal physical product of the input multiplied by how much
the firm gets, per unit, from selling that extra output. In the case of a
price taking firm, and section 11.2 only considers competitive firms, the
marginal physical product is just multiplied by the price of output, which
is of course constant for the firm. In the case of a firm facing a downward
sloping demand curve for its product, a monopolist for example, we
cannot just multiply MPL by the original product price to get the monetary
value to the firm of the extra output. Why not? Because to sell more
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Block 9: The labour market
output the price will have to fall, not just for the marginal unit but for all
units. If you don’t remember why this is, revise the monopoly block and
chapter. When the demand curve is downward sloping the optimal rule
for hiring an input is, in the case of labour, to hire labour until the wage is
equal to the marginal revenue product of labour (MRPL)1, i.e. until
W = MRPL = MRQ * MPL
where MRQ is the marginal revenue that the firm gets from selling an extra
unit of output. Recalling from Block 7 that:
1
ε
(
(
MRQ = P 1 +
where ε is the price elasticity of demand for output, the hiring rule
becomes to higher labour up to the point where:
1
.MPL
ε
(
(
W=P 1+
In the case of perfect competition where ε is minus infinity, just reduces to
W = P * MPL, or W = MVPL in the textbook. Note that because ε is negative,
the labour demand curve for a non-competitive firm lies below the labour
demand curve for a competitive firm with the same MPL curve and is steeper.
As in Figure 11.1, output, and hence the derived demand for labour, is less
responsive to wage changes the less elastic is the demand for output.2
Activity SG9.3
Imagine you are the manager of a small firm which makes and sells doughnuts and you
need to decide how many workers to employ. Use the information below to make your
decision. A doughnut sells for £1.50. All workers work an eight-hour shift and the wage
rate given is the hourly rate. The market for doughnuts is perfectly competitive. Explain the
reasoning behind your decision.
MPL
Some textbooks using
the term marginal
revenue product for
both competitive and
non-competitive firms,
others, such as BVFD,
reserve the term MVPL
for the competitive case
where MR=P.
1
Workers
Output per hour
MVPL(£)
1
20
7
2
30
7
3
37
7
4
42
7
5
44
7
This is the basis for one
of the Hicks-Marshall
laws of derived demand:
other things equal the
elasticity of labour
demand with respect to
the wage is high when
the price elasticity of
demand for output is
high.
2
Wage rate (£)
Industry demand curve for labour
► BVFD: read section 11.3.
As explained in this short section and the accompanying diagram, the
industry demand curve for labour is steeper than the industry MVPL
schedule, the horizontal addition of the original MVPL curves of each firm
in the industry, since a lower wage increases industry output, leading to
a fall in equilibrium price and a shift in the MVPL schedule. The industry
demand curve for labour connects points on multiple MVPL schedules.
The slope of the labour demand curve reflects the elasticity of demand for
the product being produced, since demand for labour is derived demand,
depending on demand for the output.
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EC1002 Introduction to economics
Labour supply
► BVFD: read section 10.4 and Maths 10.2, as well as case 10.1.
This section applies the theory of consumer choice to an individual’s
decisions of how to allocate their time between hours of leisure and
hours of paid work3 for individuals who are in the labour force as well as
the decision about whether or not to participate in paid work in the first
place. You should treat Maths 11.1 as an integral part of this section, not
an optional extra. In fact, even the diagrammatic treatment in Maths 11.1
does not go far enough in that, although it indicates whether the income
or substitution effect dominates for a given wage change, it does not show
these effects separately in the first diagram of the Maths box. You are
now asked to remedy this shortcoming by drawing for yourself a choice
diagram which does show the separate income and substitution effects.
In this basic
model these are
the only uses of an
individual’s time.
The model can be
extended/modified
to incorporate other
important uses of
time such as unpaid
work in the home.
3
Activity SG9.4
Draw a large diagram showing a budget constraint and indifference curve for three
different wage levels, such that it can be used to derive a backwards-bending labour
supply curve. For each of the two increases in the wage level, clearly indicate the income
and substitution effects, noting which is larger in each case (you may need to refer back
to Figure 5.14 in Chapter 5 to remember how income and substitution effects can be
distinguished graphically).
This section of the text assumes that leisure is a normal good4, more of it
will be consumed as real income increases. This is likely to be a realistic
assumption, in practice, for most people. However, suppose that leisure is,
in fact, an inferior good. How would this change the analysis of income
versus substitution effects? Could there be a backward bending labour
supply curve in such circumstances?
Participation rates
One important concept from this section is the reservation wage – the
lowest wage a worker is willing to accept to work in a given occupation.
For this section, pay attention to the way that the four main factors which
increase participation are represented graphically, as per Figure 11.6.
Activity SG9.5
Match the factor which increases participation to the description of the graphical
representation of this factor in Figure 11.6.
110
Higher real hourly wage rate
Shorter distance AC
Lower fixed costs of working
Shorter distance BC
Lower non-labour income
Flatter indifference curves
Changes in tastes in favour of
more work and less leisure
Steeper budget constraint line
In fact they make
the even stronger
claim that leisure is
probably a luxury good.
Remind yourself of the
distinction between a
normal and a luxury
good (Block 3 – BVFD
section 4.6).
4
Block 9: The labour market
Supply of labour to an industry
As is mentioned in this section, the supply of certain types of labour to the
economy as a whole is relatively fixed in the short run. In the long run,
population growth and education and training can increase the supply.
How elastic the supply of a certain type of labour is to a particular industry
depends in part on how large that industry is relative to the economy as a
whole.
Labour market equilibrium
► BVFD: read section 11.5 and case 11.2 as well as concept 11.1.
Labour mobility
The extent of labour mobility into and out of an industry affects the slope
of the industry’s labour supply curve and the extent to which this curve
shifts when there is a change in wages in other industries. When there
is a high degree of labour mobility, wage increases in one industry easily
flow over into other industries. Labour mobility is a crucially important
determinant of a country’s economic efficiency, both in static terms,
ensuring labour is allocated to its most productive uses and in dynamic
terms, facilitating the emergence of new activities and industries while
allowing for the orderly decline of some existing activities and industries
where output demand is falling. Geographic mobility, and in particular
international migration, is perhaps the most important dimension of
labour mobility, but occupational mobility, the ability of workers to
undertake new tasks in an ever-changing economy is also important for
efficiency and growth. Labour mobility is a subject which has attracted
increasing attention, both politically and in terms of economic research,
in recent years, but is perhaps too much of a specialised topic for an
introductory course and is more typically reserved for specialised courses
in labour economics. However, a bit of basic supply and demand analysis
can help us to see that some of the more extreme positions taken on
international migration are likely to be misleading. Below we show the
market for a particular type of labour, it could be nurses, builders, etc. Let
us take the latter case.
Wage
Domestic supply
W1
Total supply
W2
Demand
N3
N1
N2
Employment
Figure 9.1: International migration and labour supply.
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EC1002 Introduction to economics
If only domestic builders supply the market, N1 will be employed and
the wage will be W1. Suppose now that there is immigration of builders
shifting the total supply outwards (and possibly, as in the diagram, making
it more elastic). Employment increases to N2 and the wage falls to W2.
We see that immigrant builders do not displace domestic builders on a
1 for 1 basis (as some crude views of immigrant labour would have us
believe). N2–N1 immigrant builders are employed, while the employment
of domestic builders falls by the smaller amount N1–N3. It is equally wrong
of course to say that building wouldn’t get done at all without immigrant
builders. Without the immigrant builders, the higher wages of builders
leads to a fall in the amount of building that gets done, but there is, again,
equilibrium in the market for building and builders.
Monopsony
A single purchaser in any market is called a monopsonist. When an
employer is a monopsonist, workers must either accept the wage offered,
or move to a different market. The analysis of monopsony in the labour
market is, in effect, the mirror image of the monopoly analysis of a firm in
the product market. The labour supply curve is upward sloping, since more
workers will be willing to work when the wage is higher. The upward
sloping labour supply curve represents the average cost curve of labour for
the monopsonist. The marginal cost of labour lies above this curve,
because if a non-discriminating monopsonist hirers one more worker, they
must also pay the higher wage to all the workers who are already
employed. The monopsonist is aware that by hiring more workers, it is
increasing the price of labour – as such, it will hire fewer workers than
under a competitive market structure. The employment decision of a firm
with monopoly power in its output market has been dealt with above,
where the rule to hire labour up until W = P 1 + 1 .MPL was discussed.
ε
(
(
► BVFD: read section 11.6 and case 11.3.
Many of the concepts in this chapter are analogous to concepts from
the general demand and supply analysis of Chapter 3. For example,
economic rent – payment to a worker in excess of their reservation wage
– is analogous to producer surplus and is represented graphically by the
area above the labour supply curve and below the equilibrium wage. The
diagram (Figure 11.10) presented in the section refers to the market but,
of course, some individuals with reservation wages well below the market
wage of W0 can earn very substantial economic rents.
Disequilibrium in the labour market
► BVFD: read section 11.7 and concept 11.2.
This section introduces five reasons why labour markets may not clear –
minimum wage laws, trade unions, scale economies, the insider–outsider
dichotomy, and efficiency wages. If wages are fully flexible, they will be
able to rise and fall to the equilibrium level where demand and supply
are equated and the labour market clears. These five factors provide an
explanation why wage levels may stay above the equilibrium rate, leading
to some of the labour force being unemployed. There is something of a
semantic issue involved in the use of the market clearing concept here.
What is really meant by a non-clearing market in this section is that the
equilibrium wage is above the competitive wage. Nevertheless, it could be
argued that in each of these cases the market does in fact clear, subject to
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Block 9: The labour market
the institutions in place at the time. Take the case of the minimum wage
in Figure 11.11. The minimum wage essentially rules out that part of the
labour supply curve below W2. Although some workers would be prepared
to work at W < W2, the law of the land does not permit firms to employ
them at these wages, so the supply curve is essentially horizontal at W2
until it hits the supply curve at L = L2. Firms wanting to hire labour in
excess of L2 will have to pay above the minimum wage. So one could say
that the market clears where this modified supply curve intersects the
demand curve (at L = L1). In concept 11.2 this is the argument used.
The case of efficiency wages is another example where it is not really clear
that this is a disequilibrium situation. Firms pay above a market clearing
wage but get higher productivity as a result. Workers may collectively
accept a slightly lower probability of employment as a price worth paying
for the higher wages under such arrangements.
Incidentally, one of the most famous historical cases of efficiency wages
is the case of the Ford Motor Company just over 100 years ago. In 1913
the daily wage at the company was $2.50. Turnover and absenteeism
were high but there was a plentiful supply of workers willing to work at
that wage. Then, at the beginning of 1914 Henry Ford doubled the daily
rate to $5 (for workers who had been with the company for at least six
months) as well as shortening the working day. Workers queued outside
Ford factories for employment on the new terms. Quit rates, absentee rates
and firing rates fell dramatically; productivity increased and company
profitability did not suffer in spite of this huge pay rise.
► BVFD: read the summary and work through the review questions.
Overview
The three main factors of production are labour, capital and land. Labour
includes all forms of effort supplied by people to those who employ them
for monetary remuneration. Physical capital is the stock of produced
goods that are used in the production of other goods and services. Land
comprises all free gifts of nature such as land, forests, minerals etc.
Firms choose a production technique to minimise the cost of producing
a particular output level. By considering each level of output, they can
construct a total cost curve. Factor demand curves are derived demands.
A shift in the output demand curve for the industry will shift the derived
factor demand curve in the same direction. A firm will hire a variable
factor until its marginal cost equals its marginal value product (or
marginal revenue product in the case of a firm which is not a price taker).
A rise in the price of a factor reduces the quantity demanded of that factor
due to both substitution and output effects. A rise in the price of another
factor leads to an increase in demand due to the substitution effect and a
decrease in demand for that factor due to the output effect. It is unclear
which of these effects will dominate.
The supply of labour depends in part on the decisions of individuals to
participate in the labour force and also on the number of hours they
choose to supply. Four things raise the participation rate in the labour
force: higher real wage rates, lower fixed costs of working, lower nonlabour income and changes in tastes in favour of working. Higher wages
impact on the hours of work decision through both a substitution effect,
tending to increase the supply of hours worked, and an income effect,
which at high wage levels tends to reduce the supply of hours worked.
This leads to the labour-supply curve being backward bending. The
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EC1002 Introduction to economics
industry supply curve of labour depends on the wage paid relative to
wages in other industries using similar skills. Workers in unpleasant jobs
are often paid compensating wage differentials. Workers earning above
their reservation wage are said to be earning economic rent.
The wage is the rental price of labour but certain factors may lead to
wage levels being above the equilibrium level, leading to unemployment
in the labour market. These factors include minimum wage agreements,
trade unions, scale economies, insider–outsider distinctions and efficiency
wages.
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the correct response.
1. A profit maximising firm will employ labour up to the point where:
a. Marginal revenue = marginal product.
b. Marginal cost = marginal product.
c. Marginal revenue product = average cost of labour.
d. Marginal revenue product = marginal cost of labour.
2. The labour supply curve:
a. is always upward sloping
b. is always downward sloping
c. slopes upwards when the substitution effect dominates
d. slopes upwards when the income effect dominates.
3. Which of the following could explain a decrease in the demand for
labour in a particular job?
a. additional training that increases the productivity of each unit of
labour in this market
b. an increase in the amount of risk associated with this job
c. a decrease in the amount of risk associated with this job
d. a decrease in the productivity of each unit of labour in this market.
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. A fall in the rental rate of capital will always lead to a decrease in the
labour employed by a firm.
2. Parvati, who recently received a pay rise, committed to more hours
of work than last year. Hence, she must consider labour as an inferior
good.
3. The engineering industry has a high degree of labour mobility. Hence,
provided they have the technical skills needed for the job, engineers
will easily flow to industries that offer a higher wage than the industry
in which they currently work.
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Block 9: The labour market
Long response questions
1. a.Describe the impact of a change in the hourly wage on a person’s
labour supply decision, regarding both hours of work and their
participation decision.
b. Alisha earns £20 per hour for up to eight hours of work per day
and is paid £25 for every hour in excess of this. She receives
£20 per day from the government in child benefit (regardless of
whether or not she works) and pays £8 per hour for childcare for
each hour she works. If she works, she pays £5 per day for an allday bus ticket. Graph Alisha’s budget line, for an 18-hour day.
c. Give some reasons why labour markets may not clear, illustrating
with diagrams as much as possible.
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EC1002 Introduction to economics
Notes
116
Block 10: Welfare economics and the role of government
Block 10: Welfare economics and the role
of government
Introduction
Blocks 10 and 11 are about the role of government in the economy seen
from the perspective of microeconomics. The rest of the subject guide
is largely about the role of the government seen from the perspective of
macroeconomics.
Questions of what the role of government should be are extremely
important. They usually involve economics, but also involve moral and
political issues well beyond economics. At the start of the book in Chapter
1.5, BVFD explains the distinction between positive and normative
economics. ‘In positive economics, we aim to work as detached scientists.
Whatever our political sympathy or ethical code we examine how the
world actually works.... Normative economics is based on subjective
value judgements, not on the search for any objective truth…’ There are
substantial disagreements over how the world works, particularly on the
rate at which prices adjust to their market clearing level. The different
views have implications for public policy. BVFD Chapter 2.10 discusses
some popular criticisms of economics and economists, including the point
that economists disagree about important things. This is more of an issue
for macroeconomics than microeconomics. This is in large part because it
is in some ways easier to do empirical work on microeconomics and it is
easier to make comparisons across different time and places when looking
at only part of the economy.
Blocks 11 and 12 discuss what microeconomics has to say on public policy,
much of it organized around the question as to when markets work well
and when they work badly. Markets do a remarkable job in coordinating a
huge number of decisions. Very few people believe that governments should
try to suppress all markets and work with an entirely planned economy
as was attempted in the Soviet Union. Indeed it is impossible to suppress
markets altogether, and markets cannot in practice be suppressed entirely
by making them illegal when there are large profits to be made. Conversely
few people believe that there should be no role for government in the
economy; even the most pro-market people usually believe that there is a
role for government in the legal system and national defence. Other people
believe there should be a much wider role for government. What does
microeconomics have to say on this? There are a number of questions:
•
Are there prices at which all markets clear, that is supply and demand
are equal in all markets? In the diagrams you are familiar with there
are always supply and demand curves that intersect giving market
clearing price and quantity. The difficulty is that supply and demand in
one market depends on prices in other markets – this is what general
equilibrium as opposed to partial equilibrium is about. Imagine that
the market for cars fails to clear – demand exceeds supply so there
is some form of rationing. If the price of cars increases to a level that
clears the car market this has an effect on the demand for petrol, so
the price of petrol has to change – but then demand for the machinery
use in oil refineries for turning crude oil into petrol changes and so on,
and so on. It was established in the 1950’s by Arrow and Debreu that
in the general competitive model of perfect competition there is an
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EC1002 Introduction to economics
equilibrium, that is, a set of prices at which all markets clear. Proving
this required the use of some very sophisticated mathematics.
•
Are markets efficient? The concept of efficiency used here is Pareto
efficiency i.e. that it is impossible to make someone better off without
making somebody else worse off. The answer to the question as to
whether markets generate a Pareto efficient outcome is yes in the model
of general competitive equilibrium; this is the first theorem of welfare
economics. There are strong assumptions here, in particular the absence
of imperfect competition and the existence of complete markets. This
rules out externalities, see BVFD Chapter 14.5. It also requires that the
economy works as if you could buy now everything you wanted in the
future, taking into account the circumstances. For example there is a
market which sells the use of an umbrella next Wednesday if it turns out
to be raining, but not if it turns out not to be raining. The lack of this
kind of markets is referred to briefly in BVFD Chapter 14.7.
•
Does equity, the distribution of wealth and income, matter?
Economists usually consider this to be a normative question, a moral
and political judgement. But there may be important ways in which a
highly unequal society functions differently from a more equal society,
even for the well off.
•
Is there a conflict between equity and efficiency? The answer is
no in the model of general competitive equilibrium if there is a
way of redistributing endowments. This is the second theorem of
welfare economics. (See BVFD 14.2, particularly concept 14.2 for
an explanation of what an endowment is). Again there are strong
assumptions underlying this result. Other models describe a conflict
between equity and efficiency, for example in assessing the deadweight
loss due to a tax. In practice there are very few policy changes which
are Pareto improvements. There are gainers and losers. Who gains and
who loses has very important implications for politics.
•
Are there ways in which markets fail? The answer is yes. Market
failure is an important topic in economics, see BVFD 14.4–14.8. Most
importantly the idea of market failure has very important implications
for policy on climate change. As BVFD says in the section on equity
and efficiency in section 14.2 there are differences of opinion as to
how important people think market failure is. There is a correlation
between views on the importance of market failure and positions on
the political spectrum, with relatively more left-wing people tending
to think that governments should take action to correct market failure
and more right-wing people disagreeing. This is broadly correct but
overly simple – people may believe one type of market failure is
important, but not be so concerned about others.
•
What is the nature of government? Many of the ideas discussed in
this block were originally developed by people living in the US or
Europe under some form of democracy – although economists from
a much wider range of nations have contributed to their subsequent
development. Government, or the lack of government, has had very
different impacts in different countries at different times. This is a topic
much studied by economic historians and development economists.
This is a good time to think back to the questions from Chapter 1 of
BVFD which asked: what, how and for whom to produce. We have seen
how this question is answered by free markets, concentrating mostly on
markets for a single product or factor. Many economists would agree
that the free market can do quite a good job in allocating resources. But
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Block 10: Welfare economics and the role of government
how can we define what it means to do ‘a good job’? Welfare economics
uses the concepts of efficiency and equity to make normative judgements
about the workings of the market. There are reasons why markets fail in
certain circumstances and this can provide a justification for government
intervention in the economy. This block defines and discusses the concept
of externalities, where there is a clear role for government intervention
in the market. The following block will discuss the tools governments
use including taxation, redistributive spending and regulation. This block
on welfare economics is the first step towards looking at the economy
as a whole system. In contrast to the second part of the course on
macroeconomics, this block still uses microeconomic techniques; however,
it examines welfare at the economy-wide level rather than focusing on a
particular market. As such, the concept of general equilibrium is also an
important part of this block.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
define welfare economics
•
describe horizontal and vertical equity
•
discuss the concept of Pareto efficiency
•
recognise how the ‘invisible hand’ may achieve efficiency
•
define the concept of market failure
•
recognise why partial removal of distortions may be harmful
•
identify the problem of externalities and possible solutions
•
discuss how taxes can correct for externalities
•
discuss how monopoly power causes market failure
•
analyse distortions from pollution and congestion
•
analyse the economics of climate change
•
discuss why public goods cannot be provided by a market.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 14, except 14.7 and
14.8.
Synopsis of this block
This block examines how well markets work without intervention, as
well as various justifications for government intervention in markets. The
concepts of efficiency and equity are used to evaluate and make normative
judgements about various outcomes. Definitions are provided for horizontal
and vertical equity, as well as productive, allocative and Pareto efficiency.
Perfectly competitive markets are both productive and allocative efficient.
The concept of general equilibrium is introduced, which refers to a situation
where multiple (or all) markets are simultaneously in equilibrium. Reasons
for market failure include taxes, imperfect competition, externalities,
missing markets and imperfect information. When only one market is
distorted, the first-best solution is to remove the distortion. However,
when this is not possible or there are reasons why governments prefer not
to remove the distortion (for example for equity reasons), the theory of
the second-best says it is better to spread the distortion thinly over many
markets than concentrate it in one market. Governments can also act
against externalities and other distortions by allocating property rights or
imposing regulations.
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EC1002 Introduction to economics
Equity and efficiency
► BVFD: read the introduction to Chapter 14 and section 14.1.
This section introduces the twin notions of equity and efficiency. It is
particularly important to understand clearly the definitions of Pareto
optimality (an allocation of resources is Pareto efficient if any reallocation
would make at least one person worse off) and Pareto gain/improvement
(a reallocation of resources that makes at least one person better off
without making anyone worse off). Many would argue that governments
should favour reallocations that result in Pareto improvements, although
that is itself a value judgement (note the key word ‘should’). While the
notions of Pareto efficiency and Pareto improvements are useful principles,
they do have their shortcomings when applied to actual policy decisions,
for at least two reasons. Firstly, there are generally many Pareto optimal
allocations so further value judgements are required to choose the best
allocation from the set of such efficient allocations. Secondly, many policy
decisions have both winners and losers; adopting policies of this kind are
not Pareto improvements because some people are made worse off.
Equity can be broken down into horizontal and vertical equity. Horizontal
equity is ‘the identical treatment of identical people’ while vertical equity
has to do with treating people in different situations differently so as to
reduce inequalities between them. Vertical equity is the more contentious
of these two principles; it is hard to see why one would not want to treat
identical people identically, while the optimal amount of vertical equality
is a matter of considerable debate.
Efficiency has to do with making the best use of scare resources to satisfy
people’s needs and desires and can be broken down into productive and
allocative efficiency. To discuss efficiency further, it is useful to come
back to the production possibility frontier PPF introduced in Block 1 and
illustrated below.
Output of
good A
F
B
C
A
D
E
Output of good B
Figure 10.1: The production possibility frontier.
Productive efficiency is represented by any point on the PPF. Points beyond
the frontier (such as F) are unattainable and points inside (such as A)
are inefficient. Productive efficiency implies that goods and services are
produced at their lowest cost (recall from Block 5 that this has to do with
firms choosing their cost-minimising mix of inputs using the condition that
their isocost curves and isoquants are tangent to each other). More output
of one good can only be obtained by sacrificing output of other goods.
Allocative efficiency has to do with the choice between different
combinations of output – only one point on the PPF is allocatively efficient.
This is the point that aligns the efficient production possibilities with the
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Block 10: Welfare economics and the role of government
needs and preferences of society. A point on the PPF is allocatively efficient
when it is not possible to move to a different point on the PPF and make
someone better off without making someone else worse off. Allocative
efficiency is achieved when P = MC, since this means that benefit and cost
are equated. Allocative efficiency occurs when the marginal benefit equals
the marginal cost of producing one extra unit.
An equilibrium may be productively efficient without being allocatively
efficient. In other words, a market where the output generated is being
maximised isn’t necessarily maximising social welfare.
As stated above, a Pareto efficient allocation is an allocation there is no
other feasible allocation that makes someone better off without making
anyone else worse off. It relates to both productive and allocative efficiency.
Equity and efficiency are separate concepts. Efficiency doesn’t
automatically imply equity.
For example:
An economy contains two people and two goods, oranges and bananas.
Both people like both goods, but value them differently. For person 1,
one orange is exactly equivalent to two bananas, while for person 2,
two oranges are exactly equivalent to one banana. In this case, the three
following allocations are all Pareto efficient:
•
Person 1 has all the oranges and person 2 has all the bananas.
•
Person 1 has all the oranges and all the bananas.
•
Person 2 has all the oranges and all the bananas.1
It is clear that while options 2 and 3 are both Pareto efficient, they are also
highly inequitable!
It is often, but not always, the case that there is a trade-off between equity
and efficiency. An example of a government policy designed to increase
equity that can have a negative effect on efficiency is progressive marginal
taxation, since the high marginal tax rates on those with higher incomes
can reduce work incentives, reducing GDP and/or growth. In addition,
if everyone had the same income, there would be no incentive to work
hard, to change jobs, or even to get an education. Given the widespread
existence of progressive income taxation it would appear that people are
happy to trade off some efficiency for the improvement in equity, which
progressive income taxes deliver. Although equity and efficiency are often
conflicting objectives, it is important to note that this need not always
be the case. An improvement in efficiency should generally improve the
workings of the economy and generate increased growth for all. Increased
efficiency and greater equity are compatible with each other. Another
possible example of a policy that may not imply a trade off is subsidising
the education of children in low income households; this can lead both to
a more equal distribution of earnings and a more productive workforce.
There is no reason why improved efficiency must necessarily lead to
inequality.
► BVFD: read section 14.2, as well as concepts 14.1 and 14.2.
Why are these three
combinations Pareto
efficient? If person 1
has no bananas then
any trade that makes
him better off must
involve him getting at
least twice as many
bananas as he gives up
in oranges, which results
in person 2 being worse
off. Similarly, if person 2
has no oranges then any
trade that makes her
better off must involve
her getting at least
twice as many oranges
as she gives up in
bananas, which results
in person 1 being worse
off. On the other hand,
if person 1 has some
bananas and person 2
has some oranges, then
by transferring one
banana from person 1
to person 2 and one
orange from person 2 to
person 1, both of them
are made better off.
1
Efficiency and market structure
We have seen previously (in Block 6) that perfect competition is allocative
efficient because it maximises the sum of producer and consumer surplus.
A further reason is because under perfect competition, marginal cost
will be equal to price in all industries. In order to maximise profits, firms
will produce where MR = MC. Also, MR = P under perfect competition
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EC1002 Introduction to economics
because the firms face a flat demand curve and therefore have a flat MR
curve which is the same as the demand curve. Thus, P = MC under perfect
competition.
Productive efficiency can occur under a variety of market structures, as
firms will wish to produce at minimum cost in order to maximise profits.
However, allocative efficiency only occurs under perfect competition.
In imperfectly competitive markets, firms are allocatively inefficient as
P > MC.
Perfect competition has consumers trying to maximise their utility and
producers trying to maximise their profits. Market forces ensure that
an equilibrium is reached where gains to all parties are maximised.
Competitive equilibrium ensures that there is no resource transfer between
industries that would make all consumers better off.
General equilibrium
► BVFD: read concept 14.1 – general equilibrium.
Concept box 13.1 takes a general equilibrium perspective. Up to now, we
have examined equilibrium in markets for a single good or a single factor
of production, this is known as a partial equilibrium approach. General
equilibrium refers to a situation where multiple (or all) markets are
simultaneously in equilibrium.
Concept box 14.2 shows a general equilibrium between two consumers
in an exchange economy, but at the level of the market we can use our
basic supply and demand analysis to analyse general equilibrium. We
need to move from a partial to a general equilibrium approach when
there is significant interdependence between markets; where markets
are completely independent of each other, partial equilibrium analysis
suffices. The following activity is designed to help you to understand how
two markets interact and how equilibrium is attained when the goods
are substitutes. The technique is applicable also in input markets and for
complementary goods or factors.
