Ec f mic e IB D COURSEBOOK E e T aga e a C A A H H D :E K 1I &R F E 1 1.1 1.2 1.3 1.4 1.5 U de a d T e ee ba U de a d T e e d A b ef g e a e f ec c c ec c e : e ce a g e db e f de f ec c f ec c g : e g ca f ec a d / c ed d ce (HL ) b c dea 2M 2 C 2.1 2.2 2.3 2.4 2.5 2.6 3 G e e P ce c I d ec a e S b de e e a e M 5.1 5.2 5.3 5.4 6 P ce e a c f de a d ( ED) I c eea c f de a d ( ED) P ce e a c f ( E ) G 4.1 4.2 4.3 4.4 5 I d c c e e a e De a d S C e e a e e b : de a d a d T e e f e ce ec a a d a e eff c e c C e f e a g be a fc e a d E 3.1 3.2 3.3 4 :D M I: C T e ea g f c e ce Ma e fa e a d e e a e : d e g g Nega e d c e e a e Nega e c e e a e aea d II: P c a be ef a dc , , 6.1 6.2 6.3 6.4 6.5 7 P e d c e e a e P ec e e a e Ma e fa e a d b c g d A e c f a (HL ) E ed b f c e a d ea M (HL ) III: M 7.1 7.2 7.3 7.4 7.5 7.6 7.7 (HL I d c f , d e a d a e c e P f a a b e a a d ce Pe fec c e M M cc e O g G e e e e e e ab e f a e ) e 3M 8 8.1 8.2 8.3 8.4 8.5 9 Ec c ac Mea e f ec c ac Ca c a ba ed a a c e acc T eb e c ce Na a c e a c a d a e a e ea Agg ega e de a d (AD) a d e agg ega e de a d c e S agg ega e a d e b e AD-A de L gagg ega e a d ge b e ea / e ca de Agg ega e a de b e Ke e a de S f g agg ega e c e e e g e I ca f e Ke e a de a d e e a / e c a ca de 9.4 9.5 9.6 M I: L 10.1 10.2 10.3 11 L L E ca , fa be ee II: E Ec cg S a ab e e e f g e P e a c f c be ee e e a d fa , e deb (HL ) ac ec c b ec e E 12.1 12.2 12.3 12.4 12.5 13 e e a d ab e a e f g e ea M 11.1 11.2 11.3 12 e A 9.1 9.2 9.3 10 g D 13.1 13.2 13.3 13.4 13.5 13.6 I e a P e Ca e f ec c e a a d e T e ac f c e a d ea e a P ce ed ce c e a d ea e a - e a d e I d c ac ec c ce De a d a age e a d ea c De a d a age e a d f ca c T e Ke e a e (HL ) F e c e e a d Ke e a ec ec e ded f HL O ) S - de ce c e (S e e a ae a E a a f de a d- de a d a d ab e a e f f a a d ec 13.7 4 14 I 14.1 14.2 14.3 15 I 15.1 15.2 15.3 15.4 16 ce e e e , E :P I T e be ef f F ee ade: ab T e f ade e a a ade ea dc a a e ad a age (HL ec : e c f ee ade :P ) II A g e f a d aga ade ec Ec c eg a : ad g b c Ec c eg a : ea W d T ade O ga a E 16.1 16.2 16.3 16.4 17 G - de cg F a ge c a C e e ce G e e T e ba a ce f ge a e f c a ge e e a e e c a ge a e : a e a a F (HL 17.1 17.2 17.3 17.4 H e c e acc a d e f a c a acc C a ga dc a g e c a ge a e e E a a g ea U de a d g c e acc def c a d 18.1 18.2 S a ab e de e Mea g de e a e e a ed ) e c a ge a e e 18 19 e e B 19.1 19.2 19.3 P e c ce ( a ) Ec c ba e P ca a d c a ba e 20.1 20.2 20.3 20.4 20.5 20.6 20.7 20.8 20.9 20.10 I e a a ade a eg e D e f ca a d ca e e e Ma e -ba ed ce I e e c e : ed b F e g d ec e e a d F eg ad M a e a de e e a a ce I a c a ge S e g a d a fg e P ge a d ee g e ec ed S 20 a d a e f a c e g d (MNC ) a e e a ab e De e e e a eG a e ed a ac e F A e i , A e , K ia Abo he a hor Ellie T agake ha a BA f m C l mbia Uni e i , MS cSc f m he Uni e i f Bi mingham and PhD f m he Uni e i f Ma land. She ha ked in he a ea f ec n mic de el men f ag ic l e in ec n micall le de el ed c n ie , financial e ice and heal h em , in e e al na i nal and in e na i nal gani a i n , incl ding he W ld Bank and W ld Heal h O gani a i n. She i a highl e e ienced a h , i h n me fe i nal blica i n . Man f he e a e in he a ea f heal h em financing and ef m in an i i n ec n mie , and ha e been an la ed in e e al lang age incl ding R ian and Chine e. She i al a highl e e ienced eache and e amine , ha ing a gh f man ea in he Ec n mic De a men a he Ame ican C llege f G eece and al ha ing e ed a IB Ec n mic Chief E amine . She c en l e e a IB Seni E amine and Managing Di ec f Hellenic Ag ic l al En e i e . Ackn ledgemen A h I would like to express my deepest gratitude to Peter Rock-Lacroix for his detailed, thorough and exhaustive review of the entire book, including the materials accompanying the digital version. In addition to offering most insightful and creative suggestions for improvements and catching errors, Peter was a continuous encouraging and supportive presence throughout the entire writing process. I am also grateful to Dimitris Doulos, Roma Kaur and Charles Wu for their valuable comments on the first three chapters of the book that helped set guidelines for the remainder of the writing. In addition, I would like to extend my sincere thanks to many friends and colleagues around the world who contributed to the previous two editions of the book. They include Henry Tiller, former IB Economics Chief Examiner, and Emilia Drogaris, both of whom commented extensively on the second edition, and Julia Tokatlidou for her extensive review of the first edition. I would also like to express my gratitude to Tibor Cernak, Simon Foley, Hana Abu Hijleh, Kiran Asad Javed, Jane Kerr, Pat Lasonde, James Martin, Peter Rock-Lacroix, Sachin Sachdeva, Vijay Peter D Sou a, Charles Wu, Lar Lun, Constantine Ziogas for their comments and suggestions for improvements. My warmest thanks also go to K.A. Tsokos for the guidance and inspiration that his book, Ph sics for the IB Diploma, provided for me. A h and bli he The author and publishers acknowledge the following sources of cop right material and are grateful for the permissions granted. While ever effort has been made, it has not alwa s been possible to identif the sources of all the material used, or to trace all cop right holders. If an omissions are brought to our notice, we will be happ to include the appropriate acknowledgements on reprinting. UN Sustainable Development Goals from https://www.un.org/sustainabledevelopment/sustainabledevelopment-goals/ 2019 United Nations, reprinted with permission of the United Nations Thanks to the following for permission to reproduce images: Cover Russ Widstrand/Getty Images Inside Tony Wu Photography/Shutterstock; Hulton Archive/GI; Culture Club/GI; Bettmann/GI; BSIP/GI; Florian Gaertner/GI; Miroslav_1/GI; Jaboo2foto/GI; Ullstein Bild/GI; Rawpixel.Com/Shutterstock; Artmarie/GI; Craig Ferguson/Lightrocket/GI; Luoman/GI; Carsten Koall/GI; Quangpraha/GI; Douglas Graham/GI; Lillitve/GI; Florian Gaertner/GI; Maja Hitij/GI; Education Images/GI; EtiAmmos/GI; Per-Anders Pettersson/GI; Ofirperet /GI; Stockshoppe/Shutterstock; Tommasourbinati/GI; John Thys/GI; John Longley/GI; Jasondoiy/GI; Jasper Juinen/GI; Pavelvinnik/GI; Str/GI; Tony C French/GI; Pongkiat Rungrojkarnka/GI; Yuliya Derbisheva/GI; Alira a Khatri's Photography/GI; Petmal/GI; Senhan Bolelli/Anadolu Agency/GI; Flyingrussian/GI; Ds c/GI; Hadynyah/GI; Oli Scarff/GI; Drante/GI; Kheng Guan Toh/Shutterstock; Smith Collection/Gado/GI; John Moore/GI; Blocberry/GI; Bro o owska/GI; Dea/G. Dagli Orti/GI; D3sign/GI; Tim Graham/GI; Robert Hradil/GI; Rebeca Mello/GI; Australian Scenics/GI; Benoitb/GI; Str/GI; Barcroft Media/GI; Ted Aljibe/GI; The Washington Post/GI; Frankvandenbergh/GI; Tkkurikawa/GI; Jxf sy/GI; Maria Toutoudaki/GI; Pacific Press/GI; A_Noina/Shutterstock; Farm Images/GI; Ute Grabowsky/GI; Himarkley/GI; Jan Sochor/GI; Moment/GI; Bra il Photos/GI; Guido Dingemans, De Eindredactie/GI; Sopa Images/GI; Karelnoppe/GI; Nurphoto/GI; Jasmin Merdan/GI; John Borthwick/GI; Ashraf Sha ly/GI; Bennett Raglin/GI. Ke : GI= Getty Images. H Th o gho e hi book o b ill find lo of diffe en fea e o help o lea ning. CONCEPTUAL UNDERSTANDINGS The e a emen in od ce he ke concep of he ni . LEARNING OBJECTIVES A b lle ed li a he beginning of each ec ion clea l ho he lea ning objec i e of he ec ion. The e objec i e link o he a e men objec i e and o come in he IB economic g ide. TEST YOUR UNDERSTANDING Te o nde anding q e ion appea a he end of e e opic, and help o e ie he lea ning objec i e of he ec ion. The can be ed a he ba i fo cla di c ion o home o k a ignmen . If o can an e he e q e ion , i mean o ha e nde ood he impo an poin of a ec ion. REAL WORLD FOCUS Real o d foc fea e help o ela e he heo o a e lea ning o p ac ice in eal life. The e a e follo ed b q e ion in ended o foc o a en ion on impo an heo e ical idea and hei ele ance o eal o ld i a ion . Ke poin , ch a impo an la , concep , defini ion and concl ion , a e highligh ed in an o ange bo . Thi help o foc on he impo an ma e ial in a chap e and can facili a e e ie ing. EXAM STYLE QUESTIONS Yo can find q e ion in he le of IB e am in he 'Digi al co ebook: E a ma e ial' ec ion. BEFORE YOU START Thi ho ec ion of a emen and q e ion ill help o o eflec on p io lea ning, check ha kno ledge o ill need fo he chap e and p o oke o o n ho gh abo he opic. D be ee c e a d g e e e ae a The book i di ided in o co e and highe le el ma e ial. A e ical line n do n he ma gin of all highe le el ma e ial, allo ing o o ea il di ing i h highe le el f om co e ma e ial. THEORY OF KNOWLEDGE Theo of kno ledge fea e enco age o o hink c i icall abo economic a a ocial cience, he na e of economic kno ledge, diffic l ie in ol ed in acq i ing economic kno ledge, h economi di ag ee, he ole of al e , lang age, e hic , belief and ideolog in he de elopmen of economic kno ledge. Each fea e end i h q e ion in ended o im la e f di c ion on he e impo an heo of kno ledge i e . he hinking and INQUIRY AND REFLECTION The e q e ion appea a he end of each chap e and enco age o o eflec on he de elopmen of o kill p oficienc and o p og e again he objec i e . The a e in ended o enco age o c i ical hinking and inq i -ba ed lea ning. Ke e m a e highligh ed in a ge b d fon a hei fi appea ance in he book o o can immedia el ecogni e hem. A he end of he book, he e i a glo a ha define all he ke e m . Digi al c a e ial Thi digi a c hi c eb eb c ai . The digi a c I d ci i e al a e eb a eb IB Ec e k: E be f fi e ha a e i e ded fi e a e a f : ic a e a i a d g ide e :E a He e i fi d a e a a i f a he IB e a a e i eed i f ai ea i g b ec i e i h c e di g a e e b ec i e begi i g f each ec i a d b ec i f he b , c a d e ha a e a e i , he d a i f each e a a e a d he e ce age f each i gge i he ihe a ,a da e a ai fi e a a e e Checkli c eb fi a k a e ial Checkli : Real ld i ic hel e a d ke c a a a e e a d e a e f , i c di g ha a ea a he ea a he begi i g f he a IB c e, ef . ga i e he ce Each f he h ee ai i f he b (Mic ec ic , Mac ec ic a d The G ba Ec ) i di ided i ec i headed b a real- orld issue. The e a e i ea d i e , each f c i g a b ad, ge e a e i i d ci g he ai ic f he b e e cha e . I addi i he e a e i e ke concepts i g h gh ec ic c e. I hi chec i i fi d gge i h i he e c ce he ea di e . Checkli : Mea e e f ec ic ac i i , ell-bei g, ec The e a e e e a a e a i g ea e he e i h a a defi i i f each, he Checkli : Calc la i ic i e ali a d f he e i a ec ic a iab e . The a e a i ed di i g i h be ee he a d a id c f i . a SL a d HL The IB Ec ic ab ide de ai ed i f ai a ca c a i ha h d be ab e ef , a b h SL a d HL. Thi chec i i a he e ca c a i ha ca ea i g h gh he a e e ha de a d ha he a e a d chec he ff a g h gh ac ice e e ci e . Y i fi d e ac ice e e ci e i he Te Y U de a di g e i i he b . Checkli : P licie f Pa e 3 (HL l ) O e f he e i i Pa e 3 a de ec e da ic i de add e i e. Thi chec i i c de a icie ha a e i c ded i he IB Ec ic ab cha e he e he ic i di c ed. B g i g h gh hi i ca ea i chec fa i ia i h a he icie ha a be e i ed ec e d i Pa e 3. Y e i eai g icie i he Te Y U de a di g e i a e a i I Ref ec i ac i i ie . I addi i eache a gi e ic e i f he a a ic a , a g i h he ff ha ae i fi d e i a d eache e ce. I a diag a ih i h e he The IB Ec ic ab ide a de ai ed i f a diag a ha eed de a d a d d a . He e i fi d a he e diag a e d ced a d ga i ed b cha e a d ic i hi each cha e , iha e if he diag a i HL . I addi i f each diag a he e i a i ha h d be ab e i aeb e f he diag a i e i .Y eache ca gi e ac ice e i ih diag a f he eache e ce. Q a i a i e ech i e Thi ec i c ai a he a i a i e ech i e eed de a d i de e ce i Ec ic c e. I e ab e e ie e e hi g f e ce age a d e ce age cha ge de a di g he e e ia f e a i hi be ee a iab e , a d i e e i g a d c ci g diag a a d g a h . IB Pa e 1 (HL a d SL) He e i fi d a e e i b , c e i g a he cha e . Y eache e ce. f hi a e a SL a d HL, c e eache ca ide ih a di g each cha e i he che e ha a e i c ded i he Pa e 2 (HL a d SL) He e i fi d c e e Pa e 2 e i . G i g h a g d idea f he c e f hi a e . Y eache ca i c ded i he eache e ce. Pa e 3 (HL hi a i fi d c e e Pa e 3 de a d h hi a e i c ed. Y i c ded i he eache e ce. le e a i ide che e ha a e ih l ) I S gh he e ca ef ide ih a e i . G i g h gh he e ca ef i a eache ca ide i h a che e ha a e a e ial Thi i a e e i f he a e ia i a e ia , b ha a be f i e e i e i ec ic . he b de . I i c de a be f ic ha a e e i ed h d i e gai a dee e de a di g f e Table of contents for digital material Introduction to IB Economics assessment: Exam papers and internal assessment Checklist: Real world issues and key concepts Checklist: Measures of economic activity, well-being, economic inequality and poverty Checklist: Calculations at SL and HL Checklist: Policies for paper 3 (HL only) Important diagrams with tips on how to use them Quantitative techniques Paper 1 (SL and HL) Paper 2 (SL and HL) Paper 3 (HL only) Supplementary material 1 Economics for the IB Diploma - Tragakes © Cambridge University Press 2020 T 1.1 1.2 2.1 2.2 2.3 4.1 5.1 5.2 6.1 7.1 8.1 8.2 9.1 10.1 10.2 11.1 12.1 12.2 13.1 15.1 18.1 19.1 20.1 K d a Ref a i , cie ce a d h Wh d ec i f e di ag ee? The ea i g a d i ica i f a i cia e fa e A i , e ce i f fai e a d e f-i e e ed beha i f a i a ec ic deci i - ake H i a a e he c i ici f fi a i i a i a he fi ai g a ? A ca i e efficie c : i i ea a e-f ee? Ec ic hi ki g ai abi i a d E i O , i e f he 2009 N be P i e i Ec ic The e hica di e i f ai abi i a d e e i g he g ba c i a e I e ai i eai a ke fai e: he ibi i f a i cia i he e e ce f e e e i e a i ie Pe fec c e i i a d he ea d The b i e c c e, ac a a d e ia : i g a iab e ha ca be b e ed The GDP c ce C f ic i g ec ic e ec i e a d he e f ec i i ica be ief a d ide g Wha i a a ab he a a a e f e e ? Ch i g be ee e e a d i f a i : he e f i ic a d ide g i ec ic ic The c f ic be ee ec ic g ha d ai abi i Ab ea d eai e e P i ci e f e i f a a i Pa adig hif i ac ec ic I he e a a a ec i he ec ic a g e i fa f f ee ade? The a e f ec ic de e e The a e f ed ca i M a i e f ade ibe a i a i i de e i g c ie Unit 1 Introduction to Economics CONCEPTUAL UNDERSTANDINGS 1 Economic i a ocial cience in hich here i in e dependence be een people ho in erac i h each o her o impro e heir economic ell-being, and ho are infl enced and empo ered b heir al e and na ral rro nding . 2 The economic orld i d namic and 3 Economic heorie are fo nded on he principle of logic complemen ed b empirical da a, ed o b ild model ha r o e plain o r comple economic orld. Indi id al and gro p of indi id al di pla mo i a ion and beha io r ha are comple and aried. Their nder anding i facili a ed b he con rib ion of e eral di cipline ha in erac i h economic , ch a p cholog , philo oph , poli ic and hi or . 4 Economic deci ion-making i cen ral o de ermining he rela i e economic ell-being of indi id al and ocie ie . 5 The ke problem of economic deri e from ca ci , hich nece i a e choice. Thi in rn lead all economie o confron rade-off , oppor ni co and he challenge of ainabili . 6 Economic hinking face a n mber of deba e . Among he mo impor an of he e i he deba e be een economic gro h and e i , and he deba e be een free marke (and heir efficienc ) and go ernmen in e en ion. 7 Unlimi ed economic gro h ba ed on he e of fini e re o rce canno con in e indefini el . E abli hed heorie and approache o he i e of economic gro h are being challenged b ne model and ocial mo emen i h a ie o rede igning he econom o ppor long- erm pro peri . bjec o con in o change. Man rgen i e in o r orld oda , ch a po er , poll ion, he en ironmen , economic gro h, andard of li ing, nemplo men , infla ion, echnolog , in erna ional rade and man more, in ol e economic . The objec i e of economi i o e plain, anal e and nder and i e ch a he e in he hope of finding a o deal i h hem o a o bring abo impro emen in he ell-being of people e er here. Marrake h, Morocco. Woolen handmade ha for ale in he marke q are of he old ci _______________________________________________________________________ C a T 1 da c c BEFORE YOU START As ou begin this course, ou ma alread have an idea of economics . What do ou think the subject is about? Sciences like ph sics, biolog and chemistr are e amples of natural sciences . Anthropolog , ps cholog and economics are e amples of social sciences . In hat a s do ou think natural and social sciences are similar and in hat different? a s are the What do ou think the purpose of government should be in societ ? Chapter 1 of this book is an introduction to the social science of economics. We ill discover the meaning of economics, and ill discuss ke concepts forming the basis of the economic perspective of the orld. We ill see ho economists use models and theories to anal se economic problems, and ill also learn about the organising principles of market, planned and mi ed economies. The chapter ill end ith an account of famous economists ho made important contributions to economic thought. 1.1 U LEARNING OBJECTIVES After stud ing this section ou ill be able to: define all the terms appearing in in the te t (AO1) e plain the social nature of economics (AO2) distinguish bet een microeconomics and macroeconomics (AO2) e plain the nine central concepts that run through our course in economics (AO2) e plain the meaning of scarcit (AO2) as unlimited human needs and ants met b limited resources in relation to sustainabilit identif and e plain the four factors of production (AO2) e plain the meaning of opportunit cost and its relationship to choice and free goods (AO2) E T The are academic disciplines that stud human societ and social relationships. The are concerned ith discovering general principles describing ho societies function and are organised. The social sciences include anthropolog , economics, political science, ps cholog , sociolog and others. Economics is a social science because it deals ith human societ and behaviour, and particularl those aspects concerned ith ho people organise their activities and ho the behave to satisf their needs and ants. It is a social science because its approach to stud ing human societ is based on the scientific method, hich e ill consider belo . M The stud of economics breaks do n the economic orld into t o levels. One of these is like looking at the economic orld through a microscope, hile the other is like looking at it through a telescope. The micro level, called , e amines the behaviour of individual decision-making units in the econom . The t o main groups of decision-makers e stud are consumers (or households) and firms (or businesses). Microeconomics is concerned ith ho these decisionmakers behave, ho the make choices, hat are the consequences of their decisions and ho their interactions in markets determine prices. (Micro comes from the Greek ord μικ or micr , meaning small) The macro level, called , e amines the econom as a hole to obtain a broad or overall picture of the econom . Macroeconomics uses aggregates, hich are holes or collections of man individual units, such as the sum of consumer behaviours and the sum of firm behaviours, and total income and output of the entire econom , as ell as total emplo ment and the overall price level. (Macro comes from the Greek ord μάκ ο or makros, meaning large.) The ideas and principles that are developed in microeconomics and macroeconomics are the building blocks that economists use to stud man specific areas of economics. Some of these areas are studied at the micro level, such as market failure (Chapters 5 7) and others at the macro level, such as unemplo ment and inflation (Chapter 10). In addition, the ideas and principles developed in microeconomics and macroeconomics are applied to the stud of man other areas, such as International economics and Development economics, hich ou ill discover in Unit 4 of this book. K The concepts listed belo ill be discussed in a number of different conte ts in our stud of economics. While economists agree on the definitions of each of these, there are debates over ho some of these concepts should be interpreted or applied, especiall in connection ith formulating appropriate economic policies to address important economic objectives. You ill encounter man of these as ou read this book. S One of the most important concepts in economics, , refers to the idea that resources are insufficient to satisf unlimited human needs and ants. In fact, it is said that if there ere no scarcit , there ould be no social science of economics. This is because economics is the stud of ho our scarce or limited resources can best be used in order to satisf the unlimited needs and ants of human beings. C In a ver important sense, economics is the stud of . Since resources are scarce, it is not possible for all human needs and ants to be satisfied. This means that choices must be made about hat ill be produced and hat ill be foregone (not produced and therefore sacrificed). Economics studies ho different decision-makers make choices bet een competing alternative options, and anal ses the present and future consequences of their choices. E E refers to making the best possible use of scarce resources to avoid resource aste. In vie of the scarcit of resources, it is important to use these in a s that ensure the are not asted. In part, efficienc means using the fe est possible resources to produce goods and services. But, in addition, it requires that scarce resources are used to produce the goods and services that mostl satisf societ s needs and ants. This is kno n as , used as a benchmark or standard to determine the appropriateness of economic actions from the point of vie of minimising resource aste. E E is the idea of being fair or just. Equit is not the same as equalit , hich is the sameness of treatment or outcomes for people or groups of people in a societ . Fairness is a normative concept (to be discussed later) because ideas of hat is fair var according to beliefs, value judgements and ideologies. In economics, the ideas of equit and inequit are usuall identified ith equalit and inequalit , and are used mostl in connection ith equalit in the distribution of income, ealth and human opportunit . In all economic s stems, these kinds of inequities or inequalities are present both ithin and bet een societies, and are significant issues, as man people cannot meet their basic needs and lack opportunities. There is much debate among economists on ho much and hat t pes of government intervention in markets are appropriate in order to address these issues effectivel . E - E is a concept that has several different dimensions. It refers to levels of prosperit , economic satisfaction and standards of living among the members of a societ . Economic ell-being includes: securit ith respect to income and ealth, having a job and housing the abilit to pursue one s goals, ork productivel and develop one s potential the abilit to have a satisfactor qualit of life, hich includes numerous factors such as health, education, social connections, environmental qualit , personal securit the abilit to maintain all of the above over time.1 There are ver significant variations in levels of economic ell-being both ithin nations and bet een nations. S S refers to the long-term maintenance or viabilit of an particular activit or polic . In economics, it is most commonl used to refer to the abilit of the present generation to satisf its needs b the use of resources, and especiall non-rene able resources, ithout limiting future generations abilit to satisf their o n needs. The problem arises because the present generation at an moment in time engages in man economic activities of production and consumption that too often destro or degrade (lo er the qualit of) the environment and non-rene able resources. The result of such activities is that future generations ill be penalised. Therefore the issue is ho to develop methods of production and patterns of consumption that ill not result in such environmental and resource destruction and degradation. C Panta rhei is a famous sa ing b the Greek philosopher Heraclitus, that means ever thing flo s . Heraclitus taught that is an essential part of life. This idea is ver important in economics, here much of hat e stud is in a continuous state of change. In economics, e can distinguish bet een the idea of change: (i) in economic theor and (ii) in real- orld events. In economic theor , economists ver often stud change bet een one situation and another situation that has been caused b a change in one or more variables. It is important to bear this in mind in our stud of economics as ou ill often be asked to anal se and evaluate this kind of change in a large variet of conte ts. Regarding the stud of real- orld phenomena, the orld is characterised b continuous change in the institutional, technological, social, political and cultural environments in hich economic events occur. I I refers to the idea that economic decision-makers interact ith and depend on each other. Such interdependence occurs on all levels, from individuals, to communities, to nations and to groups of nations. Interdependence arises from the fact that no one is self-sufficient, requiring everincreasing degrees of interactions and interdependence. Consumers, orkers, firms, governments and all other individuals or groups of individuals depend on one another for the achievement of their economic goals. With increasing globalisation ( hich refers to the interactions and integration of economies orldide), interdependence increases. In a highl interdependent orld, events in one part give rise to man and possibl unintended consequences in other parts, ith outcomes that cannot al a s be predicted or discovered b looking at the constituent parts in isolation. Economists must therefore take into consideration both intended and unintended consequences of economic decisions and events hen there is a high degree of interdependence. I In economics, t picall refers to government intervention, meaning that the government becomes involved ith the orkings of markets. While markets offer numerous advantages as a a to achieve important economic objectives, it is generall recognised that markets on their o n often cannot achieve important societal goals, such as the goals of equity, sustainability, economic well-being or efficiency. When this occurs, hether at the micro or macro levels, there ma be good reason for the government to intervene in order to correct for the market s deficiencies. Ho ever, economists and polic -makers often disagree idel on the need for, degree and method of intervention that is necessar . A ke debate that ou ill repeatedl encounter in our studies of economics involves the advantages and disadvantages of free markets versus government intervention. T : T The term economics is derived from the ancient Greek e pression o kov v iv (oikon nemein), hich originall meant one ho manages and administers all matters relating to a household . Over time, this e pression evolved to mean one ho is prudent in the use of resources . B e tension, economics has come to refer to the careful management of societ s scarce resources to avoid aste. Let s e amine this idea more carefull . Human beings have ver man needs and ants. Some of these are satisfied b ph sical objects and others b non-ph sical activities. All the ph sical objects people need and ant are called goods (food, clothing, houses, books, computers, cars, televisions, refrigerators and so on); the non-ph sical activities are called services (education, health care, entertainment, travel, banking, insurance and man more). The stud of economics arises because people s needs and ants are unlimited, or infinite. Whereas some individuals ma be satisfied ith the goods and services the have or can bu , most ould prefer to have more: more and better computers, cars, educational services, transport services, housing, recreation, travel and so on; the list is endless. Yet it is not possible for societies and the people ithin them to produce or bu all the things the ant. Wh is this so? It is because there are not enough . Resources are the inputs used to produce goods and services anted b people, and for this reason are also kno n as . The include things like human labour, machines and factories, and gifts of nature like agricultural land and metals inside the earth. Factors of production do not e ist in unlimited abundance: the are scarce, or limited and insufficient in relation to unlimited uses that people have for them. S is a ver important concept in economics. It arises henever there is not enough of something in relation to the need for it. For e ample, e could sa that food is scarce in poor countries, or e could sa that clean air is scarce in a polluted cit . In economics, scarcit is especiall important in describing a situation of insufficient factors of production, because this in turn leads to insufficient goods and services. Defining scarcit , e can therefore sa that: S is the situation in hich available resources, or factors of production, are finite, hereas ants are infinite. There are not enough resources to produce ever thing that human beings need and ant. W The conflict bet een unlimited ants and scarce resources has an important consequence. Since people cannot have ever thing the ant, the must make choices. The classic e ample of a choice forced on societ b resource scarcit is that of guns or butter , or more realisticall the choice bet een producing defence goods (guns, eapons, tanks) or food: more defence goods mean less food, hile more food means fe er defence goods. Societies must choose ho much of each the ant to have. Note that if there ere no resource scarcit , a choice ould not be necessar , since societ could produce as much of each as as desired. But resource scarcit forces the societ to make a choice bet een available alternatives. Economics is therefore a stud of choices. The conflict bet een unlimited needs and ants, and scarce resources has a second important consequence. Since resources are scarce, it is important to avoid aste in ho the are used. If resources are not used effectivel and are asted, the ill end up producing less; or the ma end up producing goods and services that people do not reall ant or need. Economics must tr to find ho best to use scarce resources so that aste can be avoided. Defining economics, e can therefore sa that: E is the stud of choices leading to the best possible use of scarce resources in order to best satisf unlimited human needs and ants. As ou can see from this definition of economics, economists stud the orld from a social perspective, ith the objective of determining hat is in societ s best interests. TEST OUR UNDERSTANDING 1.1 1 Think of some of our most important needs and ants, and then e plain hether these are satisfied b goods or b services. 2 Outline h economics is a stud of choices. Describe its relationship to scarcit . Outline ho scarcit is related to the need to avoid aste in the use of resources. 3 E plain h diamonds are far more e pensive than ater, even though diamonds are a lu ur hile ater is a necessit ithout hich e cannot live. S T Economic activities in man (if not most) countries are often achieved at the e pense of the natural environment and natural resources. Economic growth, hich involves increases in the amount of goods and services produced, ver often results in increased air and ater pollution, and the destruction or depletion of forests, ildlife and the o one la er, among man other natural resources. Increasing a areness of this issue has given rise to the concept of sustainable development, defined as development hich meets the needs of the present ithout compromising the abilit of future generations to meet their o n needs .2 Sustainable development occurs hen societies gro and develop ithout leaving behind fe er or lo er-qualit resources for future generations. If e, in the present, use up resources at a rate that leaves fe er or lo er-qualit resources behind, e are satisf ing our needs and ants no at the e pense of people in the future, ho ith fe er or lo er-qualit resources ill be less able to satisf their o n needs and ants. If e change the global climate and use up clean air, seas and rivers, forests and the o one la er, e put future generations at a disadvantage and even in danger. Using the definition of sustainable development, e can see that sustainability or sustainable resource use involves using resources in a s and at rates that do not reduce their quantit or qualit over time. As a rule, this term is used ith reference to rene able resources, or those kinds of natural resources that are able to reproduce themselves (such as forests, fish and sea life, air qualit , the fertilit of the soil). Sustainable resource use does not mean that these kinds of natural resources should not be used at all, but rather that the should be used at a rate that gives them enough time to reproduce themselves, so that the can be maintained over time in terms of quantit and qualit and not be destro ed or depleted. It is clear that the issue of sustainable use of resources arises from the fact that these resources are scarce. If the ere not scarce, it ould not matter at all ho fast e used them or destro ed them as there ould be plent more. S refers to maintaining the abilit of the environment and the econom to continue to produce and satisf needs and ants into the future; sustainabilit depends cruciall on , referring to the preservation of the environment over time. The problem of sustainabilit arises because resources are scarce. Threats to sustainabilit do not onl result from high-income production and consumption patterns that rel strongl on polluting fossil fuels as ell as other activities that destro the environment. In addition, in ver poor societies, threats to sustainabilit often arise from povert itself, hich drives ver poor people to destro their natural environment as the make efforts to survive. E amples include cutting do n forests, overgra ing, soil erosion and man more. In all these cases, there ma be an unsustainable use of resources, as fe er and lo er-qualit resources are left behind for future generations. While virtuall ever one toda agrees on the importance of sustainabilit , there is vast disagreement about hat this means from a practical point of vie , and ho this can be achieved in practice. We ill discuss the issue of sustainable resource use and policies to achieve this in Chapter 5. TEST OUR UNDERSTANDING 1.2 1 E plain the relationship bet een scarcit and sustainabilit . 2 Consider the follo ing: Dangerous levels of industrial air pollution in India reduce life e pectanc b seven ears for 40% of its population. This refers to the people living in the states of the Indo-Gangetic plain, here pollution has increased b 72% in a period of 18 ears. The population of Delhi faces an average loss of 10.2 ears. The public is outraged. The government has begun to respond to this public health emergenc .3 Research an e ample of a challenge India faces and outline ho it is a threat to sustainable development. Describe ho India s rapid economic gro th impacts its future generations. R We have seen that resources, or all inputs used to produce goods and services, are also kno n as factors of production. T Economists group the factors of production under four broad categories: L consists of all natural resources, including all agricultural and non-agricultural land, as ell as ever thing that is under or above the land, such as minerals, oil reserves, underground ater, forests, rivers and lakes. Natural resources are also called gifts of nature . L includes the ph sical and mental effort that people contribute to the production of goods and services. The efforts of a teacher, a construction orker, an economist, a doctor, a ta i driver or a plumber all contribute to producing goods and services, and are all e amples of labour. C , also kno n as physical capital, is a manmade factor of production (it is itself produced) used to produce goods and services. E amples of ph sical capital include machiner , tools, factories, buildings, road s stems, airports, harbours, electricit generators and telephone suppl lines. Ph sical capital is also referred to as a capital good or investment good. E (management) is a special human skill possessed b some people, involving the abilit to innovate b developing ne a s of doing things, to take business risks and to seek ne opportunities for opening and running a business. Entrepreneurship organises the other three factors of production and takes on the risks of success or failure of a business. O The term capital , in the most general sense, refers to resources that can produce a future stream of benefits. Thinking of capital along these lines, e can understand h this term has a variet of different uses, hich although are seemingl unrelated, in fact all stem from this basic meaning. P , defined above, is one of the four factors of production consisting of man-made inputs that provide a stream of future benefits in the form of the abilit to produce greater quantities of output: ph sical capital is used to produce more goods and services in the future. H refers to the skills, abilities and kno ledge acquired b people, as ell as good levels of health, all of hich make them more productive. Human capital provides a stream of future benefits because it increases the amount of output that can be produced in the future b people ho embod skills, education and good health. N , also kno n as environmental capital, refers to an e panded meaning of the factor of production land (defined earlier). It includes ever thing that is included in land, plus additional natural resources that occur naturall in the environment such as the air, biodiversit , soil qualit , the o one la er and the global climate. Natural capital provides a stream of future benefits because it is necessar to humankind s abilit to live, survive and produce in the future. F refers to investments in financial instruments, like stocks and bonds, or the funds (mone ) that are used to bu financial instruments. Financial capital also provides a stream of future benefits, hich take the form of an income for the holders, or o ners, of the financial instruments. TEST OUR UNDERSTANDING 1.3 1 Outline h resources are also called factors of production . Identif the four factors of production. 2 Outline ho ph sical capital differs from the other three factors of production. 3 Describe h entrepreneurship is considered to be a factor of production separate from labour. 4 Identif the various meanings of the term capital . Outline hat the have in common. S , : O Opportunity cost is defined as the value of the ne t best alternative that must be given up or sacrificed in order to obtain something else. Ever time e choose to do something, e give up something else e could have done instead. For e ample, our decision to read this book no means ou have given up a different activit , such as sleeping, atching TV or visiting a friend. If our best or favourite alternative to reading this book is atching TV, the TV time ou have sacrificed is the opportunit cost of reading this book. Opportunit cost in this case rises from the fact that time is limited or scarce; if it ere endless, ou ould never have to sacrifice an activit in order to do something else. When a consumer chooses to use her $100 to bu a pair of shoes, she is also choosing not to use this mone to bu books, food or an thing else; if books are her favourite alternative to shoes, the books she sacrificed (did not bu ) are the opportunit cost of the shoes. Note that if the consumer had endless amounts of mone , she could bu ever thing she anted and the shoes ould have no opportunit cost. The concept of , or the value of the ne t best alternative that must be sacrificed to obtain something else, is central to the economic perspective of the orld, and results from the scarcit that forces choices to be made. TEST OUR UNDERSTANDING 1.4 1 Define opportunit cost. 2 E plain ho scarcit and choice relate to opportunit cost. 3 Think of three choices ou have made during the past eek and describe the opportunit cost of each one. F Based on the concept of opportunit cost, e can make a distinction bet een free goods and economic goods (note that the term good is used here in a general sense to include goods, services and resources): A is an good that is not scarce, and therefore has a ero opportunit cost. Since it is not limited b scarcit , it includes an thing that can be obtained ithout sacrificing something else. An economic good is an good that is scarce, either because it is a naturall -occurring scarce resource (such as oil, gold, coal, forests, lakes), or because it is produced b scarce resources. All economic goods have an opportunit cost greater than ero. Free goods are rare. Sometimes a good can be a free good in certain situations and an economic good in others. For e ample, arable land in America before European colonisers arrived as a free good because it as so abundant; as the colonisers gre in numbers it became increasingl scarce and therefore an economic good. Salt used to be a free good that has become an economic good. O gen in the open unpolluted countr side can be a free good; in a room ith no indo s that is cro ded ith people, it becomes an economic good. Unobstructed sunshine is also a free good in man situations. It is important to distinguish free goods from goods or resources that are available free of charge to their users. There are t o categories of goods that are available free of charge, but hich do have opportunit costs and are therefore economic goods: goods provided b the government, such as the road s stem, public parks and pla grounds, free education, free health care services; all these are economic goods produced b scarce resources, and are paid for out of ta revenues (see Chapter 6); certain natural resources, such as clean air, forests, rivers, lakes and ildlife, that are not o ned b an one (the are called common pool resources; these are also economic goods because the are scarce, and are becoming increasingl scarce due to overuse and depletion (see Chapter 5). TEST OUR UNDERSTANDING 1.5 1 E plain the difference bet een a free good and an economic good. 2 Identif hich of the follo ing goods are free goods and e plain h : public parks sand in the Sahara desert garbage collection free health care services ildlife. 3 Wh do ou think free goods are rare? 1 OECD Frame ork for Statistics on the Distribution of Household Income, Consumption and Wealth, Chapter 2 Economic ell-being, OECD 2013. 2 Brundtland Commission (World Commission on Environment and Development) (1987) Our Common Future, O ford Universit Press 3 Pollution: From Punjab to Bengal, 48 crore people ma die 7 ears earl but all is not lost Dirt air: ho India became the most polluted countr on earth 1.2 : / LEARNING OBJEC I E After stud ing this section ou will be able to: define all the terms appearing in in the text (AO1) identif and explain the three basic economic questions (AO2) distinguish between the role of markets and government intervention in designing and proposing solutions to the basic economic questions (AO2) distinguish between economic s stems: the free market econom , planned econom and mixed econom (AO2) : / , Scarcit forces ever econom in the world, regardless of its form of organisation, to answer the following three basic questions: / . All economies must choose what particular goods and services and what quantities of these the wish to produce. H . All economies must make choices on how to use their resources in order to produce goods and services. Goods and services can be produced b use of different combinations of factors of production (for example, relativel more labour with fewer machines, or relativel more machines with less labour), b using different skill levels of labour, b using different technologies or b using different raw materials, for example, plastic or wood. F . All economies must make choices about how the goods and services produced are to be distributed among the population. Should ever one get an equal amount of these? Should some people get more than others? Should some goods and services (such as education and health care services) be distributed more equall ? R / The first two of these questions, what/how much to produce and how to produce, are about resource allocation, while the third, for whom to produce, is about the distribution of output and income. R refers to assigning available resources, or factors of production, to specific uses chosen among man possible alternatives, and involves answering the what/how much to produce and how to produce questions. For example, if a what/how much to produce choice involves choosing a certain amount of food and a certain amount of weapons, this means a decision is made to allocate some resources to the production of food and some to the production of weapons. At the same time, a choice must be made about how to produce: which particular factors of production and in what quantities (for example, how much labour, how man machines, what t pes of machines, etc.) should be assigned to produce food, and which and how man to produce weapons. If a decision is made to change the amounts of goods produced, such as more food and fewer weapons, this involves a reallocation of resources. Sometimes, societies produce the wrong amounts of goods and services relative to what is sociall desirable. For example, if too man weapons are being produced, we sa there is an overallocation of resources to production of weapons. If too few sociall desirable goods or services are being produced, such as education or health care, we sa there is an underallocation of resources to the production of these. The third basic economic question, for whom to produce, involves the distribution of output and is concerned with how much output different individuals or different groups in the population receive. This question is also concerned with the among individuals and groups in a population, since the amount of output people can get depends on how much of it the can bu , which in turn depends on the amount of income the have. When the distribution of income or output changes so that different social groups now receive more, or less, income and output than previousl , this is referred to as . E O R NDER ANDING 1.6 1 State the three basic economic questions that must be addressed b an econom . 2 Explain the relationship between the three basic economic questions, the allocation of resources and the distribution of income or output. 3 Consider the following, and identif each one as referring to output/income distribution or redistribution; or to resource allocation, reallocation, overallocation or underallocation (note that there ma be more than one answer). Evidence suggests that over the last two decades in man countries around the world the rich are getting richer and the poor are getting poorer. In Bra il, the richest 10% of the population receive 48% of total income. Whereas rich countries t picall spend 8 12% of their income on providing health care services to their populations, man poor countries spend as little as 2 3% of their income. Man developing countries devote a large proportion of their government budget funds to spending on universit level education, while large parts of their population remain illiterate. If countries around the world spent less on defence, the would be in a position to expand provision of social services, including health care and education. Pharmaceutical companies spend most of their research funds on developing medicines to treat diseases common in rich countries, while ignoring the treatment of diseases common in poor countries. A Countries around the world differ enormousl in the wa s the make allocation and distribution decisions. At the heart of their differences lie the methods used to make the choices required b the what/how much, how and for whom to produce questions. There are two main methods that can be used to make these choices: the market method and the command method. M In the market method, resources are owned b private individuals or groups of individuals, and it is mainl consumers and firms (or businesses) who make economic decisions b responding to prices that are determined in markets (we will see how this happens in Chapter 2). In the command method, resources (land and capital in particular) are owned b the government, which makes economic decisions b commands. In practice, commands involve legislation and regulations b the government, or in general an kind of government decision-making that affects the econom . In the real world, there has never been an econom that is entirel a market econom or entirel a command econom . Real-world economies combine markets and commands in man different wa s, and each countr is unique in the wa s the combine them. Economies ma lean more toward the command econom (as in planned economies of communist s stems), or more toward the market econom (as in highl market- oriented economies). Whatever the case, in the last 40 or so ears, there has been a trend around the world for economies to rel more and more on the market and less on commands. When the government makes decisions that affect the econom , this is known as government intervention, because the government intervenes (or interferes) in the workings of markets. Examples of government intervention include provision of public education, public health care, public parks, road s stems, national defence, flood control, minimum wage legislation, restrictions on imports, antimonopol legislation, tax collection, income redistribution and man more. Whatever the reasons for and t pes of government intervention in the market, changes the allocation of resources (and distribution of output and income) from what markets would have achieved working on their own. The market econom offers important benefits that we will discover in Chapter 2. Yet it does not alwa s produce the best answers to the what/how much, how and for whom questions for man reasons to be discussed in later chapters. Therefore, a market econom cannot operate effectivel without some government intervention. Whereas practicall ever one agrees that some government intervention in markets is necessar , economists disagree widel over how much governments should intervene and how the should intervene. There are two broad schools of thought on this issue. One focuses on the positive aspects of markets, while the other focuses on the imperfections of markets. According to the first perspective, economists argue that in spite of imperfections, markets are able to work reasonabl well on their own, and can produce outcomes that generall promote societ s wellbeing. Markets can achieve a reasonabl good allocation of resources, answering the what/how much to produce and how to produce questions quite well. Government intervention changes this allocation of resources, and often worsens it, giving rise to resource waste. Therefore, while some minimum government intervention ma be needed in certain situations, this should not be ver extensive. According to the second school of thought, markets have the potential to work well, but in the real world their imperfections ma be so important that the make government intervention necessar for their correction. This means that markets, working on their own, do not do a ver good job of allocating resources in societ s best interests. The purpose of government intervention, therefore, is to help markets work better and arrive at a better pattern of resource allocation and distribution of income and output. E : , , It is suggested that ou reread this section after reading Chapters 2 and 4 7, as ou will then be better able to understand it. The market and command methods to answer the basic economic questions discussed above can be thought of as two ideal t pes of economies: a based on the market approach and a based on the command approach. An ideal t pe is an abstract idea that does not claim to represent the real world, but rather contains some characteristics that serve as a standard for comparison of real-world situations. (Note that an ideal t pe is not ideal in the sense of perfect or excellent.) As we also discussed above, real-world economies combine markets and commands in man different wa s, resulting in . E O R NDER ANDING 1.7 1 Identif some more examples of command methods (government intervention) in market economies. 2 Outline the main source of the disagreement between those who argue there should be little government intervention in the econom and those who argue that government intervention should be more extensive. The ideal-t pe free market and planned economies are distinguished from each other on the basis of three criteria. Re ce e hi : blic i a e ec Ownership of societ s resources can be public or private . The public sector refers to the parts of the econom that are under the ownership of the government (whether national, regional or local). The government is also sometimes referred to as the state . The private sector includes the parts of the econom that are under the ownership of private individuals or groups of individuals; these include consumers (households), firms (businesses) and resource owners, as well as organisations such as NGOs (non-governmental organisations) and interest groups (for example, consumer protection organisations). The free market econom has private sector resource ownership, and the planned econom has public sector resource ownership. Ec mic deci i -maki g Economic decisions and choices regarding the what/how much, how and for whom questions can be made b the public sector, i.e. the government, or b the private sector. There are man private decision-makers, as noted above, but the most important of these are consumers (households), firms (businesses) and resource owners. The free market econom has private sector economic decision-making and the planned econom has public sector economic decision-making. Ra i i g em 4 can be defined as a method used to apportion or divide something up between The term its interested users. In economics, it refers to the method used to make resource allocation and output/income distribution decisions. There are two kinds of rationing s stems: price rationing and non-price rationing. The free market econom uses price rationing to make resource allocation and output/income distribution decisions. This means that all economic decisions relating to what will be produced, how it will be produced, and who will receive the output are made on the basis of prices of goods, services and resources that have been determined in markets. The planned econom uses non-price rationing to make resource allocation and output/income distribution decisions. This means that all decisions relating to what/how much will be produced, how it will be produced, and who will receive the output, are made b use of methods that have nothing to do with prices determined in markets. Non-price rationing results when there are no markets, or when governments interfere in markets, in which case the government acts as a central authorit and makes economic decisions b commands. Both price rationing and non-price rationing will become much clearer to ou after ou have studied Chapter 2. In the free market econom households and firms (the private sector) are the main owners of resources, as well as the economic decision-makers who make bu ing and selling decisions, and who are linked together in product and resource markets. As we will see in Chapter 2, product and resource markets determine prices of goods, services and resources, which act as the basis of price rationing. The planned econom is characterised b the absence of markets or the limited operation of markets. As the owner of resources and economic decision-maker, the government makes all allocation and distribution decisions through non-price rationing. This is called a planned econom because the government authorit makes detailed plans of all economic activities, on the basis of which it directs and coordinates economic decisions through commands. There remain ver few countries in the world that are still highl centrall planned; these include North Korea and, to a lesser extent, Cuba. Most other countries have begun to introduce major reforms intended to strengthen the role of markets. In the real world, virtuall all economies combine elements of both markets and commands. Differences between actual economies lie mainl in the wa s the two are combined and in the degree to which one predominates. For this reason, most economies in the world toda are mixed economies. Increasingl , mixed economies are becoming mixed market economies. That is, most economic activit is market-based based rather than centralised, and price rationing is more common than non-price rationing. In mixed market economies, public or private sector ownership and decision-making often go together. For example, privatel owned firms usuall make decisions about what and how the will produce and sell, while the government makes decisions about economic activities that fall under its ownership (such as public health services, public road s stems, public parks, defence facilities and man others). However, the government s decision-making role in the mixed market econom is not limited to activities falling under its ownership; it also extends into private sector activities. For example, the United States, one of the more market-oriented countries in the world, has government decision-making that affects the private sector in numerous areas such as minimum wage legislation, subsidies for agricultural products, tariffs on imports, regulation of private sector activities, anti-monopol legislation, tax collection, income redistribution and man others. All mixed market economies, in fact, have government involvement with the private sector that is either a response to the failure of the market mechanism to work well, or in response to the demands of politicall powerful interest groups. We will examine government intervention in the market extensivel for both these sets of reasons in later chapters. Government involvement in the private sector varies widel from countr to countr in extensiveness. For example, the free market pla s a more prominent role in the United Kingdom and the United States compared to France and Japan. Also, government involvement in the private sector varies in the form that it takes. For example, in the Nordic countries (Denmark, Finland, Iceland, Norwa and Sweden), there is extensive government intervention in income redistribution; in Japan, extensive government intervention takes the form of planning and coordinating private sector activities. In mixed market economies, both price and non-price rationing can be observed, but with price rationing predominating. In general, price rationing arises in situations where there is a market for resources, goods and services. If there is no market (or if markets are not free because of government intervention), then some form of non-price rationing occurs. For example, when governments in market economies provide national defence, public health care s stems, public road s stems and flood control, the do not rel on price rationing to determine resource allocation and output distribution, and the role of the government agencies that plan and provide these services is similar to the role of the central planner. Consider the case of national health s stems, where the government, through tax financing, undertakes to provide health care services that are made available to the entire population free (or nearl free) of charge. Since there is no price charged to the consumer who receives a service, some mechanism other than price, i.e. non-price rationing, must be used to distribute the service among its users. The most commonl used non-price mechanism is the waiting line or waiting period (queue). There have been significant changes over time in the relative prominence of private versus public sector activities. During much of the 20th centur , man countries throughout the world saw major increases in government participation in economic decision-making. Since the 1980s, there has been a shift once again in the direction of less public sector involvement and a corresponding growth in private sector activities. In man countries around the world, including both more developed and less developed ones, the increasing importance of market-based activities has been due to the growing popularit of man suppl -side economic policies (to be discussed in Chapter 13), as well as a recognition of the limitations of central planning. Table 1.1 provides a summar of the three criteria as the appl to each t pe of econom . E 1 O R NDER ANDING 1.8 Identif the basic economic questions that must be answered b free market economies, command economies, and mixed economies. 2 Use the criteria appearing in Table 1.1 to compare and contrast the main characteristics of the market and command economies. 3 Outline wh the command econom is also referred to as a centrall planned econom . 4 Compare and contrast the methods b which allocation and distribution choices are made in the market econom and the command econom . 5 Define and explain the difference between price rationing and non-price rationing. Describe the functions of these two rationing mechanisms. Identif the kind of economic s stem in which each one predominates. 6 Describe examples of command practices in mixed economies. 7 Outline wh most economies in the world toda are mixed market economies. C F ( ) R E R - P ( M ( ) ) private sector public sector public and private sectors private sector public sector public and private sectors price rationing non-price rationing price rationing and non-price rationing 1.1: Free market, planned and mixed economies E ( ) The interested student ma explore this topic in the 'Digital coursebook: Extra material' section. 4 Will be introduced in Chapter 2 as a s llabus term. 1.3 LEARNING OBJEC I ES After studying this section you will be able to: • define all the terms appearing in in the text (AO1) • identify and explain the relationships illustrated in the production possibilities curve model PPC (AO2) • use the PPC model to explain opportunity cost, scarcity, choice, unemployment, efficiency, actual growth and growth in production possibilities (AO2) • draw a diagram to explain all the above concepts in the PPC model (AO4) • distinguish between increasing versus constant opportunity cost in the PPC model (AO2) • draw a diagram to illustrate the difference between increasing and constant opportunity cost in the PPC model (AO4) • identify and explain the interdependent activities of decision-makers in the circular flow of income model: households, firms, the government, banks and the financial sector, and the foreign sector (AO2) • explain the role of leakages and injections in the circular flow of income model (AO2) • draw a diagram to identify and explain the relationships illustrated in the circular flow of income model including leakages and injections (AO4) Everyone is familiar with the idea of a model. As children, many of us played with paper aeroplanes, which are models of real aeroplanes. In chemistry at school, we studied molecules and atoms, which are models of what matter is made of. A is a simplified representation of something in the real world; it represents only the important aspects of the real world being investigated, ignoring unnecessary details. This way it allows us to focus on important relationships. Models are used a lot by scientists and social scientists in their efforts to understand or explain real-world situations. I Consider a simple hypothetical economy producing only two goods: microwave ovens and computers. This economy has a fixed (unchanging) quantity and quality of resources (factors of production) and a fixed technology (the method of production is unchanging). Table 1.2 shows the combinations of the two goods this economy can produce. Figure 1.1 plots the data of Table 1.2: the quantity of microwave ovens is plotted on the vertical axis, and the quantity of computers on the horizontal axis. If all the economy s resources are used to produce microwave ovens, the economy will produce 40 microwave ovens and 0 computers, shown by point A. If all resources are used to produce computers, the economy will produce 33 computers and 0 microwave ovens; this is point E. All the points on the curve joining A and E represent other production possibilities where some of the resources are used to produce microwave ovens and the rest to produce computers. P M C A 40 0 B 35 17 C 26 25 D 15 31 P M C 0 E 33 1.2: Combinations of microwave ovens and computers For example, at point B there would be production of 35 microwave ovens and 17 computers; at point C, 26 microwave ovens and 25 computers, and so on. The line joining points A and E is known as the d c b e c e (PPC) (or d c b e f e , PPF). In order for the economy to produce the greatest possible output, in other words somewhere on the PPC, two conditions must be met: • A . This means that all resources are being fully used. If there were unemployment of some resources, in which case they would be sitting unused, the economy would not be producing the maximum it can produce. • A . Specifically, there must be efficient resource use. The term efficiency in a general sense means that resources are being used in the best possible way to avoid waste. (If they are not used in the best possible way, we say there is inefficiency .) Efficiency in production means that output is produced by use of the fewest possible resources; alternatively, we can say that output is produced at the lowest possible cost. If output were not produced using the fewest possible resources, the economy would be wasting some resources. The ( ) represents all combinations of the maximum amounts of two goods that can be produced by an economy, given its resources and technology, when there is full employment of resources and efficiency in production. All points on the curve are known as . F 1.1: Production possibilities curve What would happen if either of the two conditions (full employment and efficiency) is not met? Very simply, the economy will not produce at a point on the PPC; it will be somewhere inside the PPC, such as at point F. At F, the economy is producing only 15 microwave ovens and 12 computers, indicating that there is either unemployment of resources, or inefficiency in production, or both. If this economy could use its resources fully and efficiently, it could, for example, move to point C and produce 26 microwave ovens and 25 computers. However, in the real world no economy is ever likely to produce on its PPC. An economy s ac a , or the quantity of output actually produced, is always at a point inside the PPC, because in the real world all economies have some unemployment of resources and some inefficiency in production. The greater the unemployment or the inefficiency, the further away is the point of production from the PPC. , The production possibilities model is very useful for illustrating the concepts of scarcity, choice and opportunity cost: • B , PPC. With its fixed quantity and quality of resources and technology, the economy cannot move to any point outside the PPC, such as point G on Figure 1.1, because it does not have enough resources (i.e. there is resource scarcity). • B , . Assuming it could achieve full employment and efficiency, it must decide at which particular point on the PPC it should produce. (In the real world, the choice would involve a point inside the PPC.) • B , . If the economy were at any point on the curve, it would be impossible to increase the quantity produced of one good without decreasing the quantity produced of the other good. In other words, when an economy increases its production of one good, there must be a sacrifice of some quantity of the other good. This sacrifice is the opportunity cost. Let s consider the last point more carefully. Say the economy is at point C, producing 26 microwave ovens and 25 computers. Suppose now that consumers would like to have more computers. It is impossible to produce more computers without sacrificing production of some microwave ovens. For example, a choice to produce 31 computers (a move from C to D) involves a decrease in microwave oven production from 26 to 15 units, or a sacrifice of 11 microwave ovens. The sacrifice of 11 microwave ovens is the opportunity cost of 6 extra computers (increasing the number of computers from 25 to 31). Note that opportunity cost arises when the economy is on the PPC (or more realistically, somewhere close to the PPC). If the economy is at a point inside the curve, it can increase production of both goods with no sacrifice, hence no opportunity cost, simply by making better use of its resources: reducing unemployment or increasing efficiency in production. In Figure 1.2(a) the PPC s shape is similar to that of Figure 1.1, while in Figure 1.2(b) it is a straight line. When the PPC bends outward and to the right, as in Figure 1.2(a), opportunity costs change as the economy moves from one point on the PPC to another. In part (a), for each additional unit of computers that is produced, the opportunity cost, consisting of microwave ovens sacrificed, gets larger and larger as computer production increases. This happens because of specialisation of factors of production, which makes them not equally suitable for the production of different goods and services. As production switches from microwave ovens to more computers, it is necessary to give up increasingly more microwave ovens for each extra unit of computers produced, because factors of production suited to microwave oven production will be less suited to computer production. By contrast, when the PPC is a straight line (as in Figure 1.2(b)), opportunity costs are constant (do not change) as the economy moves from one point of the PPC to another. Constant opportunity costs arise when the factors of production are equally well suited to the production of both goods, such as in the case of basketballs and volleyballs, which are very similar to each other, therefore needing similarly specialised factors of production to produce them. As we can see in Figure 1.2(b), for each additional unit of volleyballs produced, the opportunity cost, or sacrifice of basketballs, does not change. F 1.2: Production possibilities curve with increasing and constant opportunity costs E E refers to increases in the quantity of output produced in an economy over a period of time. What are the causes of growth? We can find the answer to this question in the production possibilities model. We have seen that any economy is most likely to be actually situated at some point inside its PPC, as it is very difficult for an economy ever to be fully efficient and have maximum employment of all resources. The further away an economy is situated from its PPC, the greater its resource unemployment and inefficiency. Therefore, by reducing unemployment and increasing efficiency, a country moves closer to its PPC and increases the actual quantity of output produced. It follows that ed c e e a d c ea e eff c e c a e fac ha ca ca e g h f ac a . In Figure 1.3(a), the movement from point A to point B illustrates ac a g h. However, reduction of unemployment and inefficiencies can only result in a limited amount of economic growth. As the economy moves closer to its PPC, the ability to achieve more growth is exhausted, and more growth can only occur if there is g h d c b e , illustrated by an outward shift of the PPC. An outward shift of the PPC means the economy can produce more of both goods (X and Y), shown in Figure 1.3(b) by the shifts from PPC1 to PPC2 to PPC3. In this figure, the growth in production possibilities is accompanied by outward movements of the economy s points of actual production, from A to B to C. The factors that lead to outward shifts of the PPC, or growth in production possibilities are: • increases in the quantity of resources (factors of production) in the economy • improvements in the quality of resources (for example, through more educated labour) • technological improvements. As its production possibilities grow, unemployment must be kept at low levels and inefficiencies should be reduced to ensure that actual output continues to grow along with production possibilities, as in Figure 1.3(b). For example, an increase in the size of the labour force will do little to increase actual output produced if much of this labour remains unemployed (in this case the economy could remain stuck at point A even as PPC1 shifts to PPC2). Similarly, the discovery of major oil reserves may do little to expand actual output if these reserves remain unexploited, or if their exploitation is undertaken inefficiently. It is important to distinguish between ac a g h, which involves a movement from one point inside the PPC to another point closer to the PPC, and g h d c b e involving an outward shift of the PPC. A is caused by reduction in unemployment and increases in efficiency in production. G is caused by increases in the quantity of resources, improvements in the quality of resources and technological improvements. F 1.3: Using the production possibilities model to illustrate economic growth The PPC can also shift inward, indicating a decrease in production possibilities, or that less of the two goods can be produced, as shown in Figure 1.3(c). This results from a decrease in the quantity of resources or deterioration in resource quality. An outward or inward shift need not be parallel; this is illustrated in Figure 1.3(d). For example, a technological change favouring the production of one good (X) increases the production of that good proportionately more. Similarly, an influx of unskilled workers into a country results in a larger proportionate increase in the production of goods using relatively more unskilled labour. ES 1 O R NDERS ANDING 1.9 Consider the production possibilities data in Table 1.2 and Figure 1.1. If the economy is initially at point A and moves to point B, computer production will increase by 17 units. Calculate the opportunity cost of the increase in computer production. If the economy moves from D to C, calculate the gain and its opportunity cost. If it moves from point C to B, calculate the gain and its opportunity cost. 2 Use the concept of opportunity cost to explain why the following two statements have the same meaning: efficiency in production means producing by use of the fewest possible resources efficiency in production means producing at the lowest possible cost. 3 Distinguish between output actually produced and output on the PPC. Outline why an economy s actual output is most likely to be located somewhere inside its PPC. 4 5 Say an economy is initially at point F, producing 15 microwave ovens and 12 computers (Figure 1.1). State what would be the opportunity cost of moving to a point on the production possibilities curve, such as point C, where it would be producing 26 microwave ovens and 25 computers. Using diagram(s), distinguish between actual growth and growth in production possibilities. List the factors that can give rise to each of these. 6 Use the production possibilities curve model and diagrams to show how the following can result in actual growth or growth (or decrease) in production possibilities: a discovery of new oil reserves firms hire more workers a vaccine for contagious diseases is invented firms improve how they manufacture and lower their costs of production the widespread use of a new technology a violent conflict destroys a portion of a country s factories, machines and road system large cuts in government spending on education and health care lower levels of education and health in a population an increase in the quantity of capital goods an improvement in the level of education and skills of workers industrial pollution destroys the environment. 7 Using diagrams, distinguish between increasing and constant opportunity costs. 8 Using the production possibilities model, explain the relationship between scarcity, choice and opportunity cost. The is a simple model that illustrates some economic concepts and relationships that will help us understand the overall economy. In its simplest version, shown in Figure 1.4, the model illustrates a c ed ec , meaning it has no links with other countries (it is closed to international trade), and is also a model of an economy with no government and no banks or financial market. It is assumed that the only decision-makers are (or consumers) and (or businesses); both are shown in square boxes. Households and firms are linked together through two markets: product markets and resource markets, shown in diamonds. Households are owners of the four factors of production: land, labour, capital and entrepreneurship. Firms buy the factors of production in resource markets and use them to produce goods and services. They then sell the goods and services to consumers in product markets. We therefore see a flow in the clockwise direction of factors of production from households to firms, and of goods and services from firms to households. In the counterclockwise direction, there is a flow of e used as payment in sales and purchases. When households sell their factors of production to firms, they receive payments taking the form of e (for land), age (for labour), e e (for capital) and f (for entrepreneurship). These payments are the c e f h eh d . The payments that households make to buy goods and services are h eh d e e d e (or consumer spending). The payments that firms make to buy factors of production represent their c f d c , and the payments they receive by selling goods and services are their e e e . All payment flows, known as e f , are shown in Figure 1.4 F 1.4: Circular flow of income model in a closed economy with no government This model demonstrates an important principle: the c e f involving the money that goes from firms to households is equal to the e e d e f from households to firms, which is the money that households spend to buy things from firms. In other words, the household incomes coming from the sale of all the factors of production equals the expenditures by households on goods and services. This is the c c a f f c e. In addition, these two flows must be equal to the value of goods and services, or the value of total output produced by the firms, known as the a e f f . The reasoning of this is as follows: if each good and service is multiplied by its respective price, we obtain the value of each good and service, and adding them all up we arrive at the value of total output. This value is the same as consumer expenditure, since spending by consumers is equal to each item they buy multiplied by its price. Therefore: The shows that in any given time period (say a year), the value of output produced in an economy is equal to the total income generated in producing that output, which is equal to the expenditures made to purchase that output. A The real-world economy is more complicated than this simple model suggests. We arrive at a closer picture of the real world by adding and (also known as hd a a ) to the money flow of Figure 1.4. To understand what these are, consider a pipe with water flowing through it, as in Figure 1.5. As water flows through the pipe, some leaks out (the leakages), while new supplies of water are injected in (the injections). It is the same with the flows of money in the circular flow model. F 1.5: Leakages and injections Leakages and injections are paired together so that what leaks out of the flow can come back in as an injection. The most important pairs are the following: saving investment taxes government spending imports exports S Saving is the part of consumer income that is not spent but rather is saved. Investment is spending by firms for the production of capital goods, which is one of the four factors of production. This is why capital goods are also known as investment goods. How are saving and investment linked together as leakages and injections? When households save part of their income, this represents a leakage from the circular flow of income because it is income that is not spent to buy goods and services. Households place their savings in financial markets (bank accounts, purchases of stocks and bonds, etc.). Firms obtain funds from financial markets (through borrowing, issuing stocks and bonds, etc.) to finance investment, or the production of capital goods. These funds therefore flow back into the expenditure flow as injections. This process is shown in Figure 1.6, which, in addition to the money flows of Figure 1.4, shows the three leakage/injection pairs. (For simplicity, Figure 1.6 contains only money flows.) Leakages appear in the left-hand side of the figure, and injections on the right. We can see that saving leaks out of the flow of consumer expenditures (saving is money that is not spent), and after passing through financial markets is injected back into the expenditure flow as investment. F 1.6: Circular flow of income model with leakages and injections Taxes and government spending are connected to each other through the government. Households pay taxes to the government; this is a leakage because it is income that is not spent to buy goods and services. The government uses the tax funds to finance government expenditures (on education, health, defence, etc.) and this spending is an injection back into the expenditure flow. I I are goods and services produced in other countries and purchased by domestic buyers. E are goods and services produced domestically and purchased by foreigners. When an economy has international trade with imports and exports, it is known as an e ec . Imports and exports are linked together through other countries . Imports are a leakage because they represent household spending that leaks out as payments to the other countries that produced the goods and services. Exports are an injection because they are spending by foreigners who buy goods and services produced by the domestic firms. In the real world, leakages and injections are unlikely to be equal, and this has important consequences for the size of the circular flow. If a leakage is greater than an injection, then the size of the circular flow becomes smaller. Suppose saving (a leakage) is larger than investment (an injection). This means that part of the household income that leaks as saving into financial markets does not come back into the flow as investment. The result is that fewer goods and services are purchased, firms cut back on their output, they buy fewer factors of production, unemployment increases (since firms buy a smaller quantity of labour) and household income is reduced. If a leakage is smaller than an injection, the size of the circular flow becomes larger. Suppose spending on exports is greater than spending on imports; then the expenditure flow increases since the injection is larger than the leakage. Foreigners demand more goods and services, firms begin to produce more by purchasing more factors of production, unemployment falls (as firms buy a larger quantity of labour), and household income increases. To summarise, leakages from the circular flow of income (saving, taxes and imports) are matched by injections into the circular flow of income (investment, government spending and exports), though he e eed be e a each he . In the c c a f f c e de if injections are larger than leakages the size of the flow increases; if leakages are larger than injections the size of the flow shrinks. ES 1 O R NDERS ANDING 1.10 Identify the two markets shown in the circular flow of income model. Using examples, outline what is exchanged (bought and sold) in each of these. Identify the three flows shown in the circular flow model. 2 The circular flow of income model shows that households and firms are both buyers and sellers simultaneously. Explain how this is possible. 3 Use the simple circular flow of income model to: show the circular flow of income show the equivalence between factor income flow, household expenditure flow and the value of output flow. 4 Define leakages and injections in the circular flow of income. Use the circular flow of income model to illustrate how the three pairs of leakages and injections are linked together. 5 Distinguish between a closed economy and an open economy. 6 Describe what happens to the size of the income flow when: leakages are larger than injections injections are larger than leakages. The circular flow of income model is a simple model that de c be basic economic relationships, bringing together and showing how microeconomics and macroeconomics relate to each other. (Microeconomics and macroeconomics were introduced at the beginning of this chapter. We can see in this model that the basic decision-making units, c e and f , are interdependent; they are linked together through their buying and selling activities which occur in markets. We will study the behaviour of consumers and firms in c ec c . These buying and selling activities, when added all up, lead to flows of income, output and spending, which are also interdependent. We will study these under ac ec c. 1.4 T LEARNING OBJECTIVES After studying this section you will be able to: define all the terms appearing in in the text (AO1) distinguish between positive and normative economics (AO2) explain the use of logic, hypotheses, models and theories in positive economics (AO2) explain the role of the ceteris paribus assumption (AO2) explain the roles of empirical evidence and refutation in positive economics (AO2) explain the role of value judgements in policy-making in normative economics (AO2) distinguish between equity and equality (AO2) P E Economists think about the economic world in two different ways: One way of thinking tries to describe, explain and predict economic events; this is called positi e economics. It is based on positi e statements, which are about something that is, was or will be. Positive statements are used to describe, explain or predict economic events by use of hypotheses, theories and models. Positive statements: may describe something; for example, the unemployment rate is 5% and industrial output grew by 3% are two statements describing the level of unemployment and growth of industrial output may be statements in a hypothesis that tries to e plain something; for example, the statement a higher price of apples results in fewer apples purchased is a statement that provides an explanation of why fewer apples are purchased may be statements that predict a future event; for example, unemployment will increase next year predicts what will happen to unemployment next year. The other way of thinking deals with how things in the economy should or ought to be; this is called normati e economics. It is based on beliefs or value judgements about what should happen, about hat is good or bad, about hat is right or rong. It is used in making economic policies. Examples include the following: The unemployment rate should be lower is a statement based on a belief or value that high unemployment is not a good thing. Health care should be available free of charge is a statement about a value that everyone in a society should have access to free health care. The government should spend more money on building schools is a policy recommendation about what the government should do. See Table 1.3 for more examples of positive and normative economics. Note that statements in positive economics may be factually correct or they may be false. For example, we may say that the unemployment rate is 5%; if the unemployment rate is 5%, this statement is correct; but if the unemployment rate is actually 7%, the statement is false. Statements in normative economics, by contrast, cannot be true or false. They can only be assessed relative to beliefs and alue judgements. Consider the normative statement the unemployment rate should be lower . We cannot say whether this statement is true or false, though we may agree or disagree with it, depending on our beliefs about unemployment. If we believe that the present unemployment rate is too high, then we will agree; but if we believe that the present unemployment rate is not too high, then we will disagree. P N Incomes have fallen by 7%. Incomes should be increased. Free university education will increase government spending by 3%. There should be free university education. Income inequality is increasing. Income inequality has increased too much. Women are often paid less than men for the same work. Women and men should receive equal pay for the same work. Higher taxes will result in lower disposable incomes. Taxes are too low and should be increased. T 1.3: More examples of positive and normative economics TEST OUR UNDERSTANDING 1.11 1 Which of the following are positive statements and which are normative? It is raining today. It is too humid today. Economics is a study of choices. Economics should be concerned with how to reduce poverty. If household saving increases, there will be a fall in household spending. Households save too little of their income. 2 Explain the importance of making a distinction between positive and normative statements in economics. T In economics, as in other social (and natural) sciences, our efforts to gain knowledge about the world involve the formulation of hypotheses, theories, laws and models. All of these are based on the use of logic. All of these lie within the realm of positive economics. T As we have seen above, positive economics involves thinking about the economic world in order to try to describe, explain or make predictions about economic events. Positive economic thinking is used to describe and explain in a systematic way why economics events happen the way they do, and attempts to predict economic events that are likely to occur in the future. This type of thinking is based on the use of , a Greek word ( or logiki) which means reason. It is a method of reasoning, which involves making a series of statements each of which is true if the preceding statements are true. For example: 1 When it rains there are clouds in the sky. 2 It is now raining. 3 Therefore there are clouds in the sky. The truth of the third statement is based on the truth of the previous statements. Therefore, we can say that the third statement is logical, as it is based on logic. Economists use logical thinking to acquire knowledge of the economic world. Since economics is a social science, economists acquire knowledge by use of the scientific method (you may already be familiar with this from your study of the natural sciences like physics, biology and chemistry). The scientific method is based on the use of logic. T A is an educated guess, usually indicating a cause-and-effect relationship about an event. Hypotheses are often stated as: if . . ., then . . . In order to formulate a hypothesis, economists make observations of the world around them and identify a question they would like to answer. Let s consider an example from economics. We observe that people living in the city of Olemoo buy different amounts of oranges per week at different times in the year. We want to answer the question: why are more oranges bought in some weeks and fewer in others? We then identify variables that we think are important to answer the question. A variable is any measure that can take on different values, such as temperature, or weight or distance. In this example, the variables we choose to study are the quantity of oranges that residents of Olemoo buy each week, and the price of oranges. Our next step is to make a h pothesis about how the variables are related to each other. We have seen that a hypothesis is an educated guess about an if . . . then . . . relationship. Our hypothesis is the following: if the price of oranges increases, he the quantit of oranges Olemooans ant to bu each eek ill fall. Notice that this hypothesis indicates a cause-and-effect relationship, where price is the cause and the quantity of oranges bought is the effect . The hypothesis also involves a prediction, because it claims that changes in the price of oranges will lead to a particular change in the quantity of oranges Olemooans buy. T If our hypothesis is to make sense, we need to also make assumptions. An assumption is a statement that is supposed to be true for the purposes of building the hypothesis. In our example, an important assumption is this: the price of oranges is the only variable that influences the quantity of oranges that Olemooans want to buy, while all other variables that could have influenced their buying choices do not play a role. This is called the ceteris paribus assumption. Ceteris paribus is a Latin expression that means other things equal . Another way of saying this is that all other things are assumed to be constant or unchanging. Why is this assumption important? Our hypothesis stated that the quantity of oranges that will be bought is determined by their price. Surely, however, price cannot be the only variable that influences how many oranges Olemooans want to buy. What if the population of Olemoo increases? What if the incomes of Olemooans increase? And what if an advertising campaign proclaiming the health benefits of eating oranges influences the tastes of Olemooans? As a result of any or all these factors, Olemooans will want to buy more oranges. This complicates our analysis, because if all these variables change at the same time, we have no way of knowing what effect each one of them individually has on the quantity people want to buy. We want to be able to isolate the effects of each one of these variables; to test our hypothesis we specifically wanted to study the effects of the price of oranges alone. This means we have to make the assumption that all other things that could affect the relationship we are studying must be constant, or unchanging. More formally, we would say that we are examining the effect of orange prices on the quantity of oranges people want to buy, ceteris paribus. This means simply that we are studying the relationship between prices and quantity on the assumption that nothing else happens that can influence this relationship. By eliminating all other possible interferences, we isolate the impact of price on quantity, so we can study it alone. In the real world all variables are likely to be changing at the same time. The ceteris paribus assumption does not say anything about what happens in the real world. It is simply a tool used by economists to construct hypotheses, models and theories, thus allowing us to isolate and study the effects of one variable at a time. We will be making extensive use of the ceteris paribus assumption in our study of economics. T Now we are in a position to test our hypothesis to see if its predictions fit with what actually happens in the real world. To do this, we compare the predictions of the hypothesis with real-world events, based on . Empirical evidence refers to real-world information, observations and data that we acquire through our senses and experience (empirical comes from the Greek word or empeir a meaning experience). Here, the methods of economics differ from those of the natural sciences. Whereas in the natural sciences it is often (though not always) possible to perform experiments to test hypotheses, in economics the possibilities for experiments are very limited. Economists therefore rely on a branch of statistics called econometrics to test hypotheses. This involves collecting data on the variables in the hypothesis, and examining whether the data fit the relationships stated in the hypothesis. In our example, we must collect data on the quantity of oranges bought by Olemoo s residents during different weeks throughout the year, and compare these quantities with different orange prices at different times in the year. (Econometrics is usually studied at university level, and is not part of IB requirements.) We are now in a position to compare the predictions of our hypothesis with real-world outcomes. If the data did not fit the predictions of the hypothesis, the hypothesis would be rejected, and the search for a new hypothesis would begin. In our example, this would happen if we discovered that as the price of oranges increases, the quantity of oranges Olemooans want to buy each week also increases. Clearly, this would go against our hypothesis, and we would have to reject the hypothesis as invalid. If, on the other hand, the data fit the predictions, the hypothesis would be accepted. In our example, this would occur if our data show that as the price of oranges increases, Olemoo s residents buy fewer oranges. We can therefore conclude that according to the evidence, our hypothesis is a valid one. T We have seen that a hypothesis is an educated guess about a cause-and-effect relationship in a single event. A is a general explanation of a set of interrelated events, usually (though not always) based on several hypotheses that have been tested successfully (in other words, they have not been refuted, or disproven, based on evidence; see the discussion below on refutation). A theory is a generalisation about the real world that attempts to organise complex and interrelated events and present them in a systematic and coherent way to explain h these events happen. Based on their ability to systematically explain events, theories attempt to make predictions. Referring to the example of oranges, the relationship between the price of oranges and the quantity of oranges residents of Olemoo buy at each price was a hypothesis. This kind of hypothesis has been successfully tested a great many times for many different goods, and the data support the presence in the real world of such a relationship. However, this relationship is not a theory, because it only shows how two variables relate to each other, and does not explain anything about h buyers behave the way they do when they make decisions to buy something. To explain this relationship in a general way, economists have developed utility theory and indifference curve analysis based on a more complicated analysis involving more variables, assumptions and interrelationships. These theories try to answer the question as to h people behave in ways that make the observed relationship between price and quantity a valid one. (Utility theory will be examined at HL in Chapter 2). T A la , in contrast to a theory, is a statement that describes an event in a concise way, and is supposed to have universal validity; in other words, to be valid at all times and in all places. Laws are based on theories and are known to be valid in the sense that they have been successfully tested very many times. They are often used in practical applications and in the development of further theories because of their great predictive powers. However, laws are much simpler than theories, and do not try to explain events the way theories do. For example, the simple relationship between the quantity of a good that people want to buy and its price, while not a theory, has the status of one of the most important la s of economics: it is the la of demand. This law is a statement describing an event in a simple way. It has great predictive powers and is used as a building block for very many complex theories. We will study the law of demand in detail in Chapter 2 and we will use it repeatedly throughout this book in numerous applications, and as a building block for many theories. T In your study of economics, you will encounter many theories and some laws. Your study of both theories and laws will make great use of economic models. Models are sometimes used to illustrate theories (or laws) and sometimes to describe the connections between variables. Whereas sciences like biology, chemistry and physics offer the possibility to construct three-dimensional models (as with molecules and atoms), this cannot be done in the social sciences, because these are concerned with human society and social relationships. In economics, models are often illustrated by use of diagrams showing the relationships between important variables. In more advanced economics, models are illustrated by use of mathematical equations. (Note that both diagrams and mathematical equations are used to represent models in natural sciences, such as physics, as well.) Models are often closely related to theories, as well as to laws. A theory tries to explain h certain events happen and to make predictions. A law is a concise statement of an event that is supposed to have universal validity. Models are often built on the basis of well- established theories or laws, in which case they may illustrate, through diagrams or mathematical equations, the important features of the theory or law. When this happens, economists use the terms model and theory interchangeably because in effect they refer to one and the same thing. For example, in Chapter 9, different models of the macroeconomy will be used to illustrate alternative theories of income and output determination. However, models are not always representations of theories. In some cases, economists use models to isolate important aspects of the real world and show connections between variables but without any explanations as to h the variables are connected in some particular way. In such cases, models are purely descriptive; in other words, they describe a situation without explaining anything about it. For example, the production possibilities curve model presented above in Section 1.3 is a simple model that is very important because of its ability to describe scarcity, choice and opportunity cost. Similarly, the circular flow of income model, also presented in Section 1.3, describes how decision-makers are related to each other in the economy and introduces the concepts of output, income and spending. In the case of both models, there is no theory or explanation involved. Yet descriptive models that are not based on a theory are in no way less important than models that illustrate a theory. Both kinds of models are very effective as tools used by economists to highlight and understand important relationships and phenomena in the economic world. In our study of economics, we will encounter a variety of economic models and will make extensive use of diagrams. T The concept of is very important in economics (as in any social science or science). To refute something means to contradict it, disprove it or show it to be false. Refutation in the sciences and social sciences is the idea that it must be possible to refute or dispro e a hypothesis or a theory. It must be possible to subject it to empirical testing, where the data or empirical observations can disprove it if it is false or invalid. In other words, if a hypothesis or theory cannot be refuted or disproven by empirical testing, then it is not scientific. Refutation is also known as falsifiabilit , because if something is refuted, it is falsified, in other words it is shown to be false. You may note that our hypothesis about Olemooans is refutable or falsifiable. The hypothesis is if the price of oranges increases, then the quantity of oranges Olemooans want to buy each week will fall . We could collect data on quantities and prices of oranges, and if the data do not fit the hypothesis, the hypothesis would be refuted, in other words it would be falsified or disproven. TEST OUR UNDERSTANDING 1.12 1 The relationships between hypotheses, theories, laws and models described here apply generally to all the social sciences and sciences based on the scientific method. Yet they may differ between disciplines in the ways they are used and interpreted. As you study economics, you may want to think about the following: How are theories and laws used in economics as compared with other disciplines? Do they play the same role? Are they derived in the same ways? Do they have the same meaning? 2 Explain the scientific method. Outline the steps it involves. 3 Distinguish between hypotheses, theories, laws and models. 4 Explain why it is important to compare the predictions of a hypothesis with real-world outcomes. Explain the role of empirical evidence and refutation in the scientific method. 5 Describe how models help economists in their work as social scientists. 