Activity SG10.1
Coffee and tea are substitutes. The demand for each depends on its own price as well as
the price of its substitute. Supply and demand curves are given as follows:
Coffee demand:
Q DC = 60 – 6PC + 4PT
Coffee supply:
Q SC = 3PC
Tea demand:
Q DT = 20 – 2PT + PC
Tea supply:
Q ST = 2PT
where PC is the price of coffee, PT the price of tea.
a. Find the equilibrium prices and quantities for coffee and tea. Hint: both markets must
be simultaneously in equilibrium.
b. Suppose that there is a major failure in the coffee crop, leading to a large reduction
in supply. Use supply and demand diagrams to trace out the effect in both markets. In
the new equilibrium what happens to the equilibrium price and quantity of tea?
The Edgeworth box
► BVFD: read concept 13.2 – the Edgeworth box2
122
Named after Francis
Ysidro Edgeworth
(1845–1926) a pioneer
of neo-classical
economics, especially
utility theory (including
indifference curves). He
was the founding editor
of The Economic Journal,
the most prestigious
British academic journal
of economics.
2
Block 10: Welfare economics and the role of government
The Edgeworth box, here applied to exchange only (there is also a
production version) is one of the more ingenious diagrams in economics. It
looks complicated and difficult, and it does take a bit of time to master, but
the basic ideas are actually quite straightforward. The key question behind
the movements within an Edgeworth box is, if the two parties trade, can
they achieve a better allocation compared to their initial endowment,
and will this outcome be Pareto optimal? In fact, market forces (working
through the price mechanism) will achieve a Pareto-optimal allocation
when the two parties trade with each other. Furthermore, changes can
be made to the initial endowment so that any particular Pareto-optimal
outcome can be achieved. As such, the Edgeworth box can be used to
demonstrate the two theorems of welfare economics defined above.
Activity SG10.2
Household A and B of an exchange economy with two goods x and y have the utility
functions
UA(xA, yA) = xAyA
UB(xB, yB) = xByB
Household A has the initial endowment 10,16) and Household B has (25,12), so the total
amount of good x in the economy is 35, while the total amount of good y is 28.
a. Illustrate the initial endowment in an Edgeworth box
b. Assuming that this point is not on the contract curve, draw possible indifference
curves for the two households and indicate the area where trade could result in an
improvement for both households (you can draw standard indifference curves without
reference to the utility functions given above).
y
y
c. These utility functions imply MRSA = xAA and MRSB = xBB . Also, suppose the price
of good x is £0.80, while the price of good y is £1. Use this information to find the
Pareto optimal point. Clearly state which household sells which quantity of which
good and the final Pareto-optimal allocation.
d. Calculate the utility of the two households at the initial endowment and at the new
optimal point.
e. Draw your solution onto your graph along with the budget constraint and the new
utility curves at this point. Also draw the contract curve on your diagram.
Distortion of the market
► BVFD: read section 14.3.
This section reviews the effect of a specific tax on a good and emphasises
that, at least in the absence of other distortions, this will lead to a
distortion in the market for the taxed good – the marginal benefit to
consumers is no longer equal to the marginal cost to producers. The fact
that taxes are often distortionary is not an argument against all taxation,
but highlights one important aspect of taxation that must be considered
in designing a tax system. ‘Second best’ has to do with introducing new
distortions to offset existing distortions and improve efficiency. Taxation is
one specific distortion, and the concept of second-best implies widespread
taxation may be more efficient than taxes in a single market, because
this helps to keeps relative prices intact. Chapter 15 (covered in the next
block) goes into more detail on taxation. Another way of stating the theory
of second best is that when there are several distortions in place (taxes
and subsidies on various goods for example) it is not always desirable to
eliminate some of these distortions; if markets were otherwise competitive,
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EC1002 Introduction to economics
eliminating all distortions would be efficient, but eliminating some but not
others could actually make the situation worse (increase inefficiency). The
intuition is that some of the distortions may have been offsetting others
and piecemeal removal of distortions may destroy this balance.
Sources of market failure
► BVFD: read section 13.4.
This section introduces the potential sources of market failure that can
prevent a free market allocation of resources from being efficient, but
doesn’t analyse them in depth; subsequent sections do that. The following
is a list of sources of distortions that lead to market failure. Read through
and make sure you understand what each of these means:
•
market power
•
asymmetric information
•
taxation
•
common property
•
public goods
•
missing markets
•
externalities
Common property
All of these are described in BVFD except common property, which refers
to a resource such as fishing grounds or common grazing land, which is
open to everyone, but where one person’s activities detract from the total
available to everyone (in this sense common property can be thought of
as a kind of externality). For example, fish in the ocean can be caught
by anyone, but once one is caught, no-one else can catch it. Common
property tends to be over used, leading to a degradation or depletion
of the resource. This is because individuals only take into account their
private costs and benefits and neglect the social cost of their actions.
For this reason, various kinds of sea life are nearing extinction due to
overfishing. This problem applies to any common resource which is
unregulated.
Externalities
► BVFD: read section 14.5 and case 14.1.
This section explores in greater detail one of the sources of distortions
listed above – externalities. Externalities can either be positive or negative
and occur when there is a divergence between the private marginal costs
and benefits and the social marginal costs and benefits of production
and consumption. If a restaurant plays loud music, this could be either a
positive or negative externality for the restaurant next door, depending
on whether that restaurant’s clients like the music and are attracted to
eat there because of it, or if it detracts from their dining experience and
makes them less likely to choose that restaurant. In the case of a negative
externality, the restaurant playing the loud music may be required to
compensate its neighbour for their lost customers. In the case of a positive
externality, they could even ask the neighbouring restaurant to contribute
to the costs of playing the music, since that restaurant is also gaining a
benefit from it. The issue with externalities is that these payments will not
generally occur unless there is regulation, because there is no market for
the externality. The amount of noise produced by the first restaurant will
therefore be inefficient – either too much (ignoring the negative impact on
its neighbour) or too little (ignoring the positive impact on its neighbour).
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Block 10: Welfare economics and the role of government
Activity SG10.3
Using the equations below, find the level of production which will occur without
regulation and the socially optimal level of production, and calculate the social cost of
the externality. Graph your answers and shade in the area representing the social loss of
inefficient production.
Example 1: Grating, unpleasant music
Demand: DD = £40 – 0.3*Q
Marginal private cost: MPC = £10
Marginal social cost: MSC = £10 + 0.1*Q.
Example 2: Beautiful, pleasant music
Marginal private benefit: MPB = £20 – 0.2*Q
Marginal social benefit: MSB = £24 – 0.2*Q
Marginal cost: MPC = MSC = £4 + 0.2*Q.
As the next section BVFD Chapter 14.6 discusses, we live in an age where
the theory of externalities is ever more important; climate change, the
effects of pollution on human health and biological diversity, and many
other examples are increasingly at the centre of policy debates. This
section of BVFD covers the assignment of property rights as a method of
dealing with externalities. It is important to realise that, just as the optimal
size of the neighbour’s tree is not zero in the example illustrated in Figure
14.7, the fact that industrial production generates pollution as a side effect
does not mean that the socially optimal level of pollution is zero; what
is required is that the marginal cost of pollution is equal to the marginal
benefit (if it seems strange to you that pollution can have benefits,
consider the effect on the costs of production of requiring firms to reduce
pollution levels).
► BVFD: read Maths A 14.1.
This maths box provides a mathematical explanation of Coase theorem,
which states that an efficient use of resources can be achieved through
the allocation of property rights, and that this is not affected by whether
the party causing the externality or the party suffering from it is given
the property rights. In the story in this Maths box, the right to pollute
is given to Firm A. Since Firm A can sell this right to Firm B, the cost
and revenue functions of Firm B become relevant to Firm A’s production
decisions. For this reason, Firm A will decide on a level of polluting where
the marginal private cost is equal to the marginal social cost – the efficient
level of pollution in this scenario. As the textbook suggests, try to work
out the case where B is given ownership of the right to pollute. Please
work through the maths box to absorb the basic ideas behind the Coase
theorem (and also understand the reasons why it may be difficult to apply
in practice).
► BVFD: read section 14.6 and activity 14.1.
The analysis of greenhouse gas emissions is an application of the principles
discussed in section 14.5 – namely a situation where marginal social
costs dramatically exceed marginal private costs. Having determined the
optimal level of emissions in the aggregate, the key economic principle in
terms of achieving this target efficiently is the equalisation of the marginal
cost of emissions reduction between businesses/factories. That is the aim
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EC1002 Introduction to economics
of the market-based programmes such as cap-and-trade, as they use the
trading of credits between firms to allow firms with a lower marginal cost
of reducing emissions to reduce more and firms with a higher marginal
cost of reducing emissions to reduce less. This section also introduces
the important topic of social discounting and its central role formulating
climate change policy. Discount rates have to do with adjusting future
or past values so that values from different time periods can be properly
compared. The choice of the appropriate social discount rate is complex,
and probably involves some value judgements. Complex as these issues are
(and they would be studied in more depth in a specialist course on public
economics, environmental economics or cost-benefit analysis), they are
vital in determining today’s policies.
Taxes and externalities
► BVFD: read section 15.4, case 15.3 and Maths 15.2.
We have seen how an externality distorts the market, giving rise to
inefficiency. While the assignment of property rights can correct the
externality, this may not be possible. Externalities are thus an area that
may provide a strong justification for intervention through regulation.
These sections show that a tax, known as a Pigouvian tax, can be used to
correct for an externality. This is shown formally in Maths 15.2. The firm
with a negative production externality will take this into account when
determining the level of production, such that their quantity of production
will be the socially optimal quantity.
It is also possible to introduce Pigouvian subsidies to increase activities
with positive externalities.
While this maths box uses calculus, the basic analysis is the same as that
illustrated in Figure 15.6. The tax has to be set at a level equal to the
marginal damage caused by the externality at the socially optimal level
of output – it has to raise private costs so that private decision making
generates the socially optimal quantity.
While this seems like an easy fix, determining the optimal size of the
Pigouvian tax is non-trivial, as that would require estimation of the
marginal damage caused by the externality.
Public goods
► BVFD: read section 15.2 and case 15.2.
Markets tend to deal best with private goods, but there are several other
types of goods which exist. These categories depend on the combinations
of two distinct characteristics: rivalry and excludability, as defined in
BVFD. The table below clarifies all four theoretical types of goods with
examples.
Rival
Excludable
Non-excludable
Private goods Examples:
ice cream, mobile phones
Common property Examples:
fisheries, common grazing land
Non-rival (up to Club goods Examples:
capacity)
cinemas, toll roads
126
Public goods Examples:
defence, police force
Block 10: Welfare economics and the role of government
Activity SG10.4
Complete the following table:
Good
Excludable/
non-excludable?
Rival/ non-rival?
Type of good
Air
Bacon
Coal
House
Private park
Publicly
broadcast radio
Satellite
Timber
For public goods, non-excludability results in the free-rider problem.
Because people cannot be excluded from consuming the good once it has
been produced even if they don’t pay for it, they have no incentive to pay
voluntarily and the good is unlikely to be produced at all.1 That is why
there is a clear role for government in the production of public goods,
especially important goods such as national defence and policing. It should
be noted, however, that the characteristics that make it difficult to get the
good produced privately may also cause problems for public provision.
It is important to understand, see Figure 15.2 and the accompanying
text, that in analysing the optimal (efficient) amount of the public good
to produce, the demand curves of individual consumers are summed
vertically in order to get the overall demand or the marginal social
benefit at each quantity. Compare this with the method of getting the
market demand curve from the demand curves of individual consumers
for a private good. There, we summed the individual demand curves
horizontally. Each consumer of a private good equates marginal benefit
to price and price is equal to MC in a competitive market. The differences
between private and public good equilibria can be characterised, for the
case of N consumers, as follows:
Private good (perfect competition):
q1 + q2 + ... + qN = Q
MB1 = MB2 = ... = MBN = P = MC
Public good:
q1 = q2 = ... = qN = Q
MB1 + MB2 + ... + MBN = MSB = MC
where qi are individual quantities and Q is total quantity. The MBs are
private marginal benefits, MSB is social marginal benefit and MC is
marginal cost.
► BVFD: read the summary and work through the review questions.
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EC1002 Introduction to economics
Overview
This block provides an introduction to welfare economics, which involves
normative judgements as to how well the economy is working. Two
key concepts are equity (horizontal and vertical equity) and efficiency
(productive and allocative efficiency, as well as Pareto efficiency). The
textbook shows that perfect competition, under strict assumptions, is
Pareto efficient, since under perfect competition MC = MB = P. Much of
economic policy making concerns a conflict between equity and efficiency.
For example, redistributive taxes improve vertical equity but are not
allocative efficient. Perfectly competitive markets are rare in practice
and, in reality, there are many distortions which lead to market failure.
Distortions occur whenever free market equilibrium does not equate
marginal social cost and marginal social benefit. Key sources of distortions
are taxes, imperfect competition, externalities, and missing markets. The
first best solution to a distortion is to remove it and restore efficiency,
however, if distortions cannot be removed or if policy makers would rather
leave them in place than lose the benefits to equity that arise through
these distortions, the second-best solution is to spread distortions widely
over many markets rather than concentrating the distortion in a single
market, looking for ways in which distortions can be offsetting rather
reinforcing. A major cause of market failure is externalities – there are both
production or consumption externalities and these can be either positive or
negative. An externality occurs when there is a divergence of private and
social costs and benefits due to the absence of a market for the externality
itself. Inefficiencies can also occur due to information problems, such as
moral hazard, adverse selection and incomplete information. Regulations
provide information and express society’s value judgements about
intangibles. Externalities provide a further justification for government
intervention. These can be dealt with through the allocation of property
rights, the levying of taxes and/or subsidies which cause the private sector
to internalise the externality, or the imposition of standards/regulation.
Public goods are non-rival and non-excludable, and as such will tend
to be underprovided in private markets due to the free-rider problem.
Governments can provide public goods, though the socially optimal level
can be difficult to determine in practice.
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. Suppose that Bill, Jill and Al constitute the entire market for
consumers of national defence. Each individual has an identical
demand curve for national defence, which can be expressed as
P = 50 – Q. Suppose that the marginal cost for national defence can
be expressed as MC = £30. What is the optimal quantity of national
defence?
a. 150 units
b. 60 units
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Block 10: Welfare economics and the role of government
c. 40 units
d. 20 units.
Draw a diagram showing the analysis.
2. Which of the following statements is correct?
a. If a good is public then consumption by one person does not
reduce the amount available for other people.
b. A public good is a good that the government pays for.
c. Congested roads carrying a large amount of traffic are public
goods.
d. A public good is a good produced by the government
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. Each person should be willing to spend more on a public good than a
private good, as the benefits it creates can be enjoyed by everyone.
2. There is no need to impose a carbon tax if property rights are assigned.
3. If there is a negative production externality, then the optimal output is
zero.
Long response question
1. Planting a tree improves the environment: trees improve soil
quality and water retention in the soil, transforming greenhouse
gases into oxygen. Assume that the value of this environmental
improvement to society is £1 per tree for the expected lifetime of the
tree. The following equation provides the marginal private benefit:
MPB = 40 – 54 Q where Q refers to the quantity of trees demanded in
thousands.
a. Assume that the marginal cost of producing a tree for planting
is constant at £20. Draw a diagram that shows the market
equilibrium quantity and price for trees to be planted.
b. What type of externality is generated by planting a tree? Find the
optimal number of trees planted and illustrate. How does this
differ from the market outcome?
c. What is the deadweight loss corresponding to the market
outcome?
d. What policies would you suggest to reach the optimal outcome?
2. An artist produces metal sculptures using a noisy production process.
Let’s say the demand curve (showing the marginal social benefit) can
be expressed by the function:
MSB: P = 80 – 2Q where Q is the number of sculptures
The artist’s marginal private cost of producing sculptures is given by:
MPC: P = 2Q
while the marginal social cost is higher, since other people also
experience negative effects due to the noisy production process:
MSC: P = 6Q.
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EC1002 Introduction to economics
Given these equations, find
a. the free market equilibrium (price and quantity)
b. the socially optimal price and quantity
c. the Pigouvian tax that should be charged on the artist so that the
social optimal quantity of sculptures is produced
d. the revenue this tax will raise.
Food for thought – Box 3: Why is climate change such a challenge?
Climate change is one of the most pressing global challenges, with potentially disastrous
consequences, as highlighted by the 2022 UN-IPCC report . It finds that many of the humaninduced changes (the continued sea level rise, rising global temperatures and frequency of extreme
weather) are unprecedented, and already ‘irreversible’ for centuries or millennia ahead.
Scientists generally attribute the increase in global temperature to human-induced expansion of
the ‘greenhouse effect’, where the atmosphere traps heat radiating from Earth toward space. This
is closely linked to increased greenhouse gas (GHG) emissions. Thus, a key channel for containing
climate change is to reduce GHG emissions to sustainable levels. But why aren’t we doing a better
job at doing so? The answer – or at least part of the answer – relates to fundamental concepts of
externalities and coordination failure.
First, the decision to either directly or indirectly contribute to GHG emissions is often an example
of externality: where a person’s decision affects unrelated third parties. For instance, a farmer may
not consider the full cost of burning forests to clear land for farming, leading to too much forest
burning than is desirable and, in turn, more GHG emissions than is socially optimal.
Second, at an international level, the aim of reducing GHG emissions is complicated by the presence
of coordination failure between countries. Countries have often, and continue to, pledge their
emissions reduction goals (for instance, the Kyoto Protocol in 1992 and, more recently, the Paris
Agreement in 2016), however, these pledges remain non-binding and countries are tempted to
‘miss their aims’, despite evidence showing that international coordination is critical to reverse
global warming and tackle climate change.
When each country considers if they will act on their pledge to cut GHG emissions, they face a
dilemma: whereas the cost of policies to curtail emissions are clear (higher energy costs, loss of
competitiveness in the short run), the benefits of enforcement (less global warming, less extreme
climate) are highly dependent on other countries’ actions. If other countries choose not to enforce
their pledges, then the efforts of individual countries may be of limited effectiveness in reversing
the global trend. Meanwhile, there is no ‘international government’ to enforce international pledges
so, despite coordination being beneficial to all, there is likely to be a coordination failure, with each
country experiencing an incentive to deviate from their pledge.
To read more about the challenges of international climate coordination, you can access a recent
article by joint 2019 Economics Nobel prize winners Abhijit Banerjee and Esther Duflo:
Banerjee, A. and E. Duflo ‘If we can vaccinate the world, we can beat the climate crisis’ , The
Guardian June 2021.
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Block 11: Introduction to macroeconomics
Block 11: Introduction to
macroeconomics
Introduction
Macroeconomics is the study of the economy as a system. While
microeconomics is focused on the choices of an individual household or
firm and interactions in a particular market, macroeconomics examines
the whole economy and is therefore concerned with aggregates. The
demands of all the individual consumers and the supply provided by
all individual firms are aggregated together into a whole. It examines
incomes, production and prices in the aggregate rather than for particular
individuals, firms, markets or industries. The role of the government and
the financial markets in the economy also become much clearer, as do the
effects of international trade and financial transactions. Macroeconomics
makes it possible to examine certain questions which relate to the
whole economy, and which are difficult to answer if we just focus on
any individual market. Issues such as unemployment, inflation and the
business cycle can be studied much more effectively using the tools of
macroeconomic analysis and these and other issues will be covered in the
second part of the guide. We do this through the study of macroeconomic
frameworks that help us explain key trends and fluctuations in total
economic activity. This block provides an introduction to macroeconomics.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
describe the nature of macroeconomics as the study of the whole
economy
•
discuss internally consistent national accounts; why measuring GDP by
income, by expenditure or by output produces the same result
•
explain the circular flow between households and firms
•
recognise and understand the identity Y ≡ C + I + G + NX
•
explain why leakages always equal injections
•
identify nominal versus real measures of national income and output
•
describe the shortcomings of GDP as a measure of economic activity
and wellbeing
•
analyse more comprehensive measures of national income and output.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 17.
Synopsis of this block
This block (based on Chapter 17 of the textbook) provides an introduction
to macroeconomic analysis. The major concepts you will need to gain a
detailed understanding of are GDP – what it means and how it is measured;
national income accounting, especially the concept of value added; and
the circular flow of income, including injections and leakages into and out
of the system. These will be introduced in the textbook chapter and the
exercises and revision questions in this block are designed to help you work
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EC1002 Introduction to economics
through the key points and gain a better understanding. This will provide a
foundation for more in-depth analysis in the following blocks.
Macroeconomic analysis
► BVFD: read the introduction to Chapter 17 and sections 17.1.
The introduction to Chapter 17 offers a helpful yet brief explanation of the
difference between microeconomics and macroeconomics in terms of how
economic analysis is simplified so that it is manageable – microeconomics
focuses on particular markets, while macroeconomics stresses broad
aggregates.
The six definitions within section 17.1 are important, basic concepts
that you need to know – make sure you are familiar with them before
continuing.
The key questions we wish to answer from the study of macroeconomics
are:
•
Why do economies typically grow and why do some grow perform
better than others?
•
Why do economies go through “booms” and “busts” or even financial
crises?
•
Why is there always unemployment? Why does it vary across time and
countries?
•
Can governments stabilise the economy? How should they set
economic policies such as taxes, public spending, and interest rates?
•
Interdependency of different parts of the economy is more important
in macro.
•
One person’s spending is another person’s income; one person’s
borrowing is another person’s saving.
► BVFD: read section 17.2.
Activity SG11.1
Do you know the long-term trend of growth, unemployment and inflation for your
own country? If you live outside the UK/USA/EU/China it would be useful to attempt
to replicate Table 15.1 for your own country. This will help to provide you with some
empirical context for your study of macroeconomics and also show you how your own
country relates to the places that the textbook has selected. You can use the following
websites to do some research:
• stats.oecd.org
• data.worldbank.org
• www.imf.org/external/datamapper
• www.worldeconomics.com
The circular flow of income
► BVFD: read sections 17.3,17.4 and case 17.1
The economy can be described using a simple two-sector model containing
just households and firms, as represented in Table 17.4 and Figure 17.2.
Households earn income in exchange for offering their factor services,
then save or spend this income on goods and services, produced by firms
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Block 11: Introduction to macroeconomics
who hire labour, capital and benefit from investment. It is a very simple
framework with an injection into the system (investment) and a leakage
(savings) out of the circular flow. Later, other sectors will be built into this
model to make it more realistic.
You may find the following comments on Table 17.4 helpful:
•
It is assumed that firms pay out to households the difference between
the revenue they receive and the amount they pay to other firms for
inputs which are used up in production. This is the value added by
firms. It is helpful to think of this payment as having three parts:
•
Payment for things sold to firms by households. Think of this as
the wages paid to labour.
•
Interest paid to households in return for money they saved and
lent to firms to finance investment in the past.
•
Supernormal profits paid to households who own the firms.
•
You may know that in reality firms do not pay out all their profits to
households, they retain some profits and use them to fund investment.
You do not need to know about this for EC1002.
•
If you are still having difficulty understanding what is happening in
table 17.4 you might find it helpful to change the word ‘car maker’ to
‘start-up’ in row 3, column 4. Assume that the car marker already has
machines and does not need any new machines to produce cars this
year. The story is now:
•
•
The steel maker sells steel to the car maker and machine maker for
£4,000. It pays zero to other firms. Value added £4,000 = amount
paid to households.
•
The car maker buys steel from the steel maker for £3000 and sells
cars to households for £5,000. Value added £5,000 – £3,000 =
£2,000 = amount paid to households.
•
Machine maker buys steel from the steel maker for £1,000. Sells
machines to the start-up for £2,000. Value added £2,000 – £1,000
= £1,000 = amount paid to households.
•
Start up invests in machines, it buys machines for £2,000. It not
does not sell anything. It has to borrow £2,000 from households to
buy the machines. This £2,000 is equal to both household savings
and investment by the firm b. Value added zero = amount paid to
households.
Now think about the situation in which the car maker and the start-up
merge, but all the transactions are the same. This gets back to table
17.4 in the book. It is now important to make a distinction between
final and intermediate goods. Steel is an intermediate good, it is all
used up in production and none of it goes to households. Cars are a
final good, they go to households. Machines are a final good, they are
there are the end of the year. Value added for the merged car marker
and start-up is (revenue – amount paid to producers of intermediate
goods), and is, as before, £2,000. By assumption the value added is all
paid out to households, so the merged firm has to borrow £2,000 from
households in order to pay for investment in machines.
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EC1002 Introduction to economics
Measuring GDP
This section also describes the three equivalent ways of measuring the
total economic activity in the economy, namely the:
•
value of all goods and services produced
•
total value of earnings arising from the factor services supplied
•
total value of spending on final goods and services.
In principle, all methods should give the same answer; in practice,
however, there are small statistical discrepancies.
Also, ‘Food for thought box 4’ tackles the broader challenge of how we
should measure the well-being of nations.
When measuring GDP we need to think about intermediate goods. These
are goods that are used in the production of other goods or services.
What if firms need to buy goods/services from other firms to produce?
We must avoid double counting. For example, e-commerce firms use
telecommunications services as an input. An important concept that
accounts for the fact that some ouput also serves as an input is that of
value added:
Value added = Value of production – Value of intermediate goods used.
Activity SG11.2
Which of these three do you think is easiest to measure? What kind of data would you
use if you were to try to measure economic activity in these three ways?
Activity SG11.3
Fill in the blanks in the table below (based on Table 17.4)
(1) Good
(2) Seller
(3) Buyer
(4) Transaction (5) Value
Value
Added
Wood
Timber
producer
Stamp
manufacturer
£100
Wood
Timber
producer
Paper
Manufacturer
£800
Stamps
Stamp
manufacturer
Paper
manufacturer
£300
Special paper
with stamped
design
Paper
manufacturer
Households
£1,200
(6) Spending
on Final Goods
Total
Transactions
GDP
► BVFD: read Maths 17.1.
It is important that you understand national income identities by the end
of your study of macroeconomics for EC1002. You will likely benefit
from the following discussion when you come to the revision stage of your
studies, since the argument underlying it will be built up stage by stage
through the course, as we introduce government and international trade.
134
(7) Household
Earnings
Block 11: Introduction to macroeconomics
The first very important identity is:
GDP ≡ Y ≡ C + I + G + X – Z
where
C denotes consumption
I denotes investment
G denotes government expenditure
X denotes exports
Z denotes imports.
This equation represents GDP calculated by the expenditure method. You
can also think of this as what the economy produces. The identity is also
sometimes written as:
Y ≡ C + I + G + NX
where NX = X − Z corresponds to net exports.
The other very important national income identity is
Y≡C+S+T−B
Where S denotes saving, T taxes, B denotes benefits (such as state
pensions). This reflects what households do with their income.
Let’s think a little further about where this comes from. Households have
disposable income Y – T + B, which they can either save or spend on
consumption. It can also be rewritten as:
Y ≡ C + S + NT
Where NT = T – B denotes net taxes.
Taken together the two identities imply:
C + I + G + NX ≡ C + S + NT
Which can be rearranged to give:
(S – I) + (NT – G) ≡ NX
To explain the significance of this equation slightly differently from the
text, suppose that the economy is running an external deficit (NX is
negative, imports are greater than exports). This must have its counterpart
either as a private sector deficit or as a public sector deficit (or both). If,
in any sector, spending exceeds receipts there must be borrowing to pay
for the excess spending. Suppose S = I in the private sector then, if the
government is running a deficit (G > T), the government is borrowing
from abroad and there is a deficit with the rest of the world (imports
greater than exports). On the other hand, if the government account is in
balance (spending = tax receipts) then a trade deficit (exports insufficient
to pay for imports) requires borrowing in the private sector (I > S).
Furthermore, we can simplify to the simpler framework of Figure 17.2; if
the economy is closed or has balanced trade (NX = 0), and no government
or a balanced budget (NT – G = 0), then it follows that savings must equal
investment.
It is important to recognise this is an identity – that is, it must always be
true.
In later blocks we move away from pure definition and examine in some
detail economic theories about how each of the components of national
income are determined. To understand why this identity must always hold,
suppose that not all of the output the economy produced was actually sold
in the period under consideration. Does this mean output is larger than
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EC1002 Introduction to economics
expenditure? No, the unsold output is inventory accumulation by firms (it
is as if firms sold these goods to themselves) and this is included as part
of investment. If in subsequent years firms run down their inventories, net
investment falls.
Note you will sometimes see this written as (S – I) + (T – G) ≡ NX where
T is direct taxes minus welfare transfers. The general significance of the
equation is the same as the one above.
Before moving on to consider some welfare aspects of GDP, this might be a
good time to remind yourselves of the relation between the major national
income concepts summarised in Figure 17.3.
Thus:
•
National Income at basic prices + indirect taxes = Net
National Product
•
(Income) at market prices + depreciation = Gross Domestic
Product at market prices + net property income from abroad =
Gross National Product (Income) at market prices
Activity SG11.4
1. Answer the following questions to check your understanding:
a. Which components of GDP would each of the following transactions affect:
b. Your family buys a new TV.
c. All motorways are repaved.
d. You buy a bottle of Italian wine.
e. Porsche opens a new factory in England.
2. Why, in the absence of government and foreign sectors, are saving and investment
always equal? How does this change when the government and foreign sectors are
introduced?
3. The level of wealth can be measured by looking either at the gross national product
or at the GDP. Suppose that the government wants to maximise total income of
British citizens: which of the two concepts should it look at? Would you change
your answer if the aim is that of maximising the total amount of economic activity
occurring in the UK?
4. Leakages and injections – complete the following table.
Item
Leakage or Injection?
Savings
Amount (£m)
30
80
Taxes
40
Government Spending
20
Imports
25
Exports
What is the formula that summarises this relationship?
Gross domestic product (GDP)
► BVFD: read section 17.5 and case 17.2 and try to complete activity 11.1.
This section deals with real versus nominal GDP, the GDP deflator, per
capital GDP and the scope of GDP.
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Block 11: Introduction to macroeconomics
Activity SG11.5
Complete the exercises below to check your understanding.
1. Say the price level rises 10% from an index of 1 to an index of 1.1 and nominal GDP
rises from £4 trillion to £4.6 trillion. What is nominal GDP in the second period? What
is real GDP in the second period?
2. The table below shows nominal GDP for two countries A and B. Which economy
experienced higher growth in real GDP per capita between 1960 and 2010?
Country A
Country B
1980
2020
Nominal GDP (current £bn)
20
2000
GDP deflator (2010=100)
8
100
Population (bn)
1
5
Nominal GDP (current £bn)
60
5000
GDP deflator (2010=100)
1
100
Population (bn)
3
5
► BVFD: read section 17.6.
Activity SG11.6
From the chapter as a whole, what are the advantages and limitations of GDP as a
measure of wellbeing in an economy?
► BVFD: read the summary and work through the review questions.
Overview
This block started by describing the scope of macroeconomics and
macroeconomics as a study of the economy as a whole. The circular
flow was also introduced, and the block extended the discussion in the
textbook to introduce the five-sector model, including households, firms,
the government, the financial sector and the overseas sector. Leakages
from the circular flow are always equal to injections, by definition. The
net output of all factors of production is called GDP and this can be
measured in three different but equivalent ways: income, production and
expenditure. For the production method, including only the value added
at each stage is important to avoid double counting. GDP can be measured
at market prices or at basic prices (exclusive of indirect taxation).
Furthermore, there is an important distinction between nominal GDP
(measured at current prices) and real GDP (measured at constant prices).
GDP, and in particular per capita GDP, is a useful indicator of a country’s
economic situation, however, it does have limitations in terms of accuracy
and comprehensiveness.
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
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EC1002 Introduction to economics
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. Assume that a firm buys all the parts that it puts into a car for
$10,000, pays its workers $10,000 to fabricate the car, and sells it for
$22,000. In this case, the value added by the firm is:
a. $2,000
b. $12,000
c. $20,000
d. $22,000.
2. Assume GDP is 6,000, personal disposable income is 5,100, the
government budget deficit is 200, consumption is 3,800 and the trade
deficit is 100.
a. Saving (S) = 1,300, Investment (I) = 1,300, Government
spending (G) = 1000.
b. Saving (S) = 100, Investment (I) = 100, Government spending
(G) = 200.
c. Saving (S) = 200, Investment (I) = 100, Government spending
(G) = 200.
d. Saving (S) = 1300, Investment (I) = 1,200, Government spending
(G) = 1,100.
3. The leakages and injections approach implies that the government
surplus is equal to:
a. private saving less private investment plus net exports
b. private investment less private saving plus net exports
c. private investment plus private saving plus net exports
d. none of the above.
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. Katherine, who lives in Germany, recently bought a Lamborghini
produced in Italy. Hence, Katherine’s purchase does not enter
Germany’s GDP calculation.
2. In the absence of government and foreign sectors, saving and
investment are equal.
3. The table below shows nominal GDP for two countries A and B. From
the data in this table we can conclude that country A experienced
higher growth in real GDP per capita between 1960 and 2010 than
country B.
Country A
Country B
138
1960
2010
Nominal GDP (current £bn)
20
2000
GDP deflator (2010=100)
8
100
Population (bn)
1
5
Nominal GDP (current £bn)
60
5000
GDP deflator (2010=100)
1
100
Population (bn)
3
5
Block 11: Introduction to macroeconomics
Long response question
1. The graph below shows the per capita annual GDP growth rate for
Pakistan and the USA between 2000 and 2014.
6%
4%
Pakistan
2%
USA
0%
–2%
–4%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Data from the World Bank. Source: www.google.com/publicdata/
explore?ds=d5bncppjof8f9_
a. What are the key features of the trend path for each country?
b. Why is it important to compare per capita growth rates when
countries have different rates of population growth? How might
this apply to the case of Pakistan and the USA?
c. Although Pakistan shows a faster growth rate for many of the
years in the graph above, the level of per capita GDP is much
lower, as can be seen below. Briefly discuss how the magnitude of
each component of GDP is likely to differ for countries at different
stages of development.
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EC1002 Introduction to economics
Food for thought – Box 4: How should we measure the wellbeing of nations?
GDP, the value of goods and services in an economy, remains a central measurement, critical in
informing macroeconomic analysis and policy, but — though hailed as a giant conquest of 20thcentury economics — has come under increasing fire in the 21st. In response, new indicators have
been developed to supplement GDP, and the measurement of GDP itself has undergone many
improvements by national statistical and inter-governmental agencies.
The strongest and most longest-standing critique of GDP is that it is an inadequate measure of the
welfare of the population, a task for which it was, indeed, not designed. The substantial growth
of inequalities within countries (in contrast to the decline between countries) has highlighted the
reality that GDP growth per capita may be very unequally shared. Median per capita household
income is an obvious and important additional focal measure to highlight.
In a more fundamental contribution, the United Nations Development Programme in 1990 launched
the Human Development Index (HDI) as a weighted composite of variables representing national
income per capita, but also health (life expectancy) and education (initially years of schooling
and literacy rates). The HDI has itself been the focus of criticism, improvement and change, with
particular attention to inequality.
In a different direction, increased awareness that reported happiness has a tenuous link with
income has led to the increased prominence of wellbeing measures, reflected in the annual
World Happiness Report and the OECD’s ongoing ‘How’s Life?’ project. The latter was conceived
in response to the 2010 ‘Stiglitz-Sen-Fitoussi Report’ commissioned by the French government,
which examined the limitations of GDP in a comprehensive critique spanning 291 pages. The 2015
British ‘Bean Report’ by LSE Professor Sir Charles Bean devotes a more modest 100 of its pages
to desirable improvements in GDP, addressing both old and new challenges, some of which are
enumerated here.
The fact that a huge oil spill might increase GDP by stimulating economic activity in the clean-up is
an example often cited in criticism of GDP. In response to increasing awareness of environmental
damage, many ‘natural capital accounting’ measures have been developed, which continue to gain
prominence in national reporting as countries progress towards Sustainable Development Goals.
GDP from its inception excluded the value of services produced within the home, believing it would
be impossible to measure and impute these with any accuracy. This led initially to critiques by those
who believe it undervalues the contributions of women. Now this ‘production boundary’ presents
an even larger challenge in the digital age, in which we produce our own entertainment online, act
as our own travel agents and conduct valued searches for information without any cost except the
inconvenience of ads. The world of extremely low marginal cost created by increasing digitalisation
has accelerated the need to address problems posed by the fact that (more difficult to measure)
services have been steadily expanding as a weight in national output at the expense of goods.
Each criticism and new challenge has, in turn, given rise to improvements in and additions to the
measurement of GDP and well-being, but none has yet produced a replacement for GDP itself as a
‘clear and appealing’ overview of a national economy, in the words of EU critics of the original.
Read more about the OECD How’s Life? Project on their website.
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Block 12: Supply-side economics and economic growth
Block 12: Supply-side economics and
economic growth
Introduction
We begin the study of macroeconomics by focusing on the determinants
of productive potential in the long run, since GDP is the sum of goods
produced. Starting with supply-side economics, the block moves on to
discuss historical trends of long-term growth in various countries as well
as models which have been proposed to explain these trends.
Sustained economic growth has led to vast improvements in living
standards, as measured by growth in per capita output. We wish to explore
the sources of this growth and examine whether we can expect it to
continue indefinitely. Moreover, what policies are good (or bad) for growth?
At the same time, there is a lot variation in growth across countries, with a
large gap between rich and poor countries. We therefore are also interested
to examine whether we can expect the poor to catch up with the rich.
The two key models presented in this block are the Solow model –
including population growth, depreciation and technical progress;
and the Romer model of endogenous growth. We build the Solow
model up formally, beyond the coverage in the textbook, whereas for
the Romer model we focus on the main ideas rather than the formal
mathematics. Work through the material carefully – the equations, the
graphical representations, and the explanations – so you gain a robust
understanding of these models and their insights. You are also encouraged
to do some research for your own country to find out what the long-term
rate of growth has been, specific factors driving or hindering growth in
different periods, and how this fits into the world economy, as well as with
the models seeking to explain long-run growth.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
explain supply-side economics
•
discuss growth in potential output
•
describe Malthus’ forecast of eventual starvation and how technical
progress and capital accumulation made this forecast wrong
•
describe the Solow model of economic growth
•
explain the convergence hypothesis
•
analyse the growth performance of rich and poor countries
•
discuss endogenous growth and the potential impact of policy on
growth
•
discuss the implications of growth for environmental sustainability.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 18.
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EC1002 Introduction to economics
Synopsis of this block
This block discusses supply-side economics and long-run economic growth.
Data on growth rates from a variety of countries over different periods
are presented. Although many factors contribute to countries growth
rates, the basic inputs are land, raw materials, labour, human capital and
physical capital. The way these inputs are combined through technology
also has a huge impact, and technological progress is identified as the
key factor facilitating permanent growth in output per worker. This block
introduces models seeking to explain economic growth, notably the Solow
growth model and the Romer model of endogenous growth. Furthermore,
limitations in the measurement of economic growth and the costs of
growth itself are also discussed.
Supply-side economics
► BVFD: read the introduction to Chapter 18 and section 18.1.
While the main focus of this block is on economic growth (i.e. sustained
increases in economic well-being, the chapter begins with a discussion
of factors that can lead to one-off changes in output. Analytically, these
can be characterised as increases in any of the inputs in the economy’s
aggregate production function (see BVFD section 18.3) or anything that
makes a given level of these inputs more productive.
Economic growth can be represented very simply as an outward shift in a
country’s PPF. The frontier is determined by the quantity and productivity
of a country’s resources (land, labour, capital and raw materials), and an
increase in either will lead to an expansion in the country’s production
possibilities.
Output of
good A
The textbook
discussion on increasing
labour input implicitly
holds population
constant, but of course
increases in population
can increase labour
input and total output
as well. The effect of
population growth on
per capita output is, of
course, another matter,
as we discuss below.
1
Output of good B
Figure 12.1: PPF before and after economic growth.
Section 18.1 discusses supply-side policies with regards to labour input1
and labour productivity. More broadly, supply-side policy includes any
policy that improves an economy’s productive potential, with the aim of
shifting long-run aggregate supply (LRAS) to the right (we will discuss
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Block 12: Supply-side economics and economic growth
the LRAS curve a lot further in Block 17). Supply side policies include low
marginal tax rates, competition policy, privatisation of state industries, and
reducing unnecessary red tape and bureaucracy. Generally, supply-side
policies aim to increase flexibility in product or labour markets, remove
distortions to incentives, improve the quantity and quality of labour, and
increase an economy’s competitiveness.
Below is an extract from a speech on the role of supply side policies by
Jean-Claude Trichet, the President of the European Central Bank, in 2004:
The supply side of an economy is responsible for mobilising
resources to supply goods and services, entailing as a crucial part
the supply of labour and capital. The supply side thus contributes
to determining the economy’s potential growth path and the
real income of its citizens. Any malfunctioning of the economy’s
supply side is thus tantamount to leaving opportunities for
raising the welfare of its citizens non-exploited. In this regard,
the best economic measure for raising income opportunities
is the implementation of policies, which help the supply side
operate flexibly and efficiently. These policies include, among
many others, education, research and development. For the
euro area, the focus is increasingly shifting to how lasting
impediments to the functioning of these policies can be removed
with the help of structural reforms. Such well-designed structural
reforms increase the mobility of production factors towards their
most efficient use, thus raising factor productivity, opening up
additional employment opportunities and allowing for lower
prices of goods and services. By exploiting the opportunities of
such a more efficient allocation of production factors, welldesigned structural reforms allow the economy to reach a higher
sustainable long-run growth path, higher employment, higher
real incomes and thus a higher level of welfare.
As noted in BVFD, however, effective supply-side policies are difficult
to implement and often have dramatic consequences for equality and
redistribution. Various policies have been more or less successful in
different contexts, BVFD arguing that such policies are most likely to
succeed in countries where free markets can operate with minimum
regulation at the one extreme or centrally planned economies at the other.
Activity SG12.1
Do some research to find out if the current government in your country is pursuing active
supply-side policies and provide some examples of these.
Economic growth
► BVFD: read section 18.2.
This section explores the historic trends in economic growth, noting that
there was very little economic growth in what are now industrial economies
until the 18th century. Thereafter we see growth taking off in many
countries, albeit with some countries growing at a faster rate than others.
An interesting observation reinforced in Figure 18.2 and in Table 12.1 is
that anything that affects the long-run rate of economic growth by even a
very small amount makes a vast difference to potential output after a few
decades. For example, a difference in annual growth rates of just half a per
cent leads to huge differences in living standards after 25 or 50 years.
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EC1002 Introduction to economics
Annual growth
rate of income
per capita
Increase in standard of living
10 years
25 years
50 years
100 years
3.00%
34%
109%
338%
1,822%
3.50%
41%
136%
458%
3,019%
Source: own calculations based on Mankiw (Macroeconomics, 8th edition, 2012)
Table 12.1. Annual growth and standard of living differentials over time.
Inputs to production
► BVFD: read sections 18.3 and 18.4 as well as case 18.1.
These two sections describe the inputs to production and provide
information that will be very useful in understanding the models of
economic growth introduced later in the chapter. Section 18.3 can be
summarised in a production function as follows:
Y = f(Capital,Labour,Human Capital,Land,Raw Materials)
The amount of output that the available factors of production can
produce depends not only on the amount of each factor, but also on scale
economies and the way that the factors of production are combined, for
example, higher human capital may lead to higher output directly as well
as through increasing the productivity of capital.
Adding technical knowledge to this, as per section 18.4, can be expressed
in the following production function, where A represents technical
progress.
Y = A * f(Capital,Labour,Human Capital,Land,Raw Materials)
This section emphasises the importance of investment to drive invention
and innovation. Much technical progress is the result of activities by profitseeking firms. To encourage this, governments provide protection for their
ideas in the form of patents. Furthermore, governments also subsidise
research and development, for example in universities.
Writing in the late 18th century, Robert Malthus was concerned that the
fixed supply of land in the face of a growing population would, due to
diminishing returns to labour, result in eventual starvation as output
would grow less quickly than the population. Known as the ‘Malthusian
trap’, and depicted in Figure 18.4, Malthus argued that the growth in
population would drive down output per worker as the economy moves
along the production function (from A to B in Figure 18.4). Yet this
prediction proved incorrect, precisely because of investment in capital
goods and technological change that shifts up the production function
itself as in Figure 18.5.
Solow growth model
► BVFD: read section 18.5 and Maths A18.1.
This section discusses how capital accumulation is important for
sustained economic growth. In particular, the second part of section 18.5
introduces the Solow growth model, one of the most used models
in all of macroeconomics, which provides major insights into some of
the mechanisms at work in the growth process. This model was initially
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Block 12: Supply-side economics and economic growth
developed in the mid-1950s by the American economist Robert Solow,
working at MIT. Solow received the Nobel Prize in Economics in 1987 for
his contribution to growth theory.
Although the textbook describes this model (in particular in the two
diagrams 18.5 and 18.6 and Maths A18.1), it is laid out in more detail
below. This should help to make the exposition clearer so you can gain a
thorough understanding of this important model.
The Solow model starts with a simplified production function including
just capital (K) and labour (L). Labour can be defined to include human
capital; for simplicity, no distinction is made between the total population
and the labour force; also, for simplicity’s sake, land (including raw
materials) is considered as fixed and is not included.
Y = Af(K, L)
As stated above A can be thought of as a representing technology and
changes in A as representing technical progress; higher A makes both
labour and capital more productive (A is sometimes said to represent
total factor productivity).
Two key assumptions of this model are that there are constant returns to
scale (CRS) and diminishing marginal productivity of capital (MPK).CRS
means that if we multiply K and L by a constant, then Y is also multiplied
by that constant. Hence, multiplying by 1 L enable us to write the
production function in the ‘per worker’ version:
(
Y
K
= Af
,1
L
L
(
Ignoring the constant 1 and defining per capita output as and the capital
per worker as , we can express the production function in ‘per worker’
terms:
y = Af (k)
This is illustrated in Figure 18.5 of BVFD – the green line shows the
path of income against capital per worker and is concave because of the
decreasing MPK. Adding more capital per worker, k, increases output per
worker, y, but with diminishing returns. A slightly fuller version of that
diagram is presented here as Figure 12.2. This enables us to analyse the
Solow model in a bit more detail. The per worker production function is
represented by the curve labelled y. This production function represents
the supply side of the model.
The demand side is represented very simply by the equation Y = C + I,
as we saw in Block 11 (assuming G = NX = 0). Let us further assume a
constant marginal (and average) propensity to save of s. This tells us a
fraction s of income is saved and the rest consumed, so we can substitute
C = (1 – s)Y. Dividing through by L again we have:
y = (1 – s)y + i
Where denotes investment per capita. Solving gives:
i = sy = sAf(k)
(recall that savings equals investment in a closed economy). This
investment schedule is also shown in Figure 12.2 and by the orange line in
BVFD Figure 18.5. The dotted line from k* up to the green line represents
output at that level of capital per worker (y*). This can be divided into
investment (below point E) and consumption (above point E).
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EC1002 Introduction to economics
This is the basic model. It is very simple. The production function
determines the economy’s output and the consumption function determines
how this output is divided between consumption and investment.
There is one additional feature which is important; the Solow model
makes the growth of the economy’s capital stock endogenous to the
model. Investment increases the capital stock (capital deepening), while
depreciation of capital reduces it (equipment that wears out and needs to
be replaced). Let δ be the depreciation rate i.e. the proportion of the capital
stock that wears out each year. Thus:
∆K = I – δK
Dividing through by L, this can be written in per-worker terms:
∆k = i – δk = sy – δk = sAf(k) – δk
(This is equivalent to equation (1) in Maths2 A18.1, though there is no
explicit parameter A).
For the capital stock to be constant we require ∆k = 0, i.e. i = δK. We call
this position the steady state. If is not constant, but is growing (due to
population growth or immigration) at a constant rate n, then in order to
keep the capital per worker constant not only does worn out capital have
to be replaced but additional investment is required to provide capital for
the new workers resulting from population growth; so now for ∆k = 0 we
require:
i = (δ + n)k
In Figure 12.2 this is shown by the straight line with slope (δ + n). The
(δ + n)k line depicts the amount of investment that is required for capital
per worker to remain constant when there is population growth and
depreciation; in this sense, one can think of this as ‘break-even’ investment.
Having put the elements of the model in place, we can look at its long-term
equilibrium and what happens when the economy is not at the equilibrium.
Suppose the economy is at k1 in Figure 12.2. Investment is greater than
needed to offset depreciation plus population growth, so the capital stock
(per worker) increases. It will go on increasing until i = (δ + n)k (i.e. until
new investment exactly offsets depreciation and population growth). Of
course, as k increases, so does y (via the production function). Therefore,
knowing the steady state level of capital per worker, k*, also gives us
income and consumption per worker. In Figure 12.2, income per worker is
given by the point where the dotted line rising vertically from k* meets the
production function and is indicated on the diagram as y*. Consumption
per worker is the gap between income and savings.
When i = (δ +n)k we are at the steady state and so the capital stock per
worker does not change, nor does output per worker. We call these steady
state levels of capital and output per worker k*, y* respectively. To make
sure you understand how the economy always moves to the steady state
trace out what happens when k > k*.
So, in spite of its name, the long-run equilibrium in the Solow growth
model is characterised by constant output per worker and capital per
worker (with n = 0 the steady state levels of Y and K, not just per worker,
will also be constant). Growth occurs in the transition to the steady state
(or to a new steady state if something previously held constant changes).
While we don’t prove it formally here, an important aspect of transition
dynamics is that the further below its steady state output an economy is the
more rapidly it will grow (towards it). An analogous result applies if y > y*.
146
Note: Δk (used above)
denotes the change in
capital between two periods,
such as two months or
two years, while (used in
Maths 18.1) denotes the
continuous rate of change
in capital.
2
Block 12: Supply-side economics and economic growth
(δ + n)k
y, δ, i
y
y*
i = sy
consumption
net investment
depreciation
k1
k*
k
Figure 12.2: The Solow model.
Shifts in the parameters will shift the relevant lines and lead to a different
steady-state rate of capital per person. The savings rate plays an
important role in the Solow model, but it is important to understand
the exact nature of this role. For a given production function, a higher
propensity to save results in higher k* and y*. As can be seen in BVFD
Figure 18.6, a higher savings rate s shifts the savings/investment line
upwards (but not the y curve). This leads to a higher steady state level
of capital per worker and a higher output per worker. On the other hand,
a higher rate of population growth or depreciation will shift the breakeven investment line upwards, leading to a lower steady state capital per
worker and lower output per worker. Thus, the Solow model predicts that
countries with high savings rates and low rates of population growth will
tend to have higher per capita income. To some extent, this is empirically
corroborated.
Activity SG12.2
Use a graph to demonstrate how an increase in the rate of population growth can lead to
changes in the long-run level of per capita output. Will this affect the long-run per capita
growth rate?
Technical progress
► BVFD: read section 18.6.
Although the Solow model provides some useful insights, the basic model
discussed in the previous section predicts that the rate of per person
output growth tends to zero (i.e. at the steady state, growth in per
capita output is zero). Yet this is not what is observed in practice in the
developed industrial economies. What could possibly explain long run
growth? Extending the Solow model to include technical progress is key to
explaining long-run growth and the improvement in living standards over
generations.
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EC1002 Introduction to economics
We can do this in two ways. Firstly, there is the possibility of growth
in parameter (total factor productivity). Growth of this parameter
reflects Hicks neutral technical progress, which means that the
entire production function shifts upwards. That is, the economy is more
productive in combining capital and labour to produce goods and services
in general. If this happens once, then the economy transitions to the new
steady state and again there is no long term growth in per capita income.
However, if total factor productivity grew at a constant rate, the steady
state would keep changing giving rise to growth..
Activity SG12.3
Use a graph to demonstrate how an increase in total factor productivity can lead to
changes in the long-run level of per capita output. Will this affect the long-run per capita
growth rate? What if total factor productivity rises at a constant rate annually?
Another possibility is labour augmenting technical progress. Let us
explain more clearly what is meant by labour augmenting technical
progress. Consider the labour input to the production function. We have
written this as where is the number of workers. In practice, however,
we are concerned not just with the number of workers but with their
productivity. So, we can think of the labour input as being the product
L × E (henceforth ), where E is efficiency per unit of labour. So LE is units
of effective labour (worker-equivalents in BVFD), not just a head count
of workers. Now suppose that due to technical progress E is growing at a
rate t. Hold L constant to keep things simple. Effective labour is growing at
the rate of technical progress, t. If we were to redefine y, and k as output
and capital per unit of effective labour then the steady state equilibrium
would have constant y* = Y * LE and k* = K * LE For the capital stock
per effective worker to be constant, investment is needed not just to
cover depreciation and population growth but to supply the extra units of
effective labour with capital to work with – failure to do this would result
*
in reductions in capital per unit of effective labour. Note now that if Y LE
is constant, then with L constant and E growing at a rate t, Y* and
Y * L must also be growing at a rate t. Hence, with technical progress the
Solow model can produce long-run growth in per capita output.
If we drop the assumption that population and the workforce are constant,
output per worker still grows at t, but total output, Y, in the steady state
grows at t + n.
This extended model is depicted in BVFD Figure 18.7 (for the case where
δ = 0). The two differences to the diagram now that technical change has
been added is that the break-even investment line has the slope (t + n)k
and that all variables are now measured per unit of effective labour or
per worker-equivalent, not per worker. Since the technological progress
was assumed to be labour augmenting, labour productivity has increased.
Investment at the rate (t + n)k now ensures that steady state capital per
worker-equivalent, and hence output per worker-equivalent, are constant.
Since worker-equivalents grow at rate t + n and workers grow at rate n
(which is slower – since t is a positive number), output per worker and
capital per worker are increasing at rate t. With technical progress, there is
a steady state level for output and capita per worker-equivalent, but output
and capital per worker continue to grow at a positive rate over time.
Thus, the Solow model provides good insights into factors leading to
high levels of output per capita (high saving rate (s), high total factor
productivity (A), low depreciation (δ). Growth or decline will occur due
to transition dynamics when something shocks the economy away from
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Block 12: Supply-side economics and economic growth
its steady state. The model is less successful at explaining long run growth
in per capita output (income), unless ongoing technical progress can
generate such growth. However, as BVFD point out, the fact that there is no
examination of where technical progress comes from – it is simply assumed
– the model is unsatisfactory. This shortcoming is what modern endogenous
growth theory attempts to rectify, but before turning to that section 18.7 of
the text provides some more empirical background on economic growth.
OECD and growth
► BVFD: read section 18.7 and case 18.2 and complete activity 18.1
Looking at economic growth for different countries over time shows
complex patterns. There is no single, overarching path that every country
takes and can be easily described and predicted. Context matters. That is
why this section and case 18.2, although interesting, may seem somewhat
inconclusive – the OECD countries have experienced episodes of faster
and slower growth, depending on an array of factors, and the convergence
hypothesis has both examples which support it and examples which lead
many to question it. Some commentators would also question whether
the post-1973 slowdown in productivity growth really is a cyclical short
run phenomenon as BVFD argue or whether it represents a more seismic
change. There are many unanswered questions in this still developing
field. Nonetheless, the models that have been proposed and the improved
data that have been becoming more available have provided insights
into important factors behind the growth (or stagnation) of countries at
different times. Some of the factors mentioned in this section and the case
box include: historical levels of capital and output; growth in inputs –
labour, capital and human capital; productivity growth; technical progress;
the spread of technology; trade openness; absence of internal strife; a
country’s social and political framework; and supply shocks. Some of these
lie outside the sphere of influence of a domestic government, while others
can be influenced by social movements and policy decisions.
Activity 18.1 should be a good guide to whether you have properly
understood the Solow model.
Romer’s model of endogenous growth
► BVFD: read section 18.8.
One of the critiques of the Solow model is that long-term growth
comes from the rate of technical change, which is assumed rather than
endogenous to the model. In order to generate long-run growth we need
accumulation of something in the production function, but which is not
subject to diminishing returns.
This section discusses endogenous growth and Romer’s model, which is
sometimes known as the AK model. You are not required to know formal
equations of the Romer model beyond what is below. A discussion of the
key assumptions and insights of the model are what you should focus on.
Up to now we assumed a production function with diminishing marginal
returns to increases in the capital stock, which is why the production (and
savings) curves were drawn as concave to the origin in previous sections.
In contrast, the endogenous growth model proposed by Paul Romer does
not assume diminishing returns to capital, but rather constant returns to
capital, such that:
Y = AK
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EC1002 Introduction to economics
where output is proportional to capital. A represents Hicks neutral
technology or total factor productivity as before and can be held constant
in very basic endogenous growth models. Dividing through by gives the
production function in per capita terms.
y = Ak
We note that it is linear, rather than concave, due to the fact that it is not
subject to diminishing returns (MPK = A). This allows us to draw a new
diagram where we see growth is ongoing:
Output/
worker
y
sy
y1
(δ + n)k
k1
Capital/
worker
Figure 12.3: The Romer model
But why does the return to capital not diminishing? What is the intuition
behind this representation and is it reasonable? If K includes ideas and
knowledge (instructions, recipes, management techniques) as well as
objects (machines, buildings, workers, etc.) then it may well be reasonable
that K doesn’t run into diminishing returns. This is partly due to the public
goods nature of ideas – they are non-rival (although sometimes excludable
by patents and the like – recall the discussion of public goods in Block
10). If one firm uses a given technique to produce an industrial product,
or a formula to produce a medical drug, that technique, that formula,
is not used up – it is available for other firms to use also. If one firm
introduces ‘just-in-time’ inventory control that technique is still available
to other firms. One simple characterisation of constant marginal product
of K is that as countries become richer and increase physical capital, they
simultaneously increase investment in human capital; the increase in the
‘ideas’ component of K offsetting any tendency to diminishing marginal
returns in the ‘objects’ component of K.