6 Consider the statement, If you increase your consumption of calories, you will put on weight. Explain why this statement is not necessarily true. Rephrase the statement to make it more accurate. (Hint: What might happen to your weight if at the same time that you consume more calories you also began an intensive exercise programme?) THEOR OF KNO LEDGE 1.1 R , We have seen how hypotheses are tested using the scientific method. If the data support the predictions of a hypothesis, the hypothesis is accepted. However, this does not make the hypothesis necessarily true . The only knowledge we have gained is that according to the data used, the h pothesis is not false. There is always a possibility that as testing methods are improved and as new and possibly more accurate data are used, a hypothesis that earlier had been accepted now is rejected as false. Therefore, no matter how many times a hypothesis is tested, we can never be sure that it is true . But by the same logic, we can never be sure that a hypothesis that is rejected is necessarily false. It is possible that our hypothesis testing, maybe because of poor data or poor testing methods, incorrectly rejected a hypothesis. Testing of the same hypothesis with different methods or data could show that the hypothesis had been wrongly rejected. If our results from hypothesis testing are subject to so many uncertainties, how can economic knowledge about the world develop and progress? Economists and other social and natural scientists work with h potheses that ha e been tested and not refuted (not falsified or disproven). While the possibility exists that the hypotheses may be false, they use these hypotheses on the assumption that they are not false. As more and more testing is done, and as unfalsified hypotheses accumulate, it becomes more and more likely that they are not false, though e can ne er be sure. This way, it is possible to accumulate knowledge about the world, however, this is done on the understanding that this knowledge is tentative and provisional; in other words, it can never be proven to be true. T Is it possible to ever arrive at the truth of a statement about the real world based on empirical testing? Even assuming that testing methods could be perfected and data vastly improved, can there ever be complete certainty about our knowledge of the social (and natural) worlds? T V - It was noted earlier that normative economics is based on beliefs and alue judgements about what should happen, about what is good or bad, or about what is right or wrong. Value judgements are opinions; they are subjective judgements rather than factual statements. Note that statements based on normative economics are not refutable or falsifiable. They cannot be shown to be false. One can only agree or disagree with them depending on one s own beliefs and value judgements. Value judgements in normative economics are important for economic policy-making. They identify the important economic problems that should be addressed and recommend policies to solve them. Economic policies are government actions that try to solve economic problems. Examples of economic policies are government actions to lower unemployment, lower inflation, protect the environment, improve the quality of education, reduce levels of poverty, provide free health care services and many more. When a government makes a policy to lower unemployment (the number of people who are looking for work but can t find a job), this is based on the value judgement that high unemployment is not a good thing. If a government pursues a policy to make health care available to everyone free of charge, this is based on a value judgement that people should not have to pay for receiving health care services. Positive economics and normative economics, while distinct, often work together. To be successful, an economic policy aimed at lowering unemployment (the normative dimension) must be based on a body of economic knowledge about what causes unemployment (the positive dimension). The positive dimension can provide guidance to policy-makers on how to achieve their economic goals. P is the study of economics based on the scientific method, used to arrive at knowledge about the economic world. It includes descriptions, models, hypotheses, theories and laws. N forms the basis of judgements about what economic goals and economic policies ought to be. It is based on value judgements, because it identifies important economic problems that should be addressed and prescribes what should be done to solve them. E An important concept from normative economics that you will encounter in this book is equit , which refers to the idea of being fair or just. The idea of equity, or fairness is a normative concept because fairness depends on people s beliefs or value judgements, which differ from person to person. Equalit , on the other hand, is the state of being equal with respect to something. For example, equality with respect to income would mean that each member of a society receives exactly the same income. Equality is a positive concept, since two or more things are either equal or not equal based on a measure. The idea of equality in income distribution may or may not be equitable, depending on how equity is interpreted. If it is believed that income distribution is equitable or fair if income is distributed equally, then equity in income distribution means income equality. However, if it is believed that it is equitable or fair for people s income to be in proportion to their work effort (a different equity principle), this would give rise to income inequality, since not everyone s work effort is the same. In spite of different possible interpretations of the meaning of equity, in most countries around the world, the pursuit of equity is usually interpreted to refer to government policies that try to reduce inequalities in income, wealth and opportunity. This is because of the widely shared belief or value judgement that the free market without government intervention results in highly unequal income and wealth distributions that are considered to be unfair. For this reason, we often find writers referring to a more equitable or more equal distribution of income or wealth to mean the same thing. Both expressions are correct, provided it is understood that in these cases, equit in income distribution is interpreted as greater equalit (or less inequalit ). E means fairness while meanings, in economics interpreted to mean equality. means being the same. While the two concepts have different is most often interpreted to mean , while equity is Note that the pursuit of equity in the sense of equality does not refer to efforts to achieve complete income or wealth equality, but rather the reduction of inequalities that are considered to be unfair. You should also note that the ideas of equity and equality in distribution involve answers to the for hom to produce basic question of economics (see Section 1.2). The other two questions, hat/ho much to produce and ho to produce are answered by use of positive economics. TEST OUR UNDERSTANDING 1.13 1 Suppose the government of Country X implements a series of policies to reduce income inequalities. Identify possible value judgements that may have led to this policy. 2 Distinguish between equity and equality. THEOR OF KNO LEDGE 1.2 ? As you will discover in the course of reading this book, there are many areas of economic theory as well as policy on which there are major disagreements and debates among economists. Why do economists disagree so much? It would seem that use of the scientific method in economics, by forcing hypotheses to undergo tests, and allowing the real-world evidence to sift through valid and invalid hypotheses, would eliminate much disagreement. Why do economists continue to disagree in spite of their use of the scientific method? To try to answer this question, we should consider the point mentioned earlier on the difficulties of testing hypotheses due to the inability of economists to perform controlled experiments. The scientific method, as we have seen, involves relating evidence to educated guesses about causeand- effect relationships between variables to see if they match. Economists face some difficulties in this effort. First, the inability to perform controlled experiments means that economists collect data about real-world events that are the result of many variables changing at the same time. To test hypotheses, economists devise complicated econometric models that try to isolate the interfering effects of numerous variables, and try to link causes with effects. Sometimes, economists have to deal with incomplete or unreliable real-world data. In some cases, they may even be faced with variables that are not measurable and have no data, in which case they must use substitute variables (called proxy variables) or substitute relationships between variables. As a result of these difficulties, it is not unusual for two or more economists to be testing the same hypothesis and to come up with conflicting results. For all these reasons, while the testing methods of economists do produce some useful results, these are sometimes not as accurate and as reliable as the results of experiments in other disciplines performed under controlled conditions. This means it may be more difficult for hypothesis testing in economics to refute (reject) invalid hypotheses. If the evidence does not reject a hypothesis, economists hold on to it and may continue to use it in their work (possibly until further testing in the future). However, this does not mean that the hypothesis is a valid one. It may be invalid, but the evidence just has not been discriminating enough to reject it. This has important implications for economics. It means that there may be several conflicting hypotheses that economists are holding on to and working with, not all of hich are alid h potheses, and some of which may be false. Moreover, economists may use these hypotheses to build theories. A theory was described earlier as being based on several hypotheses that have not been rejected, based on evidence. This means it is possible to have theories built on invalid hypotheses, which simply have not (yet) been shown to be invalid. But if the hypotheses on which theories are built are invalid, then surely the theories themselves are also invalid. This explains one possible reason why we sometimes see several conflicting theories being used at the same time. Maybe only one of them (or even none of them) is valid. Whatever the case, as economists usually prefer to support one theory over another, this may be an important reason why they sometimes disagree. As we will see in Theory of knowledge 9.1 (Chapter 9), the inability of empirical evidence to effectively discriminate between competing theories allows much room for value judgements and ideologies to enter into one s individual preference for one economic theory over another. T As you read this book and learn more about economics, you may want to keep the following questions in mind: Can you think of other possible reasons why economists often disagree? What other social sciences/sciences cannot test hypotheses by performing controlled experiments? Do you think economists disagree more or less than (or the same as) other social and natural scientists? Do you think the difficulties of economics are due to its being a young social science that will slowly mature and resolve these difficulties as econometric methods and the quality of data improve? Or are they due to problems that are inherent in the nature of the subject and therefore cannot be easily resolved? Do you think these difficulties seriously affect the progress and development of new economic knowledge? Or can economics continue to progress in spite of these difficulties? 1.5 A : LEARNING OBJEC I ES After stud ing this section ou ill be able to: define all the terms appearing in in the te t (AO1) e plain the major schools of thought from the 18th centur to the present: (AO2) 18 : Adam Smith and laisse faire 19 : utilit theor in classical microeconomics the concept of the margin Sa s La in classical macroeconomics the Mar ist critique of classical economics 20 : the Ke nesian revolution the emergence of macroeconomic polic the monetarist/ne classical counter-revolution 21 : behavioural economics and the dialogue ith ps cholog gro ing a areness of the interdependence bet een the econom , societ and the environment, and the need to move to ard a circular econom The histor of economic thought is a fascinating account of ho economic ideas have evolved over the ears. Man of the economic ideas and theories ou ill learn about in our stud of economics can be traced back to the contributions of famous economists ho lived and orked decades, and even centuries, ago. Although economic thinking has developed and progressed over time, leading to a deeper understanding of economic events, man of these contributions still lie at the heart of economics that e stud toda . I i gl ec mme ded ha ead hi ec i agai af e c m le i g he e f hi b k. It is onl then that ou ill be able to appreciate the richness of the ideas of these famous economists, because onl then ill ou be able to recognise in their ork our o n understanding of economics. Until about the 18th centur , there ere no distinct disciplines as e kno them toda . Investigation of events and phenomena in the social orld ere part of hat as kno n as m al hil h , hile investigation of events and phenomena in the natural orld ere part of hat as kno n as a al hil h . In the area of hat e no kno as ec mic , scholars and philosophers since the time of the ancient Greeks, t o and a half thousand ears ago, have concerned themselves ith ideas that tr to e plain economic events, but no one had attempted to provide a theor e plaining the econom in a s stematic a . The first scholar to do this as Adam Smith. 18 :A S F 1.7: Adam Smith, Scottish philosopher and political economist, often considered to be the Father of Economics , author of A I i i he Na e a d Ca e f he Weal h f Na i (the Weal h f Na i for short) A S (1723 1790) as a Scottish philosopher ho is often referred to as the Fa he f Ec mic . Adam Smith studied moral philosoph at the Universit of Glasgo and at O ford Universit , eventuall ending up back at the Universit of Glasgo , here he taught moral philosoph . He is best kno n for the ideas e pressed in his book The Weal h f Na i ,5 published in 1776. The Weal h f Na i is considered to be a masterpiece that has influenced economics for generations up to the present da . Although it borro s heavil from the ideas of various scholars of the time, it represents the first attempt ever to set forth a comprehensive theor of ho an econom can hold itself together, functioning in a harmonious a , and ho such an econom can gro over time. Adam Smith lived at a time hen the traditional rights of rulers to impose authoritarian controls and restrictions on their subjects in Europe as coming more and more under attack. Smith believed that strong, repressive governments ere not essential to the orkings of an econom . He therefore set out to sho ho an economic s stem ithout government could not merel function, but could moreover thrive and prosper to the great benefit of its citi ens. In this task, Smith borro ed heavil from the ideas of the natural la s set forth b Isaac Ne ton (1642 1727), the great mathematician, ph sicist, astronomer and theologian. Just as Ne ton discovered natural la s that govern the ph sical orld ith harmonious regularit , so Smith believed he as uncovering the natural la s of the social orld that govern economic relations ith that same regularit . Smith begins ith the idea of a market and the behaviour of individuals in a market that ill produce beneficial results for the hole of societ . He sho s ith painstaking detail and numerous e amples in The Weal h f Na i that if individuals behave in a self-interested a , so that each person tries to do the best for herself or himself, there ill result a greater good for societ . In a famous quote from The Weal h f Na i , Smith rites: I i f m he be e le ce f he b che , he b e e , f m hei ega d hei i ee . he bake , ha e e ec di e , b Such behaviour gives rise to c m e i i , hich regulates the behaviour of people acting in their selfinterest. Competition is ver important because it keeps people s self-interest in check. Suppose, for e ample, that a producer of shoes raises price to a high level e pecting more personal gain. Other producers of shoes ho also ant to sell their products ill sell them at a lo er price, so the high-price seller ill be forced to lo er the price. This process continues until the price of shoes falls to the lo est possible level. Similarl , competition ill lead to the production of those goods and services that are mostl anted, because self-interest ill lead producers to make those goods that the ill be able to sell. In the same a , occupations that are difficult or dangerous ill command higher ages because orkers ill onl be illing to take on such jobs if the ages are high enough to compensate them for the hard ork and risks. These ideas gave rise to the famous e pression the i i ible ha d f ma ke , hich refers to the presence of thousands or millions of individual decisions made b individual decision-makers that are self-regulated through interactions in markets, ithout the presence of a government deciding hat/ho much to produce. The invisible hand results in a more efficient use of resources. This is also kno n as a econom (from French, meaning le i d ) hich refers to a free market ithout government intervention. It is not necessar to have a government telling people hat to do or ho to do it, because the market orking on its o n can do a much better job of this. Ho ever, Adam Smith did foresee a role for government as ell. Governments in his vie have three important functions: to take care of national defence, to oversee securit and a s stem of justice, and to provide public infrastructure (roads, bridges, canals and so on), hich are essential to the proper functioning of an econom and therefore should be financed from ta ation. The idea of competition, being central to Smith s ideas, as carried further. Smith as ver concerned about the possible gro th of firms to become large corporations or monopolies, hich ould restrict competition. He as keenl a are of the po er of large firms to raise the prices to high levels and keep them there due to the absence of competition. As he rote: The ice f m l i he ice f f ee c m e i i , e e he c cca i he highe hich ca be g . The a a , i he l e hich ca be ake . al ice, Smith believed that competition ould ensure that monopolies and large corporations ill not be able to arise. The Weal h f Na i also presents a theor of economic gro th. Economic gro th is seen to depend on the division of labour (the separation of processes into man different tasks, each one performed b different orkers) hich permits eciali a i of labour to take place. Specialisation of labour involves the pursuit b orkers of a particular task involving skills appropriate to the task in question. If orkers specialise in particular activities that the can perform best, then more output ill be produced and this ill lead to economic gro th. Smith e tended the idea of specialisation be ond hat takes place ithin countries to international trade bet een countries. He is responsible for the idea of ab l e ad a age of a countr in international trade. According to this idea if each countr produces the goods it can produce at the lo est cost and trades them for goods produced at a lo er cost in other countries, then all the countries involved ill be better off. Therefore, Adam Smith as an advocate of free trade (trade ithout restrictions). The theor of absolute advantage ill be discussed in Chapter 14 (at HL onl ). Whereas Smith rote that self-interested behaviour leads to the beneficial invisible hand of the market, he did not rite that people s actions are determined onl b self-interest. In an earlier book, The The f M al Se ime (1759), Smith argued that people have the abilit to put themselves in the position of another person, in other ords to empathise. This makes them behave in a s that create happiness for other people, because doing so gives them pleasure. This is important because in later ears Smith s ideas ere misinterpreted to mean that people behave onl selfishl and ith greed. The concepts of demand, suppl and markets that ou ill read about in Chapter 2 are e tensions and elaborations of Adam Smith s thinking. Adam Smith is best kno n for the idea that the self-interested behaviour of decision-makers ithout government intervention results in competitive markets that give rise to a more efficient use of resources and greater output, thus benefitting societ . This is kno n as the i i ible ha d f he ma ke . 19 The economic ideas that developed during the 19th centur are kno n as . Economic thinking as modified and refined considerabl since the time of Adam Smith. The main economists of the time ere concerned ith issues like the process of economic gro th and the distribution of income. A number of scholars made important contributions, such as David Ricardo ( ho e ill encounter in Chapter 14), and Jerem Bentham and John Stuart Mill ho e ill briefl discuss belo . Jerem Bentham (1748 1832) and John Stuart Mill (1806 1873) ere British philosophers ho also made contributions to economics. Jerem Bentham as the founder of ili a ia i m, a philosoph of ethics (a philosoph about hat is right and rong) hich taught that an action is right if it promotes the most happiness for the largest number of people. Bentham s theor of ethics is based on the idea that: i i he g ea e ha i e f he g ea e mbe ha i he mea e f igh a d g. Therefore actions are right or rong according to the consequences the have on the happiness of other people. John Stuart Mill furthered Bentham s ideas b blending them ith human rights, including the rights of minorities and omen. He as a fervent believer in human freedom and as opposed to forcing people to do things against their ill. Mill s theor of ethics can be summarised in his statement that: ac i a e igh i e e e f ha i e . i a he e d m e ha The idea of the greatest happiness is based on the concept of ha e i a ha i e . . . . . . i e , g a he e d d ce he ili , hich Bentham defined to be: bjec , he eb i e d d ce be efi , ad a age, lea e e he ha e i g f mi chief, ai , e il, ha i e . e, g d, Similarl , Mill defines happiness as pleasure and the absence of pain. Utilit , the central concept in the philosoph of ethics of utilitarianism, evolved to become a central concept of economics that underlies economic theories up to the present da . Classical economists developed the philosoph of ethics kno n as ili a ia i m, according to hich an action is right if it promotes the most happiness for the largest number of people. Classical economists ere concerned about the concept of al e, specificall hat gives things their value and hat determines their price. One theor that as popular at the time as the labour theor of value, according to hich the price of a good as determined b the quantit of labour that as necessar to produce it. It so happened that three economists, orking independentl of each other, came to use the concept of ili in order to arrive at a theor of ho prices are determined. The ere Stanle Jevons (English, 1835 1882), Carl Menger (Austrian, 1840 1921) and L on Walras (French, 1834 1910). Although the differed idel in the methods the used, the all agreed on t o fundamental points: the concept of ili , or satisfaction or pleasure derived from consuming something, is central to an idea of value that helps determine prices, and hat matters is not the total utilit of consuming something but rather the e of consuming one more unit of the good, kno n as ma gi al ili . a or addi i al utilit Suppose that utilit can be measured in units of il (imaginar units that measure satisfaction). According to Amandla s tastes and preferences, eating one ice cream provides her ith 5 utils of satisfaction. If she eats a second one, she receives a total utilit for the t o ice creams of 9 utils; her total utilit has increased b onl 4 utils because she enjo ed the second ice cream less than the first. Hence, her marginal utilit is 4 utils. As she enjo s each successive ice cream less than the previous one, her marginal utilit keeps falling. Some ears later, in the earl part of the 20th centur , Alfred Marshall (English, 1842 1924) used these ideas to come up ith the la of demand and the demand curve that e are familiar ith toda . If Amandla gets less and less marginal utilit from consuming more ice creams, she ill onl be illing to bu more if their price falls, hence the la of demand. The entire anal sis of demand and suppl and market equilibrium that e stud toda is attributable to Alfred Marshall. The concept of ma gi al is ver important in economics. It ill be encountered several times (Chapters 2 and 7, at HL onl ). In the 19th centur , the concept of , underl ing utilitarianism, referring to the satisfaction derived from consuming something, as combined ith the concept of , meaning e tra or additional, leading eventuall to as the basis of a theor of value that determines prices of goods and services. It forms the basis of rational consumer behaviour that is used to the present da in microeconomics. S Whereas e refer here to classical microeconomics and macroeconomics, these terms did not e ist at the time, as there as no distinction during the 19th centur bet een the micro and macro levels of anal sis. As e ill see belo , macroeconomics as a distinct branch of economics as born in the 20th centur . The classical economists of the 19th centur believed that the problem of unemplo ment could not arise under normal circumstances. While there could be occasional disturbances in an econom due to such events as ars, droughts or other major disruptions, ordinaril unemplo ment could not arise for e tended periods because it as thought that the econom ould keep on producing as much as is required in order to keep orkers full emplo ed. This idea came to be kno n as Sa La , after the French economist Jean-Baptiste Sa (1767 1832). Sa as strongl influenced b Adam Smith, and as an advocate of free markets and laisse faire. The la that as named after him stated ver simpl that l c ea e i dema d. What this means is that overall spending in an econom cannot fall enough to prevent all the output produced from being bought. We can see hat this means ver clearl b e amining the circular flo of income model presented in Section 1.3. Firms produce goods and services, and the pa households for providing them ith the resources. The households receive this income and spend it to bu the goods and services. Therefore l c ea e i dema d; the output that firms produce provides households ith the income the need to bu that output. Therefore, orkers ill keep on orking to produce that output and there ill be full emplo ment. This simple idea came to be ver seriousl questioned during the Great Depression of the 1930s, hich sa falling output and ver high unemplo ment rates in man countries. These events gave rise to the birth of macroeconomics as a distinct branch of economics and the development of ne theories to e plain unemplo ment. According to S L , suppl creates its o n demand, a theor that claims that the econom tends to ard full emplo ment in the absence of an government intervention. M F 1.8: Karl Mar , German philosopher and political economist, hose theories formed the basis of modern communism, author of Ca i al: C i i e f P li ical Ec m (Da Ka i al for short) K M (1818 1883) as a German philosopher ho had a profound influence on the course of global events during the 20th centur , as man of his ideas formed the ideological basis for the establishment of communist regimes around the orld. In addition to being a philosopher, Mar as an economist, historian, political theorist, sociologist and linguist. Mar produced a huge amount of ritten ork but perhaps the best kno n is his book Ca i al: C i i e f P li ical Ec m (for short Da Ka i al in German, 1867), hich as ritten over eighteen ears. In this book, Mar presented hat he considered to be a scientific account of the la s of capitalist development, hich ould eventuall result in the do nfall of capitalism. (Ca i ali m is the free market s stem, based on private o nership of the means of production, and driven b the desire to make profits.) Mar s anal sis is based on a version of the labour theor of value, hich as noted earlier as the standard e planation of value in the 19th centur , until the appearance of marginal anal sis. The value of a good as determined b the amount of labour that as used to produce it. Ho ever, Mar observed that the price actuall paid for a good as usuall far greater than the value of labour that as put into producing it, measured b the ages paid to labour. The difference bet een the t o, or the price of the good minus the value of labour to produce it, as termed l al e b Mar , and corresponded to profit made b the o ners of the factories. Surplus value represented e ploitation of orkers b the o ners of factories. The factor o ners had an incentive to pa orkers as little as possible, forcing them to ork under appalling conditions, so that the could make the surplus value and hence their profits as large as possible. It is be ond doubt that conditions in 19th centur factories in England, here Mar as living at the time, ere trul appalling, as the ritings of authors such as Charles Dickens clearl sho . As a historian, Mar sa economic s stems being transformed over time in a particular order. Feudalism had been replaced b capitalism, and according to the historical la s he claimed to have discovered, capitalism as going to be replaced in the future b communism. This ould happen because of the innate instabilit of capitalism. Competition ould force capitalists (the o ners of factories) to keep investing in ne machiner in order to reduce labour costs and hence beat their competitors. But b using machines in place of labour, the capitalists ould reduce the surplus value of labour that gave rise to their profits. Therefore the result ould be declining profits for the capitalists. At the same time that capitalists profits ere e pected to fall, orkers ould become increasingl unemplo ed and povert -stricken as the ere replaced b more machines. Workers ere e pected to become more and more pitted against capitalists. The capitalist s stem ould eventuall be overthro n, to be replaced b communism here the means of production (the factories) ould be o ned collectivel b the people. Mar did not at an time describe his visions of communism in a s stematic a , but it is clear from his ritings that the s stems that came into being in the 20th centur ere not based on his ideas. His predictions have not materialised, since capitalist profits do not appear to be falling. While capitalism does periodicall undergo crises, such as the Great Depression of the 1930s and the global financial crisis of 2008, it does not appear to be on the verge of collapse. The communist s stems that came into being in the 20th centur ere not the result of capitalism s collapse, but rather the result of force. Yet Mar continues to be highl influential because he had keen insights into the orkings of capitalism hich are still highl relevant toda . These include the recurrence of crises, hich is similar to hat is kno n toda as the business c cle, the impoverishment of the middle class as income inequalities gro rapidl , the lack of gro th in real ages over decades in man developed countries (related to the gro th in income inequalities), increasing job insecurities and the risks of gro ing unemplo ment due to rapid technological change. Moreover, Mar has had a profound influence in other social sciences, including sociolog , anthropolog and political science. Karl Mar is still idel read toda , and there has been a gro ing interest in his ork since the onset of the global financial crisis in 2008. Interestingl , a search on Ama on UK ields more results for Karl Mar than for Adam Smith. Karl Mar developed a theor according to hich ca i ali m ld be e e all e laced b c mm i m because of the market s stem s internal contradictions that ould lead to its collapse. While this has not materialised, Mar is still highl regarded for his numerous insights into ho capitalism orks. 20 K F 1.9: John Ma nard Ke nes, British economist, hose theories replaced classical economics, author of The General Theor of Emplo ment, Interest and Mone (The Ge e al The for short) It as noted earlier that in the 19th centur , it as believed that, in accordance ith Sa s La , suppl creates its o n demand. In this a of thinking, it as not possible to have e tended periods of unemplo ment. Therefore hen the Great Depression of the 1930s occurred, bringing ith it ver significant declines in output along ith high unemplo ment in man countries, economists ere at a loss to e plain ho this had occurred. J M K (1883 1946), an e tremel influential British economist, set forth an economic theor that entirel replaced the classical theor and Sa s La . Ke nes is best kno n for his book The Ge e al The f Em l me , I e e a d M e (for short, The Ge e al The , 1936). Ke nes argued that the state of full emplo ment in an econom as onl a special case that could not occur all the time. If spending decreased, there as nothing to ensure that an econom ould return to a situation of full emplo ment on its o n. Classical economists thought that if overall demand decreased and there as a fall in spending, then prices ill fall, hich ill cause spending to increase again, so output and emplo ment ill once again go to the full emplo ment level. Also, classical economists thought that if there as a decrease in spending so that output fell, then there ould be some temporar unemplo ment that ould cause ages to fall, making emplo ers increase the number of orkers the hire. This ould also bring emplo ment back up to the full emplo ment level once again. But according to Ke nes, ages ere stick , meaning the could not fall easil . In addition, falling ages meant that orkers ould have less mone to spend, hich ould cause overall demand and spending to fall further. But stick ages meant stick prices, because producers could not lo er their prices if the had to go on pa ing the same levels of ages. As a result, the economic s stem could not on its o n go back to full emplo ment. Ke nes argued that a situation like this requires government intervention in the form of increased government spending, hich ould give the econom the push it needed to get it going again. Using the idea of the m l i lie , he sho ed that if the government increased its o n spending on such things as building roads or schools, there ould be a multiplied spending effect in the econom . This ould help the econom to get out of its state of lo output and unemplo ment. Ke nes thoroughl dismissed the laisse faire econom of the 19th centur and provided a justification for government intervention that is urgentl needed to avoid prolonged recessions (negative gro th) and high unemplo ment. We ill discuss Ke nes contribution in Chapter 9. One of the important contributions of John Ma nard Ke nes is the idea that a ec m lef i ill ece a il lead f ll em l me , thus requiring government intervention in order to ensure that full emplo ment ill be achieved. Macroeconomic polic as inspired b the ork of John Ma nard Ke nes discussed above. The term macroeconomics, as a field of economics distinct from microeconomics, did not even e ist until 1945 hen it as coined b Jacob Marschak.6 According to the thinking of the classical economists, there as no need for macroeconomic polic since the econom as assumed to correct itself automaticall through market forces in the absence of government intervention. We ill discuss macroeconomic policies in detail in Chapter 13. / - In the earl 1970s, the global econom e perienced cost-push inflation, also kno n as stagflation, on account of the first oil price crisis. Ke nesian economics, ith its focus on aggregate demand, as unable to provide a solution to inflation of this t pe. These events paved the a for the emergence and gro ing popularit of t o schools of thought: and . Monetarism, attributed to the Nobel Pri e inning economist Milton Friedman (1912 2006), emphasises the role of mone in the econom . It is argued that changes in the mone suppl have major effects on output in the short run, and on the price level in the long run. Ne classical economics, associated partl ith another Nobel Pri e inning economist Robert Lucas (born 1937) emphasises the importance of individuals rational e pectations of inflation and government polic actions. While these t o theories are quite different from each other, e are considering them together because the share a unif ing principle regarding he le f ma ke i b i gi g he ec m back a i a i he e he e i f ll em l me ih a g e me i e e i . In fact, according to these t o schools of thought, it is government intervention itself, in such areas as minimum age la s and the operation of trade unions, that leads to stick ages that do not fall, thus preventing the automatic adjustment of the econom back to full emplo ment. If all ages and all prices could respond freel to the forces of demand and suppl , markets on their o n ould achieve high levels of output and full emplo ment. It is clear from the above that this approach involves a rejection of Ke nesian economics, hich requires government intervention for the smooth functioning of an econom . It advocates a return to the classical idea of automatic full emplo ment through the orkings of a laisse -faire econom ; hence the use of the term e cla ical. The monetarist/ne classical approach has been the inspiration of market-based suppl -side policies. We ill discuss this model and its implications for polic in Chapters 9 and 13. According to the monetarist/ne classical schools of thought, government intervention prevents the econom from reaching a state of full emplo ment on its o n, hereas a free market econom ithout the government intervening ill tend to ard full emplo ment. 21 B Since the earl part of the 21st centur , there has been a gro ing dialogue bet een economists and ps chologists, resulting in a ne field of economics kno n as . Behavioural economics questions the idea that marginal utilit underlies demand and rational consumer behaviour ( hich e discussed earlier). It is argued that consumers do not have the necessar information available, but also and most importantl the human mind orks in a s that are not rational in the a s the theor presupposes. Rather than rel on a theor that e plains the behaviour of consumers, behavioural economics relies on e periments and the accumulation of evidence about ho consumers behave under a broad variet of different circumstances. This information is then used to formulate economic policies that ill encourage consumers to behave in a s that are held to be sociall desirable. The gro ing importance and influence of behavioural economics is evidenced b the fact that, in a span of 15 ears, three Nobel Pri es have been a arded to scholars dealing ith this subject. The include Daniel Kahneman (2002) for his ork on human judgement and decision-making under uncertaint ; Robert J Shiller (2013) for his anal sis of asset prices in the area of behavioural finance; and Richard Thaler (2017) for his ork sho ing that people are predictabl irrational in a s that contradict economic theor . (Behavioural economics ill be studied at HL in Chapter 2.) , , Earlier in this chapter e discussed the issue of sustainabilit , hich arises from conditions of scarcit of resources. We learned that sustainabilit refers to the maintenance of resource quantities and qualit over time. Until recentl , economists carried out their ork in isolation, ithout taking into consideration the interrelationships and interdependencies that e ist bet een the econom , societ and the environment. In recent ears there is increasing a areness of the need to consider three pillars of sustainabilit together: the econom , societ and the environment, sometimes abbreviated as profit, people, planet. In addition, it is imperative to move a a from the traditional e tractive take-make-dispose model, hich characterises our current approach to producing products and disposing of aste. This approach involves e tracting resources, making them into products and then thro ing them out. The imperative of achieving sustainable development requires that e adopt a . The idea behind a circular econom is that goods should be produced in such a a that the can be repaired rather than thro n out. In addition, the ould be made out of biological materials so that once discarded the can go back to the biosphere and prevent pollution of the planet. According to London s Waste and Rec cling Board: A ci c la ec m i a m e efficie a d e i me all d al e a i e he adi i al li ea ec m . I i e i hich e kee e ce i e f a l g a ible, e ac he ma im m al e f m hem hil i e, he ec e a d ege e a e d c a d ma e ial a he 7 e d hei life. We ill stud the problem of sustainable resource use in Chapter 5. Novel thinking in the 21st centur includes: (i) the contributions of ps cholog to economics, hich offer alternative a s of understanding ho consumers make decisions, ith a vie to influencing consumer choices to ard sociall desirable outcomes; and (ii) the development of ne models regarding sustainabilit that focus on the close interdependencies bet een the econom , societ and the environment, and the concept of a circular econom . ES 1 O R NDERS ANDING 1.14 Referring to the concept of laisse faire, e plain Adam Smith s main contribution to economics. 2 Outline the three phases of macroeconomic thought on the need for government intervention in the econom for the purpose of achieving full emplo ment, from the 19th centur to the late 20th centur . 3 E plain ho perceptions regarding the concept of the present. 4 Outline the meaning of a ci c la ec 5 Select a famous economist ou are interested in and present his/her ork, either individuall or in a group. E AM S ili have evolved from the 19th centur to m and its importance to sustainable development. LE Q ES IONS You can find questions in the st le of IB e ams in the 'Digital coursebook: E tra material' section. 5 The full title of the book as A I i i he Na 6 The other- orldl philosophers 7 London Waste and Rec cling Board (LWARB) e a d Ca e f he Weal h f Na i . 2 M Mic ec ic i c ce ed i h he beha i fc e , fi a d e ce e , h a e he i a ec ic deci i - ake i a a ke ec . We i d he de f de a d a d , hich f he ba i f he a ke ec a di e f he i a a a ica i ic ec ic . We i ea ab he be efi f f ee a ke a e a hei i e fec i i a a ie f i ai he e he fai ee i a ec ic bjec i e . We i a e a i e he e f g e e . We i ee ha effec g e e ha e he he i e fe e i a ke a e a h he ca he achie e be e cia c e he a ke fai ef e . The e i de e i ic ec ic a e i a beca e he ide a i igh i he ki g f he a ke ec ,a di he effec f diffe e e f g e e i e e i . I addi i , he f he ba i f addi i a ic e i d i ae a f hi b k. Rea c ec d i e 1: H a e ch ice e a d d ce he he ic bjec i e ? ade b ee hei CONCEP AL NDE ANDING 1 The ec e ce a e a ca ed (a ig ed) e ice i e ded ee eed a d a ai c e a d d ce i a ke . 2 The ch ice aki g. 3 The achie e e fa g ea e i ca be). 4 C i ade b c e a d ca i e efficienc change gi e i e d a ic d ce ea he h d ci f g d a d gh he i e ac i f a e he e fc ha a i i ed ( ade he e fa e i e deci i - a ke . The e ic a e add e ed i Cha e 2 a d 3. I Cha e 2 e i di c e he ba ic b i di g b ck f ic ec ic : de a d, a d a ke . We i e a i e h c e a d d ce i e ac i a ke a d e i ee i e de ai ha Ada S i h ea b he i i ib e ha d. We i a e a i e e ece de e e ha a e ai ee a ai fc e a d fi beha i . Cha e 3 i i d ce a e c ce , ha f e a ici , hich ea e h c e a d fi e d cha ge i ice , a d a be e de a d he ki g f a ke . A b ge i g ch ie ________________________ ffe Chapter 2 Competitive markets: Demand and supply BEFORE YOU START O er time, ou see prices of goods and ser ices change. Wh do ou think sellers of goods and ser ices change their prices? When ou bu goods and ser ices, do ou think our choices are al a s in our best selfinterest? Ho do consumers and producers make choices in tr ing to meet their economic objecti es? In this chapter e e amine hat lies at the heart of e er market-based econom : the forces of demand and suppl . We ill then see ho the interactions of demand and suppl arri e at equilibrium market prices, and e ill stud the special qualities of free competiti e markets. This chapter ill also e amine some recent de elopments in the fields of consumer and producer beha iour that pro ide no el e planations on ho these fundamental decision-makers make choices. 2.1 I d ci c eii e a ke LEARNING OBJECTIVES Af e d i g hi ec i ill be able defi e all he e m a ea i g i li e he mea i g f a c : a ge b d i eii e he e (AO1) a ke (AO1) Ma ke The a e f a ke A ma ke igi all a a lace he e e le ga he ed b a d ell g d . S ch ma ke ill e i da , f e am le ca le ma ke , fi h ma ke , f i a d ege able ma ke a d flea ma ke , i l i g a h ical mee i g lace he e b e a d elle mee face face. The e m a ke ha i ce e l ed i cl de a g d , e ice e ce a e li ked ge he ki d f a a geme he e b ca a e cha ge. e a d elle f The ma ke ma be i a ecific lace ( ch a a ege able ma ke ), i ma i l e ma diffe e lace ( ch a he il ma ke ). B e a d elle ma mee ( a , i a h ), he ma e e mee , c mm ica i g b fa , h e, i e e , cla ified ad , a he me h d hich all hem c e i f ma i ab ice, a i a d ali . A ma ke ca be l cal, he e he b e a d elle igi a e f m a l cal a ea; i ma be a i al, i hich ca e he b e a d elle a e f m a he e i hi a c ; i ma be i e a i al, i h b e a d elle f m a he e i he ld. F e am le, mall eighb h d bake ie d ce a d ell b ead a d he baked g d f he l cal c mm i hi i a l cal ma ke . L cal akea a e a a al d ce f he l cal ma ke . The lab ma ke , he he ha d, e d be m l a a i al ma ke . B c a , he ld il ma ke i cl de il d ce i diffe e c ie , a d b e f il i all e e he e i he ld, a ell a h le ale , e aile a d he i e media ie i l ed i b i g a d elli g il a d he ld. G d a d e ice a e ld i d c ma ke , hile e e ce ma ke (fac ma ke ). ce (fac f d ci )a e ld i TEST YOUR UNDERSTANDING 2.1 1 Wha i a ma ke ? 2 S gge m e e am le The ea i g f a c f l cal, a i al a d i e a i al ma ke . eii e a ke C e i i i ge e all de d be a ce i hich i al c m e e i de achie e me bjec i e. F e am le, fi m ma c m e e i h each he e h ill ell he m , c me ma c m e e e h ill b a ca ce d c, ke c m e e e h ill ge he be j b i h he highe ala ie , c ie c m e e e hich ill ca e he bigge e ma ke . Be d hi e e da e e, c m e i i i mic ec mic cc he he e a e ma b e a d elle ac i g i de e de l , ha e ha he abili i fl e ce he ice a hich a d c i ld. Thi h ld be c a ed i h ma ke o e (al k a mono ol o e ) hich efe he c l ha a elle ma ha e e he ice f he d c i ell . The g ea e he ma ke e , he g ea e i he c l e ice. O he he ha d, he g ea e he deg ee f c m e i i be ee elle , he malle hei ma ke e , a d he eake i hei c l e he ice. I hi cha e e ill d c e i i e a ke c m ed f la ge mbe f elle a d b e ac i g i de e de l , ha e i di id al elle mall g f elle ha he abili c l he ice f he d c ld. I ead, he ice f he d c i de e mi ed b he i e ac i f ma elle a d b e , h gh he f ce f dema d a d l . 2.2 D LEARNING OBJECTIVES After stud ing this section ou ill be able to: define all the terms appearing in in the te t (AO1) e plain the la of demand (AO2) dra a demand curve (AO4) e plain the relationship bet een individual demand and market demand (AO2) anal se the non-price determinants of demand as causes of demand curve shifts (AO2) using diagrams distinguish bet een movements along the demand curve and shifts of the demand curve (AO4) e plain the assumptions that underlie the la of demand (HL onl ) (AO2) the la of diminishing marginal utilit the income and substitution effects U D is concerned ith the behaviour of bu ers. Consumers (or households) are bu ers of goods and services in product markets, hereas firms (or businesses) are bu ers of factors of production in resource markets. In our anal sis of demand and suppl e ill focus mainl on product markets and therefore on the behaviour of consumers as bu ers (though the same general principles described here appl also to the behaviour of firms as bu ers in resource markets). I As bu ers, consumers are demanders of those items the ish to bu . The of an individual consumer indicates the various quantities of a good (or service) the consumer is willing and able to bu at different possible prices during a particular time period, ceteris paribus. A consumer s demand for a good can be presented as a demand schedule, or as a table listing quantit demanded at various prices. Table 2.1 sho s a consumer s demand schedule for chocolate bars. When the price of chocolate bars is $5, the consumer is illing and able to bu t o chocolate bars in a eek. When the price is $4, the consumer is illing and able to bu four chocolate bars in a eek, and so on. P ($) Q ( ) 5 2 4 4 3 6 2 8 1 10 T F 2.1: Demand schedule for a consumer 2.1: Demand curve for an individual consumer Willing means the consumer ants to bu the good; able means that the consumer can afford to bu it. (You ma ant to bu a Ferrari, but can ou afford it? If not, our desire to bu one ill not sho up as demand for Ferraris. Or, ou can afford a Ferrari but ou have no desire to o n one; again ou ill not have an demand for Ferraris.) Ceteris paribus means that all things other than price that can affect ho much the consumer is illing and able to bu are assumed to be constant and unchanging (see Chapter 1, and Quantitative techniques chapter in the 'Digital coursebook: E tra material' section). In fact, the consumer s demand is affected not onl b price, but also b man other things, like income, tastes and prices of related goods. For the moment, e ignore all these and concentrate onl on the relationship bet een the quantit of a good and its price. The information contained in the demand schedule can be plotted as a graph, sho n in Figure 2.1. The price of chocolate bars is plotted on the vertical a is and quantit of chocolate bars on the hori ontal a is. The curve in Figure 2.1 is a . Note that even though this is a straight line, it is referred to as a curve . The demand schedule and demand curve do not tell us an thing about ho man chocolate bars the consumer ill actuall bu and hat price the consumer ill pa . This information ill be given to us later through the interaction of demand ith suppl . The demand information onl tells us ho man chocolate bars the consumer ould be prepared to bu if the price ere $5, or $4, and so on. T The demand curve plotted in Figure 2.1 illustrates a ver important relationship: as the price of a good falls, the quantit of the good demanded increases. When t o variables change in opposite directions, so that as one falls, the other increases, the are said to have a negative (or indirect ) relationship. This relationship is a causal one, because changes in price cause changes in quantit demanded. The negative relationship bet een price and quantit demanded is kno n as the la of demand. According to the , there is a negative relationship bet een the price of a good and its quantit demanded over a particular time period, ceteris paribus: as the price of the good increases, quantit demanded falls; as the price falls, quantit demanded increases, ceteris paribus. The la of demand is most likel to be consistent ith our e perience. The higher the price of a good, the less of it ou are probabl illing and able to bu . F So far e have considered the demand for a good of one individual consumer. Market demand sho s the total quantities in the market for the good consumers are illing and able to bu at different prices (during a particular period of time, ceteris paribus). Market demand is the sum of all individual demands for that good. Figure 2.2 sho s ho the quantit demanded b consumer A is added to the quantit demanded b consumer B, and so on until all the quantities demanded b all consumers of chocolate bars are added up. (Note that consumer A has a different demand for chocolate bars than consumer B, indicating different preferences). For e ample, at the price of $4, e add the four bars demanded b consumer A to the five bars demanded b consumer B, and so on to all the quantities demanded b other consumers, to arrive at the sum of 6000 chocolate bars per eek. This sum is a point on the market demand curve Dm. When e add individual demands in this a for each of the possible prices, e derive the entire market demand curve Dm, sho ing the total demand in the chocolate bar market. F 2.2: Market demand as the sum of individual demands M is the sum of all individual demands for a good. The market demand curve illustrates the la of demand, sho n b the negative relationship bet een price and quantit demanded. N T - The are the variables other than price that can influence demand. The are the variables assumed to be unchanging b use of the ceteris paribus assumption. Changes in the non-price determinants of demand cause shifts in the demand curve: the entire demand curve moves to the right or to the left. In Figure 2.3. note that the vertical a is is labelled P , standing for price, and the hori ontal a is is labelled Q , standing for quantit . Suppose the original demand curve is given b D1. If price is P1, then the demand curve D1 indicates that quantit Q1 ill be demanded. If the demand curve shifts to the right, to D2, at the same price P1 a larger quantit , Q2, ill be demanded. If, on the other hand, the demand curve shifts to the left, from D1 to D3, then a smaller quantit , Q3, ill be demanded at the same price P1. A right ard shift of the demand curve indicates that more is demanded for a given price; a left ard shift of the demand curve indicates that less is demanded for a given price. A right ard shift of the curve is called an increase in demand; a left ard shift is called a decrease in demand. F 2.3: Shifts in the demand curve The non-price determinants of market demand include: I . A good is a hen demand for it increases in response to an increase in consumer income (demand for the good varies directl ith income). Most goods are normal goods. Therefore, an increase in income leads to a right ard shift in the demand curve, and a decrease in income leads to a left ard shift. I . While most goods are normal, there are some goods here the demand falls as consumer income increases; the good is then an (the demand for the good varies inversel ith income). E amples of inferior goods are second-hand clothes, used cars and bus tickets. As income increases, consumers s itch to more e pensive alternatives (ne clothes, ne cars and cars or aeroplanes rather than travelling b bus), and so the demand for the inferior goods falls. Thus an increase in income leads to a left ard shift in the demand curve and a decrease in income produces a right ard shift. P . If preferences and tastes change in favour of a product (the good becomes more popular), demand increases and the demand curve shifts to the right; if tastes change against the product (it becomes less popular), demand decreases and the demand curve shifts to the left. P . T o goods are ( ) if the satisf a similar need. An e ample of substitute goods is Coca-Cola and Pepsi . A fall in the price of one (sa , Coca-Cola) results in a fall in the demand for the other (Pepsi). The reason is that as the price of Coca-Cola falls, some consumers s itch from Pepsi to Coca-Cola, and the demand for Pepsi falls. On the other hand, if there is an increase in the price of Coca-Cola, this ill result in an increase in the demand for Pepsi as some consumers s itch from Coca-Cola to Pepsi. Therefore, for an t o substitute goods X and Y, a decrease in the price of X produces a left ard shift in the demand for Y, hile an increase in the price of X produces a right ard shift in the demand for Y. In brief, in the case of substitute goods, the price of X and demand for Y change in the same direction (the both increase or the both decrease). Other e amples of substitute goods are oranges and apples, Cadbur s and Nestl chocolate, and milk and oghurt. P . T o goods are ( ) if the tend to be used together. An e ample of complementar goods is computers and computer soft are. In this case, a fall in the price of one (sa , computers) leads to an increase in the demand for the other (computer soft are). This is because the fall in the price of computers results in a bigger quantit of computers being purchased, and the demand for computer soft are increases. Therefore, for an t o complementar goods X and Y, a fall in the price of X leads to a right ard shift in the demand for Y, and an increase in the price of X leads to a left ard shift in the demand for Y. In the case of complementar goods, the price of X and the demand for Y change in opposite directions (as one increases, the other decreases). More e amples of complementar goods are shoes and shoe laces, tennis shoes and tennis rackets, and table-tennis balls and table-tennis rackets. Note that most goods are not related to each other; these are called independent goods. For e ample, pencils and apples, cars and ice cream, telephones and books are unrelated to one another, and the change in the price of one ill have little or no effect on the demand for the other. T . If there is an increase in the number of consumers (demanders), demand increases and therefore the market demand curve shifts to the right; if the number of consumers decreases, demand decreases and the curve shifts to the left. This follo s simpl from the fact that market demand is the sum of all individual demands. F 2.4: Movements along and shifts of the demand curve M It is important to distinguish bet een movements along a demand curve, and shifts of a demand curve. Whenever the price of a good changes, ceteris paribus, it leads to a movement along the demand curve. In Figure 2.4(a), if the price falls from P1 to P2, the quantit of the good demanded increases from Q1 to Q2. A movement along the demand curve from A to B has occurred; this is referred to as an increase in quantit demanded. An increase in price gives rise to a decrease in quantit demanded, resulting in a movement from B to A. B contrast, an change in a non-price determinant of demand results in a shift in the entire demand curve, as sho n in Figure 2.4(b); this is called a change in demand. For e ample, if there is an increase in the number of bu ers, the demand curve shifts right ard from D1 to D2; this is called an increase in demand, sho n in Figure 2.4(b). A decrease in the number of bu ers causes a left ard shift of the demand curve from D1 to D3; this is called a decrease in demand. To summarise: An change in price produces a change in quantit demanded, sho n as a movement on the demand curve. An change in a non-price determinant of demand leads to a change in demand, represented b a shift of the entire demand curve. TEST OUR UNDERSTANDING 2.2 1 Define demand . State the la of demand. E plain hether the la of demand sho s a negative or positive relationship. Sho the la of demand in a diagram. Describe the relationship bet een individual demand and market demand. Distinguish bet een a change in demand and a change in quantit demanded and e plain the cause or causes of each. Ho ould ou sho the difference bet een a movement along the demand curve and a shift of the demand curve in a diagram? Identif the non-price determinants of demand. 2 Using diagrams, sho the impact of each of the follo ing on the demand curve for product A. The number of consumers in the market for product A increases. Consumer income increases and product A is an inferior good. Consumer income decreases and product A is a normal good. A ne s report claims that use of product A has harmful effects on health. The price of substitute good B falls. The price of complementar good B increases. A (HL ) T The la of diminishing marginal utilit is based on a simple theor of consumer behaviour that e plains the negative relationship bet een price and quantit demanded, or the la of demand. U is the satisfaction that consumers gain from consuming something. It is a subjective concept, because satisfaction is something that depends entirel on personal tastes and preferences, hich var from person to person. Utilit cannot be measured, but for the purposes of developing the theor , e assume that utilit is quantifiable (it can be measured in terms of numbers of units), and the unit that e use is the util. Utils do not e ist in actual fact, ho ever e assume the e ist for the purposes of building the theor . Total utilit is the total satisfaction that consumers get from consuming something, hile marginal utilit is the e tra satisfaction that consumers receive from consuming one more unit of a good. Table 2.2 sho s ho total utilit and marginal utilit are related to each other. You can see that both total utilit and marginal utilit are measured in utils. Table 2.2 sho s Anna s preferences hen she bu s T shirts. The first T shirt provides her ith 15 utils of total utilit . This is also her marginal utilit . When she bu s a second T shirt, her total utilit increases from 15 utils to 27 utils, but her marginal utilit , or e tra satisfaction from bu ing the second T shirt has fallen to 12 utils. The marginal utilit of the second unit is simpl the total utilit of the second unit minus the total utilit of the first unit, hich is 27 utils 15 utils = 12 utils. And so on ith each e tra T shirt she bu s. Her total utilit increases, but her marginal utilit falls. Marginal utilit keeps decreasing and at some point it ma even become negative, meaning that total utilit starts to fall. This pattern illustrates the la of diminishing marginal utilit , hich is based on the idea that the satisfaction consumers get from consuming more and more units of a good decreases. The la of diminishing marginal utilit e plains the la of demand. As e kno , according to the la of demand, as the price of a good decreases, quantit demanded increases ceteris paribus. The la of diminishing marginal utilit sho s that if the consumer derives less and less utilit from each e tra unit of a good consumed, then she or he ill bu additional units onl if the price of the good falls. According to the , as consumption of a good increases, marginal utilit , or the e tra utilit the consumer receives, decreases ith each additional unit consumed. This underlies the la of demand, as it sho s that a consumer ill be illing to bu an additional unit of a good onl if its price falls. N T T T (U ) M (U 0 0 1 15 15 2 27 12 3 36 9 4 42 6 5 45 3 6 45 0 7 42 3 ) 2.2: Total and marginal utilit The concept of marginal utilit is the basic building block of the theor of consumer behaviour, according to hich consumers arrange their purchases of man different goods in a a that ill allo them to ma imise the total utilit the derive. T The income and substitution effects are an alternative e planation of the la of demand. As e have seen, the la of demand sho s the relationship bet een the price of a good and quantit of the good demanded, ceteris paribus. An price change causes a change in quantit demanded, sho n as a movement along the demand curve. We ill no see that the total effect of a price change on quantit demanded can be broken do n into t o separate effects: the substitution effect and the income effect, ith the total effect of a price change being the sum of these t o effects. The : If the price of a good falls, the consumer substitutes (bu s more) of the no less e pensive good. Therefore quantit demanded increases. There is al a s a negative relationship bet een price and quantit demanded as a result of the substitution effect: as price falls, the quantit of the good demanded increases; as price increases, quantit demanded falls. The : Consider again a fall in price. This means that the consumer s real income (or purchasing po er) has increased. (To understand hat this means consider the follo ing e ample. Sa ou have $12 and ou ant to bu some pencils. When the price is $4 per pencil, ou can bu three pencils. Suppose then that the price of pencils falls to $3 per pencil. You can no bu four pencils. The sum of mone at our disposal ($12) has not changed, and et the purchasing po er of $12, or hat our mone can bu , has increased as a result of the fall in the price of pencils. Real income is the same as purchasing po er ; it increases as prices fall, and it decreases as prices rise.) Therefore as price falls and real income increases, quantit demanded of the good increases. Once again there is a negative relationship bet een price and quantit demanded. The substitution effect and the income effect reinforce each other: a fall in price leads to an increase in quantit demanded, both because of the substitution effect and because of the income effect. In the case of most goods, hose price is a small fraction of income, the substitution effect is the most important part of the e planation of the la of demand, because being a small fraction of income, the effect that a price change has on real income ill be tin . The income effect becomes important onl in the case of purchases of goods hose price take up a large fraction of income. Note that the above anal sis refers to normal goods, here income and demand change in the same direction; as real income increases, consumers ant to bu more of the good. If ou are interested in seeing hat happens in the case of inferior goods ou can read about it in the 'Digital coursebook: E tra material' section as Supplementar material. TEST OUR UNDERSTANDING 2.3 1 Using an e ample, e plain the la of diminishing marginal utilit . Ho is this la related to the do n ard sloping demand curve? 2 E plain ho the income and substitution effects can e plain the do n ard sloping demand curve. 2.3 Suppl LEARNING OBJECTIVES After st d ing this section o ill be able to: define all the terms appearing in orange bold in the te t (AO1) e plain the la of s ppl (AO2) dra a s ppl c r e (AO4) e plain the relationship bet een indi id al s ppl and market s ppl (AO2) anal se the non-price determinants of s ppl as ca ses of s ppl c r e shifts (AO2) sing diagrams, disting ish bet een mo ements along the s ppl c r e and shifts of the s ppl c r e (AO4) e plain the ass mptions that nderlie the la of s ppl (HL onl ) (AO2) la of diminishing marginal ret rns increasing marginal cost Understanding the law of suppl and the suppl curve S ppl is concerned ith the beha io r of sellers, hich incl de firms in the prod ct markets and ho seholds in reso rce markets. As e are foc sing on prod ct markets, e ill consider the beha io r of firms as sellers (tho gh the same general principles also appl to sellers of factors of prod ction in reso rce markets). Individual suppl Firms prod ce goods and ser ices, and the s ppl them to prod ct markets for sale. As sellers, therefore, the are s ppliers of goods and ser ices. The suppl of an indi id al firm indicates the ario s q antities of a good (or ser ice) a firm is illi g a d able to prod ce and s ppl to the market for sale at different possible prices, d ring a partic lar time period, ce e i a ib . A firm s s ppl of a good can be presented as a s ppl sched le, or a table sho ing the ario s q antities of a good the firm is illing and able to prod ce and s ppl at ario s prices. Table 2.3 sho s a firm s s ppl sched le for chocolate bars. The same information appears as a graph in Fig re 2.5, here price is plotted on the ertical a is and q antit on the hori ontal a is. The line appearing in the diagram is the suppl curve of the firm. If the price is $4, the firm s pplies 500 chocolate bars in the co rse of a eek; if price ere $3, then the firm o ld s ppl 400 chocolate bars, and so on. As in the case of demand, here price is onl one thing that determines ho m ch is demanded, so in the case of s ppl , price is onl one thing that infl ences ho m ch the firm s pplies to the market; hence the ce e i a ib ass mption. For the moment, e ill ignore other possible infl ences on s ppl and foc s onl on the relationship bet een price and q antit . Price of chocolate bars ($) 5 Quantit of chocolate bars supplied (per week) 600 Price of chocolate bars ($) Quantit of chocolate bars supplied (per week) 4 500 3 400 2 300 1 200 Table 2.3: S ppl sched le for a firm Figure 2.5: S ppl c r e for a firm The s ppl sched le and the s ppl c r e do not tell s an thing abo t ho man chocolate bars the firm ill act all s ppl to the market nor hat price the firm ill recei e. The s ppl information tells s onl ho man chocolate bars the firm o ld be prepared to prod ce and sell if the price ere $5, or $4, and so on. The law of suppl The s ppl c r e in Fig re 2.5 ill strates an important relationship: as price increases, q antit s pplied also increases. When t o ariables change in the same direction (as one increases, the other also increases), the are said to ha e a positi e (or direct ) relationship. This relationship is a ca sal one, beca se changes in price ca e changes in q antit s pplied. The positi e ca sal relationship bet een the t o ariables, price and q antit s pplied, is s mmarised in the la of s ppl . According to the law of suppl , there is a positi e relationship bet een the q antit of a good s pplied o er a partic lar time period and its price, ce e i a ib : as the price of the good increases, the q antit of the good s pplied also increases; as the price falls, the q antit s pplied also falls, ce e i a ib . From individual suppl to market suppl Market s ppl indicates the total q antities of a good that firms are illing and able to s ppl in the market at different possible prices and is gi en b the s m of all indi id al s pplies of that good. Fig re 2.6 pro ides an e ample here at each price, the q antit s pplied b firm A is added to the q antit s pplied b firm B, and so on, ntil all the q antities s pplied b all firms prod cing chocolate bars are added p. For e ample, at the price of $3, firm A s pplies 400 bars per eek and firm B s pplies 300 bars. If e add these q antities together ith all the q antities s pplied b other firms, e obtain 8000 bars per eek, hich is a point on the market s ppl c r e, Sm, corresponding to the price of $3. When the firms s pplies are added p this a for each possible price, e deri e the market s ppl c r e, Sm. Figure 2.6: Market s ppl as the s m of indi id al s pplies Market suppl is the s m of all indi id al firms s pplies for a good. The market s ppl c r e ill strates the la of s ppl , sho n b a positi e relationship bet een price and q antit s pplied. The vertical suppl curve Under certain special circ mstances, the s ppl c r e is ertical at some partic lar fi ed q antit , as in Fig re 2.7. A ertical s ppl c r e tells s that e en as price increases, the q antit s pplied cannot increase; it remains constant. The q antit s pplied is independent of price. There are t o reasons h this ma occ r: There is a fi ed q antit of the good s pplied beca se there is no time to prod ce more of it. For e ample, there is a fi ed q antit of tickets in a theatre, beca se there is a fi ed n mber of seats. No matter ho high the price, it is not possible to increase the n mber of seats in a short period of time. There is a fi ed q antit of the good beca se there is no possibilit of e er prod cing more of it. This is the case ith original antiq es (for e ample, Stradi ari s iolins) and original paintings and sc lpt res of famo s artists. It ma be possible to make reprod ctions, b t it is not possible to make more originals. Figure 2.7: The ertical s ppl c r e Non-price determinants of suppl and shifts of the suppl curve The non-price determinants We no t rn to the non-price determinants of suppl , or the factors other than price that can infl ence s ppl . Changes in the determinants of s ppl ca se shifts in the s ppl c r e. A right ard shift means that for a gi en price, s ppl increases and more is s pplied; a left ard shift means that for an price, s ppl decreases and less is s pplied. As Fig re 2.8(b) sho s, hen s ppl is S1, q antit Q1 ill be s pplied at price P1. If there is an increase in s ppl to S2, at the same price P1, then Q2 q antit is s pplied. If s ppl falls to S3, then Q3 q antit is s pplied at the same price P1. A right ard shift of the s ppl c r e indicates that more is s pplied for a gi en price; a left ard shift of the s ppl c r e indicates that less is s pplied for a gi en price. A right ard shift of the c r e is called an i c ea e i l ; a left ard shift is called a dec ea e i l . The non-price determinants of market s ppl incl de the follo ing: Costs of factors of production (factor or resource prices). The firm b s ario s factors of prod ction (land, labo r, capital, entreprene rship) that it ses to prod ce its prod ct. Prices of factors of prod ction (s ch as ages, hich are the price of labo r) determine the firm s costs of prod ction. If a factor price rises, prod ction costs increase, prod ction becomes less profitable and the firm prod ces less; the s ppl c r e shifts to the left. If a factor price falls, costs of prod ction fall, prod ction becomes more profitable and the firm prod ces more; the s ppl c r e shifts to the right. Technolog . A ne impro ed technolog lo ers costs of prod ction, th s making prod ction more profitable. S ppl increases and the s ppl c r e shifts to the right. In the (less likel ) e ent that a firm ses a less prod cti e technolog , costs of prod ction increase and the s ppl c r e shifts left ard. Prices of related goods: competitive suppl . Competitive suppl of t o or more prod cts refers to prod ction of one or the other b a firm; the goods compete for the se of the same reso rces, and prod cing more of one means prod cing less of the other. For e ample, a farmer, ho can gro heat or corn, chooses to gro heat. If the price of corn increases, the farmer ma s itch to corn prod ction as this is no more profitable, res lting in a fall in heat s ppl and a left ard shift of the s ppl c r e. A fall in the price of corn res lts in an increase in heat s ppl and a right ard shift of the s ppl c r e. Prices of related goods: joint suppl . Joint suppl of t o or more prod cts refers to prod ction of goods that are deri ed from a single prod ct, so that it is not possible to prod ce more of one itho t prod cing more of the other. For e ample, b tter and skimmed milk are both prod ced from hole milk; petrol (gasoline), diesel oil and heating oil are all prod ced from cr de oil. This means that an increase in the price of one leads to an increase in its q antit s pplied and also to an increase in s ppl of the other joint prod ct(s). Figure 2.8: Mo ements along and shifts of the s ppl c r e Producer (firm) price expectations. If firms e pect the price of their prod ct to rise, the ma ithhold some of their c rrent s ppl from the market (not offer it for sale), e pecting that the ill be able to sell it at the higher price in the f t re; in this case, there is a fall in s ppl in the present and a left ard shift in the s ppl c r e. If the e pectation is that the price of their prod ct ill fall, s ppl increases in the present to take ad antage of the c rrent higher price, hence a right ard shift in the s ppl c r e. Taxes (indirect taxes or taxes on profits). Firms treat ta es as if the ere costs of prod ction. Therefore, the imposition of a ne ta or the increase of an e isting ta represents an increase in prod ction costs, so s ppl ill decrease and the s ppl c r e shifts to the left. The elimination of a ta or a decrease in an e isting ta represents a fall in prod ction costs; s ppl increases and the s ppl c r e shifts to the right. (See Chapter 4.) Subsidies. A subsid is a pa ment made to the firm b the go ernment, and so has the opposite effect of a ta . (S bsidies ma be gi en in order to increase the incomes of prod cers or to enco rage an increase in the prod ction of the good prod ced.) The introd ction of a s bsid or an increase in an e isting s bsid is eq i alent to a fall in prod ction costs, res lting in a right ard shift in the s ppl c r e, hile the elimination of a s bsid or a decrease in a s bsid leads to a left ard shift. (See Chapter 4). The number of firms. An increase in the n mber of firms prod cing the good increases s ppl , res lting in a right ard shift in the s ppl c r e; a decrease in the n mber of firms decreases s ppl and prod ces a left ard shift. This follo s from the fact that market s ppl is the s m of all indi id al s pplies. Shocks , or sudden unpredictable events. S dden, npredictable e ents called shocks , can affect s ppl , s ch as eather conditions in the case of agric lt ral prod cts, ar, or nat ral/manmade catastrophes. For e ample, the Lo isiana oil spill in 2010 res lted in a decrease in the s ppl of locall prod ced seafood. Movement along a suppl curve and shift of the suppl curve J st as in the case of the demand c r e, so in the case of the s ppl c r e e disting ish bet een mo ements along and shifts of the entire c r e. Mo ements along a s ppl c r e can be ca sed onl b changes in price. In Fig re 2.8(a), as price increases from P1 to P2, q antit s pplied increases from Q1 to Q2. There has been a mo ement along the s ppl c r e from A to B. This is called a cha ge i a i lied. If there is a change in a non-price determinant of s ppl , s ppl ill increase or decrease, and the entire c r e ill shift to the right or to the left, as in Fig re 2.8(b). This is called a cha ge i l . An change in price prod ces a cha ge i a i lied, sho n as a mo ement on the s ppl c r e. An change in a determinant of s ppl (other than price) prod ces a cha ge i l , represented b a shift of the hole s ppl c r e. TEST YOUR UNDERSTANDING 2.4 1 a Define s ppl . b State the la of s ppl . c E plain the relationship bet een price and the q antit s pplied. d Sho the la of s ppl in a diagram. e Describe the relationship bet een indi id al s ppl and market s ppl . f Disting ish bet een a change in s ppl ca se or ca ses of each. g Dra t o diagrams to sho the difference bet een a mo ement along the s ppl c r e and a shift of the s ppl c r e. h Identif the non-price determinants of s ppl . and a change in q antit s pplied and e plain the 2 Gi e some e amples of goods ith a ertical s ppl c r e. 3 Using diagrams, sho the impact of each of the follo ing on the s ppl c r e of prod ct A. a The n mber of firms in the ind str prod cing prod ct A decreases. b The price of oil, a ke inp t in the prod ction of prod ct A, increases. c Firms e pect that the price of prod ct A ill fall in the f t re. d The go ernment grants a s bsid on each nit of A prod ced. e The price of prod ct B falls, and B is in competiti e s ppl f The price of prod ct B increases, and B is in joint s ppl g A ne technolog is adopted b firms in the ind str prod cing A. ith A. ith A. Assumptions underl ing the law of suppl (HL onl ) The la of s ppl is based on the relationship bet een prod ction and the costs of prod ction. We begin this section b introd cing some ne concepts that are essential to nderstanding the relationship bet een prod ction and costs. Law of diminishing marginal returns The short run and the long run in microeconomics All firms se i (or reso rces, or factors of prod ction) to prod ce o tp t. The q antities of inp ts needed to prod ce o tp t is determined b a technical relationship bet een inp ts and o tp t. This technical relationship depends on a distinction bet een the h and the l g : The short run is a time period d ring hich at least one inp t is fi ed and cannot be changed b the firm. When e sa fi ed, e mean it is nchanging in q antit and q alit . For e ample, if a firm ants to increase o tp t, it can hire more labo r and increase materials, tools and eq ipment, b t it cannot easil change the si e of its b ildings, factories and hea machiner . The b ildings, factories and hea machiner that are nchanging are fi ed, hereas the labo r and materials are a iable. As long as the firm has at least one fi ed inp t, it is operating in the short r n. The long run is a time period hen all inp ts can be changed. Using the e ample abo e, in this time period the firm can b ild ne b ildings and factories and b more hea machiner ; it can change all of its inp ts. In the long r n the firm has no fi ed inp ts; e sa all inp ts are a iable. Note that the short r n and the long r n do not correspond to an partic lar length of time. Some ind stries ma change their fi ed inp ts o er eeks or months hile others ma do so o er man ears. We ill make e tensi e se of the distinction bet een the short r n and the long r n in Chapter 7. For no o sho ld note that the ideas de eloped in this section are concerned l i h he h . The meaning of marginal product We ill no e amine the relationship bet een inp ts and o tp t in the short r n. Since e are st d ing the short r n, e kno the firm has both fi ed and ariable inp ts. For simplicit , let s consider a farm that prod ces potatoes, here the si e of the farm and the agric lt ral machiner and tools are fi ed. The ariable inp ts are labo r and other agric lt ral inp ts (seeds, fertiliser and so on). The onl a the farmer can increase the q antit of o tp t in the short r n is b increasing the q antit of the ariable inp ts it ses. We can no disting ish bet een: total product, hich is the total q antit of o tp t (potatoes) prod ced b the firm marginal product, hich is the e tra or additional o tp t (potatoes) prod ced b one additional nit of a ariable inp t, hich e ill ass me to be labo r; it tells s b ho m ch o tp t increases as labo r increases b one orker. Table 2.4 sho s ho the total prod ct and marginal prod ct of each orker change as the n mber of orkers increases. We can see that the total prod ct increases contin o sl . The marginal or e tra prod ct added b each orker is simpl the addition to total prod ct b each orker. So the first orker adds 20 kilos of potatoes to total prod ct, the second orker adds 30 kilos (= 50 20), the third orker 40 kilos (= 90 50) and so on. Number of workers (the variable input) 0 Total product (kilos of potatoes) 0 Marginal product (kilos of potatoes) - Number of workers (the variable input) Total product (kilos of potatoes) Marginal product (kilos of potatoes) 1 20 20 2 50 30 3 90 40 4 120 30 5 140 20 6 150 0 Table 2.4: Total prod ct and marginal prod ct Diminishing marginal returns What is interesting to note in Table 2.4 is that the marginal prod ct of o r ariable inp t of labo r at first increases, it reaches a ma im m ith the third orker, and then begins to fall. This pattern of increasing and then falling marginal prod ct is so ni ersall alid it has the stat s of a la : it is kno n as the la f dimi i hi g ma gi al e or for short, the la f dimi i hi g e . Let s e amine the reasoning behind this pattern. When there are ero orkers on the land, there is no o tp t at all; it is eq al to ero. When one orker is hired, there ill be some o tp t and so total prod ct is 20 kilos of potatoes. Marginal prod ct is also eq al to 20 kilos. B t one orker alone on the farm m st do all the plo ghing, planting, har esting, and so on, and so o tp t is q ite lo . When a second orker is hired, the t o orkers share the ork, and total prod ct increases to fift kilos, indicating that the o tp t prod ced b the t o together is more than do ble the o tp t of the first orking alone. The additional (or marginal) prod ct d e to the second orker (30 kilos) is greater than that of the first (20 kilos). This process is repeated ith the addition of the third, and marginal prod ct increases. With three orkers, marginal prod ct is the greatest it can be; hen the fo rth orker is added, marginal prod ct begins to fall, and falls contin o sl thereafter. This is the point at hich diminishing ret rns begin. Wh does this happen? It happens beca se of o ercro ding: each additional orker has less and less land to ork ith, and so prod ces less and less o tp t. E ent all , the conditions on the farm become so cro ded that the si th orker adds ero e tra o tp t. More generall , marginal prod ct ill begin to fall at some point not j st on a farm ith a fi ed piece of land, b t hene er more and more nits of a ariable inp t are added to a fi ed inp t (pro ided the technolog of prod ction is nchanging). For e ample, in the case of a factor here more and more orkers are hired, each e tra orker ill ha e fe er and fe er machines and eq ipment to ork ith, and so ill add less and less o tp t. Imagine hat o ld happen if diminishing ret rns did not e ist. Using o r farm e ample, it o ld be possible for food prod ction to increase indefinitel j st b contin o sl adding ariable inp ts to a fi ed piece of land a clear impossibilit ! According to the law of diminishing marginal returns as more and more nits of a ariable inp t (s ch as labo r) are added to one or more fi ed inp ts (s ch as land), the marginal prod ct of the ariable inp t at first increases, b t there comes a point hen it begins to decrease. This relationship pres pposes that the fi ed inp t(s) remain fi ed, and that the technolog of prod ction is also fi ed. Increasing marginal costs and the firm s suppl curve We ill no disco er the relationship bet een diminishing marginal ret rns, costs of prod ction, and the firm s s ppl c r e. The meaning of marginal costs In economics e make freq ent se of the concept of total cost, hich refers er simpl to all costs of prod ction inc rred b a firm. We can no consider the meaning of a ne concept, ma gi al c . REAL WORLD FOCUS 2.1 David Ricardo and the end of agricultural output growth Da id Ricardo, a famo s English economist of the 19th cent r , belie ed that agric lt ral o tp t o ld e ent all stop gro ing, beca se as more and more labo r and capital inp ts ere added to land that as fi ed in q antit , the additional o tp t of labo r and capital o ld become smaller and smaller ntil it o ld no longer be possible for total o tp t to increase f rther. Figure 2.9: Chit an, Nepal. People orking in rice field at s nrise Appl ing our skills 1 E plain the concept that describes the process Ricardo as referring to. 2 To hat e tent do o think Ricardo s fears ere j stified? 3 S ggest reasons for the gro th of agric lt ral o tp t in the real orld in spite of a fi ed q antit of land. Marginal cost i he e a addi i al c f d ci g e m e i f ho m ch total costs increase if there is an increase in o tp t b one nit. . It tells s b To nderstand hat this means, e can e amine Table 2.5. We can see that as the n mber of nits of total prod ct increases, total cost increases, hich is hat e o ld e pect since more o tp t al a s in ol es more cost. Marginal cost sho s the addition to total cost arising from the prod ction of one more nit of o tp t. So prod ction of the first nit adds $12 to total cost, the second nit adds $8 to total cost, the third nit $6, and so on. Total product (number of units) Total cost ($) Marginal cost ($) 1 12 12 2 20 8 3 26 6 4 34 8 5 46 12 6 62 16 Table 2.5: Total cost and marginal cost How marginal costs are related to diminishing marginal returns Yo ma ha e noted that marginal cost at first decreases and then increases. In fact this is the opposite of hat happens ith diminishing marginal ret rns. This is not a coincidence, in fact the pattern follo ed b marginal cost is determined entirel b diminishing marginal ret rns. This can be seen in Fig re 2.10. When marginal prod ct increases, marginal cost decreases; hen marginal prod ct is ma im m, marginal cost is minim m; and hen marginal prod ct falls, marginal cost increases. Let s e amine this relationship more caref ll . Remember that at lo le els of o tp t, the marginal prod ct of labo r, or the o tp t of each e tra orker increases. So each orker prod ces more and more o tp t. Since orkers add to costs, and each orker prod ces more and more o tp t, the cost of prod cing each additional nit of o tp t falls. On the other hand, hen marginal prod ct or the additional o tp t of each orker becomes less and less, the cost of each e tra nit prod ced (marginal cost) m st be increasing. Similarl , hen the additional o tp t prod ced b an e tra orker is the most it can be, then the e tra labo r cost of prod cing an additional nit of o tp t is the least it can be. Figure 2.10: Marginal prod ct, marginal cost and the firm s s ppl c r e Marginal cost and the firm s suppl curve As e disc ssed earlier, the firm s s ppl c r e sho s the q antities of a good the firm is illing and able to prod ce and sell at ario s prices, ce e i a ib . We no kno , ho e er, that the firm has costs of prod ction. These costs m st be co ered thro gh the firm s earnings from selling its o tp t. The firm s earnings per nit of o tp t sold are determined b the price of each nit of the good. It follo s then that the firm ill be illing and able to s ppl some q antit as long as the price is eno gh to co er its costs. Therefore e can think of the s ppl c r e as sho ing the price that the firm is illing to accept to prod ce one more nit of the good. In fact, hen marginal cost is increasing, the firm can onl prod ce more o tp t if the price of the good increases to co er the e tra cost of each e tra nit prod ced. As a res lt, a portion of the p ard sloping part of the marginal cost c r e in Fig re 2.10 is the firm s s ppl c r e. This is represented in the bold face portion of the marginal cost c r e. The s ppl c r e begins at the point on the marginal cost c r e here the firm is making eno gh re en e so that it is better off prod cing than sh tting do n.1 The firm s s ppl c r e is a portion of its marginal cost c r e that sho s the priceq antit combinations here the e tra cost of prod cing one more nit of o tp t (the marginal cost) is eq al to the price of that nit. TEST YOUR UNDERSTANDING 2.5 1 1 E plain the la of diminishing marginal ret rns and o tline h this la holds onl in the short r n. 2 E plain h marginal cost falls as marginal prod ct increases, and h it increases as marginal prod ct falls. 3 Anal se the relationship bet een a firm s marginal costs and its s ppl c r e. This occ rs hen the firm is co ering all of its ariable costs. An e planation of this topic is be ond the scope of the IB s llab s. 2.4 C : LEARNING OBJECTIVES After studying this section you will be able to: define all the terms appearing in in the text (AO1) draw a diagram to illustrate how demand and supply interact to determine market equilibrium (AO4) analyse demand curve and supply curve shifts that give rise to a new market equilibrium, using the concepts of excess demand (shortage) and excess supply (surplus) (AO2) draw diagrams to illustrate how shifts in demand and supply give rise to a new equilibrium (AO4) The market demand and market supply for chocolate bars that we considered separately earlier in this chapter show the quantities consumers and firms are illi g a d able to buy and sell at each price. We will now put market demand and market supply together to find out how these interact to determine what happens in the market for chocolate bars. M E ( ) ( ) Figure 2.11 presents the same market demand and supply curves that appeared in Figures 2.2(c) and 2.6(c). The same information appears as a demand schedule and a supply schedule in Table 2.6. In both Table 2.6 and Figure 2.11 we see that when the price of chocolate bars is $3, quantity demanded is exactly equal to quantity supplied, at 8000 chocolate bars. Note that there is only one price where this can occur. At a higher price, say $4, quantity supplied (10 000 bars) is greater than quantity demanded (6000 bars). There is , or a of 4000 bars (10 000 6000). At the even higher price of $5, there is a larger excess supply (surplus) of 8000 bars. Suppose the price in this market is initially $5. At this price, chocolate producers would be willing and able to produce 12 000 bars, but consumers would only be willing and able to buy 4000 bars. What will happen? With unsold output of 8000 bars, producers will lower their price to encourage consumers to buy more chocolate. As the price falls, quantity supplied becomes smaller and quantity demanded becomes bigger. As long as there is a surplus, there will be a downward pressure on the price. The price will keep falling until it reaches the point where quantity demanded is equal to quantity supplied, and the surplus is eliminated. At a lower price than $3, say $2, quantity demanded (10 000 bars) is larger than quantity supplied (6000 bars). There is now or a of 4000 bars (10 000 6000). If price were even lower, at $1, the shortage would be larger, at 8000 bars. At a price of $1, producers would be willing and able to supply only 4000 bars, whereas consumers would be willing and able to buy 12 000 bars. Producers will notice that the chocolate bars are quickly sold out, and so begin to raise the price. As they do so, quantity demanded begins to fall and quantity supplied begins to rise. The shortage in the chocolate market exerts an upward pressure on price. The price will keep increasing until the shortage is eliminated; this will happen when quantity supplied is exactly equal to quantity demanded. P ($) Q Q ( ) ( ) P ($) Q Q ( T F ) ( ) 5 4000 12 000 4 6000 10 000 3 8000 8000 2 10 000 6000 1 12 000 4000 2.6: Market demand and supply schedules for chocolate bars 2.11: Market equilibrium The existence of e ce de a d (a shortage) or e ce l (a l ) in a free market will cause the price to change so that the quantity demanded will be made equal to quantity supplied. In the event of excess demand, price will rise; in the event of excess supply, price will fall. M E is defined as a state of balance between different forces, such that there is no tendency to change. This is an important concept in economics that we will encounter repeatedly. When quantity demanded is equal to quantity supplied, there is ; the forces of supply and demand are in balance, and there is no tendency for the price to change. Market equilibrium is determined at the point where the demand curve intersects the supply curve. The price in market equilibrium is the , and the quantity is the . At the equilibrium price, the quantity consumers are willing and able to buy is exactly equal to the quantity firms are willing and able to sell. This price is known as the a ke ice. In the market for chocolate bars in Figure 2.11, the equilibrium price is $3 per chocolate bar, and the equilibrium quantity is 8000 bars. At any price other than the equilibrium price, there is a ke di e ilib i . In a free competitive market, a market disequilibrium cannot last, as demand and supply force the price to change until it reaches its equilibrium level. , quantity demanded equals quantity supplied, and there is no tendency for the price to change. In a market disequilibrium, there is excess demand (shortage) or excess supply (surplus), and the forces of demand and supply cause the price to change until the market reaches equilibrium. C Once a price reaches its equilibrium level, consumers and firms are satisfied and will not engage in any action to make it change. However, if there is a change in any of the non-price determinants of demand or supply, a shift in the curves results, and the market will adjust to a new equilibrium. C ( ) In Figure 2.12(a), D1 intersects S at point a, resulting in equilibrium price and quantity P1 and Q1. Consider a change in a determinant of demand that causes the demand curve to shift to the right from D1 to D2 (for example, an increase in consumer income in the case of a normal good). Given D2, at the initial price, P1, there is a movement to point b, which results in excess demand equal to the hori ontal distance between points a and b. Point b represents a disequilibrium, where quantity demanded is larger than quantity supplied, thus exerting an upward pressure on price. The price therefore begins to increase, causing a movement up D2 to point c, where excess demand is eliminated and a new equilibrium is reached. At c, there is a higher equilibrium price, P2, and greater equilibrium quantity, Q2, given by the intersection of D2 with S. F 2.12: Changes in demand and the new equilibrium price and quantity A decrease in demand, shown in Figure 2.12(b), leads to a leftward shift in the demand curve from D1 to D3 (for example, due to a decrease in the number of consumers). Given D3, at price P1, there is a move from the initial equilibrium (point a) to point b, where quantity demanded is less than quantity supplied, and therefore a disequilibrium where there is excess supply equal to the hori ontal difference between a and b. This exerts a downward pressure on price, which falls, causing a movement down D3to point c, where excess supply is eliminated, and a new equilibrium is reached. At c, there is a lower equilibrium price, P3, and a lower equilibrium quantity, Q3, given by the intersection of D3 with S. C ( ) We now consider supply curve shifts that can arise from changes in the determinants of supply. In Figure 2.13(a), the initial equilibrium is at point a where D intersects S1, and where equilibrium price and quantity are P1 and Q1. An increase in supply (say, due to an improvement in technology) shifts the supply curve to S2. With S2 and initial price P1, there is a move from point a to b, where there is disequilibrium due to excess supply (by the amount equal to the hori ontal distance between a and b). Therefore, price begins to fall, and there results a movement down S2 to point c where a new equilibrium is reached. At c, excess supply has been eliminated, and there is a lower equilibrium price, P2, but a higher equilibrium quantity, Q2. A decrease in supply is shown in Figure 2.13(b) (say, due to a fall in the number of firms). With the new supply curve S3, at the initial price P1, there has been a move from initial equilibrium a to disequilibrium point b, where there is excess demand (equal to the distance between a and b). This causes an upward pressure on price, which begins to increase, causing a move up S3 until a final equilibrium is reached at point c, where the excess demand has been eliminated, and there is a higher equilibrium price P3 and lower quantity Q3. F 2.13: Changes in supply and the new equilibrium price and quantity F You may remember from Chapter 1, Section 1.1, that free goods are goods that are not subject to the condition of scarcity and have a ero opportunity cost, while economic goods are subject to scarcity and have an opportunity cost greater than ero. We are now in a better position to understand the difference between the two by use of demand and supply analysis. Figures 2.14(a) and (b) show a free and economic good respectively. A f ee g d is a good for which the quantity supplied is greater than the quantity demanded when the price is ero. Supply is so large relative to demand that there is excess quantity supplied even at a ero price. An ec ic g d is a good for which quantity supplied is smaller than quantity demanded when the price is ero. A free good can change into an economic good as a result of a leftward shift in the supply curve (reduced supply) or a rightward shift in the demand curve (increased demand). When demand and supply intersect at a price greater than ero, the good has become an economic good. F 2.14: Free and economic goods REAL P ORLD FOCUS 2.2 I: A For thousands of years the avocado was held to be a sacred fruit in Central America.Yet this was not so in much of the rest of the world. In 1982, it was reported that an oversupply of avocados in the United States led to a drop in price so large that producers considered selling it as food for dogs (though avocados cause an upset stomach in dogs). An important reason why consumers avoided avocados was their high fat content. In more recent years, consumers regard for the avocado has changed dramatically, thanks to the distinction that science has made between the good and bad fat content of foods. Avocados are plentiful in good or healthy (monounsaturated) fats, and in addition contain a host of healthful minerals and vitamins. Consumers around the world are now eating far more avocados than ever before, and their price is rising. F 2.15: Green Hass avocado fruit S P II: P ( : RiverheadLOCAL ) The summer of 2018 was the hottest in the UK since 1976. As a result there was a significant drop in quantities produced of many crops. By the fall UK farmers noted that potato crops were reduced by one-third. This gave rise to an increase in the price of potato chips (crisps). S : I de e de A Using diagrams in each case, analyse and explain 1 the effect on avocado prices of consumers perceptions that avocados are unhealthy due to their high fat content 2 the effect on avocado prices of the information that avocados are very healthy 3 the effect on the price of potato chips (crisps) of extreme weather conditions in the UK. TEST OUR UNDERSTANDING 2.6 1 In Figure 2.11. state whether there is excess supply (a surplus) or excess demand (a shortage), and how large this is if price per chocolate bar is: $5, $4, $3, $2, and $1. 2 Use a demand and supply diagram to: show equilibrium price and quantity, show possible disequilibrium prices and quantities, relate disequilibrium prices to excess demand (shortages) and excess supply (surpluses), explain the meaning of market equilibrium , and explain the roles of demand and supply in achieving market equilibrium. 3 Use supply and demand diagrams to illustrate the following events. Free ing weather destroys the orange crop and the price of oranges rises. The mass media report on the fat content of cheese and the price of cheese falls. A new technology of production for computers is developed and the price of computers falls. Milk, an input for ice cream production, becomes more expensive and the price of ice cream increases. The mass media report on the health benefits of olive oil and the price of olive oil increases. 