Costs of growth
► BVFD: read section 18.9 and case 18.3
Growth in output and consumption is often associated with resource
depletion and environmental problems. At the same time inequality has
risen dramatically in recent decades as countries have grown.
Focus is now on promoting ‘sustainable growth’ and lowering inequality,
which are included in the Sustainable Development Goals (SDGs).
► BVFD: read the summary and work through the review questions.
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Block 12: Supply-side economics and economic growth
Overview
This block starts by discussing supply-side economics. Supply-side policies
aim to improve an economy’s productive potential. Higher labour input
and increases in labour productivity are important elements of supply-side
economics as are increased flexibility in product or labour markets and
improved competitiveness. Although policies which boost aggregate supply
are desirable, in practice this may be difficult to achieve.
Second, this block examines long-term economic growth. Economic
growth is most commonly measured by real GDP or real GDP per capita.
Even small annual changes in economic growth can lead to huge changes
in living standards in the long term. Potential output can be increased
either by increasing the inputs of land, labour, capital and raw materials,
or by increasing the output obtained from given input quantities. Technical
advances are an important source of productivity gains, and can be
fostered for example through subsidised research in universities and the
provision of patents for companies that make new discoveries.
The simplest theory of growth, as characterised in the Solow growth
model, has a steady state in which capital, output and labour all grow at
the same rate. Whatever its initial level of capital, the economy converges
on this steady state path. This theory can explain output growth but not
growth in output per worker (productivity growth). Labour augmenting
technical progress allows permanent growth of labour productivity.
Convergence theory argues that countries will converge, both because
capital deepening is easier when capital per worker is lower and because
of catch-up in technology. There have been several examples of this in
recent decades, where developing countries have grown much faster
than developed countries, though not all countries fit into this pattern.
Institutional frameworks impact on the adoption of new technology, which
strongly influences growth rates. Theories of endogenous growth are
built on the assumption of constant returns to capital. If this assumption
holds, the long-run growth rate of productivity can be influenced by
choices about saving and investment, providing incentives for government
to support investments in education, training, physical capital and
innovation.
Although economic growth is associated with improved living standards,
it doesn’t necessarily measure happiness (recall ‘Food for thought Box 4’
in Block 11). Furthermore, continual increases in output and consumption
today have severe consequences for the environment and for future
generations.
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
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EC1002 Introduction to economics
Sample questions
Multiple choice questions
1. ‘Capital widening’ refers to that part of investment needed to:
a. increase the per capita capital-labour ratio
b. replace capital that has depreciated
c. equip new units of labour at the same capital–labour ratio
d. do all of the above.
2. Real GDP tends to understate income in developing economies by:
a. underestimating saving
b. ignoring government deficit spending
c. omitting non-market transactions
d. all of the above.
3. Convergence implies that:
a. rich nations will grow faster than poor nations
b. the rich will get richer and the poor will get poorer
c. the rich will get poorer and the poor will get richer
d. poor nations will grow faster than rich nations.
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. Growth is always desirable.
2. In the absence of technical progress the economy converges to a state
in which output per worker always increases.
3. In the absence of technical progress an increase in the saving rate
results in a steady state with higher output per worker.
Long response question
1.
a. Starting with two production functions, show the difference
between the key assumptions of the Solow model with technical
progress and Romer’s model of endogenous growth.
b. What is the long-run growth rate of per worker output implied by
each model and what are the implications of this for government?
c. In a model without technical progress, use a diagram to
demonstrate how an increase in the rate of population growth can
lead to changes in the long-run level of per capita output. Will this
affect the long-run per capita growth rate?
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Block 13: Output and aggregate demand
Block 13: Output and aggregate demand
Introduction
In Block 12 we studied the determinants of potential output and the
dynamics for growth in living standards. We now shift our focus to the
difference between actual output and potential output. While potential
output tends to increase steadily over time, actual output tends to
fluctuate strongly, sometimes growing faster than potential output and
sometimes growing slower or even decreasing. Much of macroeconomics
is concerned with modelling the gap between actual and potential output
and understanding shorter run fluctuations in economic activity and the
effects of macroeconomic policy in managing those fluctuations. In Block 13,
we start to develop a model of the determination of output, which will be
developed further over the rest of the macroeconomic blocks. In blocks 13 to
15 we operate under a basic assumption that the price level is constant (i.e.
there is no inflation). We then relax this assumption. To start with, the focus
is on demand and actual output is assumed to be demand-determined.
Aggregate demand is defined initially as planned or desired spending and
short-run equilibrium is defined as the point where aggregate demand is
equal to actual output. In the Block 11 we saw that income and output can
be defined as Y = C + I + G + NX. In equilibrium, output and aggregate
demand are equal, hence Y = AD = C + I + G + NX. Chapter 16 goes into
more detail on consumption (C) and investment (I), while Chapter 17 looks
at government spending (G) and net exports (NX).
One very important concept in this block is the multiplier, which shows how
much equilibrium output changes due to a change in aggregate demand.
You will need to understand this, be able to calculate it and show how it is
affected by changes in consumption behaviour, taxation and imports.
In macroeconomics, there are two major policy instruments available to
the government: fiscal policy and monetary policy. Fiscal policy has to do
with government spending, taxation and the budget. By the end of this
block, you should have a good understanding of fiscal policy, including its
limitations.
The analysis in these two chapters is best understood by use of graphs, in
particular, the consumption function, the aggregate demand schedule, and
graphs of leakages against injections. You will also need to understand
the meaning of the 45-degree line (along which the values on the x-axis
are equal to the values on the y-axis) and how this can be used to indicate
equilibrium, as well as inflationary and deflationary gaps. You will need to
learn these graphs and practise drawing them. They are the building blocks
you will need in later analysis.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
contrast actual output and potential output
•
show how aggregate demand determines short-run equilibrium output
•
explain inflationary and deflationary gaps
•
define the marginal propensity to consume c and the marginal
propensity to import z
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EC1002 Introduction to economics
•
analyse consumption demand, investment demand, foreign trade and
equilibrium output
•
calculate the multiplier and the balanced budget multiplier
•
explain the paradox of thrift
•
analyse how fiscal policy affects aggregate demand
•
evaluate the limits to discretionary fiscal policy as well as automatic
stabilisers
•
explain the structural budget and the inflation-adjusted budget.
•
discuss how budget deficits add to national debt.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapters 16 and 17.
Synopsis of this block
This block covers two chapters from the textbook. Chapter 19 explores
aggregate demand, focusing on the components consumption and
investment, and examines equilibrium output, which is assumed to be
demand determined at this stage. Another important concept is the
multiplier, which shows by how much changes in autonomous demand
lead to even greater changes in output. In the simple model presented
1
in this chapter, the multiplier is equal to 1–c
, where c is the marginal
propensity to consume. Chapter 20 goes on to examine the other two
key components of aggregate demand, namely government spending
and net exports. Government decisions on spending, together with
taxation, make up the government’s fiscal policy. This is one of the two
main macroeconomic policy tools (the other is monetary policy). This
block discusses various aspects of fiscal policy, including the balanced
budget multiplier, the fiscal stance, and automatic stabilisers, as well as
the implications of deficits for national debt. This chapter also examines
the impact of imports and exports on national income. Having included
1
these two sectors, the full multiplier becomes 1–c(1–t)+z
where t is the
proportional net tax rate, c is the marginal propensity to consume and z is
the marginal propensity to import.
► BVFD: read the introduction to Chapter 19, case 19.1, sections 19.1 and
19.2 and concept 19.1.
Components of aggregate demand: consumption and
investment
Chapter 19 of BVFD looks at a closed economy with no government. (An
economy is closed if there are no imports and exports.) There are two
components of aggregate demand, consumption and investment. The
national income identities are
Y≡C+I
which is aggregate demand, and
Y≡C+S
which is what consumers use their income for. This implies I ≡ S,
investment must equal saving. This is an identity, it must always hold.
Equilibrium requires that planned investment is equal to planned saving.
For example, suppose the only good consumers consume is cars. The
car manufacturer decides how many cars to produce at the start of the
year. Consumers decide how many cars to buy at the end of the year. If
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Block 13: Output and aggregate demand
consumers demand fewer cars than are made, the unsold cars are an
unplanned investment in inventory.
•
Consumption – has to do with households and includes durable
goods (e.g. cars), nondurable goods (e.g. clothing) and services (e.g.
getting a haircut)
•
Investment – mainly has to do with firms and can be defined as
spending on capital (i.e. fixed assets used in future production).
It includes business fixed investment (such as spending on plants
and equipment), residential fixed investment (which is spending
by consumers and landlords on new housing units) and inventory
investment (which is the change in the value of all firms’ inventories).
Activity SG13.1
a. Draw the consumption function. What does the intercept mean? What does the slope
indicate?
b. Interpret the meaning of the following identities:
Y≡C+S
MPC + MPS ≡ 1
Equilibrium output
► BVFD: read section 19.3 and complete activity 19.1.
It is important to understand that in the short-run equilibrium, actual
output equals the output demanded by households as consumption and
by firms as investment. Thus in short-run equilibrium, actual output and
actual income are equal to aggregate demand (desired spending). In a
graph of desired spending against output and income, drawing a 45-degree
line from the intersection of the x and y-axis shows all of the points where
desired spending and output (and income) are equal. Where the aggregate
demand function crosses this line, we can find the short-run equilibrium
point. This diagram (Figure 19.6) is known as the Keynesian cross.
► BVFD: You must read and understand Maths 19.1. Some people find the
algebra easier to understand than the diagram.
What is the mechanism by which the economy is brought into short-run
equilibrium? Running down inventories (i.e. unplanned destocking), or
the reverse – making unplanned additions to inventory, can move the level
of output to the short-run equilibrium level. Output equals expenditure
because unsold output goes into inventory and is counted as ‘inventory
investment’ whether or not the inventory build-up was intentional. In
effect, we are assuming that firms purchase their unsold output.
Nonetheless, it is important to remember that nothing guarantees that the
short-run equilibrium is the level of potential output. Potential output is
the economy’s output when inputs are fully employed.
► BVFD: read case 19.2 – how did the financial crash affect the economy in
the country where you live? Also read section 19.4.
Planned investment equals planned savings only in equilibrium. Draw
the savings and investment functions and indicate the equilibrium output
level. What is the mechanism that brings the level of output back to
equilibrium, such that planned investment and planned savings are equal?
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EC1002 Introduction to economics
Activity SG13.2
Using the following savings and investment functions, calculate the equilibrium level of
output Y and the level of planned saving and planned investment. Draw a diagram.
S = –5 + 0.3Y
I = 55
► BVFD: read Maths 19.1.
This maths box shows why planned investment equals planned savings.
Read it through and then, without looking at the textbook, use the following
equations to show that planned investment equals planned savings:
Y = AD = C + I (in equilibrium)
C = A + cY
S=Y–C
The multiplier
► BVFD: read sections 19.5 and 19.6 and concept 19.2.
These sections introduce the concept of the multiplier. A change in
autonomous spending will result in an even greater change in equilibrium
output. The multiplier shows by how much greater the change in
equilibrium output will be, relative to the initial change in autonomous
spending. At this stage, the multiplier (which equals 1/[1 – c] or
equivalently, 1/s) only depends on the marginal propensity to save. In later
chapters when we add in the government and overseas sector, the multiplier
will also depend on taxation and imports, since these are also leakages from
consumption, just like savings.
Coming back again to Maths box 19.1 – equilibrium demand is autonomous
demand multiplied by the multiplier. The following question should now be
very straightforward:
Activity SG13.3
Given, C = 10 + 0.5Y, calculate the equilibrium output when I = 20.
Now check that Y = AD = C + I in equilibrium.
The paradox of thrift
► BVFD: read section 19.7 and case 196.4.
This is the interesting result that a change in the amount households wish
to save at each income level leads to a change in equilibrium income, but
no change in equilibrium saving, which still equal planned investment in
equilibrium.
The role of confidence
► BVFD: read section 19.8 and concept 19.3.
Business confidence plays a major role in global markets and is largely
determined by news or beliefs about the future. The emotion that drives
business and consumer confidence is sometimes also known as ‘animal
spirits’, a term used by John Maynard Keynes in The general theory of
employment, interest and money (1936).
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Block 13: Output and aggregate demand
► BVFD: read the Summary and attempt the revision questions of
Chapter 19.
Fiscal policy: government spending and taxation
BVFD sections 20.1–20.6 introduce the government. All this material is
very important and must be studied carefully.
As you know, Y = C + I + G + NX. Having examined consumption and
investment, we now introduce government spending and net exports.
► BVFD: read sections 20.1 and 20.2 as well as Maths 20.1.
The argument in BVFD 20.2 is graphical and algebraic. You may find
it helpful to see it in algebra. In a closed economy aggregate demand
consists of three things, consumption C, investment I and government
expenditure G.
Remember to begin with the situation with no government. Aggregate
demand is C + I. Consumption is given by the consumption function .The
consumption function gives C = A + cY, where A is autonomous demand
and c is the marginal propensity to consume. It is assumed that A > 0 and
0 < c < 1. It follows that:
Y = C + I = A + cY + I
implying that
Y=
A+I
(1 – c)
where 1/ (1 − c) is the multiplier. At this stage in the argument, A and I
are autonomous. They vary, but there is no description of why and how
they vary in the model at this stage. The model tells you the effects of
variation in A and I on aggregate demand.
Now we introduce the government. Aggregate demand is Y ≡ C + I +
G, where G is government expenditure. Households use their income to
consume, save and pay taxes so Y ≡ C + S + T. The accounting identity is
C+I+G=C+S+T
so
G−T=S−I.
The gap between savings and investment S − I is equal to the government
deficit G – T. Another way of looking at this is that
S≡I+G+T
This is an identity. Savers can do two things: they can lend money to firms
which use it for investment or they can lend it to the government to cover
the deficit. Equilibrium requires that planned saving is equal to planned
investment + the planned government deficit.
Suppose to begin with that the government decides how much to spend
G and the total amount of tax they want households to pay T. Households
spend out of their income after tax Y − T and the consumption function is
C = A + c(Y – T). Then
Y = C + I + G = A + c(Y – T) + I + G
A, T, G and I are treated as autonomous. Then
(1 – c) Y = A + I + G – cT .
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EC1002 Introduction to economics
Hence:
Y=
A + I + G – cT
(1 – c)
The multiplier is on government expenditure is 1/ (1 − c).
Now suppose that instead of deciding on total tax revenue government
sets the tax rate t; for every additional pound that the household earns
it pays extra tax £t. After tax income is (1 − t)Y and the consumption
function is A + c (1 − t)Y. Aggregate demand is Y = C + I + G, so
Y = C + I + G = A + c(1 – t)Y + I + G
so
(1 − c(1 – t))Y = A + I + G
Y=
A+I+G
1 – c(1 – t)
The multiplier is now 1/ (1 − c (1 − t)) which is smaller than the
multiplier with no government 1/ (1 − c), but remains greater than 1.
What is the intuition behind this? Fiscal spending increases aggregate
demand and thus income but with proportional taxes this induces a higher
tax bill increasing leakages.
The arithmetic example in BVFD section 20.3 discusses a situation which
BVFD call the ‘balanced budget multiplier’. This is not the usual
meaning of the term balanced budget multiplier, and you
should not read the arithmetic example they provide.
The standard model with a balanced budget multiplier assumes
that government expenditure G = T = tax revenue so consumption
C = A + c(Y − G). Then
Y = C + I + G = A + c(Y – G) + I + G
so
(1 – c)Y = A + I + (1 – c)G
so
Y=
A+I
+G
(1 – c)
expenditure is 1. This is the balanced budget multiplier. Output increases
with G even though the budget is balanced.
Activity SG13.4
Draw the aggregate demand schedule with and without the government sector given the
following parameters:
C = 200 + 0.6YD
I = 300
G = 200
t = 0.3
What is the change in equilibrium output?
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Block 13: Output and aggregate demand
The budget
► BVFD: read section 20.4 to 20.6 as well as concept 20.1. Complete
activity 20.1.
Activity SG13.5
Complete the following table.
Three ways of reducing debt as a percentage of nominal GDP:
Grow Your Way Out
Create Inflation
Default
Explanation:
Explanation:
Explanation:
Historical example:
Historical example:
Historical example:
Recommended approach?
Recommended approach?
Recommended approach?
Foreign trade: exports and imports
► BVFD: read section 20.7.
This introduces the fourth sector in our circular flow model: the rest of the
world. We now have the complete equation: In equilibrium,
Y = AD = C + I + G + X – M
► BVFD: read Maths A20.
The full multiplier, taking into account all leakages savings, taxation
and imports, is lower than in the simple, two-sector model, at
1/[1 – c(1 – t) + z].
Activity SG13.6
Show the full multiplier for an open economy 1/[1 – c(1 – t) + z] is equivalent to can
equivalently be expressed as the 1/[t+s (1 – t) + z].
This activity showed that 1/[1 – c(1 – t) + z] = 1/[t + s(1 – t) + z].
These two expressions of the full multiplier (for an open economy with
government) show how including the additional sectors reduce the size
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EC1002 Introduction to economics
of the multiplier compared to an economy with just households and firms
(where the multiplier is simply 1/[1 – c] = 1/s). While a closed economy
with no government sector has only one leakage – savings – an open
economy with government has three leakages – savings, taxation and
imports. In both cases, the multiplier is calculated as the inverse of the
marginal propensity to withdraw. The lower the marginal propensity to
withdraw (lower savings rate, lower marginal tax rate, lower marginal
propensity to import), the greater the final increase in income that will
result from additional spending.
► BVFD: read the summary and complete the review questions.
Overview
This block examines the components of aggregate demand, as well as how
aggregate demand determines output, based on the multiplier effect.
Aggregate demand is defined in this block as planned or desired spending
and short-run equilibrium is defined as the point where aggregate
demand is equal to actual output. In equilibrium, output and aggregate
demand are equal, hence Y = AD = C + I + G + NX. Chapter 19 of the
textbook examines consumption and investment. Consumption consists of
autonomous consumption (at zero income) plus the proportion of income
that is spent rather than saved. This proportion is represented by the
marginal propensity to consume (MPC). Investment is treated as constant.
When prices and wages are fixed, the goods market is in equilibrium when
planned spending equals actual spending and actual output (not potential
output). In equilibrium, planned saving equals planned investment. When
the goods market is not in equilibrium, companies’ inventory levels will
change to restore equilibrium – either through unplanned disinvestment
(reductions in inventories) or unplanned investments (increases in
inventories). Changes in inventory send a signal to firms to increase or
decrease future output levels. Such changes in planned investment lead to
greater changes in equilibrium output, due to the multiplier effect. In its
simplest form, the multiplier is equal to 1/(1 – MPC).
Chapter 20 of the textbook examines the government spending and net
exports components of aggregate demand/output. The government levies
taxes and buys goods and services. Taxes reduce private disposable income
and hence consumption. Government spending raises aggregate demand
and equilibrium output. An equal increase in government spending and
taxation leads to an increase in aggregate demand and output, which is
known as the balanced budget multiplier. Government decisions regarding
spending and taxation are known as fiscal policy. Fiscal policy can either
be expansionary or contractionary, in practice however, fiscal policy
cannot completely stabilise output. The budget deficit is a poor indicator
of the government’s fiscal stance, because it is not only influenced by
discretionary policy decisions, but also by economic conditions. Automatic
stabilisers such as unemployment benefits act to reduce fluctuations in
GDP. Budget deficits add to the national debt.
The final element of the equation is net exports. Exports raise aggregate
demand and can be viewed as autonomous. Imports are a leakage and
are assumed to rise with domestic income. Both taxes and imports reduce
the effect of the multiplier. In the full model, the multiplier is equal to
1
1
=
[1–c(1–t)+z]
[t+s(1–t)+z] . In equilibrium, desired leakages (S + NT + Z)
must equal desired injections (G + I + X).
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Block 13: Output and aggregate demand
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. Which of the following statements is false?
a. Actual saving is always equal to actual investment.
b. Planned saving is always equal to planned investment.
c. Firms adjust their inventories which ensures that saving and
investment are equal.
d. Consumers must sometimes adjust their savings patterns so that
saving and investment are equal.
2. Potential output is:
a. The maximum an economy could conceivably make.
b. The output when every market in the economy is in long-run
equilibrium.
c. The amount of production a country is striving for through
technological innovation.
d. The output when there are no unemployed workers.
3. In the model of national income determination investment,
government expenditure, and tax revenue, are all taken to be
exogenous. A more sophisticated model recognises that there are
automatic stabilisers. Which of the following statements about the
model with automatic stabilisers is correct?
a. Tax rates must change for automatic stabilisers to work.
b. In the model with automatic stabilisers tax revenue automatically
falls when national income increases.
c. In the model with automatic stabilisers government expenditure
automatically increases when national income increases.
d. The multiplier is lower in the model with automatic stabilisers
than it is in the model without automatic stabilisers.
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. Consider a closed economy with no government. Assume that
consumption is given by C = A + cY and Y = C + I where A is a
positive constant and 0 < c < 1. If saving and investment are at their
planned levels and S = I then the economy is in equilibrium.
2. In a closed economy with no government consumption is given by
C = A + 0.75Y. Hence the multiplier is also 0.75.
3. Assume that consumption is given by C = A+c(Y–T) and Y = C + I
+ G where A is a positive constant and 0<c<1. If consumers become
more willing to consume out of disposable income (so c increases),
then income must fall.
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EC1002 Introduction to economics
Long response questions
1. The country of Researchland has been recently founded. It started as
a simple economy with no government. The country will then elect
its government and will finally become open to trade. This question
guides you through the formation of the country.
a. When Researchland is a closed economy with no government we
know that:
C = 100 + 0.4Y
I = 300
Draw the aggregate demand (AD) scheduled and find:
i.
the multiplier,
ii. the equilibrium level of income,
iii. the budget deficit or surplus and the trade balance.
b. The citizens of Researchland elect a government acting according
to the following equations:
G = 200
t = 0.2
Draw the aggregate demand (AD) scheduled and find:
i.
the multiplier,
ii. the equilibrium level of income,
iii. the budget deficit or surplus and the trade balance.
c. Researchland now opens its borders to trade. The following data
describes the patterns of trade:
X = 300
z = 0.4
Draw the aggregate demand (AD) scheduled and find:
i.
the multiplier,
ii. the equilibrium level of income,
iii. the budget deficit or surplus and the trade balance.
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Block 14: Money and banking; interest rates and monetary transmission
Block 14: Money and banking; interest
rates and monetary transmission
Introduction
This block introduces an economic approach to the analysis of money. The
ultimate aim of this block is understanding how monetary policy works.
There are two types of policy here. Traditionally, monetary policy worked
by controlling the monetary supply, and was based on two beliefs about
the way that monetary policy works. The first belief is that it is possible
for central banks to control the money supply. The second was that central
banks should target the rate of growth of the money supply because that
determines the rate of inflation. Things are now different, so for EC1002
you need to know very little about the traditional theory of money supply.
The way the financial system now works makes it extremely difficult to
control the money supply, and central banks have largely given up trying
to do so. The central banks of the UK (Bank of England), the USA (Federal
Reserve, often called the Fed) and the Euro Area (European Central Bank,
ECB) all have an inflation rate target. They are also concerned with the
level of output. They implement monetary policy by setting the interest
rate. Since the financial crisis they have also used quantitative easing,
which is explained in BVFD 22.6. Singapore does monetary policy very
differently, targeting the exchange rate rather than the inflation rate (a
topic discussed later in the course).
A recent innovation that has arisen from the digital revolution is
blockchain and cryptocurrencies. You can read more about this in case
21.1 and in Food for thought Box 5 ‘Is bitcoin money?’
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
explain the medium of exchange and other functions of money
•
explain how banks create money
•
differentiate between liquidity crisis and solvency crisis
•
define narrow and broad money
•
identify motives for holding money
•
discuss how money demand depends on output, prices and interest
rates
•
describe the central bank’s role in influencing the money supply and in
financial regulation
•
describe money market equilibrium
•
discuss intermediate targets and the transmission mechanism of
monetary policy
•
describe how a central bank sets interest rates and how interest rates
affect consumption and investment demand.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapters 21 and 22 (excluding
Maths A21.1 and Maths A22.1).
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EC1002 Introduction to economics
Synopsis of this block
Chapter 21 of the textbook starts by introducing money and its functions –
as a medium of exchange, a store of value, a unit of account and a standard
of deferred payment. The way that banks create money is described. The
demand for money relates to people’s motives for holding money rather
than interest-bearing financial instruments such as bonds. The quantity of
real money demanded falls as the interest rate rises. Higher real income
raises the demand for real money at each interest rate. Chapter 22
introduces the role of central banks, especially the Bank of England, and
the instruments available to the central bank in influencing the supply of
money. This chapter also examines money market equilibrium. Finally,
the targets and instruments of monetary policy are introduced, as are the
transmission mechanisms for how these impact on the real economy.
Money and banking
► BVFD: read sections 21.1–21.3 and the final part of 12.4, ‘Measures of
money’.
The bank deposit multiplier is the ratio of broad to narrow money.
The information contained in these four sections is useful background
knowledge. Read the sections through carefully and test your
understanding with the following quick questions:
•
What are the main functions of money?
•
How do banks make profits?
•
How do banks create money?
Financial crises
► BVFD: read section 21.6 and case 21.2.
If you are interested in learning more about the causes of the financial
crisis, there is a great deal of information online, including several
documentaries which have been made about it, such as ‘Inside Job’
(2010). You may also want to research the changes to regulation that have
been implemented and are still being implemented in many economies
worldwide as a result of the crisis.
► BVFD: read the summary and work through the revision questions.
Demand for money
► BVFD: the introduction to Chapter 22 and section 22.1.
This section discusses the demand for money and explains the three main
reasons people hold money rather than storing all their wealth in interestbearing assets such as bonds. These three reasons are the transactions
motive, the precautionary motive and the asset motive.
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Block 14: Money and banking; interest rates and monetary transmission
Activity SG14.1
What will happen to the demand for money in the following cases, assuming all other
factors remain constant?
a. Real incomes fall (say, because of a recession).
b. There is a general rise in prices.
c. Interest rates fall.
Money market equilibrium and monetary control
► BVFD: read sections 22.2–22.3.
Historically the money market was modelled with central banks
controlling the nominal money supply. With fixed prices this also implies
control real money balances, assuming a stable money multiplier. Thus
real money supply was drawn as a vertical schedule, as in Figure 22.1,
with a downward sloping money demand schedule (LL), such that the
interest rate adjusts to equilibrate the market.
Yet this representation of the money market doesn’t accurately describe
the fact that modern central banks set the interest rate rather than target
money supply. If we model the central bank as fixing the interest rate then
they must supply whatever money supply is demanded for selected interest
rate to prevail. The money supply in circulation is thus pinned down by
the LL schedule, given the target. This is illustrated in Figure 22.2.
Monetary policy: targets, instruments and the
transmission mechanisms
► BVFD: read sections 22.4 and 22.6.
Section 22.4 explores the ultimate objectives of monetary policy, which
could include price stability, output stabilisation, influencing the exchange
rate etc. The instrument used to achieve the target or objective is the
variable over which the central bank makes decision, such as the interest
rate.
The table below provides a summary of the transmission mechanisms of
monetary policy, showing how changes in interest rates and the money
supply impact on aggregate demand and output. However, it does not
include some important details on the permanent income hypothesis
and life-cycle hypothesis, and the link between short-term and long-term
interest rates. You can read about these in 22.5 the content and figures
will not be directly examinable.
Interested students who would like to know more about how QE works
can refer to the following articles:
www.economist.com/node/21558596
www.economist.com/blogs/economist-explains/2015/03/economistexplains-5
www.bbc.com/news/business-15198789
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EC1002 Introduction to economics
Transmission mechanisms of monetary policy:
Y = C + I + G + NX
Consumption
Investment
Wealth
Consumer
Credit
Permanent
Income
Fixed Capital
Inventories
Higher real
money supply
increases
wealth directly
The credit
available to
consumers
increases
Lower interest
rates increase
wealth
indirectly
Low interest
rates make
borrowing for
consumption
more
affordable
Consumption
demand
reflects longrun disposable
income. Lower
interest rates
increase
consumption
by increasing
the present
value of
expected future
labour income
Lower
interest rates
mean more
investment
opportunities
exceed their
opportunity
cost (with a
more powerful
impact on
long-term
investments)
Lower interest
rates reduce
the opportunity
cost of holding
inventories
Complete Activity 22.1.
► BVFD: read the summary and complete the review questions.
Overview
The four main functions of money are as a medium of exchange, a store
of value, a unit of account and a standard of deferred payment. Narrow
money, also known as high-powered money or the money base, consists
of currency in circulation plus bank’s cash reserves. Broad money (M4),
the money supply, includes deposits at banks and building societies. This
chapter examines how banks operate, as this helps generate the money
supply. Money supply is greater than the money base by a factor known
as the money multiplier, which depends on banks’ reserve ratios and the
public’s holdings of cash relative to deposits.
Moving on to the demand for money, the textbook discusses how people
have various motives for holding money, including the transactions motive,
the precautionary motive and the asset motive. The cost of holding money
is the interest foregone through not holding assets as bonds. The quantity
of real money demanded rises as the interest rate falls, and is higher at
each interest rate when real income is higher.
Banks play an important role in the economy, but this is not without risk.
Regarding financial crises arising in the banking sector, it is important to
distinguish between liquidity crises and solvency crises. One approach to
dealing with the recent financial crisis (quantitative easing) also explored
in the textbook.
We can bring together demand and supply to discuss equilibrium in
money markets. Nowadays, central banks focus on the interest rate rather
than setting a specific money supply target. The central bank’s decisions
regarding interest rates known as monetary policy. Interest rates are a
common instrument of monetary policy, and a common target is price
stability (low inflation rates).
Changes in interest rates affect the real economy through their impact
on consumption and investment. Consumption, because higher interest
rates reduce household wealth, make borrowing dearer and reduce the
166
Government
Spending
Net Exports
(Fiscal policy
is generally
determined
independently
of monetary
policy)
(The effect of
interest rates
on net exports
is covered in
later parts of
the textbook)
Block 14: Money and banking; interest rates and monetary transmission
present value of future labour income, leading to a fall in consumption.
Investment, because higher interest rates mean fewer investment projects
exceed their opportunity cost and the opportunity cost of holding
inventories increases, leading to a fall in investment.
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. All of the following are examples of financial intermediaries except:
a. commercial banks
b. stock exchanges
c. pension funds
d. insurance companies.
2. A credit crunch reduces aggregate demand by:
a. increasing the exchange rate
b. increasing interest rates
c. reducing consumption and investment spending
d. reducing the money supply.
6. Given a fixed money supply, more competition in banking could lead
to:
a. an increase in the interest rate paid on bonds
b. a decrease in the interest rate paid on bonds
c. no change in the interest rate paid on bonds
d. a decrease in the interest rate paid on bank deposits.
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. Central banks with an inflation rate target are not interested in what
happens to the output of a country.
2. A fall in real incomes results in a lower demand for money.
3. When the central bank lowers the interest rate it causes a reduction in
investments, as the return from financial assets is lower at lower rates.
Long response question
A farmer’s harvest will be worth £200 if she can borrow £100 worth of
fertiliser. The fertiliser needs to be applied now and harvest will take place
in six months’ time. There are N savers in the economy, each endowed
with £1. Each agent faces a p% chance that there will be an emergency
such as they will absolutely need their £1 three months from now.
a. Explain why a financial intermediary is needed in this situation.
b. What is the minimum value of N such that a financial intermediary can
solve the problem of getting money from savers to borrowers? (Hint: it
depends on p).
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EC1002 Introduction to economics
c. On the basis of this example, can you see what economists mean when
they say banks are engaged in maturity transformation?
d. Now for something a bit harder. Instead of p being a fixed number, suppose
that p can turn out to be small (with 90% probability) or large (with 10%
probability). Can you see a bank run developing in this case?
e. What could the role of a central bank be in this case?
Food for thought – Box 5: Is Bitcoin money?
The continued spectacular rise in price of the original and leading
cryptocurrency, Bitcoin, soaring to $60,000 per BTC in February 2021, though
falling back to a mere 44 times its initial value in August 2021, has raised the
question again: Is Bitcoin money? Could it become money anytime soon?
Economists, as opposed to Bitcoin publicists, who have turned their attention
to this over the past five years, or so, answer pretty universally ‘no’. In fact,
it is the very appealing and eye-catching volatility of Bitcoin as an asset that
makes it very difficult for it to fulfil all the functions of money, even to be a
moderately stable store of value like gold.
Is Bitcoin, in fact, a medium of exchange, the most basic function of money? It
is far from universally accepted; analysing the actual usage of Bitcoin through
its registers with great care, one study found only a small percentage use it in
this way. One-third or more simply hold it as an asset. Even when Bitcoin is
used for transactions, prices are not set in BTC but dollars, euros or pounds
sterling. Some sellers have sometimes advertised they will take Bitcoin,
with great fanfare. A columnist in Forbes Online noted that almost all such
vendor offers which received publicity were a gimmick of sorts. (‘Bitcoin is a
Cryptocurrency, but is it money?’ 23 March 2021).
Is it then ‘a store of value’ – those investors have bought it and put it away
after all. Not all ‘asset classes’ are stable stores of value, and Bitcoin certainly
is not. The evidence, again, from usage and surveys, confirms that any asset
with that degree of volatility does not fit that traditional definition.
Of course, too, it is not a unit of account. No one measures their wealth in
Bitcoins. Once again, it is the volatility and dramatic change in Bitcoin that
simultaneously undermines its use as currency.
For more information, read:
• Danielsson, J. ‘What happens if bitcoin succeeds?’ VOX EU, February 2021.
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Block 15: Monetary and fiscal policy
Block 15: Monetary and fiscal policy
Introduction
Block 13 discussed the goods market while Block 14 covered the money
market. This block introduces a framework called the IS–MP model
which brings these two markets together in a basic general equilibrium
analysis, that is, it analyses the requirements for the goods and money
markets to be simultaneously in equilibrium and how this simultaneous
equilibrium is affected when certain factors, initially held constant, are
allowed to change. The IS-MP model is a simple and effective model
for examining the two key tools of demand management – fiscal and
monetary policy. After completing this block, you should understand how
the combination of these two policies (i.e. the ‘policy mix’) affects the level
of demand in the economy. This block completes the demand side of the
macroeconomics part of the course. At this stage, we are still making the
strong assumption that the price level is fixed, an assumption that will be
relaxed subsequent chapters. Because the price level is fixed there is no
distinction between nominal and real values, so that all the variables in
the analysis of this chapter can be thought of as real.
Historically the model was called the IS-LM model, where the LM schedule
depicted a monetary policy that targets money supply. This has now been
updated to reflect the fact that central banks target the interest rate. The
textbook has an appendix on the IS-LM model but you are not required to
study it and will not be examined in it. Note, some sources might call the
MP curve the LM, even though its interpretation and meaning is not the
same as the original LM of the IS-LM model.
The IS-MP model has its limitations. One criticism is that it assumes fixed
prices. Another is the fact that it is a static model, while interest rates
are meaningless unless time is a factor. Nonetheless, it is a useful model
for clarifying several fundamental mechanisms and is often still used by
policy-makers (see, for example, a defence for teaching it by the Nobel
Prize laureate Paul Krugman: http://web.mit.edu/krugman/www/islm.
html).
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
describe different forms of monetary policy
•
derive the IS curve
•
explain the MP curve
•
find equilibrium in both the output and money markets
•
link shifts in the curves to fiscal and monetary policy respectively
•
discuss the impact of fiscal policy
•
discuss the impact of a shock to money demand
•
use graphs to describe the effect of the mix of monetary and fiscal
policy.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 23 (except 23.6 and
the appendix).
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EC1002 Introduction to economics
Synopsis of this block
This chapter introduces the IS-MP model and uses this to give insights
into how monetary and fiscal policy work and how the government and
the central bank manage demand in the economy. A derivation of the
IS-MP model is included in this block (although this is not covered in the
textbook). The IS curve shows all the combinations of interest rates and
output at which the goods market (Y = C + I + G) is in equilibrium, and
the MP curve shows the combinations of interest rate and income that imply
a particular level of money demand (which the central bank supplies in
order to ensure the money market is in equilibrium).
Monetary policy
► BVFD: read section 23.1.
A key distinction is made here between rules and discretion and focuses on
monetary policy as a relationship between the state of the economy and
the interest rate chosen by the central bank.
The IS-MP model
► BVFD: read section 23.2 and case 23.1.
To derive the IS curve, we focus on the investment component of
aggregate income and start with the investment demand schedule which
shows how a decrease in interest rates leads to an increase in investment.
For example, in the graph below, a fall in interest rates from 10% to 8%
leads to an increase in investment from 150 to 200.
r
10%
8%
I
150 200
I
Δ = 50
Figure 15.1: Investment schedule.
Since investment is part of autonomous demand, the increase in investment
of 50 leads to an increase in autonomous demand of 50. As such, the
increase in demand shifts up the AD curve. If we assume that the multiplier
is equal to 5, this would lead to an increase in output from 1,500 to 1,750.
170
Block 15: Monetary and fiscal policy
AD
AD (r = 8%)
B
Δ = 50
AD (r = 10%)
A
350
300
45°
1500 1750
Y
r
10%
A
B
8%
IS
1500 1750
Y
Figure
Deriving
the
curve.
A: at 15.2:
an interest
rate
ofIS10%
the goods market is in equilibrium at 1500
B: atAanshows
interest
of 8% theingoods
market
is in equilibrium
1750
Point
anrate
equilibrium
the goods
market
where theatinterest
The
IS
curve
gives
you
all
the
combinations
of
interest
rate
and
income
rate is 10% and output is 1,500. Point B shows an equilibrium where the
where rate
the goods
is in equilibrium
interest
is 8% market
and output
is 1,750.
Mapping points A and B onto a graph of interest rates against output gives
us the IS curve. The IS curve shows all the combinations of interest rate
and income where the goods market is in equilibrium.
Deriving the IS curve
Recall the basic macroeconomic equation for a closed economy with no
government. In this case
Y = C + I.
As saving S = Y − C this implies that S = I. For this reason the curve
derived from this argument is called the IS curve (I investment, S saving).
Up to now the consumption function has been C = A + cY . Now suppose
that consumption depends on income Y and the interest rate r for reasons
discussed in Block 14, so the consumption function becomes C = A0 − ar
+ cY where a > 0; consumption is lower when the interest rate is higher.
Investment also depends on r so I = I0 − br, so
Y = A0 − ar + cY + I0 − br
which implies that
(1 − c) Y + (a + b)r = A0 + I0 .
As c < 1, so 1 − c > 0, and as a > 0 and b > 0, so a + b > 0. If you draw
this line in a diagram with r on the vertical axis and Y on the horizontal
axis you get a downward sloping straight line.
Now continue to assume that the economy is closed and introduce a
government with expenditure G and tax revenue T so
Consumption = A0 − ar + c(Y − T)
Investment= I0 − br
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EC1002 Introduction to economics
Equilibrium requires that at their planned levels
Y = C + I + G = A0 − ar + c(Y − T) + I0 − br + G
so
(1 – c)Y + (a + b)r = A0 + I0 + G − cT.
As c < 1, a >0 and b >0, given the values of G and T this is a downward
sloping straight line in a graph with Y on the horizontal axis and r on the
vertical axis. Again, this line is called the IS curve. Movements along the
line are caused by changes in the interest rate. An expansionary fiscal policy,
that is, an increase in G or a decrease in T, shifts the IS curve upwards. If
consumers become more optimistic so A0 increases, or investors become
more optimistic so I0 increases, this also shifts the IS curve upwards.
Activity SG15.1
Given the following information, provide a graphical derivation of the IS curve: The
multiplier is equal to three. When interest rates are equal to 5%, autonomous demand is
200. When the interest rate rises to 8%, investment falls from 100 to 80.
The MP curve
The MPLM curve reflects the central bank’s monetary policy – that is, its
desired interest rate at each income level, money supply being passively
adjusted to maintain money market equilibrium.
Movements along the MP schedule reflect changes to implement current
monetary policy. If income rises, approaching potential output, then
central bank raises the interest rate.
•
A shift in MP curve corresponds to a change in monetary policy. A
looser monetary policy would imply a lower level of interest at any
particular income level, so the MP curve would shift downwards.
Irrespective of the shift, the central bank is passively adjusting money
supply to equal the new level of money demand.
•
The slope of the MP reflects how aggressively the central bank raises
interest rates as output and income increase. A shallow slope would
mean interest rates are not adjusted much when income changes.
•
A vertical MP schedule describes the extreme monetary policy stance
of aiming to stabilising output completely, no matter what! Read
pg. 463 for a discussion of why targeting a particular output level is
unrealistic. What would a horizontal MP reflect? Read concept 23.1 for
more details.
► BVFD: read section 23.3 to 23.5 and concept 23.1.
Complete activity 23.1.
Combining the IS and MP together gives Figure 15.3 (or figure 23.2 in
the textbook). Point X where they meet gives the interest rate- output pair
that simultaneously brings about equilibrium in the goods market and the
money market, given the central bank’s policy preferences.
172
Block 15: Monetary and fiscal policy
r
MP
X
r*
IS
Y*
Y
Figure 15.3: IS-MP
The IS-MP in action
The framework allows us to examine the effects of fiscal policy (BVFD
figure 23.4), shocks to money demand, and to explore the effects of policy
mix (BVFD figure 23.5).
As illustrated in BVFD figure 23.4, an increase in government spending,
G, shifts out the IS curve, as aggregate demand rises for any given interest
rate. For a given MP this leads to an increase in output and an increase in
interest rates. However, this increase in interest rates will lead to a fall in
private spending – as consumption and investment are crowded out. This
means that the overall increase in output is less than it otherwise would
have been. To a certain extent, the increase in government spending has
replaced private spending that would otherwise have taken place. If the
central bank also decides to loosen monetary policy, then it is possible to
keep the interest rate unchanged (in which case there is no crowding out
of consumption and investment) and the full change in income takes place
(as determined by the government spending multiplier).
Not all economists are convinced by the notion that increases in
government spending crowd out private investment. One counter
argument is that when confidence is very low, say in a deep recession,
government spending may actually crowd in private spending by boosting
confidence in the future performance of the economy.
What about a shock to money demand? It has no impact on our IS-MP
framework at all, since any change in money demand is immediately
accommodated in order to implement the monetary policy reflected by the
MP curve.
Activity SG15.2
Using the IS-MP framework, analyse i) a fiscal contraction, and ii) a tightening of the
central bank’s monetary policy so that a higher interest rate is set at each level of income.
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EC1002 Introduction to economics
Activity SG15.3
Describe the policy mix you would adopt in the following situations, assuming you are in
a position of power over both fiscal and monetary policy, and provide an explanation of
the reasoning behind your decision:
a. A very deep recession.
b. There is a need to build a solid foundation for long-term growth, but there is currently
a temporary bubble in the economy.
c. The country is heavily engaged in a war which is being fought outside of the country.
► BVFD: read section 20.7, the summary and work through the review
questions.
Overview
This block introduces the IS-MP model and explains the shape and
meaning of each curve. Fiscal policy shifts the MP curve while monetary
policy shifts the LM curve. A loosening of fiscal policy leads to a higher
interest rate and higher output, with government spending a large
part of total spending. An expansionary monetary policy leads to lower
interest rates and higher output, with private consumption spending
and investment making up a large part of total spending. These two
policies can be used to support each other or balance each other out.
Often, fiscal policy will be heavily influenced by political concerns, while
in many countries the central bank makes decisions on monetary policy
independent from political influences. This model provides a simple way
of depicting the effects of each policy, as well as policy mixes.
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. A movement along the IS curve represents:
a. A change in fiscal policy.
b. A change in monetary policy.
c. A decline in investment spending, but an increase in savings.
d. A decline in savings, but an increase in investment spending.
2. Suppose the government cuts taxes but does not change expenditure
or monetary policy. Assume that the central bank is setting the interest
rate. Which of the following statement is correct?
a. The IS curve shifts downwards.
b. The MP curve shifts downwards.
c. Income increases but the interest rate remains the sane.
d. Both income and the interest rate increase.
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Block 15: Monetary and fiscal policy
3. Which of the following causes a shift in the MP curve?
a. The government decides to lower taxes.
b. People start spending more, so the marginal propensity to consume
increases.
c. The government imposes a ban on imports from another country.
d. The central bank decides to loosen monetary policy.
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. Central banks can offset temporary demand shocks but in doing so
they will face a trade-off between stabilising output or inflation.
2. Central banks are unlikely to be able to perfectly stabilise output.
3. Crowding out prevents any additional money spent by the government
to increase the output of a country.
Long response question
1. a. The IS–MP diagram has income on the horizontal axis and the
interest rate on the vertical axis. What is the MP schedule in this
diagram? Why is it upward sloping?
b. What is the IS schedule in the IS–MP diagram? Why is it
downward sloping? Assume the economy is closed and explain
your answer mathematically.
c. Use the IS–MP model to show how fiscal and monetary policy can
be used to increase output without changing the interest rate.
d. What are the limitations of the IS–MP model that policymakers
should be aware of?
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EC1002 Introduction to economics
Notes
176
Block 16: Aggregate demand and aggregate supply
Block 16: Aggregate demand and
aggregate supply
Introduction
Blocks 13–15 discuss economic ideas that have their origins in the 1930s,
particularly in Keynes’ 1937 book, ‘The general theory of employment,
interest and money’ (always called the general theory) and Hicks’ 1937
paper which introduced the IS-LM model. The 1930’s were a time of
high unemployment and low or even negative inflation (deflation). In
this situation it was natural to ignore inflation and focus on a situation
in which the economy has the potential to produce more than it was
producing so the level of output is determined by aggregate demand. Both
Hicks (1904–1989) and Keynes (1883–1946) were very concerned about
of the possibility of inflation and, wrote about this elsewhere, but in the
situation of the 1930’s it was not a major issue. Following the 2007–08
financial crisis many countries again found themselves in a low inflation
and high unemployment situation and some economists have returned to
the ideas of Keynes and other economists of the 1930s. After World War II
(1939–45) Keynesian economics was largely the framework for economic
policy in many countries, including the USA and UK, until the 1970’s.
During this period both inflation and unemployment were low.
Prompted by a range of factors, including policy responses to the
Covid-19 pandemic and disruptions to the supply of energy, in 2022 we
find ourselves in a new era of inflation. Central banks have been raising
interest rates with caution to contain inflation, while also trying not to
slow or reverse economic recovery from the pandemic. Therefore, the
assumption of fixed prices, appropriate for the past three decades, is no
longer appropriate. We therefore should explore what drives prices and
examine the macroeconomy and macroeconomic policies in the context
of flexible prices. This block examines aggregate supply and aggregate
demand, looking at both short- and long-run adjustment.
Blocks 17 and 18 explore inflation and unemployment in a closed
economy.
Macroeconomics as discussed in BVFD works with the assumption that in
the long-term wages and prices move to their equilibrium level at which
all markets clear. However, in the short term prices are ‘sticky’ so do not
change easily, the movement to the market clearing equilibrium may be
slow, and there is scope for government intervention. We now turn to
the the relationship between short-run and long-run equilibrium in this
setting.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
describe inflation targets for monetary policy
•
explain and graph the rr schedule
•
describe how inflation affects aggregate demand
•
define aggregate demand and graph the AD schedule
•
define aggregate supply in the classical model
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EC1002 Introduction to economics
•
analyse the equilibrium inflation rate
•
describe complete crowding out in the classical model
•
recognise why wage adjustment may be slow
•
analyse short-run aggregate supply
•
discuss the effects of short-run and permanent demand and supply
shocks
•
describe how monetary policy reacts to demand and supply shocks
•
recognise flexible inflation targets
•
explain the Taylor rule.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 24.
Synopsis of this block
In a context of flexible prices and wages, this block firstly defines
aggregate demand and the AD curve, and then aggregate supply and the
AS curve. The AD-AS model can be used to show how output and the
rate of change of the price level are determined. This block examines how
the economy adjusts to different kinds of demand and supply shocks and
how the government (through the central bank) can respond to bring
output back to the potential level of output and keep inflation on target.
The different perspectives of the classical and Keynesian school on the
flexibility of prices is a key element of this chapter. One major reason
why prices are not flexible is that wages are sticky downwards. The
advantages and limitations of government intervention are discussed, as
well as various approaches to monetary policy, including flexible inflation
targeting and the Taylor rule.
Aggregate demand
► BVFD: read section 24.1.
In the early blocks on macroeconomics, there was an underlying
assumption that the price level is fixed, and aggregate demand was simply
defined as planned or desired spending. From this block onwards, we
leave this assumption behind, and can now represent aggregate demand at
various price levels. This is summarised by the (dynamic) AD curve, which
shows the relationship between output and inflation.
Section 24.1 explains why the AD curve is downward sloping in a model
with inflation on the vertical axis. Interest rates and central bank inflation
targeting are the links between inflation and output. When inflation is
high, inflation-targeting central banks raise interest rates and this reduces
those components of aggregate demand, such as investment, which are
sensitive to interest rates. Consumption is also affected by interest rates
because people often buy durable goods (such as washing machines)
on credit. In the UK, changes in the interest rate immediately affect the
cost of many mortgages (loans for buying housing). This also decreases
consumption. . It is important to be clear that the implementation of a
given monetary policy moves the economy along a given rr schedule
while a general tightening or loosening of monetary policy shifts the
whole rr schedule upwards or downwards.
► BVFD: read concept 24.1.
178
Block 16: Aggregate demand and aggregate supply
The approach adopted in BVFD for explaining the AD schedule is clarified
further in concept 24.1. This shows how input/output, interest rates and
inflation are all interrelated.
You may find it easier to see what is happening in concept box 24.1 if
you work with an algebraic model of aggregate demand. Using notation
π inflation, Y output and r real interest rate the central bank sets its real
interest rates according to its policy rule
r = gπ
where g > 0 because high inflation results in a high interest rate. This
is called the ii schedule in concept box 24.1. Monetary policy becomes
tighter if g becomes larger, because the bank sets a higher real interest rate
at each level of inflation. The IS schedule is downward sloping and has an
equation of the form r = ℎ − kY where k > 0 because at a higher interest
rate there is less consumption and investment so less output. Thus
gπ = h – kY
so
π = (h – Y) / g
is the equation of the aggregate demand schedule giving the inflation rate
π as a function of the level of output Y. As g >0 and k > 0 the aggregate
demand schedule is downward sloping.
Aggregate supply
► BVFD: read section 24.2 and case study 24.1.
We now move away from the Keynesian model, with rigid wages and
prices in which output is entirely demand determined, and include a
supply-side in the model of output determination. Aggregate supply
describes the relationship between the output that businesses willingly
produce and the rate of inflation, with other factors held constant.
Initially, the textbook introduces the vertical aggregate supply curve. This
is often known as the long-run aggregate supply curve, as it is based on
the assumption that prices and wages are completely flexible and the
real wage adjusts to clear the labour market. While almost all economists
would agree that prices and wages are flexible in the long run, the
classical school assumed they were always flexible.
For example, suppose inflation increased; if nominal wage growth did not
change then real wages would fall. But in the classical model, nominal
wage growth would match the new, higher, rate of inflation so that real
wages would be unaffected and there would be no forces acting to change
aggregate output. The vertical aggregate supply curve shows that in the
long-run there is no relationship between inflation and the level of output
(similar arguments make the level of output independent of the price
level, but in this chapter, as explained above, we relate output to inflation
rather than to the price level). The level of output is the full employment
equilibrium level and, in the long run, can co-exist with inflation at any
level. Resources are fully employed since price and wage flexibility ensures
that all markets, including the labour market, are in equilibrium, with no
shortages or surpluses.
Optional: For some interesting examples of money illusion and a fuller
discussion, see: Shafir, Diamond and Tversky (1997) ‘Money illusion’,
available at: http://qje.oxfordjournals.org/content/112/2/341.short
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EC1002 Introduction to economics
Equilibrium inflation
► BVFD: read section 24.3 to 24.5.
Now we can finally put together the pieces of the full model – aggregate
demand and aggregate supply – to show both the level of output and the
inflation rate. Where the two curves intersect, there is equilibrium in the
goods market, the money market and also the labour market. The position
of the vertical AS curve reflects potential output. The position of the AD
curve reflects the government’s monetary policy and the impact of interest
rates on the goods market.
In the long run, aggregate supply is vertical at the level of potential
output determined by the economy’s available inputs and its technology
(broadly defined). All prices, inputs and outputs increase at the same rate
so nothing real changes. For example both money wages (nominal wages)
and prices change at the same rate so the real wage, which affects both the
supply of and demand for labour, is unchanged. The equilibrium inflation
rate coincides with the inflation target.
Figure 24.5 shows why it can be useful to understand the AD curve from
the perspective of interest rates. Then, we can see how the government
can respond actively to a shift in aggregate supply. In this case, the
government responds to an increase in aggregate supply by reducing
interest rates, as this leads to an increase in aggregate demand such that
inflation is maintained at the target rate.
Activity SG16.1
Beginning at point C in Figure 24.6, where would the economy end up if there was an
adverse supply shock shifting the AS curve from AS1 to AS0 and the central bank did not
react?
Activity SG16.2
Select the appropriate response below with regards to the following two statements:
i. Central banks can offset temporary demand shocks but in doing so they will face a
trade-off between stabilising output or inflation.
ii. Central banks can offset temporary supply shocks without facing any trade-off
between stabilising output or inflation.
a. i is true and ii is false.
b. ii is true and i is false.
c. i and ii are both true.
d. i and ii are both false.
In the classical model, fiscal expansion cannot increase output. To stop
inflation rising above the target, an increase in government spending
will have to be countered by a rise in real interest rates to restore
aggregate demand to the level of potential output. This means that higher
government spending simply crowds out an equal amount of private
spending, leaving demand and output unchanged. This sub-section on
demand shocks shows why it was so revolutionary for John Maynard
Keynes to suggest, in the Great Depression of the 1930s, that the solution
was to increase government spending. One key contribution of Keynesian
economics was that, at least in the short run, prices and wages may be
sticky, such that output is not at the full employment equilibrium level. In
such a situation, increasing the level of aggregate demand by increasing
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Block 16: Aggregate demand and aggregate supply
government spending can increase output without bringing the inflation
rate above target.
Monetarism, whose most famous and influential exponent was Milton
Friedman of the University of Chicago, became popular in the 1970s and
1980s and proposes that an increase in the money supply will lead to an
increase in prices (or, in terms of the framework of this chapter, faster
growth of the nominal money supply leads to higher inflation) but would
not affect real variables in the long run. This is based on the ‘quantity
theory of money’, which is discussed further in the next chapter in chapter
25.1 (but is not part of the course and thus not examinable).
Seen very broadly, the perspectives of the classical school and the
Keynesian school can be synthesised by taking a long-run/short-run
approach. In the long run, the AS curve is vertical, as proposed by the
classical school. The following section shows why, as proposed by the
Keynesian school, this does not hold in the short run, where prices and
wages are ‘sticky’ (i.e. do not move flexibly, especially downwards).
Wage rigidity
► BVFD: read section 24.4.
This section discusses wage rigidity. It summarises why prices are sticky
(especially downwards), since wages, the largest component of firms’
costs, adjust slowly to changes in demand. Prices may also be sticky for
other reasons, such as the fact that it is costly for firms to set, implement
and advertise new prices – this may lead to a reluctance to increase prices,
even in situations where a price increase would be expected, for example
due to a major increase in costs or demand.
Short-run aggregate supply
► BVFD: read section 24.5.
Why do SAS curves slope upwards? The discussion below should help you
understand the explanation in the textbook.
In the short run, some prices cannot adjust or can only do so partially. To
derive an upward sloping short-run supply curve, this chapter assumes
a very specific type of labour market rigidity, namely that, in the shortrun, firms are stuck with a given rate of growth (note: not level) of
nominal wages inherited from previous wage negotiations. Prices change
more easily than wages. Both suppliers and demanders of labour will
have negotiated the rate of growth of money wages on the basis of their
inflation expectations (i.e. they will have implicitly been negotiating
over real wages). If the rate of change of nominal wages is fixed by wage
agreements but inflation deviates from the rate assumed by the parties
to such agreements then the real wages will differ from those implicitly
agreed by the negotiating parties.