4 Assuming a competitive market, use demand and supply diagrams to show in each of the following cases how the change in demand or supply for product A creates a disequilibrium consisting of excess demand or excess supply, and how the change in price eliminates the disequilibrium. Consumer income increases (A is a normal good). Consumer income falls (A is an inferior good). There is an increase in labour costs. The price of substitute good B falls. The number of firms in the industry producing product A increases. A successful advertising campaign emphasises the health benefits of product A. 2.5 T LEARNING OBJECTI ES After stud ing this section ou ill be able to: define all the terms appearing in in the te t (AO1) anal se the price mechanism ith respect to its functions including (AO2) resource allocation (signalling and incentive functions) rationing e plain the meaning of consumer and producer surplus, as (AO2) ell as social or communit surplus dra a diagram sho ing ma imum social surplus at competitive market equilibrium (AO4) e plain the conditions for achievement of allocative efficienc at competitive market equilibrium (AO2) social surplus is ma imum marginal benefits are equal to marginal costs calculate consumer and producer surplus from a diagram (AO4) Prices determined b the forces of suppl and demand in competitive markets are kno n as the . The price mechanism serves some important functions that e ill no e plore. F P In Chapter 1 e sa that the condition of scarcit forces societies to make choices. As the production possibilities model illustrated (Figure 1.1), assuming the econom is producing on its production possibilities curve (PPC), it must decide on hat particular point on the PPC it ishes to produce. This involves a choice about ha /ho m ch o od ce, hich is a decision on one aspect of resource allocation. It also involves a choice about hich of its available resources and in hat quantities, it ill allocate to produce the combination of goods and services it has chosen. This is a choice on the ho o od ce question of resource allocation. This brings us to an important question. Ho does a societ make a choice about here to be on its PPC? Who decides, and ho is this decision carried out? In a market econom , it is simpl prices in free markets, resulting from the interactions of demanders and suppliers, hich make the decisions and carr them out. We have learned that hen markets operate under competitive conditions, market demand and market suppl , composed of numerous individual demanders and suppliers, determine equilibrium prices and quantities for goods (and services and resources). At these equilibrium positions, the bu ing and selling choices of all bu ers and sellers are satisfied and are in balance. This market mechanism, orking through prices, is kno n as the in i ible hand of he ma ke , a phrase first used b Adam Smith, hose contributions to economics ere e plained in Chapter 1. The invisible hand succeeds in coordinating the bu ing and selling decisions of thousands or millions of decision-makers in an econom ithout an central authorit . The ha /ho m ch o od ce question of resource allocation is ans ered because firms produce onl those goods consumers are illing and able to bu , hile consumers bu onl those goods producers are illing and able to suppl ; and the ho o od ce question of resource allocation is ans ered because firms use those resources and technologies in their production process that the are illing and able to pa for. Ho do prices and markets achieve the task of resource allocation? The ke to the market s abilit to allocate resources can be found in the and functions of prices in resource allocation. As signals, prices communicate information to decisionmakers. As incentives, prices motivate decision-makers to respond to the information. We ill e amine the signalling and incentive functions of prices b use of the follo ing t o e amples. A Suppose consumers decide the ould like to eat more stra berries because of their health benefits (a change in tastes); demand increases and the demand curve shifts to the right from D1 to D2 in Figure 2.16(a). At the initial price, P1, this results in a shortage equal to the difference bet een Q2 and Q1: the quantit demanded Q2, due to the increase in demand to D2, is larger than quantit supplied, Q1. The price of stra berries therefore begins to rise and ill continue to rise until the shortage has disappeared. This happens at price P2 and quantit Q3, given b the point of intersection of the suppl curve ith the ne demand curve, D2. F 2.16: Price as a signal and incentive What has happened? The ne , higher price signalled or conve ed information to producers that a shortage in the stra berr market had emerged. The increase in price is also an incentive for producers to increase the quantit of stra berries supplied; at the higher price, stra berr production is more profitable, so producers move along the suppl curve from point A to point C, increasing quantit supplied from Q1 to Q3. But the ne , higher price is a signal and incentive for consumers: it signals that stra berries are no more e pensive, and is an incentive for them to bu fe er stra berries. The therefore move along the ne demand curve from B to C, bu ing fe er stra berries than at the original price P1 (Q3 is smaller than Q2). The increase in the price of stra berries resulted in a ealloca ion of e o ce . More resources are no allocated to stra berr production. (This affects the ans er to the ha o od ce question of resource allocation.) A The second e ample is from the labour market (a resource market). The vertical a is in Figure 2.16(b) measures the price of labour (the age) and the hori ontal a is the quantit of labour. Firms are interested in bu ing labour services, and their demand for labour is given b D. O ners of labour services ( orkers) suppl their labour in the labour market, and the initial suppl of labour is sho n b S1.2 Assume that because of immigration (foreign orkers enter the countr ), the suppl of labour increases, so the labour suppl curve shifts to S2. At the old age, W1, there is a surplus of labour sho n b the difference bet een Q2 and Q1 of labour. The surplus causes the age to start falling, and this falls until the surplus has disappeared. The ne equilibrium age is W2, and the equilibrium quantit of labour Q3, given b the intersection of D ith S2. The falling age has acted as a signal and an incentive. It signalled to firms that there as a surplus in the labour market, and it provided them ith an incentive to hire more labour; therefore, the move along the labour demand curve from point A to point C (Q3 is larger than Q1). The lo er age is also a signal to orkers, providing them ith the incentive to move along the ne suppl curve, S2, from B to C, here the offer less of their services at the lo er age (Q3 is less than Q2). With firms and orkers responding to price signals and incentives, there occurred a reallocation of labour resources ith firms no producing output ith a larger quantit of labour. (This affects the ans er to the ho o od ce question of resource allocation.) P Ra ioning is a method of apportioning or parceling out goods and services among consumers or households. The market mechanism uses ice a ioning for this purpose, hich involves the use of prices freel determined in markets. This simpl means that hether or not a consumer ill get a good is determined b the price of that good. All those ho are illing and able to pa the price of a good or service ill get it, and all those ho are not illing or able to pa the price ill not get it. Price, and price alone is the factor that decides. This happens because at the market-determined equilibrium price and quantit , the bu ing and selling choices of all bu ers and sellers in the market for a good are satisfied and are in balance. Price rationing is simpl the market mechanism at ork, kno n as Adam Smith s in i ible hand of he ma ke (see Chapter 1), hich coordinates the countless bu ing and selling decisions of decision-making units in an econom ithout an central authorit . When the price mechanism is not orking properl , such as in planned economies (see Chapter 1) or if there are price controls (see Chapter 4), then non- ice a ioning s stems come into pla in order to apportion goods and services among their various users. The most common non-price rationing method is the aiting line or queue, here consumers get a good on a first come, first served basis. Non-price rationing ill be discussed in Chapter 4. TEST O R NDERSTANDING 2.7 1 E plain the role of prices in resource allocation. Describe ho this relates to Adam Smith s in i ible hand. 2 Consider the market for coffee, and suppose that the demand for coffee falls (because of a fall in the price of tea, a substitute good), leading to a ne equilibrium price and quantit of coffee. Using diagrams, e plain the role of price as a signal and as an incentive for consumers and for firms in reallocating resources. 3 Consider the labour market, and suppose the suppl of labour falls (due to large-scale departure of orkers to another countr ), resulting in a ne equilibrium price and quantit of labour. Using diagrams, e plain the role of price as a signal and as an incentive for orkers (the suppliers of labour) and firms (the demanders of labour) in reallocating resources. 4 Distinguish bet een price rationing and non-price rationing. A Efficienc , as e sa in Chapter 1, is one of the ke concepts running through this course, and ver broadl means making the best possible use of resources. We ill no stud ho competitive markets achieve a special t pe of efficienc called allocative efficienc . A refers to producing the quantit of goods mostl anted b societ . Allocative efficienc is achieved hen the econom allocates its resources so that the societ gets the most benefits from consumption. Since allocative efficienc refers to producing hat consumers mostl ant, it ans ers the ha /ho m ch o od ce question in the best possible a .3 R : Before e consider allocative efficienc at competitive market equilibrium, e ill pause a moment to e plore a different interpretation of demand and suppl . T Consumers bu goods and services because these provide them ith some benefit, or satisfaction. The greater the quantit of a good consumed, the greater the satisfaction. Ho ever, the e tra benefit provided b each additional unit increases b smaller and smaller amounts. Imagine ou bu a soft drink, hich provides ou a certain amount of benefit. You are still thirst , so ou bu a second soft drink. Whereas ou ill enjo this ou ill most likel enjo it less than the first; the second soft drink provides ou ith less benefit than the first. If ou bu a third, ou ill get even less benefit than from the second, and so on ith each additional soft drink. The e tra benefit that ou get from each additional unit of something ou bu is called the (marginal means e tra or additional). No remember that the demand curve, as ou learned earlier in this chapter, sho s the various quantities of a good that a consumer is illing and able to bu at different possible prices, ce e i a ib . But it can also be thought of as sho ing the amount of mone that the consumer is illing to pa to get one more unit of the good. Since the e tra or marginal benefit that the consumer gets from bu ing one more unit of the good becomes smaller and smaller as the quantit increases, this means that the price the consumer is illing to pa also gets smaller and smaller as the number of units bought increases. Since marginal benefit decreases as the quantit of a good consumed increases, consumers ill be illing to bu an e tra unit of the good onl if its price falls. The demand curve can therefore also be called a ma ginal benefi (MB) c e (Students stud ing this course at HL ill notice that the concept of marginal benefits is ver similar to the concept of marginal utilit e amined earlier. The difference bet een the t o is actuall ver subtle. Marginal utilit as e have seen is something that cannot be measured. Marginal benefit, on the other hand, is interpreted to indicate the consumer s illingne o a for the last or marginal unit bought, hich is simpl price, and is therefore measurable. The differences bet een the t o concepts are be ond the scope of the IB s llabus.) T In order to be able to produce goods and services, firms have co , hich involve pa ments that must be made in order to acquire factors of production. For e ample, a farmer must bu seeds and fertilisers, pa orkers to ork on the land, and so on. The e tra cost of producing one more unit of output is called the ma ginal co . Marginal cost t picall increases as the units of output produced increase. (The reasons for this ere studied at HL earlier in this chapter in Section 2.3.) This means that the farmer can onl produce more output if the price of the good increases to cover the e tra cost of each e tra unit produced. The firm s suppl curve as ou ma remember, sho s the various quantities of a good that a firm is illing and able to produce and suppl at various possible prices, ce e i a ib . But in vie of the firm s costs of production, the suppl curve also sho s the price that the firm is illing to accept in order to produce one more unit of the good. Since marginal cost increases as the quantit of a good produced increases, producers ill be illing to produce and sell an e tra unit of the good onl of its price increases. The suppl curve can therefore also be called a ma ginal co (MC) c e. A : B= C As e kno , market equilibrium occurs at the point of intersection of the demand and suppl curves, but depending on ho e interpret the demand and suppl curves, market equilibrium can be thought of differentl . If e interpret the demand curve as a marginal benefit (MB) curve, and the suppl curve as a marginal cost (MC) curve, then market equilibrium occurs here MB = MC. The equalit of MB ith MC tells us that the e tra benefit to societ of getting one more unit of the good is equal to the e tra cost to societ of producing one more unit of the good. When this happens, societ s resources are being used to produce the right quantit of the good; in other ords, societ has allocated the right amount of resources to the production of the good, and is producing the quantit of the good that is mostl anted b societ . Thi i none o he han alloca i e efficienc and is sho n in Figure 2.17. To understand this, consider that if MB > MC, then societ ould be placing a greater value on the last unit of the good produced than it costs to produce it, and so more of it should be produced. If MC > MB, then it ould be costing societ more to produce the last unit of the good produced than the value societ puts on it, and so less should be produced. If MC = MB, then just the right quantit of the good is being produced. Putting the above points together, e can conclude that at the point of competitive market equilibrium, here MB = MC, the econom achieves allocative efficienc . For allocative efficienc to be achieved for an entire econom , the condition MB = MC, must hold in all markets. I There is another a e can understand ho allocative efficienc is achieved b the competitive market econom ; this involves the concepts of consumer surplus and producer surplus. C C is defined as the highest price consumers are illing to pa for a good minus the price actuall paid. The highest price the are illing to pa is given b the demand curve. The price actuall paid is determined at the market equilibrium b suppl and demand. Consumer surplus is sho n in Figure 2.17 as the shaded area bet een the demand curve, and the equilibrium price Pe, up to quantit Qe. Consumer surplus is the area under the demand curve and belo the price paid b the consumer, up to the quantit purchased. Consumer surplus indicates that hereas man consumers ere illing to pa a higher price to get the good, the actuall received it for less. For e ample, man consumers ere illing to pa price P2 to get quantit Qa, et the got Qa b pa ing onl the lo er price Pe. The difference bet een P2 and Peis consumer surplus for quantit Qa. Similarl , man consumers ere illing to pa price P3 in order to get quantit Qb, et the got it b pa ing onl Pe. Again, the difference P3 Pe is consumer surplus for quantit Qb. The same principle applies to all possible prices bet een the highest price P1 and the equilibrium price Pe. Therefore, all the consumers ho ere illing to pa a higher price than Pe to get the good received some benefit over and above hat the actuall paid for the good. This e tra benefit is called consumer surplus. F 2.17: Consumer and producer surplus in a competitive market P P is defined as the price received b firms for selling their good minus the lo est price that the are illing to accept to produce the good. The price received is given b the market equilibrium price. The lo est price the are illing to accept is sho n b the suppl curve. Producer surplus appears in Figure 2.17 as the shaded area bet een the suppl curve, and the equilibrium price Pe, up to quantit Qe. Producer surplus is sho n as the area above the firms suppl curve and belo the price received b the firm, up to the quantit produced. As e can see in Figure 2.17, firms that ere illing to produce quantit Qa for price P5 actuall received price Pe. The difference Pe P5 is producer surplus for quantit Qa. Similarl , the producer surplus for quantit Qb is given b the price Pe actuall received minus P4 that the firms ere illing to accept for producing Qb. The same principle applies to all possible prices bet een the lo est price P6 and the equilibrium price Pe. Therefore, total producer surplus is sho n b the shaded area bet een the equilibrium price Pe and the suppl curve, up to the quantit produced and sold. C : At the point of competitive market equilibrium, the sum of consumer and producer surplus is ma imum, or the greatest it can be. To see h , consider hat ould happen if an quantit less than Qe ere produced in Figure 2.17. If, sa , Qb is produced, the sum of consumer plus producer surplus ould be smaller, as this sum ould be equal to the shaded area bet een the demand and suppl curves onl o o Qb. It follo s, then, that the sum of consumer plus producer surplus is ma imised at the point of market equilibrium. The sum of consumer and producer surplus is kno n as (or 4 ). At the point of competitive market equilibrium, social surplus, defined as the sum of consumer plus producer surplus, is ma imum. Let s no e amine the importance of ma imum social surplus at the point of competitive market equilibrium. You ill note that competitive market equilibrium is none other than the point here marginal benefit equals marginal cost, or MB = MC. Based on our discussion above, e kno that hen MB = MC there is allocative efficienc . Therefore ma imum social surplus is just another a of sa ing that there is allocative efficienc . At the point of competitive market equilibrium sho n in Figure 2.17, production of a good occurs here MB = MC, hich is also he e ocial l , o he m of con me l od ce l i ma im m. This means that markets are achieving allocative efficienc , producing the quantit of goods mostl anted b societ . Societ is making the best possible use of its scarce resources. When the competitive market realises allocative efficienc , e sa that social elfare is ma imised. What does this mean? The term in economics refers to the amount of consumer and producer surplus. Welfare is clearl ma imum hen social surplus is ma imum, or hen MB = MC. We can therefore sa that: In competitive markets, hen MB = MC, or hen social surplus is ma imum, social elfare is ma imum. C Figure 2.18(a) is similar to Figure 2.17 onl in that it includes figures that allo us to calculate consumer and producer surplus. To see ho this is done, note the follo ing t o terms. P in e ce = the point on the P a is that is met b a curve. In Figure 2.18(a), the demand curve has a P intercept = 6.5 and the suppl curve has a P intercept = 1. Q in e ce = the point on the Q a is that is met b a curve. In Figure 2.18(a), e are not sho n an Q intercept. Ho ever, in Figure 2.18(b) e see that the suppl curve has a Q intercept = 2. Let s begin ith a calculation of consumer and producer surplus in Figure 2.18(a). Consumer surplus, as e kno , is the area under the demand curve and belo the price paid b consumers, up to the quantit purchased. It is simple to calculate consumer surplus if e think of it as half the area of the rectangle hose one side equals the P intercept of the demand curve minus the price paid b consumers, and hose other side equals the number of units purchased. C = (P intercept of D curve minus P of consumers) Q purchased 2 Therefore consumer surplus= (6.5 3) 4.52 2 = 3.5 4.5 2 =$7.88 Producer surplus is the area above the suppl curve and belo the price received b producers, up to the quantit produced. In Figure 2.18(a), it is half the area of the rectangle hose one side equals the price received b producers minus the P intercept of the suppl curve, and hose other side equals the number of units sold. P = (P of producers minus P intercept of S curve) Q sold 2 Therefore: producer surplus= (3 1) 4.5 2 = (2 4.5) 2 =$4.50 Notice that both consumer surplus and producer surplus are given in terms of $, this is because the e press a mone a al e that has been gained b consumers and producers. It follo s then that social surplus, being the sum of consumer and producer surplus = $7.88 + $4.50 = $12.38. Ho ever, it should be noted that the suppl curve does not al a s have a P intercept. This can be seen in Figure 2.18(b), here the suppl curve begins on the Q a is, having a Q intercept = 2. In cases like this, the formula given above for producer surplus is not appropriate. Instead, to find the area above the suppl curve and under the price up to the quantit produced e need to use the formula for a a e i m. A trape ium is a geometrical shape here one pair of opposite sides is parallel but the other pair is not parallel. In Figure 2.18(b), let s call the lengths of the t o parallel sides a and b, hile the distance bet een these t o sides is called c. The area of a trape ium then is: area of trape ium= (a+b) c 2 Therefore considering Figure 2.18(b) e can calculate that: producer surplus= (4+2) 3 2 = 6 3 2 =$9.00 Consumer surplus in Figure 2.18(b), using the formula given earlier is: consumer surplus = (6.5 3) 4 2 = 3.5 4 2 =$7.00 Social surplus, being the sum of consumer and producer surplus = $7.00 + $9.00 = $16.00. As e ill discover in later chapters, consumer surplus is al a s given b the area of a triangle. Producer surplus and social surplus are usuall given b the area of a triangle but sometimes the ma be the area of a trape ium. Therefore, before ou use a formula for a calculation, ou must first identif hether ou are calculating the area of a triangle or the area of a trape ium. F A 2.18: Calculating consumer and producer surplus and social surplus S Adam Smith did not think of consumer and producer surplus, or marginal benefits and marginal costs, but he did come up ith the idea that individuals acting in the best self-interest ould through the orkings of markets, produce an outcome for societ that ould be in societ s best interests. We are no in a far better position to understand the in i ible hand that as introduced in Chapter 1. It means that the market is able to coordinate the decisions of countless actions of individual economic decisionmakers ithout an central authorit , simpl through the orkings of demand and suppl , hile at the same time promoting efficienc hich encourages the best allocation of scarce resources. This is perhaps the most important contribution of Adam Smith to economic thought. A We have seen that the competitive market succeeds in achieving allocative efficienc , thus ensuring the best possible use of scarce resources. This idea suggests that there should not be government intervention in markets, as these ork ver ell on their o n. Ho ever, there are t o important issues that arise, calling into question the idea that governments should not intervene. The first is that efficienc can onl arise under a number of ver strict and highl unrealistic conditions that are practicall never met in the real orld. In the real orld the market fails to achieve allocative efficienc . Market failures are an important justification for government intervention. When markets fail to achieve allocative efficienc , this means that social surplus is reduced, resulting in hat is kno n as (also called dead eigh lo ). In other ords, social elfare is no longer ma imum on account of a portion of it being lost. Welfare loss ill be discussed in later chapters. The second is that the competitive market is unable to provide a satisfactor ans er to the fo hom o od ce question, or output and income distribution, thus also inviting some government intervention. The topic of distribution and hat can be done to improve outcomes ill also be e amined in Chapters 12 and 19, as ell as in Chapter 6 at HL. It is also discussed in the Theor of kno ledge feature 2.1. These observations do not lessen the significance of the market s potential advantages; the onl point out that in the real orld, there is a need for government policies to counteract the failings of markets, thus allo ing them to realise their potential advantages. There are important reasons h economists stud the competitive market e tensivel . One is that government policies can be assessed ith respect to their efficienc consequences (Chapter 4). Another is that it can form the basis for government policies that tr to create conditions in the real orld that allo actual economies to come closer to achieving economic efficienc (Chapters 5 7). A third is that it provides standards for economic efficienc against hich actual outcomes, hich are less than perfectl efficient, can be assessed (Chapters 4 and 7). TEST O R NDERSTANDING 2.8 1 E plain the meaning of allocative efficienc . 2 E plain the meaning of consumer surplus, producer surplus, social (or communit ) surplus, and ma imum social elfare . 3 Use a demand and suppl diagram to illustrate consumer and producer surplus. Identif the level of output here their sum is ma imum. E plain the condition MB = MC, and use our diagram of part (a) to sho at hich level of output this condition is satisfied. Outline hat the conditions of ma imum consumer plus producer surplus, and MB = MC tell us about allocative efficienc , and hat the tell us about social elfare. 4 5 Describe some limitations of the concept of ma imum social elfare. Using the diagram calculate consumer and producer surplus at the initial equilibrium given b S1 and D. Suppose the suppl curve shifts to S2. Calculate the ne consumer and producer surplus that arise at the ne equilibrium. Calculate the increase or decrease in consumer and producer surplus due to the shift in the suppl curve. E plain hat accounts for the changes in consumer and producer surplus in terms of the changes in P and Q. THEOR OF KNO LEDGE 2.1 T We must be ver careful hen interpreting the meaning of ma im m ocial elfa e. The achievement of MB = MC, or ma imum social surplus, deals ith the ha /ho m ch o od ce and ho o od ce questions, and therefore ith ho a societ can realise allocative efficienc . Even if it is assumed that allocative efficienc is achieved, in hich case e have ma imum social elfare , this tells us nothing about ho output and income are, or should be, distributed. The achievement of allocative efficienc is, in fact, consistent ith an possible distribution of output or income. This means that e can have an e tremel unequal distribution of output and income, here one person in societ gets all the output, or a highl equal distribution here ever one gets an equal share, and both of these situations can lead to allocative efficienc . This idea highlights the point that hen e efe o ma im m ocial elfa e, e a e onl alking abo making he be o ible e of ca ce e o ce , hile a ing no hing abo ho ge he benefi of ha he e o ce od ce. For an distribution of income and output, ranging from the most unequal to the most equal, it is possible to have a situation of ma imum social surplus and therefore allocative efficienc . The pursuit of efficienc , dealing ith the ha /ho m ch o od ce and ho o od ce questions, is based on social scientific investigation, and tries to discover the most effective a s to increase efficienc in resource allocation. Man economists ould argue that this is a matter of positive economics (see Chapter 1 on the distinction bet een positive and normative economics). On the other hand, the fo hom o od ce question is a matter of normative economics. Positive economic thinking, based on the scientific method described in Chapter 1, is not intended to make judgements about hat is fair or unfair, or equitable or inequitable. It is intended to deal ith issues of things that are or ill be under different conditions. Therefore, hile it can tell us about hat methods are most likel to lead to increases in efficienc , it is not intended to tell us about ho income and output should be distributed. The issue of equit (introduced in Chapter 1) is a normative issue, because hat is considered fair is a matter of beliefs and value judgements about things that ought to be . What share of total income, or hat particular goods and services o gh individuals to have? Is there a minimum income that people o gh to have? If so, based on hat kinds of equit principles o gh distribution and redistribution to take place? There are no right or rong ans ers to these questions. The ans ers that are chosen are based on beliefs and value judgements about hat is good for societ and the people ithin it. According to the standard vie , economists should be concerned ith positive aspects of economics. Their positive thinking could tell us about the likel consequences of policies to change the distribution of income, but should not make recommendations about ho the distribution of income ought to change. We ill continue ith the topic in Theor of kno ledge 6.1 in Chapter 6. T What is the significance of language in conve ing meaning; does the e pression ma imum social elfare accuratel reflect its actual meaning? If economists, as social scientists, cannot make recommendations about normative issues like the distribution of income, ho are these decisions made? (Think about the political process, social values, tradition and histor .) Based on our reading about economics in the press and listening to the ne s, do ou think that economists in the real orld make a clear distinction bet een positive and normative ideas? Do ou agree ith the principle that economists (and social scientists generall ) should onl be concerned ith positive thinking (social scientific investigation) and should leave normative issues (about things that ought to be) to societal decision-making? 2 The demand curve has the usual do n ard-sloping shape, because as the age falls, firms are prompted to hire more labour and so the quantit of labour demanded increases. The suppl curve has the usual up ard-sloping shape because the higher the age, the more illing orkers ill be to suppl their labour in the market. 3 At the same time it also ans ers the ho be ond the scope of the IB s llabus. 4 Note that the term surplus is used in t o senses in this chapter. In one sense it refers to e cess suppl (Section 2.4) and in the other it refers to benefits received b consumers and producers. You can avoid confusing the t o concepts b noting that henever the term is used on its o n, it refers to e cess suppl . o od ce question in the best possible a . An e planation of this is 2.6 Critique of the ma imising behaviour of consumers and producers (HL onl ) LEARNING OBJECTIVES Af e d ing hi ec ion o ill be able o: define all he e m appea ing in orange bold in he e (AO1) e al a e he a (AO3) ma imi a ion and pe fec info ma ion mp ion of con me a ionali , efe ing o he follo ing poin , di c b beha io al economi (AO3) bia e incl ding ili he limi a ion of anda d con me beha io made le of h mb, ancho ing, f aming, a ailabili bo nded a ionali bo nded elf-con ol bo nded elfi hne impe fec info ma ion di c policie in pi ed b beha io al economic (AO3) choice a chi ec e i h e pec o defa l , e ic ed and manda ed choice n dge heo di ing i h be een a io objec i e of b ine e (AO3) p ofi ma imi a ion al e na i e objec i e incl ding co po a e ocial e pon ibili , ma ke ha e, a i ficing, go h Rational economic decision-making S anda d economic heo ie and model a e ba ed on an impo an a mp ion, ha of a ional elfin e e , o a a ec c dec - a . Thi mean ha indi id al a e a med o ac in hei be elf-in e e , ing o a e (make a la ge a po ible) he a i fac ion he e pec o ecei e f om hei economic deci ion . I i a med ha con me pend hei mone on p cha e o ma imi e he a i fac ion he ge f om b ing diffe en good and e ice . Simila l , i i a med ha fi m (o p od ce ) o ma imi e he p ofi he make f om hei b ine e ; o ke o ec e he highe po ible age hen he ge a job; in e o in he ock ma ke o ge he highe po ible e n on hei in e men , and o on. A e ill ee in he di c ion belo , he a mp ion of a ional economic deci ion-making and he p inciple of elf-in e e ed ma imi a ion nde l ing economic heo ha come o be e io l q e ioned. Rational consumer choice The anda d heo of con me beha io choice hich e di c belo . i ba ed on ome a mp ion of rational consumer Assumptions of rational consumer choice Consumer rationalit Acco ding o a a c e c a e and p efe ence hich a i f ce con me make p cha ing deci ion acco ding o hei h ee a mp ion . 1 The con me i able o ank good acco ding o he p efe ence . Thi mean ha if conf on ed i h o good , o o g o p of good , A and B, he con me can a i h ce ain ha he p efe A o B, o he p efe B o A, o he i indiffe en be een A and B. (Thi i called he c e e e a mp ion.) 2 P efe ence among al e na i e choice a e con i en . Thi mean ha if he con me p efe A o B, and B o C, hen he m p efe A o C. (Thi i called he a a mp ion.) 3 The con me al a p efe mo e of a good o le . If he e a e o g o p of good he e one g o p con ain mo e of one good han he o he g o p, he con me ill al a p efe he g o p ha ha mo e of he one good. (Thi i called he -a a a mp ion.) Perfect information I i f he a med ha con me ha e a hei di po al pe fec info ma ion abo all hei al e na i e , o ha he e i no nce ain . In o he o d , hen a con me choo e good A o e good B, he po e e all po ible info ma ion abo good A and good B, o ha he e a e no do b , q e ion o nce ain ie abo he good being cho en. The con me ha kno ledge of all po ible p od c , p od c q ali ie and p ice . Utilit ma imisation U , a e a ea lie in hi chap e , efe o he a i fac ion ha con me de i e f om con ming ome hing. Acco ding o he heo of con me beha io , con me a e e , meaning he make i a la ge a po ible, b b ing he combina ion of good and e ice ha e l in he g ea e amo n of ili fo a gi en amo n of mone pen ( he con me b dge o income). Thi beha io i ba ed on he a mp ion of a ionali and pe fec info ma ion ha e e p e en ed abo e. The concep of ma ginal ili , and he la of dimini block of he heo of con me beha io ha allo choice among al e na i e in o de o ma imi e ili hing ma ginal ili , a e f ndamen al b ilding economi o ho ho con me make hei 5 . Behavioural economics: limitations of the assumptions of rational behaviour Beha io al economic a in od ced in Chap e 1, Sec ion 1.5. I i a ne b anch of economic ongl infl enced mainl b p cholog , b al o b ociolog and ne o cience, ba ed on he idea ha h man beha io i fa mo e comple han con me a ionali a me . While he a mp ion of a ionali ha al a been q e ioned on he g o nd ha people e of en do no beha e a a ionall a i p e med, i i onl ince abo he beginning of he 21 cen ha beha io al economic began o flo i h in o a di inc b anch of economic . Beha io al economic c i ici e con me a ionali follo ing g o nd . and he idea of ili ma imi a ion on he Biases A bias (al o kno n a c e b a ) i a e m f om p cholog ha efe o ema ic e o in hinking o e al a ing. Bia e a e depa e f om no mal anda d of ho gh o j dgmen . Bia e ha affec con me choice incl de he follo ing: Rules of thumb. Rules of thumb a e imple g ideline ba ed on e pe ience and common en e, implif ing complica ed deci ion ha o ld ha e o be ba ed on he comple con ide a ion of e e po ible choice. E ample of le of h mb a e: one po ion of alad i eq al o o handf l ; a c p of fil e coffee ha 80 mg of caffeine; one e ing of f i i he i e of a fi . The e e ample ho ha a he han make complica ed mea emen and calc la ion people of en el on imple le o implif deci ion . Anchoring. Anchoring in ol e he e of i ele an info ma ion o make deci ion , hich of en occ d e o i being he fi piece of info ma ion ha he con me happen o come ac o . Fo e ample, o find a pai of jean o an ha co $150, and hen o find a imila one fo $100 ha o b hinking i a ba gain, b hen o di co e o co ld ha e go en he ame hing fo $50 ome he e el e. Framing. Framing deal i h ho choice a e p e en ed o deci ion-make (f amed). Fo e ample, con me p efe beef de c ibed a 80% lean a he han 20% fa . Ye he a ional con me o ld be indiffe en be een he o a he info ma ion i e ac l he ame, i i onl p e en ed (f amed) diffe en l . In ano he e ample, con me co ld be illing o pa a highe p ice fo a faded pai of jean in a bo iq e han fo he iden ical pai of jean in a di co n o e. In he fi e ample he p cha e i f amed b lang age; in he econd i i f amed b he elle en i onmen . Availabilit . Availabilit efe o info ma ion ha i mo ecen l a ailable, hich people end o el on mo e hea il , ho gh he e i no ea on o e pec ha hi info ma ion i an mo e eliable han o he info ma ion ha a a ailable a an ea lie ime. Thi ma be d e a lea pa l o he fac ha people emembe ecen e en o info ma ion mo e eadil han olde e en o info ma ion. Fo e ample, if a con me ha ecen l ecei ed a lo of ad e i ing info ma ion abo he pe io i of one b and o e o he b and , he ma be mo e likel o elec ha b and, ha ing been infl enced b he ecen ad e i ing. The p e ence of bia e ha infl ence con me choice ha led o al e na i e concep and idea p fo a d ha ma be mo e acc a e de c ip ion of con me beha io : Bounded rationalit Bounded rationalit i an idea de eloped b He be Simon, ho ecei ed he Nobel P i e in economic on 1971 fo hi o k on economic deci ion-making. Simon a g ed ha people do no ha e an nlimi ed capaci o p oce info ma ion and ha ea ching fo info ma ion needed o ma imi e ili i i elf a co l p oce . He he efo e gge ed he concep of bo nded a ionali o de c ibe con me beha io . Bo nded a ionali i he idea ha con me a e a ional onl i hin limi , a con me a ionali i limi ed b con me in fficien info ma ion, he co line of ob aining info ma ion, and he limi a ion of he h man mind o p oce la ge amo n of info ma ion. Acco ding o Simon, a he han ma imi e, con me a f ce, meaning he eek a a i fac o o come a he han an op imal (o be ) one. Bounded self-control Bounded self-control i ela ed o bo nded a ionali ( ee abo e). I efe o he idea ha people in eali e e ci e elf-con ol onl i hin limi . Thi mean he of en do no ha e he elf-con ol ha o ld be eq i ed of hem o make a ional deci ion . People ma a ime ea oo m ch, pend oo m ch, a e oo li le o o k oo li le; all hi i incon i en i h he a mp ion of a ional beha io . Bounded selfishness Ano he ela ed concep i ha of bounded selfishness, hich i he idea i hin limi , and ha he a mp ion of elf-in e e ed beha io nde l p inciple canno e plain he n me o acco n of elfle beha io and he p blic good e en a he co of ed ced pe onal elfa e ( he e poin Theo of kno ledge 2.2 belo ). ha people a e elfi h onl ing he ma imi a ion illingne o con ib e o a e f he di c ed in Imperfect information The heo of con me beha io a e ha e een i ba ed on he a mp ion ha con me ha e acce o all he info ma ion needed o make f ll info med deci ion , ega ding p ice , p od c , p od c q ali . If he did no ha e acce o ch comple e info ma ion, hei deci ion and choice o ld no be op imal, o be . Ho e e , i i ab ndan l clea ha con me do no and canno po ibl ha e ch f ll acce o info ma ion. Thi mean he a e nable o ma imi e ili a he make choice ba ed on fa l and incomple e info ma ion. Theor of knowledge 2.2 Altruism, perceptions of fairness and self-interested behaviour of rational economic decisionmakers Economi ha e long been a a e of he p e ence of al i m and ac ba ed on pe cep ion of fai ne in he beha io of economic deci ion-make . Fo e ample, hen con me make anon mo dona ion o cha i o ol n ee hei e ice h o gh man ho of o k fo he p blic good, he a e no mo i a ed b e pec a ion of mone a gain. Fi m , oo, of en ac in he p blic in e e b no fi ing o ke in ime of ece ion o a no o inc ea e nemplo men and ca e pe onal ha d hip, e en ho gh hi c in o hei p ofi . Economi ome ime a g e ha he e i no eal conflic be een ch al i ic beha io and beha io ba ed on elf-in e e , beca e people engaging in al i ic and cha i able ac gain a i fac ion f om hei con ib ion o ocie , and hi o k o inc ea e hei ili . Selfle ne and ca ing fo o he a e h in e p e ed o be con i en i h a ional elf-in e e and i h ili ma imi a ion. The efo e in hi ie con me a e beha ing a ionall e en hen he beha e al i icall . A e io p oblem i h hi a g men i ha if he a mp ion of ili ma imi a ion i in e p e ed o b oadl ha e e h man ac i con i en i h i , i lo e i ef lne a a heo of con me beha io . To p i impl , if i e plain e e hing, b being con i en i h all h man ac ion , i e plain no hing. In he o d of He be Simon, Economic heo ha ea ed economic gain a he p ima h man mo i e. An empi icall g o nded heo o ld a ign compa able eigh o o he mo i e , incl ding al i m and he o gani a ional iden ifica ion a ocia ed i h i . 6 In o he o d , al i m ho ld be ea ed epa a el , and no be made con i en i h he a mp ion of a ional elf-in e e h o gh an all-incl i e in e p e a ion of ili . Simon hinking b ing o mind he idea of Adam Smi h, di c ed in Chap e 1, Sec ion 1.5. In all likelihood, Smi h o ld be e emel p i ed and di appoin ed o di co e ha hi con ib ion o economic ega ding he in i ible hand of ma ke ha e been aken o of con e o mean ha he be e l fo ocie a i e beca e people beha e e ba f e fe e . A no ed in Chap e 1, in hi ea l book, T e T e f M a Se e , Smi h a g ed ha people elfi hne i e ained b mo al en imen , hich a e he need fo elf- e pec and he e pec of o he , a i ing f om empa h ( hich he efe o a mpa h ) and he de i e fo hono and j ice. O he economi of he cla ical pe iod, among hom a Da id Rica do, ag eed i h Smi h ha people mo i a ion a e comple , in ol ing a combina ion of elf-in e e and o he mo i e like empa h and conce n fo o he people. I a onl m ch la e , in he la e 19 h and ea l 20 h cen ie , ha economi implified and ed ced h man mo i a ion olel o he idea of ili ma imi a ion in he name of a ional elf-in e e . Thi ga e i e o he e m ec c (f om he La in o d meaning man, and he G eek o d ec c meaning economic) o ha an la e in o ec c a , a m hical being ho goe abo life a ionall ma imi ing hi elf-in e e . A Ga Becke , a no ed Nobel P i e inne (1992) a ed decade la e , elf-in e e i a med o domina e all o he mo i e . Since Simon ime, economi and o he cien i ha e ca ied o ho and of e pe imen ha p o ide ample e idence of he p e ence of al i m in h man being . I i belie ed ha al i m ma de i e f om c l e, o f om p chological de elopmen and ociali a ion, o f om inna e biological ai . (See al o Theo of kno ledge 5.1 in Chap e 5 on ainabili and a ional elf-in e e .) Thinking points H ec c , an a med being ho i fo e e a ionall ma imi ing ili a a con me (o fo e e a ionall ma imi ing p ofi a a p od ce ), i a f ndamen al b ilding block of mic oeconomic heo . Thi m hical being came in o e i ence a a ime hen economi ee ing o imi a e he me hod of he cience , e peciall ph ic . J a ph ic a me he e i ence of in pa icle (like a om ) ha beha e in a ce ain p edic able a , o con me and fi m became he pa icle of economic ha beha e in ce ain p edic able a . Al ho gh a om a e no i ible i h he naked e e, ph ici ha e de eloped ool o de ec hei e i ence and de c ibe hei beha io . Wha ool do economi homo economic ? In ha ph ici a a e ph ici and economi e o make a mp ion abo he e i ence and beha io ool he ame o diffe en f om economi ool a e eliable o he ame e en ? ool ? Do o of hink Behavioural economics in action Beha io al economic die ho indi id al and g o p of indi id al make deci ion . In ead of el ing on a mp ion abo h man beha io , a in he heo of con me beha io , beha io al economic elie e en i el on e pe imen ha o ob e e and nde and ho people beha e and eac in a a ie of i a ion . Nudge theor The o d d e mean poking omeone gen l o ge a en ion. A an economic e m, a nudge ha come o mean a me hod de igned o infl ence con me choice in a p edic able a , i ho offe ing financial incen i e o impo ing anc ion , and i ho limi ing choice. A an economic e m he o d d e a coined b o Ame ican economi , Richa d Thale and Ca S n ein in hei no cla ic book of 2008, N d e: I Dec ab Hea , Wea a d Ha e . N dge o infl ence people o beha e in ociall de i able a , b i ho impo ing an con ain on hei beha io , and b main aining f eedom of choice. Richa d Thale ecei ed he Nobel P i e in Economic in 2017 in pa fo hi o k on beha io al economic . While beha io al economic a ini ia ed in he Uni ed S a e , i ha aken a ong hold o e polic in man co n ie in he o ld, i h ome co n ie e abli hing n dge ni o p e and ppo hi app oach o a a ie of p blic polic a ea . I i no onl go e nmen b al o he p i a e ec o ha ha e nde aken n dge ini ia i e . E ample of n dge and hei e l incl de he follo ing: In he Uni ed Kingdom, a pa men of la e a pa e inc ea ed b 15% hen he e e old b he UK e en e e ice ha mo people in hei a ea had al ead paid hei a e . Thi o ked beca e he la e a pa e e e made o feel he e e he e cep ion o ha a he no m in hei comm ni . In a Dani h m nicipali , he ee ligh n ed hen ola panel a e no longe po e he ligh , making e iden mo e a a e of hei elec ici con mp ion. fficien o P ing heal h food in mo e i ible and acce ible po i ion in o e ha been ho n o inc ea e ale of ch food . In addi ion, colo f l foo ep leading con me o he loca ion of heal h food ha al o been effec i e. When non-pa e of ehicle a e ecei ed pe onali ed me age a he han a ning le e , he n mbe of pa e do bled; hen he me age incl ded a pho o of he ca in q e ion, he n mbe of pa e ipled. When a pa e ecei ed no ifica ion f om a a ho i ie in hi e en elope in ead of b o n i h hei name hand i en a he han ped, he e a a 16% inc ea e in people pa ing hei a . The e e ample indica e ha people e pond fa o abl migh no o he i e be inclined o do. hen d ed o pe fo m ac ion ha he Beha io al pa e n ch a he e a e aken a e idence ha bo o ing f om p cholog , ociolog and ne o cience in an a emp o nde and h h man being beha e he a he do can ha e impo an e l in changing beha io o enco age achie emen of ociall de i able e l . Beha io al economic ha been mo e cce f l in he a ea of finance, he e i ha al ead ongl infl enced economic hinking. O he a ea he e i i making ome head a a e de elopmen , heal h, la and economic , p blic economic , o gani a ional economic and age de e mina ion. Choice architecture Choice architecture i he de ign of pa ic la a o en i onmen in hich people make choice ; i i ba ed on he idea ha con me make deci ion in a pa ic la con e and ha choice of deci ion-make a e infl enced b a e e e ed e . Choice a chi ec a e indi id al o o gani a ion ha a ange he con e in hich choice a e made. The e m c ce a c ec e a al o coined b Richa d Thale and Ca S n ein in hei book on n dge no ed abo e. F a , hich a e plained ea lie , i a e impo an pa of choice a chi ec e, a i define he con e in hich choice a e p e en ed o deci ion-make , h ing o infl ence hei deci ion . Choice a chi ec e offe diffe en kind of choice ha a e de c ibed belo . Default choice i a choice ha i made b defa l , hich mean doing he op ion ha e l hen one doe no do an hing. People of en make choice b defa l d e o habi o lack of in e e in aking a delibe a e ac ion, e en if doing no hing ma no he be choice fo hem. Some ime he feel mo e comfo able no ha ing o make a choice. The efo e one a of ind cing people o follo a pa ic la co e of ac ion i o p o ide i a a defa l choice. See Real o ld foc 2.3 belo fo an e ample of he ole of defa l choice in o gan dona ion. Restricted choice i a choice ha i limi ed b he go e nmen o o he a ho i . People e e he e a e bjec o co n le e ic ion of all kind , anging f om peed limi , o ing age, and ec cling eg la ion o moking p ohibi ion and ocial no m like haking hand . I i a g ed ha e ic ion ch a he e a e nece a beca e people ha e oo man choice a ailable o hem, and in he ab ence of mo e and be e info ma ion, o d e o poo j dgemen , he of en make poo choice . The efo e choice a chi ec e can ake ad an age of e ic ion o enco age people o make choice i h ociall de i able o come . Mandated choice i a choice be een al e na i e ha i made manda o (comp l o ) b he go e nmen o o he a ho i . I can be ho gh of a eq i ed choice. I i a f ee choice, b i i comp l o o make ha f ee choice. See Real o ld foc 2.3 fo an e ample of he ole of defa l choice in o gan dona ion. No e ha defa l choice, e ic ed choice and manda ed choice a e diffe en pe of d e i hin c ce a c ec e ha a e in ended o o k o a d infl encing people choice in a di ec ion held o be ociall de i able. REAL WORLD FOCUS 2.3 Choice architecture, nudging and organ donation In he a ea of o gan dona ion, i i a challenge o inc ea e he n mbe of o gan dono in man co n ie a o nd he o ld. Man co n ie ha e a defa c ce fo people o be ei he (a) dono , in hich ca e he a oma icall become a dono if he do no hing, and o ld ha e o make a delibe a e effo o egi e a a non-dono ; o (b) non-dono , in hich ca e he a oma icall become a non-dono and o ld ha e o egi e o become a dono . In co n ie he e he defa l op ion i o be a dono , fo e ample A ia, Belgi m, F ance, H nga , Poland, Po gal, and he Uni ed Kingdom, he pa icipa ion a e in o gan dona ion i e high, ome ime a m ch a 90% of he pop la ion o mo e. B con a , in co n ie he e he defa l op ion i o be a non-dono , fo e ample Denma k, Ge man , and he Uni ed S a e , he pa icipa ion a e i m ch lo e . Figure 2.19: O gan dono ca d O gan dona ion can al o be ed o ill a e a da ed c ce. In he a e of Illinoi in he Uni ed S a e , in o de o ge a d i e licence ene ed i i manda o (comp l o ) o an e a q e ion on he he one i he o be an o gan dono . The e l ha gi en i e o a 60% a e of igning p o be a dono , compa ed o onl 38% fo he US na ional a e age he e manda ed choice doe no e i . The defa l choice ha make people dono b defa l he efo e appea o be effec i e. Ho e e , n dge ma in ome ca e backfi e, gi ing i e o oppo i e e l han he de i ed one . In he Ne he land , a 2016 la made being a dono he defa l choice, in he hope ha he n mbe of dono o ld inc ea e. Ye in a d i e ha ook place ho l af e he bill a pa ed, he p i ing e l a ha he e e e e a a -d a d . A likel e plana ion fo ch an ne pec ed e l ma be ha he D ch pop la ion ebelled again he n dge in en ion . The e had been a lo of p e co e age of he go e nmen deci ion o change he defa l choice, and i appea he D ch people did no an he go e nmen o make choice fo hem. Sources: Dee G , H a Ma a e e , 12 Se e be 2018 d e e e, UCLA A de Re e , Sc Appl ing our skills 1 Acco ding o he e pe ience of man co n ie , he defa l choice fo o gan dona ion appea o be cceeding in inc ea ing he n mbe of dono . Can o hink of o he a ea he e hi pe of defa l choice co ld be applied? 2 Wha i he le on abo 3 Some ob e e a g e ha n dging, in pi e of i po en ial benefi , al o ca ie a i k of manip la ion of he p blic opinion in b le a ha ma no al a be de ec able. Wha n dging ha can be lea ned f om he D ch e pe ience? f doe he D ch e pe ience a abo hi po ible i k? (See al o Q e ion 4 nde I a d ef ec a he end of hi chap e .) The response of mainstream economists to the critique of utilit theor In e pon e o he c i ici m of ili heo and a ional beha io , man main eam economi o ld a g e ha in pi e of i impe fec ion , he heo of con me beha io ba ed on he a mp ion of a ionali doe a ea onabl good job in e plaining and p edic ing ho con me beha e nde man ci c m ance . The e i e idence ha con me do e pond a ionall o mone a fac o . Fo e ample, an inc ea e in he ga oline o pe ol a ill mo likel lead o a lo e q an i of pe ol demanded, a p edic ed b he do n a d loping demand c e ba ed on con me a ionali . E ample abo nd of e ha ha e empi icall ho n (no ef ed) he e i ence of do n a d loping demand c e , hich a e ba ed on he heo of ili ma imi a ion. So e en if con me do no beha e a ionall all he ime acco ding o he le of a ionali , on a e age, o e all, hei beha io i con i en i h he p edic ion of ili heo . Mo eo e , ome economi o ld a g e ha choice a chi ec e and he e of n dge i manip la i e, a i a emp o e e ci e con ol and infl ence o e con me choice . The idea of f ee choice i he efo e eakened and become an ill ion of f ee choice a he han ac al f ee choice. Wha ma be o e i ha i of en affec con me on a b-con cio le el, making hem do hing ha he migh no choo e o do if he e e f ll a a e of he f ll implica ion of hei choice . In effec , choice a chi ec e ake ad an age of he incomple e info ma ion a ailable o he con me , and elec i el p o ide info ma ion ( ch a h o gh f aming and choice a chi ec enco age con me o ac in a pa ic la a . Fo he e ea on i i a g ed ha he e ho ld be an pa enc and open di c fo economic polic . ion of n dge e) o ed Evaluating behavioural economics and economic polic Potential advantages Beha io al economic ma be a ela i el beha io o ac in ociall de i able a . imple and lo -co a o infl ence people I ha been ed cce f ll in a n mbe of a ea , gge ing ha he me hod of choice a chi ec e and n dging ma ha e n me o po ible applica ion in a ea ha a e a e ne plo ed. I offe con me and ci i en , gene all , f eedom of choice i ho fo cing hem o do an hing o p e en ing hem f om doing an hing, hence i ho e ic ing hei choice . I ma be able o o e come he eakne e of he heo of con me beha io , hich i no al a able o e plain he incon i encie and eeming i a ionali of ac al con me beha io . Policie a e ba ed on p inciple of p cholog , p e io l e ed o e man ea . ch a f aming, man of hich ha e been The de elopmen of policie i ba ed on ial , indica ing he e of a fle ible ial-and-e o me hod of di co e ing polic mea e ha can o k in achie ing de i ed e l . Potential disadvantages The bod of kno ledge being de eloped i no ba ed on an nde anding of h man beha io , and i he efo e nable o lead o a ema ic and nif ing heo of ho con me beha e i h gene al applicabili . The e l ing n ema ic app oach (diffe en policie fo diffe en i a ion ) ma no be alid o e ime o ac o diffe en income g o p , ocial g o p o c l e ; hi ed ce he applicabili of he policie being de eloped o e ime and ac o ocial, economic and c l al go p. The e ma be i k of ing p chological p inciple o manip la e con me , in m ch he ame a ha ad e i ing and ma ke ing ha e been ing imila p inciple o e man ea in o de o manip la e con me a e and p efe ence fo he p po e of con incing con me o ac in a ha a e no nece a il in hei be in e e ( ch a ad e i ing fo ga and fa food p od c ha a e nheal h ). The e ma be i k ha beha io al policie ma be ed a b i e fo nece a b poli icall co l economic policie , ch a he impo i ion of a e on ociall ha mf l good kno n a de e d o good leading o e a e e e a e ( ee Chap e 5). T adi ional economic policie (fo e ample indi ec a e , 4 and 5) ma be mo e effec i e. b idie , o be di c ed in Chap e I ma be a ne fo m of go e nmen eg la ion, onl camo flaged nde he g i e of f eedom of choice, and he efo e mo e dange o a people ma no be a a e of i e i ence and i effec on hei choice . Choice a chi ec e and n dging ma cce f ll affec people choice , b no be a eflec ion of hei e p efe ence . he e choice ma TEST YOUR UNDERSTANDING 2.9 1 a Di c ha i mean o be a a ional con me in economic . b To ha e en a e o pe onall a a ional con me ? 2 Fo each of he bia e di c ed in he e , e plain h heo of con me beha io . he co ld no occ acco ding o he 3 In he e ample of n dge gi en in he e , iden if 4 Di ing i h be een defa l , e ic ed and manda ed choice. E plain ho a n dge . 5 Di ing i h be een bo nded a ionali , bo nded elf-con ol and bo nded elfi hne . P o ide an e ample fo each of he e. E plain h he a e all incon i en i h a ional con me beha io . 6 Di c he f aming elemen in he n dge. he e can be ed he po en ial ad an age and di ad an age of beha io al economic . Firm business objectives Rational producer behaviour: profit ma imisation S anda d economic heo of he fi m a me rational producer behaviour acco ding o hich fi m a e g ided b he goal o ma imi e p ofi . P ofi ma imi a ion in ol e de e mining he le el of o p ha he fi m ho ld p od ce o make p ofi a la ge a po ible. On a e gene al le el, p ofi i eq al o he o al e en e ea ned b a fi m min inc ed b he fi m in he p oce of p od cing i o p . he o al co S ppo e o ha e a pi a e a an and o ell 400 pi a a da a $7 each. Yo ha e e en e of 7 400 = $2800 pe da . On he o he hand he co of b ing he pi a ing edien , pa ing o o ke and mee ing all o he e pen e of nning o e a an amo n o $2650 pe da . Yo p ofi pe da i P ofi = e en e co = 2800 2650 = $150 pe da . The objec i e of p ofi ma imi a ion i o make he diffe ence be een e en e and co a la ge a po ible o a o make p ofi a la ge a po ible. We ill come back o he opic of p ofi ma imi a ion in Chap e 7 (a HL). Alternative business objectives O e he ea , economi ha e de eloped man heo ie abo fi m beha io . The follo ing i a b ief e of ome of he mo e impo an one . The common heme of all of he e i ha p ofi ma imi a ion ma no be he o e iding objec i e of fi m , a in fac he ma ha e o he goal ha ma be mo e impo an . Corporate social responsibilit : ethical and environmental concerns The elf-in e e ed beha io of fi m of en lead o nega i e con eq ence fo ocie . I i of en he ca e ha he ell-being of fi m i no con i en i h he ell-being of ocie . A p ime e ample i he elf-in e e ed fi m ha poll e he en i onmen . (S ch ac ion of fi m ill be e amined in Chap e 5 nde he opic of nega i e e e nali ie and common pool e o ce .) In addi ion, fi m can engage in ac ion ha mo con me o ld con ide o be e hicall naccep able, ch a he p ac ice in man de eloping co n ie of emplo ing poo l paid child en fo ced o o k long ho , o emplo ing labo ha i fo ced o o k nde nheal h o dange o condi ion . The e i a ion ma a i e in co n ie he e he e i ide p ead po e , and go e nmen legi la ion p o ec ing he igh of child en and o ke i ei he non-e i en o poo l enfo ced. Ho e e , man fi m inc ea ingl ecogni e ha he p i of elf-in e e need no nece a il conflic i h e hical and en i onmen all e pon ible beha io . A nega i e image of he fi m held b o ke and b e of he p od c can c deepl in o he fi m e en e and p ofi b lo e ing o ke p od c i i and he fi m ale . F he , ociall i e pon ible fi m beha io ma lead o go e nmen eg la ion of he fi m in ended o minimi e he nega i e con eq ence of he fi m ac ion fo ocie , he ea ociall e pon ible beha io co ld in ead e l in le go e nmen eg la ion. The efo e, fi m face incen i e o di pla corporate social responsibilit b engaging in ociall beneficial ac i i ie . The e can ake man fo m , incl ding: a oidance of poll ing ac i i ie engaging in en i onmen all o nd p ac ice ppo fo h man igh , ch a a oiding e ploi a ion of child labo and labo in gene al in le de eloped co n ie , o a oiding in e men in co n ie i h poli icall opp e i e egime a and a hle ic pon o hip dona ion o cha i ie . Man of he e p ac ice a e he e l of inc ea ed con me a a ene of ocial and en i onmen al i e , g o ing con me conce n o e e hical and en i onmen al a pec of b ine p ac ice , and e en con me ac i i m ha e l in bo co of offending fi m . One indica ion of he infl ence and conce n of con me i he apidl g o ing in e e in in e men in companie ( h o gh ock ma ke ) ha mee ce ain ocial, e hical and ecological c i e ia. Economi ed o hink ha e hical and en i onmen all e pon ible beha io of fi m o ld ed ce hei p ofi . Thi a ba ed on con ide ing onl he co a pec of p ofi ; fo e ample, fi m ing cheap child labo face lo e co , and hence ill make highe p ofi han fi m a oiding ch p ac ice . Ye p ofi depend no onl on co , b al o on e en e ha ill fall if con me a oid b ing he p od c of offending fi m . A n mbe of die ha e a emp ed o mea e he effec of ociall e pon ible beha io on he p ofi of fi m . Doe e hical and en i onmen all e pon ible beha io lo e o inc ea e fi m p ofi ? The e l of he e die ha e been inconcl i e. The beha io of fi m hem el e , ho e e , gge ha he of en do no an o i k con me di plea e. Market share Market share efe o he pe cen age of o al ale in a ma ke ha i ea ned b a ingle fi m. Fo e ample, if a p od c ha o al ale i hin a co n of $50 million, and a fi m ell $10 million o h of ha p od c , hen ha fi m ha a 20% ma ke ha e. A high ma ke ha e mean ha he fi m i enjo ing la ge ale of i p od c o p od c , and i an indica ion of he p od c pop la i among b e . A la ge ma ke ha e mean ha i i likel pe ni of o p a he fi m g o , o be fi m o inc ea e i p ofi abili . ha he fi m i achie ing ec e f ca e (falling co died a HL in Chap e 7). Economie of cale allo a In gene al, ma ke ha e i o impo an ha la ge companie ch a m l ina ional co po a ion (la ge fi m ha ha e p od c i e facili ie in mo e han one co n ) of en mea e hei pe fo mance in e m of hei ma ke ha e in pecific co n ie . Ma ke ha e i an impo an indica o of pe fo mance beca e i allo he fi m o moni o ho ell i i doing in ela ion o i compe i o . A fi m ha cceed in main aining i ma ke ha e o e ime mean ha i i ha a e g o ing a he ame a e a he o e all ma ke . A g o ing ma ke ha i doing ell in ela ion o i compe i o . I i likel ha i e en e a e g o e en e of compe i o fi m . A falling ma ke ha e on he o he hand mean doing a ell a i compe i o in e m of ale of i p od c . likel ea ning e en e e i a ign ha he fi m ing fa e han he ha he fi m i no In o de o inc ea e i ma ke ha e, he fi m ma o lo e i p ice , o in od ce ne o inno a i e p od c in o he ma ke , o e ad e i ing. Each of he e a egie ma ha e he effec of lo e ing p ofi . Lo e p ice ma ed ce e en e ( ho gh no nece a il , hi ill be e plo ed in Chap e 3). The in od c ion of ne p od c in ol e inc ea ed co on e ea ch and de elopmen , hile ad e i ing al o in ol e inc ea ed fi m pending o pa fo he ad e i ing. Po ible lo e p ice i h highe co ill c in o p ofi . Ho e e , a long a he fi m emain p ofi able, and i con in e o ea n a a i fac o le el of p ofi , he benefi of main aining o inc ea ing ma ke ha e a e likel o make he lo e p ofi o h hile. Growth ma imisation Ano he po ible objec i e i ma imi a ion of g o be a ac i e fo he follo ing ea on : h a he han p ofi .7 Growth ma imisation can A g o ing fi m can achie e economie of cale ( ee Chap e 7) and lo e i a e age co inc ea ing i p ofi abili . , h A a fi m g o i can di e if in o p od c ion of diffe en p od c and ma ke and ed ce i dependence on a ingle p od c o ma ke . A la ge fi m ha g ea e ma ke po e and inc ea ed abili po en iall inc ea ing i p ofi abili . o infl ence p ice , h A la ge fi m ed ce i i k beca e i ma be le affec ed in an economic do n ece ion) and i le likel o be aken o e (bo gh ) b ano he fi m. again n (a The objec i e of g o h ma imi a ion econcile he in e e of bo h o ne and manage , beca e bo h g o p ha e m ch o gain f om a g o ing fi m. O he ma imi a ion objec i e ma pi fi m o ne again fi m manage ; fo e ample, p ofi ma imi a ion i fa o ed b o ne hile e en e ma imi a ion i fa o ed b manage . Revenue ma imisation In one heo of fi m beha io , i i a g ed ha he epa a ion of fi m managemen f om fi m o ne hip, hich inc ea ingl domina e b ine o gani a ion, ha mean ha fi m objec i e ha e changed. Whe ea p ofi ma imi a ion ma be he dominan mo i e of he adi ional o ne -managed fi m, fi m manage ho a e hi ed b he o ne o pe fo m managemen a k ma be mo e in e e ed in inc ea ing ale and ma imi ing he e en e ha a i e f om la ge q an i ie old. Thi goal of fi m i efe ed o a e e e a a .8 Inc ea ing ale and ma imi ing e en e ma be mo e ef l o a fi m han p ofi ma imi a ion fo he follo ing ea on : Sale can be iden ified and mea ed mo e ea il o e he ho ale a ge can be ed o mo i a e emplo ee . Re a d fo manage p ofi . e m han p ofi , and inc ea ed and emplo ee a e of en linked o inc ea ed ale I i of en a med ha e en e f om mo e ale ill inc ea e mo e apidl he ca e, p ofi (= o al e en e o al co ) ill al o inc ea e. Inc ea ed ale gi e i e o a feeling of fail e. (N e a e e e a a , e cce , a , a he han inc ea ed han co ; if hi i he ea declining ale c ea e a feeling of e ab .) Satisficing Man of he abo e objec i e a me ha he fi m ie o ma imi e ome a iable, he he i i p ofi , ma ke ha e, g o h o e en e. He be Simon, a Nobel P i e- inning economi (al o men ioned ea lie in connec ion i h he idea of bo nded a ionali a a c i iq e of con me a ionali ), ha a g ed ha he la ge mode n en e p i e canno be looked pon a a ingle en i ih a ingle ma imi ing objec i e; in ead i i compo ed of man epa a e g o p i hin he fi m, each i h i o n objec i e hich ma o e lap o ma conflic . Thi m l iplici of objec i e doe no allo he fi m o p e an kind of ma imi ing beha io . Fi m he efo e o e abli h p oce e h o gh hich he can make comp omi e and econcile conflic o a i e a ag eemen , he e l of hich i he p i of man objec i e ha a e placed in a hie a ch . Thi beha io a e med satisficing b Simon. (Simon ed hi e m o de c ibe he beha io of con me a ell.) I efe o he idea ha fi m o achie e a a i fac o le el of p ofi oge he i h a i fac o e l fo man mo e objec i e , a he han op imal o be e l fo an one objec i e. TEST YOUR UNDERSTANDING 2.10 Imagine o a e he o ne of a b ine . Di c and j a e no di ec l conce ned i h p ofi ma imi a ion. if an b ine goal o ma ha e ha THEORY OF KNOWLEDGE 2.3 How important are the criticisms of profit ma imisation as the firm s main goal? S anda d economic heo a me ha p ofi ma imi a ion i he mo impo an goal of fi m . A e ill ee in Chap e 7, he d of fi m beha io i ba ed e hea il on he a mp ion of p ofi ma imi a ion. Ye hi a mp ion i c i ici ed fo e e al ea on : The e of ma ginal concep (fo e ample a a c ) in he heo i n eali ic; fi m canno ea il iden if ma ginal co , and do no e en o do o; he efo e, hi heo doe no acc a el de c ibe me hod ac all ed b fi m o de e mine p ice and o p . The model i ba ed on he a mp ion ha fi m ha e pe fec info ma ion a hei di po al, he ea in fac he info ma ion on hich he ba e hei deci ion i highl f agmen a and nce ain; fi m do no kno ha demand c e he face fo hei p od c and he do no kno ho compe i o fi m ill beha e in e pon e o hei ac ion . Sho - n p ofi ma imi a ion ma be n eali ic; fi m ma p efe lo e p ofi in he ho in e change fo la ge p ofi o e he long n. n The fac o de e mining demand and ppl fo p od c and e o ce a e con in o l changing, i h demand and ppl c e con in o l hif ing, o ha an p ofi -ma imi ing deci ion ega ding p ice and o p made oda nde c en condi ion ma be i ele an b he ime he o p i p od ced and ead fo ale in he ma ke . The e i eal- o ld e idence gge ing ha fi m beha io ma be mo i a ed b a a ie objec i e o he han p ofi ma imi a ion, hich e e di c ed abo e. of Mil on F iedman, an Ame ican Nobel P i e- inning economi , a g ed in a famo book9 ha i doe no ma e if he a mp ion of a heo a e n eali ic, a long a he heo ha p edic i e po e . In fac , good heo ie a e of en ba ed on n eali ic a mp ion ha do no acc a el de c ibe he eal o ld, beca e he ole of a mp ion i o po a onl he impo an a pec of a p oce ha i modelled o heo i ed abo , igno ing he i ele an de ail . Pa l Sam el on, ano he Ame ican Nobel P i e- inning economi , f ndamen all di ag eed. Sam el on a g ed ha he p edic ion of a heo can onl be a empi icall alid a he heo i elf, and a he a mp ion on hich he heo e . If he a mp ion a e n eali ic o in alid, hen he heo and i p edic ion ill imila l be in alid; i i no po ible o ha e a heo ih p edic i e po e if i a mp ion a e n eali ic. If he p edic ion of a heo a e empi icall alid, o i he heo and i a mp ion . Logicall , hen, i i no po ible o epa a e he p edic ion of a heo f om he a mp ion of he heo ; he all and o fall oge he . Thinking points Remembe ha a heo ie o e plain eal- o ld e en . Doe i ma e if a heo n eali ic a mp ion ? i ba ed on A o ead h o gh Chap e 7, o ma an o keep he e i e in mind, a e ill enco n e f he n eali ic a mp ion in ome ma ke model di c ed in ha chap e ( ee al o Theo of kno ledge 7.1 abo pe fec compe i ion). INQUIRY AND REFLECTION The follo ing q e ion ill help o eflec on o lea ning and enhance o nde anding of ke opic in hi chap e . The a e gge ion fo inq i ie ha o can nde ake on o o n o in g o p in o de o e i e he lea ning objec i e of hi chap e . 1 Ad e i ing make g ea e of bia e ha infl ence con me a of hinking. A o a ch TV, hen a comme cial come on, o ee if he me age being con e ed o he con me make e of bia e in o de o con ince con me o b he p od c . 2 An a ea ha ha been e amined e en i el in ol e p o iding heal h l nche a chool and ing n dge o enco age pa en and den o p efe he e. In e iga e ha kind of n dge ha e been gge ed, hen and he e he ha e been implemen ed, and ha e e he e l . T o de ign a p og amme he e o co ld ecommend n dge ha o hink ma be effec i e in inc ea ing demand fo heal h chool meal . 3 Wa o deci ion o d IB economic a a ional choice? Iden if he condi ion ha o ld ha e o be a i fied fo hi choice o ha e been a a ional one. If i a no a ional, iden if ome bia e ha ma ha e affec ed o choice. 4 Richa d Thale and Ca S n ein, ho became famo fo hei con ib ion o n dge . coined he ph a e be a a a e a o de c ibe n dge a a fo m of go e nmen in e en ion. The o d be a a (f om he La in o d be a hich mean f eedom) efe o a philo oph he e libe o f eedom and a onom a e he main p inciple , meaning ha people ho ld ha e f eedom of choice and ho ld be f ee of a ho i . The o d a e a (f om he G eek o d a e hich mean fa he ) efe o ac ion ha limi people f eedom o a onom ; ch ac ion a e of en j ified on he g o nd ha he a e in he people be in e e . Con ide he ph a e be a a a e a , and de e mine he he he e o concep ma be con adic o o he he he can be made con i en i h each o he a Thale and S n ein ha e ied o do h o gh he polic of n dge . EXAM STYLE QUESTIONS Yo can find q e ion in he le of IB e am in he 'Digi al co ebook: E a ma e ial' ec ion. 5 I i be ond he cope of hi book o e plain ho a ional con me in o de o ma imi e ili . 6 He be Simon, Al 7 Thi i ba ed on he o k of R. Ma i and o he . 8 The e en e-ma imi a ion goal of fi m 9 Mil on F iedman (1953) The Me hodolog Uni e i of Chicago P e . i m and Economic , Ea e he la Ec of dimini hing ma ginal cJ ili i ed o e plain a Vol. 18, No. 1 (Win e , 1992), pp. 73 83 a de c ibed b W. J. Ba mol in 1959. of Po i i e Economic in E a in Po i i e Economic , C a e 3 Ea c e BEFORE YOU START When the price of a good or service that ou ant rises, ho likel is it that ou ill purchase it an a ? You might sa it depends. What factors might influence our decision? If producers of a good or service ant to increase their revenue, sometimes the increase their price. Does this strateg al a s ork? Wh or h not? If someone is poor and over time becomes richer, hat kinds of changes might ou e pect to see in her or his purchasing habits? What if she or he is rich and over time becomes poorer? The topics above relate to the concept of elasticit . E a c is a measure of the responsiveness of a variable to changes in price or an of the variable s determinants. In this chapter e ill e amine three kinds of elasticities: price elasticit of demand, price hich e amines the responsiveness of quantit demanded to changes in income elasticit of demand, hich e amines the responsiveness of demand to changes in income price elasticit of suppl , price. hich e amines the responsiveness of quantit supplied to changes in Each of these has a number of applications to important economic problems. 3.1 Price elasticit of demand (PED) LEARNING OBJECTIVES Af e d ing hi ec i n ill be able : define all he e m a ea ing in orange bold in he e in e he f m la f ice ela ici f demand (PED) an i and al e en e (AO4) iden if he a i d a diag am deg ee and ange f al e f h ing he ange f al e f (AO1) calc la e PED, change in ice, change PED (AO2) PED, incl ding (AO4) ela i el ela ic and inela ic demand c n an al e f e fec l ela ic demand, e fec l inela ic demand and ni a e lain and ill a e in a diag am changing PED al ng a c e (HL nl ) (AO2, AO4) anal e he de e minan al e en e (AO2) d a a diag am h h al e en e change in e ela ic inela ic demand (AO4) di c n a d l ing demand f PED (AO2) e lain he ela i n hi be een PED and a l PED aigh -line d PED ne a ice change de ending n : i im ance f fi m and g e nmen deci i n-making (AO3) anal e he ea n h ima c mm di ie gene all ha e a l man fac ed d c (HL nl ) (AO2) e PED han Price elasticit of demand Understanding price elasticit of demand (PED) Acc ding he la f demand, he e i a nega i e ela i n hi be een ice and an i demanded: he highe he ice, he l e he an i demanded, and ice e a, ce e i a ib . We n an kn b h ch an i e nd change in ice. Price elasticit of demand (PED) i a mea e f he e n i ene f he an i fag d demanded change in i ice. PED i calc la ed al ng a gi en demand c e. In gene al, if an i demanded i highl e n i e a change in ice, demand i efe ed a being ice e a ic; if an i demanded i n e e n i e, demand i ice i e a ic. The formula for PED S e e a e c n ide ing PED f g d X. The f m la ed ice ela ici f demand (PED) = e cen age change in an i demanded e cen age change in If e abb e ia e change in b he G eek le e mea e i PED i : ice , hi f m la can be e i en a : PED= % Q % P Sim lif ing, he ab e f m la can be e i en a : PED= Q Q 100 P P 100 = Q Q P P = he e Q = Qfinal al e Qini ial al e Q = Qini ial al e P = Pfinal al e Pini ial al e P = Pini ial al e The sign of PED Since ice and an i demanded a e nega i el ela ed, PED i a nega i e n mbe . An e cen age inc ea e in ice (a i i e den mina ) gi e i e a e cen age dec ea e in an i demanded (a nega i e n me a ), leading a nega i e PED. Simila l , a e cen age ice dec ea e e l in a e cen age an i inc ea e. H e e , he c ac ice i d he i ig a d c ide PED a a ii e be . (In ma hema ic hi i called aking he ab l e al e.) Thi i d ne a id c nf i n hen making c m a i n be een diffe en al e f PED. U ing i i e n mbe , e can a , f e am le, ha a PED f 3 i la ge han a PED f 2. (Had e been ing he min ign, 2 ld be la ge han 3.) The use of percentages Ela ici i mea ed in e m f e cen age change f P and Q f ea n : We need a mea e f e n i ene ha i inde enden f ni . ni f ange i h ni fc m e ca . Al , e an ac c n ie ha ha e diffe en c encie ; an ela ici mea c m a able i h an ela ici mea ed in en nd . The e e ela ici ie in c mm n e m . I i meaningle inc ea e in ice diffe en f a g d he fi ca e he e i all e I make li le en e c m a e be able c m a e ela ici ie ed in e m f e ill n be e f e cen age all hink f change in ice an i ie in ab l e e m (f e am le, a $15 a 20 ni dec ea e in an i ). A $15 ice inc ea e mean me hing e h e iginal ice i $100 han f a g d h e iginal ice i $5000. In a 15% inc ea e, and in he ec nd he e i a 0.3% inc ea e. U ing e cen age n i ene in e ec i e. The ame a g men a l all he ela ici ie e ill c n ide . Calculating PED, change in price and change in quantit We can n i $255 e e he f m la ab e calc la e PED. S e c n me b ni , and he b 5000 TV hen he ice i $300. 6000 TV hen he ice PED= 6000 5000 5000 255 300 300 = 1000 5000 45 300 = 0.20 0.15 = 1.33 1.33 ince e d N e ha ela ici he min i mea ign. The ef e PED f ed a a n mbe , n TV i 1.3.1 a a e cen age, and he e a e n ni . If e kn PED and he e cen age change in P, e can calc la e he e cen age change in Q. S e PED = 1.25 and ice f g d X i c ea e b 12%. Calc la e he e cen age change in Q demanded: PED=1.25= % Q 0.12 ⇒% Q= 0.12 1.25= 0.15 15%.Q an i dec ea ed b 15%. Simila l , if e kn PED and he e cen age change in Q demanded, e can calc la e he e cen age change in P. S e PED = 0.80 and an i f g d Y demanded fa b 16%. Calc la e he e cen age change in P: PED=0.80= 0.16 % P =⇒0.80 % P= 0.16 ⇒% P=0.20 20%. P ice inc ea ed b 20%. Y ma n e ha he e e ha e ed nega i e ign in he calc la i n h dec ea e , h e e hi i n nece a ince he final ela ici al e i aken a a i i e n mbe (ab l e al e). T al e en e calc la i n ( efe ed in he lea ning bjec i e ) ill be e en ed bel . TEST YOUR UNDERSTANDING 3.1 1 a b Think f me f a i fied b g d Iden if he f m b fac im an need and an , and hen e lain he he he e a e e ice . f e ea PED a if i d c i n. 2 Sae h ee i i e, e en h gh i i 3 I i b e ed ha hen he ice f i a i $16 e i a, 100 i a a e ld; hen he fall $12 e i a, 120 i a a e ld. Calc la e ice ela ici f demand. 4 A 10% inc ea e in he ice f a a ic la g Calc la e he ice ela ici f demand. 5 The PED f g d X i 0.8. If he dec ea e in an i demanded. 6 The PED f g d Y i 1.5. If an i dec ea e in he ice f g d Y. d gi e i e all nega i e. an 8% dec ea e in an i ice b gh . ice f g d X inc ea ed b 15%, calc la e he e cen age fg d Y inc ea e b 30%, calc la e he e cen age The range of values for PED The al e f PED in l e a c m a i n f n mbe : he e cen age change in an i demanded ( he n me a in he PED f m la) and he e cen age change in ice ( he den mina ). Thi c m a i n ield e e al ible al e and ange f al e f PED. The e a e ill a ed in Fig e 3.1 and mma i ed in Table 3.1. Demand is price inelastic when PED < 1 (but greater than ero). The e cen age change in an i demanded i malle han he e cen age change in ice, he al e f PED i le han ne; an i demanded i ela i el ne ni e change in ice, and demand i price inelastic. Fig e 3.1(a) ill a e ice inela ic demand: he e cen age change in an i demanded (a 5% dec ea e) i malle han he e cen age change in ice (a 10% inc ea e), he ef e PED i le han ne. Demand is price elastic when PED > 1 (but less than infinit ). an i demanded i la ge han he e cen age change in ice, he ne; an i demanded i ela i el e n i e ice change , and Fig e 3.1(b) he e cen age change in an i demanded ( 10%) i change in ice (5%), he ef e PED i g ea e han ne. In addi i n, he e a e h ee demand c e: ecial ca e The e cen age change in al e f PED i g ea e han demand i price elastic. In la ge han he e cen age he e PED i c n an ( nchanging) al ng he f ll leng h f he Demand is unit elastic when PED = 1. The e cen age change in an i demanded i e al he e cen age change in ice, PED i e al ne; demand i hen i e a ic; he e i unitar PED. Fig e 3.1(c) h a ni ela ic demand c e, he e he e cen age change in an i demanded ( 5%) i e al he e cen age change in ice (5%). Demand is perfectl inelastic when PED = 0. The e cen age change in an i demanded i e ; he e i n change in an i demanded, hich emain c n an a Q1 n ma e ha ha en ice; PED i hen e al e and demand i perfectl inelastic. F e am le, a he in addic an i f he in demanded i n e n i e change in he ice f he in. Fig e 3.1(d) h ha a e fec l inela ic demand c e i e ical. Demand is perfectl elastic when PED = infinit . When a change in ice e l in an infini el la ge e n e in an i demanded, demand i perfectl elastic. A h n in Fig e 3.1(e) he e fec l ela ic demand c e i h i n al. A ice P1, c n me ill b an an i ha i a ailable. If ice fall , b e ill b all he can (an infini el la ge e n e); if he e i an inc ea e in ice, an i demanded d e . Thi a a en l ange kind f demand ill be c n ide ed in Cha e 7 (a HL). The n me ical al e f PED can he ef e a f m e infini . In gene al, he la ge he al e f PED, he g ea e he e n i ene f an i demanded. While he ca e f ni ela ic, e fec l inela ic and e fec l ela ic demand a e a el enc n e ed in ac ice, he ha e im an a lica i n in ec n mic he . Value of PED Classification Interpretation Frequentl encountered cases 0 < PED < 1 (g ea e han e and le han ne) ice inela ic demand an i demanded i ela i el n e n i e ice 1 < PED < (g ea e han 1 and le han infini ) ice ela ic demand an i demanded i ela i el e n i e ice Special cases: constant PED along the length of the demand curve PED = 1 ni ela ic demand PED = 0 e fec l inela ic demand an i demanded i c m le el n e n i e ice PED = e fec l ela ic demand an i demanded i infini el e n i e Table 3.1: Cha ac e i ic f ice ela ici f demand e cen age change in an i demanded e al e cen age change in ice ice Figure 3.1: Demand c e and PED PED and the steepness of the demand curve The a ie f demand c e and hei PED in Fig e 3.1 gge ha he fla e he demand c e, he m e ela ic he demand ( he highe he PED); he ee e he demand c e, he le ela ic he demand ( he l e he PED). H e e , i i n al a acc a e c ncl de ha demand i m e ela ic le ela ic in diffe en demand c e im l b c m a ing hei ee ne . The ea n i ha demand c e d a n n diffe en cale a e n c m a able. Fig e 3.2 h iden ical demand c e i h diffe en cale n he h i n al a i . I ld be inc ec c ncl de ha he ee e demand c e ha a le ela ic demand. Figure 3.2: T iden ical demand c e S hen i i c ec c m a e PED f demand c e b efe ing hei ee ne ? Thi ca be d e he he demand c e in e ec a me in , ch a demand c e D1 and D2 in Fig e 3.3. In hi fig e, f an ice, D1 i fla e and m e ela ic han D2. F e am le, if ice fall f m P1 P2, he e l ing e cen age change in an i ill be la ge f D1 (inc ea e f m Q1 Q3) han f D2 (inc ea e f m Q1 Q2). In gene al, hen demand c e in e ec , hen f an gi en ice, he fla e he demand c e, he m e ela ic i he demand. Thi gene ali a i n h ld f c m a i n be een demand c e a a a ic la ice. We f en e he ela i e ee ne f demand c e be an indica i n f PED, ha c m a ing demand c e , he ne ha i fla e i aid be m e ela ic hile he ne ha i ee e i aid be m e inela ic. (Thi i d ne n he a m i n ha if he e e d a n n he ame diag am he ld in e ec a me in .) Figure 3.3: Demand c e and PED TEST YOUR UNDERSTANDING 3.2 1 2 S ecif he al e f each f he f ll ing PED and h demand c e ha c e nd each ne: a e fec l ela ic demand, b ni a c e fec l inela ic demand. , ing diag am , he ha e f he PED ( ni ela ic demand) and P ide e am le a ela ic, and b inela ic. 3 Iden if hich eal ld. 4 A ming f a gi en fg d likel ice ela ici demand c ice. ha e demand ha i f demand al e ange f al e e in e ec , e lain hich f he e ee m f e en l in he ill be ela i el m e ela ic Changing PED and the straight-line demand curve (HL onl ) Wh PED varies Al ng an d a di g, aigh - i e de a d c e, he PED a ie (change ) a e m e al ng he c e. Thi a lie all demand c e f he e h n in Fig e 3.1(a) and (b). I e cl de ni ela ic, e fec l inela ic and e fec l ela ic demand c e ( he e PED i c n an ). We can ee in Fig e 3.4 ha hen ice i l and an i i high, demand i inela ic; a e m e he demand c e a d highe ice and l e an i ie , demand bec me m e and m e ela ic. The fig e h he PED al e al ng diffe en a f he demand c e. The ea n behind he changing PED al ng a aigh -line demand c e ha d i h h PED i calc la ed. A high ice and l an i ie , he e cen age change in Q i ela i el la ge ( ince he den mina f Q/Q i mall), hile he e cen age change in P i ela i el mall (beca e he den mina f P/P i la ge). The ef e, he al e f PED, gi en b a la ge e cen age change in Q di ided b a mall e cen age change in P e l in a la ge PED (ela ic demand). A l ice and high an i ie , he i e h ld . The al e f PED i gi en b a l e cen age change in Q di ided b a high e cen age change in P, e l ing in a l PED (inela ic demand). Figure 3.4: Va iabili f PED al ng a aigh -line demand c e On an d n a d- l ing, aigh -line demand c e, demand i ice-ela ic a high ice and l an i ie , and ice-inela ic a l ice and la ge an i ie . A he mid in f he demand c e, he e i ni ela ic demand. The ef e, he e m ela ic and inela ic h ld n be ed efe ( i h he e ce i n f he h ee ecial ca e he e PED i c n an ), b demand c e c e nding a a ic la ice ice ange. an en i e demand c e nl a i n f he Wh PED varies along a straight-line demand curve from a different perspective A fa im le e lana i n f he a ing PED al ng a N e ha he l e f demand c PED= Q Q P P = Q P N e kn 1/ l e i al aigh -line demand c e i he f ll ing. e2 = P Q, hile PQ=1 l e ha he l e al ng a c n an . PQ aigh line i al a c n an , he ef e he in e e f he l e = The ef e PED i e al a c n an n mbe m l i lied b P/Q. A e m e d n he demand c e, e kn ha P ge malle and malle , hile Q ge bigge and bigge , he ef e P/Q bec me c n in l malle . Thi mean ha a e m e d n he demand c e, PED, hich i e al a c n an n mbe ime an e e dec ea ing n mbe , m be ge ing malle and malle . We h im le e lana i n f h PED c n in l dec ea e a e m e d n he demand c e. ha e a TEST YOUR UNDERSTANDING 3.3 1 U ing he inf ma i n in Fig e 3.4, calc la e PED be een: a in a and b, he e ice inc ea e f m $10 $15; b in c and d, he e ice inc ea e f m $25 $30; and c in e and f, he e ice inc ea e f m $40 $45. d S a e he gene al inci le ab ha calc la i n h . al e f he PED al ng he aigh -line demand c e Determinants of price elasticit of demand We ill n c n ide he fac ha de e mine he he he demand f ag d i ela ic inela ic. Number and closeness of substitutes The m e b i e a g d ( e ice) ha , he m e ela ic i i demand. If he ice f a g d i h man b i e inc ea e , c n me can i ch he b i e d c , he ef e e l ing in a ela i el la ge d (la ge e n i ene ) in an i demanded. F e am le, he e a e man b and f h a e, hich a e cl e b i e f each he . An inc ea e in he ice f ne, i h he ice f he c n an ill lead c n me i ch he he ; hence demand f a ecific h a e b and i ice ela ic. If a g d e ice ha fe n b i e , hen an inc ea e in ice ill b ing f h a ela i el mall d in an i demanded. An inc ea e in he ice f e l (ga line) i likel lead a ela i el mall dec ea e in an i demanded, beca e he e a e n cl e b i e ; he ef e, demand f e l i ice inela ic. Al im an i he cl ene f b i e .F b i e han C ca-C la and ange j ice; e b i abi i . The cl e b i e ae demanded a change in he ice f he b i he c n me i ch f m ne d c he e am le, C ca-C la and Pe i a e m ch cl e a ha C ca-C la and Pe i ha e g ea e each he , he g ea e he e n i ene f an i e, hence he g ea e he PED, beca e i i ea ie f he . A fac ha affec he n mbe f b i e i he he he g d i defined b adl na l .F e am le, f i i a b ad defini i n in c m a i n ecific f i like ange , a le and ea , hich a e na l defined. If e had c n ide ed f i in ela i n f d, f d i b ad and f i i na . The in he e i ha he na e he defini i n f a g d, he g ea e he n mbe f cl e b i e and he m e ela ic he demand. The demand f a le i m e ela ic han he demand f f i ; demand f f i i m e ela ic han he demand f f d. Simila l , a H nda ha a highe PED han all ca c n ide ed ge he . Necessities versus lu uries Necessities a e g d e ice e c n ide be e en ial nece a in li e ; e cann d ih hem. Lu uries a e n nece a e en ial. The demand f nece i ie i le ela ic han he demand f l ie . F e am le, he demand f medica i n end be e inela ic beca e e le heal h life de end n hem; he ef e, an i demanded i n e e n i e change in ice. The demand f f d i al inela ic, beca e e le cann li e i h i . On he he hand, he demand f diam nd ing i ela ic a m e le ie hem a l ie . In gene al, he m e nece a a g d, he le ela ic he demand. A ecial ca e f nece i i a c n me addic i n a g d. The g ea e he deg ee f addic i n b ance (alc h l, ciga e e , and n), he m e inela ic i he demand. A ice inc ea e ill n a b ing f h a ignifican ed c i n in an i demanded if ne i e e el addic ed. Length of time The l nge he ime e i d in hich a c n me make a cha ing deci i n, he m e ela ic he demand. A ime g e b , c n me ha e he ni c n ide he he he eall an he g d, and ge inf ma i n n he a ailabili f al e na i e he g d in e i n. F e am le, if he e i an inc ea e in he ice f hea ing il, c n me can d li le i ch he f m f hea ing in a h e i d f ime, and he ef e demand f hea ing il end be inela ic e h ei d. B a ime g e b , he can i ch he hea ing em , ch a ga , he can in all be e in la i n, and demand f hea ing il bec me m e ela ic. Proportion of income spent on a good The la ge he i n f ne inc me needed b a g d, he m e ela ic he demand. An i em ch a a en ake a e mall i n f ne inc me, he ea a ca ake a m ch la ge i n. F he ame e cen age inc ea e in he ice f en and in he ice f ca , he e n e in an i demanded i likel be g ea e in he ca e f he ca han in he ca e f en . TEST YOUR UNDERSTANDING 3.4 1 Iden if and e lain he de e minan f 2 S a e in hich ca e demand i likel and h : be m e ela ic in each f he f ll a b ch c la e Cadb ange j ice ice ela ici f demand. ing ai fg d, ch c la e ae c ciga e e ee d a n e ad e hea ing il in ne eek f b ead ac m e in ne ea mea . Applications of price elasticit of demand P ice ela ici f demand i a e im f he e ill be c n ide ed bel ; he an c nce in ec n mic , i h n me ill be died in la e cha e . a lica i n . S me PED and total revenue PED and the effects of price changes on total revenue Total revenue (TR) i he am n f m ne e al he ice (P) f he g d ime he ecei ed b fi m hen he ell a g d ( e ice), and i an i (Q) f he g d ld. The ef e, TR = P Q. REAL WORLD FOCUS 3.1 What happens when demand is highl price inelastic? A gi l ell lem nade a a and f 50 cen (= $0.50) a c . On a e h da , he lem nade bec me e en m e la , and he gi l eali e he can ai e he ice a li le and ill ell all he lem nade. One af e n n, a diabe ic b c me al ng a king f lem nade i h e a ga beca e hi bl d ga ha fallen dange l l le el . The gi l ee an ni and inc ea e he ice b 500%. The b d e n ha e en gh m ne , b he ell him he ill gi e him he lem nade igh a a ided he mi e n h me af e a d, ge he m ne and e n a he he f ll ice. Ha ing n ch ice, he b ag ee . Figure 3.5: Li le gi l elling lem nade Appl ing our skills 1 2 a De c ibe he b b Iden if ice ela ici ha de e minan Wha ld ha e ha faced i h a 500% inc lem nade. Sources: Ada ed f ega di g hea h ca e f demand f f PED acc n f ee lem nade a ha a ic la m men . hi . ened he an i f lem nade demanded if he he child en e e ea e in i ice? E lain in e m f hei ice ela ici f demand f Te Se a i, F ee a e d a a i The De e e Ne , 15 N e be 2009. d he igh hi g We a e in e e ed in e amining ha ill ha en he fi m al e en e (TR) hen he e i a change in he ice f he g d i d ce and ell . We kn ha an inc ea e in P lead a dec ea e in Q demanded and ice e a. Wha can e a ab he e l ing change in al e en e? Will i inc ea e, dec ea e a he ame? The change ill de end n ice ela ici f demand f he g d. We ha e he f ll ing h ee ibili ie : Demand is elastic (PED > 1) When demand i ela ic, an inc ea e in ice ca e a fall in al e en e, hile a dec ea e in ice ca e a i e in al e en e. T ee h , c n ide ha if demand i ela ic, PED>1, an inc ea e in ice e l in a i na el la ge dec ea e in an i demanded. F e am le, if ice i e b 10% an i demanded ill fall b m e han 10%. The dec ea e in an i ha a bigge im ac n al e en e han he inc ea e in ice; he ef e, al e en e fall . If he e i a ice dec ea e, a 10% ice fall e l in a la ge han 10% inc ea e in an i demanded, and al e en e inc ea e . When demand i ela ic, an inc ea e in ca e a i e in al e en e. ice ca e a fall in al e en e, hile a dec ea e in ice Demand is inelastic (PED < 1) When demand i inela ic, an inc ea e in ice ca e an inc ea e in al e en e, hile a dec ea e in ice ca e a fall in al e en e. Since PED < 1, an inc ea e in ice ca e a i na el malle dec ea e in an i demanded. F e am le, a 10% ice inc ea e d ce a malle han 10% dec ea e in an i demanded, and al e en e i e . If ice fall , a e cen age ice dec ea e gi e i e a malle e cen age inc ea e in an i demanded and al e en e fall . In b h ca e , he effec n al e en e f he change in ice i la ge han he effec f he change in an i . When demand i inela ic, an inc ea e in ice ca e a fall in al e en e. ice ca e an inc ea e in al e en e, hile a dec ea e in Demand is unit elastic (unitar PED; PED = 1) When demand i ni ela ic, he e cen age change in ice, and al e en e emain c n an . When demand i ni ela ic, a change in ice d e n an i i e al he e cen age change in ca e an change in al e en e. Using diagrams to illustrate PED and the effects of price changes on total revenue Fig e 3.6 h h ee demand c e . The fi h a ice ange he e PED>1, he ec nd a ice ange he e PED<1 and he hi d ni a PED h gh i ange. In all h ee diag am al e en e TR i h n b he ec angle e e en ed b P Q. Elastic demand: as P increases TR falls: P and TR change in opposite directions In Fig e 3.6(a), he e demand i ela ic, a he ini ial ice and an i , P1 and Q1, al e en e i gi en b he m f he ec angle A and B. When ice inc ea e P2 and an i d Q2, al e en e i gi en b he m f he ec angle A and C. D e he ice inc ea e ec angle B a l and he ec angle C a gained. Since he l (B) i la ge han he gain (C), al e en e fell. We can e he ame diag am e l e a ice dec ea e hen PED > 1, im l b a ini ial ice and an i a e P2 and Q2; ice hen fall P1 hile an i inc ea e TR i gi en b ec angle B, hich i g ea e han he l h n b ec angle C, h inc ea e . ming ha he Q1. The gain in al e en e Inelastic demand: as P increases TR increases: P and TR change in same direction The e e l can be een in Fig e 3.6(b). Wi h a ice inc ea e, al e en e gained ( ec angle C) i la ge han al e en e l ( ec angle B); he ef e, al e en e inc ea e . If ice fall f m P2 P1, he gain in al e en e ( ec angle B) i malle han he l ( ec angle C) and al e en e fall . Unitar PED: an change in P leaves TR unchanged In Fig e 3.6(c), a ice and an i change, he gain in and al e en e emain nchanged. al e en e i e ac l ma ched b he l , Figure 3.6: PED and al e en e Calculating total revenue at different points on the demand curve We can e he inf ma i n in Fig e 3.6 calc la e al e en e a ice change . In Fig e 3.6(a) he e demand i ela ic, ini iall TR = P1 Q1= 4 11 = $44. Af e he ice inc ea e TR = P2 Q2 = 5 8 = $40. The ef e he inc ea e in ice ca ed a fall in al e en e, c nfi ming he in ha hen demand i ela ic P and TR change in i e di ec i n . In Fig e 3.6(b) demand i inela ic. Ini iall TR = P1 Q1 = 5 14 = $70. Af e he ice inc ea e TR = P2 Q2 = 7 12 = $84. The ice inc ea e he e led an inc ea e in al e en e c nfi ming he in ha hen demand i inela ic ice and al e en e change in he ame di ec i n. PED and firm pricing decisions The ab e di c i n h ha b ine e m ake PED in acc n hen c n ide ing change in he ice f hei d c . If a b ine an inc ea e al e en e, i m d i ice if demand i ela ic, inc ea e i ice if demand i inela ic. If demand i ni ela ic, he fi m i nable change i al e en e b changing i ice. A fi m al e en e h ld n be c nf ed i h Figure 3.7: PED, indi ec a e and g e nmen a fi . P fi i al e en e min al c . e en e PED and indirect ta es G e nmen f en im e a e n ecific g d . S ch a e a e a e f i di ec a ( be di c ed in Cha e 4). If g e nmen a e in e e ed in inc ea ing hei a e en e , he m c n ide he PED f he g d be a ed f he f ll ing ea n. The l e he ice ela ici f demand f he a ed g d, he g ea e he g e nmen a e en e . Thi can be een in Fig e 3.7, h ing he ca e f inela ic demand in a (a) and ela ic demand in a (b).3 When a a i im ed n a g d, i ha he effec f hif ing he l c e a d. The ea n i ha f e e le el f he fi m i illing and able l he ma ke , i m ecei e a ice ha i highe han he iginal ice b he am n f he a . (Thi i e i alen a lef a d hif f he l c e; f an e lana i n ee Q an i a i e echni e cha e in he 'Digi al c eb k: E a ma e ial' ec i n.) The c e hif f m S1 S2 ha he e ical di ance be een S1 and S2 i e al he am n f he a e ni f . The ne , af e - a e ilib i m cc a ice P and an i Q , de e mined b he in e ec i n f he demand c e, D, and he ne l c e, S2. The haded a ea e e en he g e nmen a e en e, b ained b m l i l ing he am n f a e ni ime he n mbe f ni , an i Q . A c m a i n f he fig e indica e ha a e en e i la ge hen demand i inela ic. Thi e l f ll f m he inci le ha hen demand i inela ic (0 <PED < 1), an inc ea e in ice (he e d e he inc ea e in he a ) lead a i na el malle dec ea e in an i demanded, and hence an inc ea e in al e en e (i.e. a e en e). Indi ec a e a e he ef e all im ed n g d like ciga e e and e l (ga line), hich ha e a l PED. TEST YOUR UNDERSTANDING 3.5 1 E lain and h , ing diag am , h al e en e ill change if a ice inc ea e and demand i ela ic, b ice dec ea e and demand i inela ic, c ice inc ea e and demand i d ice inc ea e and demand i inela ic, e ice dec ea e and demand ha f ice dec ea e and demand i ela ic. e fec l inela ic, ni ela ici , and 2 U ing diag am , di c h a fi m kn hel i in i icing deci i n . 3 Refe 4 ice ela ici f demand f i d c can Fig e 3.2 in hi cha e . a Calc la e he change in al e en e hen ice inc ea e f m $4 $5. b Calc la e he change in al e en e hen ice inc ea e f m $1 $2. c Gi en e l in (a) and (b), c mmen n he i e f he PED f $4 $5, and he i e f he PED f a ice change f m $1 $2. d Calc la e PED f (HL nl ) Refe ing he ice change c nfi m Fig e 3.4 calc la e he change in a ice inc ea e f m $10 $15, and b ice inc ea e f m $40 $45. c 5 ledge f an a ice change f m e . al e en e ha e l N ing hen al e en e inc ea ed and hen i dec ea ed, e lain ha h ab PED al ng a aigh -line demand c e. hen: calc la i n The g e nmen ld like le indi ec a e n ce ain g d ai e a e en e. U ing diag am , e lain h ice ela ici f demand can hel i decide hich d c i h ld a . PED in relation to primar commodities and manufactured products (HL onl ) Wh man primar commodities have a lower PED compared with the PED of manufactured products Primar commodities a e g d a i ing di ec l f m he e f na al e ce , he fac f d c i n land ( ee Cha e 1). P ima c mm di ie he ef e incl de ag ic l al, fi hing and f e d c , a ell a d c f e ac i e ind ie ( il, c al, mine al , and n). Ag ic l al d c incl de f d, a ell a he , n n-edible c mm di ie ( ch a c n and bbe ). Man ima c mm di ie ha e a l PED, hich i all l e han he PED f man fac ed d c (a ell a e ice ). Manufactured products a e g d d ced b lab all king ge he i h ca i al a ell a a ma e ial , ch a f e am le ca , c m e and ele i i n . F d ha a highl ice inela ic demand, beca e i i a nece i and i ha n b i e . The ame a lie a a ie f he ima d c ( ch a il and mine al ). In he ca e f f d, in de el ed c n ie he PED i e ima ed be be een 0.20 and 0.25. B c n a , he demand f man fac ed d c end be m e ice ela ic, beca e he e d c , h gh he ma be nece i ie (in me ca e ), all d ha e b i e . The ef e, gi en a ice change, an i demanded i gene all m e e n i e in he ca e f man fac ed d c c m a ed i h ima c mm di ie . (N e, h e e , ha he e a e e ce i n . F e am le, medica i n a e man fac ed d c , e hei demand end be inela ic beca e he a e nece i ie and ha e n b i e .) Man ima c mm di ie ha e a ela i el l PED ( ice inela ic demand) beca e he a e nece i ie and ha e n b i e (f e am le, f d and il). The PED f man fac ed d c i ela i el high ( ice ela ic demand) beca e he all ha e b i e . Consequences of a low PED for primar commodities (Supplementar material) L ice ela ici f demand, ge he i h fl c a i n in l e h e i d f ime, c ea e e i blem f ima c mm di d ce , beca e he e l in la ge fl c a i n in ima c mm di ice , and he e al affec d ce inc me . C n ide he diag am in Fig e 3.8. Pa (a) h ela i el inela ic demand ( ch a f ima c mm di ie ) and a (b) h ela i el ela ic demand ( ch a f man fac ed d c ). Figure 3.8: P ice fl c a i n a e la ge f ima c mm di ie beca e f l PED B h diag am h he effec n ice and an i hen he e i a dec ea e in l (f m S1 S2) and hen he e i an inc ea e in l (f m S1 S3). A c m a i n f he diag am e eal ha hif in he l c e e l in la ge ice fl c a i n hen demand i inela ic, and m ch milde ne hen demand i ela ic. La ge ice fl c a i n e h e i d f ime a e efe ed a ice a i i . (V la ili mean in abili high a iabili .) Fig e 3.8 e lain he ea he end T e l f ll h , in he eal ld, ice f ima c mm di ie can be highl be m ch le in he man fac ing and e ice ec . f m hi : la ile, A ima c mm di ice fl c a e idel , d d ce e en e ( ice an i ) d ce ecei e f m elling hei inc me , . hich de end n he In ie f he ela i n hi be een PED and al e en e ( ee ab e), a fall in he l fa ima c mm di i h inela ic demand (f m S1 S2 in Fig e 3.8(a)) lead an inc ea e in al e en e f d ce beca e he e cen age inc ea e in ice i la ge han he e cen age dec ea e in an i . An inc ea e in l lead l e e en e ( he e cen age dec ea e in ice i la ge han he e cen age inc ea e in an i ). The e in lead me ne ec ed c ncl i n . The h ha a c in ag ic l e, a d e ea he c ndi i n , hich e l in a fall in l (S2 in Fig e 3.8(a)), lead highe ice and highe al e en e f fa me . A g d c e l ing in a l inc ea e, S3, lead l e ice and l e fa me e en e . We c me, he ef e, he i nic c ncl i n ha a c ma be g d f fa me hile a g d c ma be bad f hem. If l f ag ic l al d c e e ela i el able, he blem ld be le e i a ag ic l al d c ice ld al be m e able. H e e , ag ic l al d c i n de end n man fac be nd he fa me c n l, ch a d gh , e , fl d , f and he ch na al di a e , a ell a e ce i nall g d ea he c ndi i n , hich cc e h e i d f ime. The e ca e f e en and la ge l change ( l c e hif ). The blem f n able fa me e en e i an im an ea n behind g e nmen in e en i n fa me inc me , hich e ill d in Cha e 4. The im lica i n f n able ima d c ice f fa me e en e and he ec n m ill be e l ed in Cha e 19 . TEST YOUR UNDERSTANDING 3.6 1 1 S e fl ding de ha i likel ha en d ce i inela ic. a b an ial i n f hi ea n c . U ing diag am , e lain fa me e en e , a ming he demand f he d c he 2 a U ing e am le , e lain h man ima c mm di ie ha e a ela i el l hile man man fac ed d c ha e a ela i el high PED. b U e he c nce f PED and diag am e lain h ag ic l al d c ice end fl c a e m e (a e m e la ile) c m a ed i h man fac ed d c ice e he h e m. (O i nal) Y ma n e ha he al e f hi c mbina i n. In he calc la i n ab ice an i c mbina i n, e diffic l can be e c me b e mid in f m la: PED = In he Q X a e age Q X e i PED ela ici f demand de end n he ch ice f he ini ial ice an i e, hi a aken be 300, 5000. If e had aken 255, 6000 a he ini ial ld ge a PED al e f 0.94. (Y c ld calc la e hi a an e e ci e.) Thi f he mid in f m la . N e ha ae n e i ed kn he P X a e age P X e am le, PED= 1000 5500 45 277.5 =1.12, he e 5500= (5000+6000) 2 and 277.5= (255+300) 2 i.e. e e he a e age f he ini ial P . N e ha a en 2 Q al e and he a e age f he P e i ed kn he mid in f m la. al e in ead f he ini ial Q and I ma be n ed ha ic l eaking he l e f he demand c e i Q/ P. The ea n i ha ma hema icall he l e i defined a he change in he de enden a iable di ided b he change in he inde enden a iable. In he ca e f demand, Q i he de enden a iable and P i he inde enden a iable. H e e beca e f he ac ice f e e ing he P and Q a e , and ing P n he e ical a i , e ma ake he l e a being P/ Q. In an ca e hi d e n make an diffe ence he in f he a g men in he e beca e b h Q/ P and P/ Q a e c n an al ng a aigh line. 3 N e e a e a ming ha he demand c e a e d a n n he ame cale, and ha if he he ame diag am he ld in e ec , he ef e he PED a e c m a able. e e d a n in 3.2 I (YED) LEARNING OBJECTI ES Af er d ing hi ec ion o ill be able o: define all he erm appearing in e he form la for income ela ici q an i demanded (AO4) in he e (AO1) of demand (YED) o calc la e YED, change in income and dra an Engel c r e diagram o ho income ela ic, income inela ic and inferior good (AO4) depending on he ign of YED, di ing i h be een normal and inferior good (AO2) depending on he al e of YED (le han one or grea er han one), di ing i h be een nece i ie , er ice and l r good (AO2) appl YED o (HL onl ) (AO3) di c i rele ance o firm di c change in he ec oral r c re of an econom I Con mer income i an impor an fac or infl encing demand for a good and he po i ion of he demand c r e. We ha e alread enco n ered he role of income in Chap er 2, here e a ha income i a fac or ha ca e demand c r e hif ( ee Chap er 2). I (YED) i a mea re of he re pon i ene of demand o change in income, and in ol e demand c r e hif . I pro ide informa ion on he direc ion of change of demand gi en a change in income (increa e or decrea e) and he i e of he change ( i e of demand c r e hif ). C YED, The form la for YED ha he ame ba ic form a he o her ela ici form lae, and ho he rela ion hip be een he percen age change in q an i demanded of a good, X, and he percen age change in income, hich e abbre ia e a Y: income ela ici of demand (YED) = percen age change in q an i demanded of good percen age change in income YED= % Q % P Which can be re ri en a : Q Q 100 Y Y 100 = Q Q Y Y here Q = Qfinal al e Qini ial al e Q = Qini ial al e Y = Yfinal al e Yini ial al e P = Yini ial al e S ppo e o r income increa e from $800 per mon h o $1000 per mon h, and o r p rcha e of clo he increa e from $100 o $140 per mon h. Wha i o r income ela ici of demand for clo he ? YED= 40 100 200 800 = 0.40 0.25 =+1.6 Yo r income ela ici demand for clo he i +1.6. If e kno YED and he percen age change in q an i demanded, i i imple o calc la e he percen age change in income. S ppo e YED = 0.75 and q an i demanded of a normal good ha increa ed b 15%. The percen age change in income i fo nd b aking YED=0.75= 0.15 % Y ⇒0.75 % Y=0.15⇒% Y =0.20 or 20%. Income increa ed b 20%. Similarl if e kno YED and he percen age change in income, e can calc la e he percen age change in q an i demanded. S ppo e YED = 1.25 and income increa e b 20%. The percen age change in Q i fo nd b : YED=1.25= % Q 0.20 ⇒% Q=1.25 0.20=0.25 or 25% Q an i demanded increa ed b 25%. I Income ela ici of demand pro ide o kind of informa ion: he ign of YED: po i i e or nega i e he n merical al e of YED: he her i i grea er or maller han one (a T ming i i po i i e). : The ign of YED ell he her a good i normal or inferior: YED > 0. A po i i e income ela ici of demand indica e ha he good in q e ion i normal; demand for he good and income change in he ame direc ion (bo h increa e or bo h decrea e). Mo good are normal good ( ee Chap er 2). YED < 0. A nega i e income ela ici of demand indica e ha he good i inferior: demand for he good and income mo e in oppo i e direc ion (a one increa e he o her decrea e ). E ample incl de b ride , ed clo he and ed car ; in he e ca e , a income increa e , he demand for he e good fall a con mer i ch o con mp ion of normal good (ne car , ne clo he and o on; ee Chap er 2). The difference be een normal and inferior good can be een in Fig re 3.9, ho ing a demand c r e, D1, and hif of he c r e ha occ r in re pon e o increa e in income. A income increa e , he demand c r e hif righ ard from D1 o D3 or D4 hen good are normal (YED > 0), b hif lef ard o D2 hen good are inferior good (YED < 0). T : , Here e are making a di inc ion be een good ha ha e a YED ha i po i i e and le han one: han or grea er YED < 1: Necessities. If a good ha a YED ha i po i i e b le han one, i ha : a percen age increa e in income prod ce a maller percen age increa e in q an i demanded. Nece i ie are income inela ic good . YED > 1: Lu uries and ser ices. If a good ha a YED ha i grea er han one, i ha : a percen age increa e in income prod ce a larger percen age increa e in q an i demanded. L rie and er ice are income ela ic. Nece i ie , ch a food, clo hing and ho ing, end o ha e a YED ha i po i i e b le han one; he are normal good ha are income inela ic. In he ca e of food, a income increa e , people b more food b he amo n of income pen on food increa e more lo l han income. In de eloped co n rie , YED for food i abo 0.15 o 0.2. Thi mean ha a 1% increa e in income prod ce a 0.15% o 0.2% increa e in pending on food; or a 10% increa e in income re l in a 1.5% o 2% increa e in pending on food. B con ra , l rie , ch a je eller and e pen i e car , a ell a man er ice , ch a ra el o o her co n rie , pri a e ed ca ion and ea ing in re a ran are income ela ic: a income increa e , he amo n of income pen on ch good increa e fa er han income ( he denomina or in he YED form la i maller han he n mera or). Wha i a nece i and ha i a l r depend on income le el . For people i h e remel lo income , e en food and cer ainl clo hing can be l rie . A income increa e , cer ain i em ha ed o be l rie become nece i ie . For e ample, i em like Coca-Cola and coffee for man poor people in le de eloped co n rie are l rie , herea for con mer in de eloped co n rie he ha e become nece i ie . Income ela ici of demand for par ic lar i em herefore arie idel depending on income le el . While YED for food i abo 0.15 0.20 in more de eloped co n rie , i i abo 0.8 in poor co n rie . For an increa e in income of 10%, pending on food increa e b onl 1.5% 2% in rich co n rie and b 8% in poor co n rie . In Fig re 3.9, e ee ha in he ca e of nece i ie , an increa e in income ill prod ce a rela i el mall righ ard hif in he demand c r e; in he ca e of l rie and er ice , he righ ard hif ill be larger. F 3.9: Demand c r e hif in re pon e o increa e in income for differen YED TEST O R NDERSTANDING 3.7 1 E plain he meaning of income ela ici demand c r e? 2 E plain he difference be een normal and inferior good and pro ide e ample of each. 3 Yo r income increa e from 1000 a mon h o 1200 a mon h. A a re l , o increa e o r p rcha e of pi a from 8 o 12 per mon h, and o decrea e o r p rcha e of chee e and iche from 15 o 10 per mon h. Calc la e o r income ela ici of demand. Wh do e a i in ol e a hif ing of demand for pi a and for chee e and iche . Wha kind of good are pi a and chee e and iche for o ? Sho ing diagram he effec of o r increa e in income on o r demand for pi a and chee e and iche . 4 T A 15% increa e in income lead o a 10% increa e in demand for good A and 20% increa e in demand for good B. Iden if hich of he o good i income ela ic and hich i income inela ic. Iden if hich of he o good i likel o be a nece i good and hich a l r good. E The Engel c r e i a far more acc ra e a o ill ra e YED han demand c r e hif . I i named af er Ern Engel, a German a i ician and economi ho li ed in he 19 h cen r , and ho a he fir o d he rela ion hip be een con mer income and demand for a prod c . An Engel c r e i ho n in Fig re 3.10, here he er ical a i mea re he income of a con mer per eek, he hori on al a i mea re he q an i of ho dog he or he b each eek, hile he olid line ho he c r e i elf. We can ee raigh a a ha ho dog are a normal good from poin A o poin C, ince a income increa e from $100 o $250, he q an i increa e from 4 ho dog o 9 ho dog . A income increa e f r her o $350 he q an i remain con an a 9 ho dog , b a income increa e e en more he q an i fall from 9 o 8 ho dog . We can ee herefore ha hen income goe abo e $350, ho dog become an inferior good for hi con mer. Wi h income on he er ical a i and q an i can ee he follo ing: on he hori on al a i of an E YED>0 in he p ard loping par of he c r e ho ing q an i hich indica e he good i normal YED<0 in he do n ard loping par ho ing q an i indica e he good i inferior. diagram, e and income bo h increa ing, decrea ing a income increa e , hich The Engel c r e can al o ho he her a good i income inela ic or income ela ic. In Fig re 3.10, for er lo income le han $150, ho dog are a l r a YED>1. A he higher income le el be een $250 and $350, ho dog ha e become a nece i a YED < 1. There i a imple r le ha allo loping par of he Engel c r e. o di ing i h be een a l r and a nece i on he p ard Imagine each egmen of he Engel c r e e ending back ard o o ch ei her he er ical a i or he hori on al a i , a ho n b he do ed line : YED>1 if he line o che he er ical a i , a YED<1 if he line o che he hori on al a i , a i h he line AB, o ha i i a l r or er ice i h line BC, o ha i i a nece i . F 3.10: The Engel c r e ho ing differen YED (The ma hema icall inclined den can ea il ee h YED= Q Q Q Y = Q Y YQ=YQ Y Q hi i o. A e kno Imagine no a line joining he origin i h poin B on he Engel c r e. The lope of hi line i Y/Q. No e al o ha he lope of he Engel c r e i Y/ Q. Therefore YED ha been ri en a he ra io of he o lope : lope of OB/ lope of Engel c r e. No no e ha OB i eeper han AB, herefore he lope of OB> he lope of he Engel c r e from A o B, and o YED>1 p o poin B. On he o her hand, OB i fla er han BC, herefore he lope of OB< he lope of he Engel c r e from B o C, and o YED < 1 from B o C.) The Engel c r e ho a con in m: a er lo income a good ma be a l r ; a income increa e i become a nece i and finall a high income le el i become inferior. The informa ion in Fig re 3.10 can be ill be gi en o o a an e erci e. ed o calc la e YED in order o confirm he abo e poin . Thi TEST O R NDERSTANDING 3.8 1 Dra an Engel c r e for a pical good and e plain ho i change from income ela ic o income inela ic o inferior a income increa e . 2 De cribe h income ela ici of demand for food ha been e ima ed o be abo more de eloped co n rie and abo 0.8 in le de eloped co n rie . 3 U ing he informa ion in Fig re 3.10, calc la e YED for an increa e in income from $100 o $150, 0.15 o 0.2 in $150 o $250, $250 o $350, and $350 o $450. E plain ha o r re l for he e YED ell o abo ario income le el . A YED he na re of he good for he (HL ) : O er ime, a co n rie e perience economic gro h, ocie income increa e . Increa ing income mean a gro ing demand for good and er ice . S ppo e ha o al income in an econom gro a an a erage ra e of abo 3% per ear. If good and er ice ha e income ela ic demand (YED > 1), hi mean ha demand for he e good and er ice gro a a higher ra e han 3%. E ample all incl de re a ran , mo ie , heal h care and foreign ra el. O her good and er ice ha e income inela ic demand (YED < 1), meaning ha he demand for he e gro a a ra e of le han 3%. E ample incl de food, clo hing and f rni re. The fir gro p ( i h he ela ic demand) incl de good and er ice prod ced b ind rie ha gro and e pand fa er han o al income in he econom , hile he econd gro p incl de good or er ice prod ced b ind rie gro ing more lo l han o al income. The higher he YED for a good or er ice, he grea er he e pan ion of i marke i likel o be in he f re; he lo er he YED, he maller he e pan ion. Prod cer in ere ed in prod cing in an e panding marke ma herefore an o kno YED of ario good and er ice . In con ra o period of economic gro h, if an econom i e periencing a rece ion (falling o p and income , ee Chap er 8), good and er ice i h high YED (YED>1) are he harde hi , e periencing he large decline in ale . Prod c i h lo YED (YED<1) can a oid large fall in ale , hile inferior good (YED<0) can e en e perience increa e in ale . YED The implica ion of differing YED for he econom follo from ha happen o par ic lar ind rie in he econom a income gro , di c ed abo e. E er econom ha hree ec or (or par ): he primar ec or incl ding primar prod c (agric l re, fore r , fi hing and e rac i e ind rie ), he man fac ring ec or and he er ice ec or (incl ding en er ainmen , ra el, banking, in rance, heal h care, ed ca ion, and o on). Wi h economic gro h, he rela i e i e of he hree ec or all change o er ime, and he e change can be e plained in erm of income ela ici of demand. Agric l re, he main par of he primar ec or, prod ce food, hich a no ed abo e ha a YED ha i po i i e b le han one (i i income inela ic). A ocie income gro o er ime, he demand for agric l ral o p gro more lo l han he gro h in income. O her primar prod c al o ha e a lo income ela ici of demand. For e ample, co on and r bber ha e n he ic b i e , o a income increa e a rela i el larger propor ion of i i pen on he n he ic ma erial , hile a rela i el lo er frac ion goe o ard co on and r bber. B con ra , man fac red prod c (car , ele i ion , comp er , and o on) ha e a YED ha i all grea er han one (income ela ic), o ha a ocie income gro , he demand for he e prod c gro fa er han income. Man er ice ha e e en higher YED , o he percen age increa e in he demand for he e i m ch larger. Therefore, o er ime, he hare of agric l ral o p in o al o p in he econom hrink , hile he hare of man fac red o p gro . Wi h con in ed gro h, he er ice ec or e pand a he e pen e of bo h agric l re and man fac ring. REAL ORLD FOC S 3.2 I According o he World Bank (an in erna ional organi a ion ha lend o de eloping co n rie , ee Chap er 20), he global ra e of gro h in demand for agric l ral commodi ie like rice and hea ill fall from an a erage of 2.8% per ear in he period 2010 2016 o an a erage of 1.8% in he period 2017 2018. The rea on for hi e pec ed rend i ha a con mer income increa e, con mer i ch from commodi ie like rice and hea o o her food ha ha e a high pro ein and fa con en . F 3.11: A Nepali oman inno ing rice, hich i he major crop in Nepal A 1 E plain he meaning of income ela ic demand and income inela ic demand. 2 Ba ed on he informa ion in he e , o line o r concl ion abo he YED of commodi ie like rice and hea , in compari on i h he YED of food i h a high pro ein and fa con en . In o her ord , hich of he o i likel o be grea er? 3 E plain h good and er ice from ri ing con mer income . i h highl income ela ic demand and o gain he mo S : Mana Chakra ar World Bank a o eaken , 13 J ne 2018, Li emin long erm gro h in commodi con mp ion F 3.12: Changing rela i e hare (a percen age of o al o p ) of primar , man fac ring and er ice ec or for a h po he ical econom a i gro In Fig re 3.12, hi i ho n for a h po he ical gro ing econom in he change of rela i e ec or i e from par (a) o (b) o (c). Economicall le de eloped co n rie all ha e a large primar ec or d e o he impor ance of agric l re and e rac i e ac i i ie , hile man fac ring and er ice are far le impor an . The de eloped co n rie of oda ere in a imilar po i ion man decade ago. The hi orical e perience of bo h more and le de eloped co n rie ho ha i h economic gro h, he primar ec or become le and le impor an , and i par l replaced b man fac ring and er ice . A he econom gro f r her, he rela i e impor ance of he primar ec or con in e o hrink, and man fac ring become increa ingl replaced b er ice . Th , hile le de eloped co n rie are all domina ed b he primar ec or, more de eloped co n rie are domina ed b er ice . In he de eloped orld oda , among he ind rie e periencing he fa e gro h are er ice , incl ding ed ca ion, heal h care, ra el and financial er ice . No e ha if o al o p i increa ing o er ime, a falling hare for a par ic lar ec or ( ch a he primar ec or) doe no nece aril mean ha primar ec or o p i falling. Mo likel i mean ha hi ec or o p i gro ing, b more lo l han o al o p . An increa ing hare for a ec or mean ha i o p i gro ing more rapidl han o al o p . TEST O R NDERSTANDING 3.9 1 Di c 2 E plain a likel rea on behind he ob er ed rapid gro h in cer ain er ice ind rie , incl ding heal h care, ed ca ion and financial er ice , compared i h o her ind rie a food (in he primar ec or) and f rni re (in he econdar ec or). 3 h firm o ld be in ere ed in kno ing he YED of ario good and er ice . Di c he role of YED in he ob er ed pa ern of change in he rela i e hare of he primar , econdar and er iar ec or in he econom a a co n r gro and de elop . ch 3.3 Price elasticit of suppl (PES) LEARNING OBJECTIVES Af e d ing hi ec ion o ill be able o: define all he e m appea ing in orange bold in he e e he fo m la fo p ice ela ici change in q an i (AO4) iden if he a io of (AO1) ppl (PES) o calc la e PES, change in p ice and deg ee and ange of al e fo PES (AO2) d a diag am ho ing he ange of al e fo PES, incl ding ela i el ela ic and inela ic ppl ; and con an al e fo pe fec l ela ic ppl , pe fec l inela ic ppl and ni a PES (AO4) anal e he de e minan of PES (AO2) appl PES o anal e he ea on h p ima man fac ed p od c (HL onl ) (AO2) commodi ie gene all ha e a lo e PES han Price elasticit of suppl Understanding price elasticit of suppl Un il no , e ha e died o demand ela ici ie , bo h of hich in ol e con me e pon e . We no n o e amine p ice ela ici of ppl , hich conce n fi m (b ine ) e pon e o change in p ice. Acco ding o he la of ppl , he e i a po i i e ela ion hip be een p ice and q an i pplied: hen p ice inc ea e , q an i pplied inc ea e and ice e a, ce e a b . B b ho m ch doe q an i pplied change? Price elasticit of suppl (PES) i a mea e of he e pon i ene of he q an i of a good pplied o change in i p ice. PES i calc la ed along a gi en ppl c e. In gene al, if he e i a ela i el la ge e pon i ene of q an i pplied, ppl i efe ed o a being ela ic; if he e i a ela i el mall e pon i ene , ppl i e a c. Calculating PES The fo m la fo p ice ela ici of ppl (PES) follo he ame gene al fo m of ela ici fo m lae, onl no e con ide he ela ion hip be een he pe cen age change in he p ice of a good, X, and he pe cen age change in q an i of X pplied: p ice ela ici of ppl (PES) = pe cen age change in q an i of good X PED= % Q % P hich can be e i en a Q Q 100 P P 100 = Q Q P P he e Q = Qfinal al e Qini ial al e Q = Qini ial al e pplied pe cen age change in p ice of good X P = Pfinal al e Pini ial al e P = Pini ial al e Calculating PES, change in price and change in quantit S ppo e he p ice of a be ie inc ea e f om 3 pe kg o 3.50 pe kg, and he q an i of a be ie pplied inc ea e f om 1000 o 1100 onne pe ea on. Calc la e PES fo a be ie . PES= 100 1000 0.50 3.00 = 0.10 0.17 =+0.59 P ice ela ici of ppl fo a be ie i +0.59. If o a e gi en PES and he pe cen age change in q an i pplied, o can find he pe cen age change in p ice b ol ing fo hi ba ed on he fo m la abo e, in e ac l he ame a a in he ca e of PED. Simila l , o can ol e fo he pe cen age change in q an i pplied if o a e gi en PES and pe cen age change in p ice. Interpreting price elasticit of suppl The range of values for PES P ice ela ici of ppl ange in al e f om e o o infini . Beca e of he po i i e ela ion hip be een p ice and q an i pplied, PES i po i i e. The al e of PES in ol e a compa i on of he pe cen age change in q an i pplied ( he n me a o in he fo m la fo PES) i h he pe cen age change in p ice ( he denomina o ). Thi compa i on ield he follo ing po ible al e and ange of al e of PES, hich a e ill a ed in Fig e 3.13 and mma i ed in Table 3.2: Suppl is price inelastic when PES < 1. The pe cen age change in q an i pplied i malle han he pe cen age change in p ice, o he al e of PES i le han one; q an i pplied i ela i el n e pon i e o change in p ice, and ppl i ce e a c o e a c. Fig e 3.13(a) ho an inela ic ppl c e (PES < 1), he e a 10% p ice inc ea e lead o a 5% inc ea e in q an i pplied. When PES < 1, he ppl c e e end p a d and o he igh f om he ho i on al a i ; i end-poin c he ho i on al a i .4 Suppl is price elastic when PES > 1. The pe cen age change in q an i pplied i la ge han he pe cen age change in p ice, o he al e of he PES i g ea e han one; q an i pplied i ela i el e pon i e o p ice change , and ppl i ce e a c o e a c. Fig e 3.13(b) ho an ela ic ppl c e (PES > 1) he e he pe cen age inc ea e in p ice (10%) i malle han he pe cen age inc ea e in q an i (15%). When PES > 1, he ppl c e e end p a d and o he igh f om he e ical a i ; i end-poin c he e ical a i .5 Figure 3.13: S ppl c e and PES In addi ion, he e a e h ee pecial ca e of con an PES along he leng h of he ppl c e: Suppl is unit elastic when PES = 1. The pe cen age change in q an i pplied i eq al o he pe cen age change in p ice, o PES i eq al o one; ppl i e a c; he e i unitar PES. In Fig e 3.13(c), all h ee ppl c e ho n a e ni ela ic ppl c e , i.e. fo all h ee, PES = 1. An ppl c e ha pa e h o gh he o igin ha a PES eq al o ni . The ea on fo hi i ha along an aigh line ha pa e h o gh he o igin, be een an o poin on he line he pe cen age change in he e ical a i ( he p ice) i eq al o he pe cen age change in he ho i on al a i ( he q an i ). The efo e, fo line ha pa h o gh he o igin, i i impo an no o conf e he eepne of he c e i h he ela ici of he c e. Suppl is perfectl inelastic when PES = 0. The pe cen age change in q an i pplied i e o; he e i no change in q an i pplied no ma e ha happen o p ice; PES i eq al o e o and ppl i aid o be perfectl inelastic. In Fig e 3.13(d), he ppl c e i e ical a he poin of fi ed q an i pplied, Q1. Thi i he ame a he ppl c e ho n in Fig e 2.7 in Chap e 2. E ample of a e ical ppl c e incl de he ppl of fi h a he momen hen fi hing boa e n f om ea; he ea on en i e ha e of f e h p od ce b o gh o ma ke ; he ppl of Pica o pain ing . Suppl is perfectl elastic when PES = . The pe cen age change in q an i pplied i infini e; an change in p ice lead o an infini el la ge e pon e in q an i pplied; ppl in hi ca e i called perfectl elastic, and i ho n in Fig e 3.13(e) a a ho i on al line. (We ill enco n e ch a ppl c e in Chap e 14.) P ice ela ici ie of ppl mo commonl enco n e ed in he eal o ld a e ho e ep e en ing ela ic o inela ic ppl , i h pe fec l ela ic, pe fec l inela ic and ni ela ic ppl being pecial ca e . No e ha onl hen o ppl c e in e ec ( hen he ha e a p ice and q an i combina ion) i i po ible o make compa i on of p ice ela ici ie of ppl b efe ence o he eepne of he c e . (We ha e he ame condi ion fo making compa i on of PED in he ca e of demand c e a e plained ea lie ). In he ca e of in e ec ing ppl c e , he fla e he ppl c e, he mo e ela ic i i a an gi en p ice. Fo e ample, in Fig e 3.14, a an one pa ic la p ice le el, S3 i mo e ela ic han S2, hich i mo e ela ic han S1. Figure 3.14: The leng h of ime and PES Value of PES Classification Interpretation inela ic q an i ela i el p ice pplied i n e pon i e o q an i ela i el pplied i e pon i e o p ice Frequentl encountered cases 0 < PES < 1 (g ea e han e o and le one) 1 < PES < (g ea e han one and le infini ) ppl han ela ic ppl han Special cases PES = 1 ni ela ic ppl PES = 0 pe fec l inela ic PES = pe fec l ela ic Table 3.2: Cha ac e i ic of p ice ela ici of pe cen age change in q an i pplied eq al pe cen age change in p ice ppl q an i pplied i comple el n e pon i e o p ice ppl q an i pplied i infini el e pon i e o p ice ppl Determinants of price elasticit of suppl We ill no con ide he fac o ha de e mine he he he ppl fo a good i ela ic o inela ic. Length of time An impo an fac o de e mining PES i he amo n of ime fi m ha e o adj hei inp ( e o ce ) and he q an i pplied in e pon e o change in p ice. O e a e ho ime, he fi m ma be nable o inc ea e o dec ea e an of i inp o change he q an i i p od ce . In hi ca e, ppl i highl inela ic, and ma e en be pe fec l inela ic (PES = 0). In Fig e 3.14, hi i ep e en ed b S1. Fo e ample, a fi hing boa pon i e n f om a fi hing ip ha onl o man fi h o ppl in he ma ke . E en if he p ice of fi h i e , he e can be no e pon e in q an i pplied. A he leng h of ime ha fi m ha e inc ea e , he e pon i ene of q an i pplied o p ice change begin o i e, and PES inc ea e . In Fig e 3.14, he ppl c e S2 co e pond o a ime pe iod hen he fi hing boa can be aken o o ea mo e of en, and mo e labo can be hi ed o fi h, o a p ice inc ea e o P2, q an i pplied inc ea e o Q2 ( he 10% p ice inc ea e f om P1 o P2 lead o a 3% inc ea e in q an i pplied, indica ing inela ic ppl , a PES < 1). If an e en longe ime pe iod goe b , he abili of fi m o e pond o p ice change become m ch g ea e . The o ne of he fi hing boa can no no onl hi e mo e labo b can al o b mo e fi hing boa , h g ea l inc ea ing he amo n of fi h ha can be pplied. Thi i ho n b he ppl c e S3, fo hich he p ice P2 gi e i e o he m ch la ge q an i Q3 ( he 10% p ice inc ea e f om P1 o P2 lead o a 15% inc ea e in q an i pplied, indica ing ela ic ppl , a PES > 1). The efo e, he la ge amo n of ime fi m ha e o adj hei inp inc ea e , he la ge he PES. Mobilit of factors of production The mo e ea il and q ickl e o ce can be hif ed o of one line of p od c ion and in o ano he ( he e p ice i inc ea ing), he g ea e he e pon i ene of q an i pplied o change in p ice, and hence he g ea e he PES. Fo e ample, a fa m o ke can mo e mo e ea il f om a be c l i a ion o co n c l i a ion han he ame fa m o ke can mo e o ca p od c ion. Spare (unused) capacit of firms Some ime fi m ma ha e capaci o p od ce ha i no being ed (fo e ample, fac o ie o eq ipmen ma be idle fo ome ho each da ). If hi occ , i i ela i el ea fo a fi m o e pond i h inc ea ed o p o a p ice i e. B if he fi m capaci i f ll ed, i ill be mo e diffic l o e pond o a p ice i e. The g ea e he pa e ( n ed) capaci , he highe he PES ( he mo e ela ic he ppl ). Abilit to store stocks Some fi m o e ock of o p he p od ce b do no ell igh a a . Fi m ha ha e an abili o e ock a e likel o ha e a highe PES fo hei p od c han fi m ha canno o e ock . o Rate at which costs increase If he co of p od cing e a o p inc ea e apidl , hen ppl ill be inela ic, a fi m ill ha e diffic l e panding hei o p ince he a e nlikel o an o inc la ge co . On he o he hand, if he co of p od cing mo e o p i e lo l , i ill be ea ie fo fi m o e pand hei o p o ppl ill be ela ic. Fo e ample, if he p ice of fe ili e i i ing apidl , h ai ing he fa m co of p od c ion, he fa me ill find i mo e diffic l o e pand o p q ickl , he efo e PES i likel o be lo e han if he p ice of fe ili e e e able. TEST YOUR UNDERSTANDING 3.10 1 a E plain he meaning of p ice ela ici b Wh do e a i mea of e e pon i ene ppl . of q an i a gag e c e? 2 Iden if he al e o ange of al e fo each of he follo ing PES , and ho , he hape of he ppl c e ha co e pond o each one: a b 3 pe fec l ela ic ni ela ic ppl ppl c pe fec l inela ic ppl . a Iden if he p ice ela ici in he eal o ld. b Compa e he e b d a ing of ppl ppl c al e o ange of al e ha e ee mo f eq en l e in a ingle diag am. 4 U ing e ample , e plain he de e minan of PES. 5 S ppo e ha in e pon e o an inc ea e in he p ice of good X f om $10 o $15 pe q an i of good X p od ced 6 ing diag am , ni , he a doe no e pond a all d ing he fi eek, b inc ea e f om 10 000 ni c inc ea e f om 10 000 o 18 000 ni o e o ea . Calc la e PES fo each of he e h ee ime pe iod and iden if hen i i p ice ela ic, p ice inela ic o pe fec l inela ic. a E plain ha fac o can acco n fo he diffe ence in he i e of he h ee ela ici ie of q e ion 5. b D a a ppl c diag am. o 12 000 ni o e fi e mon h , and e ha i likel o co e pond o each of he h ee ela ici ie in a ingle Applications of price elasticit of suppl (HL onl ) PES in relation to primar commodities and manufactured products Wh man primar commodities have a lower PES compared with the PES of manufactured products In gene al, p ima commodi ie all ha e a lo e PES han man fac ed p od c . The main ea on i he ime needed fo q an i pplied o e pond o p ice change . In he ca e of ag ic l e, i ake a long ime fo e o ce o be hif ed in and o of ag ic l e. Fa me need a lea a plan ing ea on o be able o e pond o highe p ice . In mo a ea he e i a limi ed amo n of ne land ha can be b o gh in o c l i a ion. In ome egion of he o ld land app op ia e fo ag ic l e i h inking d e o en i onmen al de c ion (ca ed b o e -fa ming ha deple e he oil of mine al needed b c op ). Unde ch condi ion , ha i needed i an inc ea e in o p pe ni of land c l i a ed (c op ield ), b hi eq i e echnological change in ag ic l e, in ol ing ne eed o o he inp ha a e mo e p od c i e, and ake a g ea deal of ime. Al o needed a e mo e and be e i iga ion em , al ho gh man co n ie face a g o ing a e ho age. All he e fac o e plain h a long ime i needed fo he q an i of an ag ic l al commodi o e pond o inc ea e in p ice. In he ca e of o he p ima p od c , ch a oil, na al ga and mine al , ime i needed o make he nece a in e men and o begin p od c ion. Beca e of he co in ol ed, fi m do no e pond q ickl o p ice inc ea e , and ai fo a e io ho age (e ce demand) in he commodi o a i e befo e he ake ac ion o inc ea e p od c ion. Consequences of a low PES for primar commodities (Supplementar material) Ea lie , in o di c ion of p ice ela ici of demand (PED), e a ha p ice inela ic demand fo p ima p od c i an impo an fac o con ib ing o ho - e m p ice and e en e in abili fo p od ce ch a fa me . Inela ic ppl of ag ic l al and o he p ima p od c al o con ib e o p ice and income in abili fo p ima p od c p od ce . Fig e 3.15 ho a fl c a ing demand c e: in pa (a) i in e ac i h inela ic ppl , hich i pical in he ca e of p ima p od c , and in pa (b) i h ela ic ppl , mo e pical of man fac ed p od c . Clea l , p ice fl c a ion a e la ge in he ca e of inela ic ppl . La ge p ice fl c a ion mean la ge e en e fl c a ion , o n able e en e fo p od ce of p ima commodi ie . We ill come back o he implica ion of n able p ice and e en e fo p od ce and fo he econom in Chap e 4 and 19. Figure 3.15: P ice fl c a ion a e la ge fo p ima commodi ie beca e of lo PES Short-term and long-term price elasticities of suppl I a no ed abo e ha ag ic l al p od c (and o he p ima commodi ie ) all ha e lo e p ice ela ici ie of ppl han man fac ed p od c beca e he need mo e ime o e pond o p ice change . Thi gge ha o e longe pe iod of ime he PES of ag ic l al p od c i la ge . Table 3.3 ho ha hi i in fac he ca e. The longe he ime p od ce ha e o make he nece a adj men , he g ea e he e pon i ene of q an i pplied o p ice change ( ee Fig e 3.14). Commodit Short-term PES Long-term PES Cabbage 0.36 1.20 Ca o 0.14 1.00 C c mbe 0.29 2.20 Onion 0.34 1.00 G een pea 0.31 4.40 Toma oe 0.16 0.90 Ca liflo e 0.14 1.10 Cele 0.14 0.95 Table 3.3: Sho - n and long- n PES fo elec ed ag ic l al commodi ie TEST YOUR UNDERSTANDING 3.11 1 a E plain h he PES fo man p ima commodi ie i ela i el lo and fo man man fac ed p od c i ela i el highe . b U e he concep of PES o e plain h ag ic l e m. (Op ional) al p od c p ice a e ola ile o e he ho Summar of PED, ED and PES Table 3.4 p o ide a mma of ke cha ac e i ic of all he ela ici ie con ide ed in hi chap e . Elasticit Possible values Description Examples P ice ela ici of demand PES= % Q % P PED = 0 pe fec l inela ic concep ed in economic heo 0<PED<1 p ice inela ic ga oline, ciga e e , food PED = 1 ni ela ic concep ed in economic heo PED>1 p ice ela ic ach , e pen i e holida PED = pe fec l ela ic concep ed in economic heo Income ela ici of demand YED= % Q % Y P ice ela ici of ppl PES= % Q % P Table 3.4: Ela ici YED > 0 no mal good ne ca , ne clo he YED < 0 infe io good YED >1 income ela ic, l e pen i e ca and clo he , man e ice YED < 1 income inela ic, nece i food, medicine PES = 0 pe fec l inela ic concep ed in economic heo PES <1 p ice inela ic oil and ga oline, ome ag ic l al p od c ed ca , ed clo he PES = 1 ni ela ic PES >1 p ice ela ic an good ha can be p od ced q ickl PES = pe fec l ela ic concep ed in economic heo concep : a concep ed in economic heo mma INQUIRY AND REFLECTION The follo ing q e ion ill help o eflec on o lea ning and enhance o nde anding of ke opic in hi chap e . The a e gge ion fo inq i ie ha o can nde ake on o o n o in g o p in o de o e i e he lea ning objec i e of hi chap e . 1 Re ea ch and find p od c ha a e bjec o indi ec a e in he co n o li e in. Do o hink he a e likel o be p ice ela ic o p ice inela ic? I he go e nmen likel o ha e high o lo e en e a i ing f om he indi ec a e ? 2 Think of ome good ha a e likel o ha e changing YED on acco n of hei being l nece i ie and infe io good depending on he income le el. 3 Con ide a good i h a PES ha ange f om e o, po i i e b le one depending on he ime pe iod and e plain h PES a ie . T de e minan of ppl o e plain o an e . ie , han one, and g ea e han o con ide a man EXAM STYLE QUESTIONS Yo can find q e ion in he le of IB e am in he 'Digi al co 4 The ea oning he e i e ac l he ame a in he ca e of he Engel c Engel c e o che he ho i on al a i . 5 He e, oo, he logic i he ame a in he Engel c ebook: E e a ma e ial' ec ion. he e YED<1 if he e en ion of he e he e YED>1 if he Engel c e o che he e ical a i . C a G c 4 c c BEFORE YOU START Sometimes governments ta goods and services. What might be some reasons for doing so? Sometimes governments give mone government would do this? to (subsidise) certain producers. Wh do ou think Besides ta ing and subsidising, can ou think of other wa s that governments intervene in markets? This chapter will e amine the following t pes of government intervention in markets: price controls: price ceilings price floors indirect ta es subsidies. We will see what effects these policies have on markets and we will evaluate their effects on stakeholders. 4.1 G e e e e a e LEARNING OBJECTIVES A : a ge b d (AO1) (AO2) Wh g I C e e e e e a e 1, .T . I C Ea e e ef he g G e 13. e i di ec a e , , .N 12. I C C 3 , .T 0<PED<1, P , , de / . f G .S .S , ). I , ( ice f b idie .F , , , , a, P a iff C de 14. h eh d c e H ( , , , ). T b idie , ice cei i g di ec ii f e ice , .A , a e , , ; C I f e ce he e e f d c 12 , , a fe 20. ff ( ), , i di ec a e .O . I f e ce e e fc ; fh eh d /c e , I , ( (de e i g ei g ; .M C 5 6. T ii f e ice ( eh d , di ec a dc d) d ). E , ), .T , , , b idie 2), c dge ( C , i di ec a e dge , c a da dc a d eh d . N c a da dc .I - C ec a Ma ke fai C 2 e fa C 1. e e ( C .I 5 7). , , . , , ii P f e ice c ee i di ec a e , eh d .A a da dc (e a b idie , 5 7. ) T ( C .P dge , di ec C ) .A 1, .M , , , .G .S ice cei i g a d b idie . O Wha f c ec C d e g e c e e? e e e a 12 e 20. a e a he T de a d . f ag d e ice, h : , affec i g a ke each f he e e .T c : ( T C 2 , HL). . k i f e ce 4.2 P LEA NING OBJEC I E Af e d ing hi ec ion o ill be able o: define all he e m a ea ing in e lain he con e ence of ice ceiling and d a diag am o ill akeholde (AO4) a e he effec e al a e he effec of ice ceiling and calc la e he effec (AO4) of in he e of (AO1) ice floo on ma ke and akeholde (AO2) ice ceiling and ice floo on ma ke and ice floo on ma ke and akeholde (AO3) ice ceiling and ice floo on ma ke and akeholde (HL onl ) I The fi e of in e en ion e ill con ide in ol e ice con ol . P efe o he e ing of minim m o ma im m ice b he go e nmen (o i a e o gani a ion ) o ha ice a e nable o adj o hei e ilib i m le el de e mined b demand and l . P ice con ol e l in ma ke di e ilib i m, and he efo e in ho age (e ce demand) o l e (e ce l ). P ice con ol diffe in a f ndamen al a f om o he e of go e nmen in e en ion ha e ill d belo (indi ec a e and b idie ). When a a i im o ed o a b id g an ed, he ma ke e e a a e e b , he e he e i a balance of demand i h he ne l . P ice con ol diffe beca e, once he a e im o ed, he do no allo a ne e ilib i m o be e abli hed, and in ead fo ce a i a ion he e he e i e g a e d e b . Ma ke di e ilib i m mean ha he ma ke i e en ed f om eaching a ma ke -clea ing he e eme ge ho age (e ce demand) o l e (e ce l ) ( ee Cha e 2). In he di c ion ha follo , i i im o an o bea in mind ha meaning . In one en e i efe o e ce l e l ing hen an i demanded, a e di c ed in Cha e 2. In he econd con me o od ce ecei e f om b ing o elling ( ee Cha ma o nd, beca e in he econd en e i efe ed o a l o ocial l (o comm ni l ). P ice, and he e m ha o diffe en an i lied i g ea e han en e i efe o he benefi ha e 2). Thi i no a conf ing a i con me l ,o od ce : ? A go e nmen ma in ome i a ion e a legal a ce fo a a ic la good; hi i called a ce ce g. I mean ha he ice ha can be legall cha ged b elle of he good m no be highe han he legal ma im m ice. P ice ceiling a e all e in o de o make ce ain good mo e affo dable o eo le on lo income . Fig e 4.1 ho ho hi o k . The e ilib i m ice i Pe, de e mined b he fo ce of demand and l . The ice ceiling, Pc, i e b he go e nmen a a le el belo he e ilib i m ice, leading o a ho age (e ce demand), ince an i demanded, Qd, i g ea e han an i lied, Q . If he ma ke e e f ee, he fo ce of demand and ha en, beca e he ice hi he legall e l o ld fo ce ice ceiling. ice o Pe. Ho e e , no hi canno No e ha o ha e an effec , he ice ceiling m be be he e ilib i m ice. If i e e highe han he e ilib i m ice, he ma ke o ld achie e e ilib i m, and he ice ceiling o ld ha e no effec . F 4.1: P ice ceiling (ma im m ice) and ma ke o come A i a e belo affo dable o eo le on lo income . he e ilib i m ice, in o de o make good mo e C B im o ing a ice ha i belo he e ilib i m ice, a ice ceiling e l in a lo e an i lied and old han a he e ilib i m ice. Thi i ho n in Fig e 4.1, he e he ice ceiling, Pc, gi e i e o an i , Q , ha fi m l , hich i le han he e ilib i m an i , Qe, ha lie o ld l a ice Pe. In addi ion, he ice ceiling, Pc, gi e i e o a la ge an i demanded han a he e ilib i m ice: he an i con me an o b a ice Pc i gi en b Qd, hich i g ea e han an i , Qe, ha he o ld b a ice Pe. A ice ceiling doe no allo ho age (e ce demand). he ma ke o clea ; i c ea e a i a ion of di e ilib i m he e he e i a C A ice ceiling, Pc, e belo he e ilib i m ice of a good c ea e a ho age. A Pc, no all in e e ed b e ho a e illing and able o b he good a e able o do o beca e he e i no eno gh of he good being lied. In Fig e 4.1, he ho age i e al o Qd Q . N - The e m a g efe o a me hod of di iding ome hing among o ible e ( ee Cha e 2). In a f ee ma ke , hi i achie ed b he ice em: ho e ho a e illing and able o a fo a good ill do o, and he good i a ioned among e acco ding o ho b i ; hi i called ce a g. Ho e e , once a ho age a i e d e o a ice ceiling, he ice mechani m no longe achie e i a ioning f nc ion. Some demande illing and able o b he good a Pc in Fig e 4.1 ill go n a i fied. Ho ill he an i Q be di ib ed among all in e e ed b e ? Thi can onl be done h o gh - ce a g me hod , hich incl de: ai ing in line and he fi -come-fi - e ed he di ib ion of co on o all in e e ed b good in a gi en ime e iod inci le: ho e ho come fi e , o ha he can fa o i i m: he elle can ell he good o hei ( efe ed c ill b he good cha e a fi ed amo n of he ome . ) U de g d (o a a e ) a e in ol e b ing/ elling an ac ion ha a e n eco ded, and a e all illegal. In he ca e of ice ceiling , he a e a ecial kind of ice a ioning. The in ol e b ing a good a he ma im m legal ice, and hen illegall e elling i a a ice abo e he legal ma im m. Unde g o nd ma ke can a i e hen he e a e di a i fied eo le ho ha e no cceeded in b ing he good beca e he e a no eno gh of i , and a e illing o a mo e han he ceiling ice o ge i . If he e e e no ho age, he ice of he good o ld be a i e ilib i m ice, and no one o ld be in e e ed in a ing a highe han e ilib i m ice fo i . Unde g o nd ma ke a e ine i able, and f a e he objec i e o gh b he ice ceiling, hich i o e a ma im m ice. The ice ceiling, being lo e han he e ilib i m ice, e l in a malle an i lied; in Fig e 4.1 Q < Qe, no eno gh e o ce a e alloca ed o he od c ion of he good, e l ing in nde od c ion ela i e o he ocial o im m (o be ). Socie i o e off d e o nde alloca ion of e o ce and alloca i e inefficienc . N Alloca i e efficienc , and he condi ion of ma im m ocial l and MC = MB e e e lained in Cha e 2. In a com e i i e f ee ma ke e ilib i m, ho n in Fig e 4.2(a), con me l a ea a he haded a ea abo e ice Pe and nde he demand c e o an i Qe; od ce l i he haded a ea abo e he l c e and nde ice Pe o Qe. A he com e i i e f ee ma ke e ilib i m, he m of con me and od ce l , o ocial l , i ma im m, and MB = MC, indica ing ha alloca i e efficienc i achie ed. F 4.2: Effec of a ice ceiling (ma im m ice) on con me and od ce l In Fig e 4.2(b), if he e e e no ice con ol, he ma ke o ld de e mine ice Pe and an i Qe a e ilib i m. Con me l o ld be e al o a ea a + b. P od ce l , o ld be e al o a ea c + d + e. Con me l od ce l o ld be ma im m, and e al o a + b + c + d + e. Al o, MB = MC, and he e o ld be alloca i e efficienc . If a ice ceiling, Pc, i im o ed, onl he an i Q i od ced and con med. Con me l i no he a ea nde he demand c e and abo e Pc, b onl o Q , ince ha i all ha i con med. The efo e, con me l become a + c. P od ce l i he a ea abo e he l c e and belo Pc, al o onl o Q ince ha i all ha i od ced. P od ce l he efo e fall o a ea e. To al ocial l af e he ice ceiling i a + c + e. Com a ing i h o al ocial l befo e he ice ceiling, e ee ha he haded a ea b and d ha e been lo and e e en e fa e . Welfa e lo e e en benefi ha a e lo o ocie beca e of e o ce mi alloca ion. lo (al o kno n a dead e gh ) e e en ocial o ocie beca e e o ce a e no alloca ed efficien l . l o elfa e benefi ha a e We can ee he e i alloca i e inefficienc al o beca e MB > MC a he oin of od c ion, Q : he benefi con me ecei e f om he la ni of he good he b i g ea e han he ma ginal co of od cing i . The efo e, ocie i no ge ing eno gh of he good, a he e i an nde alloca ion of e o ce o i od c ion. A ce ce g c ea e a elfa e lo , indica ing ha he ice ceiling in od ce alloca i e inefficienc d e o an nde alloca ion of e o ce o he od c ion of he good. Thi i ho n b Q < Qe. Al o, MB > MC, indica ing ha ocie i no ge ing eno gh of he good. C S a eh de b i. a e indi id al o g o of indi id al ho ha e an in e e in ome hing and a e affec ed C Con me a l gain and a l lo e. The gain a ea c f om od ce b he lo e a ea b ( ee Fig e 4.2(b)). Thi i beca e ho e con me ho a e able o b he good a he lo e ice a e be e off. Ho e e , ome con me emain n a i fied ince he don ge o b he good a all, beca e a he ceiling ice he e i no eno gh of he good o a i f all demande . P P od ce a e o e off, beca e i h he ice ceiling he ell a malle an i of he good a a lo e ice; he efo e, hei e en e d o f om Pe Qe o Pc Q . Thi i clea al o f om hei lo of ome od ce l , a ea c ( hich i an fe ed o con me ), a ell a a ea d ( elfa e lo ) in Fig e 4.2(b). The fall in o (f om Qe o Q ) mean ha ome o ke a e likel nem lo men ; clea l he e o ke ill be o e off. o be fi ed, e l ing in G The e ill be no gain o lo e fo he go e nmen b dge , e he go e nmen ma gain in oli ical o la i among he con me ho a e be e off d e o he ice ceiling. P ice ceiling a e fo he mo a e in o de o make ce ain good con ide ed o be nece i ie mo e affo dable o lo -income ea ne . Ren con ol con i of a ma im m legal en on ho ing, hich i belo he ma ke -de e mined le el of en ( he ice of en al ho ing). I i nde aken b go e nmen in ome ci ie a o nd he o ld o make ho ing mo e affo dable o lo -income ea ne . Con e ence of en con ol incl de: ho ing become mo e affo dable o lo -income ea ne a ho age of ho ing, a he han he an i a ailable long ai ing li an i of in e e ed enan a ma ke fo en ed ni he e enan (an nde g o nd ma ke ) of ho ing demanded a he legall ma im m en i g ea e ai ing fo hei n o ec e an a a men /fla ble hei a a men a en abo e he legal ma im m n-do n and oo l main ained en al ho ing beca e i i n ofi able fo landlo d o main ain o eno a e hei en al ni ince lo en e l in lo e en e . F Some go e nmen e food ice con ol a a me hod o make food mo e affo dable o lo -income ea ne , e eciall d ing ime hen food ice a e i ing a idl . The e l of food ice con ol follo he ame a e n a di c ed abo e: lo e food ice and g ea e affo dabili ; food ho age a an i demanded i g ea e han an i lied; non- ice a ioning me hod ( ch a e e) o deal i h he ho age ; de elo men of nde g o nd ma ke ; falling fa me income d e o lo e e en e ; mo e nem lo men in he ag ic l al ec o ; mi alloca ion of e o ce ; o ible g ea e o la i fo he go e nmen among con me ho benefi . EAL O LD FOC 4.1 P Some ea ago, d e o high a e of infla ion (a i ing gene al ice le el), he Vie name e go e nmen con ide ed he im o i ion of ice con ol . The e con i ed of ice ceiling on n me o od c , incl ding chemical fe ili e , al , milk o de , ice, ga , animal feed , coal, cemen , a e , e book and man mo e. If i in od ced he e mea e , he icing le o ld a l no j o dome ic go e nmen o ned b ine e b al o i a e fi m and fo eign-o ned b ine e . I a fea ed ha Vie nam migh be mo ing a a f om i f ee ma ke o ien a ion of ecen ea and back o a d he a of a command econom . Fo eign di loma a ned he go e nmen ha ice con ol o ld damage b ine confidence in he co n . F 4.3: Vie nam. T an o on he Saigon Ri e A 1 O line ha i mean o mo e o a d he a 2 Di c he con e ence fo he econom and akeholde go e nmen im o ed he ice con ol . ha migh ha e a i en if he 3 Wh do o confidence? hink ha of a command econom . ice con ol co ld damage b ine : Ada ed f The Ec I e ge ce U V e W e Ne A a , 21 Se e be 2010. , V e a ec : ef -bac ? 4.1 1 Define a hem. 2 U ing a diag am, e lain h 3 D a a diag am ill a ing a ice ceiling, and anal e i effec on ma ke o come ( ice, an i demanded, an i lied, ma ke di e ilib i m) and con e ence fo he econom ( ho age , non- ice a ioning, alloca i e inefficienc , elfa e lo ). 4 ice ceiling and, o iding e am le , o line ome ea on Iden if nde ice a ioning and non- ice a ioning. hich non- ice a ioning a i e . ome fo m of non- ice a ioning. O line h 5 ice con ol lead o di e ilib i m ma ke o come . E lain he diffe ence be een De c ibe he ci c m ance h go e nmen im o e nde g o nd ma ke a e a fo m of D a a diag am ho ing e ilib i m. od ce and con me ice a ioning. l in a f ee ma ke com e i i e A ming a con me ice ceiling i im o ed in hi ma ke , d a a ne diag am ho ing he ne l , od ce l and elfa e lo . Com a ing o diag am fo a (a) and (b), ha can o concl de abo l , od ce l and elfa e lo ? con me De c ibe he ela ion hi be een ma ginal benefi and ma ginal co a he ne e ilib i m. O line ha hi e eal abo alloca i e efficienc (o inefficienc ). 6 E amine he con e ence of ice ceiling fo diffe en akeholde in he ca e of: en con ol , and food ice con ol . C (HL ) Fig e 4.4 o ide i h a n me ical e am le of a ice ceiling. A e ilib i m, ice i e al o 8 and an i demanded and lied i 20 000 ni of he good e eek. When a ice ceiling i im o ed a Pc= 5.00 e ni , an i demanded become Qd= 30 000 ni , and an i lied Q = 10 000 ni . ( The ho age, o e ce ni e eek. F ) demand, i e al o Qd Q , hich in hi ca e i 30 000 4.4: Calc la ing effec of a 10 000 = 20 000 ice ceiling C Con me e endi e i gi en b he ice e ni of he good ime he n mbe of ni cha ed. A e ilib i m, io o he ice ceiling, con me end Pe Qe = 8 20 000 ni = 160 000. Af e he ice ceiling i im o ed, con me end Pc Q = 5.00 10 000 ni = 50 000. The change i he efo e 160 000 le han a e ilib i m. 50 000 = 110 000, meaning ha con me no C ) ( end 110 000 Fi m e en e i he ame a con me e endi e bo h befo e and af e he im o i ion of he ice ceiling. Thi i beca e e en e i e al o ice e ni ime an i of ni old, and bo h he ice (Pc) and he an i (Q ) a e he ame fo bo h con me and od ce . The efo e, befo e he ice ceiling i im o ed, fi m e en e i 160 000, and af e he ice ceiling, fi m e en e i ed ced o 50 000. The efo e, fi m e en e fall b he amo n 110 000. No e ha he change in con me e endi e and he change in fi m e en e a e he ame, beca e ice and an i e e he ame fo con me and fi m bo h befo e and af e he ice ceiling a im o ed. C In Cha e 2, e a ho con me and od ce l a e calc la ed. Yo ma emembe ha a ma ke e ilib i m con me l i half he a ea of he ec angle ho e one ide e al he P in e ce of he demand c e min he ice aid b con me , and ho e o he ide e al he n mbe of ni cha ed: Con me l The efo e, = (P in e ce of D c e min P of con me ) Q ing he info ma ion in Fig e 4.4, con me Ini ial con me l = (14 8) 20 000 2 = 6 l cha ed 2 befo e he ice ceiling i : 20 000 2 = 60000 No no ice ha af e he ice ceiling i im o ed, con me l no longe ha he a ea of a iangle. I con i of a a e i m com o ed of a ea a + c. The fo m la fo a a e i m a al o e en ed in Cha e 2. I he f he a a e de e he d a ce be ee he d ded b 2. The efo e: Final con me l = [(14 5) + (11 5) ] 10 000 2 = (9+6) 10 000 2 = 150 000 2 = 75 000 The efo e con me l ha inc ea ed b 75 000 60 000 = 15 000. P od ce l a ma ke e ilib i m i half he a ea of he ec angle ho e one ide e al he ice ecei ed b od ce min he P in e ce of he a l c e, S1 and ho e o he ide e al he n mbe of ni old: P od ce l The efo e Ini ial = (P of od ce l od ce l od ce min P in e ce befo e he ice ceiling i : od ce P od ce l l The elfa e lo Welfa e lo E e) Q old 2 = (8 2) 20 000 2 = 6 20 000 2 = 60 000 No ice ha af e he ice ceiling i im o ed can a l he iangle fo m la: Final of S c od ce l i he a ea of iangle e he efo e e = (5 2) 10 000 2 = 3 10 000 2 = 15 000 ha dec ea ed b i gi en b 60 000 15 000 = 45 000. he a ea of iangle a l b: = (11 5) (20 000 10 000) 2 = 6 10 000 2 = 30 000 O NDE ANDING 4.2 1 In he e am le of he ma ke ill e a 10. 2 The diag am belo ho he ho age (e ce a a ed in Fig e 4.4, commen on he effec of a ice ceiling ice ceiling of 30 ha ha been e fo good X. Calc la e: demand), he change in con me e endi he change in od ce e en e, he change in con me he change in e, od ce l , l , and elfa e lo . P : ? A legall e ce i called a ce f . The ice ha can be legall cha ged b elle of he good m no be lo e han he ice floo , o minim m ice. In Fig e 4.5, a ice floo , Pf, i e abo e he e ilib i m ice, Pe. A Pe, con me a e illing and able o b Qd of he good, b fi m a e illing and able o l Q of he good. The efo e, a l , o e ce l , e al o he diffe ence be een Q and Qd, a i e . If he ma ke e e f ee, he fo ce of demand and l o ld fo ce he ice do n o Pe. Ho e e , no hi canno ha en. F 4.5: P ice floo (minim m ice) and ma ke o come No e ha o ha e an effec , he ice floo m be ab e he e ilib i m ice. If i e e belo he e ilib i m ice, he ma ke o ld achie e e ilib i m and he ice floo o ld ha e no effec . P ice floo a e commonl ed fo o ea on : (a) o o ide income o fo fa me b offe ing hem ice fo hei od c ha a e abo e ma ke -de e mined ice ; and (b) o o ec lo - killed, lo - age o ke b offe ing hem a age ( he minim m age) ha i abo e he le el de e mined in he ma ke . No e ha he fi of he e in ol e ice con ol in od c ma ke , hile he econd conce n ice con ol in a e o ce ma ke . While ma ke o come a e imila , each e of ice con ol ha diffe en con e ence fo he econom and akeholde . We ill he efo e con ide each one e a a el . A o i a e belo he e ilib i m ice, in o de o o fa me o o inc ea e he age of lo - killed o ke . o ide income To a oid ge ing conf ed abo hich i hich, no e ha he o i ion of a ice floo and a ice ceiling in ela ion o he e ilib i m ice i al a he o o i e of he floo and ceiling of a oom. The ce f ab e a d he ce ce g be . C C Fa me income in man co n ie , e l ing f om he ale of hei od c in f ee ma ke , a e of en n able o oo lo . Some im o an ea on fo bo h in abili and lo income e e con ide ed in Cha e 3. Un able income a i e f om n able ag ic l al od c ice , hich a e d e o lo ice ela ici ie of demand and lo ice ela ici ie of l fo ag ic l al od c . Lo fa me income ma a i e f om lo income ela ici ie of demand. One me hod go e nmen e o o fa me income i o e ice floo fo ce ain ag ic l al od c , he objec i e being o ai e he ice abo e hei e ilib i m ma ke ice. The con e ence a e e lained belo . Fig e 4.6 ill a e he ma ke fo an ag ic l al od c i h a ice floo , Pf, e abo e he e ilib i m ice, Pe. The ice floo e l in a la ge an i lied, Q , han he an i lied a ma ke e ilib i m, Qe. In addi ion, he ice floo , Pf, lead o a malle an i demanded and cha ed han a he e ilib i m ice: he an i con me an o b a Pf i Qd, hich i malle han he an i Qe ha he bo gh a ice Pe. F 4.6: An ag ic l al od c ma ke ih ice floo and go e nmen cha e of he l A ice floo e l in di e ilib i m he e he e i a l (e ce l ). A common ac ice i fo he go e nmen o b he e ce l , and hi ca e he demand c e fo he od c o hif o he igh o he ne demand c e D l go e nmen cha e . B b ing he e ce l , he go e nmen i able o main ain he ice floo a Pf. I ho ld be no ed ha if he go e nmen did no b he l , he e ilib i m le el. The ea on i ha fa me o ld ha e e ce o ha e o lo e he ice in o de o be able o ell all he l . ice o ld fall back o i i h no b e , and o o ld G The go e nmen m make a deci ion abo ha o do i h he l (e ce l )i cha e . One o ion i o o e i , gi ing i e o addi ional co fo o age abo e he co of he cha e. Ano he me hod i o e o he l ( ell i ab oad); hi of en e i e g an ing a b id ( hi i mone gi en o od ce , o be di c ed la e in hi cha e ) o lo e he ice of he good ince fo eign co n ie o ld no an o b i a he high ice. Clea l , b idie in ol e addi ional co fo he go e nmen . In gene al, an co e cho en b he go e nmen o ge id of he l e i oblema ic. F Highe han e ilib i m od c ice can lead o inefficien od c ion; inefficien fi m i h high co of od c ion do no face incen i e o c co b ing mo e efficien od c ion me hod beca e he high ice offe hem o ec ion again lo e -co com e i o . Thi lead o inefficienc . O Too man e o ce a e alloca ed o he od c ion of he good, e l ing in a la ge han o im m (o be ) an i od ced. Whe ea he o im m an i i Qe, ac all Q i od ced. N In Fig e 4.7(a), ice Pe and an i Qe e e en ma ke e ilib i m i h no ocial l i ma im m. In a (b), hen he e i no ice floo , con me c and od ce l b d + e. Al o, MB = MC. ice floo , and he e l i gi en b a + b + Af e a ice floo , Pf, i im o ed, con me l become he a ea nde he demand c e and abo e Pf, o he an i con me b , Qd, and o fall o a. P od ce l become he a ea abo e he l c e and belo Pf, o he an i od ced, Q , and o become d + e + b + c + f. Thi mean ha he m of con me l od ce l c ea e b he a ea f af e he ice floo i im o ed. Thi ha en beca e od ce gain he a ea b and c lo b con me , and in addi ion gain f. On he o he hand, go e nmen ending o b he e ce l i e al o he ice aid e ni , Pf, ime he l an i i cha e : Pf (Q Qd), co e onding o he ec angle o lined in bold. Since go e nmen ending i financed o of a e i h al e na i e e (o o ni co ), go e nmen ending o main ain he ice floo in ol e lo e fo ocie . The efo e, he e i a gain in l of f and a lo e al o he ec angle ho n in bold. S b ac ing he lo f om he gain e a e lef i h he bl e haded a ea, hich i elfa e lo , e e en ing lo of benefi d e o alloca i e inefficienc ca ed b o e alloca ion of e o ce o he od c ion of he good. Thi i al o ho n b MB < MC a he oin of od c ion, Q , indica ing ha ocie o ld be be e off if le of he good e e od ced. F 4.7: Welfa e im ac of a cha e of he l ice floo (minim m ice) fo ag ic l al od c and go e nmen Ano he a o ee ha he bl e haded a ea i he elfa e lo i o no e im l ha he ice floo e l in a gain of f and a lo of c + e + f + g, o he bold ec angle of go e nmen ending. And o he ne lo i im l ha a of go e nmen ending ha i no gained. In o he o d he ne change i f (c + e + f + g) = (c + e + g). A ice floo c ea e elfa e lo , indica ing ha he ice floo in od ce alloca i e inefficienc d e o an o e alloca ion of e o ce o he od c ion of he good, ho n b Q > Qe. Al o MB < MC, indica ing ha ocie i ge ing oo m ch of he good. C C Con me a e o e off, a he m no a a highe ice fo he good (Pf > Pe), hile he b malle an i of i (Qd < Qe). Thi i clea al o f om hei lo of ome con me l . a P P od ce gain a he ecei e a highe ice and od ce a la ge an i , and ince he go e nmen b he l , he inc ea e hei e en e f om Pe Qe o Pf Q . Remembe , hi i he main a ionale of ag ic l al ice floo . Al o, od ce become o ec ed again lo -co com e i ion and do no face a ong incen i e o become efficien od ce ; he a e he efo e le likel o go o of b ine if he a e od cing inefficien l ( i h highe co ). Wo ke a e likel o gain a em lo men inc ea e on acco n of g ea e od c ion of he good. G When he go e nmen b he e ce l , hi i a b den on i b dge , e l ing in le go e nmen f nd o end on o he de i able ac i i ie in he econom . The co o he go e nmen a e aid fo o of a e (and he efo e b a a e ). In addi ion, he e a e f he co of o ing he l o b idi ing i fo e o ( ale o o he co n ie ). The E o ean Union, he Uni ed S a e and man o he mo e de elo ed co n ie el on ice floo fo ag ic l al od c o o hei fa me . The l e a e ome ime e o ed ( old o o he co n ie ), leading o lo e o ld ice d e o he e a l made a ailable in o ld ma ke . Co n ie ha do no ha e ice o a e fo ced o ell hei ag ic l al od c a lo o ld ice . The lo ice in he e co n ie ignal o local fa me ha he ho ld c back on hei od c ion, e l ing in an nde alloca ion of e o ce o he e od c . The e e en of en o k again he in e e of le de elo ed co n ie ( hi o ic ill be di c ed in Cha e 19). O e all, a global mi alloca ion of e o ce can e l in a a e of e o ce , a ice floo ca e highco od ce o od ce mo e and lo -co od ce o od ce le han he ocial o im m. E O NDE ice floo , and ANDING 4.3 1 Define a hem. o iding e am le , e lain ome ea on h go e nmen im o e 2 D a a diag am ill a ing a ice floo ha i im o ed in a od c ma ke , and anal e i effec on ma ke o come ( ice, an i demanded, an i lied, ma ke di e ilib i m, e ce l , fi m inefficienc , alloca i e inefficienc , elfa e lo ). 3 Iden if ome mea e go e nmen can ake o di o e of l e ha e l f om he im o i ion of a ice floo in an ag ic l al od c ma ke . Commen on he oblem a ocia ed i h he e mea e . 4 A ming a go e nmen ice floo i im o ed in a ma ke fo an ag ic l al od c , and ha he cha e he en i e e ce l ha e l in o de o main ain he ice: d a a diag am ill a ing elfa e lo , and commen on he ela ion hi be een ma ginal benefi and ma ginal co in he ne e ilib i m and ha i e eal abo alloca i e efficienc (o inefficienc ). 5 E amine he con e ence fo diffe en akeholde of a ho e e ce l i cha ed b he go e nmen . ice floo fo an ag ic l al od c C (HL ) Fig e 4.8 o ide a n me ical e am le of a ice floo on an ag ic l al od c . A e ilib i m, ice i e al o 20 and an i i e al o 60 000 kg e eek. When a ice floo i im o ed a Pf = 25, an i demanded i Qd = 40 000 kg e eek and an i lied i Q = 80 000 kg e eek. ( ) The l , o e ce e eek. l i e al o Q Qd, hich in hi ca e i 80 000 40 000 = 40 000 kg C Con me e eek. A e million e million e endi e i gi en b he ice e kg of he good ime he n mbe of kg cha ed e ilib i m, befo e he ice floo , con me end Pe Qe = 20 60 000 kg = 1.2 eek. Af e he ice floo i im o ed, con me end Pf Qd = 25 40 000 kg = 1 eek. The efo e, con me end 200 000 le on he good e eek. C Befo e he ice floo , od ce e en e i he ame a con me e o ice e kg ime an i old, and bo h he ice (Pe) and he con me and od ce . The efo e od ce e en e befo e he Once he ice floo i im o ed and he go e nmen cha e he ecei e e en e of Pf Q , and o od ce e en e inc ea e o eek. The efo e, he change i 800 000, o addi ional od ce e endi e, ince e en e i e al an i (Qe) a e he ame fo ice floo i 1.2 million e eek. l (e ce l ), fi m 25 80 000 kg = 2 million e en e of hi amo n e eek. F 4.8: Calc la ing effec cha e of he l of a ice floo on an ag ic l al od c i h go e nmen G In o de o cha e he e ce l of he ag ic l al od c , he go e nmen end an amo n e al o he ice of he good a he ice floo ime he n mbe of kg cha ed, o Pf (Q Qd) = 25 40 000 = 1 million. No e ha go e nmen e endi e ( 1 million) i e al o o al o al con me e endi e ( 1 million) e eek. od ce e en e ( 2 million) min C No ice ha all a ea of con me and a ea of iangle . In hi ca e, a l = (P in e ce l l dec ea ed b P od ce l i gi en b : P od ce l = (P of od ce Af e he Final P of con me ) Q l od ce min od ce l cha ed 2 befo e he l i: l 450 000 P in e ce 200 000 = 250 000. of S c e) Q old 2 i: = (20 5) 60 000 2 = 15 60 000 2 = 450 000 ice floo i im o ed od ce l od ce l i: = (25 5) 80 000 2 = 20 80 000 2 = 800 000 ice floo , a e he i: = (35 25) 40 000 2 = 10 40 000 2 l ice floo l (35 20) 60 000 2 = 450 000 The efo e, con me Ini ial e min ice floo i im o ed con me Final con me Befo e he of D c ing he info ma ion in Fig e 4.8, con me Ini ial con me Af e he l , bo h befo e and af e he e kno , he fo m la fo calc la ing con me Con me The efo e, od ce ice floo i : The efo e, od ce l c ea ed b 800 000 450 000 = 350 000. The elfa e lo i gi en b he haded a ea in Fig e 4.7, hich acco ding o Fig e 4.8 i he ec angle of go e nmen ending min a ea f. We ha e fo nd abo e ha go e nmen ending on he b id i A ea f = (25 20) (80 000 40 000) 2 = (5 40 000) 2 The efo e, elfa e lo E O = 1 million NDE ANDING 4.4 In he e am le of he ma ke ill e a 15? 2 The diag am belo l ho a (e ce a ed in Fig e 4.8, ha ice floo l ), e, od ce e en e, he change in con me he change in o ld be he effec of a ice floo of $50 ha ha been e fo good Y. Calc la e: he change in con me e endi he change in = 100 000 100 000 = 900 000. 1 he 1 million. od ce l , l , and elfa e lo . M I Man co n ie a o nd he o ld ha e la ha de e mine he minim m ice of labo ( he age a e) ha an em lo e (a fi m) m a . The objec i e i o g a an ee an ade a e income o lo -income o ke , ho end o be mo l n killed. (The ma ke -de e mined age of killed o ke a e all highe han he minim m age.) Fig e 4.9 ho he ma ke fo labo . The demand fo labo c e ho age, and he l of labo S l and demand de e mine an i of labo demanded i F 4.9: Labo ma ke he an i of labo ha fi m a e illing and able o hi e a each c e ho he an i of labo ha o ke l a each age. he e ilib i m ice of labo , hich i he age, We, he e he e al o he an i of labo lied, Qe. i h minim m age ( ice floo ) The minim m age, Wm, lie abo e he e ilib i m age, We. The efo e, a Wm, he an i of labo lied, Q , i la ge han he an i of labo lied hen he labo ma ke i in e ilib i m (Qe). The an i of labo demanded, Qd, i le han he an i demanded a e ilib i m, Qe. The e e l a l of labo in he ma ke e al o he diffe ence be een Q and Qd. The labo ma ke doe no clea hen he e i a minim m age. C Lab (e ce )a d e e The im o i ion of a minim m age in he labo ma ke c ea e a l of labo e al o Q Qd in Fig e 4.9, hich i nem lo men , a i co e ond o eo le ho o ld like o o k b a e no em lo ed. The nem lo men i d e a l o he dec ea e in an i of labo demanded b fi m ( he diffe ence be een Qe and Qd) and a l o an inc ea e in he an i of labo lied ( he diffe ence be een Q and Qe). Thi occ beca e he highe age make o k mo e a ac i e, ca ing a mo emen he labo l c e. Thi nem lo men i likel o in ol e n killed o ke . I ega e a age be e age Illegal em lo men of ome o ke a age belo he legal minim m ma e l ; hi of en in ol e illegal immig an ho ma be illing o l hei labo a e lo age . M a ca f ab e ce The minim m age affec he alloca ion of ab e ce , a i e en he ma ke f om e abli hing a ma ke -clea ing ice of labo . In Cha e 2, e a ho he age ac a a ignal and incen i e o o ke ( he lie of labo ) and fi m ( he demande of labo ) o de e mine he o imal alloca ion of labo e o ce . The im o i ion of a minim m age change he e ignal and incen i e fo n killed labo , ho e age i affec ed b he ice floo . The efo e, ind ie ha el hea il on n killed o ke a e mo e likel o be affec ed, and ill hi e le n killed labo . M a ca d c a e Fi m el ing hea il on n killed o ke e e ience an inc ea e in hei co of od c ion, leading o a lef a d hif in hei d c l c e ( ee Cha e 2), e l ing in malle an i ie of o od ced. The efo e, he mi alloca ion of labo e o ce lead al o o mi alloca ion in od c ma ke . C F (e e f ab ) Fi m a e o e off a he face highe co W e ( e f ab of od c ion d e o he highe labo co . ) The im ac on o ke a e mi ed. Some gain beca e he ecei e a highe age han e io l (Wm > We), b ome lo e beca e he lo e hei job. No e ha he o ke ho lo e hei job a e ho e e e en ed b Qe Qd. Thi i no he f ll amo n of nem lo men c ea ed b he minim m age, beca e he minim m age lead o add a nem lo men of Q Qe, ince mo e o ke l hei labo in he ma ke hen he age inc ea e . C e Con me a e nega i el affec ed, beca e he inc ea e in labo co lead o a dec ea e in l of od c (a lef a d hif in fi m l c e ) ca ing highe od c ice and lo e an i ie . P Economi ag ee ha ice floo fo ag ic l al od c lead o l e (e ce lie ) and a e highl inefficien fo he ea on di c ed abo e. Ye he con in e o be ed in man co n ie beca e of ong oli ical e e e e ed b fa me ho claim o need he e fo income o . The effec of minim m age , on he o he hand, a e con o e ial, a i i e ionable he he he lead o nem lo men o he e en ha economic heo edic . The e i ag eemen ha if a minim m age i e a a high le el ela i e o he f ee ma ke e ilib i m age, i i likel o c ea e ome nem lo men . Ye a la ge and g o ing n mbe of die ho ha a minim m age ma ha e no effec o e en a o i i e effec on a em lo men . Some fi m e ond o he minim m age b main aining he ame n mbe of o ke b c ing non- age benefi ( ch a aid holida o ick lea e). Al o, i i o ible ha labo od c i i (defined a he amo n of o od ced e o ke ) ma inc ea e d e o he minim m age, a o ke feel mo i a ed o o k ha de , i h he e l ha ome fi m hi e mo e n killed labo in e on e o minim m age . While he effec of minim m age emain con o e ial, he e i gene all ong oli ical o fo hei con in ed e on he g o nd of g ea e e i in income di ib ion. In fac , he deba e i no abo he he o no he e ho ld be minim m age , b a he ha hei le el ho ld be. Some ime ice ma be fi ed a a a ic la le el, ch a i h icke ice fo hea e , mo ie and o e en , he e ice a e all fi ed ahead of ime b he o gani ing bod ( hich ma be i a e o blic), and o canno inc ea e o dec ea e acco ding o l and demand. Fig e 4.10 ho he ma ke fo icke fo a o e en . The l c e i e ical beca e he e i a fi ed l of icke (d e o a fi ed n mbe of ea ; ee Cha e 2). The icke ice i fi ed a Pf b he o gani ing bod . Fig e 4.10(a) ill a e an e en fo hich he e i la ge demand, gi en b D1. If he ice co ld e ond o ma ke fo ce , i o ld i e o Pe, b ince i i fi ed a Pf a ho age of icke a i e e al o he ho i on al diffe ence be een oin a and b. Fig e 4.10(b) ill a e an e en fo hich he e i lo demand, gi en b D2. He e, he e ilib i m ice o ld ha e been Pe, ho e e ice i fi ed a he highe le el Pf , e l ing in a l of icke e al o he ho i on al diffe ence be een oin c and d. F 4.10: P ice fi ing and E O NDE l e and ho age ANDING 4.5 1 Define a minim m age. S gge hem. 2 D a a diag am ill a ing he im o i ion of a minim m age, and anal e i effec on ma ke o come ( he age, an i of labo demanded and lied, ma ke di e ilib i m) and con e ence fo he labo ma ke ( nem lo men of labo , illegal o k, e o ce mi alloca ion, elfa e lo ). 3 S gge h , in ac ice, minim m age ma no lead o inc ea ed nem lo men if he a e no e oo high. 4 U ing diag am ho ho e ce a e e a a le el ha i lo e han e ilib i m, and ea on h man go e nmen a o nd he o ld im o e demand o e ce l of icke e l hen icke ice highe han e ilib i m. 4.3 I LEARNING OBJECTIVES Af er d ing hi ec ion o ill be able o: define all he erm appearing in in he e (AO1) e plain he con eq ence of indirec a e on marke and akeholder (AO2) dra diagram o ill ra e he effec of indirec a e on marke and akeholder (AO4) e al a e he effec of indirec a e on marke and akeholder (AO3) calc la e he effec of indirec a e on marke and akeholder (HL onl ) (AO4) I T I b are impo ed on pending o b good and er ice . The are paid par l b con mer , are paid o he go ernmen b prod cer (firm ), and for hi rea on are called indirec . There are o pe of indirec a e : e cise ta es, impo ed on par ic lar good and er ice , alcohol ch a pe rol (ga oline), cigare e and ta es on spending on all (or most) goods and services, ch a general sales ta es ( ed in he Uni ed S a e ) and value added ta es ( ed in he E ropean Union, Canada and man o her co n rie ). Indirec a e differ from go ernmen ( ee Chap er 12). In hi chap er, e ill , in ol ing pa men of he a b he a pa er direc l o he d e ci e a e . I Ta e ha e he effec of changing he alloca ion of re o rce . In Chap er 2 e learned ha price ac a ignal and incen i e , hich de ermine he pa ern of re o rce alloca ion. Since indirec (e ci e) a e are impo ed on par ic lar good , he increa e he price paid b con mer , ca ing con mer o red ce heir pending on a ed good . E ci e a e al o lo er he price recei ed b prod cer , ca ing hem o prod ce le . Therefore, b changing price ignal and incen i e , e ci e a e affec he alloca ion of re o rce . The in ere ing q e ion i he her indirec a e ork o red ce or o increa e alloca i e efficienc . The an er depend on he degree of alloca i e efficienc in he econom before he a i impo ed. If an econom begin i h an efficien alloca ion of re o rce , he a crea e alloca i e inefficienc and a elfare lo . We ill ee ho hi happen belo . In an econom i h an inefficien re o rce alloca ion, indirec a e po en iall ha e he effec of impro ing re o rce alloca ion if he are de igned o remo e he o rce of alloca i e inefficienc . Thi ill be died in Chap er 5. Go ernmen impo e e ci e a e for e eral rea on : I . Go ernmen collec re en e from indirec a e . A e kno from Chap er 3, he lo er he price ela ici of demand, he grea er he go ernmen re en e genera ed. I . The con mp ion of cer ain good i con idered harmf l for he indi id al (for e ample, cigare e moking, e ce alcohol con mp ion or gambling). Ta ing he e good i likel o red ce heir con mp ion. Ho e er, he e en o hich he e a e are cce f l in red cing con mp ion depend on he price ela ici of demand; if i i lo , an indirec a ill likel re l in onl a rela i el mall decrea e in q an i demanded ( ee Chap er 5). I . Some e ci e a e foc on (e pen i e car , boa , f r , je eller , and o on). The objec i e i o a good ha can onl be afforded b high-income earner . Pa men of a a on he p rcha e of he e good red ce af er- a income, h narro ing difference i h he income of lo er-income earner . I ( ) . If here are marke imperfec ion (in he form of nega i e e ernali ie ), pre en ing he achie emen of alloca i e efficienc , indirec a e can be ed o r o impro e he alloca ion of re o rce . Thi opic ill be di c ed in Chap er 5. In hi chap er, e a me ha he econom begin i h alloca i e efficienc in order o ee ho in rod c ion of indirec a e lead o alloca i e inefficienc . I he : D ad alo em Indirec , e ci e a e can be: specific ta es, a fi ed amo n of a per ni of he good or er ice old; for e ample, 5 per packe of cigare e ad valorem ta es, a fi ed percen age of he price of he good or er ice; in hi ca e, he amo n of a increa e a he price of he good or er ice increa e . In o r d of indirec a e , e ill con ider onl a for each ni of he good old. pecific a e , in o her ord a pecific amo n of When a a i impo ed on a good or er ice, i i paid o he go ernmen b he firm. Thi mean ha for e er le el of o p he firm i illing and able o ppl o he marke , i m recei e a price ha i higher han he original price b he amo n of he a . Thi in ol e a hif of he ppl c r e p ard b he amo n of he a , and i ho n in Fig re 4.11(a). The a ca e a parallel p ard hif , beca e he a i a fi ed amo n for each ni of o p . Therefore, in Fig re 4.11(a) S2 i parallel o S1 (No e ha hi i eq i alen o a lef ard hif of he ppl c r e, meaning ha for each price, he firm i illing o ppl le o p ; hi eq i alence i e plained in Q an i a i e echniq e chap er in he 'Digi al co r ebook: E ra ma erial' ec ion). I The impac of pecific a e on marke o come are ho n in Fig re 4.11(b). The ppl c r e are he ame a in Fig re 4.11(a); a demand c r e ha al o been added. The pre- a eq ilibri m i de ermined b he in er ec ion of he demand c r e D and he ppl c r e S1, o he price paid b con mer and recei ed b prod cer i P* and q an i demanded and pplied i Q*. If he go ernmen impo e a pecific a on he good, he ppl c r e hif p ard o S2 = S1 + a . The demand c r e remain con an a D ince demand i no affec ed. The ne marke eq ilibri m i de ermined b he demand c r e D and he ne ppl c r e S2, o he price paid b con mer increa e o Pc, and he q an i p rcha ed fall o Q . The amo n of a per ni of o p i ho n on he er ical a i b Pc Pp, or he er ical difference be een he o ppl c r e . Wherea prod cer recei e from con mer Pc per ni , he m pa he go ernmen Pc Pp per ni ( a per ni ). Therefore, Pp i he final price recei ed b prod cer af er pa men of he a . F 4.11: S ppl c r e hif d e o an indirec a The a i aid o dri e a edge be een he price Pc paid b con mer and he price Pp recei ed b prod cer . The marke o come d e o he a are he follo ing: eq ilibri m q an i prod ced and con med fall from Q* o Q eq ilibri m price increa e from P* o Pc, hich i he price paid b con mer con mer e pendi re on he good i gi en b he price of he good per ni ime he q an i ni bo gh ; i herefore change from P* Q* o Pc Q price recei ed b he firm fall from P* o Pp, hich i Pp = Pc of a per ni he firm re en e fall from P* Q* o Pp Q he go ernmen recei e a re en e, gi en b (Pc Pp) Q , or he amo n of a per ni ime he n mber of ni old; hi i he haded area in Fig re 4.12 here i an nderalloca ion of re o rce o he prod c ion of he good: Q i le q an i , Q*. han he free marke C C Con mer are affec ed in o a : b he increa e in he price of he good (from P* o Pc, ho n in Fig re 4.11(b)) and b he decrea e in he q an i he b (from Q* o Q ). Bo h he e change make hem or e off, a he are no recei ing le of he good and pa ing more for i . P ( ) Prod cer are affec ed in o a : b he fall in he price he recei e (from P* o Pp), and b he fall in he q an i of o p he ell (from Q* o Q ). The e effec ran la e in o a fall in heir re en e , from P* Q* before he a o Pp Q . Firm are herefore or e off a a re l of he a . T The go ernmen i he onl akeholder ha gain , a i no ha re en e eq al o (Pc Fig re 4.11(b). Thi i po i i e for he go ernmen b dge . Pp) Q in A lo er amo n of o p , from Q* o Q , mean ha fe er orker are needed o prod ce i ; herefore, he a ma lead o ome nemplo men . Worker are or e off if he become nemplo ed. S : Socie i or e off a a re l of he a , beca e here i an nderalloca ion of re o rce o he prod c ion of he good (Q < Q*). Wha happen o ocial rpl af er he impo i ion of he a ? We can ee hi in Fig re 4.12. Par (a) ho he ma im m con mer pl prod cer rpl in a compe i i e free marke ha e are familiar i h. The effec of he indirec a can be een in par (b), here con mer rpl become he haded area nder he demand c r e and abo e Pc p o Q . Prod cer rpl become he haded area abo e he ppl c r e S1 and belo Pp p o Q . A por ion of con mer rpl became go ernmen a re en e, and ano her por ion a lo a riangle a. A por ion of prod cer rpl al o became go ernmen a re en e, and ano her por ion a lo a riangle b. To al go ernmen re en e can be een in Fig re 4.12(b). No e ha hen iden if ing prod cer rpl af er he impo i ion of an indirec a , e al a he initial suppl curve, hich i S1 in Fig re 4.12b. refer o The con mer and prod cer rpl ha i ran formed in o go ernmen a re en e come back o ocie in he form of go ernmen pending from he a re en e . Therefore, he af er- a ocial rpl in Fig re 4.12(b) i eq al o af er- a con mer and prod cer rpl pl go ernmen re en e. Ho e er, af er- a ocial rpl i le han pre- a ocial rpl b he amo n of riangle a + b. The area a + b repre en ocial rpl ha i comple el lo , and i elfare lo . In hi ca e, elfare lo appear beca e he a ca e a maller han op im m q an i o be prod ced: Q < Q*. The a ha ca ed nderprod c ion of he good rela i e o ha i ociall de irable, and an nderalloca ion of re o rce , or alloca i e inefficienc . No e ha a he ne poin of prod c ion, Q , MB > MC, meaning ha he benefi con mer recei e from he la ni of he good he b are grea er han he marginal co of prod cing i . Con mer o ld be be er off if more of he good ere prod ced (for an e plana ion ee Chap er 2). The impo i ion of an indirec a re l in red ced con mer and prod cer rpl , par of hich i ran formed in o go ernmen re en e, and par of hich i a elfare lo . The elfare lo in hi ca e i he re l of nderalloca ion of re o rce o he prod c ion of he good ( nderprod c ion). Thi i al o indica ed b MB > MC: oo li le of he good i prod ced and con med rela i e o he ocial op im m. F 4.12: Effec of indirec a e on con mer and prod cer rpl TEST OUR UNDERSTANDING 4.6 1 De cribe ha indirec mean in reference o indirec a e . 2 S a e ome rea on h go ernmen impo e indirec a e . 3 O line ho indirec a e affec he alloca ion of re o rce . 4 E plain h in con ra 5 The go ernmen i con idering impo ing a 0.50 a per li re of pe rol (ga oline). o price con rol , an indirec a doe no re l in di eq ilibri m. a Dra a diagram for he ga oline marke before he impo i ion of he a , ho ing he price paid b con mer , he price recei ed b prod cer and he q an i of pe rol (ga oline) ha i bo gh / old. Dra a diagram for he pe rol (ga oline) marke af er he impo i ion of he a , ho ing he price paid b con mer , he price recei ed b prod cer and he q an i of pe rol (ga oline) bo gh / old. 6 For q e ion (5): anal e he impac on he marke of he a on pe rol (ga oline), and di c 7 he con eq ence for akeholder . U ing a diagram, ho he effec of an indirec a on con mer and prod cer rpl , a ell a elfare lo . E plain h elfare lo ari e a a re l of a mi alloca ion of re o rce . C (HL ) S ppo e he go ernmen impo e an indirec (e ci e) a on romple of 6 per ni . Thi mean ha he ppl c r e ill hif p ard b 6 for each le el of o p Q. H , S2 In Fig re 4.13, he ne ppl c r e, S2 = S1 + a , lie 6 abo e he ini ial ppl c r e, S1. We can co n 6 p ard along he er ical a i from he P in ercep of S1, and hen dra a line parallel o S1 from hi ne P in ercep . Thi i gi e he ne ppl c r e, S2. For an Q, he er ical difference be een he o ppl c r e i 6, hich i he a per ni of o p . F 4.13: Demand and ppl i h indirec a e H , , Af er he a i impo ed, he demand c r e D and he ne ppl c r e, S2, de ermine a ne eq ilibri m price, hich i Pc or he price paid b con mer , a ne eq ilibri m q an i , Q , and Pp or he price recei ed b prod cer (Pp = Pc a per ni ) ( ee al o Fig re 4.11(b)). Therefore, a he ne af er- a eq ilibri m, he price paid b con mer i Pc = 19, he eq ilibri m q an i of romple demanded and pplied i 22 ni per da , i.e. Q = 22, and he price recei ed b prod cer i Pp = Pc a per ni = 19 6 = 13. The e re l are ho n in Fig re 4.13. We ha e fo nd ha he price paid b con mer ha increa ed from 16 o 19, he price recei ed b prod cer ha fallen from 16 o 13, and he q an i prod ced and con med ha fallen from 28 ni o 22 ni . We no an o e hi price and q an i informa ion, oge her i h he graph in Fig re 4.13, o calc la e he follo ing: con mer e pendi re, prod cer re en e, go ernmen re en e, con mer rpl and prod cer rpl . C Con mer e pendi re i gi en b he price paid per ni of romple ime he n mber of romple p rcha ed. Therefore, before he a , con mer pen P* Q* = 16 28 ni = 448 per da ; af er he a a impo ed, con mer pen Pc Q = 19 22 ni = 418 per da . Therefore con mer e pendi re fell b 30 per da (= 448 418). P Prod cer re en e i gi en b he price recei ed per ni of romple ime he n mber of romple old. Therefore, before he a , prod cer re en e a P* Q* = 16 28 ni = 448 per da , hich i he ame a ha con mer pen ; firm re en e a e ac l eq al o con mer e pendi re. Af er he a a impo ed, firm re en e fell o Pp Q = 13 22 ni = 286 per da . Prod cer re en e fell b 162 per da (= 448 286). Firm re en e i no le han con mer e pendi re. G Go ernmen re en e can be calc la ed in I i eq al o a per ni (Pc romple = 132. o a : Pp) ime he n mber of ni old, Q , and i herefore 6 22 I i al o eq al o he difference be een con mer e pendi re and prod cer re en e af er he a : 418 286 = 132. C , A e ha e een abo e, con mer and prod cer rpl bo h before and af er he indirec a are he area of riangle , herefore e e he familiar riangle form la o calc la e hem. Fig re 4.14 i he ame a Fig re 4.12, b al o ho P and Q al e , hich are he ame al e a in Fig re 4.13. In par (a), con mer rpl i he haded area nder he demand c r e and abo e P* = 16, p o Q* = 28. In par (b), i i he haded area nder he demand c r e and abo e Pc = 19, p o Q = 22. A o ma recall, con mer rpl i: Con mer rpl = (P in ercep of D c r e min Therefore, con mer rpl P of con mer ) Q p rcha ed 2 before he a i : (30 P*) Q* 2 = (30 16) 28 2 = 14 28 2 = 392 2 = 196 Con mer rpl af er he a i : (30 P c ) Q 2 = (30 19) 22 2 = 11 22 2 = 242 2 = 121 In he ca e of prod cer Prod cer rpl rpl , o ma recall ha i i : = (P of prod cer min P in ercep of S 1 c r e) Q old 2 In Fig re 4.14(a), prod cer rpl i he area abo e he ppl c r e S and belo P* = 16, p o Q* = 28. In Fig re 4.14(b), i i he area abo e he ppl c r e S1 and belo Pp = 13, p o Q = 22. F 4.14: Calc la ing con mer and prod cer rpl before and af er an indirec a To calc la e prod cer rpl , e can hink of i a half he area of he rec angle ho e one ide eq al he price recei ed b prod cer min he P in ercep of he ini ial ppl c r e, S1, and ho e o her ide eq al he n mber of ni old: Prod cer rpl = (P of prod cer min Therefore, prod cer rpl P in ercep of S 1 c r e) Q old 2 before he a i : (P* 2)*Q* 2 = (16 2) 28 2 = 14 28 2 = 382 2 = 196 Prod cer rpl af er he a i : ( P P 2) Q 2 = (13 2) 22 2 = 11 22 2 = 242 2 = 121 No e ha o calc la e prod cer curve, S1. rpl af er he a ha been impo ed, e e he ini ial suppl (Yo ma ha e no iced ha con mer and prod cer rpl are eq al o each o her, bo h before and af er he a ; this is coincidental, as the need not be equal to each other.) The elfare lo can be fo nd b aking he pre- a m of con mer and prod cer rpl ( o al ocial rpl ), and b rac ing from ha he po - a m of benefi (po - a con mer rpl , prod cer rpl and a re en e): 196 + 196 (121 + 121 + 132) = 18. Thi i al o eq al o he area of he riangle: (Pc P p )(Q* Q ) 2 = (19 13)(28 22) 2 = 6 6 2 = 18 TEST OUR UNDERSTANDING 4.7 1 U ing he concep of alloca i e efficienc e plain h an indirec a crea e 2 In he marke for good e a, he P in ercep of he demand c r e i a he poin here Q = 0 and P = 7, and he P in ercep of he ppl c r e i a he poin here Q = 0 and P = 1. The poin of in er ec ion of he demand c r e and he ppl c r e a free marke eq ilibri m i a he poin here Q = 6 and P = 4. Dra he demand and ppl c r e , and iden if elfare lo . he eq ilibri m price and q an i . S ppo e ha price i mea red in $, and q an i of e a in onne per da , and ha a a of $2 per onne i impo ed; dra he ne ppl c r e and iden if he price paid b con mer , he price recei ed b prod cer and he ne eq ilibri m q an i . E plain h per ni . he increa e in price paid b con mer i maller han he amo n of a U ing o r re l , calc la e he change in con mer e pendi re, he change in firm re en e, go ernmen re en e, he change in con mer rpl , he change in prod cer rpl and elfare lo . Iden if , in o r diagram, he area ha corre pond o go ernmen re en e, elfare lo and af er- a con mer and prod cer rpl . O line ho he rela ion hip be een marginal benefi and marginal co a he ne (af er- a ) eq ilibri m rela e o alloca i e efficienc (or inefficienc ). T (S ) When a good i a ed, par of he a i paid b con mer and par b prod cer ; herefore he a b rden i hared be een he o. If o are in ere ed in eeing ho he a i hared o can read abo i in he 'Digi al co r ebook: E ra ma erial' ec ion a S pplemen ar ma erial. 4.4 Subsidies LEARNING OBJECTIVES Af e d i g hi defi e a e ai ec i he e he c i be ab e : a ea i g i orange bold i e e ce d a diag a i f b idie a e he effec he e (AO1) a ke a d akeh de (AO2) f b idie a ke a d akeh de (AO4) e a a e he effec f b idie a ke a d akeh de (AO3) ca c a e he effec f b idie a ke a d akeh de (HL ) (AO4) Introduction to subsidies The meaning of subsidies A subsid , i a ge e a i di id a , ch a fi f di ec ca h a e e a e, de , fi eedi g a i ice ; a e ief (i.e. a I hi a e e e, efe a i a ce b he g e e i di id a g f ,c e , i d ie ec f a ec . S b idie a ake he f he f f a i a ce ch a -i e e i e e -f ee a (f -i c e c e f he cha e f g d a d e ice ch a h i g, a ce), he ii f g d a d e ice b he g e e a be - a ke i g e a e ); a d he . ec i , e i c ide ae a a fi ed a e b idie c i f i i g f a e b he g e e , a d a e he ef e c c b fi . S ch . Subsidies and the allocation of resources S b idie , ike a e , ha e he effec f cha gi g he a ca i f e ce beca e he affec e a i e ice , h cha gi g he ig a a d i ce i e ice c e . A b id g a ed a fi ( g f fi ) ha he effec f i c ea i g he ice ecei ed b d ce , ca i g he d ce e, a d e i g he ice aid b c e , ca i g he b e. The ef e, he a ca i f e ce cha ge a d e i g ea e d ci a dc i ha i he f ee a ke . A i h i di ec a e , e a e i e e ed i eei g he he he g a i g f a b id i e e he a ca i f e ce . He e, , he a e de e d he deg ee f a ca i e efficie c i he a ke bef e he b id . I a ec he e e ce a e a ca ed efficie , a b id i d ce a ca i e i efficie c a d e fa e e . Thi i be he ic f hi ec i . B if he ec begi i h a ca i e i efficie c (d e a ke i e fec i ), he a b id ca k i e he a ca i f e ce if i i de ig ed c ec he ce f he i efficie c . Thi i be e a i ed i Cha e 6. Wh governments grant subsidies The e a e e e a ea h g e e ga b idie fi : Subsidies can be used to increase revenues (and hence incomes) of producers. S b idie ha e he effec f i c ea i g he e e e f d ce . The ef e, g e e fe ga b idie a ic a d ce h e e e e (a d he ef e i c e ) he d ike . Subsidies can be used to make certain goods (necessities) affordable to low-income consumers. S b idie ha e he effec f e i g he ice f he g d ha i aid b c e , h aki g he g d e aff dab e. F e a e, a g e e a ih ake a f d a e ( ch a b ead ice) e aff dab e d ce f he g d. -i c e ea e . I ca d b g a i ga b id Subsidies can be used to encourage production and consumption of particular goods and services that are believed to be desirable for consumers. A b id ha he effec f i c ea i g he a i fag d d ced a d c ed. If a g e e i he e c age c i f a g d beca e i i c ide ed be de i ab e (f e a e, ed ca i , acci a i ), i ca e a b id achie e hi . Subsidies can be used to support the growth of particular industries in an econom . Si ce b idie ha e he effec f i c ea i g he a i f d ced, if g a ed fi i a a ic a i d , he he g h f ha i d .F e a e, b idie he a i d a e i e ded e he g h f a e . O he e a e i c de che ica , e i e , ee , f i f e a d a e. Subsidies can be used to encourage e ports of particular goods. Si ce b idie aid b c e , he a e e i e g a ed g d ha a e e ed ( d i ce e e ice i c ea e he a i fe ( ee Cha e 14). e he ice he c ie ), Subsidies are a method to improve the allocation of resources (reduce allocative inefficiencies) b correcting positive e ternalities. I a ed ab e ha a ke i e fec i e e he achie e e f a ca i e efficie c ; i e ca e ( ch a he he e a e i i e e e a i ie ), i a be ib e e b idie i e a ca i e efficie c ( ee Cha e 6). S b idie a e a c e ia ic i ec ic beca e he a e e e e i e a d a e f e de ig ed achie e ce ai bjec i e ha a be c i e i h he i a bjec i e . F e a e, a c ie g a b idie f i f e , hich c a bjec i e f ai ab e de e e a d hich a c adic he bjec i e f he b idie i e ded he g h f a e a i e e e g . F i -f e b idie a e k a e e e b idie . S b idie f ag ic e a de a e a high c e ia ( ee Cha e 14). Subsidies: impacts on market outcomes and consequences for stakeholders Illustrating and anal sing impacts of subsidies on market outcomes I Fig e 4.15, he i i ia , e- b id e i ib i i de e i ed b he i e ec i f he de a d c e D a d he c e S1, gi i g i e e i ib i ice P* aid b c e a d ecei ed b d ce , a d e i ib i a i Q*. N he g e e g a a b id c i i g f a a e he fi f a fi ed a f each i f d. Thi ea ha f each i f he fi i i i g a d ab e d ce, i ecei e a e ice ha he igi a b he a f he b id ; hi d ce a d a d, a a e hif f he c e b he a f he b id , he e c e S2 = S1 b id . (The ea e b ac he b id i ha i k c a c c , h ca i g a d a d hif f he S c e. I i he e ac i e f he i di ec a hich i added he S c e ca e a a d hif . (See Q a i a i e ech i e cha e i he 'Digi a c eb k: E a a e ia '). The de a d c e e ai c a a D i ce de a d i affec ed. The de a d c e a d e c e S2 de e i e a e e i ib i , he e ice i Pc ( he ice aid b c e ) a d he a i d ced a d d i c ea e Q b. Si ce he e ica diffe e ce be ee he c e e ee he b id e i f , he fi ecei e ice P , hich i e a he ice aid b he c e , Pc, he b id e i f . Figure 4.15: I The a ke ac c e i ib i b idie a ke e d e he b id a e he f a i d ced a d c he e i ib i he f ice fa ice ecei ed b f P* c e i g: ed i c ea e f Pc; hi i he d ce i c ea e f P* Q* Qb ice aid b c e P he a f he b id i gi e b (P Pc) Q b, he a f b id b he be f i d; hi i he e i e haded a ea, a d e e e g e ide he b id he e i a e a ca i a ke a i , Q*. f e ce he d ci f he g e e d: Q b i g ea e ha i i ied e di g he f ee Consequences of subsidies for various stakeholders Consumers C e a e affec ed b he fa i ice f he g d f a i cha ed (f Q* Q b). B h he e cha ge P* Pc (Fig e 4.15) a d he i c ea e i ake he be e ff. Producers P d ce a e a be e ff, beca e he ecei e a highe ice (P > P*) a d d ce a a ge a i (Q b > Q*), ee i Fig e 4.15. The ice a d a i effec a aei a i c ea e i e e e . Bef e he g a i g f he b id , fi had e e e f P* Q*. F i g he b id , fi e e e i c ea e P Q b. The government The g e e a he b id , hich i a b de i b b id , he g e e a ha e ed ce e e di e e ai e a e , i a ha e a b dge defici (g e e Wha e e he ca e, he i ac he g e e b dge i dge . T b ai he e e e f he e he e i he ec , i a ha e e e di e g ea e ha a e e e ). ega i e. Workers A e a d f Q* Q b, fi a e ike he ef e ke h fi d e j b a e be e ff. hi e e ke d ce he e a , Societ as a whole: consumer and producer surplus, and welfare loss S cie a a h e i e ff beca e he e i a e a ca i f e ce he g d; Q b > Q*. I addi i , cie i e ff beca e he highe ice ecei ed b e a i e i efficie e ,a i g he c i e d ce. Fig e 4.16 h c e a d d ce bef e a d af e he b id . I a ke e i ib i bef e he b id , cia (c e d ce ) i MC, i dica i g he achie e e f a ca i e efficie c . Af e he g a i g f he b 4.16(b), c e i The a i c e bec e he a ea ab d ce i h b d ci d ce f he ec a (a), a he f ee a i a d MB = id , b h c e a d d ce i c ea e. I Fig e he a ea de he de a d c e a d ab e ice Pc, Q b. i h b he haded a ea abe ed gai i c e . P d ce e he c e S1a d be he ice P , Q b. The a i he haded a ea abe ed gai i d ce . Figure 4.16: Effec f b idie c e a d d ce N e ha a he ide if i g d ce af e he g a i g f a c , hich i S1 i Fig e 4.16. b id , e a a efe he A he a e i e ha d ce a d c e gai , he g e e e beca e f he ega i e effec i b dge . The b id i aid f b a e ha ha e a i c (a e a i e e ha a e ac ificed). A e k ,g e e e e di e ide he b id i (P Pc) Q b. T ac a a c a c a a. The ef e, he cia e d e g e e e di g a e g ea e ha he gai i c e a d d ce b he a a. The a ea a i e fa e e ee i g be efi f cie , ca ed b a a ge ha i a i d ced: Q b > Q*. The b id ha ca ed e d ci eai e ha i cia de i ab e, a d a e a ca i f e ce , a ca i e i efficie c . We ca a ee i Fig e 4.16(b) ha a Q b, MB < MC, ea i g ha he be efi c e ecei e f he a i f he g d he b i e ha he a gi a c f d ci g i . The ef e, cie d be be e ff if e f he g d e e d ced. The g a i g f a b id e i g ea e c e a d d ce ; h e e , cie e d e g e e e di g he b id . Si ce he f g e e e di g i g ea e ha he gai i c e a d d ce , e fa e e , ef ec i g a ca i e i efficie c , hich i hi ca e i d e e a ca i f e ce he d ci f he g d ( e d c i ). Thi i a i a ed b MB < MC: ch f he g d i bei g d ced a d c ed e a i e he cia i . Foreign producers If he b id i g a ed e (g d d he c ie ), i e ice a d i c ea e he a i fe . Whi e hi i i i e f d e ic d ce , i i ega i e f he d ce f he c ie h a be ab e c e e i h he e ice f he b idi ed g d . (Thi ic i be di c ed i Cha e 14 a d 18.) TEST YOUR UNDERSTANDING 4.8 1 Defi e 2 The g e 3 4 b idie a d e idi g e a i c e, i e ide i g g a i g a 0.50 e ea b id h g e e ki g a e ga he . f chee e. a D a a diag a f he chee e a ke bef e he g a i g f he b id , h i g he aid b c e , he ice ecei ed b d ce a d he a i f chee e ha i b gh / d. b U i g he a e diag a , h ha ha e i he chee e a ke af e he g a i g f he b id , i dica i g he ice aid b c e , he ice ecei ed b d ce , he a i f chee e b gh / d a d g e e e di g he b id . C ide i g a a a e he i b di c he c e i 2 ab ac e: he e e ce f a ke f he b id , a d akeh de . U i g a diag a , h he i c ea e i c g a i g f a b id . E ai h e fa e i c ea e. Sh he e fa e i REAL WORLD FOCUS 4.2 ice e a d d ce aie e e h diag a . ha e gh b h c f he e a d d ce Farm subsidies in the United States Fa e i he U i ed S a e ha e bee ecei i g b idie f ce ai ag ic a d c (c , hea , bea , c , ice a d he ) i ce he G ea De e i f he 1930 . I 1996, a a a a ed e d b idie a d c ea e a f ee a ke i ag ic e. H e e , he f ee a ke i ag ic e e e a e ia i ed. S fa e c a a e e $20 bi i a ea . Thi i j ified b he c be ief ha he g e e i he i g a fa e i e. Ye acc di g he US De a e f Ag ic e ( he ag ic e i i ), he a ge a d ea hie fa e ecei e he b k f fa b idie . The ea i ha b idie a e aid acc di g he a fc d ced. S a e fa e ecei e e a a , hi e fa e h c i ae f i a d ege ab e ecei e b idie a a . I fac , a bi i ai e ( h a e he e f e a ge ag ic a c a ie ) ecei e fa b idie . Acc di g he E i e a W ki g G , 50 e e i he F be i f 400 ea hie A e ica ecei ed b idie i he e i d 1995 2014. Si ce 2008, he e eci ie f b idie each ecei ed a a e age f $18.2 i i . Sources: A a a a a a US a b Fa b ca a L H a -L a , 11 J 2010. C E a , R c , Ta a b b 82, Ca , 12 A 2018 Ma $1 c b, A a A , F b , 14 A 2018 c Figure 4.17: Wa hi g bi , D.C., USA. The Na i a Fa e U i ge C ge a a fa Appl ing our skills 1 Di c he c e e ce 2 S gge a ec ea a d h he g fai . f fa e b idie f e c i e ag ic ga a ag ic a ke a d akeh de . a b idie e e h gh he Calculating the effects of subsidies on market outcomes and social welfare (HL onl ) If he g e e f each kg f ga a Q. b id fe f $4 e kg, he c e hif d a d b $4 How to graph the new suppl curve, S2 I Fig e 4.18, he e c e, S2 = S1 b id , ie $4 be he i i ia c e, S1. We ca c $4 d a d a g he e ica a i f he P i e ce f S1, a d he d a a i e aa e S1 f hi e P i e ce . Thi gi e he e c e, S2. F a Q, he e ica diffe e ce be ee he c e i $4, hich i he b id e i f . The ef e, a he e e i ib i , he ice aid b c e i Pc = $18, he e i ib i a i i Q b = 24 kg, a d he ice ecei ed b d ce i P = Pc + b id e i = $18 + $4 = $22. The e e ae h i Fig e 4.18. We ha e f d ha he ice aid b c e ha fa e f b d ce ha i c ea ed f $20 $22 e kg, a d he i c ea ed f 20 kg 24 kg. We i ca c a e c d ce $20 a i $18 e kg, he d ced a d c ice ecei ed ed ha e hi ice a d a i i f ai ge he i h he g a h i Fig e 4.18 e e e di e, d ce e e e, g e e e e di e, c e a d e fa e . , Consumer e penditure C e e e di e e a he ice aid e kg f f e i e he be f kg cha ed. The ef e, bef e he b id , c e e P* Q* = $20 20 kg = $400 e da ; af e he b id , c e e Pc Q b= $18 24 kg = $432 e da . The ef e c e e e di e i c ea ed b $32 e da (= $432 $400). Producer revenue P d ce e e e i gi e b he ice ecei ed e kg f f e i e he be f kg d. The ef e, bef e he b id a g a ed, d ce e e e a P* Q* = $20 20 kg = $400 e da , hich i e ac he a e a ha c e e ; fi e e e a e ac e a c e e e di e. Af e he b id a g a ed, d ce e e e i c ea ed P Q b= $22 24 kg = $528 e da . P d ce e e e i c ea ed b $128 e da (= $528 $400). N e ha fi e e ei e ha c e e e di e. Figure 4.18: De a d a d ih b idie Government e penditure G e e e e di e he b id ca be ca c a ed i a I i e a he b id 24 kg = $96 e da . b I i a e a he diffe e ce be ee b id : $528 $432 = $96 e da . e kg (P a : Pc) i e he be f kg d (Q b), a d i he ef e $4 d ce e e e a d c e e e di e af e he Calculating the effects of subsidies on consumer and producer surplus and welfare loss C e e a d d ce e he fa i ia ia g e f b h bef e a d af e he a ca c a e he . b id a e he a ea f ia g e , he ef e E a i i g Fig e 4.18, e ca ee ha c e a he f ee a ke e i ib i (bef e he b id ) i e e e ed b he a ea de he de a d c e a d ab e ice P* = 20 a i Q* = 20. Af e he b id , i i he a ea de he de a d c e a d ab e ice Pc = 18 a i Q b= 24. C e = (P i e ce The ef e, c e fDc bef e he e i P fc e ) Q cha ed 2 b id i : (30 P*) Q*2=(30 20) 202=10 202=200 2=$100 C e af e he b id i : (30 Pc) Q b2= (30 18) 24 2=12 242=2882=$144 The ef e, c e i c ea ed b $44 (= $144 $100). P d ce bef e he b id i Fig e 4.18, i he a ea ab P* = 20 Q* = 20. Af e he b id , i i he a ea ab e he Q b= 24. P d ce i a P d ce = (P f The ef e, ca c a ed d ce d ce i g he a e i eh da P i e ce bef e he e he c c e S1 a d be e S1 a d be P = 22 i h i di ec a e : f S1 c e) Q d2 b id i : (P* 10) Q* 2 = (20 10) 20 2 = 10 20 2 = 200 2 =$100 P d ce (P af e he 10) Q b 2 = (22 10) 24 2 = 12 24 2 = 288 2 =$144 The ef e d ce i c ea ed b $44 (= $144 N e ha ca c a e c , S1 (a e d a (The e a i f c i cide a .) S cia i c ea e i We fa e (P b id i : d ce af e he b id ha bee g a ed, e i he ca e f i di ec a e ). d ce a d c i c ea ed b d ce ca be f $100). e a d d ce he a f he i c ea e i c = $44 + $44 = $88. db : P c )( Q b Q*) 2 = (22 18)(24 20) 2 = 4 4 2 =$8 e he , bef e a d af e he e he a a b id , i f he TEST YOUR UNDERSTANDING 4.9 1 U i g he c ce fa ca i e efficie c , e 2 I he a ke f g d a ha he P i e ce f he de a d c e i a he i he e Q = 0 a d P = 7 a d he P i e ce f he c e i a he i he e Q = 0 a d P = 1. The i f i e ec i f he de a d c e a d he c e a f ee a ke e i ib i i a he i he e Q = 6 a d P = 4. he de a d a d c ai h a e , a d ide if b id c ea e he e i ib i e fa e a Da b S e ha ice i ea ed i , a d a i 2 e e i g a ed. D a he e c ice aid b c e , he ice ecei ed b a i . c Ui g e e e e, g e d ce d Ide if , i diag a , he a ea ha c e d g e e e e di , he i c ea e i c e a d he i c ea e i d ce . e O i eh he e a i hi be ee a gi a be efi a d a gi a c a he e (af e - b id ) e i ib i eae a ca i e efficie c ( i efficie c ). i ice a d . a i . e e da , a d ha a b id f e, a d fi d ( h gh g a h) he d ce a d he e e i ib i , ca c a e he cha ge i c e e e di e e e di e, he cha ge i c e a d e fa e . e, he cha ge i fi , he cha ge i e, e fa e THEORY OF KNOWLEDGE 4.1 Allocative efficienc : is it reall value-free? Th gh hi cha e , e ha e ed he c e i i e a ke de , e ai ed i Cha e 2, a he ba i f aki g a e e ab g e e i e e i i he ec . Acc di g hi de , he he e i c e i i i he e e f a b e a d e e h ac acc di g hei be e f-i e e , a d he a ke f ce a e f ee de e i e e i ib i ice , a i a i i eached he e he e i a ca i e efficie c a d a i cia e fa e. Sca ce e ce a e a ca ed i he be ib e a , d ci g he f ha e e a ,a di i ib e ake a e be e ff i h aki g e e e ff, a c di i ca ed Pa a . The c ce f Pa e i a i e e ged i he a e 19 h ce af e a e i d he ec i ee i g ake ec ic e cie ific i i a ach. Scie ific ea ec ic h d ge id f a a e j dge e ab hi g ha gh be a d ba e i e f e i e ii e hi ki g ( ee Cha e 1). The fa c a ica ec i f ea ie i e (Ada S i h, Th a R be Ma h , Da id Rica d , J h S a Mi , Ka Ma a d a he ) e di c ed hei idea ab ha gh ha e i cie ( a i e idea ) ge he i h hei i i e idea f hi g ha a e i be . Ye b he a e 19 h ce , i a be ie ed ha a e cie ce i a ef ee, a d ec i e i i a e he e h d f he a a cie ce , e ecia h ic . The c ce f Pa e i a i , de e ed b Vi f ed Pa e (a I a ia e gi ee , ci gi ec i a d hi he ), a e c ed a bei g f ee f a i e a ec . I i ha de ce ai a i , e f ee ac i g c e a d d ce beha i g acc hei i di id a efe e ce , gi e i e a c e f a i efficie c a d a i e fa e (defi ed a MB = MC a i cia ). , a ed di g cia O he face, hi d ike a a e-f ee, i i e a e e . Ye i a e ea (a d he e e ), a ec i c i ici ed i he g d ha i i ac a hea i ba ed ai e idea , a d i he ef e a e-f ee. The diffic i de ec i g he e a e i ha he e a e i ici ; he a e e ici , a a e. Ec i h e i he a e-f ee a e fa e i defi ed i e a i i di id a e f Pa e efe e ce i ai fc i e a d ha he c ce d ce (deci i f ade he ba i f a i a e f-i e e ) ha de e i e c e a d d ce . I di id a efe e ce bec e he a da d, ea i g ick, b hich ec i e a a e ea d i ai a dg e e i e e i i a ke . A e a i hi cha e , a f ee c eii e a ke i be ; g e e i e e i i hi a ke ed ce e fa e. B e he e a e he defi i i f e fa e, ch a e a i f a d di ea e, h a igh , fai e a d a e. A he e a e a e ke , e fa e defi ed a a i cia i a a hich a j dge e i ade ab h e h he ec i , f eed f h ge a i e c ce , b he , b he a i e c ce , he ba i f k. S e ec i ake he e idea f he , a d a g e ha Pa e i a i b he b d f ic ec ic hich i e i a a e-f ee. The idea ha cie ie h d e a ca i e efficie c f f c c a ca c c a a b ca c c . Ye , e e be f Cha e 1, a cie ie a e h ee ba ic ec ic e i : a / c , a d c . The defi i i f ec ic c e he fi f he e a d ig e he hi d. The ea f eg ec i g he c e i i ha ec i c ide he fi e i be a f i i e hi ki g a d he hi d a a f a i e hi ki g ( ee The fk edge 2.1 i Cha e 2). H e e , if efficie c ( a a d c ) ead a i e fa e, he e he defi i i f e fa e i ba ed a a e j dg e , ec i ha e c e f ci c e a d ha e ba ed hei -ca ed ii ea a i a a e j dge e . I ie f he ab e, e ec i a g e ha he f c fg e e icie efficie c , defi ed a Pa e i a i , di e a e i a a f he be f i c e di ib i , a d j ifie g e e i ac i i hi a ea. Wha i he i f ea i i g ( c i g c e ea i i g) Pa e i a i i he ea d, if a a ge i f he a i i a i g beca e he ha e i c e? Acc di g G a M da , a S edi h ec i h cie ce a e i e i ab ba ed a e , b he e a e The a e ca i ef bjec i i i f igh , aki g he c ci , ecific he e ica e ea ch [ ] he e i hi g c ea defi ed i e f e ici a ed a h he N be P i e i 1974, he d be ade e ici : cia he e ica a a i i e e he a a i i a d e ici , a d e i he de e i e he g, , i h a e- aded c ce if he a e 1 e e ie. Thinking points I ie , i Pa e i ai D e a g age i he e a e-f ee a g age? e i a e-f ee, a i i i i cia ici e fa e c D e he i e i ab e e f a g age i he i f ec ec i a cia c i i f a e-f ee k D D D hi k he a e a a e j dge e ? a e ?I i ic k edge? edge c ib e ha e ica e he j b f a cie ce a e a e-f ee? ag ee i h M da c ai cia cie ce b aki g a e e hi k ec ba ed ic i , ha i ici ? e e ca be, c a be ee ib e each bjec i i i he e ica a e-f ee? INQUIRY AND REFLECTION The f i g e i i he ef ec ea i g a d e ha ce ic i hi cha e . The a e gge i f i i ie ha ca de ake g i de e i e he ea i g bjec i e f hi cha e . 1 de a di g f ke i Fi d if he ci a ea i ei e e c . If i d e , ea ch i e a d fi d a ci a ea he e e c a ei ace. Re ea ch he effec f he e c a de a ae hei ef e . C ide b idie h i g, hich i a e a i e ic ha c d ha e bee ed ake h i g aff dab e e e i c e .C a ea dc a he icie a d de e i e he ad a age a d di ad a age f each. U i g f ec ic , de e i e hich f he icie h d be efe ed. J if 2 k edge c c i . Fi d if b idie a e g a ed i c . If , fi d a ea de a e f e e b idie , e ea ch he akeh de i ed a d he ea h he b idie a e gi e . E a a e he e i f he b idie b c ide i g he effec f he b idie a ke a d akeh de . EXAM STYLE QUESTIONS Y 1 ca fi d e i i G. M da (1970) Ob c he e f IB e a S ca R i he 'Digi a c a c , Ge a d D ck eb h. k: E a a e ia ' ec i . Chap er 5 Marke fail re and ociall nde irable o come I: Common pool re o rce and nega i e e ernali ie BEFORE YOU START Ca e e h Wha d ac i ? I hi k f eg d gh he did c hi k h e d be he e ice ha he c d ce he ? e fg e hi cha e e i di c e h he a ke ec a ic a e i ee h e ac i f i di id a i ac he a d he e i e . We i a a ke e c e hei h c i g . e ed d ced ca e ha ed ce he ha ca ed b he ch ha fai achie e a fi i e .I g f i di id a a ha e ega i e d h g e e i e e i ca he f 5.1 T a LEARNING OBJECTIVES After studying this section you will be able to: • define all the terms appearing in • explain the meaning of common pool resources in terms of (AO2) • a b in the text (AO1) • the concepts of rivalry and non-excludability • the tragedy of the commons explain the meaning of unsustainable production (AO2) Environmental problems can be studied by examining a special category of resources known as common pool resources.1 C are resources that are not owned by anyone, do not have a price and are available for anyone to use without payment or any other restriction. Examples include clean air, lakes, rivers, fish in the open seas, wildlife, hunting grounds, forests, biodiversity, the fertility of the soil that occurs in nature, open grazing land, the ozone layer, the stable global climate, and many more. U C a : a b - ab Common pool resources differ from any other kind of resource or good, because they possess a special combination of characteristics: they are rivalrous and non-excludable. To understand what these terms mean, it is useful to consider the definition of private goods. A private good has two characteristics: • It is a : its consumption by one person reduces its availability for someone else; for example, your computer, textbook, pencils and clothes are rivalrous, because when you buy them, another person cannot buy the same ones; most goods are rivalrous. • It is ab : it is possible to exclude people from using the good; exclusion is usually achieved by charging a price for the good; if someone is unwilling or unable to pay the price, he or she will not have the benefit of using it; most goods are excludable. As noted above, most goods are rivalrous. Common pool resources are also rivalrous. If we use up clean air, there is less left over for use by others; when we catch fish in the open sea, there are fewer fish left over for others to catch; if we destroy the stability of the global climate, it will not be available for use by future generations. Also, it was noted that most goods are excludable. However, open pool resources differ because they have no price or any other means of excluding users; anyone can use them without payment or other restriction; therefore they are ab . Non-excludable means it is not possible to exclude someone from using a good or resource. Common pool resources are rivalrous but nonexcludable. This combination poses serious threats to the environment. Rivalry means that the use of resources reduces their availability for others. Nonexcludability means that the resources can be used abundantly without restrictions and therefore may be overused, degraded and depleted. There is no end to examples of overuse, depletion and degradation of common pool resources. When factories, homes or cars use fossil fuels that emit pollutants into the atmosphere or into oceans, rivers and lakes, they ‘overuse’ a portion of these natural resources without paying for them. Some of these activities give rise to global warming, with likely devastating effects on agriculture, health and ecosystems; this involves ‘overusing’ the benefits provided by a stable global climate. When fish are overfished, the fishing industry uses up an excessive amount of the global stock of fish and disrupts the marine ecosystem. Similarly, when forests are cleared to create land for use in agriculture or for the sale of timber by the lumber industry, there are huge consequences in terms of loss of biodiversity and threats to wildlife, the ozone layer and the global climate. Land is being overgrazed because of excessive grazing; arable land is lost because of soil erosion and salinisation; wildlife is endangered because of the destruction of natural habitats due to the encroachment of settlers and agriculture. In all these cases, common pool resources are used and overused, leading to serious environmental degradation and depletion. C :T a The a is a story about cattle that feed on a fertile pasture that is owned in common by a group of herders (cattle owners). In the beginning each herder had a small number of cattle and all the animals had plenty of space and grass on which to feed. As this was a profitable business, each herder began to increase the number of cattle grazing on the pasture. But as the cattle increased, after some time the pasture became overfilled with grazing cattle that had to increasingly compete with each other for food that was becoming more and more scarce. In the end the grass was all gone, the soil was eroded and the pasture could no longer be used for grazing. This story allows us to better understand the concepts of rivalry and non-excludability. The fertile pasture is rivalrous because whatever grass is eaten by one animal is not available for another. It is also non-excludable since one herder cannot exclude others from using it. This story is used by environmentalists to illustrate the overuse of a resource when there are no restrictions on its use. The tragedy of the commons has been challenged by the ideas of Elinor Ostrom, that we will study below under the topic Collective self-governance as well as in Theory of knowledge 5.1. S a ab a As we know from Chapter 1, sustainability in connection with the environment refers to the use of resources in ways that do not result in fewer or lower-quality resources for future generations. Sustainable production is production that uses resources in a sustainable way, in other words by not degrading or depleting them. By contrast, a ab refers to production that uses resources unsustainably, depleting or degrading them. S a ab : (S a a a a ab a) A simple example shown in Figure 5.1(a) illustrates the meaning of sustainable and unsustainable production and resource use. Fish in the open seas are a common pool resource that anyone has access to without payment. The horizontal axis measures the number of fishing boats, and the vertical axis measures the quantity of fish caught in tonnes. The first, second and third boats each catch 4 tonnes; therefore, in this range of ‘constant average yield’ (yield refers to the amount of output), the three boats together catch 12 tonnes, or 4 tonnes each on average. F 5.1: Illustrating sustainable and unsustainable resource use When a fourth boat goes out to sea, it brings back only 3 tonnes of fish; this translates into a smaller quantity of fish caught by each boat on average. The four boats together have caught 15 tonnes, or an average of 3.75 tonnes (= 15 4 ) instead of 4 tonnes. When the fifth boat is added, the five boats catch 17 tonnes, and the average catch falls further to 3.4 tonnes (= 17 5 ) . With the sixth boat, the total is only 19 tonnes or 3.2 tonnes for each boat on average. This is the range of ‘decreasing average yield’, meaning that each boat that goes out brings back a smaller amount of fish than the previous one. What happens if a seventh boat goes out? The total amount of fish caught by the seven boats together (17 tonnes) is less than what was caught by 6 boats (18 tonnes). As the graph indicates, in this range of ‘absolutely decreasing yield’, as more and more boats go fishing, the total amount of fish they bring back becomes less and less. This example illustrates that the fish were plentiful for the first three boats, but with the addition of the fourth, fishing became more difficult because it began to put pressure on the supply of fish in the ocean. As the supply of fish was more and more depleted, it became increasingly difficult to catch fish, so the average quantity of fish brought back fell with the addition of each boat. Finally, with the addition of the seventh boat, the fish supply was overused; the fish population was no longer able to reproduce itself, and therefore the quantity of fish in the ocean began to drop Figure 5.1(b) shows that the point of maximum yield of a common pool resource is the resource’s maximum sustainable yield. This is the maximum use that can be made of the resource that is also sustainable, in that the resource can reproduce itself. All points to the left of the maximum sustainable yield indicate sustainable levels of use; points to the right indicate unsustainable use, meaning that the resource is being depleted or degraded. The further to the right, the greater the resource depletion or degradation. In the real world, many common pool resources are used unsustainably, i.e. to the right of their maximum sustainable yield. Note that while it is an easy matter to discuss the maximum sustainable yield of a resource in theoretical terms as we have done here, it is very difficult in practice to determine what this actually is for any resource. Sustainable resource use means that resources are used at a rate that allows them to reproduce themselves, so that they do not become degraded or depleted. A ab a - ab ,a a ab Non-renewable resources are those resources that do not last indefinitely, because they have a finite supply (they need tens of thousands or millions of years to reproduce themselves). Examples include metals, minerals and fossil fuels, such as oil, natural gas and coal. Many of these resources, with the exception of fossil fuels, do not get destroyed through their use, and so through effective recycling could be made to last indefinitely. By contrast, fossil fuels are destroyed when used, and moreover have devastating effects on the earth’s atmosphere, the global climate and the ozone layer. Renewable resources are those resources that can last indefinitely if they are managed properly (not overused), because they are reproduced over relatively short periods of time by natural processes. Examples include forests, wildlife, fish, biomass, water resources, geothermal power, soil fertility and biodiversity. The idea of sustainable resource use applies mainly to renewable resources, because given appropriate management, these resources can be made to last forever. On the other hand, through mismanagement or overuse, these resources become depleted and degraded, indicating unsustainability. The idea of sustainable resource use does not apply to non-renewable resources, such as fossil fuels. If resources are non-renewable, they could be used sustainably only if they were not used at all. On the other hand, as we will see in the pages that follow the idea of sustainability is relevant to fossil fuels when referring to the negative externalities that are created by their use. TEST YOUR UNDERSTANDING 5.1 1 Provide examples of common pool resources, making reference to their overuse. 