Now suppose that for given expectations about the growth of money
wages and prices, the rate of inflation is higher than expected. Firms get
higher prices for their product and real wages are lower than expected
because prices are rising faster than was expected when nominal wage
growth was negotiated. So production becomes more profitable and firms
increase output. Similarly, if inflation is lower than expected the prices at
which firms sell their output is lower than they were counting on and real
wages are greater than expected. Output falls, unemployment increases.
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EC1002 Introduction to economics
After a period of time, if inflation deviates from its expectations and thus
the workers and firms are not receiving and paying the real wages they
negotiated, they will go back and renegotiate how fast nominal wages
grow and this in turn will shift the whole short run AS schedule, that
schedule having been drawn for a given rate of change of money wages.
The short-run aggregate supply curves in Figure 24.8 can be written:
Y = Y* + α(π – πe) where α is a positive constant and πe is expected
inflation. As explained, each supply given is based on inherited agreements
on the growth of money wages.
Shifts in the SAS curve: Each SAS curve reflects a given rate of inherited
nominal wage growth (and more generally, given input prices). When
inherited nominal wage growth is lower, firms will not increase prices
as quickly, and the SAS curve will be lower. Changes in input prices and
changes in productivity also both lead to shifts in the SAS curve.
Another interpretation of sticky wages and the response to unanticipated
inflation is discussed by Keynes in the general theory. This is the situation
in which production takes time. When the decisions are made about how
many people to employ the money wage and the nominal interest rate
are known. However, the price at which the output will be sold and the
rate of inflation are uncertain so the real wage and real interest rate are
not known for sure. People have to act on the basis of their beliefs; they
may or may not be correct about the average, but there will inevitably be
surprises.
The theory discussed here was developed before the internet was even
imagined. Now some wages are determined by algorithms and vary
minute by minute. The model discussed in BVFD simplifies by treating all
labour as being the same. More elaborate models can take into account the
fact that wages are very flexible in some but not all parts of the economy.
Adjustment to demand shocks
► BVFD: read section 24.6 and complete activity 24.1.
Section 24.6 shows how, following a demand shock, the gradual
adjustment of wage growth eventually brings output to the full
employment level (potential output) and demonstrates how short-run
aggregate supply curves and the vertical (long-run) aggregate supply curve
fit together. Below is a description of both positive and negative demand
shocks.
Starting at point A, a positive demand shock shifts the AD curve from
AD0 to AD1, leading to a higher output level and a higher rate of inflation
at point B. In time, facing higher inflation than was built into wage
negotiations and thus experiencing a falling real wage, workers will
negotiate higher wage growth and the SAS curve will start shifting
upwards to the left. The higher wage growth will be partly passed on
through higher prices, and output will fall until it is back to the long-run
equilibrium level Y*.
The adjustment process for a negative demand shock (described more
fully in section 24.6) is similar just in the opposite direction, with the AD
curve shifting left from AD0 to AD2, moving the economy into recession at
a lower rate of inflation. At point D, there is involuntary unemployment.
This will put downward pressure on future wage negotiations, resulting in
lower wage growth and a shift in the SAS curve, eventually to point E.
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Block 16: Aggregate demand and aggregate supply
AS
SAS1
Inflation
π1
π0
π2
SAS0
C
②
A
D
②
①
SAS2
B
①
E
AD1
AD0
AD2
Y*
Output, income (GDP)
Figure 16.1 Demand shocks.
► BVFD: read section 24.7.
While section 24.6 describes the adjustment mechanism of how the
economy is brought back to the potential output level via market forces
(notably the change in re-negotiated wage growth), the government can
also act discretionally to influence the level of aggregate demand. Section
24.7 outlines how the central bank can react to shocks using monetary
policy, and the advantages and limitations involved. One important point
to realise is that the downward sloping AD curve used in this chapter
implicitly assumes that the central bank is making a compromise between
stabilising inflation and output in the face of temporary supply shocks. If the
central banks cared only about the inflation target, the rr curve drawn and
explained in section 21.1 would be vertical at the target inflation rate – the
bank would immediately offset any change in actual inflation from target
by varying the interest rate. In this case the AD curve would be horizontal –
only one inflation rate would be possible, the target rate, and in the face of
temporary supply shocks real interest rates and output would have to vary
by whatever is required to maintain the inflation target. For example, an
adverse supply shock which would normally increase inflation in the short
run would have to be immediately countered by an increase in the interest
rate sufficient to hold inflation constant. Output would fall correspondingly.
Activity SG16.3
Identify the following shocks (demand or supply, permanent or temporary, positive or
negative) and use AD-AS curves to demonstrate their short-run and long-run effects on
output and inflation. Clarify the appropriate monetary policy response and its effects on
output and inflation.
i. A technological breakthrough significantly enhances productivity
ii. A major trading partner suffers a deep recession
iii. A country realises that its stock of minerals is significantly lower than what it had
previously estimated
iv. The price of a key input into production rises for some time.
► BVFD: read section 24.8, concept 24.2 and maths 24.1.
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EC1002 Introduction to economics
Activity SG16.4
Search online to find some predictions or analysis relating to the expected (or announced)
actions of a major central bank (e.g. the Bank of England, US Federal Reserve, European
Central Bank). How well do they fit with the theory described in these sections (flexible
inflation targeting and the Taylor rule)?
► BVFD: read the summary and work through the review questions.
Overview
This chapter introduces a model of aggregate demand and aggregate
supply, showing the relationships between output and inflation. The rr
schedule is introduced first to help explain the AD curve. The rr schedule
shows, under a policy of inflation targeting, how the central bank sets high
interest rates when inflation is high and low interest rates when inflation
is low. The rr schedule shifts left (right) when monetary policy is loosened
(tightened) – this means at each inflation rate, real interest rates are higher
(lower). On the assumption that the central bank is taking this approach,
the AD curve shows how higher inflation reduces aggregate demand by
inducing monetary policy to raise real interest rates.
The classical model of macroeconomics assumes full flexibility of wages
and prices and no money illusion. In the classical model, the economy is
always at full employment equilibrium. This is represented by a vertical
aggregate supply schedule at the level of potential output. Equilibrium
inflation occurs at the intersection of the aggregate demand and aggregate
supply schedules. Monetary policy is set to make the equilibrium inflation
rate coincide with the inflation target. In the classical model, fiscal
expansion cannot raise output, but will simply lead to a crowding out of an
equal amount of private spending.
In the real world, prices and wages do not adjust instantaneously. In
particular, wages are thought to be sticky downwards. This is a feature
of the Keynesian model of macroeconomics. The Keynesian model is a
good guide to short-run behaviour whilst the classical model describes
the long run. The vertical aggregate supply curve is thus called the longrun aggregate supply curve. Short-run aggregate supply curves slope
upwards. They show firms’ desired output given the inherited growth of
nominal wages. Output is responsive to inflation in the short-run because
nominal wages are already determined and people’s expectations regarding
inflation do not always prove correct. A re-negotiation of the rate of wage
growth causes a shift in the short-run aggregate supply curve.
Permanent supply shocks alter potential output. Regardless of the policy
adopted, their output effects cannot be escaped indefinitely. Temporary
supply shocks merely shift the short-run supply curve for a period.
These force central banks to make a decision on the trade-off between
output stability and inflation stability. Demand shocks however, could be
completely offset by monetary policy, if the effects were instant.
Flexible inflation targeting implies the central bank need not immediately
hit its inflation target, allowing some scope for temporary action to
cushion output fluctuations. A Taylor rule views interest rate decisions
as responding to both deviations of output from target and deviations of
inflation from target. Many central banks appear to follow a Taylor ruletype policy.
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Block 16: Aggregate demand and aggregate supply
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. In the classical model, the economy is in long-run equilibrium where
the equilibrium inflation rate is equal to the target inflation rate.
The economy suffers an adverse supply shock (such as a permanent
increase in the price of raw materials). In the new equilibrium:
a. Equilibrium inflation is below the target inflation rate and the
government needs to loosen monetary policy to achieve its target.
b. Equilibrium inflation is above the target inflation rate and the
government needs to tighten monetary policy to achieve its target.
c. Equilibrium inflation is below the target inflation rate and the
government needs to tighten monetary policy to achieve its target.
d. Equilibrium inflation is above the target inflation rate and the
government needs to loosen monetary policy to achieve its target.
2. If prices and wages are completely flexible which of the following
statements about the classical model of aggregate supply is not
correct?
a. Aggregate supply is a vertical line in the diagram with output on
the horizontal axis and inflation on the vertical axis.
b. Aggregate supply is completely unaffected by inflation.
c. If there is a shock which increases aggregate supply and no change
in monetary policy the inflation rate and output both increase.
d. If there is a shock which increases aggregate supply monetary
policy can be used to get the economy back to the original inflation
rate.
3. According to the sticky-wage model of economic fluctuations, when
inflation is lower than expected, workers get a (i) _______ real wage
than expected and (ii) _______ workers are hired than expected
(indicate which words go on the blanks labelled (i) and (ii)).
a. (i) lower, (ii) more
b. (i) lower, (ii) fewer
c. (i) higher, (ii) more
d. (i) higher, (ii) fewer.
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. Suppose the central bank of an economy controls the money supply.
With a permanent positive supply shock it is possible for the economy
to have lower inflation and lower real interest rates without the
central bank changing its monetary policy.
2. After an increase in oil prices, if the central bank wishes to maintain
the pre-shock inflation target monetary policy will have to be
tightened.
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EC1002 Introduction to economics
3. A temporary increase in raw materials prices does not warrant an
intervention from the central bank, as the shock will not cause any
change in the long-run equilibrium output of a country.
Long response questions:
1.
a. The aggregate demand and aggregate supply diagram has output
on the horizontal axis and inflation on the vertical axis. Explain the
derivation of the aggregate demand schedule from the IS schedule
and monetary policy. Why is it downward sloping? Explain your
answer mathematically.
b. What causes movements along the aggregate demand schedule?
What happens to the aggregate demand schedule if government
expenditure increases and tax revenue does not change? What
happens to the aggregate demand schedule if the target inflation
rate is increased?
c. What is the shape of the aggregate supply curve if prices and
wages are completely flexible. What determines potential output?
d. Suppose that an economy starts at a point where aggregate
demand and short and long aggregate supply are all equal. The
central bank then tightens monetary policy in order to reduce
the rate of inflation. Use a diagram to discuss what happens to
aggregate demand and supply in the short and long run.
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Block 17: Inflation
Block 17: Inflation
Introduction
In Block 16, we analysed how changes in aggregate demand and aggregate
supply affect output and inflation. Inflation, economic growth (i.e. growth
in output) and unemployment are the three key macroeconomic indicators
you will most likely have heard discussed in the media. In this block, we
focus on inflation, which is defined as a rise in the general level of prices.
This block examines the causes of inflation, its implications, as well as
policies to address it.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
discuss nominal and real interest rates and inflation
•
assess when budget deficits cause money growth
•
explain the Philips curve
•
analyse inflation expectations
•
evaluate the costs of inflation
•
discuss central bank independence and inflation control
•
analyse how central banks set interest rates.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 25 (except 25.1).
Synopsis of this block
The central topic covered in this block is the Phillips curve. The shortrun Phillips curve demonstrates a trade-off between inflation and
unemployment in response to demand shocks. The long-run Phillips curve
is vertical at equilibrium unemployment. People’s expectations regarding
inflation are central to the analysis of inflation and the difference between
the short and long-run Phillips curves. The costs of inflation include shoeleather costs and menu costs, as well as undesirable redistribution in the
case of unexpected inflation. Deflation is seen as an even greater problem
than inflation. Central bank operational independence has been a key
institutional change that has made inflation targets more credible and
facilitated a long period of low inflation in many advanced economies.
BVFD 25.1 describes the quantity theory of money. This is part of the
traditional theory of monetary economics and is not part of this course.
Money and inflation
► Read BVFD section 25.2.
This section describes the Fisher equation1:
Real interest rate = [nominal interest rate] – [inflation rate].
as well as the effect of nominal money growth on nominal interest rates
and the demand for real money. The section also distinguishes between
the Fisher equation, above, and the Fisher hypothesis which states that
real interest rates don’t vary all that much as nominal interest rates and
inflation tend to move in tandem.
Note that, strictly
speaking, this
equation is only an
approximation, but
one that is reasonably
accurate as long as
the rates are not too
large. The exact formula
is that (1+i)=(1+r)/
(1+π). Suppose the
nominal interest rate
is 8% and inflation is
5%. This makes the real
rate 2.857%. Using the
Fisher equation it is 3%.
1
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EC1002 Introduction to economics
If nominal money growth leads to a fall in demand for real money, P must
rise faster than M so that real money supply (M/P) falls in line with the
fall in demand for real money.
► BVFD: read section 25.3.
If governments have been running persistent deficits and the ratio of
accumulated debt to GDP is high they will find it difficult to continue
to finance deficits by borrowing; potential lenders fear they will not be
repaid. Governments need to tighten fiscal policy in such circumstances,
but they might instead be tempted to finance ongoing deficits by printing
money (or increasing the money supply in some equivalent manner). In an
extreme situation this results in hyperinflation.
The Phillips curve and inflation expectations
► BVFD: read section 25.4.
In 1958 Willliam Phillips published a paper establishing a statistical
relationship between unemployment and output in the UK, which became
known as the Phillips curve. This suggested that there was a trade-off.
If inflation was high unemployment was relatively low; if inflation was
low unemployment was high. However, in the late 1960s and 1970s both
inflation and unemployment were much higher than they had been in the
1950s, and early 1960s and people came to expect inflation. The Phillips
curve relationship had broken down.
The modern interpretation of the short- and long-run Phillips curve relates
closely to the concept of aggregate supply, which was introduced Block 16.
In the model short-term aggregate supply is upward sloping in a graph with
output on the horizontal axis and inflation on the vertical axis. In the long
run aggregate supply is a vertical straight line, there is no impact of inflation
on long-run aggregate supply. In the short run the the nominal (money)
wage rate is assumed to be fixed. It depends on how much inflation was
expected at the time the wage was fixed. If inflation is higher than expected
then the real wage (money wage/price of output) is lower than expected,
and employment and output are relatively high. Block 16 tells the story
in terms of output. Block 17 tells the story in terms of employment, but it
is the same story. Unexpected inflation results in higher employment and
output in the short run but expected inflation has no effect.
Up to this point in the chapter, the emphasis has been on monetary and
fiscal relationships. Section 25.4 relates these more explicitly to the
real economy (via output and unemployment) and begins to analyse
the crucial role of expectations in macroeconomics. The Phillips curve,2
which depicts the relationship between unemployment and inflation, is
introduced. Just as there was for aggregate supply, there is both a long-run
Phillips curve and a short-run Phillips curve. The short-run curve slopes
downwards, depicting a trade-off between unemployment and inflation.
This can be explained in a simple and intuitive way as follows. In the short
run, when inflation increases unemployment decreases. For example,
inflation is usually demand-pull inflation, this occurs when aggregate
demand increases. The quantity supplied by firms needs to increase to
meet the increase in aggregate demand, and to increase quantity supplied,
firms must hire more workers, hence unemployment falls. Higher prices
make firms supply more output and demand more workers. Alternatively,
when unemployment rises, inflation falls. This could be because as
188
Named after New
Zealand-born economist
A.W. Phillips, who spent
much of his academic
career at the London
School of Economics.
Apart from using
statistical methods
to investigate the
relationship between
unemployment and
inflation, the subject
of this section, Phillips
(who initially trained as
an engineer) was also
famous for building
an analogue hydraulic
computer which could
be used for modelling
the macro economy.
Several copies of this
machine still exist.
2
Block 17: Inflation
unemployment rises, people can no longer afford to buy as many goods
and services. Thus firms must lower their prices to attract customers and
inflation falls.
In its original form (naïve form, some would say) such a relationship could
be written as:
π = a0 – a1u
where a0 > 0 and a1 > 0
This trade-off at first seemed to offer a powerful lever to policy makers
seeking to an acceptable compromise in attaining two of the most
important but seemingly conflicting macroeconomic objectives (low
unemployment and low inflation). However, this trade-off was soon
revealed to be illusory over the longer term; the long-run Phillips curve is
vertical – equilibrium unemployment is independent of inflation.
Demand shocks will move the economy along the short-run Phillips curve
– permitting the economy to temporarily diverge from equilibrium levels.
Thus an inflation rate that is different from people’s expectations leads to
a movement along the short-run Phillips curve. The height of the short-run
Phillips curve is affected by people’s expectations about future inflation.
A change in expectations leads to a shift in the short-run Phillips curve.
Temporary supply shocks also affect the height of the short-run Phillips
curve (causing it to shift upwards or downwards), while permanent supply
shocks affect the position of the long-run curve.
► BVFD: read Maths 25.1.
Inflation depends on inflation expectations and the gap between the actual
and equilibrium unemployment rates. Inflation expectations also depend
on this gap. Therefore, inflation is affected by deviations of unemployment
from the equilibrium rate through two channels – directly, and also
through the impact on expectations.
Second, Equation (1) (representing the short-run Phillips curve) shows
that the gap between inflation and inflation expectations is proportionate
to the difference between actual and equilibrium unemployment.
Equation (4) shows that the gap between actual and potential output
is also proportional to the difference between actual and equilibrium
unemployment. Putting these together lets us find the short-run aggregate
supply curve (equation 5) which shows the relationship between the gap
between actual and potential output and the gap between inflation and
inflation expectations.
One of the central points in this section is the correspondence between
the Phillips curve and the aggregate supply curve (see Figure 22.6 and
associated discussion). We can see this mathematically by recalling from
the previous block that aggregate supply can be written:
Y = Y* + α(π – πe)
which we can rewrite as:
1
π = πe + α (Y – Y e)
Now we want to go from output, Y, to unemployment, U. We can do this
via a version of Okun’s Law, named after the American economist Arthur
Melvin Okun who, in the 1960s, investigated the relationship between
changes in the unemployment rate and the growth rate of output in
the USA. If we argue that deviation of output from its potential level is
inversely related to the deviation of unemployment from its equilibrium
rate (following the notation used in Maths 25.1):
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EC1002 Introduction to economics
Y – Ye = –h(U – Ue)
where h > 0.
Then substituting into the equation for inflation above we have:
π = πe – b(U – Ue)
Where b = h > 0
α
This version of the Phillips curve is sometimes called the expectationsaugmented Phillips curve, in comparison to the original or naïve
Phillips curve shown above. Note that this equation3 is the same as the
first equation in Maths 25.1, to which we return shortly. The argument
in Maths 25.1 begins with the short-run Phillips curve and shows this
to be equivalent to the short-run supply curve. Here we have done the
reverse, starting with the short-run supply curve of the previous chapter
and showing that it is equivalent to the short-run Phillips curve. It is easy
to see from this equation that when, in the long-run, actual and expected
inflation are equal, unemployment is at its natural or equilibrium rate.
Note that this argument applies to any level of actual and expected
inflation. There is no unique inflation rate corresponding to equilibrium
unemployment; equilibrium unemployment requires that expectations
about inflation are fulfilled, but this can happen at any level of inflation.
When reading news reports on the state of the economy, you may have
come across the term ‘NAIRU’, this is an acronym which means the ‘nonaccelerating-inflation rate of unemployment’. This is the unemployment
rate consistent with maintaining stable inflation. It is similar to the natural
rate of unemployment discussed in this current chapter.4 Understanding
the accelerationist hypothesis from this concept lets us understand
where the terminology of the NAIRU comes from. When output is at its
potential level, the unemployment rate is not zero, even though this state
is sometimes referred to as the ‘full employment level of output’. There will
be a certain level of unemployment that is not caused by a lack of demand,
but rather is caused by the movement of people between jobs (frictional
unemployment) or a mismatch in the skills that workers have and
the skills demanded by employers (structural unemployment). If
unemployment is pushed below its natural rate, or below the NAIRU,
inflation will tend to accelerate. To decrease unemployment permanently
without generating inflation, governments try to decrease the NAIRU by
increasing the efficiency of labour markets and focusing on skills, such as
through retraining programmes.
From our analysis above, and that in concept 22.2 which you have just
read, it is clear that people’s expectations about inflation are crucial. If
we rewrite the above equation with time subscripts, t, t = te – b(ut – u*)
and assume that people expect this period’s inflation to be the same as
last period (adaptive expectations) then we can see that if policy
makers keep current inflation above last period’s inflation they can hold
unemployment below the natural rate. Would people really be fooled by
policy makers simply accelerating inflation; would they not build this
into their inflationary expectations? Where this is the case, with so called
‘rational expectations’, the short-run trade-off between unemployment
below its equilibrium rate and accelerating inflation would not exist.5
This section contains a lot of detail on how the economy functions – it may
be good to read it through several times. Two important concepts from
this section are the natural rate of unemployment – which is the
190
Note that this equation
can also be written as
π = πe – b(u – u*) +
v where v is used to
indicate a short-run
supply shock (longrun supply shocks
change equilibrium
unemployment, u*).
Thus vertical shifts of the
short-run Phillips curve
can result from changes
in inflation expectations
and/or from temporary
supply shocks, the latter
giving rise to cost-push
inflation.
3
The natural rate of
unemployment can
be seen as a more
long-term concept,
whilst the NAIRU can
be interpreted as the
unemployment rate
consistent with steady
inflation in the near
term. In full equilibrium,
they are the same.
4
The rational
expectations hypothesis
is particularly associated
with the American
economist Thomas
J. Sargent who was
awarded the Nobel Prize
in Economics in 2011
(jointly with Christopher
A. Sims).
5
Block 17: Inflation
long-run equilibrium level of unemployment (this is not zero – more on
this later); and stagflation – which is the situation where inflation and
unemployment are both high, as many economies experienced during the
1970s due to high oil prices. The experience of stagflation in this period is
what initially led economists to question the validity of the Phillips curve.
Activity SG17.1
Based on Figure 25.6, use the LRAS and the long-run Phillips curve, together with the
short-run curves, to depict what will happen to output, unemployment and the price level
when there is:
a. a negative shock to aggregate demand in the context of a credible, constant inflation
target
b. an expectation that the inflation rate will rise and that the central bank will not be
able to contain this
c. the productivity of the labour force increases permanently (for example due to
changes in the county’s education and training systems)
d. a temporary adverse supply shock that is not fully accommodated.
The costs of inflation
► BVFD: read section 25.5.
This section discusses the costs of inflation, which are very different to what
many people think. Economists make a distinction between anticipated and
unanticipated inflation. The distinction is useful to think about. However,
in practice it is impossible to forecast the rate of inflation. Go to the Bank of
England website and search for the ‘Inflation report’. You will see fan charts
indicating the uncertainty about the future rate of inflation. Generally the
higher the rate of inflation the more uncertain it is, which is an important
reason why high inflation is problematic.
If inflation could be fully anticipated and all tax rates, nominal interest
rates, wage rates etc. fully adjusted then the remaining costs of inflation
would be shoe leather costs and menu costs (make sure you understand
these concepts). If nominal magnitudes fail to adjust perfectly there are
further costs. For example, if tax brackets do not adjust to inflation (‘bracket
creep’ or ‘fiscal drag’) taxpayers will find themselves with a higher real tax
burden (governments gain). Similarly, if capital gains tax (CGT) is levied
on the nominal value of assets people can find themselves paying CGT
on assets that have not increased in real value; again taxpayers lose and
governments gain.
Now suppose that inflation is uncertain and turns out to be higher than
expected so prices are higher. Suppose that money wages are fixed. The
real wage is then lower so output and employment are higher. Conversely if
inflation is lower than expected and the money wage is fixed the real wage
is higher and output and employment are lower. It is surprises in inflation
that matter here.
If nominal interests are indexed to expected inflation then lenders will
lose because the real interest rate they receive (the nominal rate minus the
rate of inflation) is less than they expected. On the other hand borrowers
benefit. Similarly if nominal wages are indexed to expected inflation and
actual inflation exceeds expectations workers receive lower real wages than
expected. Firms benefit, on the other hand, because their real wage costs are
lower than expected. Further costs are incurred if inflation is very volatile
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EC1002 Introduction to economics
or uncertain. Not only does this make planning and writing contracts more
difficult but imposes direct utility costs on risk averse individuals or firms.
To the extent that higher average inflation is associated with more volatile
inflation (there is some evidence for this) this is another argument in favour
of maintaining inflation at reasonably low levels.
This is not to say that zero inflation would be a sensible target either. Low
and stable inflation has benefits as well as costs. An important benefit of
having low, rather than zero, inflation arises from noting that zero inflation
would provide no margin of error in protecting against deflation. For the
perils of deflation read Case 25.1.
Controlling inflation
► BVFD: read sections 25.6 and 25.7 and complete activity 25.1.
While sections 25.6 and 25.7 are about controlling inflation we have
already dealt with the analytics of this in the previous block. The final two
sections of the current chapter add some real world institutional context.
They describe how credible low inflation targets are used to get inflation
under control, and how this has been relatively successful in the past 20
years. Central bank independence has been an important part of this.
Nonetheless, deciding where to set interest rates to achieve an inflation
target is no easy task. There are continual shocks to the economy of various
sizes, and it is not always easy to distinguish permanent and temporary
demand and supply shocks, or to know how best to respond to these. Many
central banks publish reports after their committee meetings, detailing why
they have decided to maintain or to change interest rates.6 Transparency
regarding their decision making process also helps to keep inflationary
expectations in line.
► BVFD: read the summary and work through the review questions.
Overview
The Fisher hypothesis states that higher inflation leads to higher nominal
interest rates such that real interest rates do not change greatly. This can
be expressed by the Fisher equation: real interest rate = nominal interest
rate – inflation. Furthermore, the relationship between inflation and
government indebtedness was discussed. Governments with excessive
debts may be tempted to print money – though there is some scope for
revenue generation through the inflation tax, this approach is very risky
and can result in hyperinflations. In most advanced economies, we do
not expect a close relationship between deficits and money creation.
A very important topic covered in this block is the Phillips curve. The
short-run Phillips curve demonstrates a trade-off between inflation and
unemployment in response to demand shocks. The long-run Phillips
curve is vertical at equilibrium unemployment. Permanent supply shocks
shift the long-run Phillips curve left or right, while temporary supply
shocks shift the short-run Phillips curve higher or lower. Inflationary
expectations also shift the short-run Phillip’s curve, in part because
people’s expectations regarding inflation affect negotiated wages and
nominal wage growth. Stagflation is the situation where unemployment
and inflation are both high. The costs of inflation are different to what
many people think – not simply higher prices, but other costs such as
shoe-leather costs and menu costs, as well as undesirable redistribution in
192
You can find the Bank
of England’s quarterly
inflation reports here:
www.bankofengland.
co.uk/publications/
Pages/inflationreport/
default.aspx
6
Block 17: Inflation
the case of unexpected inflation. Although inflation is seen as a problem
(although at low and stable levels it has benefits also), deflation is
potentially an even greater problem. For this reason, central banks usually
have an inflation target slightly above zero, such as the current 2 per
cent CPI target rate for the Bank of England. Central bank independence
from politics has proven effective in making inflation targets credible and
effective in recent years.
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. In the case of unanticipated inflation:
a. Creditors are hurt by lending but debtors gain by borrowing.
b. The elderly (mostly savers) are advantaged but the young (mostly
borrowers) are disadvantaged.
c. Workers gain because their real wages are higher than expected.
d. Institutional arrangements such as tax brackets and VAT rates will
be fully adjusted.
2. Which of the following statements about the Phillips curve model with
expectations is correct?
a. An expected high rate of inflation is associated with high levels of
output and employment.
b. An unexpected high rate of inflation is associated with high levels
of output and employment.
c. In the long run, governments can increase real output and
employment by using monetary policy to increase the rate of
inflation.
d. In the long run, there is nothing governments can do to increase
real output and employment.
3. Which of the Real revenue from the inflation tax:
a. always rises as the inflation rate rises
b. always falls as the inflation rate rises
c. depends on the size of the government’s real deficit
d. depends on the multiple of the inflation rate and the quantity of
real cash.
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. Higher expected inflation shifts the long-run Phillips curve leftwards.
2. A positive demand shock leads to no change in the position of the
short-run Phillips curve..
3. Inflation increases the ratio of national debt to national income.
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EC1002 Introduction to economics
Long response question
1.
a. What does the Phillips curve represent? Draw a diagram with a
short-run Phillips curve and a long-run Phillips curve and explain
why they have the shapes they do.
b. Draw diagrams (explaining your answers in words at the same
time) to depict what will happen to output, unemployment and the
inflation rate when there is:
i.
a fall in the price of oil that is fully accommodated by monetary
policy
ii. a new, very tough and inflation-hating central bank governor
appointed in a period of high inflation
c. Certain types of inflation can have very serious implications. Discuss
the implications of:
i.
negative inflation
ii. hyperinflatons.
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Block 18: Unemployment
Block 18: Unemployment
Introduction
Until the Great Depression of the 1930s, it was generally accepted in
economic theory that unemployment was solely the consequence of wages
being higher than the equilibrium wage rate and that in time, wages
would adjust naturally so that the labour market would clear. The events
of the 1930s, including very high levels of persistent unemployment,
shifted attention to the potential ‘stickiness’ of wages (i.e. the fact that
wages may not fall despite high levels of unemployment) and the level of
aggregate demand in the economy. This change was primarily thanks to
the revolutionary ideas of British economist John Maynard Keynes, who
published his best-known work The general theory of employment, interest
and money in 1936. A major policy recommendation from this work
was that governments should help reduce unemployment by increasing
government spending to substitute for a lack of demand from private
consumption and investment.
A macroeconomic approach to studying unemployment thus emphasises
the role of aggregate demand, especially any gaps between actual and
potential output. At the same time, market imperfections which cause
wages to be ‘sticky’ above the market-clearing equilibrium level are also
important factors in determining the rate of unemployment in an economy.
Key themes of this block thus include the different types of unemployment,
as well as their causes and various policies for reducing unemployment.
Although there is a positive role for short-term frictional unemployment in
terms of workers moving between jobs and achieving a better skills-match,
in general, unemployment is associated with large costs on both a personal
and societal level. As such, low unemployment is one of the three major
macroeconomic goals of economic policy, along with steady growth and
low inflation.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
discuss measured unemployment, both claimant count and
standardised rate
•
define classical, frictional, structural and demand-deficient
unemployment
•
distinguish between voluntary and involuntary unemployment
•
analyse determinants of unemployment
•
explain how supply-side policies reduce equilibrium unemployment
•
evaluate private and social costs of unemployment
•
explain hysteresis.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 26.
Synopsis of this block
The textbook chapter starts by introducing basic concepts such as the
labour force and the unemployment rate and provides some statistics as
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EC1002 Introduction to economics
to the composition of unemployment in the UK and the flows of people
between being in employment, unemployed and out of the labour force.
The various types of unemployment are introduced, notably frictional,
structural, classical and demand-deficient (or cyclical) unemployment. One
very important concept is the natural rate of unemployment, also known
as equilibrium unemployment or the steady state rate of unemployment.
Unemployment can be caused by a deficiency in aggregate demand,
i.e. when there is a business cycle slump. Such unemployment can be
addressed via demand-management tools, namely fiscal and monetary
policy. Other types of unemployment are related to imperfections in labour
markets and are better addressed by supply-side policies, such as improving
information flows and reducing skills mismatches or disincentives to labour
supply such as high marginal tax rates. The personal and societal costs of
unemployment are also discussed, including a loss of human capital and
lost output resulting from leaving resources idle.
Rates of unemployment
► BVFD: read the introduction to Chapter 26.
The introduction provides a brief historical background on unemployment
rates for the OECD countries. Figure 26.2 shows the persistent
unemployment post- 2008 recession in Ireland and Italy, for example.
Do you know how unemployment has evolved in your own country?
Activity SG18.1
Find out what the trend has been in the country where you live.
► BVFD: read section 26.1 and case 26.1.
This section contains several important definitions – the labour force; the
participation rate and the unemployment rate. The relationships between
these variables can be expressed by the following equations:
•
Let the number of employed people be E (these are people who work
for at least one hour per week).
•
Let the number of unemployed people be U (these are people who are
actively seeking work).
•
Let the labour force be LF (those who are either employed or looking
for work).
•
Let people who are not in the labour force be NFL (these are ‘inactive’
and include homemakers, students who are not working, people who
are too sick to work, etc.).
•
Let the working age population be P:
•
Working-age population: P = LF + NLF
•
Unemployment rate: u = U/LF
•
Employment rate: e = E/P
•
Labour force participation rate: lfp = LF/P.
Activity SG18.2
What is the unemployment rate in a country with a working-age population of 1,000, a
labour force participation rate of 80% and 100 unemployed people?
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Block 18: Unemployment
A striking feature of Table 26.1 is the huge diversity in the experience of
OECD countries (supposedly a relatively homogeneous group of countries;
really poor countries and many emerging economies are not OECD
members). Youth unemployment is often higher than unemployment for
the labour force as a whole. Young people tend to have unemployment
rates that are higher than the national average, partly because they
generally have less work-experience. Following the financial crisis and
European sovereign debt crisis many countries have seen extremely high
levels of youth unemployment.
Analysis of unemployment
► BVFD: read section 26.2.
Below we take the analysis of equilibrium unemployment a bit further
using the stocks and flows framework but you need also to be familiar
with the graphical analysis in BVFD using the LD, AJ and LF schedules.
Pay special attention to the role of rigid real wages in increasing
unemployment (both equilibrium and Keynesian) within this framework.
Although Figures 26.4 and 26.5 are very similar, they highlight a key
distinction which is very important in the analysis of unemployment.
Figure 26.4 shows how total unemployment at wage w2 (AC) is broken
down into voluntary (BC) and involuntary (AB) unemployment (although,
somewhat confusingly, unemployment AB is subsequently defined as
being voluntary as well (with workers being part of the institutional
arrangements responsible for wage w2 and its ‘stickiness’). In this case,
the wage is higher than the equilibrium level due to labour market
imperfections or reasons such trade union power. A rigid real wage above
the equilibrium level is causing there to be both voluntary and involuntary
unemployment. In Figure 26.5, the total unemployment at W* (AF) is also
broken down into voluntary (EF) and involuntary (AE) unemployment,
once again because of a rigid real wage above the equilibrium level. In
this case, the reason is that demand for labour has fallen from LD to LD’
(but the equilibrium wage level has not fallen to W** as it is expected to
in the longer term). The distance AE is demand-deficient or Keynesian
unemployment.
The optimal policy approaches to these two situations are quite different.
In the first case, government policy should take a supply-side approach
to addressing wage rigidities. This approach is discussed in section 26.3
(though the supply-side policies discussed in 26.3 also focus on bringing
the AJ and LF curves closer together). On the other hand, unemployment
that is caused by a deficiency in aggregate demand can be addressed
via demand-management tools, namely fiscal and monetary policy. This
is discussed very briefly in section 26.4. In some sense, it has been a
key theme of our analysis for several chapters, as our analysis of the
macroeconomy has focused on reducing or eliminating any gap between
actual and potential output. Whether it is more appropriate to apply
a supply-side approach or a demand management approach depends
on the situation of the economy – if output is close to potential output,
trying to increase demand will only lead to inflation. In this case, the
best way to reduce unemployment is to focus on the supply-side. If the
economy is below potential output, there is an important role for demand
management to boost aggregate demand and this would be expected to
bring about a substantial reduction in unemployment.
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EC1002 Introduction to economics
In the language of the diagrams described above, although involuntary
unemployment could be tackled in both graphs by addressing the rigidity
of the real wage such that wage levels would fall to w* in Figure 26.4 and
W** in Figure 26.5, the demand-management approach is favoured in the
case of demand-deficient or Keynesian unemployment, and this would
be depicted by a rightward shift in the labour demand curve back to the
original position at LD.
Activity SG18.3
Match the concept of unemployment with its definition in the schematic below.
Frictional unemployment
The unemployment created when the wage is
deliberately maintained above the level at which the
labour supply and demand schedules intersect
Structural unemployment
This occurs when output is below full capacity
Demand-deficient
unemployment
People spending short spells in unemployment as
they move between jobs
Classical unemployment
Unemployement that arises from the mismatch of
skills and job opportunities as the pattern of demand
and supply changes
Equilibrium unemployment (the
natural rate of unemployment)
Unemployed workers in the labour force who would
accept a job offer at the going wage rate
Voluntary unemployment
The unemployment rate when the labour market is
in equilibrium
Involuntary unemployment
Unemployed worker in the labour force who are not
willing to accept a job offer at the going wage rate
According to the definition in BVFD: voluntary unemployment
includes frictional, structural and classical unemployment, whereas
involuntary unemployment is equivalent to demand-deficient or cyclical
unemployment (which is also known as Keynesian unemployment).
Equilibrium unemployment/the natural rate of unemployment
This rate of unemployment is also called the steady state rate of
unemployment. It is the rate of unemployment such that the rate of inflow
of workers into unemployment equals the rate of hiring of new workers.
This means, of course, that the stock of unemployed workers remains
constant. What follows is a very simple model of flows, which simplifies
the stock-flow diagram of Figure 26.2 by ignoring flows into and out of
the box labelled ‘Out of the labour force’ (i.e. outflows of workers from
employment become unemployed and outflows from unemployment go to
employment; workers who leave employment don’t leave the labour force
and new employment comes from the stock of unemployed workers not
from outside the labour force).
If j is the rate of job loss for those with work, and h is the rate of hiring for
those without jobs, and where E is the total number of employed workers
and U is the total number of unemployed workers, in steady state the
following must hold:
jE=hU
This just says that in a steady state the outflow from employment (inflow
into unemployment) is equal to the inflow into employment (outflow from
unemployment).
Since LF = E + U (where LF is the labour force), and u = U / LF, the
following equation for the steady-state rate of unemployment also holds:
u = j / (j + h)
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Block 18: Unemployment
This equation is useful because it shows several things. Firstly, the natural
rate rises with j and falls with h. A high rate of job loss and a low rate of
hiring both increase the equilibrium unemployment rate. Secondly, 1/h
is an indicator of unemployment duration. For a given level of j, a lower
h means a longer spell of unemployment, as workers wait to fill a given
number of vacancies.3 An increase in the duration of unemployment
increases the natural rate of unemployment. Duration of unemployment is
important because a given unemployment level or rate could arise from a
relatively small number of individuals being unemployed for a long time
or a larger number of individuals being unemployed for a short time. The
implications for the individuals concerned are likely to be very different in
the two cases, as are the appropriate policies that may be used to counter
the unemployment.
You should also remember the concept of the NAIRU from the previous
block. This too is very similar to the concept of the natural rate of
unemployment, although the natural rate can be seen as a more long-term
concept, while the NAIRU can be interpreted as the unemployment rate
consistent with steady inflation in the near term. In full equilibrium, they
are the same.
Activity SG18.4
In a country with a working age population equal to 25, aggregate labour demand and
labour supply in an economy are summarised by the following equations:
Measuring
unemployment
duration in practice
is complicated by the
fact that what we
observe when we
survey the unemployed
are incomplete spells
of unemployment
whereas what we are
primarily interested in
(and certainly what
unemployed workers
are interested in) is how
long a completed spell
of unemployment lasts.
Estimating the latter
from the former raises
some quite complex
statistical issues.
3
Labour demand: ND = 24 – W
Labour supply: NS = 3 + 2W
a. Determine the equilibrium level of employment and wages as well as the
unemployment and inactivity rates in equilibrium.
b. Determine the unemployment and inactivity rates if the government imposed a
minimum wage of £9.
Changes in unemployment
► BVFD: read section 26.3.
This section explores the experience of OECD countries to emphasise
the point that changes in unemployment can come from (i) long- run
changes in aggregate supply and equilibrium unemployment, and/or (ii)
aggregate demand fluctuations. Decomposing between these two is not
straightforward. If observed unemployment coincides with equilibrium
unemployment then governments should not attempt to reduce it by
expanding aggregate demand, but instead need to address the underlying
structural factors, largely on the supply side, that determine equilibrium
unemployment. This is valuable information for policy makers.
Activity SG18.5
Use the (LD, AJ, LF) framework to illustrate the effects of the following supply-side factors
on unemployment:
a. a rise in the use of online employment websites for job search decreases skill
mismatch
b. a fall in unemployment benefit, decreasing the replacement rate
c. a fall in trade union power
d. an increase in marginal tax rates.
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EC1002 Introduction to economics
Cyclical unemployment
► BVFD: read section 26.4.
The way that cyclical unemployment is defined in L&C (UK edition p.573;
international edition p.473) helps to connect the analysis here with
what was learned in the previous chapters – ‘Cyclical unemployment, or
demand-deficient unemployment, occurs whenever there is a negative
GDP gap’ (i.e. total demand is insufficient to purchase all of the economy’s
potential output, causing a recessionary gap in which actual output is
less than potential output). Cyclical unemployment can be measured as
‘the number of people who would be employed if the economy were at
potential GDP minus the number of persons currently employed’.
While section 26.3 focused on supply-side policies to address
unemployment, this section discusses the use of counter-cyclical demand
management policies. Keynes’ original policy recommendations to
address the extremely high unemployment levels of the 1930s focused on
increasing government spending to offset the lack of private consumption
and investment. He argued it didn’t necessarily matter what the money
was spent on (though of course he favoured productive projects) – what
was important was to increase aggregate demand. This would lead to
economic growth and a fall in unemployment. Keynesian ideas strongly
influenced the US Presidents Herbert Hoover and Franklin D. Roosevelt,
who embarked on extensive public works programmes including the
building of roads and bridges as well as relief programmes providing
housing support, food, medicines, and other basic necessities to the
unemployed. The massive spending undertaken as countries invested
in armaments for the Second World War has been credited with finally
ending the mass unemployment of the depression years.
Various countries also used expansionary fiscal policy in an attempt to
re-stimulate their economies after the 2008 credit crunch. For example,
the US Economic Stimulus Act of 2008 (a $152 billion stimulus consisting
predominantly of $600 tax rebates to low and middle income Americans),
followed by the American Recovery and Reinvestment Act of 2009
(including direct spending on infrastructure, education, health, energy,
federal tax incentives, and expansion of unemployment benefits and other
social welfare provisions – with an estimated cost of $831 billion between
2009 and 2019). The Chinese government also pledged to spend 4 trillion
yuan on infrastructure and social welfare by 2010. The UK also undertook
a large fiscal stimulus programme, including a temporary 2.5 per cent cut
in VAT (sales tax) and a car scrappage scheme similar to ones in France and
Germany, although the scope for fiscal stimulus in the UK has been limited
by the huge debts the government had incurred bailing out the financial
sector. There is evidence that the expansionary fiscal policies employed
in these countries have indeed helped to combat rising unemployment –
for example, US states that increased per-capita expenditures the most,
experienced the smallest rises in unemployment rates.
This approach to addressing unemployment is more focused on the short
run, while the supply-side policies discussed in the previous section tend to
focus on reducing longer-term structural unemployment.
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Block 18: Unemployment
Cost of unemployment
► BVFD: read section 26.5 and concept 26.3.
Despite the safety net that is provided in the UK by Jobseeker’s Allowance,
most forms of unemployment apart from short-duration frictional
unemployment are associated with large personal costs – these include a
loss of income, an erosion of human capital (meaning that skills deteriorate
when they are not being used) and psychic costs such as feeling rejected
or not useful. Furthermore, although it is true that if unemployment is
voluntary then, by definition, the private benefits of unemployment exceed
the private costs, it does not follow that the voluntarily unemployed are
not suffering considerable hardship. This could well be the case where
the potential jobs available to the unemployed are low paid and at the
same time the state pays low unemployment benefits, as measured by the
replacement rate. Let us consider the case of Greece, for example. The
replacement rate is comparatively low in Greece (and falls rapidly after
the first year of eligibility) and the employment opportunities available
to Greek workers during Greece’s recent deep recession were very limited
and poorly paid. Unemployed Greek workers have had very low living
standards during this period.
The social costs of unemployment are also extensive, and include a loss of
output and aggregate income, an increase in inequality, a loss of human
capital for the society as a whole resulting in lower productivity.
Hysteresis
Concept 26.2 outlines four reasons why hysteresis (a temporary fall in
demand inducing permanently lower output and employment) may occur
and its policy implications. The existence of hysteresis is one reason why
governments are so eager to prevent unemployment rising in the first
place. Hysteresis also undermines the strict classical view of the natural
rate of unemployment whereby fluctuations in demand affect only shortrun output, employment and unemployment, all of which return to their
underlying classically-determined levels in the long run. If hysteresis could
be established empirically as a significant phenomenon, and there is still
controversy on this point, then recessions could raise the natural rate of
unemployment, leaving the economy permanently scarred.
Overview
The total working-age population consists of the labour force and those
who are ‘inactive’. The labour force consists of the employed plus the
unemployed. The participation rate is the labour force divided by the
total population. The unemployment rate is the unemployed divided by
the labour force. Unemployment can be classified as frictional, structural,
classical or demand-deficient unemployment. BVFD define ‘voluntary’
unemployment, or equilibrium unemployment, to include frictional,
structural and classical unemployment. Involuntary unemployment is
equivalent to demand-deficient unemployment, also known as cyclical or
Keynesian unemployment. The natural rate of unemployment is defined
as the equilibrium rate of voluntary unemployment. Temporary recessions
lead to increased cyclical unemployment. This can be addressed using
the demand-management tools of fiscal and monetary policy. A one
per cent increase in output is likely to lead to a much smaller reduction
in cyclical unemployment due to increases in hours worked by those
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EC1002 Introduction to economics
currently employed and increased numbers joining the labour force. In
the long run, the only way to reduce unemployment permanently is to
reduce the natural rate of unemployment through supply-side policies
such as reducing mismatch through better information and retraining,
reducing trade union power, cutting the marginal rate of income tax
and reducing unemployment benefits (of course, society may choose
a higher equilibrium rate of unemployment rather than adopt some of
these policies). There is also a link between cyclical unemployment and
the natural rate of unemployment, since short-run changes can move the
economy to a different long-run equilibrium. This is known as hysteresis.
Most forms of unemployment, apart from frictional unemployment, are
associated with large personal costs including lost income, an erosion of
human capital and psychic costs, as well as social costs including a loss of
output and aggregate income, increased inequality, a loss of human capital
for the society as a whole resulting in lower productivity, and the effects
on the public finances of unemployment benefits and lost tax revenue.
Low unemployment is one of the three major macroeconomic goals of
many governments, along with steady growth and low inflation.
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. Which of the following statements about the labour market is correct?
a. The labour force consists of people who are of working age and do
not have caring responsibilities.
b. The participation rate is the fraction of the population of working
age in the labour force.
c. Structural unemployment includes people spending a short time
unemployed as they move between jobs.
d. Classical unemployment occurs when output is below full capacity.
2. Which of the following is not true?
a. The unemployment rate is counter-cyclical.
b. The average unemployment rate differs substantially across
countries.
c. The sign of a well-functioning economy is that there is no
unemployment.
3. The fraction of employed workers who lose their jobs each month
(the rate of job separation) is 0.01 and the fraction of the unemployed
who find a job each month is 0.09 (the rate of job findings), then the
natural rate of unemployment is:
a. 1 per cent (0.01)
b. 9 per cent (0.09)
c. 10 per cent (0.10)
d. about 11 per cent (actually, 1/9).
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Block 18: Unemployment
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. The labour market is in equilibrium if demand for labour at the current
wage is equal to the size of the labour force.
2. It is impossible to increase the level of equilibrium unemployment by
improving the match between the skills employers require and the
skills workers have.
3. The labour market is in equilibrium if there is zero voluntary
unemployment.
Long response question
1.
a. Suppose that at the beginning of the month, the number
employed, E, equals 180 million; the number not in the labour
force, N, equals 50 million; and the number unemployed, U, equals
20 million. During the course of the month, the flows indicated
below occurred:
•
4.0 million – moved from employment into unemployment
(EU)
•
1.5 million – moved from employment to not being in the
labour force (EN)
•
2.2 million – moved from unemployment into employment
(UE)
•
2.7 million – unemployed people dropped out of the labour
force (UN)
•
0.3 million – moved from not being in the labour force directly
into employment (NE)
•
1.8 million – moved from not being in the labour force directly
into unemployment (NU).
i.
Assuming that the population has not grown, calculate the
unemployment and labour force participation rates at the
beginning and end of the month.
ii. Excluding movements into and out of the labour force,
calculate the rate of job loss (j), and the rate or hiring (h).
b. Use an appropriate graphical framework to illustrate the effects of
the following supply-side factors on unemployment:
i.
An increase in marginal tax rates
ii. A fall in unemployment benefit, decreasing the replacement
rate.
Food for thought – Box 6: What will the future of work look like?
Working is an integral part of our lives and jobs determine our living
standards, while linking us to the economic and social fabric of our country.
It should therefore come as no surprise that the labour market has long been
investigated by economists. Studies are not restricted to the drivers of labour
market outcomes, but also try to understand how new technology (e.g. the
introduction of self-driving cars), shocks (e.g. Brexit) alongside changes in
preferences affect the equilibrium in different sectors. As some jobs disappear,
or change radically, others are created and reach new peaks.
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EC1002 Introduction to economics
Who would have guessed 50 years ago that people in the movie industries
would have found niche jobs such as environmental designers, working to
build the realistic worlds we see in fantasy and action movies? Or the many
tailoring shops that shut down due to the rise of inexpensive, fast fashion,
brought about by the decreasing cost of fabrics and equipment needed to turn
it into clothes. These changes, as have many others affecting labour markets,
follow the introduction of new technology and changes in preferences.
Demand for new tasks increases and people with expertise can negotiate
better wages, whereas in other areas there is a fall in demand driving
unemployment.
Throughout history, the introduction of new technology, from the wheel
to quad-core processors, has altered worker productivity, enabling the
introduction of new products and driving drastic changes in the labour
market. Importantly, there is a time lag between the introduction of new
technologies and the creation of new industries and jobs. It may not always
be fast, but it creates a fertile ground for economic research. Researchers
in this field seek to forecast and alleviate the negative effects of shocks on
workers in key sectors. To advise policymakers and facilitate the transition of
those affected into other sectors, economists spend a large amount of time on
making theoretical predictions based on theory and (perhaps an even larger
amount of time) on analysing labour market data.
Economics Nobel Laureate and LSE Professor Sir Christopher Pissarides (LSE)
is one of the most prominent scholars to have worked on labour markets
and has recently focused on the impact of automation on the creation (and
destruction) of jobs. As he puts it ‘As autonomous cars develop, we’ll need to
help taxi drivers retrain to work in hospitality and as the use of the internet
spreads we’ll need to help call centre staff train in home care. We’ll need
to make society appreciate those jobs more, make them more rewarding to
hold and improve the quality of service’. He argues that good jobs are the
key to happiness and that to support it countries should implement policies
that facilitate (re)training of workers and mobility across sectors. The rise in
automation can be an important opportunity of growth but will also cause
many to lose their jobs. Economists are attempting to forecast the likely
displacement of workers due to the introduction of more automation and how
to limit economic harm and possible effects on inequality.
Try to think about whether you would be willing to move for a job: what
would induce you to leave your sector? Or your country? What would be the
key benefits and costs of such a move?
Read this interview with Sir Christopher Pissarides to find out more.
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Block 19: Exchange rates and the balance of payments
Block 19: Exchange rates and the balance
of payments
Introduction
This block examines the international sector in some detail. Net exports
has been part of our model of the economy since Block 11, but we have
not explored it in any depth. However, interactions with other countries
play an important role in almost all economies. Globalisation has
meant that the world is now very integrated, such that countries cannot
operate independently from each other. As well as trade flows, there are
also massive capital flows in foreign exchange, shares and bonds, and
other financial instruments. This block provides the tools to analyse the
international sector and its impact on the domestic economy.
Throughout the block, the UK is used as the ‘domestic’ economy and
pound sterling as the ‘domestic’ currency. A choice had to made, but US
textbooks would use the dollar as the domestic currency and Malaysian
textbooks the ringgit. In following the analysis, use whatever you are most
comfortable with as the domestic and foreign currencies, but always pay
attention to which way the exchange rate is defined (foreign in terms of
domestic or vice versa).
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
analyse the foreign exchange market
•
discuss balance of payments accounts
•
explain determinants of current account flows
•
define perfect capital mobility
•
assess speculative behaviour and capital flows
•
define internal and external balance
•
analyse the long-run equilibrium exchange rate.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 27 (except Maths
A27.1).
Synopsis of this block
This block covers Chapter 27 of the textbook, which introduces exchange
rates and the balance of payments and provides a background to the
following block on open economy macroeconomics. Exchange rates –
the number of units of foreign currency that exchange for a unit of the
domestic currency – are determined by demand and supply in the foreign
exchange market. The balance of payments consists of the current account
and the capital and financial accounts. These are discussed in more detail
in the block. Under floating exchange rates, the balance of payments will
balance automatically, though when exchange rates are fixed, there is a
need for government intervention so that the current account and capital
and financial accounts offset each other. This block also introduces real
and purchasing power parity exchange rates as well as the interest parity
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EC1002 Introduction to economics
condition. Finally, the block also discusses the importance of external
balance as well as long-run trade balance between countries.
The exchange rate
► BVFD: read section 27.1 and concept 27.1.
The exchange rate is the number of units of one currency that exchange
for a unit of another currency. A fall (rise) in the exchange rate is called
depreciation (appreciation). The exchange rate is just a price – the price
of one currency in terms of another. This price can rise or fall, like any
other price. As stated above and in the text, it is important to keep track
of which way round the price is expressed – the foreign value of the
domestic currency or the domestic value of the foreign currency. Where
we think of the exchange rate as the international or foreign price of the
domestic currency a lower exchange rate makes the domestic economy
more competitive (see the BVFD example of whisky with a UK price of £16
per bottle). Activity SG19.1 gives you some practice at keeping track of the
sometimes confusing concept of the exchange rate.
Activity SG19.1
Complete the following table:
You are in
Exchange Rate International value of the
What does it mean? (i.e. how
domestic currency, or domestic much of one currency can you
price of foreign exchange?
buy for the other?)
UK
$US1.571/£
Germany
1.244€/£
Malaysia
$US0.286/MR
UK
£0.804/€
It is common to assume the demand for imports is elastic and draw the
supply curve of currency sloping upwards. When demand for imports is
elastic, a fall in the $/£ exchange rate (the pound getting weaker against
the dollar) will lead to a fall in the volume of imports (since US goods
are now more expensive for UK residents), and this fall in volume will
be proportionately larger than the increased price of imports. Therefore,
fewer pounds in total will be spent on imports. Thus there is a positive
relationship between the exchange rate and the supply of pounds, and the
supply curve slopes upwards (when demand for imports is elastic).
Trade is often analysed as taking place between two countries (this
enables use of simple diagrammatic techniques among other things) and
in such case the definition of ‘the’ exchange rate is unproblematic. Concept
27.1 explains a relatively straightforward way to generalise the definition
of the exchange rate to the more realistic case where a country has many
trading partners – the effective exchange rate being the weighted average
of individual bilateral exchange rates. The effective exchange rate is
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Block 19: Exchange rates and the balance of payments
particularly useful for tracking the strength of a currency over time. By
its nature the effective exchange rate is expressed as an index, set at 100
(usually) at some chosen starting date.
Fixed and floating exchange rates
► BVFD: read section 27.2.
This section discusses fixed and floating exchange rates. This analysis
is essentially the same as standard supply and demand analysis, except
that when the price (the exchange rate) is fixed, this fixed price has to be
maintained by the central bank of the domestic country buying or selling
the foreign currency (although in practice the central banks of both the
domestic and foreign countries may work together to maintain the fixed
exchange rate).
To test your understanding of the basic supply and demand framework
answer the following multiple choice question.
Activity SG19.2
Assume that the UK is the domestic country (and the central bank is the Bank of England)
and that the exchange rate ($/£) is fixed. Supply the correct combination to fill the gaps
in the following sentence.
If, at the fixed exchange rate the pound (£) is ……………… the Bank of England must
……….. pounds and its dollar ($) reserves will ……..
a.
overvalued
buy
rise
b.
overvalued
sell
rise
c.
undervalued
buy
rise
d.
overvalued
buy
fall
This course considers only fixed and floating exchange rates, but there are
other exchange rate regimes. You are not expected to know about these for
EC1002, but as an economist you should be aware of what is happening
in your own country. Exchange rate regimes include (for example) a
crawling peg system, where a country’s currency is pegged to the value of
another currency, but the government explicitly recognises that this will
be allowed to change from time to time, when needed; and a managed
float, where the currency is allowed to move freely, but the government
participates in the market to damp large fluctuations. Exchange rate
regimes are represented below as a continuum, with the most government
involvement on the left and the most market flexibility on the right.