2 a Define common pool resources using the concepts of rivalry and nonexcludability. b Explain how these characteristics pose a threat to the environment. Outline how these characteristics can be illustrated by the tragedy of the commons. 1 3 Outline the meaning of sustainable production. 4 a In discussions of common pool resources, there is an emphasis on their overuse rather than their use. Explain why. b Explain why cutting down a small amount of forest over an extended period of time may be consistent with the concept of environmental sustainability. It may be noted that in the previous syllabus these were known as common access resources . The term was changed as common pool resources is more commonly used. 5.2 Ma e a ea de e a e :d e a e a d c a be e a dc LEARNING OBJECTIVES A : a eb d (AO1) (AO2) ; MSC=MSB ( ) (AO2) (AO4) (AO2) I a d c a e a ca e e c e c e: .I C 2 e a O e e a e ac e e , , , .T (MB = MC), , . H , .T , , .T : . M - ; , , .A - .O , . Ma e a a e ca .M e e ce c , .O ( ( ); ). TEST YOUR UNDERSTANDING 5.2 1 U , , , 2 E , . , . T e ea be e a dc e e a e :d e U de e e a e a d W a ea d , , ca .W .S , , .W . A e e a - , . T .I ) e e a , , ; , ee e a - ( ) E , ( , e a Ma a a dc T A ) ). a e be e a dc ,a d a a c a be e , C , ( F 2.17, C 2). S , , F i ae e 5.2: D , e . ( ( - , MPB F 5.2. 2. T 2.17). M , , , MPC F 5.2. , - , (D) (S) cia F F .T i ae N ( 5.2, P Q .Q I, i , .I .A ca , . , , be efi (MSB) .T a gi a ; a gi a (MSC) cia c cia . W (MPB) , (MPC) , a ca i e i efficie c . I , , MSB, , , MSC, , .W F T MSB . 5.2 MSC ( D = MPB = MSB, a a a a a a a ec ). S = MPC = MSC. (MPC) ca c . (MSC) a e be e . (MPB) . a a W c a be e (MSB) . MSC = MSB, MSB, MPC F MSC cia , 5.2, i .W MPC = MSC = MPB = .A MPB MPB = MPC, MSB. W MSB , MSC, E . . Y I C MSC = MSB MC = MB . 4 W MC = MB . : . T , .T C , , , 6. T c , . e ce , TEST YOUR UNDERSTANDING 5.3 1 2 a O b U . . E : a , b 3 . S , . , 5.3 Negative production externalities LEARNING OBJECTIVES Af e d ing hi ec i n ill be able : define all he e m a ea ing in orange bold in he e e lain nega i e e e nali ie d a a diag am ill f d c i n and he e l ing elfa e l a ing nega i e e e nali ie calc la e elfa e l (AO1) f d c i n and elfa e l ha a i e f m nega i e e e nali ie e lain ha nega i e e ce (AO2) d c i n e e nali ie can be ed f (AO4) d c i n (HL nl ) (AO4) ill e lain g e nmen in e en i n c ec nega i e e e nali ie e e f c mm n l e ce incl ding: (AO2) indi ec (Pig (AO2) ae f e e f c mm n d c i n and l e en ian) a e ca b n a e adable e mi legi la i n and eg la i n c llec i e elf-g e nance ed ca i n-a a ene c ea i n in e na i nal ag eemen d a diag am di c ill a e he ab eng h and limi a i n diffic l ie in mea emen eg e nmen e f he ab e g n e (AO4) e nmen licie i h e ec : (AO3) f e e nali ie deg ee f effec i ene c n e ence f akeh lde Explaining and illustrating negative production externalities Negative production externalities efe e e nal c c ea ed b d ce . The blem f en i nmen al ll i n, c ea ed a a ide-effec f d c i n ac i i ie , i e c mm nl anal ed a a nega i e d c i n e e nali . C n ide a cemen fac ha emi m ke in he ai and di e i a e b d m ing i in he cean. The e i a d c i n e e nali , beca e e and ab e he fi m i aec f d c i n, he e a e addi i nal c ha ill e n cie d e he ll ed ai and cean, i h nega i e c n e ence f he l cal inhabi an , imme , ea life, he fi hing ind and he ma ine ec em. Thi i h n in Fig e 5.3, he e he l c e, S = MPC, eflec he fi m i ae c f d c i n, and he ma ginal cial c c e gi en b MSC e e en he f ll c cie f d cing cemen . F each le el f , Q, he cial c f d cing cemen gi en b MSC a e g ea e han he fi m i aec . The e ical diffe ence be een MSC and MPC e e en he e e nal c . Since he e e nali in l e nl d c i n ( he l c e), he demand c e e e en b h ma ginal i a e benefi and ma ginal cial benefi . Figure 5.3: Nega i e d c i n e e nali Fig e 5.3 ill a e a gene al in ha h ld kee in mind hene e e amine ( d a ) an e e nali diag am: he f ee ma ke c me i de e mined b he in e ec i n f MPB and MPC, e l ing in an i Qm and ice Pm. The ciall im m ( be ) c me i gi en b he in e ec i n f MSB i h MSC, hich de e mine an i Q and ice P . We can d a an im an c ncl i n f m he nega i e e e nali in Fig e 5.3: When he e i a nega i e d c i n e e nali , he f ee ma ke e all ca e e ce he d c i n f he g d and m ch f i i d ced ela i e he cial im m. Thi i h b Qm > Q and MSC > MSB a he in f d c i n, Qm, in Fig e 5.3. n The welfare loss of negative production externalities Welfare loss Whene e he e i an e e nali , he e i a elfa e l he mi all ca i n f e ce . , in l ing a ed c i n in cial benefi , d e In Fig e 5.4(a), he haded a ea e e en he elfa e l a i ing f m he nega i e d ci n e e nali . F all ni f g ea e han Q , MSC > MSB, meaning ha cie ld be be e ff if le ee d ced. The elfa e l i e al he diffe ence be een MSC and MSB f he am n f ha i e d ced (Qm Q ). I i a l f cial benefi d e e d ci n f he g d ca ed b he e e nali . If he e e nali e e c ec ed, ha he ec n m eache he cial im m, he l f benefi ld di a ea . I ma be ef l n e ha he in f he elfa e l iangle al a lie a he Q an i f . Calculating welfare loss (HL onl ) Fig e 5.4(b) i imila 5.4(a) e ce ha i incl de fig e ha all calc la e elfa e l . T find he a ea f he haded iangle, e ake he heigh ime he id h f he iangle and di ide i b 2. N e ha he heigh f he iangle i e al he e e nal c e ni , MSC MPC, and he id h i e al he am n f e d c i n b he ma ke Qm Q : Welfa e l = (6 4) (100 70) 2 = 2 30 2 =$30 Figure 5.4: Welfa e l in a nega i e d c i n e e nali Welfare loss in relation to consumer and producer surplus (Supplementar material) We can e he c nce f c n me and d ce l nde and he e e nali . In Fig e 5.4(c), in ma ke e ilib i m, c n me l i e al hile d ce l i e al a ea f + g + h. The al e f he e e nal c be een he MSC and MPC c e Qm ( he an i d ced b he ma e al c + d + e + g + h. The al cial benefi in ma ke e ilib i m a e e l d ce l min he e e nal c : (a + b + c + d) + (f + g + h) (c + d + e + g + h) = a + b + f elfa e l d e he a ea a + b + c + d, i he diffe ence ke ), and i he ef e al c n me l e A he cial im m, a Q and P , c n me l i e al a ea a, and d ce l i e al a ea b + f. The e e nal c i n e al e . The ef e, he al cial benefi a e e al c n me l l d ce l : a+b+f C m a ing al cial benefi a he ma ke e ilib i m and a he cial a e malle a he ma ke e ilib i m b he a ea e. Thi i he elfa e l . im m, e find ha he Negative production externalities and overuse of common pool resources The c nce f nega i e e e nali ie ha e died ab e can be ed ill a e he blem f e e f c mm n l e ce and i effec n ainabili . F e am le, in he nega i e d c i n e e nali diag am f Fig e 5.3 he diffe ence be een he MPC and MSC c e can be in e e ed a he e e nal c a i ing f m he cemen fac e e f clean ai , a e and ea life n acc n f i de endence n f il f el ; i can al be in e e ed a he c cie f ca ing gl bal a ming (de ing he abili f he gl bal clima e, hich i al a c mm n l e ce). The b ning f f il f el c ea e e e nal c in e m f e e f c mm n l e ce . If i e e ible make he cemen fac a f he n nece a il i ll ing ac i i ie en i el , and H e e,i ld e hem, h leading a e e f he e e ce , he d ce ld ld n c mm n l e ce . ainable e f c mm n l e ce . Fig e 5.3 can be ed ill a e he e e f man c mm n l e ce a a nega i e d ci n e e nali . F e am le, if he S = MPC c e e e en he i a e c f a fi hing fi m ha fi he in he en ea , he e e nal c ld be de le i n f he ck f fi h, and en i nmen al damage d e di i n f he ma ine ec em, he c mm n l e ce ha he fi hing fi m ha e ed b n aid f . The c cie f he fi m fi hing ac i i ie a e gi en b MSC, hich a e he i aec l he e e nal c . TEST YOUR UNDERSTANDING 5.4 1 2 a U ing a diag am, h h ma ginal i a nega i e d c i n e e nali . b E lain he diffe ence be een he e ilib i m an i de e mined b he ma ke and he an i ha i imal f m he in f ie f cie efe ence . c De c ibe he blem i h he all ca i n f e nega i e d c i n e e nali . ce achie ed b d Sh he elfa e l c ea ed b e lain ha hi mean . he nega i e d c i n e e nali a P d c i n e e nali ie . ide e am le f nega i e i aec and ma ginal cial c he ma ke in diffe hen he e hen he e i a diag am, and b U ing diag am and e am le , e lain h anal e he e e f c mm n l e nega i e ce . d c i n e e nali ie can be ed Policies to correct negative production externalities and prevent overuse of common pool resources and their evaluation We ill e amine and e al a e a a ie e e f c mm n l e ce . f licie deal i h nega i e d c i n e e nali ie and Market-based policies I: indirect (Pigouvian) taxes An im an g f licie ha can be ed b g e nmen el n he ma ke c ec nega i e d c i n e e nali ie and m e ainable e f c mm n l e ce . Ma ke -ba ed licie k b changing he incen i e faced b fi m . In ne ch a ach he g e nmen c ld im e an indi ec a n he fi m e ni f d ced. Thi i kn n a a Pigouvian tax ( Pigovian tax), af e he Engli h ec n mi A h Cecil Pig h a he fi e he idea f im ing a a in de c ec a nega i e e e nali . In Fig e 5.5(a), he a e l in an a d hif f he l c e, f m S = MPC MSC (=MPC + a ). The imal ( be ) a lic i im e a a ha i e ac l e al he e e nal c , he MPC c e hif a d n il i e la i h MSC. The ne , af e - a e ilib i m i gi en b he in e ec i n f MSC and he demand c e, D =MPB =MSB, e e e, a a f he g d d ced, Q , and highe , imal ice, P .N e ha he ea he indi ec a e di c ed in Cha e 4 d ced a ca e eff c e c , indi ec a e in he e en c n e a e in ended ead a ca e eff c e c . Bea ing in mind di c i n f indi ec a e in Cha e 4, ma n e ha P i he ice aid b c n me , Pc, hile he ice ecei ed b d ce i P , hich i e al Pc min a e ni . Market-based policies II: carbon taxes Ca b n a e a e a kind f a de igned deal i h ha i e ha he ingle m e ing and c m le h ea he gl bal ec em: gl bal a ming, ca ed b emi i n f g eenh e ga e , he m im an f hich i ca b n di ide. When e eak f he c n ib i n f g eenh e ga e gl bal a ming, e efe h e ga e emi ed b man-made ce e , and ecificall b he b ning f f il f el ( il, c al and na al ga ). The e a e ke mea e nde di c i n in he gl bal c mm ni ca b n di ide emi i n : ca b n a e and adable e mi ( ee bel deal i h he blem f ). The carbon tax i a a e ni f ca b n emi i n f f il f el . F il f el d n all emi he ame am n f ca b n hen b ned, he ef e he ca b n a i calc la ed n he ba i f h m ch ca b n he f el emi : e e ca b e ed, e e e a . Thi can be ill a ed b he ame diag am ed h he effec f a a e ni f , in Fig e 5.5(a). F ll ing he im i i n f he a , fi m m a he highe ice b he f il f el. Thi a ea in Fig e 5.5(a) a he familia a d hif in S = MPC a d MSC beca e f he fi m highe c f d c i n, b hi ha f he c n e ence . Since he e a e he b i e ene g ce i h l e ca b n emi i n ( h a ed a a l e a e), ha d n emi ca b n (if he a e n f il f el , h n a ed a all), he inc ea e in he ice f he high-ca b n f el c ea e incen i e f fi m i ch he , le ll ing n n- ll ing ene g ce . Figure 5.5: Ma ke -ba ed licie e f c mm n l e ce c ec nega i e The e l i ha if he fi m i che al e na i e, le c ea e, beca e e e e a c f d c e d c i n e e nali ie and ll ing e bec m e ainable ce , Q F e 5.3 e a e . Thi can be een in Fig e 5.5(b), he e he MSC c e hif f m MSC1 MSC2, indica ing ha he e e nal c ae l e d e he e f he le ll ing e ce . Wi h he fall in e e nal c , he im m an i f inc ea e f m Q 1 Q 2 . (N e ha hi al in l e a l e a n ll an , h n b he malle di ance be een he demand c e and MSC2 .) Ca b n a e a e ed in man c n ie a a me h d ed ce ll i n, f e am le, Denma k, Finland, F ance, I eland, Ja an, Me ic , P land, S eden, a ell a me a e in Canada and he Uni ed S a e and m e. A a n ca b n ( n emi i n gene all ) ha he effec f c ea ing incen i e f d ce ed ce he am n f ll i n he c ea e b cha ing le ll ing e ce ( ch a f il f el ), and i ch le ll ing echn l gie (al e na i e ene g e ce ). Thi ed ce he i e f he nega i e e e nali and inc ea e he im m an i f . A a n he f he ll e d e n ha e hi effec ; i c ec he e all ca i n f e ce he g d, ed cing he an i f d ced. Market-based policies III: tradable permits Tradable permits, al kn n a ca a d ade c e e , a e a lic in l ing e e i ed fi m b a g e nmen an in e na i nal b d . The e e mi ll e can be aded (b gh and ld) in a ma ke . C n ide a n mbe f fi m h e d c i n ll e he en i nmen . The g e nmen g an each fi m a a ic la n mbe f e mi ( igh ) d ce a a ic la le el f ll an e a gi en ime e i d. The e mi ll e can be b gh and ld am ng in e e ed fi m , i h he ice f e mi being de e mined b l and demand. If a fi m can d ce i d c b emi ing a l e le el f ll an han he le el e b i e mi , i can ell i e a e mi in he ma ke . If a fi m need emi m e ll an han he le el e b i e mi , i can b m e e mi in he ma ke . Fig e 5.5(c) h a ma ke f adable ll i n e mi . The l f e mi i e fec l inela ic (i.e. he l c e i e ical), a i i fi ed a a a ic la le el b he g e nmen ( an in e na i nal a h i if e e al c n ie a e a ici a ing). F hi lic effec i el ed ce he le el f ll i n, he al ll i n ha i e mi ed ba ed n he ll i n e mi m be e a e a f c ea ed e . The fi ed l f e mi i di ib ed fi m . The i i n f he demand-f - e mi c e de e mine he e ilib i m ice. A an ec n m g and he fi m inc ea e hei le el , he demand f e mi i likel inc ea e, a h n b he igh a d hif f he demand c e f m D1 D2. Wi h l fi ed, he ice f e mi inc ea e f m P1 P2. T adable e mi a e like a e ll ing e ce f hich i emi i n , i can ell i e mi an i f ll an emi ed, im m an i f Fig e 5.5(b). n emi i n in ha he ide incen i e d ce i ch le i n nece a b e mi . If a fi m find a a ed ce i h adding fi . Pe mi a e he ef e in ended ed ce he h ed cing he i e f he nega i e e e nali , and inc ea ing he d ced, b hif ing he MSC c e ad a d MPC, a h n in T adable e mi cheme ma be e i hin a c n , ch a Ka akh an (2013), S i e land (2008), Ne Zealand (2008); i hin a g f c n ie ch a he E ean Uni n Emi i n T ading S em (EU ETS) (2005); in e na i nall ch a he Pa i Ag eemen (2016; ee bel I e a a a ee e ). T adable e mi a e h l deba ed ge he i h ca b n a e ; ee Real W ld F c 5.1. Y S ma n e in em (ETS). eading ab adable e mi ha he a e efe ed Advantages of market-based policies a an Emi i n T ading Ec n mi all efe he ma ke -ba ed l i n g e nmen eg la i n deal d c i n e e nali ie and e e f c mm n l e ce , a l ng a he a ic la e mi he e f ch licie . B h a e and adable e mi ha e he effec f e e e a , meaning ha he c ha e e e i l e e nal a e made in e nal, beca aid f b d ce and c n me h a e a ie he an ac i n. In he ca e f a e , a e e nl ide incen i e echn l g and gi en ll ing e i ch le ll ing e ce . c a e ca b a ae e d ce ed ce he an i f ce , b n ed ce he am n f i h nega i e e e nali a e e he a e n a e . Ta e d ced i h a gi en ll i n he c ea e n Ta e n ll an emi ed ide incen i e fi m ec n mi e n he e f ll ing e ce ( ch a f il f el ) and e d c i n me h d ha ll e le . Fi m d n all face he ame c f ed cing ll i n; f me, he c f ed cing ll i n a e l e han f he , and he e ill be he ne m likel c hei ll i n emi i n a id a ing he a . Fi m ha face he highe c f ed cing ll i n ill be he ne lea likel c hei ll an , and ill a he a . The e l i ha a a ead e e e a a e ea c c e ince he fi m ha ill i ch clean f m f ene g a e he ne ha can d i m e chea l . Simila l , in he ca e f adable e mi , he em c ea e incen i e f fi m c back n hei ll i n if he can d a ela i el l c . If i i a ela i el l -c ced e f a fi m ed ce i ll an emi i n , i ill be in i in e e d and ell e ce e mi . Fi m ha can nl ed ce ll i n a high c ill be f ced b addi i nal e mi . The ef e, b h a e and adable e mi a e me h d ed ce ll i n m e efficien l (a a l e c ). Disadvantages of market-based policies Whe ea a e and adable e mi a e im le in he , in ac ice he a e faced i h n me echnical diffic l ie . While i i kn n i h a ea nable deg ee f ce ain ha man-made g eenh e ga e ca e gl bal a ming, he e i emend nce ain in calc la ing he eci e c n ib i n f each f he e inc ea e in gl bal em e a e . Thi gi e i e diffic l ie in de igning effec i e ca b n a e and adable e mi cheme . Taxes Ta e face e i ac ical diffic l ie ha in l e de igning a a e al in al e ll i n. An effec i e a lic e i e an e he f ll ing e i n : he am n f he What production methods produce pollutants? Diffe en d c i n me h d c ea e diffe en ll an . I i nece a iden if ha me h d d ce hich ll an , hich i echnicall e diffic l . Which pollutants are harmful? I i nece a echnicall diffic l , and he e i m ch c n e b each e f ll an . iden if he ha mf l ll an , hich i al am ng cien i e he e en f ha m d ne What is the value of the harm? I i hen nece a a ach a m ne a al e he ha m: h m ch i he ha m d ne b each ll an h? Thi ai e e i n ha ha e n ea an e : h ha i ha med; h i he al e f ha m be mea ed? What is the appropriate amount of tax? I i nece a e al he al e f he ha m. de e mine he i e f he a make i How will consumers be affected? Indi ec a e a e e e e (a ill lea n in in Cha e 12) meaning ha l e inc me e le ha e a a highe i n f hei inc me in a han highe inc me e le, hich i c n ide ed ine i able ( nfai ). A ei Acc ding blem i h ca b n a e i ha he a e he OECD Sec e a Gene al: T e f be ee acce ab e. P c da ca b ca b c ec ce all e l make a ignifican im ac . a d e ac a c f e a c c e e a d c -effec e a c a e a e c a e. We a e ec a a e The ea n i ha i i nece a diffe ence. e e da a ee a e .2 li icall diffic l im ec e a a -ca b e ca b n a e ha a e high en A ide f m he echnical diffic l ie , he e i al a i k ha e en if a e a e im fi m ma n l e hei ll i n le el , c n in ing ll e e en h gh he a gh a d make he ed me a a a . ll ing Tradable permits T adable e mi face he echnical limi a i n ega ding d c i n me h d and ll an n ed ab e f a e . In addi i n, adable e mi e i e he g e nmen ( in e na i nal b d ) e a ma im m acce able le el f each e f ll an , called a ca . Thi a k demand ha ing echnical inf ma i n n an i ie f each ll an ha a e acce able f m an en i nmen al in f ie , hich i f en n a ailable. If he ma im m le el i e high, i ill n ha e he de i ed effec n c ing ll i n le el . If i i e l , he e mi bec me e c l , ca ing ha d hi f fi m ha need b hem. T da e, adable e mi ha e been de el ed f j a fe ll an (CO2, SO2). In addi i n, a me h d m be f nd di ib e e mi ll ing fi m in a fai a . I e f li ical fa i i m ma c me in la , a g e nmen gi e efe en ial ea men hei f iend and e . In ac ice, he m ha can be h ed f i a hif f he MPC c e me ed c i n in he i e f he e e nali , b i i nlikel ha he e e l . a d he MSC c e, a licie can achie e he ell imal REAL WORLD FOCUS 5.1 Carbon taxes versus tradable permits: how to best limit carbon dioxide emissions The e i a g ing m men m a nd he ld im lemen ca b n icing in me f m. A f 2019 e 60 c n ie , a e ci ie had im lemen ed me f m f ca b n icing, ei he h gh ca b n a e h gh adable e mi . A e f e le in fi e c n ie (A alia, India, S h Af ica, he Uni ed Kingd m and he Uni ed S a e ) f nd ha be een 60% (in he Uni ed S a e ) and 80% (in India) ed ca b n a e ided he e e e n a gl bal cale and he e en e e e e ned he e le en n clima e jec . Figure 5.6: Kli en, Ge man . Ligni e-fi ed e ai n H e e , ca b n icing emain n la am ng b h c n me and b ine e . B ine e a e f en ed beca e i ai e he c f d c i n. O he a ha i i nfai in he e en ha he ade i h c n ie ha d n ha e ca b n icing. In A alia, a ca b n a a e ealed in 2014 n he g nd ha i a de ing j b . I i f en ed b c n me beca e i ha he effec f ai ing ice . I ha a nge effec n he beca e i ai e h eh ld ene g ice .4 A ma ke -ba ed me h d ed ce emi i n , b h ca b n a e and adable e mi ide incen i e fi m i ch le ll ing f m f ene g . H e e , a e ha e een he diffe in h he a em d hi . Ca b n a e fi he ice f he ll an in he f m f a a n ca b n and all he an i f ca b n emi ed a , de ending n h fi m e nd he a ; ca and ade cheme fi he an i f he e mi ible ll an , and all i ice a , de ending n l and demand. Carbon taxes versus tradable permits: an evaluation Carbon taxes make energ prices fl c a e acc ding demand and fl c a e e en m e d e fl c a i im an f b ine e ha need more predictable. F il f el ice in gl bal ma ke l . Unde adable e mi , he ice f f il f el migh n in he ice f ca b n e mi . P ice edic abili i lan hei c ahead f ime. Carbon taxes are easier to design and implement. T adable e mi a e diffic l de ign and im lemen a he in l e c m lica ed deci i n ch a e ing he ca a he igh le el and di ib ing he e mi am ng all in e e ed e . Carbon taxes can be applied to all users of fossil fuels. T adable e mi cheme f en a ge ne a ic la ind , mall g f ind ie . Ca b n a e can be a lied all e f f il f el , incl ding all d ce and c n me . Carbon taxes do not offer opportunities for manipulation b governments and interest groups. P li ician f en efe adable e mi cheme ca b n a e , and i i belie ed ha hi ma be beca e i i ea mani la e he di ib i n f e mi f he benefi f efe ed g and e , ih affec ing he im ac n he en i nmen (beca e f he ca ). Carbon taxes do not require as much monitoring for enforcement. T adable e mi cheme e i e m ni ing f emi i n , he i e fi m ma chea b emi ing m e ll an han he a e e mi ed. Ca b n a e a e ea ie de ending n he e and an i f f il f el m ni a he cha ed. nl in l e a men fa a Tradable permit schemes face political pressures to set the cap too high. If he ca n ll an i e high, i ld ha e a e limi ed n im ac n ed cing ca b n emi i n . The e a e al me a g men again ca b n a e and in fa f adable e mi cheme : Carbon taxes face political pressures to be set too low. G e nmen ma be n illing e ca b n a e high en gh f he e ide he nece a incen i e f e i ch le ll ing ene g ce . Carbon taxes cannot target a particular level of carbon reduction. Since ca b n a e cann fi ( ca ) he e mi ible le el f ca b n emi i n , he lead nce ain ca b n- ed cing c me . Carbon taxes are regressive. A eg e i e a i ne he e he a a a f ac i n f inc me i highe f l -inc me ea ne han i i f highe -inc me ea ne , and g again he inci le f e i ( ee Cha e 12). A ca b n a n a fi m i an indi ec a ha i aid a l b d ce and a l b c n me . The ef e, c n me ld al be affec ed, and l e inc me c n me ld be affec ed i na el m e. Appl ing our skills 1 C m a e and c n a ade cheme . 2 The W ld Bank eg la l da e he f ll ing i e i h inf ma i n n ca b n icing (ca b n a e adable e mi ) ha c n ie a nd he ld a e ei he im lemen ing lanning im lemen . Selec ne m e c n ie f ch ice and in e iga e he ca b n icing ha ha been elec ed. Re ea ch he e e ience f c n c n ie i h e ec (a) li ical acce abili , (b) effec i ene i h e ec ed cing ca b n emi i n , (c) an f e lan f ackling he ca b n emi i n blem. Sources: Ca b P c me ke i e nding he deba e n ca b n a e e ca and Da b a d Government legislation and regulation G e nmen legi la i n and eg la i n el n he c mmand a ach, he e he g e nmen e i a h i enac legi la i n and eg la i n in he blic in e e ( ee Cha e 1 f a di c i n f c mmand deci i n-making). Legi la i n and eg la i n in ended ed ce he effec f d c i n e e nali ie and limi en i nmen al damage icall in l e emi i n anda d , a , licence , e mi igh e ic i n . E am le incl de: e ic i n n emi i n f ll an ma im m le el f ll an e mi ed e i emen f ed ce emi i n eel mill and elec ici banning he e f ha mf l banned in man c n ie ) i ing licence hibi ing c n e ic i n n he f m fac e mi f gene a ing lan b ance (e.g. a be ,ag ial d ci n b e ing a in all m ke ack c bbe f mine al ha a e e ic ha i a ic la ac i i ie ( ch a h n ing) c i n ( ch a h an i ie and ind ing) ind ag ic l e in ec ed a ea f l gging e ic i n in he f m f a f fi hing (ma im m e mi ible an i f fi h ha can be ca gh ) in he f m f he i e f hi ing flee , al ban f ecific a ea ecific ime f he ea e abli hmen f ec ed a ea f he ec i n f bi di e i and endange ed ec em . The im ac i l e he an i f he g d d ced and b ing i cl e Q in Fig e 5.7 b hif ing he MPC c e ad a d he MSC c e. P ll an and e ic i n achie e hi b f cing he fi m d ce le . Re i emen in all echn l gie ed cing emi i n achie e hi b im ing highe c f d ci nd e he cha e f he n n- ll ing echn l gie . Ideall , he highe c f d ci n ld be e al he al e f he nega i e e e nali . The g e nmen lic bjec i e i make he MPC c e hif a d n il i c incide i h he MSC c e, in hich ca e Q i d ced, ice inc ea e f m Pm P , and he blem f e all ca i n f e ce he d c i n f he g d i c ec ed. If ll ing fi m d n c m l i h he eg la i n , he ld ha e a fine . Figure 5.7: G e nmen eg la i n ainable e f c mm n l e ce c ec nega i e d c i n e e nali ie and m e Advantages Legi la i n and eg la i n , incl ding e ic i n ch a in he e am le ab e, ha e he ad an age ha he a e im le in effec and e ee. The a e ea ie im lemen c m a ed ma ke -ba ed lice and a id he echnical diffic l ie ha a i e in he e f ma ke -ba ed l i n . The can al be i e effec i e. F e am le, banning ha mf l b ance , hibi ing h n ing in ce ain a ea , e ic ing he an i f l gging (ch ing d n ee ) ma be he m effec i e a deal i h ce ain blem . M e e , eg la i n f ce fi m c m l and ed ce hei ha mf l ac i i ie ( hich ma ke -ba ed licie ma n al a d ). F he e ea n , eg la i n a e fa m e c mm nl ed a a me h d limi nega i e e e nali ie f ll i n in c n ie a nd he ld. Disadvantages H e e , he al face limi a i ed ce emi i n b ing le al e na i e f el . The cann di ll i n, hich ld limi he ll i n i ed ced a a highe n . In he ca ll ing e ing i h be e all c e all c . e f emi i n f ll ce , inc ea e ene g een fi m ha ha e l f ed cing ll i n (e an , he d n ffe incen i e efficienc and i ch e highe c f ed cing lained ab e). The e l i ha In addi i n, al h gh he can be im lemen ed m e ea il , he ffe f m imila limi a i n a he ma ke -ba ed licie (lack f fficien echnical inf ma i n n e and am n f ll an emi ed), and can in m ca e be nl a iall effec i e in ed cing he ll i n c ea ed. Finall , he e a e c f m ni ing and e i i n de ec ible i la i n , leading ni c , and he e ma be blem i h enf cemen . The ef e, ch mea e can nl a em a iall c ec he blem. O e all, he effec i ene f legi la i n m be a e ed in ela i n he a ic la in ended, a i can be m e effec i e in me i a i n han in he . ef hich i i C ec i n f nega i e d c i n e e nali ie b ma ke -ba ed a ache g e nmen legi la i n and eg la i n all in l e hif ing he MPC c e ad a d he MSC c e h gh a a ie f licie . F all ca i e efficienc be achie ed, he an i f he g d d ced and 5 c n med m fall Q a ice inc ea e P . Collective self-governance: the contribution of Elinor Ostrom The c nce f collective self-governance efe a l i n he e f c mm n l e ce he e he e ake c n l f he e ce and e hem in a ainable a . Thi c nce n c ne he idea f he a ed f e c , di c ed ab e, he e each e make e f he e ce a he e en e f he i h he e l l ima el deg ade and de le e i . C llec i e elf-g e nance, a he e m gge , i n a lic ha i im ed b he g e nmen . I i a he an a ach manage e ce nde aken b c mm ni ie f e ce e b hem el e , beca e he eali e ha i i in hei n be in e e k c llec i el f he e e a i n f e ce ha a e i al hei li elih d. C llec i e elf-g e nance a an a ach c mm n l e ce a made fam b Elin O m, an Ame ican li ical cien i h became he fi man ecei e he N bel P i e in Ec n mic (2009) f he k n he managemen f c mm n l e ce . O m en decade d ing h c mm ni ie gani e hem el e manage c mm n e ce ch a fi h ck , d , lake , a e and g nd a e ba in . She di c e ed ha c mm ni ie f en de el c m le mechani m n h make deci i n and h enf ce le , e l ing in c me ha diffe idel f m h e edic ed b anda d ec n mic he . In an in e ie in 2010, he aid: If ae af e a ea a ea d d de ,a d f ca a e e e f e e a f a ca e a d a e a ea d a fc ca eac e 6 e a e, a d e e be fa e . fa - e be ef e e a e ce, e e f ce e . B f e c ec f e f- a a ae a a e d e , O m and he c lleag e e f med h nd ed f e e imen , hich h ha hen e le a e e f a c mm n l e ce, he a e f en able find l i n n h manage i ainabl , ih e ing and de ing i , ded e a e d e d fc ca be ee e .7 The make le ab h each e h ld beha e and c n ib e he managemen f he e ce, and le f enf cemen and anc i n again h e h i la e he le . Man die b O m and he ch la f eal-life i a i n , in l ing he managemen f c mm n l e ce , c nfi m he e l f he e e e imen . H e e , ne e i emen f ainable e ce managemen i ha he e m be b nda ie f an a ea ( ch a a a e, a d a lake, and n) c e nding he a ea ha he e ce e a e managing. Thi ai e he e i n he he O m a ach i i able f dealing i h gl bal blem ch a he cean and clima e change. She he elf n e he f ll ing: I ea de a ca a d e a be ,b e e e cea . . . I .W e b e ea e e b a a a ca d a.I e a e f ec a a d c ec d e d a. a ef ad Advantages Elin O m k ha h n ha e le d n al a ac in he elf-in e e ed, na manne e ed b he aged f he c mm n . In ead, b king c e a i el , e le can find l i n he blem f e e f c mm n l e ce i h -d n l i n im ed b g e nmen . The e c e a i e l i n can be achie ed in he ab ence f i a e ne hi f e ce (em ha i ed b e f f ee ma ke ec n mie he e hi i an e en ial cha ac e i ic) a ell a in he ab ence f g e nmen - ned e (em ha i ed b lanned ec n mie ; ee Cha e 1 f he e di inc i n ). H e e , i i im f a d in lace ( ee Cha e 19 and 20). e an f c mmand ha e a legal em Disadvantages F e le be able manage c mm n l e ce n hei n he e a e im an c ndi i n ha m be a i fied, he m be able c mm nica e i h each he in de c ea e le f he e f he c mm n l e ce , and he e m be a b nda f he e ce. A O m he elf admi hi i diffic l f e ce ch a he cean . Education and awareness creation Ed ca i n f he blic and i i n f inf ma i n ega ding he ll ing ac i i ie f fi m ( he ac i i ie i h nega i e e e nal effec ) f en make c n me n a a f m he d c , ih nega i e effec n he fi m ale . A a e l he fi m a e f ced ake c n me ini n in c n ide a i n and change hei d c i n me h d in de ed ce he e e nali ie . Advantages The ad an age he e i ha fi m a e e m ch infl enced b kee hem ha , he i e he ill ffe d in ale . he ini n f hei c me and an Disadvantages The diffic l i h hi a ach i ha i can nl make a mall diffe ence in e m f l ing he blem f d c i n e e nali ie and ainabili . F e am le, if he e i inf ma i n ab a fi m c ea ing ignifican en i nmen al damage in a l cali ed a ea ( ch a ca ing an il ill ha affec he li elih d and heal h f he l cal inhabi an ), c n me ma bec me c nce ned and b c he fi m f a hile. H e e blem f a m e gene al and b ade na e, ch a he e f f il f el ha ca e clima e change l a h f he en i nmen al blem , e i e l i n n a fa b ade cale. In fac ca b n a e and adable e mi (di c ed ab e) a e fa m e effec i e in ackling blem f hi kind. International agreements P licie a e made mainl b na i nal g e nmen . H e e , nega i e d c i n e e nali ie and he e e f c mm n l e ce e f en ha e in e na i nal e e c i n , in hich ca e c e a i n am ng g e nmen and in e na i nal ag eemen a e c ciall im an c n l and e en nega i e c n e ence n ce ain e ce , ch a he gl bal clima e and he ne la e . In addi i n, c - e a i n am ng g e nmen i e im an f he de el men and diff i n f ne echn l gie in ended deal i h gl bal en i nmen al i e . C - e a i n be een g e nmen ma be gl bal egi nal. F e am le, he ne la e ha ffe ed ne de le i n, leading ed ced ec i n again he n l a i le adia i n. Thi e l ed f m h man ac i i ie in l ing he d c i n f ni gen ide and chl fl ca b n (CFC ). The ne la e i a c mm n l e ce. N ne n i , and n ne can claim damage f i de c i n. The e n ibili f i de c i n lie i h ll ing ac i i ie i hin i all e e c n , and he c n e ence f i de c i n a e fel gl ball . The ame c n ide a i n a l he gl bal clima e. One f m cce f l e am le f in e na i nal c llab a i n f he en i nmen i he M n eal P c l, igned in 1987 and c ming in effec in 1989, in ended ha e b ance ha ha e ca ed de le i n f he ne la e . B 2009, all membe a e f he Uni ed Na i n had a ified he ag eemen , and ignifican g e ha been made in he a ea f ha ing ne-de le ing b ance . An he cce f l e am le f a egi nal c llab a i e a angemen i he E ean Uni n adable e mi cheme f ca b n, kn n a he E ean Uni n Emi i n T ading S em (EU ETS), hich a ini ia ed in Jan a 2005. The cheme c e he ec f e and hea gene a i n, il efine ie , me al , l and a e , and ene g in en i e ind . In hi em, ne e mi , EU All ance (EUA) e mi he h lde elea e ne nne f ca b n di ide. Each emi e f ca b n i all ca ed EUA , hich a e aded in a a idl g ing ca b n ma ke . The EU ETS i he c ne ne f he E ean Uni n lic n clima e change. Acc ding a maj d , hile hi ha hel ed in ed cing ca b n emi i n i ha n had nega i e im ac n he ec n mic e f mance f fi m in e m f e en e , fi and em l men .8 An he maj , b le cce f l in e na i nal ag eemen f he en i nmen a he K P c l f 2005 2012. I bjec i e a make igna c n ie c mmi hem el e ed ce emi i n f ca b n di ide and he g eenh e ga e l d n clima e change. I al c n ained ii n f he de el men f a ma ke f adable emi i n e mi . The c n ie ha igned e e di ided in de el ed and de el ing. Onl he de el ed c n ie had emi i n e ic i n . The de el ing c n ie a ici a ed b in e ing in jec ha e e ed l e hei emi i n . The Uni ed S a e , hich a he c n i h he highe g eenh e ga emi i n , did n ign he K c l n he g nd ha i a facing nfai c m e i i n ince de el ing c n ie did n face e ic i n . China, he ec nd highe g eenh e emi e , did n a ici a e a i a n in he g f de el ed c n ie . Man en i nmen al eciali a g ed ha he ag eed ed c i n in emi i n ee mall ha e fficien im ac n he blem f gl bal a ming. In 2016, he Pa i Ag eemen came in effec , ini iall igned b 55 a ie , hich eached 197 b 2019. The e f he ag eemen i eng hen in e na i nal c - e a i n n clima e change, ba ed n he g al f limi ing he gl bal em e a e inc ea e 1.5%. In addi i n i aim inc ea e he abili f c n ie ada nega i e effec f clima e change. I e abli he binding ag eemen n all a ie e mea e d me icall ha ill ed ce g eenh e emi i n . C n ie a e f ee e mea e f hei ch ice b a ge f emi i n ed c i n m be m e ambi i han ea lie ne . The membe ha e ag eed ack hei g e and e hi each he , c - e a e and ide f clima e ac i n de el ing c n ie . In J ne 2017, he Uni ed S a e ann nced i in en i n i hd a f m he Pa i ag eemen i h N embe 2020 he effec i e da e f i hd a al. TEST YOUR UNDERSTANDING 5.5 1 F each f he e am le ided in e i n 2(a) in Te nde anding 5.4, a e and e lain me me h d( ) ha c ld be ed c ec he e e nali . 2 O line he h ee e e nali . f ma ke -ba ed licie ha can be ed 3 U ing a diag am, h h a nega i e can be c ec ed b e f d c i n e e nali c ea ed b a a e n b a e n emi i n , c 4 5 e c ec a nega i e he d ci n e ff il f el lic mea e. , adable e mi , and d legi la i n and eg la i n. e Di c a O line he meaning f and iden if b C m a e and c n a ma ke -ba ed me h d and c mmand me h d ( ch a legi la i n and eg la i n ) deal i h nega i e d c i n e e nali ie . c Iden if a Define c llec i e elf-g e nance and di c c mm n l e ce . b O line me ad an age and di ad an age me diffic l ie ha g me f each f he e e f licie ha in e nali e an e e nali . e nmen face in de igning ma ke ba ed me h d . ible limi a i n ha hi a hi a a me h d ach face . deal i h e e f 6 7 a E lain h e ec b De c ibe h c Iden if he a nega i e a e n emi i n ch a ca b n a e and adable e mi a e imila hei bjec i e . (H : hink ab incen i e .) he diffe f m a e n lic ha i efe able f m he d c i n e e nali : a a n ih f he fi m c ea ing nega i e e e nali ie . in f ie f ed cing he e e nal c a a n emi i n . f U ing e am le , e lain nde ha ci c m ance in e na i nal c - e a i n am ng g e nmen i e en ial f he e e a i n f he en i nmen . REAL WORLD FOCUS 5.2 Effects of pesticides on bees A e icide kn n a lf afl i idel ed kill in ec in ag ic l e. In 2013 i a a ed b he En i nmen al P ec i n Agenc (EPA) be ed in he Uni ed S a e . H e e , a lf afl a kn n be ic bee , he EPA ec mmended ha i h ld n be ed hen c a e fl e ing, hich i hen he a ac bee . S n af e , a n mbe f beekee ing g en he blem f he declining bee cancelled he EPA a al f lf afl a n ha mf l bee . In 2015 he EPA Sae . ed he EPA a g ing ha he e f lf afl ld la i n. A a e l , a US fede al (na i nal) c n he g nd ha he e a in fficien e idence ha i ed all ing he ale f lf afl in he Uni ed H e e , in 2016, he EPA ea ed he e f lf afl , b e cl ded c ha a e a ac i e bee and ha fl e a a i ime h gh he ea . In addi i n, he EPA all ed he m e gene al e f lf afl n an eme genc ba i . The EPA ha he a h i g an ch e em i n e en f e icide ha a e n fficiall a ed, in he e en f a dden a ea ance f in ec ha damage c . In he e i d 2017 2018, he EPA a ed m e han 100 eme genc e em i n f In 2018, i a ed n e 16 milli n ac e f fa mland f c n and gh m al ne. lf afl . Ye i i ell kn n ha he e f lf afl i ha mf l bee , i h e i c n e ence f hei e d c i e abili ie . Acc ding a eni cien i a he Cen e f Bi l gical Di e i , S a ing 16 milli n ac e f bee-a ac i e c i h a bee-killing e icide in a ime f gl bal in ec decline i * be nd he ale . . . The EPA i inel mi ing he eme genc ce ge lf afl a ed beca e i ic make i h gh n mal e icide e ie . Acc ding a d bli hed in he j nal B ca C e a , he e i a dange decline a nd he ld in m e han 40% f in ec ecie and ne hi d a e endange ed. The a e f e inc i n f in ec i eigh ime fa e han ha f mammal , bi d and e ile . The ca e i in en i e ag ic l e and e eciall he hea e f e icide . Figure 5.8: Dead bee ha died b * Thi h a e mean e icide nacce able, in le able, age Sources: Ec Wa c ; A e ca C e ca S c e ; T e G a d a Appl ing our skills 1 The e inc i n f in ec Di c h he c nce e ce d e he hea e e en a l f biodi ersit , hich i a c mm n l e ce. f i al and n n-e cl dabili can be ed e lain de le i n f hi e f e icide . 2 a U ing a diag am e lain ha kind f e e nali ca ed bee . b Iden if and e al a e licie ha c ld be c U ing a diag am, h h hi lic c ld i in ed l ed in he ca e f he ha m being deal i h hi e e nali . k c ec he e e nali . THEORY OF KNOWLEDGE 5.1 Economic thinking on sustainabilit and Elinor Ostrom, winner of the 2009 Nobel Pri e in Economics In de d f ainabili , e ha e een ha in ec n mi c i n i anal ed in e m f nega i e e e nali ie . In e e i im l he e e a c f e le dina an c n e ence n he en i nmen . In he d , he de ha i h gh f a being de e a e e fe e An im an ea n f hinking hi a ab ba ed n he ideali ed and fic i nal ld f e deci i n-make h make ch ice acc ding ignal and incen i e , all f hich lead ma Ec n mi nde anding i a e and cial benefi i fi m c n me and d ce e e nal c ha hei ac i a ed be a e a a he ca e ac i n ci n f . f hinking, en i nmen al f c mm n l e ce , hei ha d n ake acc n f he en i nmen i me hing he en i nmen i ha mic ec n mic he i fec ma ke i h n fail e , d i en b ec n mic hei be elf-in e e , e nding ice a im m cial elfa e. f e e nali ie a he di e gence be een i a e and cial c ba ed n j hi a m i n f na elf-in e e : c n me aking nl hei n i a e in e e in acc n , ign ing n gi e i e . E e nal c a i e beca e c e a d d a e e ee f c e a a e. and and ible ce a e The main ca eg ie f mea e deal i h en i nmen al e e nali ie e di c ed, g e nmen eg la i n and ma ke -ba ed licie , a e b h ba ed n hi a m i n ab elfin e e ed beha i . Reg la i n e he c mmand a ach f ce d ce and c n me ed ce he e e nal c f hei elf-in e e ed ac i n , and ma ke -ba ed licie c ea e ice incen i e ha b ing he elf-in e e ed beha i f ec n mic deci i n-make in line i h cie be in e e . Ye all hi ai e me in e e ing e i n . D e i make en e ie en i el a he b - d c f e le indiffe ence a d he en i nmen beca in e e ed being ? A e he e i a i n hen e le d n di la he na beha i a med b anda d ec n mic he ? If , ha a e he im lica i he a ia e lic e n e ? nmen al de c i n e he a e elfelf-in e e ed n , and ha ld be The e a e he kind f e i n ed b Elin O m, h n he N bel P i e in Ec n mic (2009) f he k n he c llec i e elf-g e nance f c mm n l e ce (di c ed ab e). In ne f he maj k ,O m i e ha he cen al e i n e a e e e e ac f ba c a c ae a be ef e de e de a ca e a face e a a ea d f ee- de, e , ca . 9 A di c ed in he e , O m h nd ed f e e imen h ha e le can find l i n managing e ce ainabl b making le ega ding hei beha i and managemen f he c mm n l e ce ha m be f ll ed b e e ne. He finding d n n en i el c n e he c ncl i n f anda d ec n mic he , ince lack f g d me h d f c mm nica i n be een e le d e l in he fail e e died in hi cha e . H e e , he finding de a f m anda d ec n mic he in a e im an e ec : he ha f nd ha e e fa e a e e ab e, beca e a i nal ec n mic beha i d e n al a mean ac ing in ne n be elfin e e ; i f en mean ac ing in ha i in he be e e . Thi kind f ac i n a i e a a e l f in i i n ha e mi c mm nica i n be een he e ce e , leading binding ag eemen , i h m ni ing and enf cemen le ha en e ainable e ce e. O c m c ncl i n f c n he in ha e le f en beha e c - e a e a e a e e , and hi ha e im an lic im lica i n . S me ime , he be me h d f e e ing c mm n l e ce i b all ing he e ce e hem el e manage hem, a he han h gh cen ali ed g e nmen in e fe ence. When he c ndi i n f c - e a i e l i n a e e en , he g e nmen le h ld be m e in i i n ha enable he e manage he e ce, ch a a c em f e l ing di e and in i i n ha ide cien ific kn ledge f e ce managemen . Of en, hi in l e ec gni ing ha l cal c e a i e in i i n ma be ei in i i n ha a e im ed n e le f m ab e f m ide. If e e decide ead f he ab O m ce ; he ch la e c mm n e ce ha a e g e ned b a e f le . k, e ill find ha he e he e m c mm n ce . B h he e e m mean c mm n l l Thinking points H eali ic d hink i he a m i n ha ec n mic deci i n-make a i nal elf-in e e in making ec n mic deci i n ? a e m i a ed b Man ec n mi a g e ha e en if a i nal elf-in e e i n a eali ic a m i n, i d e n ma e a l ng a he edic i n f a he fi i h ha ha en in he eal ld ( ee al The f kn ledge 7.1). Wha d e O m k ell ab hi e ec i e? If e le me ime beha e c - e a i el a he han c m e i i el , f he idea ha en i nmen al de c i n i ca ed b e e nali ie ? O m gge ha ch ice ld be in biking a he han cial benefi . Wha ha a e he im lica i n man e le ld change hei beha i if he nde d ha ce ain hei n be in e e a ell a in cie be in e e (f e am le, ing a ca ). B man e le ma n kn ab ch j in e nal and can be d ne ab hi ? 2 OECD, Fe c n ie a e 3 Ec n mi find a gl bal a 4 Wh P icing Ca b n I S ill M e The 5 See Q an i a i e echni e cha e in he 'Digi al c he e i alence f a d and lef a d hif f he 6 In e ie 7 The e e imen a e ca ied a he W k h he e O m a a fe . 8 O gani a i n f 9 Elin O m (1990) G e Uni e i P e . i h Elin O icing ca b n high en gh mee clima e a ge n ca b n ma be fea ible m, b F an K Ec n mic C - Than Reali eb l c en, , 27 Feb a k: E e. a ma e ial' ec i n f an e lana i n f 2010. in P li ical The and P lic Anal i a Indiana Uni e i e a i n and De el men eC :T eE fI f C ec e Ac , Camb idge 5.4 Negative consumption externalities LEARNING OBJECTIVES Af e d ing hi ec ion, o ill be able o: define all he e m appea ing in orange bold in he e (AO1) e plain nega i e e e nali ie of con mp ion and he e l ing elfa e lo d a a diag am ill (AO2) a ing nega i e e e nali ie of con mp ion and elfa e lo (AO4) e plain he meaning of deme i good (AO2) calc la e elfa e lo ha a i e f om nega i e e e nali ie of con mp ion (HL onl ) (AO4) e plain go e nmen in e en ion o co ec nega i e e e nali ie of con mp ion: (AO2) indi ec (Pigo ian) a e legi la ion and eg la ion ed ca ion and a a ene c ea ion n dge (HL onl ) d a diag am o ill di c a e he abo e go e nmen e pon e (AO4) eng h and limi a ion of he abo e go e nmen policie diffic l ie in mea i h e pec o: (AO3) emen of e e nali ie deg ee of effec i ene con eq ence fo akeholde Explaining and illustrating negative consumption externalities Negative consumption externalities efe o e e nal co c ea ed b con me . Fo e ample, hen con me moke in p blic place , he e a e e e nal co ha pill o e on o ocie in he fo m of co o non- moke d e o pa i e moking. In addi ion, moking- ela ed di ea e e l in highe han nece a heal h ca e co ha a e an addi ional b den pon ocie . When he e i a con mp ion e e nali , he ma ginal p i a e benefi (demand) c e doe no eflec ocial benefi . In Fig e 5.9, he b e of ciga e e ha e a demand c e, MPB, b , hen moking, c ea e e e nal co fo nonmoke . The e co can be ho gh of a nega i e benefi , hich he efo e ca e he MSB c e o lie belo he MPB c e. The e ical diffe ence be een MPB and MSB ep e en he e e nal co . No e ha ince he e e nali in ol e con mp ion (i.e. he demand c e), he ppl c e ep e en bo h ma ginal p i a e co and ma ginal ocial co . The ma ke de e mine an eq ilib i m q an i , Q e , b he ocial op im m i Q op m, and p ice Pm, gi en b he in e ec ion of he MPB and MPC c and Pop , de e mined b he in e ec ion of he MSB and MSC c e . O he e ample of nega i e con mp ion e e nali ie incl de hea ing home and d i ing ca b fo il f el ha poll e he a mo phe e. When he e i a nega i e con mp ion e e nali , he f ee ma ke o e alloca e e o ce o he p od c ion of he good, and oo m ch of i i p od ced ela i e o ha i ociall op im m. Thi i ho n b Qm > Qop and MSC > MSB a Qm in Fig e 5.9. e of In gene al, nega i e e e nali ie , he he he e a i e f om p od c ion o con mp ion ac i i ie , lead o alloca i e inefficienc a i ing f om an o e alloca ion of e o ce o he good and o i o e p o i ion. Figure 5.9: Nega i e con mp ion e e nali The welfare loss of negative consumption externalities Welfare loss The elfa e lo e l ing f om nega i e con mp ion e e nali ie i he haded a ea in Fig e 5.10(a) and ep e en he ed c ion in benefi fo ocie d e o he o e alloca ion of e o ce o he p od c ion of he good. Fo all ni of o p g ea e han Q op , MSC > MSB, indica ing ha oo m ch of he good i p od ced. The elfa e lo i eq al o he diffe ence be een he MSC and MSB c e fo he amo n of o p ha i o e p od ced ela i e o he ocial op im m (Q m Q op ). I ep e en he lo of ocial benefi f om o e p od c ion d e o he e e nali . If hi e e nali e e co ec ed, ocie o ld gain he benefi ep e en ed b he haded a ea. No e ha , once again, he poin of he elfa e lo iangle lie a he Q op q an i of o p (a in he ca e of nega i e p od c ion e e nali ie ). Calculating welfare loss (HL only) Fig e 5.10(b) i he ame a pa (a) onl i h fig e o e can calc la e elfa e lo . The a ea of he haded iangle i he heigh ime he id h of he iangle di ided b 2. No e ha he heigh of he iangle i eq al o he e e nal co pe ni , o MPB MSB, and he id h i eq al o he amo n of o e p od c ion b he ma ke o Q m Q op : Welfa e lo = (6 4) (100 70) 2 = 2 30 2 =$30 Welfare loss in relation to consumer and producer surplus (Supplementary material) Fig e 5.10(c) ho ho he elfa e lo of a nega i e con mp ion e e nali i ela ed o con me and p od ce pl and he e e nal co . In ma ke eq ilib i m, con me pl i eq al o he a ea a + b, hile p od ce pl i eq al o he a ea c + d + f. The co of he e e nali i ep e en ed b a + d + e (i i he diffe ence be een he MPB and MSB c e p o Q m). The o al ocial benefi a e he efo e con me pl pl p od ce pl min he e e nal co : (a + b) + (c + d + f) (a + d + e) = b + c + f e A he ocial op im m, con me pl i eq al o b + c, and p od ce pl i eq al o f, hile e e nal co a e e o. The efo e, he o al ocial pl i eq al o p od ce pl con me pl : b+c+f Compa ing he o al ocial benefi a ma ke eq ilib i m and a he ocial op im m, e ee he a e malle a ma ke eq ilib i m b he a ea e, hich i he elfa e lo . Figure 5.10: Welfa e lo in a nega i e con mp ion e e nali The case of demerit goods Demerit goods a e good ha a e con ide ed o be nde i able fo con me , b hich a e o e p o ided b he ma ke . E ample of deme i good incl de ciga e e , alcohol and gambling. One impo an ea on fo o e p o i ion i ha he good ma ha e nega i e con mp ion e e nali ie , in hich ca e he ma ke o e alloca e e o ce o i p od c ion. Thi co ld occ beca e of con me igno ance abo i nega i e effec o indiffe ence: con me ma no be a a e of he ha mf l effec pon o he of hei ac ion , o he ma no ca e. Negative consumption externalities and overuse of common pool resources O e e of common pool e o ce i een a e l ing mo e f om p od c ion ac i i ie han con mp ion ac i i ie , he efo e ela ing mo e o nega i e p od c ion a he han con mp ion e e nali ie . Ho e e , o e e of common pool e o ce al o e l f om nega i e con mp ion e e nali ie , ho n in Fig e 5.9. Take he demand fo hea ing oil, ep e en ed b he demand c e MPB. The o e e of clean ai ( he common pool e o ce) i he e e nal co ha ca e he ma ginal ocial benefi c e (MSB) o lie belo he MPB c e. The ame applie o he e of ca ha n on ga oline (pe ol). Mo e impo an l , ai a el i a con mp ion ac i i ha e l in ignifican and apidl inc ea ing g eenho e ga e ha ca e global a ming. The e ac i i ie on he pa of con me e l in o e e of he common pool e o ce of clean ai , e io l h ea ening he abili of he global clima e. TEST YOUR UNDERSTANDING 5.6 1 2 a U ing a diag am, ho ho ma ginal p i a e benefi and ma ginal ocial benefi diffe hen he e i nega i e con mp ion e e nali . b E plain he diffe ence be een he eq ilib i m q an i de e mined b he ma ke and he q an i ha i op imal f om he poin of ie of ocie p efe ence . c De c ibe he p oblem i h he alloca ion of e o ce achie ed b a nega i e con mp ion e e nali . d Sho he elfa e lo c ea ed b e plain ha hi mean . he ma ke he nega i e con mp ion e e nali in o hen he e i diag am, and P o ide ome e ample of nega i e con mp ion e e nali ie . Policies to correct negative consumption externalities and prevent overuse of common pool resources Market-based policies A ke ma ke -ba ed polic o co ec nega i e con mp ion e e nali ie (incl ding deme i good ) in ol e he impo i ion of indi ec Pigo ian a e , a in he ca e of nega i e p od c ion e e nali ie . Indi ec a e can be impo ed on he good ho e con mp ion c ea e e e nal co (fo e ample, ciga e e and pe ol/ga oline). The effec of an indi ec a a e ho n in Fig e 5.11(a). When ch a a i impo ed on he good ho e con mp ion c ea e he e e nal co , he e l i a dec ea e in ppl and an p a d hif of he ppl c e f om MPC o MPC + a . If he a eq al he e e nal co , he MPC + a c e in e ec MPB a he Q op le el of o p , and q an i p od ced and con med d op o Q op . (The demand c e doe no hif b emain a D = MPB.) Qop i he ociall op im m q an i , and p ice inc ea e f om Pm o Pc . The a he efo e pe mi alloca i e efficienc o be achie ed.10 Advantages and disadvantages A i h nega i e p od c ion e e nali ie , economi p efe ma ke -ba ed ol ion o he p oblem of nega i e con mp ion e e nali ie , a long a he i a ion pe mi he e of ma ke -ba ed polic . The efo e, indi ec a e a e he p efe ed mea e, a he in e nali e he e e nali (a in he ca e of nega i e p od c ion e e nali ie ). B changing ela i e p ice , indi ec a e c ea e incen i e fo con me o change hei con mp ion pa e n ; he good ha i a ed become ela i el mo e e pen i e and con mp ion i ed ced. Ho e e , he e a e a n mbe of diffic l ie in hi app oach. The fi in ol e diffic l ie in mea ing he al e of he e e nal co . Take, fo e ample, he ca e of pa i e moking, an e e nal co c ea ed b moke , o he ca e of pe ol (ga oline) con mp ion, hich c ea e e e nal co in he fo m of en i onmen al poll ion. The e a e man echnical diffic l ie in ol ed in ing o a e ho and ha i affec ed, a ell a o de e mine he al e of he e e nal co , on he ba i of hich a a can be de igned. Figure 5.11: Co ec ing nega i e con mp ion e e nali ie A f he diffic l i ha ome of he good ho e con mp ion lead o nega i e con mp ion e e nali ie (fo e ample, pe ol/ga oline and ciga e e ) ha e an inela ic demand. A o ma emembe f om Chap e 3, hen demand i inela ic, he pe cen age dec ea e in q an i demanded i malle han he pe cen age inc ea e in p ice (d e o he a ). The efo e, i i po ible ha impo ing a e on ch good a pe ol (ga oline) and ciga e e (bo h of hich ha e an inela ic demand) o k o inc ea e go e nmen a e en e hile no ignifican l dec ea ing he q an i demanded of he e good . Thi co ld mean ha in o de o achie e Q op , a e high indi ec a o ld ha e o be impo ed, hich o ld e likel be poli icall naccep able. On he o he hand, he la ge a e en e can be ed o finance ed ca ion p og amme o di co age con mp ion of pa ic la good . A tax on producers or consumers? (Supplementary material) Yo ma be onde ing h he a o co ec nega i e con mp ion e e nali ie ho ld affec p od ce , hif ing he ppl c e p a d in Fig e 5.11(a), and no con me b hif ing he demand c e do n a d, ho af e all a e he one c ea ing he e e nali h o gh con mp ion. Yo ill find he an e o hi q e ion in he 'Digi al co ebook: E a ma e ial' ec ion a S pplemen a ma e ial. Government legislation and regulation If nega i e con mp ion e e nali ie e e co ec ed, Q op q an i eflec ing alloca i e efficienc . Reg la ion can be ed o p e en impo e co on hi d pa ie , ch a legal e ic ion on ac i i ie e ic ion fo cing elle o do b ine onl i h ad l . Thi ha of he good o ld be p od ced, o limi con me ac i i ie ha like moking in p blic place o age he effec of hif ing he D1 = MPB c e o a d he MSB c e in Fig e 5.11(b), n il D2 o e lap i h MSB. Thi o ld elimina e he e e nali , i h p od c ion and con mp ion occ ing a Qop and p ice falling o Pop . Advantages and disadvantages Some eg la ion can be e effec i e in ed cing he e e nal co of ce ain con mp ion ac i i ie . E ample incl de p ohibi ing moking in p blic place and placing e ic ion on ca en e ing ci cen e . Ho e e , he canno be ed o deal i h o he kind of nega i e con mp ion e e nali ie . Fo e ample, i o ld be e diffic l o eg la e pe ol (ga oline) con mp ion; on he o he hand, impo ing indi ec a e on ch good ma be mo e effec i e ( ho gh bjec o he limi a ion no ed abo e on inela ic demand). Education and awareness-creation Ed ca ing he p blic and c ea ing a a ene b he go e nmen can be ed o o pe ade con me o b fe e good i h nega i e e e nali ie , ch a an i- moking campaign , campaign o a oid con mp ion of nheal h food , o campaign o ed ce he con mp ion of good and e ice ba ed on fo il f el e. E ample incl de ing p blic an po a ion o economi e on pe ol (ga oline) e o imp o ing home in la ion o ed ce oil con mp ion (fo hea ing) o p o iding info ma ion o con me on he amo n of ca bon p od ced b ai a el. The objec i e i o o dec ea e demand fo good gi ing i e o nega i e con mp ion e e nali ie , and he effec a e he ame a i h go e nmen eg la ion , ho n in Fig e 5.11(b). The MPB c e hif o D2 af e he campaign, he e i coincide i h MSB, he e Q op i p od ced and con med, and he p ice fall f om Pm o Pop . Advantages and disadvantages Ed ca ion and c ea ion a a ene ha e he ad an age ha he a e imple han o he me hod , b he oo ha e hei di ad an age . One of he e in ol e he co o he go e nmen of campaign , hich a e f nded o of a f nd , meaning he e a e le f nd a ailable fo e el e he e in he econom ( he e a e oppo ni co ). The e i al o he po ibili ha ch me hod ma no be effec i e eno gh in ed cing he nega i e e e nali . Nudges (HL only) N dge e e in od ced in Chap e 2 he e e a ha he fo m a pa of beha io al economic , in ol ing he de ign of me hod o infl ence con me beha io . The can be ed in a imila o ed ca ion and con me a a ene o enco age con me o el le on good i h nega i e e e nali ie , ch a nheal h food and ciga e e . Fo e ample, nheal h food can be placed in le acce ible place in hop , o g aphic pic e of he con eq ence of moking ma be placed on ciga e e pack . In ch ca e demand fo he p od c fall o ha he MPB c e hif o a d MSB a in Fig e 5.11(b). In addi ion, n dge can be ed o enco age de i able beha io , ch a c ea ing bic cle lane o mo i a e ca d i e o e bic cle in ead. Advantages and disadvantages The e ma be diffic l ie in de igning effec i e n dge a he e a e ill a ne me hod in ended o infl ence con me beha io , and no eno gh i kno n e abo ho con me e pond o pa ic la n dge and choice a chi ec e. The e i , oo, he i e ha pa ic la n dge ma no ha e he ame effec ac o income g o p o c l al g o p . Co ec ion of nega i e con mp ion e e nali ie in ol e ei he dec ea ing ppl and hif ing he MPC c e p a d b impo ing an indi ec (Pigo ian) a ; o b dec ea ing demand and hif ing he MPB c e o a d he MSB c e h o gh eg la ion , ed ca ion and a a ene c ea ion o n dge . Bo h ppl dec ea e and demand dec ea e a e in ended o lead o p od c ion and con mp ion a Qop and he achie emen of alloca i e efficienc In gene al, gi en he limi a ion abo e fo all he a io policie i i onl po ible o mo e he econom in a di ec ion o a d co ec ion of he e e nali , a he han achie ing a p eci e alloca ion of e o ce he e Q op i p od ced and con med. Ve of en, he e of e e al policie oge he ma be he be a o add e he e e nali . Fo e ample, a e en e f om he impo i ion of a Pigo ian a ma be ed o finance ed ca ion and a a ene c ea ion p og amme a ell a n dge . Go e nmen m he efo e be elec i e in he me hod he e o ed ce con mp ion e e nali ie , depending on he pa ic la good ha c ea e he e e nal co . TEST YOUR UNDERSTANDING 5.7 1 Fo each of he e ample o p o ided in q e ion 2 of Te ome me hod ha co ld be ed o co ec he e e nali . 2 U ing diag am , ho ho a nega i e con mp ion e e nali a legi la ion and eg la ion ha limi he e e nal co b ed ca ion and a a ene c (HL onl ) n dge , and d indi ec a e . e Iden if o nde anding 5.6, e plain can be co ec ed b e of , c ea ion, ome ad an age and di ad an age of each of he e polic mea e. 3 E plain he meaning of a deme i good and p o ide e ample . 4 E plain ho a nega i e con mp ion e e nali diffe f om a nega i e p od c ion e e nali . 5 a E plain ha kind of mea e e nali ie . p efe o co ec nega i e con mp ion b Iden if i a ion e economi he e he e migh no be e effec i e. REAL WORLD FOCUS 5.3 Policies to reduce sugar consumption Follo ing a 2015 epo b he Wo ld Heal h O gani a ion (of he Uni ed Na ion ) de ailing he nega i e heal h effec of ga , mo e and mo e co n ie a o nd he o ld a e impo ing a a on he ga con en of food and d ink in an effo o ed ce obe i and o he heal h p oblem like diabe e a i ing f om ga o e con mp ion. The e a e ha e gene all me i h li le oppo i ion f om he p blic. The a e a e impo ed on food and/o d ink i h ga , hich a e a ed in acco dance i h he q an i of ga he con ain. In e pon e o he implemen a ion of he e policie , man majo food p od ce a o nd he o ld ha e e ponded b c ea ing ne p od c i h no added ga , o ed ced ga , hile a he ame ime ing o main ain he o iginal a e. In ome ed ced ga i em , he ga con en i lo e ed eno gh o ha he a can be a oided al oge he . In addi ion, ome go e nmen a e o king i h food p od ce o e abli h ol n a ag eemen i h p od ce o lo e he ga con en of hei food p od c . Ano he app oach in ol e banning he ad e i emen of nheal h food d ing he ime hen child en a ch ele i ion. A ill diffe en app oach in ol e he e of elec onic o de ing em ha offe con me heal h good a he defa l op ion . Figure 5.12: Cla ic coke food label decode ho ing high ga le el Applying your skills 1 2 3 4 U U e O a ing a diag am, e plain ha kind of e e nali he a icle i efe ing o. ing a diag am, e plain ho a a on he ga con en of food and d ink can help ed ce he e nali . line a likel ea on ha he a e ha e gene all me i h li le p blic oppo i ion. Iden if and e plain he o he pe of policie (o he han indi ec a e ) ha he a icle efe o, ha co ld help o ed ce he e e nali . b U ing diag am , ho ho he e policie a e e pec ed o o k. Source: Kerry THEORY OF KNOWLEDGE 5.2 The ethical dimensions of sustainability and preserving the global climate In Chap e 1 e a ha ol ion o he p oblem of ainabili face majo echnical diffic l ie d e o nce ain ie and incomple e kno ledge of ocial and na al cien i ega ding he comple ela ion hip be een en i onmen al, economic, ocial and in i ional a iable . The e kind of echnical diffic l ie a e al o e pon ible fo he nce ain ie o nding bo h eg la o and ma ke -ba ed economic policie o add e en i onmen al e e nali ie di c ed in he p e en chap e . O e and abo e he echnical diffic l ie , he p oblem of ainabili face majo e hical i e of fai ne and j ice, ela ing o in e gene a ional eq i ( nning f om gene a ion o gene a ion), a ell a eq i ac o na ion and ocial g o p i hin na ion of he p e en gene a ion. In he a ea of clima e change alone, impo an i e incl de (a) ho ill he b den of ha ing o make ac ifice in he p e en be di ib ed among co n ie ; (b) ho ill he impac of clima e change be e al a ed; and (c) ho ill in e gene a ional eq i be acco n ed fo ?11 To de e mine he di ib ion of ac ifice , a po ible e hical p inciple ha can be ed i he poll e pa p inciple, acco ding o hich he ac ifice i di ib ed acco ding o ho m ch each co n con ib e o clima e change. In one a ian of hi p inciple, i o ld be nece a o ake in o acco n c m la i e (hi o ical) con ib ion o g eenho e ga emi ion . Thi o ld place an e a b den on he de eloped co n ie of oda , hich o e ime, ha e con ib ed fa mo e o emi ion han de eloping co n ie . A a co n e a g men , opponen efe o e c able igno ance , meaning i ho ld no be nece a o pa fo pa emi ion if he e e e made i ho kno ledge of hei effec on he global clima e. Acco ding o a diffe en e hical p inciple, he pa o ld be igno ed and f e emi ion igh o ld be di ib ed o all co n ie on a per capita ba i . On he econd i e, conce ning e al a ion of impac of clima e change, one app oach in ol e elfa e anal i . Thi ha gi en i e o di ag eemen abo ho o calc la e elfa e and add i p ac o indi id al in he p e en a ell a in he f e. Ano he app oach foc e on h man igh a he ba i fo e al a ing impac , ch a he igh o food, a e and hel e , hich ma be h ea ened b clima e change. In e gene a ional eq i , he hi d i e, i clo el ela ed o he e al a ion of impac of clima e change, a he e m acco n fo impac no onl on he p e en gene a ion b f e gene a ion a ell. The e kind of q e ion clea l belong o he no ma i e ealm of ho gh . Gi en he echnical diffic l ie a ell, i i no onde ha he e a e b oad di ag eemen o e ainabili , and no ea ol ion appea on he ho i on. Thinking points Wha do o hink ho ld be he ole of cience and ocial cience in p o iding an kind of q e ion ? To ha e en do o hink ma ke fo ce can be elied pon, if a all, o deal en i onmen al ainabili ? e o he e i h p oblem of Ma ke economie a e ba ed pon h man beha io mo i a ed b a ional elf-in e e ( ee Chap e 2). To ha e en do o hink hi elf-in e e i he oo ca e of he en i onmen al p oblem ha be e he h man ace oda ? (See al o Theo of kno ledge 5.1.) Gi en ha , hi o icall , economicall mo e de eloped co n ie ha e been mainl e pon ible fo oda en i onmen al p oblem , do o ag ee i h he ie ha economicall le de eloped co n ie ho ld impl igno e call fo hem o limi hei g o h a e o p e en f he global a ming? INQUIRY AND REFLECTION The follo ing q e ion ill help o eflec on o lea ning and enhance o nde anding of ke opic in hi chap e . The a e gge ion fo inq i ie ha o can nde ake on o o n o in g o p in o de o e i e he lea ning objec i e of hi chap e . 1 Iden if a good o e ice in o co n o a co n o a e in e e ed in ha gi e i e o a pa ic la nega i e p od c ion e e nali . E amine he e en of he e e nal co and ho he affec a io akeholde . In e iga e he ol ion ha a e being ed o ed ce i p od c ion and con mp ion. Di c he eng h and limi a ion of he e ol ion , and o iden if he effec on a io akeholde . 2 See q e ion 1 abo e and appl i o a nega i e con mp ion e e nali . 3 Iden if a cheme of adable pe mi eng h and limi a ion . 4 Iden if a common pool e o ce ha i of in e e o o and in e iga e ha , if an , mea e a e being aken in o co n of e idence o a co n o a e in e e ed in o deal i h i po ible o e e. 5 A indica ed in Real o ld foc 5.3, a n mbe of co n ie a o nd he o ld ha e impo ed o a e planning o impo e indi ec (Pigo ian) a e on a io food i em ( ga and/o fa ) ha a e con ide ed o be ha mf l o h man heal h. E amine he he ch a a i ed o i nde con ide a ion in o co n o a co n o a e in e e ed in, and e amine he e e nal co of con mp ion of ch food , a ell a he effec of he a on a io akeholde . In e iga e he he an die ha e been done o e al a e he impac of he a , and he e en o hich i ha been cce f l i h e pec o a aining i objec i e of ed cing con mp ion of ch food . Con ide al o addi ional, complemen a policie ha a e in e fo hi p po e in o co n of choice. ha ha been implemen ed. Re ea ch and di c i 6 Ai a el i he fa e -g o ing con ib o o ca bon emi ion . Re pon ible fo abo 5% of global a ming in 2018, b 2050 emi ion ma g o b mo e han 700%, aking p oneq a e of he global ca bon b dge fo limi ing he empe a e i e o 1.5%. Ye he global ai line ind ejec policie ch a ca bon p icing and eg la ion of a ia ion emi ion b go e nmen o in e na ional bodie . In ead i ha op ed fo a cheme called Ca bon Off e ing and Red c ion Scheme fo In e na ional A ia ion (CORSIA) hich ha been c i ici ed a being ineffec i e. (a) Re ea ch CORSIA and iden if ome ad an age and di ad an age a a me hod o ackle he p oblem of ai line emi ion . (b) Re ea ch and o line ep ha a elle can ake in o de o ed ce hei ca bon foo p in hen he a el b ai . EXAM STYLE QUESTIONS Yo can find q e ion in he le of IB e am in he 'Digi al co ebook: E a ma e ial' ec ion. 10 No e ha he ne eq ilib i m p ice, Pc, i he p ice paid b con me ; he p ice ecei ed b p od ce i Pp = Pc min a pe ni ( ee Chap e 4, Sec ion 4.2). 11 The Wo ld Bank (2009) World Development Report 2010: Development and Climate Change. Chap er 6 Marke fail re and sociall ndesirable o comes II: Positive e ternalities, public goods, as mmetric information and inabilit to achieve equit BEFORE YOU START Can ou think of some goods or services that hen consumed or produced bring benefits to others even though the didn t consume or produce them? You ma have noticed that some goods and services are provided free of charge, such as roads, parks, street lighting, public schools, and man more. Who pa s for these and hat might be the reasons people can enjo them ithout having to pa for them? In this chapter e continue the discussion begun in Chapter 5 on the inabilit of the market to fulfill some of its promises. We ill begin b e amining positive e ternalities of production and consumption. We ill then discover public goods, hich are not produced at all b the market even though the are sociall desirable. We ill then e amine the consequences of information as mmetries bet een bu ers and sellers, and ill conclude ith a discussion of the market s inabilit to achieve equit in the distribution of income and ealth. 6.1 P a LEARNING OBJECTIVES After stud ing this section ou ill be able to: define all the terms appearing in a b in the te t (AO1) e plain positive e ternalities of production and the resulting elfare loss (AO2) dra a diagram illustrating positive e ternalities of production and elfare loss (AO4) calculate elfare loss that arises from positive e ternalities of production (HL onl ) (AO4) e plain government intervention to correct positive e ternalities of production: (AO2) government provision subsidies dra diagrams to illustrate the above government responses (AO4) discuss strengths and limitations of the above government policies ith respect to: (AO3) difficulties in measurement of e ternalities degree of effectiveness consequences for stakeholders E a a a a E ternalities as a form of market failure ere introduced in Chapter 5, here e discussed negative e ternalities of production and consumption. We no turn our attention to positive e ternalities. P a refer to e ternal benefits created b producers. If, for e ample, a firm engages in research and development, and succeeds in developing a ne technolog that spreads throughout the econom , there are e ternal benefits because not onl the firm but also societ benefits from idespread adoption of the ne technolog . Therefore, the social costs of research and development are lo er than the private costs. In Figure 6.1, the MSC curve lies belo the MPC curve, and the difference bet een the t o curves is the value of the e ternal benefits (these can be thought of as negative costs ). The demand curve represents both MPB and MSB since the e ternalit involves onl production. The market gives rise to equilibrium quantit Qm and price Pm, determined b the intersection of the MPB and MPC curves, hile the social optimum is given b Qopt and Popt, determined b the intersection of the MSB ith MSC curves. Since Qm < Qopt, the market underallocates resources to research and development activities that lead to ne technologies, and not enough of them are undertaken. F 6.1: Positive production e ternalit When there is a positive production e ternalit , the free market underallocates resources to the production of the good: too fe resources are allocated to its production, and too little of it is produced. This is sho n b Qm < Qopt and MSB > MSC at Qm in Figure 6.1. More e amples of positive production e ternalities include: firms train orkers ho later s itch jobs and ork else here; e ternal benefits are created as the ne emplo ers and societ benefit from the trained orkers a firm provides first aid classes to emplo ees to improve ork safet ; e ternal benefits are created as this kno ledge is applied also to people outside the orkplace. T a a W a The underallocation of resources to the production of a good ith a positive production e ternalit leads to a elfare loss, sho n in Figure 6.2(a) as the shaded area. This loss is equal to the difference bet een the MSB and MSC curves for the amount of output that is underproduced relative to the social optimum (Qopt Qm). It involves e ternal benefits for societ that are lost because not enough of the good is produced. If the e ternalit ere corrected, societ ould gain the benefits represented b the shaded area. Note that the point of the elfare loss triangle lies at the Qopt quantit of output. Ca a a (HL ) Figure 6.2(b) is similar to part (a) ith figures so e can calculate elfare loss. The area of the elfare loss triangle is the height times the idth of the triangle divided b 2. The height of the triangle is equal to the e ternal benefit per unit, or MPC − MSC, and the idth is equal to the amount of underproduction b the market or Qopt Qm: Welfare loss = (6 4) (90 60) 30 = 2 30 2 =$30 W a a a) a a (S a Figure 6.2(c) sho s the elfare loss in relation to consumer and producer surplus and the e ternalit . At market equilibrium, consumer surplus is area a, producer surplus is area b + e, and the e ternal benefits are c + f (the difference bet een the MPC and MSC curves up to the point of production b the market, Qm). The total benefits are therefore consumer surplus plus producer surplus plus e ternal benefits: a + (b + e) + (c + f) = a + b + e + c + f At the social optimum, consumer surplus is a + b + c + d, producer surplus is e + f + g, and e ternal benefits are ero, making a total of: (a + b + c + d) + (e + f + g) = a + b + c + d + e + f + g Comparing total benefits at market equilibrium and at the social optimum, e find that at the social optimum there are additional benefits of the amount d + g, corresponding to the shaded area in the figure. This is the amount of elfare that is lost at market equilibrium due to underallocation of resources arising from the positive production e ternalit . F C 6.2: Welfare loss in a positive production e ternalit a D A solution often pursued b governments involves direct government provision of the good or service creating the positive production e ternalit . For e ample, governments often engage in research and development (R&D) for ne technolog , for medicine and pharmaceuticals, and man other areas. The government can also directl provide training for orkers. Governments pa for such activities ith government funds, raised through ta es. Figure 6.3(a) sho s that hen the government intervenes b providing goods and services itself, this has the effect of shifting the suppl curve (= MPC curve) do n ard (or to the right), to ard the MSC curve so that the optimum quantit of the good, Qopt, ill be produced, ith price falling from Pm to Popt . S b We studied subsidies and their effects in Chapter 4, here e sa ho their introduction into a perfect market ( ith no market failures) creates allocative inefficienc . No , e ill see ho subsidies can correct allocative inefficienc b correcting a market failure. If the government provides a subsid to a firm per unit of the good produced that is equal to the e ternal benefit, then the marginal private cost (MPC = suppl ) curve shifts do n ard (or right ard1) until it coincides ith the MSC curve, as sho n in Figure 6.3(b). The result is to increase quantit produced to Qopt and to lo er the price from Pm to Popt . The problem of underallocation of resources and underprovision of the good is corrected, and allocative efficienc is achieved. F 6.3: Correcting positive production e ternalities You ma note that direct government provision and subsidies have the same market outcomes. Correction of positive production e ternalities involves shifting the MPC curve do n ard to ard the MSC curve through direct government provision or b subsidies. For allocative efficienc to be achieved, the quantit produced and consumed must increase to Qopt as price falls to Popt. E a a a This topic ill be discussed together ith policies to correct positive consumption e ternalities belo (Section 6.2) because of similarities of the policies involved. TEST YOUR UNDERSTANDING 6.1 1 a Using a diagram, sho ho marginal private costs and marginal social costs differ hen there is a positive production e ternalit . b E plain the difference bet een the equilibrium quantit determined b the market and the quantit that is optimal from the point of vie of societ s preferences. Describe hat this tells ou about the allocation of resources achieved b the market hen there is a positive production e ternalit . Sho the elfare loss created b the positive production e ternalit in our diagram, and e plain hat this means. 2 Provide some e amples of positive production e ternalities. 3 For each of the e amples ou provided in question 2, e plain some methods that can be used to correct the e ternalit . 1 See Quantitative techniques in the 'Digital coursebook: E tra material' section for an e planation of the equivalence of do n ard and right ard shifts of the suppl curve. 6.2 P LEARNING OBJECTIVES After stud ing this section ou ill be able to: define all the terms appearing in in the te t (AO1) e plain positive e ternalities of consumption and the resulting elfare loss (AO2) dra a diagram illustrating positive e ternalities of consumption and elfare loss (AO4) e plain the meaning of merit goods (AO2) calculate elfare loss that arises from positive e ternalities of consumption (HL onl ) (AO4) e plain government intervention to correct positive e ternalities of consumption: (AO2) legislation and regulation education and a areness creation nudges (HL onl ) government provision subsidies dra diagrams to illustrate the above government responses (AO4) discuss strengths and limitations of the above government policies ith respect to: (AO3) difficulties in measurement of e ternalities degree of effectiveness consequences for stakeholders E When there is a , e ternal benefits are created b consumers. For e ample, the consumption of education benefits the person ho receives the education, but in addition gives rise to e ternal benefits, involving social benefits from a more productive orkforce, lo er unemplo ment, higher rate of gro th, more economic development, lo er crime rate, and so on. Similarl , the consumption of health care services benefits not onl the person receiving the services but also societ and the econom , because a healthier population is more productive, enjo s a higher standard of living, does not pass on contagious diseases as much and ma have a higher rate of economic gro th. In Figure 6.4, e see that the marginal social benefit (MSB) curve lies above the marginal private benefit (MPB) curve, and the difference bet een the t o consists of the e ternal benefits to societ . The sociall optimum quantit , Qopt, is given b the point here MSB = MSC, and the quantit produced b the market is given b the point here MPB = MPC. Since Q opt > Q m, the market underallocates resources to the good or service, and too little of it is produced. When there is a positive consumption e ternalit , the free market underallocates resources to the production of the good, and too little of it is produced relative to the social optimum. This is sho n b Qm < Qopt and MSB > MSC at Qm in Figure 6.4. In general, positive e ternalities (e ternal benefits), hether these arise from production or consumption activities, lead to an underallocation of resources to the good in question, and therefore to its underprovision. F 6.4: Positive consumption e ternalit T The elfare loss arising from a positive consumption e ternalit is the shaded area in Figure 6.5(a), and is the difference bet een the MSB and MSC curves for the amount of output that is underproduced relative to the social optimum (Qopt Qm). It represents the loss of social benefits due to underproduction of the good. If this e ternalit ere corrected, societ ould gain the benefits represented b the shaded area. Once again, e see that the point of the elfare loss triangle lies at the Qopt quantit of output. F 6.5: Welfare loss in a positive consumption e ternalit You ma have noticed that in the case of negative e ternalities of production and consumption, here Qopt < Qm, the elfare loss triangle al a s points left ard to ard Qopt. B contrast, in the case of positive e ternalities of production and consumption, here Qopt > Qm, the elfare loss triangle al a s points right ard, again to ard Qopt. C (HL ) Figure 6.5(b) is similar to part (a) ith figures so e can calculate elfare loss. The area of the elfare loss triangle the height times the idth of the triangle divided b 2. The height of the triangle is equal to the e ternal benefits per unit, or MSB MPB, and the idth is equal to the amount of underproduction b the market or Qopt Qm: Welfare loss = (6 4) (90 60) 30 = 2 30 2 =$30 (S ) In Figure 6.5(c) e see ho the elfare loss arises in relation to consumer and producer surplus and the e ternal benefits. In market equilibrium, consumer surplus is equal to areas b + d, producer surplus is area g, and the e ternal benefits are a + e (or the difference bet een MSB and MPB up to production at Qm b the market). The total social benefits in market equilibrium are equal to consumer surplus plus producer surplus plus the e ternal benefits: (b + d) + g + (a + e) = b + d + g + a + e =a+b+d+e+g At the social optimum, consumer surplus is given b a + b + c, producer surplus is d + e + f + g, and the e ternal benefits are ero. Therefore the total social benefits are: (a + b + c) + (d + e + f + g) = a + b + c + d + e + f + g Comparing the total social benefits at market equilibrium ith those at the social optimum, e find that at the social optimum the are greater b the amount c + f. This is the elfare loss that arises hen production occurs at market equilibrium as a result of an underallocation of resources due to the positive consumption e ternalit . T M are goods that are held to be desirable for consumers, but hich are underprovided b the market. (Note that the term good in the e pression merit good applies to both goods and services.) Reasons for underprovision include: T . In this case too little is provided b the market. E amples of merit goods include education (for the reasons noted above in the discussion of e ternalities); immunisation programmes ( hich benefit not onl those ho have received them but also the broader population b iping out a disease). L . Some consumers ma ant certain goods or services but cannot afford to bu them. Remember demand sho s the quantities of a good or service that consumers are illing and able to bu at different prices. If the have lo incomes, the ma be illing but not able to bu something, in hich case their desire does not sho up in the market, and market demand (the sum of all individual demands) is too lo . E amples include health care services, medicines, education and recreational facilities, hich people on lo incomes often cannot afford to bu in the market. C . Consumers ma be better off if the consume certain goods and services but the ma be ignorant of the benefits, and so do not demand them. For e ample, preventive health care (such as immunisation, annual health check-ups) can prevent serious diseases, but lack of kno ledge about the benefits ma lead consumers to demand too little of these services. Note that more than one factor ma be at ork simultaneousl ; for e ample, the underprovision of health care services can result from all three reasons listed above. C G Legislation can be used to promote greater consumption of goods ith positive e ternalities. For e ample, most countries have legislation that makes education compulsor up to a certain age (note that education is a merit good). In this case, demand for education increases, and the demand curve D1 = MPB shifts to the right (or up ard), as in Figure 6.6(a). Ideall , it ill shift until it reaches the MSB curve, here D2 = MSB, and Qopt is produced and consumed. E Governments can use education of the public, a areness creation, to tr to persuade consumers to bu more goods ith positive e ternalities. For e ample, the can tr to encourage the use of sports facilities for improved health. The objective is to increase demand for such services, and the effect is the same as ith legislation, sho n in Figure 6.6(a): D1 shifts to D2= MSB and Qopt is produced and consumed, hile price increases to Popt. F N 6.6: Correcting positive consumption e ternalities (HL ) Nudges have similar effects as education and a areness creation programmes. Governments can use nudges like the creation of bic cle lanes to encourage the use of bike riding for more ph sical e ercise. (Note that this nudge also has the effect of reducing the negative e ternalit of gasoline (petrol) consumption from the use of cars, noted earlier.) Here, too, the objective is to increase demand shifting D1 to ard D2. D Governments are frequentl involved in the direct provision of goods and services ith positive consumption e ternalities. The most important e amples include government (public) provision of education and health care in virtuall all countries in the orld. Education and health care are merit goods ith e ternal benefits so large and important that it is idel believed that the must not be left to private sector provision alone. In most countries here there is government provision of health care and education, there is also private sector provision of these services (though to var ing degrees). Direct government provision is sho n in Figure 6.6(b), and has the effect of increasing suppl and therefore shifting the suppl curve S right ard (or do n ard) to S + government provision. To achieve the social optimum Qopt, the ne suppl curve must intersect MPB at the level of output Qopt, as seen in the figure. At the ne equilibrium, price falls to Pc, Qopt is produced and allocative efficienc is achieved. S A subsid to the producer of the good ith the positive e ternalit has the same effects as direct government provision. It results in increasing suppl and shifting the suppl curve right ard (or do n ard), as sho n in Figure 6.6(c) ( hich is similar to Figure 6.6(b)). If the subsid is equal to the e ternal benefit, the ne suppl curve is MPC subsid ,2 and it intersects MPB at the Qopt level of output. Again, price falls from Pm to Pc, Qopt is produced and allocative efficienc is achieved. Correction of positive consumption e ternalities involves either increasing demand and shifting the MPB curve to ards the MSB curve through legislation or education and a areness creation; or increasing suppl and shifting the MPC curve do n ard b direct government provision or b granting a subsid . Both demand increases and suppl increases can lead to production and consumption at Qopt and the achievement of allocative efficienc . The price paid b consumers increases hen demand increases, and falls hen suppl increases. Note that the problem of underprovision of merit goods b the market (defined above) can be addressed b all the methods noted above: legislation, education and a areness creation, direct government provision and granting of subsidies. All are intended to increase the amount of the good produced and consumed, as increased consumption of such goods is held to be desirable for societ . E Both direct government provision and subsidies are idel used as methods to deal ith positive consumption e ternalities, and to a lesser e tent also ith positive production e ternalities. Both methods are ver effective in increasing the quantit of the good produced and consumed, and both have the added advantage of lo ering the price of the good to consumers. There are, ho ever, difficulties involved in achieving the optimum results ( here MSC = MSB). First, both direct government provision and granting of subsidies involve the use of government funds that rel on ta revenues. Governments generall have ver man possible alternative uses for these funds, each of hich has an opportunit cost. As it is not possible for the government to directl provide or subsidise all goods and services ith positive e ternalities, choices must be made on (a) hich goods should be supported, and (b) b ho much the should be supported. Ideall , choices should be made on the basis of economic criteria, hich ould specif the amount of social benefits e pected in relation to the cost of providing them, the objective being to ma imise the benefits for each good and service to be provided or subsidised for a given cost. Ho ever, in practice it is ver difficult to measure the si e of the e ternal benefits, and therefore to calculate precisel hich goods and services should be supported and the level of support the should receive. In addition, both direct provision and subsidies are often highl political in nature, as different groups compete ith each other over ho ill receive the most benefits. Governments are often susceptible to political pressures and sometimes make choices based on political rather than economic criteria. (HL onl ) Nudges are subject to the same limitations that ere noted in connection ith negative consumption e ternalities (Chapter 5), involving difficulties in designing effective nudges in vie of insufficient kno ledge about ho people respond to nudges and choice architecture, as ell as the possible different responses these ma have across income and cultural groups. Therefore, in the real orld it is ver unlikel that governments are able to shift the MPC or MPB curves b the amount necessar to correct the positive e ternalities. The most that can be hoped for is that the policies in question ill be a step in the right direction. Legislation, education and a areness creation are subject to similar limitations concerning calculating the si e of e ternal benefits. Onl sometimes can the be effective, and then can onl help shift the MPB curve in the right direction, rather than achieve a demand increase that ill bring the econom to the Qopt level of output. For e ample, the can have ver positive effects in certain cases (such as legislation requiring schooling up to a minimum age or education on the importance of good nutrition), but in other cases are ineffective (for e ample, the cannot on their o n increase consumption of health care services and education to the optimum level). Moreover, the have the further effect of raising the price of the good to consumers, hich ma make the good unaffordable for some consumer groups. Therefore, legislation and a areness creation sometimes can be used more effectivel if the are implemented together ith direct provision and subsidies. A good e ample is education, here compulsor schooling up to a certain age (legislation) goes together ith direct government provision. TEST OUR UNDERSTANDING 6.2 1 Using a diagram, sho ho marginal private benefits and marginal social benefits differ hen there is a positive consumption e ternalit . E plain the difference bet een the equilibrium quantit determined b the market and the quantit that is optimal from the point of vie of societ s preferences. Describe the problem ith the allocation of resources achieved b the market hen there is a positive consumption e ternalit . Sho the elfare loss created b the positive consumption e ternalit in our diagram, and e plain hat this means. 2 Provide some e amples of positive consumption e ternalities. 3 For each of the e amples ou provided in question 2, e plain some methods that could be used to correct the e ternalit . 4 Outline ho a positive consumption e ternalit differs from a positive production e ternalit . 5 E plain the meaning of a merit good, and provide e amples. 6 Discuss advantages and disadvantages of the polic measures that governments can use to correct positive e ternalities of production and consumption. REAL ORLD FOCUS 6.1 P A highl successful polic used in Bra il to reduce povert and income inequalities is the Bolsa Familia programme implemented b the Bra ilian government. Through this programme poor families receive cash transfers c di i that the send their children to school and get them vaccinated. These programmes are therefore called c di i a ca h a fe (CCTs). The programme is so successful in reducing povert over the short term through the cash transfers and over the long term b increasing human capital that it has attracted great attention around the orld. F 6.7: Feijao, Acre Province, Bra il. School children in a rural school classroom A stud on crime in Bra il has found that the Bolsa Familia programme has had a significant impact on crime reduction in S o Paolo. It concludes that in the areas here CCTs are implemented there is a negative impact on crime. This is not related to the increased time spent in school but rather is due to reduced povert and inequalit , resulting in a reduction primaril of robberies, hence economicall motivated crimes. S :S i e f c di i a ca h a fe ga e IZA, DP N . 6371 A You ma note that this is a t pe of positive e ternalit that cannot be anal sed b means of the usual e ternalit diagram as there is no market that can be easil identified here. Ho ever the idea of a positive e ternalit resulting from government spending on CCTs is clear. E plain hat kind of e ternalit this represents, identif the e ternal benefits and describe the implications for the government s CCT polic . S Table 6.1 summarises important information on each t pe of e ternalit . T E P T E P N Producers impose e ternal costs on societ Indirect (Pigouvian) ta es Production b use of fossil fuels; e ternal costs include global arming, negative effects on health, environmental pollution Carbon ta es Tradable permits Legislation, regulation Collective selfgovernance Education, a areness creation International agreements N P Consumers impose e ternal costs on societ Indirect (Pigouvian) ta es Use of cars and heating using fossil fuels; e ternal costs include global arming, negative effects on health, environmental pollution Legislation, regulation Producers create e ternal benefits for societ Government provision Education, a areness creation Nudges (HL onl ) Subsidies Research b private firms leads to development of ne technologies that benefit the hole of societ P Consumers create e ternal benefits for societ Education and health care lead to benefits for the hole of societ , including lo er unemplo ment, lo er crime rates, higher economic gro th T 6.1: Summar of e ternalities Legislation, regulation Education, a areness creation Nudges (HLonl ) Government provision Subsidies The information in this section applies to a e e a i ie , including the negative ones presented in Chapter 5 and the positive ones of this chapter. H Students often have difficult learning ho to dra the e ternalit diagrams and labelling the curves correctl . The follo ing rules ill help ou dra an e ternalit diagram ithout memorising. T 1 In a production e ternalit , the suppl curve splits into t o; in a consumption e ternalit , the demand curve splits into t o. 2 Suppl reflects costs; demand reflects benefits. 3 The market equilibrium quantit Qm corresponds to private costs and benefits, MPC and MPB; the social optimum reflects social costs or benefits. 4 In a negative e ternalit Qm > Qopt, meaning that he a e ide ch f a bad hi g; in a positive e ternalit Qm < Qopt, meaning that he a e ide i e f a g d hi g. H 1 Dra a demand and suppl diagram and label the a es P and Q. 2 For a production e ternalit dra t o parallel up ard sloping curves; for a consumption e ternalit dra t o parallel do n ard sloping curves. Find the t o equilibrium quantities on the Q a is (but do not label them et). 3 In a negative e ternalit , since Qm > Qopt, label the larger quantit Qm and the smaller quantit Qopt; in a positive e ternalit , since Qm < Qopt, label the larger quantit Qopt and the smaller quantit Qm. 4 Using rule 3 above, Qm gives MPC and MPB, hile Qopt gives MSC and MSB. You can no label all the curves. (Note that the demand curve, D and suppl curve, S represent i a e benefits and costs; therefore D = MPB and S = MPC.) 5 Find the triangle that points to Qopt, and that lies in bet een the t o curves that have split. This is elfare loss. S Here are some points to bear in mind: All negative e ternalities (of production and consumption) c ea e e e a c e e a c , MSC > MSB a he i f d c i b he a e . . Whe he e a e All positive e ternalities (of production and consumption) c ea e e e a be efi . Whe e e a be efi MSB > MSC a he i f d c i b he a e . he e a e All production e ternalities (positive and negative) create a di e ge ce be ee c (MPC a d MSC). i aea d All consumption e ternalities (positive and negative) create a di e ge ce be ee cia be efi (MPB a d MSB). 2 cia i ae a d You ma note that the reason for the minus sign in MPC subsid is that the amount of the subsid is b ac ed from MPC in order to arrive at the ne suppl curve. 6.3 M LEARNING OBJECTIVES After studying this section you will be able to: • define all the terms appearing in • explain public goods as being (AO2) • • non-rivalrous, non-excludable • subject to the free-rider problem in the text (AO1) evaluate government intervention to provide public goods (AO3) • direct provision • contracting out to the private sector T P - - We learned the meaning of rivalry and excludability in Chapter 5. A good is rivalrous when its consumption by one person reduces its availability for someone else. It is excludable if it is possible to exclude people from using it. Private goods as we have seen are rivalrous and excludable. Common pool resources are rivalrous and non-excludable. Public goods, by contrast, are non-rivalrous and nonexcludable. A has the following two characteristics: • It is else. - • It is - ; its consumption by one person does not reduce consumption by someone ; it is not possible to exclude someone from using the good. For example, a lighthouse is non-rivalrous, because its use by one person does not make it less available for use by others. Also, it is non-excludable, because there is no way to exclude anyone from using it. Other examples of public goods include the police force, national defence, flood control, non-toll roads, fire protection, basic research, anti-poverty programmes and many others. P How do public goods relate to market failure? In the case of excludable goods, it is possible to prevent people from buying and using a good simply by charging a price for it, since those who are unable or unwilling to pay the price do not get to use it. Therefore, private firms have an incentive to provide excludable goods because they can charge a price for them, and therefore can cover their costs. Nonexcludable goods differ: if a non-excludable good were produced by a private firm, people could not be prevented from using it even though they would not pay for it. Yet no profit-maximising firm would be willing to produce a good it cannot sell at some price. As a result, the market fails to produce goods that are non-excludable, giving rise to resource misallocation, as no resources are allocated to the production of public goods. Public goods illustrate the , occurring when people can enjoy the use of a good without paying for it. The free rider problem arises from non-excludability: people cannot be excluded from using the good. Public goods are a type of market failure because, due to the free rider problem, private firms do not produce these goods: the market fails to allocate resources to their production. Table 6.2 summarises different types of goods according to their rivalry and excludability characteristics. E R N - Private goods Quasi-public goods Goods with or without positive or negative externalities (both production and consumption) sold for a price. Merit goods (as long as they are produced by the market) and demerit goods Goods that do not fall neatly into the other three categories; often (but not always) have large positive externalities so may be provided by the government Examples: computers, books, clothes, education, petrol (gasoline) Examples: uncrowded toll roads, museums, public swimming pools that charge entrance fees, cable TV See the section below for an explanation of quasi-public goods. N - Common pool resources Public goods Natural resources that are not owned by anyone, not sold in markets and not having a price; their lack of a price makes them subject to overuse (unsustainable use), depletion and degradation See the section below for an explanation of quasi-public goods. Socially desirable goods not produced by private firms because it is not possible to charge a price; they are subject to the f ee ide p oblem: people use them without having to pay; since they are socially desirable they are produced by the government and provided free of charge Examples: forests, rivers, lakes, soil quality, fish in the oceans Examples: national defence, street lighting T Q 6.2: Summary of different kinds of goods based on rivalry and excludability - (S ) Some goods do not fit neatly into the category of private goods or public goods. They can be considered to be ‘impure public goods, also known as ‘quasi-public goods . These goods are: • non-rivalrous (like public goods), and • excludable (like private goods). Examples include public museums that charge an entrance fee and toll roads. All these are excludable because consumers must pay to use them. They are also non-rivalrous since use by one does not reduce availability for others. Since the price system can be made to work here to exclude potential users, they could be provided by private firms. However, they all have very large positive externalities, thus justifying direct government provision. G D We have seen that the market fails to allocate resources to the production of public goods. This means the government must step in to ensure that public goods are produced at socially desirable levels. Thus public goods are directly provided by the government, are financed out of tax revenues and are made available to the public free of charge (or nearly free of charge). Government provision of public goods raises some issues of choice about (a) which public goods should be provided, and (b) in what quantities they should be provided. These issues are similar to what was noted earlier in connection with direct government provision and subsidies for goods with positive externalities. Limited government funds force choices on what public goods to produce, and each choice has an opportunity cost in terms of other goods and services that are foregone (sacrificed). Here, too, the government must use economic criteria to decide which public goods will provide the greatest social benefits for a given amount of money. However, in the case of public goods, governments face a major additional difficulty in calculating expected benefits. With private goods that are provided or subsidised by the government, it is possible to make estimates of expected benefits by using the market price of the good. (Remember the market price reflects the benefits consumers receive and so reveals its value to consumers.) Therefore, the government can use the market price of private goods with positive externalities to estimate their value to consumers, but with public goods there is no such possibility as they are not produced by private firms and have no price. This means the government must try to estimate the demand (or ‘price ) of public goods through such means as votes or surveys of people who are asked how much a good would be worth to them. This information is used in co benefi anal i , which compares the estimated benefits to society of a particular good with its costs. If the total benefits expected from a public good are greater than the total costs of providing it, then the good should be provided. If benefits are less than costs, then it should not be provided. Assuming that cost–benefit analysis indicates a public good should be provided, the decision on how much of it to provide is made by comparing marginal benefits with marginal costs: the public good should be provided up to the point where MB = MC. Whereas the costs of providing a public good are relatively easy to estimate, there are clear difficulties in estimating benefits. A major difficulty arising with surveys is that people who really want something are likely to exaggerate its value. Therefore, cost–benefit analysis is a very rough and approximate method used to make choices about public goods. In addition, it should be noted that just like in the case of positive externalities which invite direct government provision and subsidies for their correction, the provision of public goods is also political in nature, with different groups competing against each other, and with government sometimes susceptible to political pressures that influence their decisions. C When the government provides a public good, it may either provide it itself directly, or it may contract it out to a private firm. C by the public sector to the private sector occurs when a government makes an agreement (or contract) with a private firm to carry out an activity that the government was previously doing itself. This is a practice that many governments around the world have been increasingly undertaking. Suppose the government would like to build a new highway system. Rather than build it itself by directly hiring engineers, workers, and supplying the materials, it may contract its construction out to a private construction firm. Note that whether goods are provided directly by the government or contracted out, they are in both cases financed out of tax revenues. The potential advantages of contracting out include the following: • It is often done by competitive tendering (a competition between firms that would like to provide the government with the service) resulting in the selection of a provider that can offer the lowest cost. • It is usually accompanied by detailed specifications regarding the activity that will be provided with criteria for measurement of the provider s performance, which may allow for better quality control. • It provides access to a broader range of skills and technology of the private firm than the government is likely to have available itself. • The private firm may be more flexible and innovative than the government. • Due to all of the above it may be possible for the public goods provided to be better quality and less costly. On the other hand, contracting out also has potential disadvantages: • The government becomes less accountable for the public goods it provides. • The government loses control over the services it has contracted out. • The costs of contracting out may be greater than if the government had provided the public good itself, as the contracting private firms often charge high prices for their services. • There is a risk that quality may be reduced because competition between firms on the basis of cost may lower the quality of the services provided. • There is a risk of making a poor contract with a private sector firm, resulting in higher costs and lower quality, along with reduced accountability and control noted above. • Contracting out needs to be monitored by the government, which adds to costs. As a result of all of the above it is difficult to generalise about the effectiveness of contracting out as a method to provide public goods. Moreover, it should be noted that contracting out only addresses issues of the quality, costs, skills, and so on discussed above; it does not address the difficulties faced by the government in making decisions about what public goods to produce and in what quantities, which as we have seen above depend on the very difficult problem of trying to determine expected benefits and costs of alternative public goods. TEST YOUR UNDERSTANDING 6.3 1 Explain how the concepts of rivalry and excludability relate to the distinction between public goods and private goods. 