Currency Board
Hong Kong, Bulgaria
Currency Union
Eurozone, dollarizaon
Fixed Peg
China, Pakistan
Crawling Peg
Cost Rica
Managed Float
India, Singapore, Russia
Crawling Bands
Denmark
Free Float
UK, USA, Sweden
Figure 19.1: A continuum of exchange rate regimes.
If intrested, you can find much more detail about exchange rate regimes
in the IMF Annual Report on Exchange Arrangements and Exchange
Restrictions (www.elibrary-areaer.imf.org). See in particular the Country
Table Matrix.
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EC1002 Introduction to economics
The balance of payments
► BVFD: read section 27.3.
The balance of payments consists of the current account and the capital
and financial accounts as well as any balancing item required because of
statistical discrepancies. The current account records transactions arising
from trade in goods and services; income (i.e. employee compensation and
investment income paid to and received from people, business or assets in
other countries; and transfers such as the government paying a pension to
someone living abroad or people sending money to relatives abroad). The
capital and financial accounts record transactions related to international
movements of ownership of financial assets, such as shares, bank loans
and government securities. Under floating exchange rates, there is no
official financing and the balance of payments is always zero.
Under fixed exchange rates the balance of payments is not necessarily
equal to zero and official financing may be required to ensure that overall
demand and supply of currency are equal and the fixed exchange rate is
maintained. Table 27.2 helps to clarify this section.
Activity SG19.3
Complete the following multiple choice questions, providing a reason for your answer.
1. The value of a country’s exports is listed in its balance of payments account as:
a. a credit
b. a debit
c. a payment
d. an investment.
2. In the balance of payments, a net inflow of capital shows up as a:
a. surplus in the capital account
b. deficit in the capital account
c. surplus in the current account
d. deficit in the current account.
Real and PPP exchange rates
► BVFD: read section 27.4.
It is important to make a distinction between the nominal exchange rate
and the real exchange rate. The real exchange rate takes into account the
differences in price levels, or the change in prices, (i.e. inflation) between
countries.
For clarity, note that:
Real exchange rate = Nominal exchange rate × (Domestic price level / Foreign price level).
This means that a rise in the domestic price level leads a rise/appreciation
in the real exchange rate (if nominal exchange rates are constant).
The purchasing power parity (PPP) theory holds that in the long run, the
average value of the exchange rate between two currencies depends on
their relative purchasing power. It should cost the same to buy a basket
of goods in US dollars in the USA, as to convert the same dollars into
Euros and buy that basket of goods in the EU. Otherwise, there would be
an incentive to buy or sell foreign currency and take advantage of this
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Block 19: Exchange rates and the balance of payments
discrepancy. The PPP exchange rate is determined by the relative price
levels in the two countries. That is why BVFD define the PPP path as ‘the
hypothetical path of the nominal exchange rate that would maintain a
constant real exchange rate’ (p.537).
To make the theory of PPP a little more ‘digestible’, The Economist came up
with the idea of the Big Mac Index in the mid-1980s. This compares the price
of a McDonalds Big Mac burger in different countries and has since become
a well-known, though rough and ready, indicator of currencies that are over
or undervalued. Since Big Macs are produced to a certain specification but
are sold at local prices, comparing the prices of Big Macs between countries
and comparing this to the market exchange rate gives an indication of how
far above or below a market exchange rate is from the PPP rate.
This example of how the Big Mac index works looks at the exchange
rate between the US dollar (USD) and the Malaysian ringgit (MYR). If
the official (nominal) exchange rate was 1USD = 3.62MYR, or 1MYR =
0.28USD (28 cents). In the USA a Big Mac costs $4.79 and in Malaysia
7.63MYR, or at the nominal exchange rate 7.63/3.62 = $2.11. At these
prices and the nominal exchange rate, the real exchange rate is given by1:
This calculation mirrors
those in Table 27.3 in
BVFD.
1
real exchange rate = RER = price of Malaysian Big Mac in terms of US Big Mac
or
RER =
=
(USD/MYR nominal exchange rate)PM
P US
(0.28 USD/MYR)(7.63MYR/Malaysian Big Mac)
(4.79USD/US Big Mac)
= 0.45
US Big Macs
Malaysian Big Macs
(i.e. at current prices and the current nominal exchange rate) one obtains
0.45 of a US Big Mac per Malaysian Big Mac. If the exchange rate reflected
PPP a Big Mac would cost the same in both countries. Clearly, at the
nominal exchange rate a Big Mac is much cheaper in Malaysia than in the
USA. In fact, one can get 2.27 (4.79/2.11) Big Macs in Malaysia for each
US Big Mac. What does this say about the value of the Malaysian ringgit
versus the US dollar? It tells us that the ringgit is undervalued. To see this,
imagine Malaysia could export its Big Macs to the USA and sell them for
$2.11 (transport costs and food decay are ignored here just to illustrate the
basic principle). There would be a big demand for ringgits by US importers
and this would bid up the dollar price of ringgits. Americans would have
to pay more dollars for their ringgits. How much more? This question is
answered by calculating x in 7.63x = 4.79. x is the dollar cost of a MYR, and
the equation calculates what this would have to be in order for an imported
Big Mac to cost the same as a domestically made one. The answer is $0.63
(63 cents).
When the dollar value of the ringgit increases from 28 to 63 cents it is no
longer advantageous to import Big Macs from Malaysia. Equivalently, while
the nominal exchange rate is 1USD = 3.62MYR, the implied PPP exchange
rate is 1USD = 1.59MYR (1/0.63). At the current nominal exchange rate
the ringgit is undervalued by (3.62 – 1.59)/3.62 (i.e. 56 per cent). While
this is an oversimplified example, it would not be sensible to defend the
precise 56 per cent undervaluation too strongly; among other shortcomings
of our example, transport costs cannot be ignored, nor can trade barriers
and in calculating PPP one needs to use the price of basket commodities
not just the price of a Big Mac. However, the basic lesson is that
calculations of real exchange rates can tell us whether nominal exchange
rates fundamentally undervalue or overvalue a currency and consequently
whether there is pressure for the currency to appreciate or depreciate.
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EC1002 Introduction to economics
For more information on this see: www.economist.com/content/big-macindex
Using the PPP exchange rate, rather than $US for example, helps provide a
better understanding of the standard of living in each country. Non-traded
goods and services tend to be cheaper in low-income than in high-income
countries and any analysis that doesn’t take these differences into account
will tend to underestimate the purchasing power of consumers in emerging
market and developing countries and, consequently, their overall welfare.
The current and financial accounts
► BVFD: read sections 27.5 and 27.6 as well as case 27.1.
The balance of payments consists of the current account, the capital account
and the financial account (ignoring the statistical discrepancy). Under
floating exchange rates, the current account is exactly equal and opposite in
sign to the sum of the capital and financial accounts. Section 27.5 discusses
the current account. The capital account is generally very small and is not
discussed here. Section 27.6 discusses the financial account.
To understand section 27.5 on the determinants of the current account,
you should be clear on the relation between the real exchange rate
(RER) and exports (X) and imports (Z). The lower the RER, the cheaper
are domestic goods relative to foreign goods; this increases exports and
decreases imports. If you understand this you will see that the following
relationship exists between the RER and net exports (X – Z), again taking
the UK as the domestic and the USA as the foreign country (this diagram is
essentially the same as Figure 27.4 in BVFD):
RER
($/£)
X-Z
Figure 19.2: Relationship between RER and net exports.
The volume of forex traded internationally is many times as great as global
GDP. While some of this is required for international trade in goods and
services, it has been estimated that at least 80% of the global currency
market consists of exchange rate speculation. Speculation can lead to a
lot of volatility and it is argued that it has been one of the major causes
of several large financial crises such as those in Mexico (1994), South
East Asia (1997–98), Russia (1998), Brazil (1999), Turkey (2000) and
Argentina (2001).
Investors move funds one country to another in response to different
interest rates in the two countries and expected movements in the
exchange rate. Starting with £1, you can invest it in the UK and get
the UK rate of interest. Alternatively, you can use the £1 to buy dollars,
invest them in the USA, getting the US rate of interest, and then sell the
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Block 19: Exchange rates and the balance of payments
dollars to get pounds. If you could be sure that the exchange rate would
not change between when you buy and sell the dollars you would put
your money in whichever country had the higher rate of interest. If you
were certain about what the exchange rate was going to do you could
take this into account when comparing the two investment strategies.
Doing the mathematics of this gives you what are called interest parity
conditions. You are not expected to know about interest parity for this
course; it is covered in EC2065 Macroeconomics. Maths A27.1 is not
on the syllabus of EC1002.
Long-run equilibrium
► BVFD: read sections 24.7 and 24.8.
BVFD argue that in long-run equilibrium, both internal and external
balance must hold. The long-run equilibrium exchange rate must thus be
compatible with internal and external balance. The next chapter, on open
economy macroeconomics, takes this assumption as the basis for much of
the reasoning.
However, long-run equilibrium is an analytical construct not often
approached in reality. In practice it can be argued that a current account
deficit is neither intrinsically ‘good’ nor ‘bad’. There are countries such as
Australia (a small open economy) which have sustained current account
deficits for several decades. The IMF writes that ‘whether a country should
run a current account deficit (borrow more) depends on the extent of
its foreign liabilities (its external debt) and on whether the borrowing
will be financing investment that has a higher marginal product than
the interest rate (or rate of return) the country has to pay on its foreign
liabilities’.3 This means that running a current account deficit (investing
more than is saved domestically) can be a good idea, even in the longterm, if it is manageable and the incoming capital flows are being invested
productively, generating more wealth for the next generation out of which
the country’s debts can be repaid.
www.imf.org/external/
pubs/ft/fandd/basics/
current.htm
3
Despite this, external balance is nonetheless important in the sense
that global imbalances can have severe consequences. For example, it is
thought that the current imbalance between the USA and China – where
the USA has massive trade deficits and China has massive trade surpluses
(partly a result of the undervalued Chinese yuan) – helped establish the
conditions which contributed to the recent financial crisis.
The following block (covering textbook Chapter 25) focuses on internal
and external balance as a way of examining the effects of various fiscal
and monetary policy stances under different types of exchange rate
mechanisms and different assumptions concerning capital mobility.
► BVFD: read the summary and work through the review questions.
Overview
This block firstly introduces exchange rates, which express the price of
one country’s currency in terms of another country’s currency. Exchange
rates are determined by the supply and demand for currency, arising
from exports/imports and trade in assets. Floating exchange rates equate
demand and supply, while fixed exchange rates require government
intervention in the forex market (buying or selling domestic or foreign
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EC1002 Introduction to economics
currency) so that supply and demand are equated. The real exchange rate
takes into consideration the domestic and international price levels.
The balance of payments consists of the current, financial and capital
accounts. Monetary inflows are recorded as credits and outflows as
debits. Under floating exchange rates, the balance of payments is always
zero. A current account deficit is balanced by a surplus in the capital and
financial account. Under fixed exchange rates, the government may have
to intervene in the forex market to offset a balance of payments surplus or
deficit – this is called official financing.
The current account consists primarily of imports and exports and is
determined by the real exchange rate (a rise in the real exchange rate
reduces domestic competitiveness and the demand for exports) as well
as domestic and foreign incomes. In practice, the capital and financial
accounts are dominated by speculative flows of currency seeking the
highest return.
As well as achieving internal balance (full employment and stable prices),
governments are also concerned with achieving external balance (a
balanced or at least manageable balance of payments). There is a single
long-run equilibrium real exchange rate that is compatible with internal
and external balance.
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. In an economy with a fixed exchange rate policy, when both capital
and current accounts are in surplus:
a. The balance of payments will be balanced through a decrease in
foreign exchange reserves and there will be an increase in the
supply of domestic currency.
b. The balance of payments will be balanced through an increase
in foreign exchange reserves and there will be an increase in the
supply of domestic currency.
c. The balance of payments will be balanced through an increase
in foreign exchange reserves and there will be a decrease in the
supply of domestic currency.
d. The balance of payments will be balanced through a decrease
in foreign exchange reserves and there will be a decrease in the
supply of domestic currency.
3. Assuming there is perfect capital mobility, according to the interest
parity condition, an increase in the domestic inflation rate relative to
other countries would lead to:
a. an increase in competitiveness
b. a decrease in the exchange rate
c. a surplus on the current account
d. none of the above.
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Block 19: Exchange rates and the balance of payments
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. If a Dominican businessperson exports goods and services to Cuba, this
will show up in the balance of payments of both countries; however,
the money spent by a Dominican taking a vacation in Cuba only shows
up in the balance of payments of the Dominican Republic.
2. In Eritrea the exchange rate between the Nakfa and the U.S. dollar
is fixed. If, at the fixed exchange rate the Nakfa is overvalued, the
Eritrean central bank needs to buy Nakfas and lower its reserves of
dollars to restore the equilibrium.
3. The UK has a floating exchange rate. If all transactions between the UK
and the rest of the world are correctly measured, then the UK balance
of payments is equal to zero.
Long response question
1.
a. Draw a graph of the supply and demand curves for the foreign
exchange market, expressed in terms of pesos per dollar. Show
the equilibrium price at 5 pesos per dollar. Suppose the demand
for dollars increases so that the new exchange rate is 7 pesos per
dollar. Has the peso appreciated or depreciated? Which currency
has strengthened? Is this good or bad for the USA? For Mexico?
b. Suppose the following data represent Mexico’s international
transactions measured in millions of pesos.
Merchandise exports
15
Merchandise imports
10
Change in foreign assets in Mexico
12
Change in assets abroad
8
Exports of services
7
Imports of services
5
Income receipts on investment
5
Income payments on investment
10
Unilateral transfers
6
i.
What is Mexico’s trade balance?
ii. What is the balance on its current account?
iii. What is the balance on its capital account?
iv. What kind of exchange rate regime is Mexico operating?
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EC1002 Introduction to economics
Notes
214
Block 20: Open economy macroeconomics
Block 20: Open economy macroeconomics
Introduction
Having been introduced to fixed and floating exchange rates in the
previous block, this block examines the workings of the economy under
different exchange rate regimes, as well as different assumptions regarding
capital mobility.
Although there is some discussion of adjustment to other shocks, the focus
of this block is on macroeconomic policy – the effectiveness of fiscal and
monetary under different exchange rate regimes and assumptions about
capital mobility. You will see that the exchange rate regime a country
adopts has a profound impact on the way the economy operates and how
it can be managed.
Learning outcomes
By the end of this block and having completed the Essential reading and
activities, you should be able to:
•
describe monetary and fiscal policy under fixed exchange rates
•
explain the effects of a devaluation
•
describe monetary and fiscal policy uner flexible exchange rates.
Essential reading
Begg, Vernasca, Fischer and Dornbusch (BVFD), Chapter 28 (except Maths
28.1).
Synopsis of this block
This block examines how the economy operates under different exchange
rate regimes – namely, fixed and floating exchange rates, and discusses
the important effects of capital mobility. Furthermore, this block makes
use of IS-LM-BP analysis to illustrate the effects of fiscal and monetary
policy under fixed and floating exchange rates. The block starts by
discussing fixed exchange rates and macroeconomic policy under fixed
exchange rates, then discusses devaluation – an occasional adjustment in
an exchange rate that is pegged at a fixed value. Finally, floating exchange
rates are examined, including what determines the level and fluctuations
in these rates as well as the operation of macroeconomic policy when
exchange rates are flexible.
The macroeconomy under fixed exchange rates
► BVFD: read section 28.1, 28.2 and case 28.1.
The choice of exchange rate regime affects the way in which monetary and
fiscal policy transmits in the economy. On the aggregate demand side we
have net exports that also determine the current account of the balance of
payments.
An important determinant of the effect of monetary and fiscal policy under
a particular exchange rate regime is the capital account and the degree
to which capital is internationally mobile. High levels of capital mobility
can be destabilising if a country has an exchange rate peg, which is why in
the post war period (1945 to 1973) when exchange rates were fixed these
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EC1002 Introduction to economics
were paired with capital controls. If investors have more funds than the
central bank then it is not possible to defend a peg.
We distinguish between different degrees of capital mobility. In one
extreme of the spectrum is perfect capital mobility, where capital is free to
move and is thus incredibly sensitive to interest rate differentials between
countries – as capital flight occurs as investors seek out the higher interest
rate on their assets. On the other is regulated capital controls that prevent
private sector capital from flowing between different currencies.
Perfect capital mobility is essentially a commitment to maintain interest
rate parity with the foreign economy, so as to prevent largescale capital
inflows or outflows. Essentially, therefore, the MP curve becomes
horizontal at the foreign interest rate i^*under a fixed exchange rate with
perfect capital mobility. External balance dictates a horizontal MP.
The implication of this is that fiscal policy is extremely effective under
a fixed exchange rate regime with perfect capital mobility. Consider a
diagram such as Figure 28.1 but modify it such that the MP curve is
horizontal. If there is a fiscal expansion (or contraction the), the IS shifts
to the right (or left), causing domestic income to rise (or fall). The effect
is far larger than in a closed economy because of the fact that there is
no crowding out of consumption and investment. This corresponds to a
movement from A to B in Figure 28.1.
Suppose instead that capital mobility was low, so capital flows would be
small in scale. It would be possible to maintain an upward sloping MP
schedule as in Figure 28.1. An interest rate differential could be sustained
between countries as capital flows are restricted to an extent, giving rise to
a smaller impact on income of A to C in Figure 28.1.
What of monetary policy? Central banks cannot implement monetary
policy under a fixed exchange rate and perfect capital mobility! This is
because the interest rate is pinned down by the overseas interest rate i^*
. If they were to try and tighten monetary policy, for example, shifting the
MP upwards, the interest rate domestically would rise above the foreign
interest rate (internal balance), attracting large scale capital inflows. The
central bank would have to intervene in the foreign exchange market to
sell domestic currency demanded by investors, thereby increasing the
money supply and restoring MP to its initial position.
In summary, under a fixed exchange rate regime and perfect capital
mobility fiscal policy is very effective while monetary policy is entirely
ineffective.
Later in the section the BVFD textbook uses the AD framework to examine
the effect of shocks on the macroeconomy, though the focus of this block is
the impact of openness and the exchange regime on policy effectiveness.
framework, which relies on changes in domestic inflation altering the real
exchange rate (even though the nominal exchange rate is fixed) and thus
international competitiveness. This is summarised in Figure 25.2.
Devalution of a fixed exchange rate
► BVFD: read section 28.3.
This section discusses the impact of a devaluation of a pegged exchange
rate in the short, medium and long run. Devaluation may be a useful tool
in response to a shock to the trade balance. It can help to achieve positive
outcomes more quickly than through a slump in the domestic economy.
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Balance of payments current account
The J-curve – This describes how a devaluation of a fixed exchange
rate may initially lead to a deterioration in the country’s current account
because the money value of imports rises while the domestic price of
exports remains steady. In time, however, once quantities begin to adjust
to the increased competitiveness brought about by the reduction in the
real exchange rate, the trade balance will improve. Examining trade
balance over time thus gives rise to a J-shaped curve (see footnote 4 in
BVFD p.555). This is demonstrated by Figure 20.3 below. As an example,
after the 1967 devaluation of pound sterling, it took between 18 and 24
months for the UK current account to move into surplus.
+
0
t0
-
Time
Figure 20.3: J-curve.
It is important to realise, however, that although countries are likely to
see an improvement in the trade balance in the medium term, in the long
run, devaluation has no real effect. As is mentioned in BVFD, empirical
evidence suggests that increases in domestic prices and wages tend to
offset the effects of the devaluation within four or five years. Looking at
Figure 25.3, the graph of the current account (value) initially shows the
J-curve shape as in the figure above, but then drops down again and levels
out in the longer term. In general – nominal change will not bring about
real change.
Activity SG20.1
What policy measures should accompany a devaluation of a pegged exchange rate to
ensure optimal results in the medium term? Under what circumstances is a devaluation
likely to have the most positive impact on the economy?
The macroeconomy under floating exchange rates
► BVFD: read section 28.4 and 28.5.
Under floating exchange rates the way the macroeconomy works is quite
different. Foreign reserves stay constant, the balance of payments is zero
and there is no need for foreign exchange intervention. As discussed
in BVFD section 28.4, in the long run, floating exchange rates adjust
to achieve the unique real exchange rate compatible with internal and
external balance’. However, in the short run, exchange rates can be very
volatile. They respond to current interest rate differentials and inflation
differentials between countries, expectations regarding the future long-run
value of the exchange rate and new information which changes people’s
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EC1002 Introduction to economics
expectations regarding interest rates, inflation or the long-run equilibrium
exchange rate.
In working through the explanation of Figure 28.4 remember that the
key assumptions are first that there are no long-run differences in interest
rates between countries and second that adjustment of the exchange rate
to eliminate interest rate differentials follows interest rate parity, with
positive (negative) interest rate differentials offset by expected and then
actual currency depreciation. As interest rate parity is not in the EC1002
syllabus, we focus discussion to the effectiveness of monetary and fiscal
policy under a floating exchange rate.
In a closed economy we analysed the effect of policy using the IS-MP
framework. We can do so here also, but factoring in that aggregate
demand that underpins the IS curve includes net exports (current
account), which adjusts with exchange rate movements. At the same time,
the exchange rate must adjust adjust to present massive capital flows in
response to interest rate changes in order to ensure external balance is
maintained.
Let us consider the effect of monetary policy under floating exchange
rates. Tighter monetary policy would cause the MP to shift up, raising the
domestic interest rate (internal balance is where IS = MP). The higher
interest rate attracts capital so the demand for the domestic currency
rises as investors seek to purchase domestic assets. This, in turn, causes
the exchange rate to appreciate, lowering net exports, shifting the IS
leftwards, moderating the effect of the interest rate, but reinforcing the
effect of the tighter monetary policy stance on domestic income. The
exchange rate movement impacts competitiveness and the short run
adjustment of the IS through the trade balance reinforces the monetary
policy adjustment making it very effective.
In contrast, fiscal policy is undermined by changes to the exchange rate
(i.e. competitiveness) in an open economy with a floating exchange rate
regime. Consider a fiscal expansion, which would raise the domestic
interest rate as IS shifts to the right. This would attract foreign capital,
putting pressure on the exchange rate to depreciate, which would reduce
the trade balance, shifting the IS leftwards again.
So, in the short run, monetary policy is powerful under flexible exchange
rates, but the effectiveness of fiscal policy is reduced.
It is important to realise that when the government fixes the exchange
rate, they lose autonomy over the interest rate. Equally, when the
government fixes the interest rate, they lose autonomy over the exchange
rate. The exchange rate adjusts to prevent massive capital flows in
response to interest rate changes.
Exchange rates also serve as a monetary policy instrument. For example,
Singapore uses the exchange rate as its primary tool for conducting
monetary policy. It manages the exchange rate through direct intervention
in the foreign exchange market (operating a managed float regime where
the trade weighted exchange rate for the Singapore dollar is allowed to
fluctuate within a policy band) and lets domestic interest rates move freely
according to market forces. This stands in contrast to ‘standard’ monetary
policy as implemented in most other countries, where interest rates are
the key tool. This has proven to be a very effective approach for Singapore,
which has a small, very open economy.
► BVFD: complete activity 28.1, read the summary and work through the
review questions.
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Block 20: Open economy macroeconomics
Overview
A country’s exchange rate regime has a profound effect on the way the
economy operates, though this depends on the size and openness of the
economy. Openness is often measured by the size of exports relative to
GDP. However, capital flows also have a big impact. Capital can either
be perfectly mobile, perfectly immobile (due to capital controls) or
partially mobile (such as when foreign and domestic assets are not perfect
substitutes). The impact of various shocks and the effectiveness of fiscal
and monetary policy depend crucially on whether there is a fixed or
floating exchange rate regime.
Under fixed exchange rates and perfect capital mobility, there is no scope
for monetary policy to influence the domestic economy, since the domestic
interest rate must match foreign rates to prevent massive capital inflows
and outflows. In the long run, internal and external balance may be
restored without policy intervention through changes in prices and output.
Fiscal policy is a powerful tool in the context of fixed exchange rates and
capital mobility, since interest rates must remain stable and there is no
crowding out of private consumption or investment.
The level of fixed exchange rates can sometimes be changed – this is
either a revaluation (rise in value) or a devaluation (fall in value) of the
exchange rate. A devaluation improves competitiveness in the short run
but is unlikely to have a large effect in the long run, though it can help
speed up adjustment to shocks.
A floating exchange rate must begin at a level from which the anticipated
convergent path to its long-run equilibrium continuously provides capital
gains or losses to offset expected interest rate differentials. The actual path
of nominal exchange rates reflects changing beliefs about the future course
of domestic and foreign exchange rates and the eventual level of the longrun exchange rate.
Under floating exchange rates, the effectiveness of fiscal policy is limited, but
monetary policy is a powerful tool. Monetary policy impacts on aggregate
demand through consumption and investment (as in a closed economy) and
also through its impact on the exchange rate and competitiveness.
Reminder of learning outcomes
Now go back to the list of learning outcomes at the start of the block and
be sure that they have been achieved.
Sample questions
Multiple choice questions
For each question, choose the correct response:
1. Suppose we have flexible exchange rates and the current account is
+50. Then the capital account:
a. is –50
b. depends on the level of sterilisation
c. depends on the balance of payments
d. depends on the amount of foreign exchange reserve accumulation.
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EC1002 Introduction to economics
2. A number of countries in Europe have adopted a single currency, the
Euro. One potential drawback of a single currency for these countries is:
a. Fiscal expansions are no longer effective.
b. They no longer have control over interest rates.
c. Their exchange rates will now be more volatile, therefore reducing
trade.
d. Capital account deficits will increase.
3. The UK has a floating exchange rate and capital mobility. The
exchange rate between the US dollar and the UK pound changed from
$1.48 dollars per pound on 23 June 2016 to $1.36 dollars per pound
on 24 June 24th 2016 following the vote to leave the European Union.
Which of the following statements is correct?
a. The UK pound appreciated relative to the US dollar.
b. The change in the exchange rate makes it less expensive for UK
residents to buy goods manufactured in the USA.
c. The change in the exchange rate makes exporting to the USA more
attractive for UK based firms.
d. The change in the exchange rate is likely to decrease the rate of
inflation in the UK.
True/False/Uncertain
For each of the following indicate whether the statements are true, false,
or uncertain, supporting your answer with a brief explanation.
1. Fiscal policy is always more effective than monetary policy as a tool to
stabilize output in an open economy.
2. Monetary policy is more effective in influencing national income
when capital is perfectly immobile internationally than when capital is
perfectly mobile.
Long response questions
1. In an open economy with a fixed exchange rate and perfect capital
mobility, a mortgage crisis leads to a fall in consumer spending
a. How does the economy come back to internal and external balance
if the government does not intervene? Explain the process in
words and illustrate graphically.
b. What would be the impact of an expansionary monetary policy?
Explain in words and illustrate graphically.
c. What would be the impact of an expansionary fiscal policy?
Explain in words and illustrate graphically.
d. Now assume the exchange rate is flexible, what would be the most
effective macro policy for the government to employ? Explain in
words and illustrate graphically.
2. China’s economy has been experiencing an investment and export
boom that has pulled the unemployment rate well below the NAIRU.
The country also has a substantial current account surplus as well as a
significant capital account surplus, a fixed exchange rate, and relative
capital immobility. The Peoples Bank of China (PBOC), China’s central
bank, always sterilises any foreign exchange market intervention
that it undertakes. The Chinese government is worried about overinvestment in many industries and rising inflation.
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a. One alternative (Scenario #1) for dealing with these concerns is
to have the PBOC use monetary policy to stabilise the economy at
potential output. Based only on this information, and making sure
to provide an explanation, use a standard IS-LM-BP model diagram
to accurately and clearly show:
i.
China’s initial economic situation.
ii. What happens to equilibrium income, interest rates, and the
balance of payments if the PBOC uses monetary policy to
stabilise the economy at potential output.
b. Re-draw your initial diagram. A second alternative (Scenario #2)
for dealing with over-investment and rising inflation is for the
government to let the exchange rate freely float, assuming that this
would return the economy to potential output. Based only on this
information, use a second standard IS-LM-BP model diagram to
accurately and clearly show:
i.
China’s initial economic situation, and what happens to
equilibrium, interest rates, and the balance of payments if
the Chinese government allows that exchange rate to become
completely flexible.
c. For each of the following variables, identify whether it is higher,
lower, the same, or indeterminate in Scenario #1 (monetary
policy) when compared to Scenario #2 (flexible exchange rate):
i.
equilibrium income
ii. interest rates
iii. investment
iv. net exports
v.
the exchange rate
vi. the balance of payments.
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Notes
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