2 Provide some examples of public goods, and outline how they relate to the concepts of nonrivalry and non-excludability. 3 Use the concepts of resource allocation and the free rider problem to explain how public goods are a type of market failure. 4 Discuss the difficulties of direct government provision of public goods. 5 Evaluate the government s policy option to contract out to the private sector the provision of public goods. 6.4 A c a (HL ) LEARNING OBJECTIVES After studying this section you will be able to: • define all the terms appearing in a b in the text (AO1) • distinguish between adverse selection and moral hazard (AO2) • evaluate government responses to the problem of asymmetric information, including legislation and regulation, and provision of information (AO3) • evaluate private responses to the problem of asymmetric information, including signalling and screening (AO3) The competitive market mechanism presupposes that all firms and all consumers have complete information regarding products, prices, resources and methods of production. However, as we know from Chapter 2 this condition is hardly ever met in the real world where firms, consumers and resource owners find themselves in situations where information is missing. A c a refers to something more than just missing information; it refers to situations where buyers and sellers do not have eq al acce to information. In some cases buyers may have more information than sellers; in other cases the opposite holds where sellers have more information than buyers. As we will see, this usually results in an nde alloca ion of e o ce to the production of goods or services, and therefore to allocative inefficiency. We will study two different types of problems of asymmetric information: adverse selection and moral hazard. A c A c refers to situations where one party in a transaction has more information about the quality of the product being sold than the other party. A c a a a ab b b Sellers often have information about the quality of a good or service that they do not make available to consumers. Sellers of used cars have information about the car’s quality that they are unlikely to reveal to potential buyers if the car has a defect. In a free and unregulated market, sellers of food could sell products that are unsafe for human consumption, possibly leading to illness and even death. Sellers of medicines could sell unsafe medications that could be ineffective or dangerous. Individuals claiming to be doctors, some of whom have little or no training, could practise medicine and even surgery, resulting in huge costs in terms of human health and safety. In a free unregulated market, the result is usually to underallocate resources to the production of the good or service. Consumers are likely to be aware of possible dangers to themselves, and will be cautious about buying the good or service, resulting in lower demand, less production and lower sales. However, if consumers are unaware of possible hidden dangers, such as with unsafe food or toys, there could result an overallocation of resources to the production of these goods and services. P b a a G b c R a According to one method, governments can pass laws and regulations that ensure quality standards and safety features that must be maintained by producers and sellers of goods and services, such as food, medications, private schools, toys, buildings and all types of construction. These methods are not without their difficulties. Legislation and regulation are time-consuming, bureaucratic procedures, which sometimes work to slow down economic activities. It takes a long time, for example, to test new medications and certify their safety, and is a costly process. Also, regulatory and quality control activities have very large opportunity costs. Just in the case of food safety control, which involves not only food and beverage products but also hygiene in restaurants, there is a huge number of products and service providers involved, who require regulation and monitoring from the level of the farm (regarding the kinds and amounts of chemical inputs) to the moment the food reaches the table. P a Governments may also respond by directly supplying information to consumers, or by forcing producers to provide information, thus protecting consumers in their purchasing decisions. This may include information about the quality of medical care by different providers, about communicable diseases, crime rates by neighbourhoods, health hazards related to different activities, products or substances, nutritional labelling on foods, and so on. In some countries, particularly in Europe, governments provide fee schedules for services (such as legal, medical, architectural) to ensure that consumers receive a particular quality of services for a particular range of prices. When the government is the provider of information, there are difficulties involving the collection and dissemination of all the necessary information to consumers, the accuracy of the information, as well as opportunity costs in providing the information. When a private seller/producer is the provider of the information, there are serious questions about whether information regarding all hazards in products or substances and materials used in products, or all information regarding the quality of services (whether legal, medical, financial, and so on) is accurate and complete. Another problem is that it is sometimes not possible to eliminate an information asymmetry between sellers and buyers, because no matter what regulations and information are provided, there is still some room for the seller to hide some information from the buyer. In the areas of health care and law, doctors and lawyers have specialised, technical information about their clients that the clients themselves do not possess. Doctors and lawyers often use this information for their own private gain by selectively revealing information to their clients that causes them to demand more services than are necessary. This practice leads to what is known as ‘supplier-induced demand’, or demand that is induced (created) by the supplier, which would not have appeared if the client had equal access to information. Lc In the case of doctors, most countries around the world have laws requiring doctors to be licensed, and a licence can only be obtained upon proof of adequate medical competence. Licensing is similarly required for many other professions in many countries, from teachers and lawyers to plumbers and electricians. Some economists criticise licensing, because it may work to limit the supply of people in a profession, raising the price of their services and increasing their incomes at the expense of consumers who must pay higher prices (this refers to ma ke po e discussed in Chapter 7 at HL). P a Sc Sc is a method used by the party with the limited information, in this case the buyer. The buyers may try to get more information about what they are buying, in other words they screen the product or the producer or seller of the product. Consumers may find information provided on the internet about reliable used car dealers, or they may informally ask friends for information about the quality of health care service providers, or legal service providers. While screening may help in providing consumers with some missing information, it can by no means on its own solve the problem as it cannot provide systematic and complete information to match the information available on the seller’s side. S a S a is a method used by the party that has more information, or in this case the seller. The purpose of signalling is to convince the buyers that the product being sold is of good quality. Common methods include the use of warranties, establishment of brand names that convey a feeling of reliability, and, in the case of used cars, making service records available or exhibiting cars in fancy show rooms. The problem with signalling is that it is unlikely to provide full information to buyers, and it may even provide inaccurate or misleading information by sellers eager to promote and sell their products. A c a a a ab b b Adverse selection where the buyer has information not available to the seller often arises in the area of insurance services, where the buyer of insurance has more information than the seller. This situation arises most often in the area of health insurance. Buyers of health insurance know more about the state of their health than sellers of insurance, and those with health problems are unlikely to tell the full truth to the insurance company. In a free unregulated market, adverse selection results in an underallocation of resources to health insurance services, as the insurance company reduces the supply of insurance to protect itself against having to provide insurance coverage to very high risks, or people who are more likely to become ill. Adverse selection also leads to high insurance costs for insurance buyers. P P b a c b a Private insurance companies usually protect themselves by offering a range of policies where the lower the cost of the insurance, the higher the deductible (out-of-pocket payments). This offers people choice, so that those who believe they have a low risk of getting sick can buy a low-cost policy with a higher deductible, while higher-cost policies with lower deductibles can be selected by people who believe they have high levels of health risk. This is actually a method of c eening undertaken by the party with the limited information, or seller of insurance. The choice of high or low deductible given to the buyers of insurance is intended to screen them by indirectly providing information about their state of health to the seller of insurance. However in practice, it does not work out this way. An important reason is that lower-income earners choose low-cost policies with high out-of-pocket payments because these are more affordable, ega dle of he a e of hei heal h. From the perspective of equity or fairness, this is undesirable because it discriminates against those on low incomes. Another reason is that in trying to protect themselves against high risks, insurance companies usually refuse to insure people above a certain age, as elderly people generally have a higher chance of becoming ill. The result is that those who mostly need health insurance coverage, who are poor people who cannot afford to buy health care in the private market and elderly people who are more likely to become ill, are left with little or no insurance coverage. G To deal with this problem, government responses may take the form of direct provision of health care services at low or zero prices to an entire population, financed by tax revenues, thus ensuring that the entire population has health insurance coverage, such as in countries with a National Health Service (as in many European countries). Alternatively, they make take the form of social health insurance, which may cover a country’s entire population (as in several European countries), or which selectively covers only certain vulnerable groups of the population (as in the United States). The benefit of these approaches, particularly in countries that offer insurance coverage to their entire population, is that no one in need of health care goes without it. A potential problem with government-funded or social health care systems involves difficulties in controlling costs of providing health care and growing burdens on the government budget or social health insurance budget. M a E a a a a a a M a a a refers to situations where one party takes risks, but does not face the full costs of these risks because the full costs of the risks are borne by the other party. It usually arises when the buyer of insurance changes his or her behaviour af e obtaining insurance, so that the outcome works against the interests of the seller of insurance. For example, buyers of car theft insurance may be less careful about protecting their car against theft, because they know they will be reimbursed if someone steals their car. Some buyers of medical malpractice insurance (doctors) may be less careful about avoiding malpractice, because of the knowledge that malpractice costs will be covered by the insurer. Unemployment insurance may lead some people to be less hesitant about becoming unemployed, in the knowledge that their insurance will provide them with some income. In all these cases, the buyers of insurance have information about their future intentions that is not available to the sellers of insurance. In a free, unregulated market, the result of moral hazard is to underallocate resources to the production of insurance services, as sellers of insurance try to protect themselves against higher costs due to the risky behaviour of the buyers of insurance. Many economists have noted that the financial crisis that began in 2008 was partly a case of moral hazard. It is argued that many financial institutions made risky loans and engaged in other highly risky financial transactions because they believed that the government would support them in the event of difficulties (which, in fact, it did). (Note that this is not a matter of taking out an insurance policy in the strict sense of the term, but it is a sort of ‘insurance’ nonetheless, in that the government provides a kind of assurance of protection in the event that financial institutions face difficulties due to poor loan repayments.) You may note that the term ‘moral hazard’ does not refer to unethical or immoral behaviour. It is simply a historical remnant of a very old insurance term that originally meant ‘subjective’. R a a a Problems of moral hazard in insurance are usually dealt with by the provider of insurance. This is often done by making the buyer of insurance pay for part of the cost of damages through deductibles (out-of-pocket payments). This is intended to make the insurance buyer face the consequences of risky behaviour, thus leading to less risky behaviour. It will be recalled from the discussion above that deductibles are a form of c eening. A problem with deductibles is that it has different effects depending on the income level of insurance buyers. As noted earlier in connection with adverse selection, private insurance companies usually offer a range of policies from which buyers can choose, where the lower the cost of the insurance, the higher the deductibles. Higher-income earners usually choose higher-cost policies with low deductibles, while lower-income earners choose low-cost policies with high deductibles because these are more affordable. This suggests that higher-income earners are more likely to engage in risky behaviour because they are offered more insurance protection, while lower-income earners are less likely to engage in risky behaviour. In the financial area, moral hazard is dealt with through government regulation of financial institutions, intended to oversee and prevent highly risky behaviour. This raises a whole set of issues regarding the types and degrees of government regulations that are required if these are to be effective. In general, following the onset of the global financial crisis in 2008 governments in Europe and the United States have taken steps to increase regulation of the financial sector, though there are concerns that this has not been enough, especially in the United States. TEST YOUR UNDERSTANDING 6.4 1 2 a Using examples, identify two main types of information problems that give rise to market failure. b Using the concept of allocative efficiency, explain why information asymmetries represent market failure. a Provide examples of information asymmetries where information is available to sellers but not to buyers. b Explain how governments can intervene to correct these information asymmetries. c Explain possible private responses to information asymmetries. Discuss some advantages and disadvantages of both government intervention and private responses. 3 a Provide examples of information asymmetries where information is available to buyers but not to sellers. b Explain how governments can intervene to correct these information asymmetries. c Discuss advantages and disadvantages of these types of government intervention. 6.5 E (HL ) LEARNING OBJECTIVES After studying this section you will be able to: define all the terms appearing in in the text (AO1) explain why the free market results in an unequal distribution of income and wealth (AO2) draw a circular flow of income diagram to show why free markets give rise to income inequalities (AO4) W In Chapter 1, we saw that equity refers to the idea of being fair and just, while equality is the state of being equal with respect to something. Therefore income equality would mean that everyone in a society receives the same amount of income. We also learned that while equity and equality have different meanings, in most countries the pursuit of equity is understood to refer to efforts to reduce significant inequalities in income and wealth. The reason for this is that people around the world generally share the belief or value judgement that the free market economy results in inequalities that are considered to be unfair. We will now see why this is so. Our study of the circular flow model in Chapter 1 shows that in a market economy the amount of goods and services that households receive depends on their income, as this determines how much they can buy. Figure 1.4, showing the simple circular flow model (with no leakages and injections), appears below as Figure 6.8. We can see here that the income of households depends on payments they receive by selling the factors of production they own. Therefore, output and income distribution in a market economy depend on how many resources consumers (households) own and are able to sell in resource markets, as well as on the prices of the factors of production they sell. F 6.8: Circular flow of income model The problem of income distribution arises because ownership of factors of production is highly unequal, and because the prices of factors of production determined in the market vary enormously. Most people have labour resources that they provide in labour markets, for which they receive wages. Yet some people are able to receive very high wages because of special skills and education or natural talents, while others who are less skilled, educated or talented may receive wages so low that they may be unable to cover the most basic needs for themselves and their families (food, shelter, clothing, etc.). Further, there may be people who would like to work but cannot do so because they lack the kinds of skills firms want to hire, or because they are sick, or old, or have special needs that prevent them from working, or because there simply are not enough jobs in the economy to provide work for everyone. Then there are some individuals who possess some of the additional factors of production of land, capital and entrepreneurial abilities, for which they receive rental, interest and profit income. These additional factors of production are generally highly unequally distributed. As a result, the marketdetermined distribution of income in an economy is likely to be very unequal, with some people receiving far larger shares than others. It follows that markets cannot ensure that everyone in a population will secure enough income to satisfy their basic needs. Most societies consider this to be a disadvantage of the free market economy, because of the belief held by most people that everyone in a population should be able to satisfy a minimum of basic human needs. Governments around the world therefore use a variety of methods to change the market-determined distribution of income and output, and arrive at a more socially desirable outcome. This is referred to as redistribution. We will come back to the topic of income distribution in Chapters 12 and 20. I As we have seen in connection with the circular flow model, income refers to the flow of money that is received by the owners of the factors of production. W , on the other hand, refers to the money or things of value that people own, such as savings deposits (money saved in a bank); stocks in the stock market; bonds; land, houses and other property; valuable paintings or jewellery, and so on; minus debt to banks or other financial institutions. Income gives rise to the possibility of saving, which can then be used to create wealth, and so wealth and income are related to each other as would be expected. Yet they are distinct and are not always closely linked together. For example, some people may have high incomes but low savings because they spend a lot, in which case they will have relatively low wealth. On the other hand, there may be people who have inherited wealth, or pensioners who have saved over a lifetime of work, who have high levels of wealth but relatively low incomes. In general, however, we can say that the higher the income, the greater the possibilities for saving and for accumulating wealth. Therefore, just as the free market economy results in income inequalities, so too it results in wealth inequalities. We will come back to the topic of inequalities in income and wealth in Chapter 12, where we will discover that inequalities in wealth are in fact far greater than inequalities in income. I It should be noted that the inability of the market to ensure that everyone in a population will secure enough income to satisfy their basic needs is not strictly speaking market failure. This follows from the way that market failure is defined. As we know, market failure is the inability of the market to achieve allocative efficiency, where MSB = MSC, or where social surplus is maximum. This bears no connection with income or wealth distribution. It is in fact possible to have allocative efficiency and maximum social surplus either with complete income equality or with extreme inequality, where for example a large portion of the population is starving. This peculiarity will be discussed in the Theory of knowledge 6.1. TEST OUR UNDERSTANDING 6.5 1 Explain, using examples, the difference between equity and equality in income wealth distribution. 2 Using the circular flow of income diagram, explain why the market system cannot ensure that everyone in a society will be able to secure an adequate income to satisfy basic needs. THEOR OF KNOWLEDGE 6.1 I : It was noted above that inequalities in income and wealth are not a type of market failure, because it is possible to have any degree of inequality where there is at the same time allocative efficiency with maximum social surplus. Yet you may wonder, how can there be maximum social surplus with extreme inequality? The answer to this lies partly in the positive-normative distinction we discussed in Chapter 2. If you revisit Theory of knowledge 2.1 in Chapter 2 (at the end of Section 2.5), you will be reminded that maximum social surplus (or welfare) refers to the what/how much to produce and how to produce questions of economics, and the idea of making the best possible use of resources, which are in the sphere of positive economics. Equality and inequality on the other hand refer to the for whom to produce question, which belongs to the sphere of normative economics. Yet this by itself is not a satisfactory explanation, especially if we remember that allocative efficiency can be defined as producing the combination of goods mostly wanted by society. In Chapter 2, Section 2.5, we saw that allocative efficiency is achieved when the economy allocates its resources so that the benefits from consumption are maximised for the whole of society. This clearly gives rise to a pu le. How can benefits from consumption be maximised for the whole of society if there is extreme inequality with a large part of the population starving? We can find the answer to this pu le in the definition of demand, which we studied in Chapter 2 (Section 2.1). As you may recall, demand shows the various quantities of a good that a consumer is willing and able to buy at different possible prices, ceteris paribus. The answer to our pu le lies in the able to buy part of this definition. If consumers have little or no income, they are not able to buy the good, and therefore they do not have any demand for it. In other words, no demand will show up in the market for the good from consumers with little or no income, however much they may want to buy it. We now have the answer to the pu le. As we know, the condition MSB = MSC is equivalent to maximum social surplus (or welfare). Alternatively, we can say that MB = MC is equivalent to maximum social surplus when there are no externalities. But MB is simply the demand curve! And MSB is also simply a demand curve for the whole of society that accounts for any possible external costs or benefits! This means that when we say that there is allocative efficiency and maximum social surplus when the benefits from consumption are maximised for the whole of society, we are simply talking about that part of society that has a demand because consumers are not only willing but also able to buy the good! Consumers from the rest of society with little or no income and hence no demand are bypassed, ignored and forgotten. In other words, allocative efficiency is defined on the basis of demand from those consumers who have enough income to make their preferences felt in the market. T The work of the classical economists, such as Adam Smith who we met in Chapter 1, was not based on the positive-normative distinction. Economists at the time, as you may remember were moral philosophers, and Adam Smith was deeply concerned with issues of ethics. It was only in the early 20th century that economists became influenced by the methods of the natural sciences and the idea that facts should be kept distinct from values. Yet in more recent years, some economists, such as Amartya Sen, an Indian Nobel Pri e winning economist for his work on Economic Development, argue that it does not make sense for economists to maintain this strict separation between facts and values. Sen s work reintroduces ethics and values into economic analysis and mixes them to create a unified whole. We will encounter Amartya Sen in Chapter 18. In your study of economics, you are encouraged to consider the positive-normative distinction. Do you agree with the idea that facts (positive) should be kept distinct from values (normative) in the study of economics? Is it even possible to always make this distinction, or do values creep into the work of economists? We will come back to this point in Theory of knowledge features 9.1, 10.1, 15.1 and 18.1. Consider what redistribution of income leading to reduced inequalities in an economy implies for the concept of allocative efficiency. In particular, consider that people who previously had no demand for a good or service may now have such a demand based on their higher income. What is likely to happen to the efficient level of output of particular goods and services? INQUIR AND REFLECTION The following questions will help you reflect on your learning and enhance your understanding of key topics in this chapter. They are suggestions for inquiries that you can undertake on your own or in groups in order to revise the learning objectives of this chapter. 1 Identify a good or service in your country or a country you are interested in that gives rise to a particular positive consumption externality. Examine the external benefits and their effects on stakeholders, investigate solutions in use, evaluate the solutions and identify effects on stakeholders. 2 Identify a public good that has been contracted out to the private sector in a country you are interested in and investigate the advantages and disadvantages that have emerged. 3 Investigate a situation where asymmetric information involves adverse selection or moral ha ard and identify public and private solutions that have been used to address it. E AM ST LE QUESTIONS You can find questions in the style of IB exams in the 'Digital coursebook: Extra material' section. Cha e 7 Ma ke fail e and ciall nde i abl c me III: Ma ke e (HL nl ) BEFORE YOU START In what ways do firms compete with each other in order to increase their sales? When firms compete with each other to increase sales, some firms might have advantages over others. Can you think of what some of these advantages may be? From the consumer s point of view can you think of some advantages and disadvantages of firms that grow to a very large size? This chapter is concerned with the relationship between the behaviour of firms and market failure. We will begin by introducing the fundamental concepts of revenues, costs and profits needed to study firm behaviour. We will then see how firm behaviour within particular markets gives rise to market power, which is linked to an important kind of market failure. 7.1 I a c c , a LEARNING OBJECTIVES A : a b (AO1) , , (AO2) , , (AO2) (AO2) , , , , , (AO2) Ma a a A a , fi m ( ) .A ind M , (F .); ,H , ; ( c .T ). I ma ke e, . A ind i able c n O l he ice a , c c e , ma ke e , , al ha e ma ke hich each indi id al fi m in he a . : ; I b he e en d c.T hich i ell i ; he g ea e am n fi m face c c e, f ma ke e. me c m e i i n ; : cc . M , .T F , , . , , .F , . I c a c A ( ), : n mbe f fi m , c a , , , ba ; . . C a ac c c c T . A ( ; ); T ; . P .E , , , , ). I , ( , .F , , C a ac . c T I , . , .F ,M 80% . T , ; , , . T ; . E , . (T .) T , .O , .I .A ,M 75% , ; , .B .M . C a ac C c cc , T ( T - ) . ; . T ; , . E , , , , , .M .I .B , .T .F R .H ,N N .T , , R ( ) . C a ac c T ; , in e de enden , .T . P ( T ) ( ). ; E ( . , ) , , , , , ( ). O .M . Ma a A T c C 2, S .T , The meaning f c m e i i e ma ke , , , .T 7.1 , .T , , . W c c . ? I , .A , .E , . P . .B , , .I . TEST YOUR UNDERSTANDING 7.1 , 1 E , . 2 D 3 I . . N b T Ea E a Ma c D c / c c P c c M c / , c , , , , O , ( , , ) M Tab 7.1: C , 7.2 P LEARNING OBJEC I E Af e d ing hi ec ion o ill be able o: define all he e m a ea ing in e lain co , e en e and in he e ofi conce (AO1) (AO2) o al e en e, a e age e en e, ma ginal e en e o al co , a e age co , ma ginal co abno mal ofi , no mal calc la ion f om da a of e en e (AO4) To nde and ma ke co and ofi . c ofi , lo ofi , ma ginal co , ma ginal e en e, a e age co , a e age e , em fi e amine ome im o an conce ela ing o e en e , R , R a e he a men fi m ecei e hen he ell he good and e ice he a e h ee f ndamen al e en e conce : o al, a e age and ma ginal e en e. od ce. The e The fi m (TR) i ob ained b m l i l ing he n mbe of ni of he good old (Q): old (P) b TR= P ice a hich a good i he Q The fi m ni of o (AR) i e en e e ni of o old, o o al e en e (TR) di ided b (Q): AR=TRQ No e ha AR i al a e al o P, o he ice of he od c . The ea on i ha ince TR=P Q,P=TRQ, he efo e P=AR. The fi m ni of o (MR) i he addi ional e en e a i ing f om he ale of an addi ional . MR= TR Q R Whe ea he defini ion of e en e a l o all fi m , he anal i of e en e i no he ame, beca e hi de end on he he o no he fi m ha an abili o con ol i ice. We m he efo e make a di inc ion ega ding e en e he e: he fi m i nable o con ol he fi m ha con ol o e mono ol . ice; ice; ice i con an a o ice a ie ih o a ie : e fec com e i ion : mono oli ic com e i ion, oligo ol , R : Table 7.2 ho o al, ma ginal and a e age e en e ba ed on info ma ion on he ice and an i of he good in i a ion he e a fi m canno con ol ice. Col mn 3, 4 and 5 a e calc la ed f om he da a in col mn 1 and 2, ing he defini ion gi en abo e. No e ha he p ice a hich he good i old doe no change; hi occ onl nde e fec com e i ion. Fig e 7.1 lo he da a of Table 7.2. 1 2 3 4 P (Q) 5A M (P) ( ) ( ) MR= RQ ( ) =P Q( ) MR= TR Q ( ) 0 1 10 10 10 10 2 10 20 10 10 3 10 30 10 10 4 10 40 10 10 5 10 50 10 10 6 10 60 10 10 7 10 70 10 10 7.2: Calc la ing o al, ma ginal and a e age e en e con ol ice; he ca e of e fec com e i ion F 7.1: To al, ma ginal and a e age e en e c con ol o e ice; he ca e of e fec com e i ion R e hen hen : ice i con an : he fi m ha no ice i con an : he fi m ha no , , Table 7.3 ho o al, ma ginal and a e age e en e f om ice and an i info ma ion in he ca e he e he fi m ha ome infl ence o e ice. The me hod of calc la ion i e ac l he ame a in he com e i i e ca e abo e, he e col mn 3 5 a e calc la ed ing he info ma ion of he fi o col mn . The diffe ence i in he ice da a, a ea ing in col mn 2, ho ing ha he p ice a hich he good i old change a he an i of o p change . The lo e he ice he g ea e he an i of o , ill a ing he la of demand. Thi occ nde all ma ke model ha e ill d o he han e fec com e i ion. Fig e 7.2 lo he da a of Table 7.3. 1 2 3 P (Q) 4 M (P) ( ) ( = P Q) ( ) 5 A MR= TR Q ( ) AR=TRQ ( ) 0 1 12 12 12 12 2 11 22 10 11 3 10 30 8 10 4 9 36 6 9 5 8 40 4 8 6 7 42 2 7 7 6 42 0 6 8 5 40 2 5 9 4 36 4 4 10 3 30 6 3 7.3: Calc la ing o al, ma ginal and a e age e en e hen ice a ie : he fi m ha con ol o e ice; he ca e of mono ol , mono oli ic com e i ion, oligo ol ome F o e 7.2: To al, ma ginal and a e age e en e c e hen ice a ie : he fi m ha ice; he ca e of mono ol , mono oli ic com e i ion, oligo ol ome con ol C To calc la e e en e , i i onl nece a o emembe and nde and he ela ion hi be een he a io e en e conce , beginning i h he idea ha TR = P Q. If o a e gi en da a on P and Q, o can find TR, and f om he e o can calc la e AR=TRQ and MR= TR Q . Yo can al o o k back a d o find TR and MR if o kno AR and Q, o o find TR and AR if o kno MR and Q. Remembe al o ha AR = P in all ca e , o ha if o kno AR, o al o kno od c . he ice of he To calc la e e en e f om a diag am, e im l ead off he info ma ion a ea ing in he g a h, and a l e ac l he ame inci le a abo e o calc la e he e en e a iable o a iable e a e in e e ed in. C When fi m e in o e o ce o od ce, he inc , hich incl de mone a men o b e o ce l an hing el e gi en b a fi m fo he e of e o ce . The e o ce incl de land, labo , ca i al and en e ene hi ( ee Cha e 1). When he fi m e e o ce i doe no o n, i b hem f om o ide and make a men of mone o he e o ce lie . Fo e am le, a fi m hi e labo and a a age; i cha e ma e ial and a he ice o he elle . S ch a men made b a fi m o o ide o ac i e e o ce fo e in od c ion a e kno n a e plici co . On he o he hand, hen he fi m e e o ce i o n , he e i ill a co , hich con i of he income ha i ac ificed hen he fi m e ch a elf-o ned e o ce. Fo e am le, in he ca e of an office b ilding o ned and ed b he fi m, he co i he en al income ha co ld ha e been ea ned if he b ilding e e en ed o . Yo can hink of hi a an o o ni co . The ho of o k a fi m o ne in o hi o he o n b ine ha e an o o ni co e al o ha he fi m o ne co ld ha e ea ned if /he had o ked el e he e. The en e ene ial abili ie he fi m o ne in o he b ine ( i k- aking, inno a i e, o gani a ional and manage ial abili ie ) in ol e a f he o o ni co e al o ha he e abili ie co ld ha e ea ned el e he e. The ac ificed income a i ing f om he e of elf-o ned e o ce b a fi m i an implici co . E 1 O R NDER ANDING 7.2 Define o al e en e, ma ginal e en e, and a e age e en e. 2 Gi en he follo ing ice and e en e and a e age e en e. P ($) Q 3 Q 4 ( ) Gi en he follo ing ice and e en e and a e age e en e. P an i ($) ( ) da a fo a od c , calc la e o al e en e, ma ginal 5 5 5 5 5 0 1 2 3 4 an i da a fo a 8 7 6 5 4 3 2 2 3 4 5 6 7 8 O line ha can be concl ded abo ho ni of o old in e ion 2 and 3. E lain he ela ion hi be een od c , calc la e o al e en e, ma ginal ice change (o doe no change) fo each ice and a e age e en e. 5 Gi en he follo ing da a, calc la e o al e en e and ma ginal e en e fo each le el of o . Iden if he ice a each le el of o . Q ( A 6 ) ( ) 1 2 3 4 5 6 20 18 16 14 12 10 Gi en he follo ing da a, calc la e o al e en e and a e age e en e fo each le el of o . Iden if he ice a each le el of o . Q ( ) M ( ) 1 2 3 4 5 6 14 12 10 8 6 4 The m of e lici and im lici co inc ed b a fi m fo i e of e o ce , he he cha ed o elf-o ned, a e kno n a economic co . When economi efe o co he mean economic co . C In Cha e 2 (Sec ion A mp ion nde l ing he la of ppl ), o e e in od ced o co of od c ion. (I i gge ed ha o e ead hi ec ion befo e con in ing f he .) Ve b iefl , he ele an a f om ha ec ion incl de he follo ing conce : ho n = he e iod of ime hen a lea one fac o of long n = he e iod of ime hen all fac o of o al co = all co of od c ion inc ma ginal co (MC) = he e To calc la e MC, e od c ion i fi ed od c ion a e a iable ed b a fi m a o addi ional co of od cing one mo e ni of o . e he fo m la MC= TC Q We no need o in od ce one mo e co conce : od ced, o o al co (TC) di ided b ni of o (AC), hich i co e ni of o (Q): AC=TCQ Table 7.4 belo i he ame a Table 2.5 in Cha e 2 ( he e o lea ned ho co ) and in addi ion incl de a ne col mn ho ing a e age co . ( , Q) ( C) M (MC) ($) ($) o calc la e ma ginal A (AC) ($) 1 12 12 12 2 20 8 10 3 26 6 8.67 4 34 8 8.5 5 46 12 9.2 6 62 16 10.33 7.4: To al co , ma ginal co and a e age co Fig e 7.3 lo ma ginal co and a e age co ba ed on he da a ha a ea in Table 7.4. A e lained in Cha e 2 he MC c e i ba ed on he la of dimini hing ma ginal e n (Sec ion A mp ion nde l ing he la of ppl ). The ame a lie o he AC c e. Yo ma ecall ha dimini hing e n hold onl in he ho n hen a lea one fac o of od c ion i fi ed. The efo e o anal i of co in hi ec ion clea l applie o he ho n. F 7.3: Ma ginal co and a e age co in he ho n I i im o an o no e he ela ion hi be een he a e age co and ma ginal co c e : hen he ma ginal co c e lie belo he a e age co c e, (MC<AC), a e age co i falling; and hen he ma ginal co c e lie abo e he a e age co c e (MC>AC), a e age co i inc ea ing. Thi mean ha he ma ginal co c e al a in e ec he a e age co c e hen hi i a i minim m. The ea on lie in he ma hema ical ela ion hi be een he a e age and ma ginal al e of an a iable. Con ide a im le e am le in ol ing e co e . Sa o ha e an a e age of 80 in o e . If o ne e co e ( he ma ginal co e) i g ea e han o a e age of 80, o a e age ill inc ea e. If o ne e co e i lo e han o a e age of 80, o a e age ill fall. The ela ion hi be een a e age and ma ginal e co e i e ac l he ame a he ela ion hi be een a e age and ma ginal co . C - Yo can calc la e co ea il if o emembe and nde and he ela ion hi be een he co conce e ha e j di c ed. If o ha e info ma ion on ni of o (Q) and o al co (TC), o can find AC = TC Q and MC= TC Q . Yo can al o o k back a d o find TC and MC if o kno AC and Q, o o find TC and AC if o kno MC and Q. To calc la e co f om a diag am, o can j ead off he info ma ion a ea ing in he g a h, and a l e ac l he ame inci le a abo e o calc la e he co a iable o a iable o a e in e e ed in. E 1 O R NDER ANDING 7.3 Define o al co , ma ginal co , and a e age co . 2 Gi en he follo ing ma ginal co . Q ( od c , calc la e a e age co and 2 5 9 14 18 21 23 24 300 400 500 600 700 800 900 1000 Gi en he follo ing da a, calc la e o al co and ma ginal co fo each le el of o Q ( A 4 and o al co da a fo a ) ( ) 3 an i ) ( ) . 1 2 3 4 5 180 140 133 135 140 Gi en he follo ing da a, calc la e o al co and a e age co fo each le el of o Q ( ) 1 2 3 4 5 Q ( ) 11 12 10 12 14 C Yo ma emembe ha he long n i he e iod of ime hen he fi m a ie (change ) all i fac o of od c ion. We a e in e e ed in e amining ho he fi m a e age co , o i co ni of o , change hen i g o la ge b inc ea ing all of i fac o of p od c ion. e A an momen in ime, hen he fi m i in he ho n, i ha a a ic la ho - n AC c e; e can call hi i SRAC. When i g o o e ime, e can hink of i a going in o he long n, inc ea ing all i fac o of od c ion, and hen going in o a ne ho n i h a ne SRAC. Imagine hi oce e ea ing i elf again and again: he fi m goe f om one ho - n o i ion o ano he and hen o ano he , and he e ho n o i ion a e connec ed o each o he h o gh momen hen he fi m en e he long n in o de o inc ea e all of i fac o of od c ion. Thi oce i ho n in Fig e 7.4(a), he e e ee ha a he fi m g o bigge , i ha a e ie of SRAC c e , SRAC1, SRAC2, and o on. Imagine no an infini e n mbe of SRAC ; he ill ace o he long n a e age co c e, o LRAC, hich i he c e ha j o che (i angen o) each of he ho - n c e . We can ee ha he SRAC c he e i mo e and mo e o he igh , b al o a fi mo he LRAC c e ha e an F e kee hif ing o he igh , hich i ha e o ld e ec ince (Q) being od ced. B no e ha he SRAC c e no onl mo e o e do n a d, and af e a oin he mo e a d. I i hi U- ha e of o e amine. 7.4: The long- n a e age co c e The ea on fo he U- ha e of he LRAC ha e no hing o do i h dimini hing ma ginal e n , hich a e a fea e of ho - n od c ion and co . The U- ha e of he LRAC c e can be fo nd in economic and di economie of cale. E all i fac o of Some ea on a e dec ea e in a e age co of od c ion o e he long n a a fi m inc ea e od c ion. The e lain he do n a d- lo ing o ion of he LRAC c e. h hi occ incl de: . A he cale of od c ion inc ea e , mo e o ke m be em lo ed, allo ing fo g ea e labo peciali a ion. Each o ke eciali e in e fo ming a k ha make e of kill , in e e and alen , h inc ea ing efficienc and allo ing o o be od ced a a lo e a e age co . . La ge cale of od c ion allo fo mo e manage o be em lo ed, each of hom can be eciali ed in a a ic la a ea ( ch a od c ion, ale , finance, and o on), again e l ing in g ea e efficienc and lo e a e age co . B ( ice e F co e ). A an i ie of in cha ed inc ea e, he ni d o . . La ge fi m ma ha e lo e in e e . ni of o ae , h con ib ing o lo e , , . Co of ce ain ac i i ie ch a ma ke ing and ad e i ing, de ign, e ea ch and de elo men , e l in lo e a e age co if he can be ead o e la ge ol me of o . Di economie of cale, on he o he hand, a e inc ea e in he a e age co of od c ion in he long n a a fi m inc ea e i o b inc ea ing all i in . The a e e on ible fo he a dlo ing a of he LRAC c e: a a fi m inc ea e i cale of od c ion, a e age co inc ea e. Rea on fo di economie of cale incl de: C . A a fi m g o la ge , i managemen ma n in o diffic l ie of co-o dina ion, o gani a ion, co-o e a ion and moni o ing. The e l in ol e g o ing inefficiencie ca ing a e age co o inc ea e a he fi m e and . C be een a io co . . A la ge fi m i e ma lead o diffic l ie in comm nica ion com onen a of he fi m, e l ing in inefficiencie and highe a e age P li le abo . If o ke begin o lo e hei mo i a ion, o feel bo ed and o ca e o k, he become le efficien , e l ing in highe a e age co . hei P S anda d economic heo a me ha fi m di la a ional beha io b ing o ma imi e hei ofi , meaning ha he o make hei ofi a la ge a o ible (Cha e 2). In gene al, ofi = e en e In economic , co of od c ion ofi i defined a : ofi = o al e en e economic co = o al e en e he m of e lici co ince economic co a e he m of e lici l + im lici co im lici co . P S anda d economic heo of he fi m a me ha fi m beha io i g ided b he fi m goal o ma imi e ofi . P in ol e de e mining he le el of o ha he fi m ho ld od ce o make ofi a la ge a o ible. Ye fi m do no al a make a ofi ; in ome ca e , hei o al e en e i no fficien o co e all co , in hich ca e he make a , hich can be ho gh of a nega i e ofi . If a fi m i making a lo , i ma e en all go o of b ine , b n il i decide o h do n, i ill be in e e ed in od cing he an i of o ha ill make i lo a mall a o ible. The efo e, he heo of he fi m i al o conce ned i h ho m ch o a lo -making fi m ho ld od ce in o de o minimi e i lo . The e a e o a oache o anal ing ofi ma imi a ion (o lo minimi a ion): one in ol e e of o al e en e and o al co and he o he in ol e e of ma ginal e en e and ma ginal co . Bo h he e a oache ield he ame e l fo he ofi -ma imi ing (o lo -minimi ing) le el of o . P Thi a oach i ba ed on he im le ofi = o al e en e (TR) o al co (TC) he e TC i he fi m economic co The fi m o ible. ofi -ma imi a ion The amo n of Po i i e Ze o ofi made b inci le ha (e lici le i o We ill e im lici ). od ce he le el of o he e TR TC i a la ge a he fi m i e al o he n me ical diffe ence be een TR and TC. ofi : TR > TC; he fi m ea n ofi : TR = TC; he fi m ea n Nega i e l . . ofi : TR < TC; he fi m make a n o he e m abno mal p ofi and no mal p ofi . P P ofi ma imi a ion ing hi a oach i ba ed on a com a i on of ma ginal e en e (MR) i h ma ginal co (MC) o de e mine he ofi -ma imi ing le el of o . The fi m ofi ma imi a ion le (and lo -minimi a ion) i o choo e o od ce he le el of o he e MC = MR. In Fig e 7.5, bo h a (a) and (b) ho he anda d MC c e ha e died abo e (a ell a in Cha e 2 in connec ion i h he fi m l c e). A e kno , he e a e o kind of ma ginal e en e c e , de ending on he he o no he fi m ha con ol o e he ice of i o . Pa (a) ho he MR c e of he fi m i h no con ol o e ice. Pa (b) ho he MR c e of he fi m i h ome con ol o e ice. Bo h a (a) and (b) ill a e he iden ical inci le abo ofi ma imi a ion. Acco ding o he ofi -ma imi ing le, MC = MR, he oin of in e ec ion be een he MC and MR c e de e mine he ofi -ma imi ing le el of o ; hi i Q ma in Fig e 7.5(a) and (b). Wh i hi o? Con ide a fi m od cing o Q1 in bo h a (a) and (b), he e MR > MC. If hi fi m inc ea e i o b one ni , he addi ional e en e i o ld ecei e (MR) ill be g ea e han i addi ional co (MC). I i he efo e in he fi m in e e o inc ea e i le el of o n il i eache Q ma he e MR = MC. If i con in e o inc ea e o be ond Q ma , a o Q2, he e MR < MC, he addi ional e en e i o ld ecei e fo an e a ni of o i le han he addi ional co , and o i ho ld c back on i Q. The e i onl one oin he e he fi m can do no hing o im o e i o i ion, and ha i Q ma , he e MR = MC, and ofi i he g ea e i can be. F 7.5: P ofi ma imi a ion ing he ma ginal e en e and ma ginal co a Fi m ma imi e ofi o minimi e lo e MR. Thi hold fo all ma ke c e. hen he od ce a an i of o oach he e MC = When e a e gi en da a fo MC and MR (and no info ma ion on o al co and o al e en e ), all e can do i find he ofi -ma imi ing le el of o he e MC = MR, b e canno find he amo n of ofi (o lo ) nle e ha e mo e info ma ion. We ill ee ho hi i done belo hen e d he ma ke c e. E O R NDER 1 Iden if he ANDING 7.4 oa oache o De c ibe he f nc ion of he e 2 o a ioning mechani m . Sa a fi m i od cing a le el of o inc ea e i ofi (o ed ce i lo ). S a e ha i ho ld do if i i 3 ofi ma imi a ion b fi m . A Q he e MC > MR. S a e ha i ho ld do o od cing Q he e MC < MR. me ha a fi m ha ha no con ol o e i ice ell i o Gi en he follo ing da a, e he o al e en e and o al co a le el of o a hich he fi m ill ma imi e ofi . Calc la e ho m ch ofi i ill make.* a $5 e ni . oach o de e mine he Calc la e he amo n of ofi (o lo ) hen Q = 3, Q = 6, Q = 10. 1 2 3 4 5 6 7 8 9 10 15 18 20 21 23 26 30 35 41 48 (Q) ($) 4 Gi en he da a in e ion 3 de e mine he le el of o a hich he fi m ill ma imi e ofi ing he ma ginal e en e (MR) and ma ginal co (MC) a oach. (Hin : o m e he info ma ion in he e ion o find MR and MC.) Did o find he ame 5 ofi -ma imi ing le el of o S o e ha a fi m i h ome con ol o e ho n in he able belo . U e he o al e en e and o al co a he fi m ill ma imi e ofi . Calc la e ho m ch ofi Calc la e he amo n of a in ice face he co e ion 3(a)? and ice e ni of o oach o de e mine he le el of o a hich ill i make.* ofi (o lo ) hen Q = 2, Q = 3, Q = 8. 1 2 3 4 5 6 7 8 15 18 20 21 23 26 30 35 10 9 8 7 6 5 4 3 (Q) ($) P 6 ($) Gi en he da a in e ion 5, de e mine he le el of o a hich he fi m ill ma imi e ofi ing he ma ginal e en e (MR) and ma ginal co (MC) a oach. (Hin : o m e he info ma ion in he e ion o find MR and MC.) Did o find he ame ofi -ma imi ing le el of o a in e ion 5? * When ing he TR and TC a oach o e l gi e o ofi -ma imi ing le el of o , he ea he MR and MC a oach gi e onl one. Thi i beca e he MR and MC a oach i ac all mo e eci e han he TR and TC a oach. I i a good idea o e he la ge of he o al e of o ha o ge b ing he TR and TC a oach. When ofi i e al o e o, and o al e en e i e al o o al economic co making no mal ofi . , he fi m i aid o be No mal p ofi can be defined a he minim m amo n of e en e ha he fi m m ecei e o ha i ill kee he b ine nning (a o o ed o h ing do n). I can al o be defined a he amo n of e en e ha co e all e lici and im lici co . The efo e, a fi m ea n no mal ofi hen o al e en e = economic co and ofi = e o. The e a a en l diffe en defini ion a e in fac con i en : he minim m amo n of e en e he fi m m ecei e o make i o h hile o a in b ine i e al o he e en e ha co e all of he fi m co , im lici l e lici . No e ha no mal ofi al o incl de he pa men fo en ep ene hip. En e ene hi , o ill emembe , incl de he alen o o gani e and manage a b ine and ake i k . En e ene hi ecei e a a men j a all o he fac o of od c ion do, and hi a men i incl ded in no mal ofi . Thi mean ha if o a e he o ne of a i a e a an hich i ea ning no mal ofi (meaning e o ofi ) o a e ill ge ing aid fo all o o k a en e ene in o b ine . The efo e o ha e no ea on o clo e do n o e a an . Thi mean ha a fi m ill con in e o no mal ofi . E O R NDER 1 Define 2 E lain h 3 A fi m ea n od ce e en if i i ea ning e o ofi , meaning i i ea ning ANDING 7.5 ofi and no mal ofi , and e lain he diffe ence be een hem. ofi can be o i i e, e o o nega i e. eo ofi , and e i doe no h do n. E lain h . 7.3 P LEARNING OBJEC I ES Af er d ing hi ec ion o ill be able o: define all he erm appearing in in he e (AO1) e plain firm in perfec compe i ion a price aker ha ing no marke po er (AO2) e plain profi ma imi a ion in he hor r n and in he long r n (AO2) e plain he meaning of alloca i e efficienc in erm of i nece ar condi ion , P = MC or MB = MC or ma im m ocial rpl (AO2) dra diagram ho ing (AO4) he perfec l compe i i e firm a a price aker here P = D = AR = MR he perfec l compe i i e firm making abnormal profi , normal profi , lo perfec l compe i i e marke eq ilibri m ho ing alloca i e efficienc di c Le he ad an age and di ad an age of perfec compe i ion (AO3) remind o r el e of he charac eri ic of perfec compe i ion: There i a er large n mber of firm in he ind All he firm in he ind r ell a homogeneo There are no barrier o en r in o he ind r . or iden ical ( ndifferen ia ed) prod c . r . D ( ) S ppo e o ha e a farm ha prod ce ra berrie . Yo are one of man mall ra berr prod cer , o r ra berrie are er imilar o ho e prod ced b o her ra berr farmer , and an one ho o ld like o prod ce ra berrie can do o ( here are no barrier o en r ). Table 7.5 mmari e he co , prod c , re en e and profi concep e ha e died. R D F To al re en e The o al earning of a firm from he ale of i o p . TR = P Marginal re en e The addi ional re en e of a firm ari ing from he ale of an addi ional ni of o p . MR= TR Q A erage re en e Re en e per ni of o p . AR= ER Q =P C E plici co The mone ar pa men made b a firm o an o ider o acq ire an inp . Q Implici co The income acrificed b a firm ha e a re o rce i o n . To al co (TC) The m of e plici and implici co A erage o al co (AC) To al co per ni of o p . AC= TC Q Marginal co (MC) The change in co ari ing from one addi ional ni of o p . MC= TC Q Long-r n a erage co (LRAC) c r e A U- haped c r e ho ing a erage co in he long r n hen all of he firm inp are ariable. P Profi To al re en e min o al co ( he m of e plici pl implici co ). TR TC Normal profi Occ r hen o al re en e eq al o al TR=TC co . I i he minim m amo n of re en e req ired b a firm o keep r nning. Abnormal profi Profi ha re l hen o al re en e i grea er han o al co . I i re en e ha i o er and abo e normal profi . TR>TC Lo Nega i e profi ; occ r hen o al re en e i le han o al co TR<TC 7.5: S mmar of co , prod c , re en e and profi concep Fig re 7.6(a) ho andard marke demand and ppl c r e for ra berrie , hich de ermine he eq ilibri m price, Pe. Fig re 7.6(b) ho he demand c r e for ra berrie a i a ea , he a be d ce . I i perfec l ela ic, appearing a a hori on al line a Pe de ermined in he marke . A perfec l ela ic demand c r e ha a price ela ici of demand (PED) eq al o infini hro gho i range ( ee Chap er 3, Sec ion 3.1). Wha doe hi mean for o ? F 7.6: Marke (ind compe i i e firm r ) demand and ppl de ermine demand faced b he perfec l A a ra berr prod cer, being mall, o can do no hing o infl ence hi price; o m accep Pe and ell he amo n of ra berr o p ha ill ma imi e o r profi . Yo r farm (or o r firm) i herefore a . If o rai e o r price abo e Pe, o ill no ell an ra berrie beca e b er ill b ra berrie el e here a he lo er price Pe. On he o her hand, ince o can ell all o an a price Pe, o o ld ha e no hing o gain and ome hing o lo e ( ome re en e) if o dropped o r price belo Pe. Therefore, o ell all o r ra berr o p a Pe. The demand c r e for a good facing he perfec l compe i i e firm i perfec l ela ic (hori on al) a he price de ermined in he marke for ha good. Thi mean he firm i a price- aker, a i accep he price de ermined in he marke . The firm ha no abili o infl ence price herefore i ha no marke po er. The firm e are con idering i he one died in Sec ion 7.2 abo e, hen e died re en e da a and c r e for he firm ha i nable infl ence ice. Con ider once again he e ample ed in Table 7.2 and Fig re 7.1. A me ha a perfec l compe i i e firm ell a good a 10 per ni . In Table 7.2, col mn 3 ho o al re en e, calc la ed b m l ipl ing ni of o p in col mn 1 b price ho n in col mn 2. Col mn 4 calc la e marginal re en e, b aking he change in o al re en e and di iding i b he change in o p . Col mn 5 ho a erage re en e, ob ained b di iding o al re en e b q an i of o p . The da a in he able re eal an in ere ing pa ern: No ma er ho m ch o p he perfec l compe i i e firm ell , P = MR = AR and he e are con an a he le el of he hori on al demand c r e. Thi follo from he fac ha price i con an regardle of he le el of o p old. Thi re l hold onl for firm opera ing nder perfec compe i ion, beca e he e are he onl firm ha are nable o infl ence price and are forced o ell all heir o p a he ingle price de ermined in he marke . The da a of Table 7.2 are plo ed in Fig re 7.7 belo hich i he ame a Fig re 7.1(b), here e ee ha ince price i con an a 10, P = MR= AR, and he all coincide i h he hori on al demand c r e. F 7.7: Demand, marginal re en e and a erage re en e in perfec compe i ion ES 1 2 O R NDERS ANDING 7.6 O line he charac eri ic of perfec compe i ion. E plain h he perfec l compe i i e firm i a price- aker. O line ha o ld happen if hi firm ried o rai e i price abo e he marke price or if i lo ered i price belo he marke price. 3 4 O line ho he demand c r e facing he perfec l compe i i e firm rela e o he ind r /marke eq ilibri m. U ing a diagram, e plain he rela ion hip be een he firm a erage re en e (AR) and marginal re en e (MR) in perfec compe i ion. O line ho are he rela ed o prod c price, he demand c r e facing he firm, and he principle ha each firm i a price aker. P Remember, he hor r n i he period hen he firm ha a lea one fi ed inp . Thi mean he n mber of firm in he ind r i al o fi ed. To en er or lea e an ind r , a firm m be able o ar all i in . Since hi canno be done in he hor r n, firm canno en er or lea e he ind r ( n il he mo e in o he long r n). In erm of o r ra berr farm, hi mean ha o ha e ome fi ed inp ch a he land o c l i a e, and perhap o r farm machiner . A long a all o her ra berr prod cer al o ha e a fi ed amo n of agric l ral land and farm machiner , no one can en er or lea e ra berr prod c ion. When a firm an canno infl ence i o ma imi e profi in he hor r n, ha m i do? Since i i a price- aker, i elling price. I can onl make a choice on ho m ch q an i of o p i ho ld prod ce. We ill ee ho in rod ced abo e. S he firm doe hi ing he marginal re en e and marginal co r le, - The anal i con i of hree ep . F ( ) profi (or minimi ing lo ) prod ce o p he profi -ma imi ing le el of o p . . A e kno , a firm in ere ed in ma imi ing here MR= MC. Fig re 7.5(a) ho Q ma o be C ( ) ( ) . A compari on of a erage re en e ( hich i eq al o price) i h a erage co ho he amo n of profi (or lo ) per ni of o p . We kno profi = T R TC. If e di ide hi hro gho b o p , Q, e ge an e pre ion for profi per ni of o p , in o her ord , in erm of a erage : profi Q = TR Q TC Q Al erna i el , profi Q =AR AC. Moreo er, ince P = AR, i follo ha profi Q =P AC Thi i he ke F o calc la ing ho m ch profi or lo ( profi Q b Q (or lo per ni of o p he firm i making. ). To do hi , e m l ipl : Q b Q) A he profi -ma imi ing le el of o p Q: If AR > AC (or P > AC), he firm make abnormal profi (po i i e profi ). If AR = AC (or P = AC), he firm make normal profi ( ero profi ) If AR < AC (or P < AC), he firm make a lo F (nega i e profi ). 7.8: Shor -r n profi ma imi a ion in perfec compe i ion U ing he abo e hree ep approach, e ill e amine he beha io r of he perfec l compe i i e firm in he hor r n, making e of he diagram in Fig re 7.8. Each of he e diagram con ain iden ical AC and MC co c r e ; no e ha MC al a in er ec AC a i minim m poin . Wha differ be een he diagram i he po i ion of he perfec l ela ic demand c r e, ho ing differen po ible price ha he firm, being a price- aker, m accep . P In Fig re 7.8(a), price P1= AR1= MR1 repre en he demand c r e facing he firm. U ing he r le MR = MC, e arri e a he profi ma imi ing le el of o p Q1 ( impl dra a er ical line from he poin of in er ec ion o he hori on al a i ). We hen compare P1 i h AC, along hi ame er ical line, and ince P1> AC, e concl de he firm i making abnormal profi per ni eq al o P1 AC1, gi en b he er ical di ance be een poin a and b. To find o al profi e m l ipl profi per ni ime he o al n mber of ni prod ced, gi en b profi = profi Q Q and i repre en ed b he haded area in he diagram. When P>AC (or AR>AC) a he le el of o p (po i i e profi ). here MC = MR, he firm earn abnormal profi P S ppo e he marke -de ermined price fall o P2, corre ponding o demand c r e D2 a in Fig re 7.8(b). Appl ing again he MR = MC r le, e find he profi -ma imi ing le el of o p Q2. Comparing P2 i h AC a o p Q2, e ee he are eq al o each o her; herefore, profi per ni i P2 AC2 = 0. Therefore, profi i ero and he firm i earning normal profi . When profi i ero, price eq al minim m AC. The firm o al re en e are eq al o i o al co . When P = minim m AC (or AR = minim m AC) a he le el of o p earn normal profi ( ero profi ). here MC = MR, he firm L If he marke price fall belo minim m AC, ch a P3 in Fig re 7.8(c), corre ponding o demand c r e D3 a in Fig re 7.8(b), he firm doe no earn eno gh re en e o co er all i co . U ing he MC= MR r le, e ee ha he profi -ma imi ing or lo -minimi ing le el of o p i Q3, a hich P3 < AC, indica ing he firm i making a nega i e profi , or lo . Therefore, Q3 i he firm lo minimi ing o p . AC3 P3, or he difference be een poin c and d, repre en he firm lo per ni of o p , or lo Q . If e m l ipl hi er ical di ance b Q3, e ge he firm o al lo , gi en b When P < minim m AC (or AR < minim m AC) a he le el of o p make a lo (nega i e profi ). he haded area. here MC = MR, he firm P In he long r n, all he firm fac or of prod c ion are ariable; herefore, he n mber of firm in he ind r i no longer nchanging. Ne firm can en er he ind r , e i ing firm can change heir i e (increa e or decrea e all heir inp ), or firm can lea e he ind r al oge her. There i herefore free en r of firm in an ind r . F 7.9: The firm and ind r long-r n eq ilibri m po i ion in perfec compe i ion N In he long-r n eq ilibri m of perfec compe i ion, all firm earn ero profi , in o her ord , he earn normal profi . The long-r n eq ilibri m po i ion of each firm and he ind r nder perfec compe i ion i ho n in Fig re 7.9. The marke e le a he price Pe, hich i j eq al o he firm minim m AC, here each firm i earning normal profi , ince P = AC (or AR = AC). Yo ma no e ha a hi poin AC m be minim m ince profi ma imi a ion occ r here MR= MC, and MC in er ec AC a i minim m poin . Each firm in he ind r prod ce o p Qf, and he ind r a a hole prod ce o p Qi (eq al o he m of all he firm o p ). Wh doe hi happen? Ho i i ha he firm ha ere in he hor r n earning abnormal profi , or ere making lo e , end p making normal profi in he long r n? S ppo e he ra berr ind r i profi able, meaning ha ra berr farm (or firm ) are making abnormal profi , o ha P> AC (or AR> AC). In he long r n, hen firm can ar all heir inp , ne farmer are a rac ed in o he ra berr ind r ince he o ld al o like o earn abnormal profi . A more and more farm begin o prod ce ra berrie , he ppl of ra berrie increa e , and hi ha he effec of red cing he price of ra berrie . B a he price of ra berrie fall , he abnormal profi of ra berr prod cer fall. The price of ra berrie con in e o fall n il i i j eq al o minim m AC. A ha poin he ra berr prod cer , ho a ice- ake m accep he price ha i de ermined in he marke , end p earning normal profi here P = AC (or AR = AC). S ppo e no ha he ra berr ind r ere lo -making, in hich ca e P< AC (or AR< AC). In he long r n ome ra berr farm o ld clo e do n, or el e he migh op prod cing ra berrie and begin prod cing ano her more profi able crop. A ra berr farmer lea e he ind r or i ch o of ra berrie , he ppl of ra berrie decrea e , ca ing he price of ra berrie o ri e. Thi proce con in e n il price i j eq al o AC. Here oo, he remaining ra berr prod cer in he ind r ill end p earning normal profi here P = AC (or AR = AC). The in ere ed den ma ee ho hi proce occ r ing diagram (pre en ed a S pplemen ar ma erial in he 'Digi al co r ebook: E ra ma erial' ec ion). In perfec l compe i i e long-r n eq ilibri m, firm profi and lo e are elimina ed, and re en e are j eno gh o co er all co o ha e er firm earn normal profi . Thi proce ill ra e an impor an principle, opening (or clo ing) ch ha price i dri en do firm in order for i o con in e opera ing. Thi i ha allo he firm o earn normal profi o ha hich i ha compe i ion lead o a proce of firm n (or p) o he lo e le el ha i accep able o he he price ha i eq al o minim m a erage co , and i i j co ering all i co . A e ill ee in he page belo , an hing ha e and elfa e l f cie . ES 1 ic c m e i i n e l in highe ice , abn mal fi f fi m O R NDERS ANDING 7.7 U ing diagram , ho hen a firm earn profi ( ho profi per ni and o al profi ), earn normal profi , and earn nega i e profi (a lo ) ( ho lo 2 per ni and o al lo ). For each of he follo ing, calc la e abnormal profi or lo calc la e o al abnormal profi or lo : per ni of o p , and hen Q = 200 ni ; AC = $8, P = $9 Q = 250 ni ; AC = $15, P = $13 Q = 150 ni ; AC = $17, P = $17 3 Gi en he informa ion in he able, if price = 6, calc la e ho m ch he profi -ma imi ing (lo -minimi ing) firm ill prod ce, and ho m ch profi or lo i ill make; if price = 4, calc la e ho m ch he profi -ma imi ing (lo -minimi ing) firm ill prod ce, and ho m ch profi or lo i ill make. ( A ( ) M ( ) ) 4 1 14.00 4 2 8.50 3 3 6.33 2 4 5.00 1 5 4.40 2 6 4.17 3 7 4.14 4 8 4.25 5 9 4.44 6 10 4.70 7 U ing a diagram ho and e plain a perfec l compe i i e firm long r n eq ilibri m po i ion. O line he proce b hich he firm reache hi po i ion. E plain ha kind of profi he firm make in long r n eq ilibri m. A In Chap er 2, e a ha compe i i e marke achie e alloca i e efficienc , beca e eq ilibri m i de ermined b MB = MC, here con mer pl prod cer ( ocial) rpl i ma im m. Thi di c ion foc ed on efficienc a he le el of he ma ke , or ind efficienc can be anal ed al o a he le el of he indi id al firm. r . We no an o ee ho R All ca i e efficienc i achie ed hen MB = MC; b ince MB = P, i follo here i alloca i e efficienc hen P = MC. No e ha hi condi ion hold onl hen here are no e ernali ie , in hich ca e i i al o r e ha MSB= MSC ( hi a o r condi ion for alloca i e efficienc hen e died e ernali ie in Chap er 5 and 6). All ca i e efficienc occ r hen firm prod ce he par ic lar combina ion of good and er ice ha con mer mo l prefer. The condi ion i he follo ing: Alloca i e efficienc i achie ed hen P = MC ( al e na i el MB =MC) The price, P, paid b con mer o acq ire a good reflec he marginal benefi he deri e from con mp ion of one more ni of he good and ho he amo n of mone he are illing o pa o b one more ni . Marginal co , MC, mea re he al e of he re o rce ed o prod ce one e ra ni of he good. When price i eq al o marginal co , here i eq ali be een ha con mer are prepared o pa for one more ni and ha i co o prod ce i . Wha o ld happen if P and MC ere no eq al o each o her? If P > MC, an addi ional ni of he good i or h more o con mer han he co o prod ce i . There i an nderalloca ion of re o rce o i prod c ion, and con mer o ld be be er off if more of i ere prod ced. If P < MC, an addi ional ni of he good co more o prod ce han i i or h o con mer ; here i an o eralloca ion of re o rce o he good, and con mer o ld be be er off if o p ere red ced. In bo h he e ca e , alloca i e inefficienc re l . Therefore, re o rce are alloca ed efficien l onl hen he price of a good i eq al o he marginal co of prod cing i . A Fig re 7.10 ho he long-r n eq ilibri m po i ion of a firm and ind r in perfec compe i ion. Par (a) ho he firm o be earning normal profi , and indica e ha in long-r n eq ilibri m, he perfec l compe i i e firm achie e alloca i e efficienc ince a he profi -ma imi ing le el of o p , Qe, P = MC. Par (b) ho he ind r o be achie ing alloca i e efficienc (MB = MC and ocial rpl i ma im m). I ill ra e ho he efficienc a he le el of he firm corre pond o efficienc a he le el of he ind r . In long-r n eq ilibri m nder perfec compe i ion, he firm achie e alloca i e efficienc here P = MC ( he e MB = MC). A he le el of he ind r , ocial rpl (con mer pl prod cer rpl ) i ma im m, and MB = MC. The achie emen of alloca i e efficienc in long-r n eq ilibri m i an impor an re l , beca e perfec compe i ion i he onl marke r c re here hi occ r . E Perfec compe i ion, ho gh no a reali ic marke orking of compe i i e marke . r c re, offer a n mber of in igh in o he I A . Perfec compe i ion lead o he be or op imal alloca ion of re o rce , achie ed hro gh P = MC (or MB = MC) in long-r n eq ilibri m. L . Con mer benefi from lo price , d e o he ab ence of abnormal profi , hich o ld ha e led o a higher price. Yo can check hi b comparing Fig re 7.8(a) and (b), ho ing ha he price hen he firm earn abnormal profi i higher han he price hen he firm earn onl normal profi . C . Inefficien firm are ho e ha prod ce a higher han nece ar co . Inefficienc co ld be d e o fac or like le prod c i e labo r, or he e of o da ed echnologie , or poor en reprene r hip. The re en e of inefficien firm are in fficien o co er all co , leading o lo e ha force he e firm o lea e he ind r in he long r n. . Change in con mer a e are reflec ed in change in marke demand and herefore marke price. B crea ing hor -r n abnormal profi or lo e , price change re l in long-r n adj men ha make he q an i of o p prod ced b he ind r re pond o con mer a e . L . The model re on ric and nreali ic a mp ion ha are rarel me in he real orld. C . Economie of cale lead o lo er a erage co a a firm gro larger and larger. In perfec compe i ion firm are oo mall o gro o a i e large eno gh o ha e economie of cale. L . All firm i hin an ind r prod ce iden ical or ndifferen ia ed (homogeneo ) prod c , ho e er con mer prefer prod c arie . L . The lack of abnormal profi in he long r n doe no offer firm he nece ar f nd o p r e re earch and de elopmen . In an ca e, ince prod c are ndifferen ia ed, firm do no ha e he incen i e o p r e prod c de elopmen or impro emen . F 7.10: Alloca i e efficienc in perfec compe i ion in he long r n ES 1 2 O R NDERS ANDING 7.8 O line h e ba ed on o man d he perfec l compe i i e marke model e en i el nreali ic a mp ion . hen hi model i E plain he meaning of and a e he condi ion for alloca i e efficienc . U ing diagram , ho ho he perfec l compe i i e fi m and ind efficienc in long-r n eq ilibri m. achie e alloca i e 3 E al a e he perfec l compe i i e marke model b referring o he in igh i offer and i limi a ion . 7.4 Monopol LEARNING OBJECTIVES Af e d ing hi ec ion o ill be able o: define all he e m appea ing in orange bold in he e e plain he monopoli ma ke po e e plain p ofi ma imi a ion b no mal p ofi , lo (AO2, AO4) e plain he monopoli ing a diag am he e AR>MC (AO2, AO4) he monopoli alloca i e inefficienc ill i h diag am di c ho ing abno mal p ofi , a ing ma ke fail e (AO2) e plain elfa e lo compa ed o pe fec compe i ion and highe p ice and elfa e lo (AO2, AO4) e plain na (AO1) al monopol and d a a diag am fo na i h a diag am ho ing lo e o p al monopol (AO2, AO4) ad an age and di ad an age of monopol (AO3) The e m monopol i de i ed f om he G eek o d (monopolio) meaning ingle elle . We begin b eminding o el e of he cha ac e i ic of monopol : he e i a ingle fi m in he ind he fi m p od ce and ell a ni e good o e ice, i h no clo e he e a e high ba ie o en in he ind b i e . Monopol lie a he oppo i e e eme of ma ke c e o pe fec compe i ion. A a ingle elle , he monopoli face no compe i ion f om o he fi m and i ha b an ial ma ke po e ( he abili o con ol p ice). Barriers to entr The e a e e e al kind of ba ie o en , de c ibed belo . Economies of scale Economie of cale e l in he do n a d- loping po ion of a fi m long- n a e age co c e (LRAC), e l ing in lo e a e age co a he fi m inc ea e i i e (Fig e 7.11). La ge economie of cale c ea e a ba ie o en . In Fig e 7.11 he a e age co of a la ge fi m on SRAC1 a e b an iall lo e han he a e age co faced b a malle fi m on SRAC2. The la ge fi m can cha ge a lo e p ice han he malle fi m, and can fo ce he malle fi m in o a i a ion he e i ill no be able o co e i co . The efo e, if ne fi m o en e he ind on a mall cale he ill be nable o compe e i h he la ge one. On he o he hand, a ne fi m a emp ing o en e he ma ke on a e la ge cale o ld enco n e h ge a - p co , and o ld be nlikel o ake he i k. Economie of cale fo m a ignifican ba ie o en al o in oligopolie . Figure 7.11: Economie of cale a a ba ie o en Natural monopolies Na al m lie a e fi m ha ha e economie of cale o la ge ha he can p od ce fo an en i e ma ke and ill no e ha hei economie of cale. The ill be e amined in mo e de ail belo . Branding B anding in ol e he c ea ion b a fi m of a ni e image and name of a p od c . I o k h o gh ad e i ing campaign ha o infl ence con me a e in fa o of he p od c , a emp ing o e abli h con me lo al . If b anding i cce f l, man con me ill be con inced of he p od c pe io i , and ill be n illing o i ch o b i e p od c , e en ho gh he e ma be ali a i el e imila . B anding ma o k a a ba ie o en b making i diffic l fo ne fi m o en e a ma ke ha i domina ed b a cce f l b and. No e ha b anding need no lead o a monopol (i i a me hod ed al o b fi m in monopoli ic compe i ion and oligopol ), b i doe ha e he effec of limi ing he n mbe of ne compe i o fi m ha en e a ma ke . E ample of b anding incl de b and-name i em ( ch a NIKE , Adida , Coca-Cola , e c.). Legal barriers E ample of legal ba ie incl de he follo ing: Patents a e igh gi en b he go e nmen o a fi m ha ha de eloped a ne p od c o in en ion o be i ole p od ce fo a pecified pe iod of ime. Fo ha pe iod, he fi m p od cing he pa en ed p od c ha a monopol on p od c ion and ale of he p od c . E ample incl de pa en on ne pha mace ical p od c , and In el and mic op oce o chip ed b IBM comp e . Licences a e g an ed b go e nmen fo pa ic la p ofe ion o pa ic la ind ie . Licence ma be e i ed, fo e ample, o ope a e adio o ele i ion a ion , o o en e a pa ic la p ofe ion ( ch a medicine, den i , a chi ec e, la and o he ). S ch licence do no all e l in a monopol , b he do ha e he impac of limi ing compe i ion. Cop rights g a an ee ha an a ho (o an a ho p in , p bli h and ell cop igh ed o k . appoin ed pe on) ha he ole igh o Tariffs, quotas and other trade restrictions limi he in o a co n , h ed cing compe i ion. an i ie of a good ha can be impo ed No all of he e legal ba ie lead o monopol , b he all ha e he effec of limi ing compe i ion, h con ib ing o he c ea ion of ome deg ee of ma ke po e . Control of essential resources Monopolie can a i e f om o ne hip o con ol of an e en ial e o ce. A cla ic e ample of an in e na ional monopol i DeBee , he So h Af ican diamond fi m, ho e con ol of he diamond ind peaked a 90% in he 1980 , allo ing i o ha e a ignifican con ol o e he p ice of diamond . (Mo e ecen l DeBee no longe ha con ol and diamond p ice a e d i en b he ma ke .) On a na ional le el, an e ample i Alcoa ( he Al min m Compan of Ame ica), hich, follo ing he e pi a ion of pa en in 1909, a able o main ain i monopol po i ion on he p od c ion of al mini m i hin he Uni ed S a e n il he Second Wo ld Wa , beca e of i con ol of almo all he ba i e e o ce i hin he co n . On a local le el, p ofe ional po leag e c ea e a local monopol b igning long- e m con ac i h he be pla e and ec ing e cl i e e of po adi m . A local monopol i a ingle p od ce / pplie i hin a pa ic la geog aphical a ea. Local monopolie appea mo e commonl han na ional o in e na ional one . Fo e ample, a local g oce o e in a e iden ial a ea loca ed ome di ance f om an o he o e ma be a local monopol . Aggressi e tactics If a monopoli i conf on ed i h he po ibili of a ne en an in o he ind , i can c ea e en ba ie b c ing i p ice, ad e i ing agg e i el , h ea ening a akeo e of he po en ial en an , o an o he beha io ha can di ade a ne fi m f om en e ing he ma ke . Demand and re enue cur es under monopol The demand cur e (AR cur e) facing the monopolist Since he p e monopoli i he en i e ind , he demand o AR c e i face i he ind o ma ke demand c e, hich i do n a d- loping. The o demand c e ho n in Fig e 7.12 indica e ha he pe fec l compe i i e fi m i a p ice- ake i h e o ma ke po e , hile he monopoli i a price-maker i h a ignifican deg ee of ma ke po e . Figure 7.12: Demand c e All fi m nde ma ke c e o he han pe fec compe i ion a e o a ing deg ee p ice-make , a he all face do n a d- loping demand c e . Of he e, he monopoli ha he g ea e deg ee of ma ke po e , o he abili o con ol p ice, beca e i i he ole o dominan fi m in he ind . Ma ke po e a i e hene e a fi m face a do n a d- loping demand c e. Fi m in all ma ke c e e cep pe fec compe i ion face a do n a d- loping demand c e, and he efo e ha e a ing deg ee of ma ke po e , o he abili o con ol he p ice a hich he ell hei o p ; he a e he efo e ice-make . Ho e e , he ea he monopoli ha a la ge con ol o e p ice, hi con ol i limi ed b he po i ion of he ma ke demand c e. In Fig e 7.12(b), hen he monopoli choo e ho m ch o p o p od ce, a Q1, i im l aneo l de e mine he p ice a hich he good can be old, o P1. I co ld no ell o p Q1 a a p ice ch a P2, ince he p ice an i combina ion P2 and Q1 i a poin a, l ing off he demand c e. The monopolist s re enue cur es When a fi m face a do n a d- loping demand c e, p ice i no longe con an fo all o p : mo e o p can onl be old a a lo e p ice. Con ide he e ample ed in Table 7.3 and Fig e 7.2 ho ing e en e da a and c e fo he fi m ha ha ome abili o con ol p ice. Table 7.6 p o ide he ame da a fo a monopoli o al, ma ginal and a e age e en e , and Fig e 7.13 plo he e da a. 1 Units of output (Q) 2 Product price (P) ( ) 3 Total re enue TR = P Q ( ) 4 Marginal re enue MR= TR Q ( ) 5 A erage re enue AR= TR Q ( ) 1 12 12 12 12 2 11 22 10 11 3 10 30 8 10 4 9 36 6 9 5 8 40 4 8 6 7 42 2 7 7 6 42 0 6 8 5 40 2 5 9 4 36 4 4 10 3 30 6 3 0 Table 7.6: To al, ma ginal and a e age e en e hen p ice a ie iho p Looking a Table 7.6 and Fig e 7.13, e ma no e he follo ing: A p ice (P) fall , o p (Q) inc ea e gi ing i e o he do n a d- loping demand c Ma ginal e en e, ho ing he change in o al e en e e l ing con in o l ; MR i e al o e o hen o al e en e i a i o p ), and become nega i e hen o al e en e fall . I ma ho he lope (g adien ) of he TR c e. The efo e hen TR i i falling, MR i nega i e. e. f om a change in o p , fall ma im m (a e en ni of be no ed ha he MR c e ma im m, MR= 0. When TR A e age e en e (col mn 5 of Table 7.6) i e al o p ice ( ee col mn 2). Figure 7.13: Re en e c Since TR = P e in monopol Q, and AR= TR Q, i follo The AR a d P c e e ee ha P i e al he dema d c AR. e faci g he fi m. The MR c e lie bel he dema d c e. The ea on i ha , nlike in pe fec compe i ion, he e MR = P, he e he fi m m lo e i p ice in o de o ell mo e o p . The lo e p ice i cha ged no onl fo he la ni of o p b all he p e io ni of o p old. Ma ginal e en e, o he e a e en e f om elling an addi ional ni of o p , i he efo e e al o he amo n of he p ice of he la ni old min ha i lo b elling all he o he ni of o p 1 a he no lo e p ice. TEST YOUR UNDERSTANDING 7.9 1 O line he a 2 U ing a diag am, e plain ho economie of cale can e l in a monopol ma ke b po ing ba ie o en . 3 U ing e ample , e plain ho b anding and legal fac o p o ide ba ie ind . 4 a Compa e and con a he demand c facing he monopoli . b E plain h one fi m i a p ice- ake and he o he a p ice-make . a E plain he ela ion hip be een he monopoli e en e (MR). 5 mp ion defining he ma ke model of monopol . O line ho o en c e in o an e facing he pe fec l compe i i e fi m and ha a e age e en e (AR) and ma ginal he a e ela ed o b p od c p ice, and c he demand c e facing he fi m. Profit ma imisation b the monopolist Profit ma imisation based on the marginal re enue and cost approach The monopoli in e e ed in ma imi ing p ofi (o minimi ing lo ) follo app oach ed b he pe fec l compe i i e fi m: he ame h ee- ep i The monopoli de e mine he p ofi -ma imi ing (o lo -minimi ing) le el o p MC = MR le. ii Fo ha le el of o p , i de e mine p ofi pe ni o lo pe ni b p ofi Q =P AC If AR > AC ( P > AC), he monopoli i making abno mal p ofi ; if AR = AC (o P = AC) i i ea ning no mal p ofi ( e o p ofi ); if AR < AC (o P < AC) i i making a lo . iii The fi m m l iplie p ofi Q b Q o de e mine o al p ofi , o lo lo . Fig e 7.14 (a), (b) and (c) ho he anda d AC and MC c p ofi ma imi a ion in pe fec compe i ion. On he e co c ma ginal e en e c e a e added. Con ide fi pa (a). We fi ing he ing Q b Q o de e mine o al e ; he e a e he ame a ho e ed fo e , he monopoli demand and find he e MR = MC, hich de e mine he p ofi -ma imi ing le el of o p , Qe. A Qe, e d a a e ical line p a d o he AR (o demand) c e and f om he e e end a ho i on al line lef a d o he e ical a i ; hi ill de e mine he p ice, Pe, a hich he monopoli ell o p Qe. Fo o p Qe, e find p ofi pe ni ( p ofi Q), gi en b P be een he a e age e en e (demand) and AC c e . To find o al p ofi , e m l ipl p ofi pe p ofi = p ofi Q Q and i ep e en ed b he haded a ea. AC; hi i he e ical di ance ni ime he o al n mbe of ni p od ced, hich i The monopoli need no al a make p ofi ; i ma make lo e if p ice canno co e AC. Thi i ho n in Fig e 7.14(c), he e he monopoli i minimi ing lo . A he le el of o p Qe, de e mined b MR = MC, he monopoli lo i minimi ed. The p ice ha ill be cha ged i gi en b Pe, fo nd b e ending a line p a d o he demand c e a o p le el Qe. Lo pe ni of o p ( lo Q ) i gi en b AC P, and o al lo i gi en b he haded a ea, fo nd b m l ipl ing lo pe ni of o p b he o al n mbe of ni p od ced. I i al o po ible ha he monopoli ea n no mal p ofi . Thi i occ he e P = AC. ho n in Fig e 7.14(b), he e Qe No e ha he di inc ion be een he ho n and he long n i no impo an in monopol a i i in pe fec compe i ion. In pe fec compe i ion, hi di inc ion i c cial beca e a fi m en e and e i an ind in he long n, abno mal p ofi and lo e di appea , and fi m a e lef i h no mal p ofi in long- n e ilib i m. Thi i no po ible in monopol , d e o he p e ence of ba ie o en . Figure 7.14: P ofi ma imi a ion and lo app oach minimi a ion in monopol : ma ginal e en e and co Unde monopol , high ba ie o en p e en po en ial compe i o fi m f om en e ing a p ofi making ind , and he monopoli can he efo e con in e making abno mal p ofi indefini el in he long n. Natural monopol A natural monopol i a fi m ha ha economie of cale o la ge ha i i po ible fo he ingle fi m alone o ppl he en i e ma ke a a lo e a e age co han o o mo e fi m . A na al monopol i ill a ed in Fig e 7.15. The na al monopoli demand c e in e ec i LRAC c e a a poin he e a e age co a e ill falling. A he le el of o p Q*, he e a e ill economie of cale. The fig e ho ha hi fi m canno p od ce an o p g ea e han Q* and no make a lo . If i did, hen P hich i gi en b he demand c e o ld be lo e han LRAC. B a e kno , P< AC mean he fi m i making a lo . So if he fi m i o ea n no mal p ofi o abno mal p ofi , i m p od ce a an i le han o e al o Q* and cha ge a p ice g ea e han o e al o AC*. Figure 7.15: Na al monopol S ppo e no ha hi fi m i pli in o o fi m of e al i e. Each o ld p od ce o p Q1 and i h a e age co a AC1. Clea l , a e age co o ld be highe , and he p ice ha o ld allo he fi m o ea n no mal p ofi , he e P= AC, o ld al o be highe . If he ma ke demand fo a p od c c LRAC hen hi i falling, hi mean ha a ingle la ge fi m can p od ce fo he en i e ma ke a a lo e a e age o al co han o o mo e malle fi m . When hi occ , he fi m i called a natural monopol . Na al monopol ac a a ong ba ie o en beca e po en ial en an eali e ha i o ld be e emel diffic l o a ain he lo co of he al ead e i ing fi m. High a e age co o ld mean ha ing o cha ge a high p ice fo he p od c , o ha he ne fi m o ld be nable o compe e i h he e i ing fi m. E ample of na al monopolie incl de a e , ga and elec ici di ib ion, cable ele i ion, fi e p o ec ion and po al e ice . The falling a e age co o e a e la ge ange of o p of en occ beca e of e la ge capi al co ( ch a la ing pipe fo a e di ib ion, o la ing cable fo elec ici di ib ion, o p ing a a elli e in o o bi ). A na al monopol ma op being na al if changing echnologie c ea e condi ion ha allo ne compe i o fi m o en e he ind and begin p od c ion a a ela i el lo co . Thi ha happened in ecen ea i h echnological change in elecomm nica ion , fo cing elephone companie ha p e io l e e na al companie o compe e i h ne en an in o he ma ke . TEST YOUR UNDERSTANDING 7.10 1 2 U ing diag am , ho he ca e he e a monopoli a ea n abno mal p ofi ( ho p ofi pe b ea n no mal p ofi , and c inc a O line he diffe ence, if an , be een he ho - n and long- n e ilib i m of a monopoli . lo e ( ho lo pe ni and o al p ofi ), ni and o al lo ). b 3 O line h a monopoli can con in e o ea n p ofi in he long The da a in he able belo monopoli . a Calc la e he monopoli b Iden if hi monopoli c Iden if he p ice a d Calc la e he monopoli Units of output 1 2 3 4 5 6 7 8 4 ho he demand c e and co n. (AC andMC) facing a o al e en e and ma ginal e en e fo each le el of o p . p ofi -ma imi ing le el of o p . hich hi le el of o p p ofi pe Price ($) be old. ni and o al p ofi . A erage cost ($) 10 9 8 7 6 5 4 3 Marginal cost ($) 14.0 8.5 6.3 5.0 4.4 4.2 4.1 4.3 4.0 3.0 2.0 1.0 2.0 3.0 4.0 5.0 a E plain he ele ance of economie of cale o na al monopol . b U ing a diag am and e ample , e plain ha a na al monopol i . c O line h a na d S gge h go e nmen of en do no b eak p na compe i ion. al monopol can be a ong ba ie o en in o an ind . al monopolie in o de o inc ea e Monopol market outcomes and efficienc Higher price and lo er output b the monopolist compared to the industr in perfect competition A compa i on of monopol i h pe fec compe i ion a he le el of he ind e eal ha p ice i highe and an i of o p p od ced lo e in monopol . Fig e 7.16 ho he long- n e ilib i m po i ion of a pe fec l compe i i e ind , compo ed of man mall fi m , and of a monopol , hich i he en i e ind . Pa (a) fo he pe fec l compe i i e ind ho e ilib i m p ice and an i o be Ppc and Qpc, Poin a, he e he ind demand and ppl c e in e ec , appea al o in pa (b), ho ing ha o ld happen o p ice and an i if he pe fec l compe i i e ind e e o gani ed a a monopol . The MC c e of pa (a), o he compe i i e ind ppl c e become he monopoli ma ginal co c e.2 The demand c e emain nchanged, b he monopoli ma ginal e en e (MRm) c e lie belo D. When he p ofi -ma imi ing monopoli applie he MR = MC, he e l i o p Qm and p ice Pm. Figure 7.16: Highe p ice, lo e o p b he fi m in monopol Since Qm < Qpc, he ind nde monopol p od ce a malle an i of o p han he ind nde pe fec compe i ion. And ince Pm > Ppc, he monopoli ell o p a a highe p ice han he pe fec l compe i i e ind . Highe p ice and lo e o p go again con me in e e . Allocati e inefficienc and market failure Loss of consumer and producer surplus The highe p ice and lo e o p of he monopoli ha e impo an implica ion fo con me and p od ce pl . Whe ea he pe fec l compe i i e ind achie e alloca i e efficienc ho n b MB= MC and ma im m ocial pl , monopol doe no . Thi can be een in Fig e 7.17, hich i he ame a Fig e 7.16, onl con me and p od ce pl ha e been added. In pa (a), a ea A ep e en con me pl , hile a ea B i p od ce pl , i h A + B ho ing ma im m ocial pl . Pa (b) ho he inefficiencie ha e l in monopol . A ea C, con me pl in monopol , i malle han a ea A in pe fec compe i ion. Pa of A a con e ed in o p od ce pl beca e of he highe monopol p ice (Pm a he han Ppc), and ano he pa of A a lo a iangle E beca e of he lo e monopol an i (Qm a he han Qpc). A ea E ep e en a elfa e lo . A ea D, p od ce pl in monopol , ho ha p od ce pl ha inc ea ed b aking a a a po ion of con me pl (d e o he monopoli highe p ice), and i ha al o dec ea ed b lo ing a ea F (d e o he monopoli lo e an i ). A ea F i al o a elfa e lo . E + F = elfa e lo ep e en lo monopol highe p ice and lo e of ocial benefi an i . (con me and p od ce pl ) d e o Figure 7.17: Con me and p od ce compe i ion pl and elfa e lo in monopol compa ed i h pe fec No e ha he p e ence of elfa e lo mean ha MC and MB a e no longe e al. A he poin of monopol p od c ion, Qm, MB > MC, meaning ha he e i an nde alloca ion of e o ce o he good, and con me a e no ge ing a m ch of i a he o ld ha e liked. The p e ence of elfa e lo in monopol indica e ma ke fail e: he e i alloca i e inefficienc , ho n al o b MB > MC a Qm, meaning he e i nde alloca ion of e o ce : oo li le of he good i p od ced. Al o, he monopoli gain a he e pen e of con me a a po ion of con me pl i con e ed in o p od ce pl . Allocati e inefficienc :P > MC Fig e 7.18 ho he long- n e ilib i m po i ion of he fi m in pe fec compe i ion and monopol . The condi ion fo alloca i e efficienc i gi en b P= MC a he p ofi -ma imi ing le el of o p . A e kno , hi condi ion hold fo he fi m in pe fec compe i ion. In Fig e 7.18(b) e can ee ha a he p ofi -ma imi ing le el of o p Qm, he monopoli p ice, Pe, i g ea e han ma ginal co . Thi i ha dl p i ing, ince P > MC i he ame a MB > MC ( ince P= MB), hich e a in Fig e 7.17(b). The efo e, e concl de once again ha he monopoli doe no achie e alloca i e efficienc . Figure 7.18: Alloca i e efficienc in pe fec compe i ion and alloca i e inefficienc in monopol In monopol he nde alloca ion of e o ce o he good i indica ed al o b P > MC a he p ofi ma imi ing le el of o p . Market failure and market po er The abo e di c ion ho clea l ha monopol i a pe of ma ke fail e, ince i e l in an nde alloca ion of e o ce o he p od c ion of he good i h elfa e lo . We can no al o ee ho ma ke e i connec ed o ma ke fail e. Ea lie in hi chap e ma ke po e a defined a he abili of a fi m o con ol he p ice a hich i ell i o p . Wh doe hi lead o ma ke fail e? The an e lie in Fig e 7.16, hich compa e pe fec compe i ion i h monopol . In pa (a) e ee he pe fec l compe i i e fi m i h i ho i on al demand c e accep ing a P ha i e al o MC, he efo e he e i alloca i e efficienc . In pa (b) e ee he monopoli i h i do n a d loping demand c e cha ging a P ha i g ea e han MC, he efo e he e i alloca i e inefficienc . In fac hi alloca i e inefficienc i he e l of he do n a d loping demand c e i h he e l ing ma ke e ha i p o ide o he fi m. We can he efo e edefine ma ke po e . Ma ke po e efe Thi can onl occ o he abili of a fi m o cha ge a p ice g ea e han ma ginal co , o P>MC. hen a fi m face a do n a d loping demand c e. In ie of hei e en i e ma ke po e , monopolie a e held o be nde i able f om a ocial poin of ie . Fo hi ea on, p i a e, n eg la ed monopolie a e illegal in mo co n ie in he o ld. TEST YOUR UNDERSTANDING 7.11 1 U ing a diag am, compa e and con a he p ice and o p o come of a pe fec l compe i i e ind and an ind o gani ed a a monopol . 2 U ing diag am , compa e and con a elfa e o come of a pe fec l compe i i e ind and a monopoli ic ind . E plain he meaning of MB > MC a he monopoli e ilib i m le el of o p . 3 U ing diag am , ho he he o no he monopoli achie e alloca i e efficienc , and compa e i h he fi m in pe fec compe i ion. 4 U ing diag am , e plain he ela ion hip be een ma ke po e and ma ke fail e. E aluating monopol and comparing ith perfect competition Criticisms of monopol Welfare loss, allocati e inefficienc and market failure In con a o pe fec compe i ion, he monopoli fail o achie e alloca i e efficienc . Fig e 7.17 ho he lo of ocial pl and he appea ance of elfa e lo hile Fig e 7.18 ho ha P> MC. Bo h diag am al o ho ha MB> MC, hich a e indica ion ha he monopoli nde alloca e e o ce o he p od c ion of a good. Monopol he efo e ep e en a fo m of ma ke fail e. Higher price and lo er output in monopol The elfa e lo no ed abo e in fac a i e beca e he monopoli p od ce a malle an i of o p and ell i a a highe p ice han a pe fec l compe i i e ind a ho n in Fig e 7.16, once again ho ing ha monopol i no in he in e e of con me . Loss of consumer surplus to the monopolist B cha ging a highe p ice han he pe fec l compe i i e fi m, ch ha P> MC mean ha a po ion of con me pl i aken a a f om con me and gained b he monopoli . Fig e 7.17, ho ha he monopoli gain a he e pen e of con me . Negati e impacts on the distribution of income Since monopolie cha ge highe p ice han pe fec l compe i i e fi m , he e i a edi ib ion of income a a f om con me ho m pa he highe p ice and o a d he o ne of he monopol in he fo m of highe p ofi . Lack of competition ma gi e rise to higher costs Whe ea fi m in pe fec compe i ion a e nde con an p e e o p od ce i h he lo e po ible co o i e, nde monopol he ab ence of compe i o fi m ma e l in highe a e age co fo man po ible ea on ch a a poo l mo i a ed o kfo ce, lack of inno a ion, poo managemen o a oidance of i k. The po ibili of main aining abno mal p ofi o e he long n d e o high ba ie o en can make he monopoli le conce ned abo keeping co lo . Thi i kno n a X-i efficie c . Possibl less inno ati e While monopolie ha e good ea on o p e R&D fo p od c de elopmen and inno a ion, he oppo i e ma al o occ . High ba ie o en , hielding monopolie f om compe i ion, co ld make hem le likel o inno a e han fi m in monopoli ic compe i ion o oligopol ( ee belo ) hich a e con an l nde p e e o inno a e o main ain o inc ea e hei ha e of ale . (See Real o ld foc 7.2.) Potential benefits of monopol Ec e f ca e Economie of cale a e a majo a g men in fa o of la ge fi m ha can achie e lo e co a he g o la ge .Monopolie , beca e of hei i e, a e e ell placed o ake ad an age of economie of cale. Lo e a e age co p o ide he monopoli i h he po ibili of lo e ing p ice , hich co ld po ibl app oach ho e achie ed in pe fec compe i ion. Con me can he efo e gain beca e lo e a e age co ma po en iall an la e in o lo e p ice , a ell a inc ea ed an i of o p . Socie al o gain f om economie of cale beca e he lo e a e age co of p od c ion mean he e i le a e in he e of e o ce . A pe fec l compe i i e fi m, d e o i e mall i e, canno cap e economie of cale. Natural monopol In he e en of a na al monopol , he e a e added benefi d e o he achie emen of e a e age co b he ingle fi m. See he di c ion abo e on na al monopolie . lo Research and de elopment (R&D) for product de elopment and technological inno ation Fi m in pe fec compe i ion a e nlikel o engage in R&D. The ha e no abno mal p ofi in he long- n i h hich he can finance R&D. The ell iden ical p od c and he efo e a e no in e e ed in p od c de elopmen ha o ld diffe en ia e hei p od c . The a e nable o c ea e ba ie o en a he a e oo mall and o ha e no incen i e o engage in R&D. B con a , a n mbe of fac o gge ha monopolie ha e good ea on o p Thei abno mal p ofi p o ide hem i h he abili e inno a ion: o finance la ge R&D p ojec . P o ec ion f om compe i ion d e o high ba ie o en ma fa o inno a ion and p od c de elopmen , b offe ing fi m he oppo ni o enjo he p ofi a i ing f om hei inno a i e ac i i ie (ne in en ion , ne p od c , ne echnologie , e c.). Thi , af e all, i he a ionale of a a ding fi m pa en p o ec ion fo a pe iod of ime. Fi m ma e p od c de elopmen and echnological inno a ion a a mean of main aining hei abno mal p ofi o e he long e m, b c ea ing ba ie o en fo ne po en ial i al . If a fi m can de elop a ne p od c ha po en ial i al a e nable o p od ce, he i al ma be le likel o o en e he ind and compe e i h he inno a ing monopoli . TEST YOUR UNDERSTANDING 7.12 1 U ing diag am , compa e and con a he ma ke c e of pe fec compe i ion and monopol , empha i ing he ad an age and di ad an age of each. 2 Di c a he fac o ha ma make monopol a de i able ma ke c e; and b h monopol a a ma ke c e, and ma ke po e gene all , come nde hea c i ici m and a e held o be again ocie be in e e . 1 To nde and hi , con ide he follo ing n me ical e ample. Sa o p inc ea e f om 3 o 4 ni . Ma ginal e en e ill be he e l of a gain and a lo . The gain i 9, ob ained f om elling he fo h ni of o p a he p ice of 9. The lo i e al o 1 fo each of he ini ial 3 ni of o p ha p e io l e e elling fo 10 and m no ell fo 9, e al o 3. Ma ginal e en e i e al o he gain min he lo , o 9 3 = 6. 2 Ho e e , no e ha he monopoli MC c e i no i ppl c e. In fac , he monopoli doe no ha e a ppl c e, beca e he e i no ingle ela ion hip be een p ice and an i pplied in monopol . The ea on i ha he MC = MR le fo he monopoli ma e l in diffe en p ice fo he ame an i , depending on demand condi ion fo he monopoli p od c . 7.5 M LEARNING OBJECTI ES After studying this section you will be able to: define all the terms appearing in in the text (AO1) explain that monopolistic competition has less market power due to many substitutes compared to monopoly and illustrate with a diagram showing a more elastic demand curve compared with monopoly (AO2, AO4) explain profit maximisation in the short run and long run, with diagrams showing abnormal profit, normal profit, loss (AO2, AO4) explain allocative inefficiency and market failure in monopolistic competition (AO2) explain that monopolistic competition has more product variety in exchange for less efficiency (AO2) discuss the advantages and disadvantages of monopolistic competition (AO3) The model of mono oli ic com e i ion is based on the following assumptions: There is a large number of firms; this is similar to perfect competition. There are no barriers to entry, as in perfect competition. There is product differentiation; unlike in perfect competition where products are identical. Product differentiation can be achieved by: physical differences products may differ in si e, shape, materials, texture, taste, packaging, etc. (think, for example, of the variety of clothes, shoes, books, processed foods, furniture) quality differences products can differ in quality location some firms attempt to differentiate their product by locating themselves in areas that allow easy access for customers, such as hotels near airports and convenience stores in residential areas services some firms offer specific services to make their products more attractive, such as home delivery, product demonstrations, free support, warranties and purchase terms product image some firms attempt to create a favourable image by use of celebrity advertising or endorsements, by brand names, or attractive packaging. Examples of monopolistically competitive industries include book publishing, clothing, shoes, processed foods of all kinds, jewellery, furniture, textiles, dry cleaners, petrol (gas) stations, restaurants. P M As the term monopolistic competition suggests, this market structure combines elements of both competition and monopoly. It resembles perfect competition because there are many firms in the industry and there is freedom of entry. It is like monopoly because of product differentiation. Each firm in an industry is a mini-monopoly in the specific version of the good that it produces. For example, Adidas is a monopoly in Adidas shoes, NIKE is a monopoly in NIKE shoes, and Puma is a monopoly in Puma shoes. This means that each of these producers faces a downward-sloping demand curve for its product. However, because each of these products is at the same time a substitute for the other, this demand curve is relatively elastic, i.e. it is more elastic than in monopoly, but less elastic than in perfect competition, as shown in Figure 7.19. F 7.19: Demand curves facing the firm under three market structures In perfect competition, if a firm raises its price, it loses all its sales to its competitors (Figure 7.19(a)). In monopoly, if a firm raises its price, it loses some but not all sales, as it is the sole producer of the good and consumers have no alternative product they can buy (Figure 7.19(b)). In monopolistic competition (Figure 7.19 (c)), if a firm raises its price, it will lose more sales than the monopolist, because consumers now do have substitutes they can switch to; but it will lose fewer sales than the perfectly competitive firm because of product differentiation the available substitutes are not perfect substitutes, as they are in perfect competition. This has important implications: it means that if consumers can be convinced that the product they are purchasing (for example, Puma shoes) is superior to the available substitutes (Adidas and NIKE shoes), then Puma has succeeded in establishing a mini-monopoly for its product. Therefore if the price of Puma shoes increases, only some, and not all, buyers of Puma shoes will switch to other brands. Those who believe that Puma shoes are superior will continue to buy them, in spite of the higher price. Firms in monopolistic competition face a demand curve that is less elastic than in perfect competition but more elastic than in monopoly. T - P occurs when a firm lowers its price to attract customers away from rival firms, thus increasing sales at the expense of other firms. N occurs when firms use methods other than price reductions to attract customers from rivals. The most common forms of nonprice competition are product differentiation (including all the features noted above, such as physical and quality differences, packaging, services provision, location, etc.), advertising and branding (creating brand names for products). Monopolistically competitive firms compete with each other on the basis of both price and non-price competition. They engage heavily in product differentiation through R&D in product development, as well as in advertising and branding. Firms that can attract customers by use of these methods increase their market power and their ability to charge a higher price without risking loss of buyers to rival firms. In general, the more differentiated the product is from its substitutes and the more successful the advertising and branding as methods of convincing consumers about the superiority of a product, the less elastic will be the demand curve facing the firm,3 the greater the market power (the ability to control price), and the larger the firm s potential to increase short-run profits. By contrast, firms that are less able to achieve consumer loyalty for their product, and whose product is less differentiated from substitutes, may have to rely more on price competition to increase their sales. TEST OUR UNDERSTANDING 7.13 1 Outline the assumptions defining the market model of monopolistic competition. 2 List some examples of monopolistically competitive firms in your neighbourhood. Analyse what makes them so. 3 Describe how a monopolistically competitive firm is like a firm in perfect competition; how it is like a monopoly. 4 Explain what firms in monopolistic competition try to achieve through product differentiation, advertising and branding, and how these activities affect the demand and revenue curves facing the firm. 5 Explain why we never see price competition and non-price competition in perfectly competitive firms, and monopolies. Explain their importance in monopolistic competition. P A The short-run equilibrium position of the individual firm in monopolistic competition is identical to that of the monopolist, the only difference being that the demand curve is more elastic and flatter in monopolistic competition than in monopoly. In the short run, the firm can make either abnormal profit (i.e. positive profit), normal profit or losses (negative economic profit). Each of these possibilities is shown in Figure 7.20. The firm applies the MR = MC rule to find the profitmaximising or loss-minimising level of output (Qe), and then for that level of output compares price (given by the demand curve) with AC to determine profit per unit or loss per unit. In part (a) of Figure 7.20 the firm earns abnormal profits, since P> AC at Qe; in part (b) the firm s profit is exactly ero since P = AC at Qe, and therefore the firm is earning normal profit; and in part (c), the firm is making losses because P< AC at Qe. Total profit or total loss is found by multiplying profit: profit Q by Q or loss Q by Q F 7.20: Short-run equilibrium positions of the firm in monopolistic competition N The assumption of free entry of firms in the industry is very important in determining the long-run equilibrium of the firm (like in perfect competition). In monopolistic competition, in the long run, profit-making industries attract new entrants; in lossmaking industries, some firms shut down and exit the industry. The process of entry and exit of firms in the long run ensures that economic profit or loss is ero and all firms earn normal profit. Figure 7.21 shows the long-run equilibrium of the monopolistically competitive firm. At the level of output where MR = MC, P= AC; therefore, profit is ero and each firm is earning normal profit. This figure is the same as Figure 7.20 where it happens that the firm is earning normal profit in the short run. The process of adjustment to normal profit in the long run is different to that of perfect competition. In monopolistic competition suppose firms are making abnormal profits in the short run. New firms will enter and they will attract customers away from the existing firms. The result will be to decrease the demand facing existing firms, so that it shifts to the left until it is just tangent to (it just touches) the AC curve. When this happens, the firms earn normal profit since P= AC. This is shown in Figure 7.21 F 7.21: Long-run equilibrium of the firm in monopolistic competition On the other hand if firms are making losses in the short run, some of them will leave the industry in the long run. As they do so, their customers switch their purchases to the remaining firms, which experience an increase in demand for their product. This appears as a rightward shift of the demand curve facing them, and this process continues until losses disappear and firms are earning normal profit where P= MC. M , Allocative efficiency is given by the condition P = MC. Figure 7.21, showing the long-run equilibrium of the firm in monopolistic competition, indicates that allocative efficiency is not achieved. Comparing price with marginal cost along the vertical line at the equilibrium level of output, Qe, we can see that price is higher than MC, indicating that there is an underallocation of resources to the production of the good: society would have liked to have more units of the good produced. In monopolistic competition P>MC or alternatively MB>MC, indicating there is market failure. The market underallocates resources to the production of the good and too little of it is produced. I Economists argue that some inefficiency in monopolistic competition is justified by the presence of product differentiation, which leads to greater product variety. In other words consumers gain product variety while giving up some efficiency. Perfect competition, by contrast achieves efficiency but at the cost of ero product variety. Because consumers enjoy product variety, it is often argued that with monopolistic competition some inefficiency may be the price consumers pay for having greater product variety. On the other hand there is much debate among economists about how much product variety is socially desirable. Some economists argue that there is too much product variety, such as for example too many brands of breakfast cereals, detergents, cars or virtually any other product. This leads to confusion among consumers, as well as high costs of advertising and new product development which result in higher prices. It is sometimes argued that consumers would be better off with less product variety and lower prices. C Below is a summary of the important differences between the market models. M S Large number of firms. Free entry of firms into an industry (no barriers to entry). Normal profit in the long run, abnormal profit or loss in the short run (due to no barriers). D M . Firms in perfect competition have no market power; they are price-takers facing a perfectly elastic (hori ontal) demand curve they face. Firms in monopolistic competition do have some market power (ability to influence price), reflected in their downward-sloping demand curve. A . Whereas the perfectly competitive firm achieves allocative efficiency in long-run equilibrium, the monopolistically competitive firm does not. Fewer than optimal resources are allocated to the production of the good. Since P> MC, consumers pay a higher price for the good than in perfect competition. Monopolistic competition is therefore a type of market failure. P . Whereas all firms in perfect competition produce the identical product, under monopolistic competition firms go to great lengths to differentiate their products. From the consumer s perspective, product variety is usually an advantage; perfect competition cannot offer this advantage. Some inefficiency in monopolistic competition may be the price consumers pay for greater product variety. E . Firms in perfect competition cannot achieve economies of scale because they are very small. Firms in monopolistic competition may have some small room for achieving economies of scale but only to a relatively small degree as these firms also tend to be relatively small. M S N . Both these market structures face downward-sloping demand curves, and therefore both have MR curves that lie below the demand curve. This means that at the profit-maximising level of output (found by MR = MC), P> MC for both (i.e. no allocative efficiency). D N . While in monopolistic competition there is a large number of firms, in monopoly there is a single firm, or else the industry is dominated by one large firm. S . In monopolistic competition firms are usually small, whereas in monopoly the fact that there is a single or dominant firm suggests a very large si e. B . Monopolistic competition is characterised by free entry whereas in monopoly there are high barriers to entry. N . Whereas the firm under monopolistic competition earns normal profit in the long run, the monopoly can earn abnormal profits due to high barriers to entry. C . Free entry and exit under monopolistic competition drive abnormal profits down to ero in the long run, and allow prices to be lower for the consumer than is possible under monopoly, where barriers to entry allow the firm to maintain abnormal profits over the long run. Therefore prices under monopolistic competition are likely to be lower and quantity larger than in monopoly and more in the interests of consumers. M . While both monopolies and firms in monopolistic competition have market power, a monopoly is likely to have more market power because there are no substitutes for the good it produces. The availability of substitutes means that consumers can switch to substitute goods, thus reducing the firm s market power. This is another reason why prices tend to be lower in monopolistic competition than in monopoly thus favouring consumers. C . Competition between firms in monopolistic competition puts a downward pressure on costs as firms compete with each other. These competitive pressures may force less efficient firms to leave the industry. The absence of competition in monopoly does not exert such a downward pressure on costs. R . The abnormal profits that monopolies can earn over the long run puts them in a better position than monopolistically competitive firms with respect to financing R&D. However, the pressures of competition faced by monopolistically competitive firms may induce them to pursue R&D for product development in order to maintain or increase their sales. E .Some small economies of scale may be achieved by firms under monopolistic competition, but the potential for this is much greater under monopoly, which can benefit consumers through lower prices. P .Whereas many monopolies sell more than one product, there is likely to be far greater product variety in monopolistic competition which is characterised by many firms producing products that are substitutes for each other. TEST OUR UNDERSTANDING 7.14 1 Use diagrams to explain how a firm in monopolistic competition can earn abnormal profit (show profit per unit and total profit), earn normal profit, and 2 Outline the role of free entry of firms in monopolistic competition in the adjustment from short-run to long-run equilibrium. 3 Using a diagram, show the firm s long-run equilibrium position in monopolistic competition. Comment on whether the firm achieves abnormal profit or normal profit in long-run equilibrium. 4 Explain why the firm in monopolistic competition represents a type of market failure. 5 Explain what is meant by the idea that some inefficiency is the price of product variety. 6 Evaluate monopolistic competition in comparison with perfect competition, and monopoly. 3 Advertising and branding work by making the demand curve shift to the right and making it rotate so it becomes steeper. These two changes mean that demand increases and it becomes less elastic. 7.6 O LEARNING OBJECTI ES Af er s d ing his sec ion o ill be able o: define all he erms appearing in in he e (AO1) dis ing ish be een coll si e and noncoll si e oligopol coll si e oligopol (AO2, AO4) and dra a diagram sho ing e plain fea res of oligopol incl ding in erdependence, risk of price coll de ers s incen i e o chea (AO2) ar, and incen i e o e plain he rele ance of price and non-price compe i ion for firms in oligopol (AO2) e plain he presence of alloca i e inefficienc and marke fail re (AO2) e plain he simple game heor pa off ma ri (AO2) e plain he meaning of marke concen ra ion and concen ra ion ra ios (AO2) disc ss ad an ages and disad an ages of oligopol (AO3) Oligopolies ha e he follo ing charac eris ics: T . The erm oligopol deri es from he Greek ord (oligopolio) meaning fe sellers . Oligopolis ic ind s ries are domina ed b a small n mber of large firms, ho gh in an one ind s r he firms are likel o ar in si e. T . All he barriers o en r disc ssed nder monopol are rele an o oligopol . The incl de economies of scale (for e ample, he aircraf and car ind s ries); legal barriers s ch as pa en s ( he pharmace ical ind s r ); con rol of na ral reso rces (s ch as oil, copper, sil er); aggressi e ac ics s ch as ad er ising or hrea s of akeo ers of po en ial ne firms. An addi ional barrier o en r in oligopol in ol es high s ar p cos s ( he cos s of s ar ing a ne firm) associa ed i h de eloping a ne or differen ia ed prod c . Man es ablished oligopolies spend enormo s s ms on prod c differen ia ion and ad er ising, making i diffic l for ne firms o ma ch s ch e pendi res. T . Firms in perfec and monopolis ic compe i ion, d e o heir large n mbers in an ind s r , beha e independen l of each o her, so hen he make decisions s ch as ho m ch o prod ce he do no ake he possible ac ions of o her firms in o considera ion. B con ras , he small n mber of firms in oligopolis ic ind s ries makes he firms m all in erdependen ; decisions aken b one firm affec o her firms in he ind s r . If an one firm changes i s beha io r, his can ha e a major impac on he demand c r e facing he o her firms. Therefore, firms are keenl a are of he ac ions of heir ri als. Mos prod c s of oligopolis ic firms are differen ia ed s ch as pharmace icals, cars, aircraf , breakfas cereals, cigare es, refrigera ors and free ers, cameras, res, bic cles, mo orc cles, soaps, de ergen s. Homogeneo s or ndifferen ia ed prod c s incl de oil, s eel, al mini m, copper, cemen . I , - I The in erdependence of oligopolis ic firms has impor an implica ions for heir beha io r: S .S ra egic beha io r is based on plans of ac ion ha ake in o acco n ri als possible co rses of ac ion. I is similar o pla ing a card game, or chess, here indi id al pla ers ac ions are based on he e pec ed ac ions and reac ions of heir ri al(s). S ra egic beha io r of oligopolis ic firms is he res l of heir in erdependence. For e ample, a firm plans a co rse of ac ion X ass ming i s ri als ill follo one polic , and i plans co rse of ac ion Y ass ming i s ri als follo a differen polic . Under oligopol , firms planning heir s ra egies make grea effor s o g ess he ac ions and reac ions of heir ri als in order o form la e heir o n s ra eg . C f ic i g i ce i e . Firms in oligopol face incen i es ha conflic , or clash i h each o her: Incen i e o coll de he erm coll ion refers o an agreemen be een firms o limi compe i ion be een hem, s all b fi ing price and herefore lo ering q an i prod ced. B coll ding o limi compe i ion, he red ce ncer ain ies res l ing from no kno ing ho ri als ill beha e, and ma imise profi s for he ind s r as a hole. Incen i e o compe e, o o chea in a coll i e ag eemen a he same ime, each firm faces an incen i e o compe e i h i s ri als in he hope ha i ill cap re a por ion of i s ri als marke shares and profi s, hereb increasing profi s a he e pense of o her firms. If firms ha e formed a coll si e agreemen , he face an incen i e o chea on heir par ners in he agreemen in order o increase heir profi s a heir e pense. E : / The charac eris ics of in erdependence, s ra egic beha io r, and conflic ing incen i es are ill s ra ed er effec i el b , a ma hema ical echniq e anal sing he beha io r of decisionmakers ho are dependen on each o her, and ho displa s ra egic beha io r. Game heor has become an impor an ool in microeconomics, and is based hea il on he ork of American ma hema ician and economis John F. Nash ( he s bjec of he 2001 film, A Bea if l Mind), ho oge her i h John Harsan i and Reinhard Sel en, recei ed he 1994 Nobel Pri e in Economics. The game e ill se here ill s ra es he p i one dilemma, sho ing ho o ra ional decisionmakers, ho se s ra egic beha io r o ma imise profi s b r ing o g ess he ri al s beha io r, ma end p being collec i el orse off. The final posi ion ha res l s from he game is called a Na h eq ilib i m. S ppose here are o oligopolis ic firms in he space ra el ind s r : In ergalac ic Space Tra el (IST) and Uni ersal Space Line (USL). Each firm m s decide on a pricing s ra eg , i.e. ha price o charge cons mers for i s space ra el ser ices, and can choose ei her a high-price or a lo -price s ra eg . Each firm is in eres ed in making i s o n profi as large as possible, b i s profi ill depend on he par ic lar combina ion of pricing s ra egies ha he o firms choose. Fig re 7.22 sho s fo r possible combina ions of pricing s ra egies and heir corresponding profi o comes (called pa offs ) for he o firms. This fig re represen s a . For e ample, if bo h IST and USL choose he high-price s ra eg , in bo 4, each ill ha e profi of 40 million Zelninks (abbre ia ed as Zs). Bo 3 sho s he profi o comes of differing price s ra egies; USL i h a lo -price s ra eg makes 70 million Zs, and IST i h a high-price s ra eg makes 10 million Zs. The reason h he lo -price firm makes m ch higher profi s is ha b charging a lo price i cap res a large por ion of sales from i s ri al. F 7.22: Game heor : he prisoner s dilemma S ppose he o firms begin in bo 1, here he are compe ing i h each o her on he basis of price (price compe i ion) and herefore ha e a lo price, leading o a lo profi of 20 million Zs each. Realising ha he ill bo h be be er off if he en er in o a coll si e agreemen and charge a high price, he collabora e and agree o adop a high-price s ra eg , h s en ering bo 4 here each one earns profi s of 40 million Zs. No each firm faces a dilemma. Le s look a he dilemma from IST s poin of ie ( ho gh USL is hinking along he same lines). IST realises ha b s icking o he agreemen , i ill con in e o earn 40 million Zs, along i h USL. On he o her hand, IST also realises ha b chea ing, in o her ords secre l breaking he agreemen , and charging a lo er price, i can earn he m ch higher profi of 70 million Zs, hile USL earns onl 10 million Zs. In addi ion, IST realises ha USL migh break he agreemen , in hich case IST ill find i self making onl 10 million Zs ( orse han e en hen i as in compe i ion i h USL, making 20 million Zs). Wha sho ld IST do? As i ries o o g ess USL, i is likel o c i s price o bea USL o he higher profi s, b since USL is hinking along e ac l he same lines, he are bo h likel o adop he lo -price s ra eg , in hich case he ill end p in bo 1 here he bo h ha e lo prices and lo profi s. This is he Nash eq ilibri m, in hich bo h firms become orse off. The Nash eq ilibri m sho s ha here is some imes a conflic be een he p rs i of indi id al self-in eres and he collec i e firm in eres . This conflic is he prisoner s dilemma. Al ho gh he firms co ld be be er off b coopera ing, each firm, r ing o make i self be er off, ends p making bo h i self and i s ri al orse off. This game ill s ra es man real- orld aspec s of oligopolis ic firms, hich: are in erdependen b o her firms; he o n s ra eg ha happens o he profi s of one firm depends on he s ra egies adop ed herefore r o predic he ac ions of heir ri als in order o plan o heir displa s ra egic beha io r compe i ors are likel o do he plan heir ac ions based on g esses abo ha heir face conflic ing incen i es he face he incen i e o coll de (agree o fi prices and mo e o bo 4 here he bo h earn high profi s); and he face incen i es o compe e, or in his case o chea on he agreemen , b lo ering heir price become orse off as a res l of price compe i ion ( r ing o cap re sales from heir ri als b c ing prices) since he ri als are likel o ma ch he price c s, all firms end p i h lo er prices and lo er profi s (bo 1); his is called a ha e a s rong in eres in a oiding price ars, beca se he realise ha e er one ill become orse off hro gh price c ing his crea es a s rong incen i e for hem o compe e on he basis of fac ors o her han price (non-price compe i ion). T - Unlike firms in monopolis ic compe i ion ha compe e on he basis of bo h price and non-price compe i ion, oligopolis ic firms go o grea leng hs o a oid p ice compe i ion. The are er caref l no o rigger a price ar, here one firm s price c is ma ched b a re alia or price c b ano her firm. As o r disc ssion of game heor sho ed, a price ar makes all he firms of an ind s r collec i el orse off d e o lo er prices and lo er profi s. A price ar ma e en lead o prices lo er han a erage cos s, and herefore losses. Ho e er, oligopolis ic firms s all do engage in in ense non-p ice compe i ion, in ol ing effor s b firms o increase marke share b me hods o her han price, hich picall incl de he follo ing: prod c de elopmen ad er ising branding n mero s ser ices s ch as q ali pgrades and o hers. c s omer ser ice, arran ies, pro ision of credi , disco n s on Non-price compe i ion is er impor an in oligopol for he follo ing reasons: Oligopolis ic firms of en ha e considerable financial reso rces (d e o large profi s) ha he can de o e o bo h R&D and ad er ising and branding. Whereas monopolis icall compe i i e firms also engage in non-price compe i ion, heir reso rces for hese p rposes are generall no as large. The de elopmen of ne prod c s pro ides firms i h a compe i i e edge; he increase heir marke po er, demand for he firm s prod c becomes less elas ic, and s ccessf l prod c s gi e rise o oppor ni ies for s bs an iall increased sales and profi s. Prod c differen ia ion can increase a firm s profi posi ion i ho crea ing risks for immedia e re alia ion b ri als. I akes ime and reso rces for ri al firms o de elop ne compe i i e prod c s. TEST OUR UNDERSTANDING 7.15 1 2 Iden if he main charac eris ics of an oligopol . Iden if he conflic ing incen i es faced b oligopolis ic firms. E plain ho 3 he rela e o heir in erdependence. Referring o he conflic ing incen i es faced b oligopolis ic firms, e plain h he pa off ma ri sho n belo ill s ra es he prisoner s dilemma confron ing he pla ers of his game. E plain he possible profi o comes of he Describe ho 4 o firms. hese o comes are rela ed o he firms in erdependence. Pro ide e amples of non-price compe i ion, and e plain h i is impor an o firms in oligopol . 5 O line h oligopolis ic firms a oid price compe i ion. Define a price ar, and o line h oligopolis ic firms a oid i . C There are o predominan pes of oligopolies: coll si e and non-coll si e. C C refers o si a ions here firms agree o coll de, hich means he form an agreemen be een hemsel es o limi compe i ion, increase marke po er and increase profi s. The mos common form of in ol es agreemen s o fi prices s ch as b holding prices cons an a some le el, raising prices b some fi ed amo n , fi ing price differences be een differen prod c s, and o hers. Coll sion is illegal in mos co n ries, beca se i orks o limi compe i ion. C A common pe of coll sion in ol es he forma ion of a ca el, hich is a formal agreemen be een firms in an ind s r o ake ac ions o limi compe i ion in order o increase profi s. The agreemen ma in ol e limi ing and fi ing he q an i o be prod ced b each firm, hich res l s in an increase in price; fi ing he price a hich o p can be sold; di iding he marke according o geographical or o her fac ors; or agreeing o se p barriers o en r . Wha e er he case, he objec i e is o limi compe i ion, increase he marke po er of he firms, and increase profi s. S ppose he firms of an ind s r decide o form a car el b fi ing price. Fig re 7.23 ill s ra es ho he car el ma imises profi . No e ha his fig re is iden ical o Fig re 7.14(a), hich ill s ra es profi ma imisa ion for a monopolis . The ke objec i e of a car el is o limi compe i ion be een he member firms and a emp o ma imise join profi s. Car el members collec i el beha e like a monopol . F 7.23: Profi ma imisa ion b a price-fi ing car el In Fig re 7.23 he demand c r e and marginal re en e c r e sho n are for he ind s r as a hole. The MC c r e is he s m of all he MC c r es of all he firms in he car el. The car el eq a es MR i h MC o find he car el s profi -ma imising le el of o p , Q ma , and hen de ermines price Pe (gi en b he demand c r e). I is hen a q es ion of di iding p ind s r o p Q ma be een all he firms, or deciding ho m ch of he o al q an i ill be prod ced b each firm. One a his can be done is o agree on ha share of he marke each firm ill ha e based on his orical marke shares. Ano her a is ha firms ma agree o compe e i h each o her for marke shares sing non-price compe i ion (prod c differen ia ion and ad er ising). The bes -kno n e ample of a car el is OPEC (Organi a ion of he Pe role m E por ing Co n ries), composed of a gro p of 13 oil-prod cing co n ries. OPEC periodicall ries o raise he orld price of oil b c ing back on i s o al o p . Each member co n r is assigned an o p le el (q o a) ha i is permi ed o prod ce. The res ric ed q an i of oil res l s in a higher price. Firms par icipa ing in a car el ha e m ch o gain: increased marke po er and hence he abili o con rol price of he prod c increased profi s d e o higher prices elimina ion of compe i ion be een he firms, and herefore no more ncer ain o g ess heir ri als. or need o Ho e er, coll si e oligopol is illegal in mos co n ries, for he same reasons ha pri a e nreg la ed monopolies are also illegal: he res ric compe i ion, raise prices, red ce q an i ies of o p and are held o be agains cons mers and socie s bes in eres s. Ho e er, in prac ice i is diffic l for a hori ies o disco er and pro e he e is ence of a car el. I is s spec ed ha here ma be far more cases of coll si e oligopol han ha are disco ered. While car els bring impor an benefi s o heir members, he are no eas se eral reasons. o crea e and main ain for T . E er firm in a car el faces an incen i e o chea on he agreemen , b offering o secre l lo er he price for some b ers. B if man firms chea , or if chea ing is disco ered b o her firms in he car el, hen he car el ma collapse. C . Since he price agreed pon b he car el is common o all he firms, firms i h higher a erage cos s ha e lo er profi s, hile lo er-cos firms enjo higher profi s. Cos differences be een firms lead o diffic l ies in agreeing on a common price. N . The larger he n mber of firms, he more diffic l i is o arri e a an agreemen regarding price and he alloca ion of o p , as he grea er n mber of differing ie s make agreemen and compromise more diffic l o achie e. T . A possible o come of one or more firms chea ing on he car el agreemen is a price ar, here one firm s price c is ma ched b re alia or price c s b o her firms. The res l of a price ar is o make all he firms of an ind s r collec i el orse off d e o lo er prices and lo er profi s (in he e ample of game heor ). O The diffic l ies in ol ed in es ablishing and main aining car els as ell as heir illegali some imes make firms rn o ards informal pes of coll sion. Info mal coll ion refers o co-opera ion ha is implici or nders ood be een he co-opera ing firms, i ho a formal agreemen . The objec i es of informal coll sion are also o co-ordina e prices, a oid compe i i e price-c ing, limi compe i ion, red ce ncer ain ies and increase profi s. One pe of informal coll sion is p ice leade hip, here a dominan firm in he ind s r ( hich ma be he larges , or he one i h lo es cos s) se s a price and also ini ia es an price changes. The remaining firms in he ind s r become price- akers, accep ing he price ha has been es ablished b he leader. The implici agreemen (as here is no formal agreemen ) binds he firms as far as price goes, b he are free o engage in non-price compe i ion. A charac eris ic of price leadership arrangemen s is ha price changes end o be infreq en , and are nder aken b he leader onl hen major demand or cos changes occ r. E amples incl de he airline ind s r , s permarke s and fas food res a ran s. N - N refers o oligopolis ic firms ha do no coll de in an a in order o fi or coordina e prices and limi compe i ion. Each firm beha es independen l ; ho e er, he are s ill a are of each o her in heir pricing decisions and displa s ra egic beha io r in ha he ake he possible ac ions of heir ri als in o considera ion. I can be obser ed ha in he real orld, prices of oligopolis ic ind s ries end o be rigid or infle ible; once a par ic lar price is reached, i ends o be rela i el s able o er long periods of ime. Moreo er, in si a ions hen prices do change, he end o change oge her for all he firms in an ind s r . S ch price rigidi ies can be easil e plained b coll si e oligopol , since firms beha e like a monopol in s ch cases and so end o ha e similar prices, b ho can he be e plained in si a ions here firms do no coll de? We can nders and he obser ed price s abili of oligopolis ic firms ha do no coll de sing he idea of s ra egic beha io r. S ppose here are hree oligopolis ic firms, A, B and C prod cing a similar prod c . A, B and C do no coll de or comm nica e i h each o her in an a , ins ead heir pricing beha io r is s ra egic, and is s rongl infl enced b heir e pec a ions of ho ri al firms ill reac if he nder ake a price change. S ppose firm A considers a price change, b before changing (increasing or decreasing) i s price, i ries o predic ho firms B and C ill reac , and ha ill be he conseq ences of heir reac ion. Firm A s reasoning is as follo s: If I raise m price, ha ill B and C do? The are nlikel o increase heir price, beca se if he con in e o sell a heir lo er price he ill ake a a a por ion of m sales, he ill be be er off and I ill be orse off. Therefore I sho ld no inc ea e m p ice. If I drop m price, ha ill B and C do? The are likel o drop heir price as ell, and so as a res l , I am nlikel o be m ch be er off han I am no , and I ma be orse off i h a lo er price, so I sho ld no d op m p ice. This line of reasoning is he same for all hree firms, A, B and C, and ends o res l in price s abili . This simple idea ill s ra es hree impor an poin s: F . O her ise he risk lo ering heir re en es and profi s, rn co ld lead o price ins abili . hich in E , . Firms are rel c an o change heir price beca se of he likel ac ions of heir ri als, hich co ld res l in lo er profi s for he firm ini ia ing price changes. F . The do no r o increase heir sales b a rac ing c s omers hro gh lo er prices. A lo er price no onl in i es price c s b ri als, i h res l ing lo er profi s for all he firms, b also risks se ing off a p ice a . T As oligopolies in ol e a small n mber of large firms ha domina e an ind s r , i is impor an o kno ho concen ra ed he ind s r s o p is among he ind s r s larges firms, as his informa ion ma pro ide cl es on he her oligopolies ha e oo m ch marke po er. A pro ides an indica ion of he percen age of o p prod ced b he larges firms in an ind s r ; i meas res . There is no fi ed n mber of firms for hich a concen ra ion is calc la ed. For e ample, e co ld sa ha he 3-firm concen ra ion ra io of ind s r X is 78%, hich means ha he hree larges firms of ind s r X prod ce 78% of he ind s r s o al o p ; or he 4-firm concen ra ion ra io of ind s r Y is 45%, hich means ha he fo r larges firms in ind s r Y prod ce 45% of he ind s r s o al o p . Table 7.7 pro ides some e amples of concen ra ion ra ios in he Uni ed S a es. We can see here are ide aria ions from ind s r o ind s r , i h he mos concen ra ed ind s r of hose appearing in he able being ranspor a ion eq ipmen and he leas concen ra ed being f rni re. I 4-firm 8-firm F 35.0% 46.7% C 44.8% 58.7% T 64.3% 77.7% F 18.8% 26.5% T 32.0% 44.9% S T : Concen a ion Ra io 7.7: Selec ed concen ra ion ra ios in domes ic US man fac ring Concen ra ion ra ios pro ide an indica ion of he degree of compe i ion in an ind s r . The s gges ha he higher he concen ra ion ra io, he lo er he degree of compe i ion, hile a lo concen ra ion ra io o ld indica e a grea er degree of compe i ion. In general, an ind s r is considered o be oligopolis ic if he fo r larges firms con rol 40% of o p . (This is an arbi rar c -off poin , as here is no hing special abo a concen ra ion ra io of 40%.) Concen ra ion ra ios ha e se eral eaknesses ha limi heir sef lness as a meas re of he degree of compe i ion: Whereas concen ra ion ra ios reflec concen ra ion in a na ional marke , he do no reflec compe i ion from abroad, arising from impor s. Concen ra ion ra ios pro ide no indica ion of he impor ance of firms in he global marke ; here ma be some compe i ion in a domes ic marke , b he firms ma ha e a er s rong, or dominan posi ion in he global marke . Concen ra ion ra ios do no acco n for compe i ion from o her ind s ries, hich ma be impor an in he case of s bs i e goods, s ch as in he case of differen me als. Whereas here ma be a high concen ra ion ra io in he al mini m ind s r , for e ample, his o ld be lo er if considered oge her i h copper, i h hich al mini m compe es. Concen ra ion ra ios do no dis ing ish be een differen possible si es of he larges firms. For e ample, a hree-firm concen ra ion ra io of 90% co ld consis of hree firms i h 30% of he marke each, or of hree firms, one of hich has 60% of he marke and he o her o ha e 15% each. REAL ORLD FOCUS 7.1 P For -fo r s a es in he Uni ed S a es filed a la s i in 2019 agains 20 pharmace ical firms for fi ing prices of o er 100 common generic (non-pa en ed) medicines, incl ding rea men s for diabe es and cancer. Follo ing a fi e- ear in es iga ion, he firms ha e been acc sed of illegal conspiracies o ei her s op prices from falling or o raise prices, in some cases b more han 1000%. The A orne General of he S a e of Connec ic s a es ha : We ha e ha d e idence ha he gene ic d g ind pe pe a ed a m l i-billion-dolla f a d on he Ame ican people. We ha e email , e me age , elephone eco d and fo me compan in ide ha e belie e ill p o e a m l i- ea con pi ac o fi p ice and di ide ma ke ha e fo h ge n mbe of gene ic d g . The legal ac ion seeks damages, ci il penal ies and co r ac ions o res ore compe i ion o he generic dr g marke . Generic dr gs are lo er-priced al erna i es o brand-name dr gs and as a res l sa e dr g b ers and a pa ers billions of dollars a ear. Ye according o he la s i : Prices for h ndreds of generic dr gs has risen hile some ha e sk rocke ed, i ho e plana ion, sparking o rage from poli icians, pa ers and cons mers across he co n r . S : CNBC; BMJ F 7.24: Caps les con aining b siness and economics form las A 1 Iden if his pharmace ical oligopol as coll si e or non-coll si e, offering reasons h . 2 Dra a diagram and se i o e plain ho 3 Normall , i is er diffic l o de ermine he presence of coll sion. O line h be he case here. his oligopol fails o achie e alloca i e efficienc . his ma no E O , As firms in coll si e oligopol beha e like a monopol , i is clear ha here is elfare loss, alloca i e inefficienc and marke fail re, as Fig re 7.22 demons ra es. Ye he same is also r e of oligopolis ic firms ha do no coll de. The also face a do n ard sloping demand c r e, and he marke prod ces a le el of o p ha is belo he le el here social s rpl s is ma im m. Therefore, here is elfare loss here oo as in he case of coll si e oligopol . C To he e en ha oligopolis ic firms s cceed in a oiding price compe i ion, he achie e a considerable degree of marke po er, and herefore face similar cri icisms as monopol : Welfare loss, alloca i e inefficienc and marke fail re. Higher prices and lo er q an i ies of o p han nder compe i i e condi ions. Loss of cons mer s rpl s o he oligopolis s d e o higher prices res l ing in P> MC. Nega i e impac s on he dis rib ion of income. There ma be higher prod c ion cos s d e o lack of price compe i ion. Possibl less inno a i e. In addi ion, here is a f r her arg men agains oligopol : Whereas man co n ries ha e an i-monopol legisla ion ha pro ec s agains he ab se of marke po er, he diffic l ies of de ec ing and pro ing coll sion among oligopolis ic firms means ha s ch firms ma ac all beha e like monopolies b coll ding and e ma ge a a ihi. B The benefi s of oligopol are also similar o he benefi s of monopol : Economies of scale can be achie ed d e o he large si e of oligopolis ic firms, leading o lo er prod c ion cos s o he benefi of socie and he cons mer ( hro gh lo er prices). Prod c de elopmen and echnological inno a ions can be p rs ed d e o he high abnormal profi s from hich research f nds can be dra n. This benefi of oligopol is more impor an han in he case of monopol , since non-price compe i ion forces firms o be inno a i e in order o increase heir marke share and profi s. Technological inno a ions ha impro e efficienc and lo er cos s of prod c ion ma be passed o cons mers in he form of lo er prices. O er and abo e he benefi s of oligopol follo ing ad an age: ha are similar o monopol , oligopol also offers he Prod c de elopmen leads o increased prod c arie , h s pro iding cons mers choice (monopol does no offer m ch prod c differen ia ion and arie ). i h grea er TEST OUR UNDERSTANDING 7.16 1 O line he meaning of coll sion. Iden if 2 ha firms in an oligopol r o achie e hro gh coll sion. Define a car el. Using a diagram, sho ho a car el resembles a monopol . E plain h car els are illegal in mos co n ries. 3 O line h he car el members face he incen i e o chea . Iden if some obs acles o forming and main aining car els. 4 5 E plain ho non-coll si e oligopol differs from coll si e oligopol . E plain he meaning of concen ra ion ra io and pro ide e amples ( he ma be h po he ical). S a e he p rpose of calc la ing concen ra ion ra ios. Iden if some shor comings of concen ra ion ra ios. 6 7 Oligopol is a pe of marke fail re. J s if his s a emen . Disc ss po en ial ad an ages and disad an ages of oligopolis ic firms. THEOR OF KNO LEDGE 7.1 P The model of perfec compe i ion is he basis of an idealised free-marke econom , here price is he ra ioning s s em ha s pplies ans ers o he ha and ho o p od ce q es ions.4 The marke and he price mechanism are he means b hich alloca i e efficienc is achie ed, h s a oiding as e of reso rces. Man economis s ha e s rongl cri icised preocc pa ion i h he perfec l compe i i e model. The no e ha he real orld is domina ed b large oligopolis ic firms and monopolis icall compe i i e firms, and he model of perfec compe i ion bears no rela ionship o ei her of hese. Tr ing o es he perfec l compe i i e model o ld be meaningless gi en he real- orld con e of firm beha io r. The er concep of compe i ion has as l differen meanings, i h compe i ion in perfec compe i ion being anon mo s and eq i alen o comple e absence of marke po er (no abili o infl ence price), and compe i ion in he o her o marke models in ol ing effor s o cap re marke shares from ri al firms, ei her hro gh price c s or hro gh prod c differen ia ion and ad er ising (non-price compe i ion). These real- orld pes of compe i ion are comple el irrele an for he perfec l compe i i e firm ha can nei her gain an hing b lo ering i s price nor can i differen ia e and ad er ise i s prod c . In addi ion, man economis s q es ion he no ion of eq ilibri m (an idea borro ed from ph sics), and poin o ha eq ilibri m for he firm makes sense onl nder condi ions of comple e cer ain and perfec kno ledge. As here is no s ch hing in he real orld, here can be no eq ilibri m. On he o her hand, defenders of he perfec l compe i i e marke model arg e ha his can be sed as a parable ha can appro ima e (or describe er ro ghl ) he o comes of real- orld firm beha io r, regardless he her hese firms are oligopolis ic or monopolis icall compe i i e. The also arg e ha in spi e of i s lack of realism, his model ser es as a ool for assessing real- orld si a ions ha depar from he ideal of alloca i e efficienc , h s helping go ernmen s prescribe polic meas res o deal i h iss es in he ind s rial sec or. T Ho sef l do o hink is he model of perfec compe i ion? Do o hink i ma ers ha i is based on highl kno ledge 2.3 in Chap er 2)? nrealis ic ass mp ions (see also Theor of Do o hink economis s sho ld foc s more on de eloping and sing more realis ic marke models, based on monopolis ic compe i ion and oligopol ? 4 I also ans ers hefo hom o p od ce q es ion on income dis rib ion. Ho e er, he ans er pro ided is generall highl nsa isfac or , and for his reason becomes a norma i e iss e abo ho go ernmen s sho ld in er ene in marke s o change marke -de ermined income dis rib ion (see Chap er 12). 7.7 G LEARNING OBJECTIVES Af e d ing hi ec i n ill be able : define all he e m a ea ing in in he e (AO1) di c ad an age f la ge fi m i h ignifican ma ke and in e men in R&D financed b abn mal fi , inn di c ik fi m (AO3) i h e ec , e , incl ding ec n mie a i n (AO3) ice, c n me ch ice in ma ke f cale d mina ed b la ge di c ad an age and di ad an age f g e nmen in e en i n deal i h ab e ma ke e incl ding legi la i n and eg la i n, g e nmen ne hi , fine (AO3) f A In he di c i n ab e n m n l and lig l e a e ffe a n mbe f en ial ad an age , incl ding: ad an age a i ing f m la ge ec n mie he abili f We ha e al ch fi m ca een ha he e a e a n mbe ha la ge fi m f cale and na R&D n ne al m n i h ignifican ma ke l d c and echn l g de el men . f di ad an age and i k in e m f: all ca i e inefficienc and elfa e l highe l ice and l e f c n me nega i e im ac l inn fi m n he di ib i n f inc me highe han nece a ibl le he la ge fi m a e age c d e lack f ice c m e i i n a i e. G : T ab se We ha e een ha all ma ke c e he han e fec c m e i i n e e en ma ke fail e, e l ing in a ice ab e ma ginal c (P> MC), and elfa e l a le e g ea e deg ee. H e e , al kn n a a i-c e i i e ac ice , efe i ai n he e fi m engage in ac i i ie ha e l in ed ced c m e i i n. Acc ding he E ean C mmi i n ( f he EU): A c a d i a ei i aec ca e ic c e i i if i i i a ii f ii i i i e f a i-c e i i e, b if he c e i i , i i c ide ed ha e ab sed it. E am le incl de: e gh a e a gi e i hi a e. A ii cha ging n ea nabl high ice de i ing malle c m e i c m ee ih b a f c me b elling a a ificiall l ice he c ing c m e i in he ma ke ( in an he ela ed ma ke ) b f cing c n me d c hich i a ificiall ela ed a m e la , in-demand d c ef ing deal i h ce ain c me ffe ing m f hei lie f m he d minan c m an making he ale f ne In gene al e can a he f ll ecial di c n d c c ndi i nal n he ale f an he c me h b can b all d c .5 ing: M ie n he h le ha e he highe deg ee f ma ke e hich i ab i e d e he lack f c m e i i n; hi i h i a e, n eg la ed m n lie a e illegal m e e he e. Fi i ig ie ma ma n ab e hei ma ke e . The ma ke e f a c ll i e lig l i imila ha f a m n l , and e e en a f m f ab e; he ef e c ll i n i illegal m e e he e. N n-c ll i e lig lie ma ma n ab e hei ma ke e, de ending n he i a i n. Fi i i ic c e i i ha e le ma ke e hich f he m ab e beca e he e i ignifican c m e i i n am ng fi m ha d ce b i a he d n eg d . REAL WORLD FOCUS 7.2 R In 2019 he In e na i nal M ne a F nd (IMF, ee Cha e 20) bli hed a d iding e idence in f he e la n i n ha c m e i i n i eakening a ma ke a e bec ming m e and m e c ncen a ed. The d e amined ma k e ma ginal c ( he am n added c b ain he ice) f 900 000 fi m in 27 c n ie . Ma k e ma ginal c a e an indica f ma ke e . I f nd ha ma k inc ea ed b 8% n a e age in he e i d 2000 2015, inc ea ing m in he Uni ed S a e and a le e e en in E e. B he d al f nd ha he i ing ma k a ed e nl a mall ha e f he fi m . The 10% f fi m i h he highe ma k inc ea ed he e b m e han 30% c m a ed hei c m e i fi m . M e e , me ge and ac i i i n , hich clea l e l in inc ea ed c ncen a i n, a e f ll ed b ignifican l highe ma k . In addi i n i f nd ha highe ma k a e linked i h le in e men in h ical ca i al, hich i e ima ed ha e e l ed in l e GDP g h b ne e cen age in in ad anced ec n mie . F he , he fi m i h he highe ma k a ke a malle ha e f he al e he c ea e, c n ib ing inc me ine ali . Finall , he d a n ha ma ke e ma e l in le inn a i n a fi m bec me c mf able in hei i i n d e dec ea ing c m e i i e e e. The e nega i e end ma S ce: The Ec i en if ma ke e i n checked. F 7.25: Da id G lia h b ine b ine e again la ge c ai n c m e i i n, ill a ing g ea diffic l ie f mall A 1 O line he meaning f inc ea ing ma ke c ncen a i n 2 De c ibe he e idence c ncen a i n. 3 E lain he i k ed b he IMF c ncl de ha he e i inc ea ing ma ke c n me and he ec n m The ef e g e nmen in e en i n in e f m n l and lig l . ne f inc ea ing c ncen a i n f ma ke . ab e f ma ke e cc mainl in he ca e L M c n ie ha e la ha m ec lig li ic fi m , a ell a e en ing an i-c ma ke ( ee Real ld f c 7.1). Thi i kn an ic m e i i e beha i ae all a ked in malle fi m . m eii nb e en ing c i be een m e i i e beha i b a ingle fi m ha d mina e a na c eii ic . Fi m ha a e f nd g il f a fine ( ee Real ld f c 7.5), ma be b ken Diffic l ie ha ma a i e in c nnec i n i h c m e i i n licie incl de: P ible diffic l ie in in e e ing he legi la i n in c nnec i n i h he beha i f he ffending fi m . Diffe en e le ma ha e diffe en ie n ha ac i n in l e an ic m e i i e beha i . The la hem el e ma be ag e, all ing m ch m f diffe en in e e a i n . Acc ding he OECD, De e mining hen a fi m beha i i an ab e f ma ke e,a a ea in c m e i i n ed a c m e i i e ac i n, i lic . 6 ne f he m c m le and c n e ial La in a a ic la c n ma be enf ced a ing deg ee , i h me g e nmen enf cing hem m e ic l han he , de ending n hei i i ie hei li ical and ide l gical ie . S me g e nmen ma acce he inci le ha g e nmen in e en i n in he ma ke in he f m f ic enf cemen f c m e i i n licie i nece a ec c n me again m n li ic ac ice and achie e all ca i e efficienc . O he g e nmen ma acce he inci le ha g e nmen in e en i n in he ma ke i n nece a achie e c n me ec i n and all ca i e efficienc , beca e e l ng e i d f ime, he ma ke and c m e i i e f ce n hei n acc m li h he e f nc i n . The e i n igh ng an e hi i e, a i de end n n ma i e idea ab he ec n m . If fi m c ll de, i i diffic l di c e e idence f he c ll i n and cc ec e l , ince i i illegal. e i , a c ll i n L A me ge i an ag eemen be een m e fi m j in Me ge ma cc f a n mbe f ea n , ch a an in e e ingle la ge fi m ma be able d ce a l e a e age c fi m ld like bec me la ge ), in e e in ac i ing ma he la ge i e f he ne , la ge fi m. ge he and bec me a ingle fi m. in ca ing ec n mie f cale (a ), an in e e in fi m g h ( he ke e , hich i made ible b Me ge a e an i e in c m e i i n lic beca e f he ibili ha he ingle fi m c ea ed f m he me ge ha e m ch ma ke e . Legi la i n all in l e limi n he i e f he c mbined fi m . (See Real ld f c 7.4.) Diffic l ie i h me ge licie incl de e i n and nce ain ie ab ha fi m h ld be all ed me ge and ha fi m h ld n , ela ed i e f in e e ing he legi la i n a ell a ide l gical diffe ence am ng diffe en g e nmen n he de i abili n f a high deg ee f ma ke e. T Fine a e f en im beha i di c e ed if a g e nmen agenc e n ible f in e iga ing an i-c m e i i e me ngd ing ( ee Real ld f c 7.5 bel f e am le ). A blem i h fine i ha fi m ill f en ge hei la e calc la e he he b eaking he la c m l ing i h he la i m e c l ( m e fi able). Of en, he fi f fi m ha ab e ma ke e a e g ea en gh ha he a e be e ff illegall ab ing hei e and a ing fine , han n ab ing hei e and n a ing fine . M e e , f en he a e n ca gh f an ic m e i i e beha i , ibl beca e f he li ical clima e, beca e he a e ca ef l c e hei ac i n . Big fi m f en neglec he e hic c l a c m liance. f ngf l beha i if he belie e ha ge ing ca gh i n a REAL WORLD FOCUS 7.3 C In 2018 he E ean C mmi i n ( f he EU) im ed a fine f $5 billi n n G gle f i la ing he EU c m e i i n le b e i ing h ne man fac e ein all G gle Sea ch and i b e a , Ch me, in de acce G gle Pla , G gle a e. Acc ding he EU, The e ac ice ha e denied i al he chance inn a e and c m e e n he me i . The ha e denied E ean c n me he benefi f effec i e c m e i i n in he im an m bile he e. 7 S n af e P e iden D nald T m ee ed The E ean Uni n j la ed a Fi e Billi n D lla fine n ne f g ea c m anie , G gle. The l ha e aken ad an age f he U.S., b n f l ng! S me ea ea lie P e iden Ba ack Obama had a ed: S e i e he E ea e e he e i ec e cia d i e ha a hi g e e. We ha e ed he i e e , c a ie ha e c ea ed i , e a ded i , e fec ed i i a ha he [E ea fi ] ca c e e. A d f e i e ha i a ed a high- i ded ii 8 i e e i e i j de ig ed ca e e f hei c e cia i e e . La e US Sena Eli abe h Wa en a g ed: T da big ech c a ie ha e ch e ch e cie , a d de c ac . The e b d ed c e i i , ed fi , a d i ed he a i g fie d agai e e e e e. A d i he 9 b i e e a d if ed i ai . T deal i h hi , he T le C inn a S F G e b eaking en, a US ec n mic , and b eaking hem a he big ech c m anie . fe di ag ee , a g ing ha la ge ech c m anie a e maj c ld eaken hem and he ef e h inn a i n. : EUROPA; The Ne Y 7.26: E gle 90 da e ec , i aei f ai f ce , he ha e h e ; Medi ean C mmi i ne Ma g e he Ve age , 18 J l 2018, hen he EU ga e end illegal ac ice face f he fine (af e being fined $5billi n) A 1 De c ibe h he E 2 T 3 C m a e and c n a G gle. ha e en d ean C mmi i n h hink he E he licie gh G gle a ab ing i ma ke e. ean C mmi i n c nce n a e legi ima e? f an im i i n f a fine e legi la i n b eak REAL WORLD FOCUS 7.4 C UK In 2019, B i ain C m e i i n and Ma ke A h i (CMA) bl cked a me ge be een A da, he Uni ed Kingd m ec nd la ge e ma ke , i h Sain b , he hi d la ge . The e ma ke c mbined ld ha e had a ma ke ha e f 30.7%, and ld ha e bec me he la ge e ma ke in he c n . In hei ed me ge , A da and Sain b a g ed ha he me ge ld ha e all ed hem c c i h e l ing ice dec ea e f a m ch a 10%. H e e , he CMA claimed e ha e f nd hi deal ld lead inc ea ed ice , ed ced ali and ch ice f d c , a e h ing e e ience f all f hei UK h e . The e i g ing c nce n in he Uni ed Kingd m ha he e i inc ea ing c ncen a i n f fi m in he d me ic ec n m , he e he e ha e been $2 illi n h f me ge and ac i i i n in he a decade. The e a e imila c nce n in he Uni ed S a e ha he ec n m ha bec me c ncen a ed, limi ing c m e i i n and ed cing elfa e ( ee al Real ld f c 7.2). The ef e he CMA deci i n n he e ma ke me ge c ld e e be an im an m men in he ef m f B i ain e -c ncen a ed ec n m . S : The Ec i F 7.27: Flin , UK. A da and Sain b A l ing kill 1 U e a diag am e lain h l e a e age c . 2 E lain he he e ical a g men behind he CMA ea ning ha he me ge e l in highe ice and ed ced ali and ch ice f d c . he me ge f he e ma ke migh ha e e l ed in ld likel T While m c n ie a nd he na al m n l , beca e i i n ld e l in highe a e age c G ld d n enc age m n l , an e ce i n i made if he e i a in cie in e e b eak i in malle fi m , a hi and a a e f e ce . One ible l i n na al m n l i na i nali e i , hich in l e an fe f ne hi f m he i a e ec he blic ec ( he g e nmen ). G e nmen ne hi all he g e nmen eg la e na al m n lie , f cing hem l e ice and inc ea e an i ie d ced in he in e e f c n me , he eb ed cing all ca i e inefficienc and elfa e l . H e e g e nmen ne hi me ime lead inefficiencie and highe han nece a c f d c i n, a g e nmen a e n d i en b he g al ma imi e fi . In gene al ince he 1990 he e ha been a end a nd ld i a i e ( he i e f na i nali e) g e nmen en e i e . G G e nmen all eg la e na al m n lie , en e m e ciall de i able ice and an i c me , and hi can be d ne e en hen he m n l emain nde i a e ne hi . The e a e a hi can be d ne. REAL WORLD FOCUS 7.5 F E U In 2019 a g f bank (Ba cla , J.P. M gan, MUFG and R al Bank f Sc land) e e fined $1.2 billi n f igging he m l i- illi n-d lla f eign e change ma ke f 11 c encie . The S i bank UBS a e em ed f m he fine beca e i ale ed he e i ence f ca el he E ean Uni n. A he ame ime an he g f bank (Ba cla , BNB Pa iba , Ci ig Bank f Sc land and UBS) e e fined $2.8 billi n b U.S. eg la al ae . S F : Ba cla , Ci ig 7.28: M , J.P. M gan, R al f igging e change and JP M gan am ng bank fined $1.2 billi n f n ain Vie , Calif nia, USA. One f he G f e igging gle b ilding In 2019, G gle a fined 1.5 f e ic ing c m e i i n b im c n ac al e ic i n n hi d- a eb i e f e en ea . ing an ic m e i i e In 2018, G gle a fined 5 billi n f e i ing h ne man fac e Sea ch and i b e a , Ch me, in de acce G gle Pla , G In 2018, Q alc mm a fined $1.2 billi n f making ignifican ing Q alc mm chi a he han c m e ing chi . In 2017, G gle a fined 2.7 billi n f ad an age in he ea ch e l . gi ing i G In 2009, In el a fined $1.45 billi n f ffe ing c In el mic ce in ead f i i al AMD. gle Sh me ein all G gle gle a e. a men A le f ing Se ice an illegal ice ed c i n if he S ed : The G a dian; B ine In ide ; Re e ; A O line h each f he e i la i n ma che he E ean C mmi i n defini i n and e am le f ab e f ma ke e ( ee Sec i n The ea i g f ab e f a e e ab e). M The g e nmen can f ce he m n l cha ge a ice e al ma ginal c , ince i h P = MC he m n li ill achie e all ca i e efficienc , i h P falling and Q inc ea ing he ciall de i able le el. Thi i called a gi a c ici g. H e e , ma ginal c icing lead l e f he na al m n li . The ea n i ha P = MC e l in a ice ha i l f he fi m be able c e i a e age c . A a e l , he fi m ill ei he g f b ine , he i e he g e nmen ld ha e b idi e i in de c e i l e . (Thi need n cc in a m n l ha i n a na al m n l .) F he e ea n ma ginal c icing i n a la a eg la e na al m n lie . (The in e e ed eade ma efe he 'Digi al c na al m n l i h ma ginal c icing, a S eb k: E lemen a a ma e ial' ec i n, ill ma e ial.) a ing a A T a id c ea ing l e f he na al m n li , g e nmen can f ce he fi m cha ge a ice e al i a e age c , he e P = AC, meaning ha he fi m ea n n mal fi . Thi i called a e age c ici g. Thi e l in a highe ice and l e an i han ma ginal c icing. H e e , i lead a ice and an i c mbina i n ha i ei ha f he n eg la ed m n li , meaning ha ice i l e and an i g ea e . Al h gh all ca i e efficienc i n achie ed h gh a e age c icing, hi lic ffe e im an ad an age : (a) he m n li make n mal fi and i n in dange f ha ing h d n; and (b) i i m e efficien han he ma ke l i n. Ye , a e age c icing al ha di ad an age . A m n li in a f ee, n eg la ed ma ke face incen i e kee i a e age c l , in de ma imi e fi . If, h gh eg la i n, i i g a an eed a ice e al i a e age c , i l e hi incen i e. If a e age c inc ea e d e inefficienc , i ill ill ecei e a ice c e ing i c . An he ible di ad an age i ha he eg la ed m n l ma c n in e i ea am n e en h gh i ma being a na al m n l (if echn l gical im emen change c c ndi i n , ch a in elec mm nica i n ). C n in ed eg la i n ide ec i n he fi m f m ne c m e i ha ld ha e been able d ce m e efficien l . TEST OUR UNDERSTANDING 7.17 1 Di c en ial ad an age f la ge fi m i h ignifican ma ke en ial i k in ma ke d mina ed b la ge fi m . e , and l , 2 O line he meaning f ab e f ma ke 3 Di c ad an age and di ad an age ab e f ma ke e. 4 e. f ible g U ing a diag am, e lain he meaning f na Di c lic i n f g e nmen e nmen in e en i n al m n deal i h na deal i h l . al m n l . INQUIR AND REFLECTION The f ll ing e i n ill hel eflec n lea ning and enhance nde anding f ke ic in hi cha e . The a e gge i n f in i ie ha can nde ake n n in g in de e i e he lea ning bjec i e f hi cha e . 1 Re ea ch and find an e am le f c ll i e lig l in c n f e idence in an he c n f ch ice. T di c e h he fi m c ll ded, h hei c ll i n a di c e ed, ha if an e e he fine im ed, and ha e e he c n e ence . 2 Re ea ch a ca e f c m e i i n lic in a c n and ind f ch ice he e fi m ha e been acc ed f an i-c m e i i e beha i . E lain h he beha i n again he in e e f c n me and cie , and h he ac i n aken b he c m e i i n a h i ld c ec he blem. 3 The e i a maj ng ing deba e ab ma ke e c ncen a i n in he la ge ech fi m like Ama n, G gle and Faceb k. Acc ding man b e e hi i e ce i el high and g ing. Re ea ch and e lain he a g men ha fa eg la i n and legi la i n limi he ma ke e f ch fi m . E lain he ible i k c n me and cie f he i ing ma ke e f he e fi m . De c ibe he a i licie ha a e being ed eg la e hi ind . E AM ST LE QUESTIONS Y can find e i n in he le f IB e am in he 'Digi al c 5 Ab e f a d minan 6 Ab e f d minance and m n 7 An i : C mmi i n fine G gle 4.34 billi n f eng hen d minance f G gle' ea ch engine 8 Wh Did he E 9 He e h eb k: E a ma e ial' ec i n. ii n li a i n ean C mmi i n Fine G e can b eak Big Tech illegal ac ice gle Fi e Billi n D lla ? ega ding And id m bile de ice 3 M Mac ec ic die he ec a a h e. We f c he a ge ic e ec ,c ed f c ec i f a c e , fi , e ce e a d a I ead f i di id a d c ice , e d he ge e a ice e e f he ec ;i f de a d f i di id a d c , e e a i e a de a d f g d a d e ice ; a i ead f i di id a fi a d i d , e e a i e he a d ced i ec . F he , e d a e e , a i e e , a e a di e ch a h e , hich i ac ec ic a e ca ed aggrega e . I d ac ec ic e i de e ha f icie g e e ca ei de achie e a ac ec ic b ec i e , ch a i fai a d e e e i ab e di ib i f i c e. Rea ec i f i a be f i e , ec a a e a a ie a ic g ha da d i e 1: Wha acc f a ia i ic ac i i e i e, a d h i hi a ? CONCEP AL NDER ANDING f he e . ead d he a d i 1 The c di i f he de a d ide a d he c i cha ge, hich ca e a ia i i ec 2 F c ai i ec ic ac i i ha e a cie ie a d he i di id a i hi he . 3 Diffe e ch f h a d gge diffe e gh i ide f he ec ic ac i i effec ffe diffe e e a a i f dea i g i h he e. ae e i e. he ec f ac ec c b ec e -be g f ic be The e ic a e add e ed i he e fi e cha e . Cha e 8 i c ce ed i h he ca e f cha ge i ec ic ac i i a d he be f h ec i ea e ec ic e bei g. Cha e 9 i d ce f da e a ac ec ic c ce ha e i e a a e he ac ec , i a ic a agg ega e de a d a d he ec e ia agg ega e . Cha e 10 a d 11 i di c he i a ac i e f i f a i , e e , ec ic g h a d deb . Fi a , Cha e 12 dea i h he cha e ge ed b i c ea i g i e a i ie a d h he e a be effec i e add e ed. Mad id, S ai . J b ee e ide a e e age c _______________________________________________ C a e 8 T e e e e a ec c ac BEFORE YOU START In the news you have probably heard reports describing the state of the economy . What do you think the economy is? News reports often comment on how the economy has improved or worsened. What do you think characterises an economy that has improved or worsened? In this chapter we will discover how economists measure an economy s total output and income. We will study the business cycle, that shows how economic activity fluctuates over time. Finally, we will examine the limitations of standard measurements of output and income, and will consider alternative methods that may be more appropriate for measuring economic well-being. 8.1 Ec c ac LEARNING OBJECTIVES Af e d g def e a ec e e be ab e a ea e e e c c a f de (AO2, AO4) The de a ge b d f The c c a f T ec c a f f c a f e ba f g f c e c e e de a de a d g e ac : ed ec e e de d ced f c e d ced ac ec C a e 1, Sec . h de C a e 1 a d da a d ag a f de F g e 8.1 e a e a F g e 1.4 (C a e 1), c be ee e d (c e )a df (b e e ), e ce a e . F g e 8.1: C c a f (AO1) g 1.3. We e d ced e e a ed ge e ea age a d ec b ef e e e g a d e de e de ce d c a e a d ee H e f ,a g d a fac d ,a e f fac f d c ( a d, ab , ca a a d e e e e ) d e a b e d c a f d ce. F b e fac f d c d e ce e d ce c e .T e e e ef e a f ec c ed f d c f e d f , a d f g d a d e ce f f T ec ec c e d ec f f mone . H e d ece e c e e fac f d c f ef f en (f a d), age (f ab ), in e e (f p ofi (f e e e e ). C e e a e ho ehold e pendi e c e b g d a d e ce . F e e a d a e co of p od c ion e e b d c , a d e ece e e en e e e e e g d a d e ce . We ee e d e e d e T ee f e a e a e f a a f e ee ,a d e ec f e d. e e e ca a ) a d e e e d e fac f e income flo f f e d e a e e pendi e flo f : e e d c e f e a e f fac f d c e a e g d a d e ce . T e ci c la flo of income. a ea e a e a e fg d a d e f e d c f eac g d a d e ce . T e ef e: d ce , e al e of o p flo . T ed b e ec e ce, g g T ec c a f f c e a a g e e e d ( a a ea ), e al e of o p d ced a ec e a e o al income ge e a ed d c g a , c e e pendi e ade c ae a . Add g ea age a d g F g e 8.2: C c a f de Lea age a d ec : ec f a e a ed ea age a g a e ga d e e ge e g ec c a f ,a a f c e de i hd a al ) e ea age a d a a ea ec e g e e e d g Sa c e e e a ec F g e 8.2 e a e a F g e 1.6, f g ) a d leakage ( e f 8.1. injec ion ( e e f fFg e ec f ef ca c e e e d g e d g e bac e a a Sa g a a f c e c e a a b f f e d c f ca ca a ). T ca a g d a e a f a c a a e (ba acc , c a f a ca a e ( g b g, d c f ca a g d . T e e f d Sa g ea f ef fc e ec ed bac ee e d ef a Ta e a d g e e e , e ef e a ea age. I a g d ( e f ef fac f a e e g d .H e e f c a d b d , e c.) a d f g c a d b d , e c.) f a ce e ef e f bac ee e d e e d e, a e g f a ca e e . e e e d g d c , ca d ace e a g ba f d f e e , e ef a ec . a e ,a d e e d g Ta e a d g e e e d g a e c ec ed g eg e e . Ta e a e a ea age ce e d a a e eg e e ead f b g g d a d e ce , a d g e e e d g a ac e (ed ca , ea , defe ce, e c.) c e bac ef a a ec . I a de A ec a a de g e a a ade a open econom . I a de ae ed ge e g e c e .I e e e a ea age beca e e a e e d e d g a ea e e c e a d ce e g d a d e ce . E e ee a ec beca e e a e e d g b f e g e b d e ca d ced g d a d e ce . The e f he c c a f ec T e e a e e f ea age a ea age a e g ea e a ec a e e , a e bac ef a e e e , e b fe e a f ab ) a d e If ec e g a d e ce (a f b T d ea he ec a a c e e ce f , e e f ec c a f bec e e d c e a ea a a g f a .T e e a fe e g d a d e ce fac f d c , e e c ea d c e ed ced. a e a ge a ea age , ea e a e d g ,f beg d ce a a ge a f ab e f ea age a d e e f a e.S ca a e ae c a e ( ce f e c c a f . If e a g a ge d e a c e ed, f c bac b a a e e e f ec c a f bec e a ge . S e .T ea a f e g e de a d a g ea e a eb c a g e fac f d c , e ), a d e d c e c ea e . e d g fg d e fa a e: Lea age f ec c a f f c e ( a g, a e a ec c a f f c e( e e ,g e e e d e a eac e . If ec a e a e a ea age , ec a e a ge a ea age e c e f bec e d ) a e a c ed b ec ga de ), g e e eed e c ef bec e a e; f a ge . be TEST YOUR UNDERSTANDING 8.1 I gge ed ec c a f a e f c e Te de . de a d g 1.10 C a e 1 e e e a f 8.2 M LEARNING OBJECTIVES define all he erms appearing in in he e (AO1) e plain he e pendi re, income and o p approaches o meas ring GDP in na ional income acco n ing, and sho heir eq i alence sing he circ lar flo of income model (AO2, AO4) e plain he follo ing meas res (AO2) nominal Gross domes ic prod c (GDP) nominal Gross na ional income (GNI) real GDP and real GNI real GDP and real GNI per person (per capi a) real GDP and real GNI per person (per capi a) a p rchasing po er pari (PPP) U I Meas remen of economic ac i i in ol es meas ring an econom s na ional income or he al e of o p , and is referred o as . The o p of an econom is referred o as , also kno n as aggregate output, hich means o al o p . Kno ing na ional income and he al e of aggrega e o p is er sef l beca se his allo s s o: assess an econom s performance o er ime (are income and o p decreasing?) make comparisons of income and o p es ablish a basis for making policies ha increasing o er ime; are he performance i h o her economies ill mee economic objec i es. Yo ma ha e no iced ha e of en refer o he al e of o p . Wh speak in erms of al es, and no in erms of q an i ies, as e did in microeconomics? The ans er is ha in macroeconomics e m s find a a o add p q an i ies of o p of h ndreds of ho sands of differen goods and ser ices. Ye ho can e add p q an i ies of comp ers, apples, cars and hea re icke s? Wha ni of meas remen can e se? To ge aro nd his diffic l , e meas re o p in mone erms, or he al e of goods and ser ices. The al e of a good is simpl i s q an i m l iplied b i s price. Some imes al e ma no be e plici l men ioned. For e ample, one ma speak of he le el of aggrega e o p or simpl aggrega e o p . Wha e er is he case, in macroeconomics o p is al a s in al e erms. H The circ lar flo of income model sho ed ha he al e of aggrega e o p prod ced is eq al o he o al income genera ed in prod cing ha o p , hich is eq al o he e pendi res made o p rchase ha o p . For his reason, he erm , or he o al income of an econom , is some imes sed in erchangeabl i h he al e of aggregate output. We ill no se his principle o see ho na ional income or he al e of aggrega e o p is meas red. There are hree a s o meas re he al e of na ional o p (or aggrega e o p ), s gges ed b circ lar flo of income model, all gi ing rise o he same res l : he he adds p all spending o b a co n r o er a ime period final goods and ser ices prod ced i hin he adds p all income earned b he fac ors of prod c ion ha prod ce all goods and ser ices i hin a co n r o er a ime period he o er a ime period. calc la es he al e of all final goods and ser ices prod ced in a co n r T The e pendi re approach meas res he o al amo n of spending o b final goods and ser ices in a co n r ( s all i hin a ear). The erm final refers o goods and ser ices read for final se, and can be con ras ed i h in ermedia e goods and ser ices, or hose p rchased as inp s for he prod c ion of final goods. When e meas re he al e of aggrega e o p , e incl de onl p rchases of final goods and ser ices. For e ample, food i ems like mea and ege ables are in ermedia e goods for a res a ran ha ses hem o prepare a meal, and he meal is he final good. If in meas ring e pendi res e incl ded spending on he food i ems pl s spending on he meal, his o ld in ol e do ble co n ing and he al e of aggrega e o p o ld be e aggera ed. On he o her hand, mea and ege ables bo gh b a ho sehold for cons mp ion co n as final goods, since he are no sed as inp s for he prod c ion of ano her good or ser ice. To al spending is broken do n in o fo r componen s: C , C, incl des all p rchases b ho seholds on final goods and ser ices in a ear (e cep ho sing, hich is classified nder in es men ).1 Cons mp ion spending is of en referred o as for shor . I , I, incl des: spending b firms on capi al goods (i.e. b ildings, machiner , eq ipmen , e c.) spending on ne cons r c ion (ho sing and o her b ildings).2 In es men spending is of en referred o as for shor . G , G, refers o spending b go ernmen s i hin a co n r (na ional, regional, local). I incl des p rchases b he go ernmen of fac ors of prod c ion, incl ding labo r ser ices. I incl des go ernmen in es men , referred o as p blic in es men , hich s all in ol es roads, airpor s, po er genera ors, b ildings. N ( ), X M, refers o he al e of all e por s (abbre ia ed as X) min s he al e of all impor s (abbre ia ed as M). E por s are goods and ser ices prod ced i hin he co n r and so m s be incl ded in he meas remen of aggrega e o p . Impor s, ho e er, in ol e domes ic spending on goods and ser ices ha ha e been prod ced in o her co n ries, and so m s be s b rac ed from e pendi res meas ring domes ic o p . If e add oge her he fo r componen s of spending, e ob ain a meas re of aggrega e o p gross domestic product (GDP): C + I + G + (X kno n as M) = GDP This approach allo s economis s o see he rela i e con rib ion of each componen of GDP, ho hese migh change o er ime, and o make comparisons o er ime or across co n ries. For e ample, if one is in eres ed in in es men , i is possible o race o ho he share of in es men in GDP changes o er ime and o see ho he share of in es men in one co n r compares i h i s share in o her co n ries. G (GDP) is defined as he marke al e of all final goods and ser ices prod ced in a co n r o er a ime period ( s all a ear). I incl des spending b he fo r componen s, C + I + G + (X M). I is one of he mos commonl sed meas res of he al e of aggrega e o p . S In es men refers o spending b firms or he go ernmen on capi al goods and on cons r c ion. There is a common misconcep ion ha in es men is nder aken onl b firms. This is incorrec , beca se as e ha e seen in he disc ssion abo e, in es men is also nder aken b go ernmen s (p blic in es men s). One reason for his misconcep ion is ha firms are major decision-makers hose con rib ion o GDP is in he form of in es men . Ano her iss e is ha in meas res of aggrega e o p , in es men in capi al incl des onl spending on ph sical capi al. I does no incl de spending on h man capi al and of en i does no incl de spending on na ral capi al (see Chap er 1, Sec ion 1.1 for hese dis inc ions). This can be conf sing, beca se economis s of en refer o in es men s in h man capi al and in es men s in na ral capi al , and e hese in es men s do no appear as in es men s in meas res of aggrega e o p . Man economis s arg e ha na ional income acco n ing me hods sho ld be changed o incl de hese pes of in es men s as ell. No e ha meas res of aggrega e o p also do no incl de financial capi al or social capi al (see Chap er 1, Sec ion 1.1), b his is j s ifiable as hese pes of capi al do no represen al e of goods and ser ices prod ced. T The income approach adds p all income earned b he fac ors of prod c ion i hin a co n r o er a ime period ( s all a ear): ages earned b labo r, ren earned b land, in eres earned b capi al and profi s earned b en reprene rship. When all fac or incomes are added p, he res l is national income. Whereas na ional income is of en sed as a meas re of he le el of economic ac i i , i is no he same as GDP. To calc la e GDP sing he income approach, i is necessar o make some adj s men s o na ional income.3 This approach allo s economis s o see he rela i e income shares of he differen fac ors of prod c ion, ho hese migh change o er ime, and o make comparisons o er ime or across co n ries. For e ample, if e are in eres ed in ages of orkers, e can see ho he share of ages in na ional income changes o er ime and ho his share in one co n r compares i h i s share in o her co n ries. T The o p approach meas res he al e of each good and ser ice prod ced in he econom o er a par ic lar ime period ( s all a ear) and hen s ms hem p o ob ain he o al al e of o p prod ced. I incl des he al e of all final goods and ser ices, in order o a oid he do ble co n ing ha o ld arise from incl ding he al es of in ermedia e goods and ser ices.4 The o p approach calc la es he al e of o p b economic sec or, s ch as agric l re, man fac ring, ranspor , banking, e c. The al e of o p of each sec or is hen added p o ob ain he o al al e of o p for he en ire econom . This approach pro ides economis s i h he oppor ni o s d he performance of each indi id al sec or b looking a i s rela i e share in o al o p , ho his changes o er ime and o make comparisons of performance across sec ors across co n ries. The hree approaches gi e rise o he same res l , af er allo ance is made for s a is ical differences ha arise in he co rse of meas ring he differen ariables in ol ed. TEST OUR UNDERSTANDING 8.2 1 E plain h he erms na ional income and aggrega e o p 2 Iden if some reasons h i is sef l o kno he al e of aggrega e o p . 3 E plain h e meas re aggrega e o p are of en sed in erchangeabl . in al e erms, and e co n onl 4 Iden if 5 he al e of final goods and ser ices hen meas ring he al e of o p . he fo r e pendi re componen s of GDP and e plain each of hese. E plain hree a s ha GDP can be meas red. O line he pe of informa ion each approach offers abo 6 Using he circ lar flo model, e plain h res l . he econom . he hree a s o meas re GDP gi e rise o he same D D GDP GNI Under he e pendi re approach o meas ring aggrega e o p , e learned he meaning of gross domes ic prod c (GDP), hich is he marke al e of all final goods and ser ices prod ced in a co n r o er a ime period ( s all a ear), and incl des he fo r componen s of spending: C + I + G + (X M). In addi ion, sing he circ lar flo of income model, e learned ha he al e of o p prod ced in an econom is eq al o he o al income genera ed in prod cing ha o p . Ho e er, in he real orld, his eq ali does no al a s hold. Some imes he o p of an econom is prod ced b fac ors of prod c ion ha belong o foreigners. Consider he case here a US m l ina ional firm in India remi s (sends back) i s profi s o he Uni ed S a es. The o p of he m l ina ional is prod ced in India, b he profi income is recei ed b residen s in he Uni ed S a es. Does he profi income co n as Indian or US income and o p ? Consider also a R ssian orker ho li es and orks in Spain, and sends a large par of her income o her famil in R ssia. Her o p is prod ced in Spain, b he income she sends home is R ssian income; sho ld his income co n as R ssia s or Spain s income and o p ? The concep s domes ic and na ional are sed o dis ing ish be een meas res of aggrega e o p and income ha deal i h his iss e. The erm domes ic in gross domes ic prod c means ha o p has been prod ced b fac ors of prod c ion domes icall , or i hin he co n r , regardless of ho o ns hem (residen s or foreigners). The erm na ional is sed in ano her meas re of aggrega e o p kno n as (GNI). The erm na ional in GNI means ha he income i meas res is he income of he co n r s residen s, regardless here his income comes from. In he firs e ample abo e, he profi income remi ed o he Uni ed S a es is incl ded in Indian GDP beca se i is crea ed b prod c ion in India, b i is par of US GNI beca se i is income recei ed b US residen s. The R ssian orker s o p in Spain is incl ded in Spain s GDP, b her income sen o R ssia is par of R ssia s GNI. GDP is he o al al e of all final goods and ser ices prod ced i hin a co n r o er a ime period ( s all a ear), regardless who owns the factors of production. GNI is he o al income recei ed b he residen s of a co n r , eq al o he al e of all final goods and ser ices prod ced b he fac ors of prod c ion s pplied b he co n r s residen s regardless where the factors are located. We ill disc ss GDP and GNI f r her in Chap er 18. I ma in eres some in erna ional comparisons. o o rn o Table 18.2 o see D Earlier e no ed ha in macroeconomics e meas re o p in al e erms, and e defined al e o be he q an i of a good m l iplied b i s price. N is mone al e, or al e meas red in erms of prices ha pre ail a he ime of meas remen . For e ample, if a pair of shoes cos s 100, his is i s nominal al e. If o b his pair of shoes, 100 is o r nominal e pendi re on hese shoes. If o r mon hl income is 2000, his is o r nominal income. Therefore, hen e calc la e he al e of aggrega e o p , or e pendi re, or income, in mone nominal e penditure, e c. erms, e speak of nominal GDP, nominal GNI, Ye prices change o er ime, and his poses a meas remen problem. Le s sa ha nominal GDP increases in a ear. This increase ma be d e o changes in he q an i ies of o p prod ced, or changes in he prices of goods and ser ices, or a combina ion of bo h. We do no kno ha par of he increase is d e o changes in o p and ha par o changes in prices. Ye e are in eres ed in kno ing ho m ch he quantit of goods and ser ices has increased. We m s herefore find a meas re of GDP ha is no infl enced b price changes. To elimina e he infl ence of changing prices on he al e of o p , e m s calc la e real al es. R is a meas re of al e ha akes in o acco n changes in prices o er ime. Meaningf l comparisons o er ime in he al e of o p , or e pendi res, or income, or an ariable ha is meas red in mone erms, req ire he se of real al es. For e ample, hen e make comparisons of GDP in a co n r o er ime, e m s be s re o se real GDP al es, as hese ha e elimina ed he infl ence of price changes, and gi e s an indica ion of ho ac al o p prod ced has changed. N GDP and GNI are meas red in erms of c rren prices (prices a he ime of meas remen ), hich does no acco n for changes in prices. R GDP and GNI are meas res of economic ac i i ha ha e elimina ed he infl ence of changes in prices. When a ariable is being compared o er ime, i is impor an o se real al es. D per capi a Per capita is a Latin e pression that means per person. A per capita meas re akes he o al al e (of o p , income, e pendi re, e c.) and di ides his b he o al pop la ion of a co n r . Therefore GDP per capi a of a co n r is o al GDP of ha co n r di ided b i s pop la ion. The dis inc ion be een o al and per capita meas res is er impor an for o reasons: D . Le s sa here are o co n ries ha ha e iden ical o al GDPs of 10 billion. Co n r A has a pop la ion of 1 million people and co n r B has a pop la ion of 2 million people. If e di ide o al GDP b pop la ion e ge GDP per capita of 10 000 for co n r A and 5000 for co n r B. Whereas bo h co n ries ha e iden ical GDPs, co n r B s per capita GDP is onl half ha of co n r A, beca se of differing pop la ion si es. P . Changes in he si e of GDP (or GNI) per capita o er ime depend er m ch on he rela ionship be een gro h in o al GDP (or GNI) and gro h in pop la ion. In general, if o al GDP increases fas er han he pop la ion, hen GDP per capita increases. B if he co n r s pop la ion increases fas er han o al GDP, hen GDP per capita falls. To al meas res of he al e of o p and income (s ch as GDP and GNI), pro ide a s mmar s a emen of he o erall si e of an econom . Per capi a fig res are sef l as a summar measure of he s andard of li ing in a co n r , beca se he pro ide an indica ion of ho m ch of o al o p or o al income in he econom corresponds o each person in he pop la ion on a erage. T GDP/GNI per capi a (PPP) In order o be able o make acc ra e comparisons of real GDP/real GNI or real GDP per capita/real GNI per capita across countries, e need o make ano her dis inc ion. The reason is ha differen co n ries ha e differen price levels. This means ha he same amo n of mone in a lo -price co n r has grea er p rchasing po er (can b more hings) han in a high-price co n r . S ppose a cand bar cos s 3 in a high-price co n r and he same cand bar cos s 1.50 in a lo -price co n r . This means ha he 3 o ha e in o r pocke can b one cand bar in he high-price co n r and o cand bars in he lo -price co n r . Yo r 3 has grea er purchasing power in he lo -price co n r . P rchasing po er refers o he q an i of goods and ser ices ha can be bo gh i h mone . Clearl if e do no ake price le el differences in o acco n , e ill no ge an acc ra e pic re of differences across co n ries in he al e of o p he prod ce. We herefore need a me hod of c rrenc con ersions (changing he c rrenc of one co n r in o he c rrenc of ano her co n r ) ha acco n s for differen price le els, and herefore differen p rchasing po ers across co n ries. S ch a me hod is pro ided b special e change ra es called (PPP ). (Yo ill learn abo e change ra es in Chap er 16.) P rchasing po er pari li erall means b ing po er eq i alence . I is defined as he amo n of a co n r s c rrenc ha is needed o b he same q an i of local goods and ser ices ha can be bo gh i h US$1 in he Uni ed S a es. The se of PPPs o make comparisons of an meas re, he her GDP or GNI or an hing else, elimina es he infl ence of price le el differences and makes comparisons across co n ries far more acc ra e. (Use of he US$ as he basis for he con ersions is onl a ma er of con en ion, as o her c rrencies o ld also ha e been s i able for his p rpose.) P rchasing po er pari ies ill be disc ssed f r her in Chap er 18. Yo ma be in eres ed o see Table 18.3, hich sho s per capi a GDP calc la ed bo h b se of s andard e change ra es (col mn 1) and b se of p rchasing po er pari ies (col mn 2). Comparisons of GDP per capita (or GNI per capita) across co n ries req ire meas res of per capita o p or income based on con ersions of na ional c rrencies in o US$ b se of p rchasing po er pari ies (PPPs), o elimina e he infl ence of price differences on he al e of o p or income. P rchasing po er pari e change ra es are comp ed and p blished on a reg lar basis b se eral in erna ional bodies, incl ding he Organisa ion for Economic Co-opera ion and De elopmen (OECD), E ropean Union, he World Bank and Uni ed Na ions agencies T gross (S ) If o are in eres ed in learning abo he meaning of gross in gross domestic product o e plana ion in he digi ial co rsebook. ill find he TEST OUR UNDERSTANDING 8.3 1 Define GDP and GNI, and o line ho he differ. Research and pro ide some e amples of co n ries here (i) GNI is likel GDP, and (ii) GDP is likel o be larger han GNI. o be larger han 2 E plain he difference be een nominal GDP and real GDP (or nominal and real GNI). 3 O line h i is impor an o se real al es hen making comparisons o er ime. 4 Yo read in he ne spaper ha go ernmen spending on ed ca ion in o r co n r increased b 7% las ear. Iden if and describe f r her informa ion ha co ld help o make sense of his fig re. 5 O line he difference be een o al GDP (or GNI) and per capita GDP (or GNI). E plain h is i some imes impor an o make a dis inc ion be een o al meas res and per capita meas res of income and o p . 6 E plain h price changes o er ime pose a problem hen e an o make comparisons of GDP (or an meas re of o p or income) o er ime. O line h he se of p rchasing po er pari ies (PPPs) is necessar o ens re ha comparisons of GDP or GNI fig res across co n ries are meaningf l. 1 Spending b cons mers is classified as spending on (i) cons mer d rable goods ( i h an e pec ed life of more han hree ears, s ch as cars, refrigera ors, ashing machines, ele isions, e c.), (ii) cons mer non-d rable goods ( i h an e pec ed life of less han hree ears, s ch as food, clo hing and medicines), and (iii) ser ices (en er ainmen , banking, heal h care, ed ca ion, e c.). 2 In es men spending incl des one more i em: changes in in en ories. In en ories refer o o p prod ced b firms ha remains nsold. B sinesses as a r le keep in en ories o help hem mee ne pec ed increases in he demand for heir prod c . Since in en ories are o p , i means ha he m s be co n ed as par of he aggrega e o p ha is being meas red. Ho e er, since he are o p ha has no been sold, he canno be co n ed nder cons mp ion e pendi re; he are herefore co n ed nder in es men . In es men spending is of en referred o as for shor . 3 A de ailed considera ion of hese adj s men s is be ond he scope of his book. For he in eres ed s den , he ill be men ioned briefl here. If e add deprecia ion and indirec a es o na ional income, e ob ain a meas re of aggrega e o p called gross na ional income (GNI). The difference be een GNI and GDP ill be considered la er in his chap er. Deprecia ion refers o he earing o of capi al goods, and ill also be considered la er. The reason e add deprecia ion and indirec a es o na ional income in order o ob ain GNI (and GDP) is ha he al e of o p meas red b he e pendi re approach incl des bo h hese i ems. B con ras , na ional income, meas ring onl he incomes of he fac ors of prod c ion, does no incl de ei her of he o. 4 The me hod sed o ob ain he al e of onl final goods and ser ices is o co n onl he al e added in each s ep of he prod c ion process. For e ample, sa he prod c ion of a good goes hro gh he follo ing s eps. Firm A sells ra ma erials for $700 o firm B. Firm B ses he ra ma erials and prod ces an in ermedia e good ha i sells o firm C for $1100. Firm C ses his in ermedia e good o prod ce a final good ha i sells for $1700. Ho m ch al e has been added in his process? Firm A added $700 of al e. Firm B added $400 of al e (= $1100 $700), and firm C added $600 of al e (= $1700 $1100). When e add hese p e ob ain: $700 + $400 + $600 = $1700. No e ha he s m of he al es ha ere added in each s ep of he prod c ion process is e ac l eq al o he al e of he final prod c . If e had added p he al es of he o in ermedia e prod c s and he final prod c , e o ld ha e: $700 + $1100 + $1700 = $3500, hich grea l e aggera es he al e of he prod c d e o do ble co n ing. B co n ing onl al es added in each s ep of he prod c ion process, he problem of do ble co n ing is a oided. 8.3 C LEARNING OBJECTI ES After stud ing this section ou ill be able to: define all the terms appearing in in the te t calculate the follo ing measures (AO4) nominal Gross domestic product (GDP) using the e penditure approach nominal Gross national income (GNI) real GDP and real GNI real GDP and real GNI per capita C GDP We ha e seen that the measurement of GDP using the e penditure approach in ol es adding up the four spending components: consumption (C), firm in estment (I), go ernment spending (G) and e ports minus imports (X M). Therefore, GDP = C + I + G + (X M). (It is also possible to calculate GDP using the income and output approaches but this is be ond the scope of IB requirements.) Suppose e are gi en the national income statistics for a countr called Mountainland in Table 8.1 (Mnl is Mountainland s national currenc ). Consumer spending 11.3 In estment spending 3.2 Go ernment spending 3.5 E ports of goods and ser ices 2.5 Imports of goods and ser ices 2.1 T 8.1: National income statistics for Mountainland, 2019 (billion Mnl) Using this information, e find that nominal GDP = 11.3 + 3.2 + 3.5 + 2.5 2.1 = 18.4 billion Mnl in 2019. Note that all these figures are in nominal terms; therefore, this alue of GDP is a nominal alue. C GNI The difference bet een GDP and GNI as e plained earlier. Gi en data on GDP, e can find GNI in the follo ing a : e add to GDP the income of domestic residents earned abroad, and subtract from GDP the income paid abroad to foreigners. Therefore: GNI = GDP + income from abroad Income from abroad therefore ha e: income sent abroad income sent abroad can be simpl GNI = GDP + net income from abroad ritten as net income from abroad . We Note that in the United Kingdom and in some other countries, net income from abroad ma be referred to as net propert income from abroad . In the United States, it is sometimes referred to as net foreign factor income or net factor income . For e ample, suppose in 2020, Ri erland s GDP as $46 billion: income earned abroad and sent home to Ri erland as $2.7 billion; income earned in Ri erland and sent abroad as $4.7 billion. What as Ri erland s 2020 GNI? Ri erland s net income from abroad as $2.7 billion minus $4.7 billion = $2 billion. Therefore, 2020 GNI = $46 billion $2 billion = $44 billion Note that this alue of GNI is a nominal alue. C GDP GNI GDP The distinction bet een nominal and real alues as discussed abo e. We ill no use a numerical e ample to sho ho real GDP can be calculated from nominal GDP. This is normall done b statistical ser ices in each countr and our e ample here is for illustration purposes onl ( ou ill not ha e to perform such calculations). Table 8.2 assumes a simple econom producing three items (burgers, haircuts and tractors). Part (a) sho s their quantities and prices for three ears and the corresponding nominal GDP. In 2001, 37 burgers selling at 3 each made the total alue of burgers 111; 15 haircuts at 18 each had a alue of 270; and 10 tractors at 50 each made the total alue of tractors 500. Adding up the three total alues, e find nominal GDP of 881 in 2001. The nominal GDP figures for 2002 and 2003 are calculated in the same a . Part (b) of Table 8.2 sho s that to find real GDP, it is onl necessar to find the alue of quantities produced in 2001, 2002 and 2003 using the same prices of a single ear, called a base ear. An ear can be used as the base ear. In the table the base ear is 2001. To calculate real GDP, e simpl multipl the quantities of output produced each ear b 2001 prices. Notice that columns 3, 6 and 9 are identical. For e ample, in 2002, the 40 burgers are alued at the 2001 burger price of 3; the 17 haircuts are alued at the 2001 price of 18, and the 11 tractors are alued at the 2001 price of 50. Adding up the resulting alues of the three items in column 7, e get a measure of real GDP of 976 in 2001 prices. Similarl , for 2003, the three quantities are also alued at the 2001 prices. Therefore, real GDP is a meas re of o tp t al ed at constant ( nchanging) prices. Nominal GDP measures the alue of current output alued at current prices, hile real GDP measures the alue of current output alued at constant (base ear) prices. Calculating nominal GDP 1 G 2 2001 Q 3 2001 P 4 2001 (Q 5 2002 Q 6 2002 P P) 7 2002 (Q 8 2003 Q 9 2003 P P) 10 2003 (Q P) B 37 3 111 40 4 160 39 5 195 H 15 18 270 17 20 340 18 21 378 T 10 50 500 11 60 660 10 65 650 1 G 2 2001 Q 3 2001 P 4 2001 (Q 5 2002 Q 6 2002 P P) (Q 881 N GDP 7 2002 8 2003 Q 9 2003 P P) 10 2003 (Q 1160 P) 1223 Calculating real GDP 1 G 2 2001 Q 3 2001 P 4 2001 5 2002 Q 6 2001 P 2001 P (Q P) 7 2002 8 2003 Q 9 2001 P 2001 P (Q P) 10 2003 2001 P (Q P) B 37 3 111 40 3 120 39 3 117 H 15 18 270 17 18 306 18 18 324 T 10 50 500 11 50 550 10 50 500 R GDP T 881 976 941 8.2: Nominal and real GDP in a h pothetical econom E amining the changes in real GDP that occurred bet een 2001 and 2003, e find that real GDP increased from 2001 to 2002 (from 881 to 976), but decreased bet een 2002 and 2003, falling from 976 to 941. Note that real GDP fell in 2002 2003 e en as nominal GDP increased o er the same period; price increases caused nominal GDP to rise, hile falling quantities meant that real GDP as falling. Note also that in the base ear, 2001, nominal GDP is equal to real GDP; this is al a s so for the base ear since real GDP is alued at base ear prices. When e refer to real GDP figures, e must also refer to the specific base ear used for the computation. In the e ample abo e, e sa in 2003 real GDP at 2001 prices as 941 . The figure of 941 is other ise meaningless, because if e had used a different base ear, e ould ha e arri ed at a completel different figure for 2003 real GDP. It is also meaningless to compare real GDP figures calculated on the basis of different base ears. GDP In the real orld, the abo e method of con erting nominal alues into real alues is e tremel length and complicated, as there are hundreds of thousands of products hose alues must be measured. Ho e er, this is not a problem because economists use short-cut methods that take the form of price indices (indices is the plural of inde ). A price inde is a measure of a erage prices in one period relati e to a erage prices in a base ear. A price inde commonl used to con ert nominal GDP to real GDP is a kno n as the GDP deflator: GDP deflator= nominal GDP real GDP 100 Statistical ser ices deri e the GDP deflator b using the alues of nominal and real GDP the ha e alread calculated (b the method in Table 8.2): GDP deflator in 2001= 881 881 100=100.0 GDP deflator in 2002= 1160 976 100=118.8 GDP deflator in 2003= 1223 941 100=130.8 These results are summarised in Table 8.3. Note that the GDP deflator is 100.0 for 2001. The inde n mber for the base ear is al a s eq al to 100, for all indices. This follo s from the equalit of nominal and real GDP in 2001, as e had selected 2001 to be the base ear. N GDP R GDP GDP 2001 881 881 100.0 2002 1160 976 118.8 2003 1223 941 130.0 T 8.3: Nominal and real GDP GDP GDP Statistical ser ices in each countr regularl publish GDP deflators (and other price indices). Using this information, it is a simple matter for economists to calculate real GDP from nominal GDP: real GDP = nominal GDP price deflator 100 For e ample, suppose e are gi en the follo ing alues of nominal GDP for a h pothetical Countr X: $7850 billion in 2001; $9237 billion in 2002; and $10 732 billion in 2003. We are also gi en the GDP deflator in Table 8.3, and are asked to calculate real GDP: real GDP in 2001= 7850 100.0 100=$7850 billion real GDP in 2002= 9237 118.8 100=$7775 billion real GDP in 2003= 10732 130.0 100=$8255 billion Note that an increasing GDP deflator indicates rising prices on a erage, hile a decreasing GDP deflator indicates falling prices on a erage. Suppose e ha e the follo ing price inde representing the GDP deflator: 2004 2005 2006 2007 2008 95.7 97.7 100.0 105.9 102.4 We can see that hereas prices on a erage increased in the period 2004 2007, in 2008 the fell. We can also see that the base ear is 2006. Note that it is possible for some ears to ha e a price inde that is less than 100.0, hich means simpl that in those ears, the a erage price le el as lo er than in the base ear. C per capita Suppose that the population of Countr X abo e as 310 million in 2001. We ould like to calculate its real GDP per capita in that ear: real GDP per capita = $7850 billion 310 billion =$25 323 Note that real GNI per capita, or an other measure per capita is calculated in e actl the same a . TEST O R NDERSTANDING 8.4 1 Calculate nominal GDP, gi en the follo ing information from the national accounts of Flatland for the ear 2019 (all figures are in billion Ftl, the national currenc ). Consumer spending = 125; go ernment spending = 46; in estment spending = 35; e ports of goods and ser ices = 12; imports of goods and ser ices = 17. 2 No suppose that profits of foreign multinational corporations in Flatland and incomes of foreign orkers in Flatland that ere sent home in 2019 ere Ftl 3.7 billion. The profits of Flatland s multinational corporations abroad and income of Flatland orkers abroad that ere sent back to Flatland ere Ftl 4.5 billion. What as Flatland s GNI in 2019? 3 You read in one source of information that real GDP in a h pothetical countr in 2001 as $243 billion; in another source of information ou read that real GDP in 2002 as $277 billion. State hat information ou need to be sure that the t o figures can be compared ith each other. 4 You are gi en the information in the table on an imaginar countr called Lakeland. N ( GDP L ) P (GDP P 2015 2016 2017 2018 2019 19.9 20.7 21.9 22.6 22.3 98.5 100.0 102.3 107.6 103.7 1.20 1.21 1.22 1.23 1.27 ) Identif the base ear. Calculate real GDP for each of the fi e ears in the table. State hich ear real GDP is the same as nominal GDP. Outline h . In 2017 2018, nominal GDP increased, but real GDP fell (check that this is hat our calculations sho ). E plain ho this could ha e happened. In 2018 2019, nominal GDP fell, but real GDP increased (check that this is hat our calculations sho ). E plain ho this could ha e happened. Calculate real GDP per capita for each of the ears. In 2018 2019, real GDP increased but real GDP per capita fell (check that this is hat our calculations sho ). E plain ho this could ha e happened. 8.4 T LEARNING OBJECTIVES After studying this section you will be able to: • define all the terms appearing in in the text (AO1) • explain the business cycle (AO2, AO4) • distinguish between short-term fluctuations and the long-term growth trend (potential output) and draw a diagram illustrating these (AO2, AO4) U T Whereas real output in most countries around the world grows over long periods of time, output growth virtually everywhere is uneven and irregular. In some years (or months) real output may grow rapidly, in other years (or months) more slowly, and in still others it may even fall, indicating negative growth. A business cycle is shown in Figure 8.3, which plots real GDP on the vertical axis, against time on the horizontal axis. GDP is measured in real terms, so that the vertical axis measures changes in the volume of output produced after the influence of price-level changes has been eliminated. The cyclical line shows actual output, or real GDP that is actually achieved over time. B consist of in the growth of real output, which are alternating periods of expansion (increasing real output) and contraction (decreasing real output). Each cycle consists of the following phases: • E . An expansion occurs when there is positive growth in real GDP, shown by those parts of the curve in Figure 8.4 that slope upward. During expansions, employment of resources increases, and the general price level of the economy (which is an average over all prices) usually begins to rise more rapidly (this is known as inflation, to be discussed in Chapter 10). • P . A peak represents the cycle s maximum real GDP, and marks the end of the expansion. When the economy reaches a peak, unemployment of resources has fallen substantially, and the general price level may be rising quite rapidly; the economy is likely to be experiencing inflation. • C . Following the peak, the economy begins to experience falling real GDP (negative growth), shown by the downward-sloping parts of the curve. If the contraction lasts six months (two quarters) or more, it is termed a , characterised by falling real GDP and growing unemployment of resources. Increases in the price level may slow down a lot, and it is even possible that prices in some sectors may begin to fall. • T . A trough represents the cycle s minimum level of GDP, or the end of the contraction. There may now be widespread unemployment. A trough is followed by a new period of expansion (also known as a recovery), marking the beginning of a new cycle. The term ‘business cycle suggests a phenomenon that is regular and predictable, whereas business cycles are in fact both irregular, as they do not occur at regular time intervals, and unpredictable. For these reasons, many economists prefer to call them ‘short-term economic fluctuations . While each cycle typically lasts several years, it is not possible to generalise, as there is wide variation in how long the cycle lasts, as well as in intensity (how strong the expansion is and how deep the contraction or recession is). Expansions usually last longer than contractions. These are the reasons why the curve in Figure 8.3 has an irregular shape. S T - - Figure 8.3 shows a line going through the cyclical line; this represents average growth over long periods of time (many years) and is known as the . The long-term growth trend shows how output grows over time when cyclical fluctuations are ironed out. As you can see in the figure, real GDP actually achieved fluctuates around potential GDP (it fluctuates around the long-term growth trend). F 8.3: The business cycle The output represented by the long-term growth trend is known as or potential GDP. To understand the meaning of potential output, we must examine the relationship between real GDP and unemployment. H When real GDP fluctuates, it does so together with other macroeconomic variables. One of the most important of these is unemployment of labour, or how many people in the workforce are out of work. When real GDP grows in the expansion phase, unemployment falls; in the contraction phase when real GDP falls, unemployment increases. You can easily see why: in an expansion, real GDP increases because firms produce more output; to do this, they hire more labour (and other resources) and unemployment falls. In a contraction, real GDP falls because firms cut back on production; as they lay off workers, unemployment increases. For every economy, there is a level of real GDP at which the economy experiences ‘full employment . This is known as the full employment level of output, or full employment level of real GDP. The term does not mean that all resources, including all labour resources, are employed to the greatest extent possible. Whenever the economy produces its ‘full employment level of output , there is still some unemployment, known as the ‘natural rate of unemployment . This is because at any time, there are some people who are in between jobs, some who are moving from one geographical area to another, some people who are training or retraining to be able to get a new or better job, and some people who are temporarily out of work. Therefore, there are always some people who are unemployed. Coming back to potential output (shown by the long-term growth trend), we can now say that this is the level of output produced when there is ‘full employment , meaning that unemployment is equal to the natural rate of unemployment. But when actual GDP is greater than potential GDP, unemployment is lower than the natural rate; when actual GDP is less than potential GDP, unemployment is greater than the natural rate. C , Figure 8.4 introduces another concept related to the business cycle. When actual GDP lies above potential GDP (as at point d), or below potential GDP (as at point e), there results a GDP gap, also known as an output gap. The output gap is simply actual GDP minus potential GDP, and may be positive or negative. When actual GDP is equal to potential GDP (as at points a, b, c) the output gap is equal to zero. The usefulness of these concepts will become apparent in later chapters when we make use of them to analyse short-term economic fluctuations and long-term growth. Figure 8.4 shows that actual GDP fluctuates around full employment GDP, also known as potential GDP. When the economy s actual GDP is at points such as a, b and c, actual GDP is equal to potential GDP, and the economy is achieving full employment, where unemployment is equal . When the economy s actual GDP is greater than potential GDP, such as at point d, there is an output gap, and unemployment falls to less than the natural rate. When actual GDP is less than potential GDP, such as at point e, there is an output gap where unemployment is greater than the natural rate. F 8.4: Illustrating actual output, potential output and unemployment in the business cycle W In an ideal world, every economy would experience economic growth over long periods of time, with continuous low levels of unemployment and a stable or gently rising price level (low inflation). Rapid economic growth, full employment, and price stability are among the key macroeconomic objectives of economies. Figure 8.5 illustrates these objectives in terms of the business cycle. Using the business cycle, we can understand macroeconomic objectives to include: Reducing the intensity of expansions and contractions: this is aimed at making output gaps as small as possible (the dotted line in Figure 8.5(a)), by flattening the cyclical curve. This would lessen the problems of rising price levels or inflation in expansions and unemployment in contractions. Increasing the steepness of the line representing potential output (the dotted line in Figure 8.5(b)), by achieving more rapid economic growth over long periods of time. F 8.5: Illustrating three macroeconomic objectives In the next chapter we will develop analytical tools to help us understand the causes of the business cycle, and in Chapter 13 we will study government policies intended to achieve full employment, price stability and economic growth. TEST OUR UNDERSTANDING 8.5 1 Using the business cycle diagram, distinguish between short-term fluctuations and the longterm growth trend. 2 Using a diagram: identify the phases of the business cycle, describe how they relate to unemployment, and distinguish between actual and potential output. 3 Describe how the ‘natural rate of unemployment relates to the ‘full employment level of output and to ‘potential output . 4 Suggest what an economy s business cycle is experiencing when there is a horizontal potential GDP line, and a downward-sloping potential GDP line. 5 Use a business cycle diagram to describe three important macroeconomic objectives. THEOR OF KNOWLEDGE 8.1 T , : We have seen in our discussion of the business cycle (see Figure 8.4) that economists are concerned with two representations of output growth: growth of actual output and growth of potential output. Growth of actual output is straightforward to measure and show graphically; it consists of real GDP (or GNI) calculated for each year, and plotted on the vertical axis against time measured on the horizontal axis. When such data are plotted for any country over long periods of time, a cyclical pattern is likely to emerge (though an irregular one, for reasons explained in the text), known as the business cycle, or short-term fluctuations. Therefore, the empirical evidence supports the existence of a business cycle. The case of potential output is different. Potential output is defined as full employment output, where unemployment is equal to the natural rate of unemployment, and its growth is shown by the long-term growth trend. However, for any particular economy, for any particular year, no one really knows what potential output is; nor does anyone know what the natural rate of unemployment is. Economists do not have any variable called ‘potential output or ‘natural rate of unemployment that they can observe in the real world and measure. Of course, economists make efforts to estimate the value of potential output (and the natural rate of unemployment), and to estimate how potential output changes over time. This then raises the question, does potential output actually e ist, in the way that actual output can be said to exist, or is it a mythical idea that economists have created to help with their analysis of the macro economy? It is not possible to provide a definite answer to this question; since potential output cannot be observed or measured, we cannot know if it exists. However, when theorising, there is nothing wrong with assuming the existence of something that cannot be directly observed; in other words, something whose existence is not supported by direct evidence. (Note that this is very different from making unrealistic assumptions, which conflict with the real world.) Physicists do this sometimes, with success. For example, to explain an event at the sub-atomic level (within atoms) it was necessary to presume the existence of a particle, though there was no direct evidence that such a particle actually existed. This fictional particle was named a neutrino, and 20 years later the neutrino was experimentally detected. Sometimes, the unobserved variable may be supported by indirect evidence. For example, say we cannot observe X, but if X exists, then it is likely that Y exists; if we can observe and measure Y, then we can infer some characteristics about X. In the case of the neutrino, its existence was inferred from indirect evidence. (Note, however, that inference is not a full-proof method to arrive at conclusions about something, and may lead to wrong conclusions. For example, it may be true that if X exists, then Y also exists; but this does not necessarily mean that if Y exists, then X exists. To understand why, suppose that X = it is raining and Y = it is cloudy. If X is true (it is raining), then Y is true (it is cloudy). But if Y is true (it is cloudy), X (it is raining) is not necessarily true.) Some economists argue that the existence of potential output is supported by indirect evidence, which may be helpful in making estimates about its size. Estimates of potential output can be useful to economists concerned with economic policy. T • Can you think of other variables used by economists that are not directly observable or measurable? • Do you think the inability to observe some variables makes the social scientific method less ‘scientific ? • What kinds of difficulties might be created for policy-makers who use the concept of ‘potential output to determine appropriate policies for the economy? 8.5 National income statistics and alternative measures LEARNING OBJECTIVES Af e d ing hi ec ion o ill be able o: define all he e m appea ing in orange bold in he e e al a e he app op ia ene mea of GDP o GNI a i ic fo he p po e of (AO3) ing economic ell-being o e ime compa ing economic ell-being ac o e plain al e na i e mea co n ie e of ell-being incl ding (AO2) he OECD Be e Life Inde he Happine Inde he Happ Plane Inde Evaluating national income statistics When eal e ca i a GDP o eal e ca i a GNI of a co n inc ea e o e ime, e migh e pec ha he pop la ion of hi co n imp o e economic ell-being. Al e na i el , if GDP e ca i a o GNI e ca i a in one co n i highe han in ano he co n , e migh e pec ha he fi co n enjo a highe economic ell-being. B o ld he e concl ion be alid? The an e i ha e canno be e. The e a e o ea on h hi i o. One i ha national income statistics (o a i ical da a ed o mea e na ional income and o p and o he mea e of economic pe fo mance) do no acc a el mea e he e al e of o p p od ced in an econom . The o he i ha economic ell-being i clo el ela ed o a a ie of fac o ha GDP and GNI a e nable o acco n fo . A a e l , e ca i a fig e of bo h GDP and GNI ma be mi leading hen ed o make compa i on o e ime o compa i on be een co n ie , and hen ed a he ba i fo economic ellbeing concl ion . Why national income statistics (GDP/GNI) do not accurately measure the ‘true value of output GDP and GNI do not include non-marketed output. GDP mea e he al e of good and e ice ha a e aded in he ma ke place and ha gene a e income fo he fac o of p od c ion. Ye ome o p of good and e ice i no old in he ma ke and doe no gene a e an income; hi i called non-ma ke ed o p . An e ample i one o n o k on epai ing and imp o ing one home; if he home epai e e ca ied o b hi ed o ke , GDP o ld be g ea e b he amo n of hei age . In de eloping co n ie ho ehold a e of en q i e elf- fficien , i h a b an ial po ion of p od c ion, ch a ag ic l al p od c ion, aking place fo a ho ehold o n e and con mp ion, and ne e eaching he ma ke place. Non-ma ke ed o p he efo e i likel o be fa g ea e in de eloping co n ie compa ed o mo e de eloped one . Man co n ie a emp o a i e a an e ima e of non-ma ke ed o p , and b adding hi o fig e on ma ke ed o p a i e a a clo e app o ima ion of e GDP/GNI. GDP and GNI do not include output sold in underground (parallel) markets. He e e ha e he ca e he e good a e aded in ma ke and do gene a e income , b he go n eco ded and he efo e a e no incl ded in GDP/GNI. An nde g o nd ma ke (al o kno n a a pa allel o an info mal ma ke ) e i hene e a b ing/ elling an ac ion i n eco ded. I ma in ol e he ale of legal good and e ice , ch a e elling a good a a highe p ice if he e i a p ice ceiling ( ee Chap e 4); o hen a pl mbe doe epai in o home and doe no epo he income ecei ed o a oid pa ing a e . Al e na i el , i ma incl de an ac ion in ol ing illegal good and e ice ( ch a d g ). In he e ca e a ell, e ima e of he i e of nde g o nd ma ke can be made, and hen added o he official (o eco ded) econom , can a i e a a clo e app o ima ion of e GDP and GNI. GDP and GNI do not take into account quality improvements in goods and services. The q ali of man p od c imp o e o e ime, e hi i no aken in o acco n in calc la ing he al e of o al o p . Technological ad ance of en pe mi imp o ed p od c o be old a lo e p ice (fo e ample, mobile phone and comp e ). Thi p oce offe ignifican benefi o con me , hich do no ho p in GDP and GNI fig e . GDP and GNI do not account for the value of negative externalities, such as pollution, toxic wastes and other undesirable by-products of production. Vi all all co n ie con ib e o en i onmen al deg ada ion, ed cing ocie ell-being, ho gh hi i no eflec ed in GDP/GNI fig e . GDP and GNI do not take into account the depletion of natural resources. The deple ion of na al e o ce ( ainfo e , ildlife, ag ic l al oil , e c.) al o ed ce ocie ell-being, e i no aken in o con ide a ion. GDP and GNI and differing domestic price levels. Good and e ice of en ell fo e diffe en p ice in diffe en co n ie . If in e na ional compa i on of GDP do no acco n fo diffe ing p ice le el ac o co n ie , he e l i a highl mi leading pic e of anda d of li ing in diffe en co n ie . Thi p oblem can be effec i el deal i h if e con e al e of GDP and GNI of diffe en co n ie in o a ingle common c enc b e of cha i g e a i ie ha ake in o con ide a ion he diffe ing p ice le el . P cha ing po e pa i ie e e di c ed abo e. Why measures of the value of output (GDP/GNI) cannot accurately measure economic well-being GDP and GNI make no distinctions about the composition of output. Whe he a co n p od ce mili a good ( eapon , g n , ank , e c.) o me i good (ed ca ion, heal h ca e, clean ae pplie , and o he e ice ) o an o he pe of good , GDP and GNI incl de he al e of all i ho an di inc ion abo he deg ee o hich he con ib e o anda d of li ing. One co n ma ha e a lo e e ca i a GDP han ano he , b highe le el of ocial e ice and me i good p o i ion han he o he . Which ha highe anda d of li ing? The GDP and GNI mea e a e nable o p o ide an indica ion. GDP and GNI cannot reflect achievements in levels of education, health and life expectancy. A ocie le el of heal h and ed ca ion con ib e ignifican l o anda d of li ing. Co n ie ma achie e highe o lo e le el of heal h and ed ca ion i h a gi en amo n of GDP/GNI e ca i a, b he e emain nacco n ed fo in mea e of GDP and GNI. Inc ea ed life e pec anc ( he n mbe of ea one can e pec o li e, on a e age) i ano he benefi of echnological imp o emen , imp o ed heal h and highe income le el ha ha con ib ed eno mo l o a highe anda d of li ing, b i no acco n ed fo in GDP and GNI fig e . GDP and GNI provide no information on the distribution of income and output. Ho eq all o neq all income and o p a e di ib ed i ano he fac o nde l ing ocie ell-being. A e he eal h and income of a na ion highl concen a ed in ela i el fe hand hile la ge po ion of he pop la ion a e nable o a i f hei ba ic need , o a e he e ela i el mo e eq all di ib ed? A e he benefi of a g o ing GDP concen a ed among a mall g o p of beneficia ie , o a e he idel di ib ed? A e ineq ali ie inc ea ing o dec ea ing? Mea e of GDP o GNI e ca i a canno add e an of he e q e ion , a he onl p o ide an indica ion of a e age o a e age i c me pe pe on. GDP and GNI do not take into account increased leisure. In man co n ie a o nd he o ld he a e age n mbe of ho o ked pe eek ha declined ignifican l , i h he n mbe of ho of lei e co e pondingl inc ea ing. Thi con ib e acco n ed fo in GDP o GNI. o ocie anda d of li ing, e i no GDP and GNI do not account for quality of life factors. A ocie ell-being depend pon a n mbe of non-economic fac o , ch a he c ime a e, a en e of ec i and peace a i ing f om ela ion i h o he co n ie , ell-f nc ioning in i ion , e le el f om o king condi ion , in ec i ie a i ing f om nce ain ie ela ing o one job, he deg ee of poli ical f eedom, and man o he . GDP and GNI canno acco n fo an of he e. National income measures and comparisons of economic wellbeing over time and between countries Comparisons over time Ea lie in he chap e e a ha o make compa i on o e ime, e m e eal al e of income and o p mea e , hich ake in o acco n change in he p ice le el o e ime. Ye e en hen ing eal al e of income and o p , i i clea f om he di c ion abo e ha compa i on of eal GDP/GNI o e ime ma be mi leading. An inc ea e in eal GDP of ome pe cen age fo a pa ic la co n ma o e e ima e o nde e ima e he e change in he pop la ion economic ell-being beca e of ch fac o a imp o ed p od c q ali , imp o emen in heal h and ed ca ion, inc ea ed lei e, imp o emen (o de e io a ion) in q ali of life fac o , po ible change in he al e of nonma ke ed o p , o in he i e of nde g o nd ma ke , and o on. Comparisons between countries Bo h he inabili of GDP/GNI o mea e he e al e of o p , and he e cl ion of man fac o ha con ib e o economic ell-being, imila l con ib e o limi ing he alidi of in e na ional compa i on b e of he e mea e . Fo e ample, one co n ma ha e a high le el of GDP e ca i a, hich i concen a ed among a mall pe cen age of he pop la ion, hile ano he ma ha e a lo e le el of GDP e ca i a, hich i mo e eq all di ib ed. A compa i on of GDP/GNI fig e ill no e eal an info ma ion on hi poin , a ell a on he o he poin li ed abo e. TEST YOUR UNDERSTANDING 8.6 1 E plain ome ea on and o p . h na ional income a i ic do no mea e he e al e of income 2 E plain ome ea on h GDP e ca i a o GNI e ca i a ma be inapp op ia e a he ba i fo making compa i on of a pop la ion economic ell-being o e ime, o compa i on be een co n ie . Alternative measures of well-being In e pon e o g o ing conce n ha na ional income acco n ing mea e ch a GDP and GNI do no acc a el eflec economic ell-being, e e al al e na i e mea e ha e been de eloped ha o cap e mo e fac o ha affec ell-being and q ali of life. OECD Better Life Index The O gani a ion of Economic Co-ope a ion and De elopmen (OECD) i an in e go e nmen al o gani a ion e abli hed in 1961, con i ing of 36 membe co n ie a of 2020. Mo of he membe a e economicall mo e de eloped co n ie . I main p po e i o p o ide a fo m fo membe co n ie o di c common p oblem and policie and o p omo e policie ha ill enco age economic ellbeing. The OECD ha de eloped he OECD Better Life Index ha i ba ed on a n mbe of fac o ha he membe co n ie hem el e elec ed a fac o ha make a be e life. The p po e of hi mea e i o p o ide a mo e acc a e ep e en a ion of ell-being and o fo m he ba i of policie in ended o imp o e he q ali of life and ell-being mo e gene all . A he OECD no e S cie al g e i ab im g e e i e l ki g e e ie ce a d li i g c di i eme i he ell-bei g f e le a d h eh ld . A e i g ch l a he f c i i g f he ec mic em b al a he di e e 5 f e le. Fig e 8.6 ho ha acco ding o he OECD he e a e o g o p of fac o ha de e mine ell-being in he p e en : q ali of life hich i mea ed in eigh dimen ion o indica o , and ma e ial condi ion hich a e mea ed in h ee. Bo h q ali of life fac o and ma e ial condi ion depend on fo pe of capi al in he f e. Na al capi al efe o en i onmen al e o ce ; h man capi al efe o le el of ed ca ion, kill and heal h; economic capi al efe o mone and eal h; and ocial capi al efe o ne o k of people i h ha ed al e and nde anding ha facili a e co-ope a ion. The e fo pe of capi al en e ha he e ill be fficien e o ce in he f e in o de fo a ocie o be able o main ain he ell-being of i pop la ion. Figure 8.6: OECD f ame o k fo mea ing ell-being and p og e U ing he ele en indica o ho n in Fig e 8.6, he OECD con c an inde ha ank he co n ie acco ding o hei pe fo mance. Each ea ince 2011 i p bli he he anking of he co n ie and in addi ion ho ho each co n fa e i h e pec o each of he ele en dimen ion . The OECD Be e Life Inde i ill nde de elopmen a diffe en dimen ion a e ome ime added o aken o . Fo e ample i ha been c i ici ed fo no aking eq i fac o in o con ide a ion. A he ime of i ing he OECD i o king on ho o inco po a e eq i in o i Inde . In addi ion i i likel ha he Inde ffe f om diffic l ie in mea emen of e e al of i dimen ion , hich ma make he alidi of compa i on ac o co n ie ome ha q e ionable. Happiness Index The Happiness Index began o be compiled in 2012 b he Uni ed Na ion S ainable De elopmen Ne o k. Thi i an o gani a ion foc ed on ga he ing cien ific and echnological kno ledge o enco age policie fo ainable de elopmen , incl ding implemen a ion of he S ainable De elopmen Goal ( ee Chap e 18) and he Pa i Clima e Ag eemen ( ee Chap e 5). The goal i o add e he in e dependen economic, ocial and en i onmen al challenge faced b he o ld. In 2019 he Happine Inde incl ded 156 co n ie . The Happine Inde i ba ed on he follo ing dimen ion : eal GDP e ca i a ocial ppo heal h life e pec anc f eedom o make life choice gene o i pe cep ion of co p ion. Da a f om all he pa icipa ing co n ie a e compiled f om he Gall p Wo ld Poll hich collec a i ic ba ed on elephone e in co n ie a o nd he o ld on n me o opic like ell-being, emplo men , acce o food and man mo e. The W ld Ha i e Re ank co n ie acco ding o he happine of hei pop la ion . In 2019, 156 co n ie e e incl ded. In addi ion, in 2018, co n ie e e anked b he happine of hei immig an . The Repo gi e each co n a ank f om one o en fo each of he dimen ion abo e, i h en being he be and one he o . The co n ie a e al o gi en an o e all ank mma i ing hei pe fo mance in all he dimen ion . The e l a e p bli hed each ea in The W ld Ha i e Re . In addi ion o p e en ing he co n anking , he epo each ea foc e on a heme opic and i ela ion o happine . In 2019, fo e ample, i a happine and comm ni , in 2018 i a mig a ion and happine , and in 2017 i a he ocial fo nda ion of happine . The Happine Inde ha been c i ici ed fo limi a ion of ome of he da a and a iable i e , and in addi ion fo being ba ed on he concep of happine . Happine i e diffic l o q an if and o mea e. Happine clea l mean diffe en hing o diffe en people, and i meaning a ie ac o c l e , po ibl making i anking le eliable fo compa i on ac o co n ie . Happy Planet Index The Happy Planet Index (HPI) a de eloped b he Ne Economic Fo nda ion (NEF), a B i i h non-go e nmen al o gani a ion (NGO, ee Chap e 20) de o ed o e plo ing ne economic model ba ed on eq ali , di e i and economic abili . In 2006, he NEF la nched he Happ Plane Inde (HPI) o challenge he idea ha g o ho ld be he mo impo an goal of economic polic . I i a g ed ha h of GDP Pe le e f li ical a ie ha he e cei e be m ca able f deli e i g a g ec m , a d lic make i i i e licie ha i c ea e i GDP a a e l . D i g ha led h - e mi m, de e i a i g cial c di i , a d a al i i he face f clima e cha ge. I fac , GDP g h i d e mea a be e life f e e e, a ic la l i c ie ha a e al ead eal h . I d e eflec i e ali ie i ma e ial c di i be ee e le i a c .I d e e l al e he hi g ha eall ma e e le like cial ela i , heal h, h he e d hei f ee ime. A d c ciall , e e -m e ec mic g h i i c m a ible i h he 6 la e a limi e a e agai . (em ha i i igi al). The Happ Plane Inde i in ended o be a mea e of ainable ell-being. I ake in o con ide a ion life e pec anc , ho people feel abo hei o n pe onal ell-being, hich a e adj ed fo ineq ali ie and ecological foo p in . I i calc la ed in he follo ing a : Happ Plane Inde (HPI)=life e pec anc Life e ec a c i da a. ell-being he a e age n mbe of ea Well-bei g i aken o be a pop la ion Poll ineq ali a pe on e pec a i fac ion mea of o come ecological foo p in o li e, ba ed on Uni ed Na ion ed b da a collec ed b he Gall p Wo ld I e ali f c me efe o ineq ali ie be een people i h ega d o life e pec anc and ell-being. A e age ell-being and life e pec anc a e adj ed do n a d o ake in o acco n ineq ali ie in he e dimen ion . Ec l gical f i i he impac on he en i onmen of each indi id al in a ocie on a e age. I i mea ed a he amo n of land needed o p o ide fo all hei eq i emen and he amo n of land needed o ab o b hei CO2 emi ion . The highe he ecological foo p in , he lo e he HPI. The HPI i calc la ed fo 140 150 co n ie , depending on da a a ailabili . Each co n co e f om 0 o 100, he highe being he be . ecei e a No e ha he Ha Pla e I de and he Ha i e I de efe o e diffe en idea . The Happine Inde i conce ned i h pe onal happine hile he Happ Plane Inde i conce ned i h happine of he plane . The Happ Plane Inde i he efo e m ch mo e of a mea e of ainabili and ho ell e o ce can ppo a pop la ion ell-being. The Happ Plane Inde ha been c i ici ed fo i mea e of ell-being, and i i al o a g ed ha he ecological foo p in on hich i i ba ed i a con o e ial concep . TEST YOUR UNDERSTANDING 8.7 1 E plain h ee al e na i e me hod o mea o gani a ion . e ell-being ha ha e been p fo a db a io 2 In each of he e ca e , iden if he fac o ha make hem pe io o anda d na ional income a i ic a a po ible ba i fo compa i on o e ime o compa i on be een co n ie . THEORY OF KNOWLEDGE 8.2 The GDP concept GDP a a concep a de eloped in he Uni ed S a e in 1934 (d ing he G ea Dep e ion) b US Nobel P i e inning economi Simon K ne . Af e he Second Wo ld Wa , i became he main me ic fo mea ing he i e of a co n econom , i p po e being o mea e he econom abili o p od ce. Ho e e , ince hen, i ha become a g ide o policie o deal i h n me o a pec of he econom , incl ding infla ion, nemplo men , a e , in e na ional ade and m ch mo e. In addi ion, i i ed a an indica o of de elopmen , ell-being and geopoli ical eng h. The US Comme ce Depa men efe o i a one of he g ea e in en ion of he en ie h cen . Ye K ne had a ned abo The al able ca aci cha ac e i a i bec me Ec mic elfa e ca k ... The elfa e f a a i i c me a defi ed ab e. Man ea la e he he limi a ion of he GDP concep :7 f he h ma mi d im lif a c m le i a i i a c m ac da ge he c lled i e m f defi i el a ed c i e ia . . . be ade a el mea ed le he e al di ib i f i c me i ca , he ef e, ca cel be i fe ed f m a mea eme f a i al o e:8 Di i c i m be ke i mi d be ee a i e , a d be ee he h a d l g . G al f ha a d f ha . a d ali f g h, be ee c m eg h h ld ecif m e g M ch mo e ecen l Jo eph S igli , ano he US Nobel P i e inning economi GDP i a g d mea e f ell-bei g. Wha he g hi g, e ill d he g hi g. If e f d ci f g d , a he ha heal h, ed ca i i he ame a ha he e mea e a e di ed; a d h f o e he follo ing:9 e mea e affec ha e d : if e mea e c l ma e ial ell-bei g , a , he , a d he e i me e bec me di ed e bec me m e ma e iali ic. In fac GDP i a ma e iali ic concep , acco ding o hich he o e iding goal of an econom i g ea e p od c ion, i ho an ega d a o he he i make people be e off. Ye in pi e of i limi a ion , i i an a ac i e me ic, beca e i i no poli ical, and a a e l , i allo go e nmen and poli ician o p e i i ho ha ing o e o o diffic l q e ion abo ha gh o be ocie goal . E e one an mo e o p a he han le o p , he efo e p i of mo e o p doe no ai e poli ical o ideological objec ion . On he o he hand, p i of g ea e income eq ali , en i onmen al ainabili and mo e p o i ion of me i good incl ding ed ca ion and heal h ca e a e poli icall highl con o e ial i e . If ocie an o p e g ea e eq ali in income di ib ion, i m ha e a mea e of ellbeing ha incl de mea e of ineq ali . If ocie an o p e en i onmen al ainabili , i m ha e a mea e of ell-being ha inco po a e achie emen in hi dimen ion. And o on i h he n me o po ible goal ha a ocie migh elec . B hen, ho i ag eemen , o poli ical con en o be eached i hin a ocie ega ding hich a e he mo e impo an ocie al goal , ince diffe en g o p ma a ach g ea e impo ance o ome goal and le impo ance o o he ? Who i o decide on ha pa ic la dimen ion ho ld be incl ded in a mea e of ell-being ha ill be ed a he ba i fo polic ? Sources: Wo ld Economic Fo m ; The Economi Thinking points E plain ha S igli mean hen he mea e he ong hing, e ill do he i e , Wha ong hing. e mea e affec ha e do: if e A e kno , economi end o a oid no ma i e i e in hei hinking. To ha e en do o hink hi i beca e al e j dgemen ho ld be kep epa a e f om economic anal i ? Do al e j dgemen omeho con amina e he impa ial handling of economic fac and da a? INQUIRY AND REFLECTION The follo ing q e ion ill help o eflec on o lea ning and enhance o nde anding of ke opic in hi chap e . The a e gge ion fo inq i ie ha o can nde ake on o o n o in g o p in o de o e i e he lea ning objec i e of hi chap e . 1 Re ea ch GNI and GDP fo a io co n ie n il o find a co n i h a la ge diffe ence be een he o al e . In e iga e o find ha acco n fo he diffe ence. 2 Selec fi e o mo e OECD co n ie o a e in e e ed in, e ea ch and find hei eal GDP o GNI pe capi a in $PPP, and ank hem f om highe o lo e . Find he co e ponding co n ie in he OECD Be e Life Inde and ank he e oo f om highe o lo e . Compa e o o anking in o de o ee he e en o hich he diffe . E amine each of he dimen ion in o de o gge po ible fac o ha migh acco n fo he diffe ence be een o GDP/GNI ank and he OECD Be e Life Inde ank . 3 Selec fi e o mo e co n ie ha appea in he Happine Inde and Happ Plane Inde . Find hei eal GNI o GDP pe capi a in $PPP and ank hem f om highe o lo e . Find he co e ponding co n ie in he Happine Inde and Happ Plane Inde and ank he e oo f om highe o lo e . Yo ho ld no ha e h ee e of ank fo o g o p of co n ie . Compa e he e h ee e i h each o he in o de o ee he e en o hich he diffe . S gge po ible ea on h he anking migh diffe f om each o he . EXAM STYLE QUESTIONS Yo can find q e ion in he le of IB e am in he 'Digi al co 5 Mea ing Well-being and P og e : Well-being Re ea ch 6 Wh do e need he Happ Plane Inde ? ebook: E a ma e ial' ec ion. 7 Simon K ne , U e and Ab e of Na ional Income Mea 8 Simon K ne , Ho To J dge Q ali 9 GDP i no a good mea e of ellbeing emen , Repo o he US Cong e , 1934 . The Ne Rep blic, 20 Oc obe 20 1962 i ' oo ma e iali ic C a e 9 A e a e de a d a d a e ae BEFORE YOU START In the previous chapter you learned what growth is and that there are short-term fluctuations and a long-term trend in growth. 1 What kinds of economic activities do you think cause short-term fluctuations in growth? 2 What kinds of economic activities do you think cause changes to the long-term growth trend? In this chapter we will develop the aggregate demand aggregate supply (AD-AS) model of the macroeconomy, an important analytical tool for studying output fluctuations, changes in the price level and unemployment, and economic growth. 9.1 A a a a (AD) a a a LEARNING OBJECTIVES After studying this section you will be able to: define all the terms appearing in a b in the text (AO1) explain the aggregate demand curve in terms of its components: consumption (C), investment (I), government spending (G), net exports (X M) (AO2) explain the determinants of the components of aggregate demand: (AO2) consumption (C): consumer confidence, interest rates, wealth, income taxes, level of household indebtedness, expectations of future price level investment (I): interest rates, business confidence, technology, business taxes, level of corporate indebtedness government (G): political and economic priorities net exports (X M): income of trading partners, exchange rates, trade policies explain shifts in the aggregate demand curve by reference to changes in the determinants of the components (AO2) draw the aggregate demand curve and shifts of the aggregate demand curve (AO4) E T a a a a a a a a a a a a a a a a Agg ega e de a d is the total quantity of aggregate (total) output, or real GDP, that all buyers in an economy want to buy at different possible price levels, ce e a b . The agg ega e de a d (AD) c e shows the relationship between the aggregate output buyers want to buy, or real GDP demanded, and the economy s price level, ce e a b . Figure 9.1(a) presents an aggregate demand curve. The hori ontal axis measures aggregate output, or real GDP, and the vertical axis measures the general price level in the economy, which is an average over the prices of all goods and services. Aggregate demand is not just the demand of all consumers, as one might think from the study of microeconomics. It consists of all the components of aggregate expenditure that we studied in Chapter 8, Section 8.2: the demand of consumers (C) the demand of businesses (firms) (I) the demand of government (G) the demand of foreigners for exports (X) minus the demand for imports (M) (X M or net exports). F 9.1: The aggregate demand (AD) curve A a a is the total amount of real output (real GDP) that consumers, firms, the government and foreigners want to buy at each possible price level, over a particular time period. T a a a (AD) shows the relationship between the total amount of real output demanded by the four components and the economy s price level over a particular time period. It is downwardsloping, indicating a negative relationship between the price level and aggregate output demanded.1 T (S a ( a a a ) a) a a a The reasons behind the downward slope of the aggregate demand are very different from demand in a single market in microeconomics. If you are interested in discovering the reasons behind the shape of the aggregate demand curve you may read about it in the 'Digital coursebook: Extra material' section. T T a a a a a a a ( AD ) a It is important to distinguish between movements along the aggregate demand curve, caused by changes in the price level, discussed above, and shifts of the aggregate demand curve, caused by the a a a a , to which we turn next. (This is analogous to shifts of and movements along the demand curve in microeconomics.) Aggregate demand curve shifts are shown in Figure 9.1(b). A rightward shift from AD1 to AD2 means that aggregate demand increases: for any price level, a larger amount of real GDP is demanded. A leftward shift from AD1 to AD3 means that aggregate demand decreases: for any price level, a smaller amount of real GDP is demanded. Since aggregate demand is composed of consumer spending (C), investment spending (I), government spending (G), and net export spending (X M), changes in aggregate demand and shifts in the aggregate demand curve can be caused by any factor that produces a change in one of these four components. Ca a C a . Consumer confidence is a measure of how optimistic consumers are about their future income and the future of the economy. If consumers are optimistic about the future, they are likely to spend more on buying goods and services, and the AD curve shifts to the right. Low consumer confidence indicates expectations of falling incomes and worsening economic conditions, due to fears of cuts in wages or unemployment, causing decreases in spending, appearing as a leftward shift of the AD curve. Governments around the world regularly measure consumer confidence (through surveys based on questionnaires of consumers) to try to predict the level of consumer spending. C a a . Some consumer spending is financed by borrowing, and so is influenced by interest rate changes. An increase in interest rates makes borrowing more expensive, resulting in lower consumer spending, and therefore a leftward shift in the AD curve. A fall in interest rates makes borrowing less expensive, and results in more consumer spending and a rightward shift in the AD curve. Interest rates can change as a result of a type of policy called monetary policy (see Chapter 13). C a a .Wa is the value of assets that people own, such as savings in their bank accounts, houses, stocks and bonds, jewellery, works of art, and so on; minus debt to banks or other financial institutions. An increase in consumer wealth (for example, an increase in the value of homes) makes people feel wealthier; therefore, they spend more and the AD curve shifts to the right. A decrease in wealth lowers aggregate demand; the AD curve shifts to the left. C a a . If the government increases c e a e (taxes paid by households on their incomes), then consumer d ab e c e, which is the income left over after personal income taxes have been paid, falls; therefore, spending drops, and the AD curve shifts to the left. If personal income taxes are lowered, the result is higher disposable income and a rightward shift in the AD curve. Changes in taxes are the result of a type of government policy called fiscal policy (see Chapter 13). C a b . Indebtedness refers to how much money people owe from borrowing in the past. If consumers have a high level of debt (such as credit card use or taking out loans), then they are under pressure to make high monthly payments to pay back their loans plus interest, and so are likely to cut back on their present expenditures. Therefore, a high level of indebtedness lowers consumption spending and shifts the AD curve to the left. A low level of indebtedness increases consumption spending and shifts the AD curve to the right. E a . Consumer spending may be influenced by what they expect prices to be in the future. If they expect prices of goods and services to fall, they may postpone spending as they wait for prices to fall, causing AD to decrease, shifting AD to the left. On the other hand if they expect future prices to increase, they may buy more now in order to avoid the higher prices later, thus causing AD to increase shifting to the right. Ca a C a b . Business confidence refers to how optimistic firms are about their future sales and economic activity. If businesses are optimistic, they spend more on investment, and the AD curve shifts to the right. Business pessimism, on the other hand, results in a leftward shift in the AD curve. C a a . Increases in interest rates raise the cost of borrowing, and force businesses to reduce investment spending financed by borrowing, and therefore the AD curve shifts to the left. Decreases in interest rates mean businesses can now finance their investment spending by borrowing at a lower cost, and the AD curve shifts to the right. As noted above, interest rates change as a result of monetary policy (see Chapter 13). C a ( ) . Improvements in technology stimulate investment spending, thus causing increases in aggregate demand and a rightward shift in the AD curve. C a b a . Business taxes in this context refer to taxes on profits (also known as corporate income taxes). If the government increases taxes on profits of businesses (as part of its fiscal policy; see Chapter 13), firms after-tax profits fall; therefore, investment spending decreases and the AD curve shifts to the left. Decreases in taxes on profits result in increased aggregate demand and a rightward AD curve shift. T a b . As in the case of household indebtedness, if businesses have high levels of debt due to past borrowing, they will be less willing to make investments and the AD curve shifts to the left. A low level of corporate indebtedness, on the other hand, leads to more investment and a rightward shift in the AD curve. L a/ a a . Sometimes, the legal and institutional environment in which businesses operate has an impact on investment spending. This is often the case in many developing economies where laws and institutions do not favour small businesses. For example, small businesses often do not have access to credit, meaning they cannot borrow easily to finance investments. Many developing economies do not have the necessary laws that secure property rights (legal rights to ownership). In such situations, increasing access to credit (the ability to borrow) and securing property rights would result in increases in investment spending, shifting the AD curve to the right. Ca a C a a . Governments have many expenditures, arising from provision of merit goods and public goods, spending on subsidies and pensions, payments of wages and salaries to its employees, purchases of goods for its own use, and so on. It may decide to increase or decrease its expenditures in response to changes in its priorities. Increased government spending shifts the AD curve to the right, and decreased government spending shifts it to the left. C a : b a a a a . The government can use its own spending as part of a deliberate attempt to influence aggregate demand. The effects of such changes in government spending on aggregate demand are exactly the same as above. This is another aspect of fiscal policy (to be discussed in Chapter 13). Ca a C a a a ab a . Consider aggregate demand in country A, which has trade links with country B. If country B s national income increases, it will import more goods and services from country A, so that country A s exports will increase. Therefore the AD curve in country A shifts to the right. If, on the other hand, country B s national income falls, it will buy less from country A, and country A s AD curve shifts to the left. C a a a . An exchange rate is the price of one country s currency in terms of another country s currency (see Chapter 16). Consider again country A, and assume that the price of its currency increases, becoming more expensive relative to the currency of country B. Country B now finds country A s output more expensive, and so it imports less from country A; therefore, country A s exports fall, and its AD curve shifts to the left. At the same time, country A now finds country B s output cheaper, and so it increases its imports from country B. Therefore, the increase in price of country A s currency has two effects: a fall in its exports and an increase in imports so that net exports, X M, fall, and the AD curve shifts to the left. In the opposite situation, where the price of country A s currency decreases, an increase in exports and a decrease in imports will result, so that X M increases, and country A s AD curve shifts to the right. C a a , a . Trade protection refers to restrictions to free international trade often imposed by governments (see Chapter 14). Suppose country A trades freely with country B (with no trade restrictions). However, country B s government decides to impose restrictions on imports from country A. Country A s exports will fall, and its AD curve will shift to the left. On the other hand, in country B, lower imports mean that the value of X M increases, and its AD curve shifts to the right. Table 9.1 summarises the factors that can cause shifts of the aggregate demand curve. S a a a a a b : Changes in consumer spending, arising from: changes in consumer confidence changes in interest rates (monetary policy) changes in wealth changes in personal income taxes (fiscal policy) changes in the level of household indebtedness expectations of future price levels Changes in investment spending, arising from: changes in business confidence changes in interest rates (monetary policy) changes (improvement) in technology changes in business taxes (fiscal policy) changes in the level of corporate indebtedness legal/institutional changes Changes in government spending, arising from: changes in political priorities changes in economic priorities: deliberate efforts to influence aggregate demand (fiscal policy) Changes in foreigners spending, arising from: changes in national income abroad changes in exchange rates changes in the level of trade protection Tab 9.1: Factors causing shifts of the aggregate demand curve TEST YOUR UNDERSTANDING 9.1 1 a Define aggregate demand and explain each of its four components. b Show aggregate demand diagrammatically and define the relationship it represents. 2 Using diagrams, distinguish between a movement along the AD curve and a shift of the AD curve, and provide examples of the causes of each. Identify the four components of spending that cause shifts of the aggregate demand curve. 3 Using diagrams, show the impact of each of the following on the aggregate demand curve; explain what happens to aggregate demand in each case; and identify the component(s) of aggregate expenditure involved. a Consumer confidence improves as consumers become optimistic about future economic conditions. b The government decides to increase taxes on firms profits. Firms become fearful that a recession is about to begin. The government decides to increase its spending on health care services. There is a decline in the real estate market (average house prices fall). The central bank (a government organisation) decides to increase interest rates. There is an increase in the level of indebtedness of consumers and firms. Real incomes in countries that purchase a large share of country A s exports fall; examine the impact on aggregate demand in country A. The government lowers personal income taxes (taxes on income of households). New legislation makes property rights more secure. There is an appreciation (an increase) in the value of the euro relative to the US dollar; examine the impact on aggregate demand in euro one countries (countries that use the euro). There is an appreciation (an increase) in the value of the euro relative to the US dollar; examine the impact on aggregate demand in the United States. A non-governmental organisation (NGO) introduces a programme providing credit to small farmers, making it easier for small farmers to borrow to finance the building of irrigation projects. S AD a a a Note that income is not included among the factors that can shift the AD curve. The reason is that c a ge a a c e ca a e a AD c e f . This follows from the point noted earlier that real GDP, measured on the hori ontal axis, also represents national income. It is not possible for any variable measured on either of the two axes to cause a shift of a curve (for an explanation, see the Quantitative techniques chapter in the 'Digital coursebook: Extra material' section).2 (This point will become clearer when we discuss the Keynesian multiplier at HL; see Chapter 13). 1 You may have noticed something odd about the definition of aggregate demand. In Chapter 8, Section 8.2 we defined GDP to be equal to spending by the four components: C + I + G + (X M). Now we are saying that aggregate demand is also equal to C + I + G + (X M). Yet aggregate demand is not the same as GDP. The explanation for this apparent oddity can be found in the 'Digital coursebook: Extra material' section Understanding aggregate demand and the multiplier in terms of the Keynesian cross model , included as Supplementary material. 2 Note that this does not contradict the ability of changes in disposable (or after-tax) income due to changes in taxes to affect aggregate demand. This is because changes in taxes and disposable income do not affect national income, as they simply involve a transfer of income from households to the government. National income remains unchanged. 9.2 S - a a AD-AS b N a :T - IB .S , (AS) . A , LEARNING OBJECTIVES A : a b (AO1) (SRAS) SRAS (AO2) : (AO2) SRAS (AO2) SRAS SRAS (AO4) (AO2) - - (AO4) , .M . S - . a a T a a T .T h n in mac ec n mic , ; .T mac ec n mic ( ), , change al ng i h change in he , .T l ng n in , ice le el. , , . .T ( ), ( ) : , , T , . . D a a a - A a a . a ( GDP) . T - a a (SRAS) ( GDP) ( ) . F 9.2( ) - , : GDP GDP, F 9.2: T - ( GDP. (SRAS) ) W SRAS a - T ( GDP) : , ; ( ), .A , , GDP S , . ; , , . C a - A 9.2( ). T a a ( ( SRAS ) SRAS 2 C , ) F . A SRAS1 SRAS2 - , : SRAS1 GDP. A SRAS3 : , GDP. I SRAS C a a .I , SRAS , , SRAS C a : , , SRAS2. SRAS1 - ab , , SRAS1 , .C , .A , SRAS3 F - , , 9.2( ). I , SRAS SRAS ; . C a a .I .T C SRAS SRAS C a S b , . S ( 5. T .L .3 b ; 4 , .S , .I . SRAS , C 2, S 2.3). F , , SRAS . SRAS , . B SRAS O SRAS , . SRAS ( , ), TEST YOUR UNDERSTANDING 9.2 . 1 2 a D b E a D . - - . . b ( )? 3 a S - (SRAS) , . b I SRAS I SRAS 4 , SRAS a T b B . SRAS ( ) - . . . T . T - I a ; . T S . . b AD-AS - b - I . AD-AS , .S b - b , T GDP. AD , F 9.3 A Pl1, GDP SRAS . Pl Y GDP Pl GDP Pl . A GDP Pl . A Pl , . , Y, , .A , Pl , , Pl2, , GDP , - F 9.3: S I a T - a - b - .S ( ). I F 9.4( ), Pl1 Pl2, , , AD GDP, AD1 AD2, Y1 Y2. T . I ), Y1 F AD Y3, AD1 ( , AD3; , GDP Pl3 . 9.4( ) SRAS .A SRAS1 ), GDP, Y2, SRAS3 ( Pl1 .O , , Pl3, Y3 SRAS2 ( , , Pl2, SRAS1 ) . F 9.4: I - TEST YOUR UNDERSTANDING 9.3 1 , , a T b F B ( ) . . - . T . T . T . A . C . C 3 4 5 .A , .T 'D , . agg ega e :E ' .S . Q 9.3 L - / LEARNING OBJECTI ES After studying this section you will be able to: define all the terms appearing in in the text (AO1) explain the monetarist/new classical perspective on the long-run aggregate supply (LRAS) curve (AO2) explain that in the monetarist/new classical model macroeconomic equilibrium in the long run is determined at full employment (or potential) output (AO2) explain that when the economy is at long-run equilibrium (full employment equilibrium) unemployment is equal to the natural rate of unemployment (AO2) draw the LRAS curve and macroeconomic equilibrium in the long run (AO4) explain inflationary and deflationary (recessionary) gaps (AO2) explain how in the monetarist/new classical perspective the economy automatically adjusts to full employment output (AO2) T T / - - This section examines the theoretical perspective of / economists, which builds on the work of the classical economists of the 19th century. Both the monetarist/new classical and classical perspectives are based on the following key principles: the importance of the price mechanism in co-ordinating economic activities; the concept of competitive market equilibrium; and thinking about the economy as a harmonious system that automatically tends towards full employment. While economists generally accept these principles in the study of microeconomics, there is major disagreement over their relevance to the study of economics at the macro level. (See Chapter 1, Section 1.5 for a brief review.) The monetarist/new classical approach to aggregate supply rests crucially on the distinction made earlier between the macroeconomic short run and long run. It examines what happens to aggregate supply when the economy moves into the long run, when all resource prices including wages change to match changes in the price level. The long-run supply relationship between the price level and aggregate output is referred to as (LRA ), shown graphically as the LRA . The LRAS curve is vertical at potential GDP, also known as the full employment level of real GDP, Yp, as shown in Figure 9.5. A vertical LRAS curve means that in the long run any change in AD results only in changes in the price level while the quantity of real GDP produced remains the same. The economy is in when the AD curve and the SRAS curve intersect at any point on the LRAS curve, seen in Figure 9.5. F 9.5: The LRAS curve and long-run equilibrium in the monetarist/new classical model According to the monetarist/new classical perspective, the long-run aggregate supply (LRAS) curve is vertical at the full employment level of output, indicating that in the long run the economy produces potential GDP, which is independent of the price level. Long-run equilibrium occurs when the SRAS and AD curves intersect on the LRAS curve at the level of full employment or potential output. L - You may recall from Chapter 8 (Section 8.4), that when the economy produces at potential output, we say that the economy is experiencing full employment . This is why the terms full emplo ment output and potential output both refer to the output that is produced when the economy is at long-run equilibrium. Note that this is the level of output determined at the point where the LRAS curve is situated as you can see in Figure 9.5. As we saw in Chapter 8, while we call this full employment output the economy still has unemployed labour and other resources. The unemployment that exists when the economy is producing its full employment output is known as the natural rate of unemployment. This will become clearer to you in Chapter 10. LRA There is a very simple explanation for the vertical shape of the LRAS curve. Since wages (and other resource prices) are now changing to match output price changes, firms costs of production remain constant even as the price level changes. Therefore, as the price level increases or decreases, ith constant real costs, firms profits are also constant, and firms no longer ha e an incenti e to increase or decrease their output le els. For example, say the price level increases. In the short run, with wages (and other input prices) constant, firms profits increase, and firms therefore increase the quantity of output produced by moving upward along an upward-sloping SRAS curve. However, in the long run, wages (and other resource prices) also increase by the same amount. In effect, nothing has changed from the firms point of view, and so they have no reason to increase the quantity of output they produce. Similarly, any price level decrease is fully matched by the same decrease in wages (and other resource prices), so that firms have no incentive to decrease the quantity of output produced. S - : ( ) As we have seen in Figure 9.5 when AD and SRAS intersect on the LRAS curve, there is long-run equilibrium. But what happens if AD and SRAS intersect at some other point that is not on the LRAS curve? There are two such possibilities, shown in Figure 9.6(a) and (b). In all three diagrams Yp represents potential output, or full employment output, which is given by the position of the LRAS curve on the hori ontal axis. At Yp, unemployment is equal to the natural rate of unemployment. F 9.6( ): ( ) . In part (a), equilibrium real GDP, Ye, lies to the left of potential GDP, Yp. When real GDP is less than potential GDP, the economy is experiencing a deflationar gap (also known as a recessionar gap), and unemployment is greater than the natural rate of unemployment. Why does this happen? The deflationary gap has been created because at the price level Ple, the amount of real GDP that the four components of aggregate demand want to buy is less than the economy s potential GDP. There is not enough total demand in the econom to make it worthwhile for firms to produce potential GDP. This also means that firms require less labour for their production; therefore, unemployment is greater than the natural rate of unemployment. F 9.6( ): . In part (b), equilibrium real GDP, Ye, lies to the right of potential GDP, Yp. When real GDP is larger than potential GDP, the economy is experiencing an inflationar gap, and unemployment is less than the natural rate of unemployment. An inflationary gap arises because with aggregate demand AD, the quantity of real GDP that the four components want to buy at the price level (Ple) is greater than the economy s potential output. There is too much total demand in the econom , and firms respond by producing a greater quantity of real GDP than potential GDP. To produce more output, firms labour needs to increase, and unemployment falls to become less than the natural rate of unemployment. F 9.6( ): F GDP, or . Part (c) is the same as Figure 9.5, showing long-run equilibrium, where equilibrium real GDP is equal to full employment or potential GDP. When the economy is producing its potential GDP, unemployment is equal to the natural rate of unemployment and there is no deflationary or inflationary gap. F 9.6: Deflationary (recessionary) and inflationary gaps in relation to potential output You can now see that the three states of the economy in Figure 9.6 correspond to the phases of the business cycle that we studied in Chapter 8: Ye of Figure 9.6(a) corresponds to a point like e in Figure 8.4, where the economy is experiencing recession, unemployment is greater than the natural rate and actual GDP is less than potential GDP. Ye of Figure 9.6(b) corresponds to a point like d in Figure 8.4, where unemployment is lower than the natural rate and actual GDP is greater than potential GDP. Finally, Yp of Figure 9.6(c) corresponds to points like a, b, and c in Figure 8.4, where the economy is producing actual GDP equal to potential GDP, with unemployment at its natural rate. Therefore, recessionary and inflationary gaps are two types of output gaps. Recessionary (deflationary) and inflationary gaps represent short-run equilibrium positions of the economy. A ( ) is a situation where real GDP is less than potential GDP (and unemployment is greater than the natural rate of unemployment) due to insufficient aggregate demand. An is a situation where real GDP is greater than potential GDP (and unemployment is smaller than the natural rate of unemployment) due to excess aggregate demand. When the economy is at its full employment equilibrium level of GDP, the AD curve intersects the SRAS curve at the level of potential GDP, and there is no deflationary or inflationary gap. This is the economy s , also known as . S AD RA It is now a simple matter to consider the possible causes of the business cycle studied in Chapter 8. In Figure 9.7(a) and (b), the economy is initially at full employment equilibrium, producing potential output Yp. In part (a), a fall in aggregate demand, shifting the AD curve leftward from AD1 to AD2 causes a recessionary gap. If the economy experiences an increase in aggregate demand, appearing as a rightward shift in the AD curve from AD1 to AD3, this causes an inflationary gap. Shifts in the SRAS curve can also contribute to economic fluctuations.4 In Figure 9.7(b), starting again from full employment equilibrium, a fall in SRAS, shifting SRAS1 to SRAS2, leads to an economic contraction, with real GDP falling to Y2 and unemployment increasing. Note, however, that this contraction differs from the recessionary gap resulting from the fall in aggregate demand: the fall in aggregate supply leads to an increase in the price le el, along ith a decrease in real GDP. This special set of circumstances is especially undesirable for an economy, as it involves the appearance of two problems: recession (with unemployment) and a rising price level. This is known as stagflation (combining stagnation with inflation ), a term coined in the 1970s. We will come back to this topic in Chapter 10. An increase in SRAS, shifting SRAS1 to SRAS3 leads to an economic expansion as real GDP increases to Y3 and unemployment falls. This expansion results in a falling price level, in contrast to the rising price level following an increase in aggregate demand. Most economists believe that changes in aggregate demand are more frequent than changes in aggregate suppl as causes of the business cycle. F 9.7: Possible causes of the business cycle A GDP ( ) In our discussion above, we saw that inflationary and deflationary gaps are two possible short-run equilibrium positions of the economy where the equilibrium level of real GDP differs from potential GDP. If the LRAS curve is vertical at potential GDP, it follows that inflationary and deflationary gaps are only short-run phenomena that cannot persist in the long run. As soon as the economy moves into the long run, the gaps disappear, and the economy achieves full employment equilibrium. To see how this occurs, consider Figure 9.8(a), where an economy is initially in long-run equilibrium at point a producing potential output, Yp. A fall in aggregate demand from AD1 to AD2 causes the economy to move in the short run from point a to point b, where there arises a deflationary gap; at b, real GDP has fallen to Ydef and the price level has fallen from Pl1 to Pl2. However, the economy cannot remain there in the long run. In the long run, the fall in the price level is matched by a fall in wages (and falls in other resource prices), so the SRAS curve shifts to the right from SRAS1 to SRAS2 until the economy is back on the LRAS curve, at point c. The assumption of age and price fle ibilit in the long run has allo ed the econom to automaticall come back to its long-run equilibrium le el of output. The deflationary gap is eliminated, and the only thing that changes due to the fall in aggregate demand is the fall in the price level (from Pl1 to Pl3).5 In Figure 9.8(b) we see what happens if there is an increase in aggregate demand. Beginning from longrun equilibrium at point a, aggregate demand shifts from AD1to AD2; in the short run the economy moves to point b, real GDP increases to Yinfl where there is an inflationary gap, and the price level increases from Pl1 to Pl2. However, the economy cannot remain at point b in the long run, because once wages (and other resource prices) increase to match the increase in the price level, SRAS shifts from SRAS1to SRAS2, and the economy arrives at point c, which is once again on the LRAS curve. In the long run, the inflationary gap is eliminated and the only thing that changes after the increase in aggregate demand is the increase in the price level (to Pl3).6 In the monetarist/new classical perspective, recessionary (deflationary) and inflationary gaps are eliminated in the long run. This ensures that in the long run the LRAS curve is vertical at the level of potential GDP. The economy has a built-in tendency towards full employment equilibrium. The move from point a to c in the long run in the case of a fall in AD that causes a deflationary gap (Figure 9.8(a)), and an increase in AD that causes an inflationary gap (Figure 9.8(b)), indicates the following important principle. F 9.8: Automatic adjustment to long-run full employment equilibrium in the monetarist/new classical model In the monetarist/new classical perspective, changes in aggregate demand can have an influence on real GDP only in the short run; in the long run, the only impact of a change in aggregate demand is to change the price level, having no impact on real GDP, as this remains constant at the level of potential or full employment output (see also Figure 9.14(a)). Increases in aggregate demand in the long run are therefore inflationary (cause inflation). TEST O R NDERSTANDING 9.4 1 Define the long run in macroeconomics and use a diagram to show the long-run aggregate supply (LRAS) curve. Outline what the vertical shape of the LRAS curve tells us about the relationship between the price level and real GDP in the long run. 2 Define and use a diagram to show long-run equilibrium in the AD-AS model (show the relationship between the LRAS, SRAS and AD curves). Outline what the long-run equilibrium says about the level of unemployment. 3 Draw two diagrams, illustrating recessionary and inflationary gaps in relation to the LRAS curve. 4 Using the three possible states of the economy shown in Figure 9.6, explain the phases of the business cycle (refer to expansions, contractions, and potential output). 5 Using diagrams explain why inflationary or deflationary gaps (short-term fluctuations) cannot persist in the long run according to the monetarist/new classical perspective. 6 Assuming the economy begins from a position of full employment equilibrium, explain how each of the events listed in the question in Test your understanding 9.3 can contribute to short-term economic fluctuations. 4 It may be noted that changes in aggregate supply can cause contractions and expansions; however, these are not called deflationary (recessionary) or inflationary gaps. The reason is that deflationary and inflationary gaps are defined in terms of the level of actual aggregate demand relative to the aggregate demand that is required to bring about full employment equilibrium. A deflationary gap is therefore caused by insufficient aggregate demand, and an inflationary gap by too much aggregate demand. 5 You may be wondering why wages will fall in the long run, thereby causing the shift in the SRAS curve that makes the economy move back to full employment equilibrium. The reason involves adjustments that take place in the labour market. As we know from our earlier discussion, if there is a recessionary gap, aggregate demand is weak and there is unemployment of labour that is greater than the natural rate of unemployment. This means that there is a surplus of labour in the labour market; in other words, the quantity of labour supplied is greater than the quantity of labour demanded. This creates pressures on wages to fall, so as to bring about a balance between the quantity of labour demanded by firms and the quantity supplied by workers. Therefore, wages fall in the long run, in order to eliminate the labour surplus, and when there is no longer any surplus labour, the economy reverts to long-run equilibrium through the shift in the SRAS curve. 6 When there is an inflationary gap, unemployment falls below the natural rate, and there is a shortage of labour in the labour market. Firms have a strong demand for labour (as well as other resources) and workers would like to negotiate higher wages because the price level has increased. In the long run, the wage is free to change in response to the forces of supply and demand, and moves upward to the point where quantity of labour demanded is brought into balance with quantity of labour supplied. When this occurs, the economy returns to long-run equilibrium through the shift in the SRAS curve. 9.4 A K a a b a LEARNING OBJECTIVES After studying this section you will be able to: define all the terms appearing in a b in the text (AO1) explain the Keynesian perspective of the aggregate supply (AS) curve (AO2) explain equilibrium in the Keynesian model (AO2) draw a diagram showing equilibrium in the Keynesian model (AO4) explain that in the Keynesian model deflationary/recessionary gaps may persist so that the equilibrium level of output may differ from the full employment level of output (AO2) This section presents the theoretical model of Keynesian economists. Keynesian economists base their ideas on the work of John Maynard Keynes, one of the most famous economists of the 20th century, whose work in the first half of the century came to form the basis of modern macroeconomics. (See Chapter 1, Section 1.5 for an overview.) Keynes questioned the classical economists view of the economic system as a harmonious system that automatically tends towards full employment, and showed that it is possible for economies to remain in a position of short-run equilibrium for long periods of time. G Wa a a b The LRAS curve in the monetarist/new classical model depends on the idea that all resource prices and product prices are fully flexible and respond to the forces of supply and demand. However, what if resource prices cannot fall, even over long periods of time? Keynesian economists argue that there is an asymmetry between wage changes in the upward and downward directions. Under conditions of an economic expansion and strong aggregate demand (rightward shifts in the AD curve causing an inflationary gap), with unemployment lower than the natural rate and a rising price level, wages quickly begin to move upward. Yet in a recessionary gap, where aggregate demand is weak and the economy is in recession with unemployment greater than the natural rate, wages do not fall easily, even over long periods of time, because of a variety of factors (such as labour contracts, minimum wage legislation; worker and union resistance to wage cuts; employer resistance due to morale). Keynesian economists also argue that not only wages but also product prices do not fall easily, even if an economy is in a recessionary gap. In a recession, if wages will not go down, firms will avoid lowering their prices because that would reduce their profits. Furthermore, large oligopolistic firms may fear price wars; if one firm lowers its price, then others may lower theirs more aggressively in an effort to capture market shares, and then all the firms will be worse off. Such factors, it is argued, make prices unlikely to fall even in a recession. T ab If wages and prices do not fall easily, this means the economy may get stuck in the short run. Consider Figure 9.9(a), which is similar to Figure 9.8(a). Beginning at point a where an economy is producing potential output Yp, aggregate demand falls so the AD curve shifts from AD1 to AD2. The monetarist/new classical model predicts that the economy will move to point b in the short run, where there is a recessionary gap and the price level falls from P 1 to P 2; in the long run it will move to point c with Pl3 and the economy is once again producing potential output Yp. However, if the price level cannot fall from P 1, the economy will move to point d on the new, lower, aggregate demand curve, AD2. Even if the price level succeeds in falling to P 2, so the economy moves to point b, the economy may get stuck there if wages do not fall (remember that wages must fall for the SRAS curve to shift to SRAS2 on the LRAS curve). It follows that if the price level cannot fall, or if wages cannot fall, the economy gets stuck in the short run, and is unable to move into the long run where it eliminates the recessionary gap. This argument suggests that the SRAS curve has the shape shown in Figure 9.9(b). The hori ontal part of the curve is based on the Keynesian idea that wages and prices do not move downward. Point d in Figure 9.9(a) corresponds roughly to point d in Figure 9.9(b). The economy is in a deflationary gap and may stay there indefinitely unless the government intervenes with specific policies. In the Keynesian model, inflexible wages and prices in the downward direction mean that the economy cannot move into the long run when experiencing a deflationary gap. Inflexible wages and prices are shown graphically by a hori ontal section of the Keynesian aggregate supply (AS) curve. F 9.9: Keynesian analysis Keynesians would not suggest that wages and prices can never fall. They would agree that if a recession or depression (which is a very severe recession) continues for a long enough time (perhaps years), wages and prices would eventually begin to fall. In the meantime a long-lasting recession would be very costly in terms of unemployment, low incomes and lost output. Therefore, it would be necessary for the government to intervene with active policies to help the economy come out of the recession. T a K a a a Figure 9.10 shows that the K a a a has three sections. In section I, real GDP is low, and the price level remains constant as real GDP increases. In this range of real GDP, there is a lot of unemployment of resources and a e ca ac . Spare capacity refers to the availability of resources including physical capital (machines, equipment, etc.) are labour that are not used. Firms can easily increase their output by employing the unemployed capital and other unemployed resources, without having to bid up wages and other resource prices. In section II, real GDP increases are accompanied by increases in the price level. The reason is that as output increases, so does employment of resources, and eventually bottlenecks in resource supplies begin to appear as there is no longer spare capacity in the economy. Wages and other resource prices begin to rise, which means that costs of production increase. The only way that firms will be induced to increase their output is if they can sell it at higher prices. Therefore, growing output leads to an increasing price level. At output level Yp, the economy has reached its full employment level of real GDP. This is also its potential output level, and unemployment has fallen to the point where it is now equal to the natural rate of unemployment. However, as we know, the natural rate of unemployment is not maximum employment, as unemployment can fall further, which is what happens when real GDP continues to increase beyond Yp. Real GDP can continue to increase until it reaches section III. F 9.10: The Keynesian aggregate supply curve In section III, the AS curve becomes vertical at Ymax, indicating that real GDP reaches a level beyond which it cannot increase anymore; at this point, the price level rises very rapidly. Real GDP can no longer increase because firms are using the maximum amount of labour and all other resources in the economy. Any efforts on the part of firms to increase their output only result in greater increases in the price level. T b a K a Macroeconomic equilibrium in the Keynesian model is determined by the point where the AD curve intersects the Keynesian AS curve. This can occur at any level of real GDP. There are three equilibrium states of the economy, shown in Figure 9.11. Figure 9.11(a) shows the AD curve intersecting the AS curve in its hori ontal section, determining Ye, which is less than Yp (potential GDP), indicating a deflationary (recessionary) gap with unemployment greater than the natural rate. Aggregate demand is too weak to induce firms to produce at Yp. In part (b), the economy is producing at Ye, which is greater than Yp, and is experiencing an inflationary gap. There is strong aggregate demand, unemployment has fallen below its natural rate, and as the economy approaches its maximum capacity, the price level has increased. Part (c) shows the case where the economy has achieved full employment equilibrium, or potential output, at Yp. These three equilibrium states of the economy can be related to the business cycle (see Chapter 8): Ye in Figure 9.11(a) corresponds to a point like e in Figure 8.4, where there is a deflationary gap; Ye of Figure 9.11(b) corresponds to a point like d in Figure 8.4, where there is an inflationary gap; and Yp of Figure 9.11(c) corresponds to points like a, b and c in Figure 8.4, where the economy s actual output is equal to its potential output. It should be noted that potential output and natural unemployment , which we have used to illustrate the three kinds of equilibrium, are actually ea concepts. On the other hand, inflationary and deflationary (recessionary) gaps are Ke e a concepts. As our analysis shows, the two models can usefully borrow concepts from each other in order to show how different real-world situations can be understood and interpreted differently depending on the theoretical approach used. The Keynesian model arrives at some conclusions that differ significantly from the conclusions of the monetarist/new classical model. Very briefly, these are that: the economy in the Keynesian model can remain indefinitely stuck in a deflationary gap, unlike in the monetarist/new classical model where the economy automatically returns to full employment equilibrium increases in aggregate demand in the Keynesian model need not necessarily result in increases in the price level, unlike in the monetarist/new classical model where increases in aggregate demand always result in a higher price level. As a result of these differences, the two models have very different policy recommendations about how to deal with some very important problems of the macroeconomy. F 9.11: Three equilibrium states of the economy in the Keynesian model TEST YOUR UNDERSTANDING 9.5 1 Define aggregate supply. Explain whether the meaning of this concept changes in the context of the SRAS, LRAS or Keynesian AS curves. 2 a Explain what it means for the shape of the aggregate supply curve if wages and prices are inflexible in the downward direction. b Can the economy move into the long run? Outline what the hori ontal section of the AS curve tells us about spare capacity in the economy. 3 a Use a diagram to show the Keynesian AS curve. b Outline what the flat section of this curve indicates about the relationship between the price level and real GDP. Outline what the upward-sloping section indicates about this relationship. Outline what the vertical section indicates. 4 Using the Keynesian model and diagrams, show the three short-run equilibrium states of the economy, describing recessionary (deflationary) and inflationary gaps and their relationship to the full employment equilibrium position of the economy (potential output). 5 Using diagrams illustrating the Keynesian model, show and explain what happens to the equilibrium level of real GDP and the price level if aggregate demand shifts within a the hori ontal section of the Keynesian AS curve, b the upward-sloping section of the Keynesian AS curve, and the vertical section of the Keynesian AS curve. REAL WORLD FOCUS 9.1 T Ia a a In early 2019 business confidence in Italy fell to the lowest level in four years, suggesting that Italy s economic contraction which began the previous year may continue. Consumer confidence also fell. Falling real GDP for the last two quarters of the previous year meant that Italy was in recession. The economic downturn was the result of falling output in agriculture, forestry, fishing and industry. Net exports on the other hand increased, but not by enough to make up for the declines. S F :B be g; BBC 9.12: Naples, Italy. Narrow street in the old part of the city A 1 Using AD-AS diagrams, explain the effect on Italy s real GDP of a the drop in business and consumer confidence, and b the increase in net exports. 2 Outline which components of aggregate demand were affected by the drop in business and consumer confidence. 3 Explain the likely position of the Italian economy in early 2019 a using a business cycle diagram, b using an AD-AS diagram with an LRAS curve, and using an AD-AS diagram with a Keynesian AS curve. 4 Outline which method of national income accounting allowed economists to determine a the increase in Italy s net exports, and b the decrease in output of the agriculture, forestry, fishing and industry sectors. 9.5 S LEARNING OBJECTIVES A : (AO1) AS (K ( ) / LRA ) (AO2) / K A LRA (AO4) C A AD-A S , LRA , K A , . .E , ( ). T . , A ; ( ). I , - F C 9.13. W 11. F ( T K A ) LRA A : I . I , LRA K A .F , , ( ) GDP. (I , LRA A .) I ( LRA A .F ). I , , .M . I . A , A .F , . I .W , , LRA , . T A .) A I , . (D . T , . F , , , , ( - - C 13, ). R . T . I , , . T .I , , . T , A . (A K LRA F 9.13: I A , , .) - T RA LRA / I - , LRA , . , .A .T F LRA 11) 11.3 (C A RA , , RA LRA , , LRA .C .T , , ?T RA , RA ; C RA . , , LRA . ( ), RA GDP A .T . , LRA ( .T AD RA ) , , , .F A , AD. W C 13. TEST OUR UNDERSTANDING 9.6 1 I LRA K A . T . T . A , A . A . T , A 2 . U , LRA K I . SRA I F A LRA / 9.14 . K / K , K ( ) A GDP. N , .P LRA . P ( , AD2 ( ) ) ( ). P , , , AD3. F 9.14: C F / K , .I LRA . ; ( ) ( ) K A 9.6 I K / LEARNING OBJEC I ES After stud ing this section ou will be able to: discuss the differing assumptions of the Ke nesian and monetarist/new classical models and their implications for the econom and for polic (AO3) A - Our stud of Figure 9.8 showed that in the monetarist/new classical model inflationar and deflationar gaps are automaticall corrected as long as resource prices, especiall wages, are free to change as the price level changes. B contrast, one of the most important ideas arising from the Ke nesian interpretation of the AD AS model is that deflationar /recessionar gaps can persist over long periods of time. According to Ke nes, this happens partl because of the inabilit of wages and prices to fall. In addition, the problem is caused b insufficient aggregate demand. Whenever aggregate demand intersects the hori ontal section of the Ke nesian AS curve, the econom is in a deflationar gap because aggregate demand is too low, and its four components are unable to bu enough output to make it worthwhile for firms to produce potential GDP. Therefore, equilibrium GDP is lower than potential GDP. In Figure 9.11(a), the equilibrium level of real GDP settles at Ye, and can remain there indefinitel . Ke nesian anal sis is therefore essentiall a short-term anal sis. This does not mean that Ke nesian economists do not consider what happens over long periods of time; it means onl that the do not accept the idea that the econom can move into what monetarist/new classical economists define as the long run (where there is full resource and product price fle ibilit ). In contrast to the monetarist/new classical model, which automaticall corrects deflationar /recessionar gaps b returning to full emplo ment equilibrium, the Ke nesian model shows that an econom can remain for long periods of time in an equilibrium where there is less than full emplo ment (i.e. a deflationar /recessionar gap), caused b insufficient aggregate demand. The two different models have important implications for economic polic . According to the monetarist/new classical model, governments should tr to make markets work as freel as possible, so that wages and product prices can respond to the forces of demand and suppl , without government interference in markets. B contrast, according to the Ke nesian model, the government must intervene in the econom with specific measures to help it come out of the deflationar gap. I Another important difference between the two models has to do with the effects of increases in aggregate demand on the price level. In the monetarist/new classical model, increases in aggregate demand alwa s result in price-level increases. In the short run, as AD shifts to the right causing a movement along an upward-sloping SRAS curve, an increase in real GDP and an increase in the price level result, as can be seen in Figure 9.4(a). In the long run, increases in aggregate demand give rise onl to increases in the price level, leaving real GDP unaffected, as in Figure 9.15(a). In the Ke nesian model, when the econom is in the hori ontal part of the AS curve, increases in aggregate demand lead to increases in real GDP without affecting the price level. This can be seen in Figure 9.15(b). It is onl when the Ke nesian AS curve begins to slope upward, when it is close to the full emplo ment level of output, that further increases in aggregate demand begin to result in changes in the price level as well. When the AS curve becomes vertical, increases in aggregate demand result in rapid price level increases while leaving real GDP unchanged. F 9.15: Effects of increases in aggregate demand on real GDP and the price level In the Ke nesian view increases in aggregate demand need not result in a higher price level. This is in contrast to the monetarist new/ classical model where increases in aggregate demand alwa s result in a higher price level. Here too, there are differing implications for economic polic . As we will see in Chapter 10, rapid increases in the price level (or inflation) are undesirable. In the monetarist/new classical view, since increases in aggregate demand will alwa s lead to increases in the price level, economic polic should focus on policies to achieve gg h, which are based on efforts to shift the LRAS curve to the right. B contrast, in the Ke nesian view, since increases in aggregate demand do not lead to price level increases when the econom is in a deflationar gap, policies focusing on increasing aggregate demand are not onl harmless, but in fact are essential in order to both prevent and reduce the si e of both deflationar and inflationar gaps. ES 1 2 O R NDERS ANDING 9.7 Compare and contrast the Ke nesian and monetarist/new classical models regarding the abilit of an econom to achieve full emplo ment equilibrium on its own without an government intervention. Using the Ke nesian model, e plain when increases in aggregate demand can be e pected to lead to increases in the price level (inflation) and when the are unlikel to do so. E plain how the Ke nesian model differs from the monetarist/new classical model in its prediction of rising price levels following an increase in aggregate demand. 3 E plain wh use of the LRAS curve to account for economic growth leads to the polic implication that governments should focus on policies that tr to influence the suppl side of the econom . 4 E plain wh use of the Ke nesian threesection aggregate suppl curve leads to the polic implication that governments should focus on the policies that tr to influence the demand side of the econom . HEOR OF KNO LEDGE 9.1 C The two perspectives we have studied in this chapter, the monetarist/new classical and Ke nesian, are based on ver different wa s of viewing the economic world. The differences between the two are not just of theoretical interest; the have important implications for the real world, because each perspective provides ver different polic recommendations to deal with macroeconomic problems. / In the monetarist/new classical perspective, the econom is seen as a stable s stem that automaticall tends towards long-run equilibrium where there is full emplo ment at the natural rate of unemplo ment. This argument has important implications for the short-term fluctuations of the business c cle and long-term economic growth. Since short-term fluctuations (deflationar /recessionar and inflationar gaps) correct themselves automaticall , there is no need for the government to do an thing to correct them. Instead, the government must ensure that markets work as competitivel as possible, so that all resource and product prices are able to rise or fall as required to allow the econom to settle at its point of long-run equilibrium, at the level of potential GDP. In fact, continues the argument, if governments do intervene with policies intended to correct shortterm fluctuations, the ma achieve the opposite of the intended results. Rather than reduce the si e of fluctuations, the ma make them bigger. Man monetarist/new classical economists believe that the departures of actual GDP from potential GDP that occur in real-world business c cles are as large as the are because of government intervention in the econom . When it comes to promoting economic growth, aggregate demand cannot affect real GDP over the long run. If aggregate demand increases, it will onl result in increasing price levels and inflation. Governments should therefore concentrate on policies that affect the suppl side of the econom , which attempt to shift the LRAS curve to the right, with the objective of increasing real GDP without causing inflation. K In the Ke nesian perspective, the econom is an unstable s stem because of repeating short-term fluctuations that cannot automaticall correct themselves. Such fluctuations arise mainl due to changes in aggregate demand caused b spontaneous actions of firms and consumers. Ke nes himself considered business c cle fluctuations to be caused mainl b changes in investment spending caused b changes in firms e pectations about the future. Optimism about the future increases investment spending, causing a rightward shift in the AD curve; pessimism decreases investment spending, leading to a leftward shift. Ke nes referred to alternating waves of optimism and pessimism as animal spirits . In the Ke nesian view, when there is a deflationar gap, there are man factors preventing the operation of market forces, and so wages and product prices do not fall easil even over long periods of time. This means the econom can remain in a less than full emplo ment equilibrium (deflationar gap) for long periods. Therefore, there is an important role for government polic to pla to restore full emplo ment and raise real GDP to the level of potential GDP. Governments should focus on policies that increase aggregate demand when there is a deflationar gap, and decrease aggregate demand when there is an inflationar gap. Policies to influence aggregate demand are particularl important when aggregate demand is low. ? Most economists toda are unlikel to be purel monetarist / new classical or purel Ke nesian . After decades of debate, man would argue that elements of both perspectives have some merit, and that policies attempting to influence both aggregate suppl and aggregate demand are important in achieving the goals of reducing short-term fluctuations while promoting economic growth. Even so, most economists are still likel to side more with one perspective or the other. Wh has the disagreement not been resolved after all these ears? According to Mark Blaug, a prominent UK economist, there has been: . . . a e di g e ie f eff d ce a deci i e e i ica e f he Ke e ia a d e a i ie f he ca e f ec ic f c a i . A de ached b e e igh be f gi e f hi i g ha hi di c i ha ed hi g b ha e i ica e ide ce i a a e i ca ab e f a i g a ec i cha ge hi i d . . . B a c e a he i e a e e ea . . . a g i g a ecia i f he i i a i f a he c e a i ica e f he e a i e effec i e e f [g e e ] icie . . . A he a e i e, i be ad i ed ha he e i e ce f hi c e , de i e a he e a dc e e i b h ca , ca be e ai ed i e f ce ai dee - ea ed ha d c e di ag ee e ab he e f-adj i g ca aci f he i a e ec i i ed ec ie a d, he ce, he e e hich [g e e ] ic i i fac abi i i g de abi i i g . . . O ce agai , he deba e be ee Ke e ia a d ea i h ha ec i (i ea he cie i ) i cha ac e i ica defe d he c e f hei be ief f he h ea f b e ed a a ie . . . 7 Blaug is suggesting that the controvers persists because economists have different beliefs. What kind of beliefs could these be? On a general level, the must be beliefs about the superiorit of one perspective over the other. However, this begs the question, where did these beliefs come from, and how can the be justified? Certainl not b the scientific method, based on empirical testing, since as Blaug clearl tells us, it has not been possible for an empirical test to falsif one or the other perspective based on the effectiveness of their polic recommendations. Therefore, ver likel , these are beliefs that come from outside the realm of social scientific thinking, which ma be political and ideological beliefs stemming from personal values. Most economists do not den the role of values and ideolog in economics. Nobel Pri e-winning economist, Robert Solow, writes the following: S cia cie i , i e e e e e e, ha e c a i e e , ide gica c i e ,a d a e f a i d. B a cia cie ce e ea ch, i e e ea ch he e g h f a e ia he c e f he hae g bi ec e, ie e c e he c e f h e ide gie , i e e , a d a e . Whe he he cia cie i i i i , e ha e e if he figh i , hi ch ice f e ea ch be , he e d he ide gie a d a e he e i e, ae a .8 he a i e , he e i be, i he d e a , hi a a ica f a e e ea e, a ef ec i f hi i e e , , Do ou agree with Solow that it is ver likel that personal value judgements influence economists choices between alternative theories (the choice of anal tical framework ) and more generall their work as social scientists? Is the effective use of the scientific method influenced b economists personal beliefs and ideologies? Do the social sciences, and economics in particular, differ from the natural sciences b having political beliefs and ideologies influence thinking? What kind of political beliefs and ideologies do ou think are likel to be linked with (a) the monetarist/new classical perspective, and (b) the Ke nesian perspective? INQ IR AND REFLEC ION The following questions will help ou reflect on our learning and enhance our understanding of ke topics in this chapter. The are suggestions for inquiries that ou can undertake on our own or in groups in order to revise the learning objectives of this chapter. 1 Research an econom that has recentl been (or is currentl ) in a recession. 2 Identif the causes of the recession and tr to link them with what ou have learned about the factors that cause aggregate demand and/or short-run aggregate suppl to shift. E AM S LE Q ES IONS You can find questions in the st le of IB e ams in the 'Digital coursebook: E tra material' section. 7 Mark Blaug (1980) The Me h d g f Ec ic , Cambridge Universit Press, pp. 217 and 221. 8 Robert M. Solow (1996) Science and ideolog Ec ic , Cambridge Universit Press. in economics in D. M. Hausman, The Phi h f C a e 10 Mac ec e fa Bef e c b ec e I: L e , a d ab e a e f a Unemplo men occ r hen people hink people become nemplo ed? ho are looking for a job canno find one. Wh do o Wha problem are a ocia ed i h nemplo men on a per onal and ocial le el? Can o of ome ac ion go ernmen can ake o help nemplo ed people become emplo ed? Price of good and er ice end o ri e o er ime. Thi i kno n a hink infla ion occ r o er ime? hink infla ion . Wh do o Thi chap er i concerned i h o impor an macroeconomic objec i e : lo nemplo men and lo and able ra e of infla ion. Bo h of he e are clo el rela ed o achie ing po en ial o p , ho n in he b ine c cle diagram in Chap er 8; ee Fig re 8.4. 10.1 Low unemployment LEARNING OBJECTIVES Af er s d ing his sec ion o ill be able o: define all he erms appearing in orange bold in he e e plain ho (AO1) nemplo men and he nemplo men ra e are calc la ed (AO2) calc la e he nemplo men ra e (AO4) e plain he diffic l ies of meas ring nemplo men (AO2) e plain and disc ss he economic, personal and social cos s of nemplo men (AO3)1 e plain he ca ses of nemplo men : c clical, s r c ral, seasonal and fric ional (AO2) dra diagrams sho ing (AO4) a fall in labo r demand for a par ic lar marke or geographical area nemplo men res l ing from a minim m age defla ionar gap sho ing c clical nemplo men e plain ha he na ral ra e of nemplo men is he s m of s r c ral, seasonal and fric ional nemplo men (AO2) Unemployment and its measurement Unemplo men , in a general sense, refers o idle, or no f ll sed reso rces. When economis s se he erms nemplo men (or emplo men ) on heir o n, he s all refer o nemplo men or emplo men of labo r. If he an o refer o ano her fac or of prod c ion, he refer o i e plici l , s ch as nemplo men of capi al reso rces , or more generall , nemplo men of reso rces . O r disc ssion in his chap er ill foc s on he econom s labo r reso rces. Unemplo men is defined as follo s: Unemployment refers o people of orking age ho are ac i el looking for a job b emplo ed. ho are no A closel rela ed erm is , referring o people of orking age i h par - ime jobs hen he o ld ra her ork f ll ime, or i h jobs ha do no make f ll se of heir skills and ed ca ion. E amples incl de people ho ork fe er ho rs per eek han he o ld like, or rained indi id als, s ch as engineers, economis s, or comp er anal s s, ho ork as a i dri ers, or ai ers or ai resses, or an hing else nrela ed o heir profession, hen he o ld ra her ha e a job in heir profession. Bo h nemplo men and nderemplo men mean ha an econom is as ing scarce reso rces b no sing hem f ll . In he case of nemplo men his is ob io s. Wi h nderemplo men , orking a a job o her han in one s profession also in ol es reso rce as e , beca se some reso rces ha ere sed for raining and ed ca ion are as ed hen people are forced o ork a a job ha does no make se of heir skills. Calculating unemployment: the unemployment rate The ab is defined as he n mber of people ho are emplo ed ( orking) pl s he n mber of people of orking age ho are nemplo ed (no orking b seeking ork). The labo r force is ac all a frac ion of he o al pop la ion of a co n r , beca se i e cl des children, re ired persons, ad l s den s, all people ho canno an o ork. ork beca se of illness or disabili , as ell as all people ho do no Unemplo men can be meas red as a n mber or percen age: As a n mber, nemplo men is he o al n mber of nemplo ed persons in he econom , i.e. all persons of orking age ho are ac i el seeking ork b are no emplo ed. As a percen age, nemplo men is called he a , defined as unemployment rate = n mber of nemplo ed labo r force 100 For e ample, if he nemplo men ra e in an econom is 6%, his means ha si o in he labo r force are nemplo ed. of e er 100 people S ppose here is a pop la ion of 35.5 million people, of hom 17.3 million are in he labo r force, 1.5 million ork par ime ho gh he o ld ra her ork f ll ime, and 1.4 million are looking for ork b canno find an . Wha is he nemplo men ra e? The nemplo men ra e is 1.4 17.3 100=8.1%, hich is he n mber looking for ork nable o find an di ided b he si e of he labo r force, imes 100. No e ha e ignore he si e of he o al pop la ion (i is irrele an ), as ell as he n mber of people ho are orking par - ime ( he are considered o be emplo ed). Underemplo men can similarl be meas red as a n mber or as a percen age. If he nderemplo men ra e is 15%, his means ha 15 o of e er 100 people in he labo r force are nderemplo ed. Difficulties in measuring unemployment The nemplo men ra e is one of he mos idel repor ed meas res of economic ac i i , sed e ensi el as an indica or of economic performance. Ye i is ac all diffic l o ob ain an acc ra e meas remen of nemplo men . Official s a is ics of en nderes ima e r e nemplo men beca se of he follo ing: , arising from Unemplo men fig res incl de nemplo ed persons ho are ac i el looking for ork. This e cl des disco raged orkers , ho are nemplo ed orkers ho ga e p looking for a job beca se, af er r ing ns ccessf ll o find ork for some ime, he became disco raged and s opped searching. These people in effec drop o of he labo r force. Unemplo men fig res do no make a dis inc ion be een f ll- ime and par - ime emplo men , and co n people i h par - ime jobs as ha ing f ll- ime jobs ho gh in fac he are nderemplo ed. Unemplo men fig res make no dis inc ion on he orks as a ai er, his co n s as f ll emplo ed. pe of ork done. If a highl rained person Unemplo men fig res do no incl de people on re raining programmes ho pre io sl los heir jobs, as ell as people ho re ire earl al ho gh he o ld ra her be orking. In addi ion, official s a is ics ma o eres ima e r e nemplo men , beca se: nemplo men fig res do no incl de people orking in he ndergro nd econom (or informal econom ). This is he por ion of he econom ha is nregis ered, legall nreg la ed and no repor ed o a a hori ies. Some people ma be officiall regis ered as nemplo ed, e he ma be orking in an nrepor ed ( ndergro nd) ac i i . A f r her disad an age of he na ional nemplo men ra e (calc la ed for an en ire na ion) is ha i is an a erage o er he en ire pop la ion, and herefore does no acco n for differences in nemplo men ha of en arise among differen a in a socie . Wi hin a na ional pop la ion, nemplo men ma differ b : region gender regions i h declining ind s ries ma ha e higher nemplo men ra es han o her regions omen some imes face higher nemplo men ra es han men e hnic gro ps some e hnic gro ps ma be disad an aged d e o discrimina ion, or d e o lo er le els of ed ca ion and raining age o h nemplo men ( s all referring o persons nder he age of 25) of en face higher nemplo men ra es han older pop la ion gro ps, of en d e o lo er skill le els; people ho are ageing also some imes face higher nemplo men ra es as emplo ers ma be less illing o emplo hem occ pa ion and ed ca ional a ainmen people ho are rela i el less skilled ma ha e higher nemplo men ra es han more skilled orkers ( ho gh in some co n ries higher nemplo men ra es ma be fo nd among highl ed ca ed gro ps). Costs of unemployment Unemplo men of labo r is one of he mos impor an economic concerns o co n ries aro nd he orld. Red c ion of nemplo men is a ke objec i e of go ernmen s e er here, as i s presence has major economic and social conseq ences. Economic costs Unemplo men has he follo ing economic conseq ences: A loss of real output (real GDP). Since fe er people ork han are a ailable o ork, he amo n of o p prod ced is less han he le el he econom is capable of prod cing. This is h nemplo men means ha an econom finds i self some here inside i s prod c ion possibili c r e (PPC; see Chap er 1, Sec ion 1.3), prod cing a lo er le el of o p han i is capable of prod cing. A loss of income for unemployed workers. People ho are nemplo ed do no ha e an income from ork. E en if he recei e nemplo men benefi s, he are likel o be orse off financiall han if he had been orking. A loss of tax revenue for the government. Since nemplo ed people do no ha e income from ork, he do no pa income a es; his res l s in less a re en e for he go ernmen . Costs to the government of unemployment benefits. If he go ernmen pa s nemplo men benefi s o nemplo ed orkers, he grea er he nemplo men , he larger he nemplo men benefi s ha m s be paid, and he less a re en e lef o er o pa for impor an go ernmen pro ided goods and ser ices s ch as p blic goods and meri goods. Costs to the government of dealing with social problems resulting from unemployment. The social problems ha arise from nemplo men (no ed belo ) of en req ire go ernmen f nds o be appropria el deal i h. Larger budget deficit or smaller budget surplus. A go ernmen b dge defici occ rs hen a re en es are less han go ernmen e pendi res, hile a b dge s rpl s is he opposi e, in ol ing grea er a re en es han e pendi res. Unemplo men leads o a loss of a re en e for he go ernmen as e ha e seen, b a he same ime grea er e pendi res for nemplo men benefi s as ell as social problems d e o nemplo men . As e pendi res rise hile a re en es fall, a b dge s rpl s ill become smaller hile a b dge defici ill become larger, in rn leading o more go ernmen deb . More unequal distribution of income. Some people ( he nemplo ed) become poorer hile o hers ( he emplo ed) are able o main ain heir income le els. Since cer ain pop la ion gro ps (e hnic gro ps, regional gro ps, e c., disc ssed earlier) ma be affec ed more b nemplo men han o hers, he effec s of increasing income ineq ali ies and res l ing po er are of en concen ra ed among pop la ion gro ps ho are more disad an aged o begin i h. If nemplo men is high or ends o persis o er long periods of ime, his ma lead o increased social ensions and social nres . Unemployed people may have difficulties finding work in the future. When people remain o of ork for long periods, he ma no find ork easil a a la er ime in he f re. This can happen beca se he nemplo ed orkers ma par l lose heir skills d e o no orking for a long ime, or beca se in he mean ime ne skills ma be req ired ha orkers ha e no been able o keep p i h, or beca se firms ha e fo nd a s o manage i h fe er orkers. This process is kno n as (from he Greek ord meaning dela or lagging behind some hing , in his case he lagging behind of emplo men ). H s eresis s gges s ha high nemplo men ra es in he presen ma mean con in ed high nemplo men ra es in he f re, e en hen economic condi ions become more fa o rable. Personal and social costs Unemplo men has he follo ing personal and social conseq ences: Personal problems. Being nemplo ed and nable o sec re a job in ol es a loss of income, increased indeb edness as people m s borro o s r i e, as ell as loss of self-es eem. All hese fac ors ca se grea ps chological s ress, some imes res l ing in lo er le els of heal h, famil ensions, famil breakdo n and e en s icide. Greater social problems. High ra es of nemplo men , par ic larl hen he are neq all dis rib ed for he reasons no ed earlier, can lead o serio s social problems, incl ding increased crime and iolence, dr g se and homelessness, arising from gro ing po er . TEST YOUR UNDERSTANDING 10.1 1 Define nemplo men and e plain ho i differs from nderemplo men . 2 O line ho e meas re he nemplo men ra e. 3 E plain h nemplo men fig res are no 4 Iden if some of he economic and social conseq ences of nemplo men . 5 Calc la e he nemplo men ra e in an econom i h a pop la ion of 57.7 million people, of hich he labo r force is 62%, and he n mber of emplo ed are 32.9 million. s all acc ra e. Types and causes of unemployment We ill e amine fo r pes of nemplo men : s r c ral, fric ional, seasonal and c clical. Structural unemployment Structural unemployment occ rs as a res l of changes in demand for par ic lar pes of labo r skills, changes in he geographical loca ion of ind s ries and herefore jobs, and labo r marke rigidi ies. Changes in demand for particular labour skills The demand for par ic lar pes of labo r skills changes o er ime. This ma be he res l of echnological change, hich of en leads o a need for ne pes of skills, hile he demand for o her skills falls. For e ample, comp er echnolog , he in rod c ion of a oma ed eller machines (ATMs), and elec rical rela s and digi al s i ching echnolog grea l red ced he need for pis s, bank ellers and elephone opera ors, hile increasing he need for orkers i h comp er li erac and comp er programming and o her skills. There are gro ing concerns ha a oma ion ( he in rod c ion of a oma ic machines in man fac ring) ma increasingl lead o job losses and herefore o more of his pe of nemplo men . According o a s d b O ford Economics, he in rod c ion of robo s aro nd he orld ma replace 20 million man fac ring jobs b 2030. Those ho lose heir jobs ill likel find jobs in o her sec ors incl ding ranspor , cons r c ion, main enance and office ork. The s d no es ha areas here orkers end o ha e lo er skills ill be s rongl affec ed.2 In addi ion, changes in demand for labo r skills ma occ r beca se of changes in he s r c re of he econom , leading o some gro ing ind s ries and some declining ind s ries. Workers ho lose heir jobs in declining ind s ries ma no ha e he necessar skills o ork in gro ing ind s ries, and become s r c rall nemplo ed. For e ample, as he agric l ral sec or declines in rela i e impor ance and he man fac ring and ser ices sec ors gro , agric l ral orkers ma lose heir jobs. Workers lacking he necessar skills o ork in ind s r or ser ices ma become s r c rall nemplo ed. (This pe of s r c ral change as e plained in erms of income elas ici of demand (YED); see Chap er 3.) These kinds of changes lead o a be een labo r skills demanded b emplo ers and labo r skills s pplied b orkers. S ch misma ches ca se s r c ral nemplo men . Changes in the geographical location of jobs When a large firm or e en an ind s r mo es i s ph sical loca ion from one region o ano her, here is a fall in demand for labo r in one region and an increase in he region here i reloca es. (The same problem co ld arise if a large firm or ind s r closes do n.) If people canno mo e o economicall e panding regions, he ma become s r c rall nemplo ed. Some imes firms reloca e o foreign co n ries, increasing he o erall s r c ral nemplo men i hin a co n r . Once again, he res l ill be a a be een labo r demanded and labo r s pplied i hin a geographical region (or co n r ). Using a diagram to show structural unemployment arising from mismatches between labour demand and labour supply S r c ral nemplo men arising from misma ches be een labo r demand and s ppl can be sho n in Fig re 10.1(a), sho ing he labo r marke for a par ic lar ind s r (or marke ) or for a par ic lar geographical area. The er ical a is meas res he age ( he price of labo r) hile he hori on al a is meas res he q an i of labo r. The demand c r e sho s he q an i of labo r firms are illing and able o hire a each age, and he s ppl c r e sho s he q an i of labo r orkers s ppl a each age. The ini ial eq ilibri m is de ermined b S and D1 a W1 and Q1. S ppose no ha d e o echnological change ha red ces demand for some labo r skills, or d e o a change in he s r c re of he econom , or d e o he mo e of an ind s r o ano her geographical area, here is a fall in he demand for labo r, sho n b he shif from D1 o D2. If marke forces orked perfec l , he problem of s r c ral nemplo men o ld be sol ed. A he lo er age W2, onl Q2 orkers o ld an o ork, so a ha lo er age here o ld no be an e cess s ppl of labo r. Ho e er in prac ice, ages do no fall easil o er shor periods of ime, and if he ere o fall he o ld need a long ime o do so. This means ha if he age remains a W1, a leas for he foreseeable f re, his gi es rise o an e cess s ppl of labo r ha corresponds o s r c ral nemplo men crea ed b he fall in he demand for labo r. E en if he age falls a li le, here o ld s ill be an e cess s ppl of labo r as long as i does no drop o he le el of W2.3 Figure 10.1: S r c ral nemplo men Labour market rigidities Lab a are fac ors pre en ing he forces of s ppl and demand from opera ing in he labo r marke . The incl de: minimum wage legislation, hich leads o higher han eq ilibri m ages labour union activities and wage bargaining with employers, res l ing in higher han eq ilibri m ages employment protection laws, hich make i cos l for firms o fire pa compensa ion), h s making firms more ca io s abo hiring orkers (beca se he m s generous unemployment benefits, hich increase he a rac i eness of remaining nemplo ed and red ce he incen i es o ork. Al ho gh economis s do no al a s agree on he effec s of hese fac ors on nemplo men , man arg e ha he are responsible for higher nemplo men ra es in co n ries i h s rong labo r pro ec ion s s ems (s ch as in E rope) compared o co n ries i h eaker labo r pro ec ion s s ems (s ch as he Uni ed S a es). Using diagrams to show structural unemployment arising from labour market rigidities Unemplo men arising from minim m ages and labo r nion ac i i ies leading o higher han eq ilibri m ages, can be sho n in a labo r marke diagram, as in Fig re 10.1(b). The higher han eq ilibri m age, Wm, res l s in nemplo men of labo r eq al o Qs Qd. Yo ma no e ha his diagram is he same as Fig re 4.9 (Chap er 4) sho ing a price floor applied in he labo r marke . Unemplo men arising from minim m age legisla ion, labo r nion ac i i ies and emplo men pro ec ion la s can also be sho n indirec l , hro gh a prod c s ppl and demand diagram, as in Fig re 10.1(c). Higher han eq ilibri m ages and emplo men pro ec ion lead o higher cos s of prod c ion for firms, ca sing he firm s ppl c r e o shif o he lef from S1 o S2, leading o a smaller q an i of o p prod ced, Q2 ins ead of Q1. Firms herefore hire a smaller q an i of labo r, and his con rib es o s r c ral nemplo men of hese pes. S r c ral nemplo men (of all pes) is a serio s pe of nemplo men beca se i ends o be long erm. A cer ain amo n of s r c ral nemplo men is na oidable in an d namic, gro ing econom , and is herefore considered o be par of na ral nemplo men . Ho e er, his does no mean i canno be lo ered. There are man policies go ernmen s can p rs e o red ce i , incl ding meas res enco raging orkers o re rain and ob ain ne skills, and o reloca e (mo e) o areas i h grea er emplo men oppor ni ies; pro iding incen i es o firms o hire s r c rall nemplo ed orkers; and meas res o red ce labo r marke rigidi ies. These policies ill be disc ssed in Chap er 13. Frictional unemployment Frictional unemployment occ rs hen orkers are be een jobs. Workers ma lea e heir job beca se he ha e been fired, or beca se he are in search of a be er job, or he ma be ai ing o s ar a ne job. Fric ional nemplo men ends o be shor erm, and does no in ol e a lack of skills ha are in demand. I is herefore less serio s han s r c ral nemplo men . A cer ain amo n of fric ional nemplo men is ine i able in an gro ing, changing econom , here some ind s ries e pand hile o hers con rac , some firms gro fas er han o hers, and orkers seek o ad ance heir income and professional posi ions. An impor an ca se of fric ional nemplo men is incomple e informa ion be een emplo ers and orkers regarding job acancies and req ired q alifica ions. Imagine 100 job acancies and 100 job applican s ho ha e e ac l he righ job q alifica ions. Beca se of incomple e informa ion, i akes ime for he righ applican s o ge ma ched p i h he righ jobs. Therefore, fric ional nemplo men is also par of na ral nemplo men . REAL WORLD FOCUS 10.1 The textile industry in Naoussa Nao ssa is a ci in nor hern Greece i h a cen riesold e iles ind s r , based on highl labo rin ensi e prod c ion me hods. When he marke s of neighbo ring ransi ion economies opened p in he 1990s, Greek firms fo nd i profi able o reloca e o co n ries incl ding Albania, B lgaria, Nor h Macedonia and Romania, on acco n of heir far lo er labo r cos s. The Greek go ernmen in rod ced legisla ion in ended o lo er labo r cos s (easier firing r les, e ension of o er- ime ork), e Greek firms sed some of hese pro isions o red ce heir local orkforce and mo e abroad. In 2005, he remo al of rade barriers on impor s of Chinese e iles (according o WTO r les; see Chap er 15) led o a h ge increase in Chinese e iles in he Greek marke , forcing man Greek e ile firms o close do n as he ere nable o compe e i h he lo er-cos Chinese impor s. Nao ssa as one of he areas mos s rongl affec ed. The combina ion of firm reloca ions and firm clos res led o he loss of ens of ho sands of jobs. In 2005, nemplo men in Nao ssa as es ima ed o ha e reached a record 35 40%. Source: A a Ma S M a L b , C b 2005; E a a a a ab a a b Ka a ,2O , 23 , b 2006. Figure 10.2: Greek e ile design i h oli e branches Applying your skills 1 Iden if he kind of nemplo men as Nao ssa e periencing b 2005. 2 Use a demand and s ppl diagram o e plain ho his pe of nemplo men came abo . 3 a Use a demand and s ppl diagram o sho he effec s of legisla ion in ending o lo er labo r cos s in he e ile ind s r . b Wh do o hink his legisla ion as ineffec i e in keeping Greek firms from reloca ing? Meas res o deal i h fric ional nemplo men aim a red cing he ime ha a orker spends in be een jobs and impro ing informa ion flo s be een orkers and emplo ers (see Chap er 13). Seasonal unemployment Seasonal unemployment occ rs hen he demand for labo r in cer ain ind s ries changes on a seasonal basis beca se of aria ions in needs. Farm orkers e perience seasonal nemplo men beca se he are hired d ring peak har es ing seasons and laid off for he res of he ear. The same applies o lifeg ards and gardeners, ho are mos l in demand d ring s mmer mon hs, people orking in he o ris ind s r , hich aries from season o season, shop assis an s, ho are in grea er demand d ring peak selling mon hs, and man o hers. Some seasonal nemplo men is na oidable in an econom , as here ill al a s be some ind s ries i h seasonal aria ions in labo r demand. Therefore, seasonal nemplo men is also par of na ral nemplo men . Structural, frictional and seasonal unemployment: the natural rate of unemployment As o kno from Chap ers 8 and 9, hen he econom prod ces a f ll emplo men o p , or po en ial o p , i has nemplo men eq al o he na ral ra e of nemplo men . We are no in a posi ion o define his more acc ra el . The na ral ra e of nemplo men is eq al o he s m of s r c ral, fric ional pl s seasonal nemplo men . Ano her a of sa ing his is ha hen an econom has f ll emplo men , i ac all has nemplo men eq al o he s m of s r c ral, fric ional and seasonal nemplo men . Theor of kno ledge 10.1 belo e amines his pec liar erminolog . Cyclical (demand-deficient) unemployment We ha e seen ha pes of nemplo men e is hen an econom is prod cing a i s po en ial or f ll emplo men le el of o p . Wha abo nemplo men arising hen he econom prod ces less han i s po en ial o p ? Unemplo men no consis s of addi ional nemplo men , o er and abo e he na ral ra e, hich is kno n as a . Cyclical unemployment, as he erm s gges s, occ rs d ring he do n rns of he b siness c cle, hen he econom is in a defla ionar /recessionar gap. The do n rn is seen as arising from declining or lo aggrega e demand (AD), and so is also kno n as demand-deficient unemployment. As real GDP falls d e o a fall in AD, nemplo men increases beca se firms la off orkers. In he p rn of he b siness c cle, as real GDP increases, he defla ionar /recessionar gap becomes smaller and c clical nemplo men falls. When he econom prod ces real GDP a he le el of po en ial o p , here is no longer an c clical nemplo men , i is eq al o ero. Al ho gh c clical nemplo men is a Ke nesian concep , i can be ill s ra ed b se of bo h he mone aris /ne classical and Ke nesian ersions of he AD-AS model, sho n in Fig re 10.3. In bo h par s, he econom is ini iall prod cing po en ial o p Yp, i h ero c clical nemplo men . A fall in aggrega e demand, ca sing AD1 o shif o AD2, crea es a defla ionar /recessionar gap as real o p falls o Yrec. A Yrec, he ne nemplo men crea ed is c clical nemplo men . Figure 10.3: C clical nemplo men Since c clical nemplo men arises from a deficienc of aggrega e demand, meas res o red ce his nemplo men in ol e he se of go ernmen policies o increase aggrega e demand, and elimina e he recessionar gap (see Chap er 13). The four types of unemployment in relation to the AD-AS model The fo r pes of nemplo men are sho n in rela ion o he AD-AS model in Fig re 10.4. (For simplici , he mone aris /ne classical model is sho n.) A o p Yp, real GDP is eq al o po en ial or f ll emplo men GDP, here here is nemplo men eq al o he na ral ra e, or he s m of s r c ral, fric ional and seasonal nemplo men , and c clical nemplo men is eq al o ero. If GDP falls o an le el less han Yp, here is a defla ionar /recessionar gap, and nemplo men increases so ha in addi ion o s r c ral pl s fric ional pl s seasonal nemplo men here is also c clical (demand-deficien ) nemplo men . If GDP increases o an le el grea er han Yp, here is an infla ionar gap, and nemplo men falls belo he na ral ra e of nemplo men . This means ha some orkers ho ere s r c rall , fric ionall or seasonall nemplo ed no find jobs. Ho e er, hese jobs end o be of a shor d ra ion, beca se he econom does no s all remain in an infla ionar gap indefini el . The go ernmen is likel o s ep in i h policies ( ha e ill s d in Chap er 13) o bring he econom back o o p le el Yp, here nemplo men ill once again reach he na ral ra e. Whereas i is a simple ma er o dis ing ish be een he fo r pes of nemplo men on a heore ical le el, in he real orld i can be er diffic l o iden if and dis ing ish be een he differen pes of nemplo men . The labo r marke is in a con in o s s a e of change, i h some orkers q i ing heir jobs, o hers being fired, i h some nemplo ed orkers ai ing for an appropria e job and o hers re raining for a ne job, i h some firms e panding, o hers con rac ing, and i h some people ne l en ering he labo r force and o hers lea ing. The ncer ain ies s rro nding he ca ses of nemplo men mean ha i is no al a s an eas ma er for go ernmen s o de ise appropria e policies o lo er i . Figure 10.4: The fo r pes of nemplo men in rela ion o he AD-AS model TEST YOUR UNDERSTANDING 10.2 1 E plain he her or no f ll emplo men mean he absence of nemplo men . 2 Describe, sing e amples, he meaning and ca ses of s r c ral, fric ional and seasonal nemplo men . 3 Use diagrams o sho s r c ral nemplo men arising from 4 a a change in demand for labo r skills, b a change in he geographical loca ion of ind s ries, and c higher han eq ilibri m ages. O line ho he s m of s r c ral, fric ional and seasonal nemplo men rela es o he concep s of f ll emplo men and po en ial o p in he con e of he AD-AS model. 5 Using a diagram, e plain c clical (demanddeficien ) nemplo men and he circ ms ances nder hich i arises. 6 Iden if and o line he differen kinds of nemplo men an econom is likel hen i is in a a defla ionar /recessionar gap, b an infla ionar gap, and c o be e periencing hen i is prod cing real GDP eq al o po en ial GDP. THEORY OF KNOWLEDGE 10.1 What is ‘natural about the natural rate of unemployment? We ha e defined he na ral ra e of nemplo men o be he s m of s r c ral, fric ional and seasonal nemplo men , or more simpl all nemplo men o her han ha ca sed b he b siness c cle. To call his nemplo men na ral appears s range; i s gges s here is some hing normal, s al or s andard abo hese pes of nemplo men . Ye , ha can be na ral abo par ic lar pes of nemplo men ? I is also s range ha na ral nemplo men corresponds o f ll emplo men . E en ho gh, as e kno , i is ne er possible o ha e f ll emplo men in he sense of ero nemplo men , h sho ld he presence of s r c ral, fric ional and seasonal nemplo men be kno n as f ll emplo men ? We can nders and he reasons behind he se of hese erms if e p he na ral ra e concep in his orical perspec i e. This concep as de eloped in he la e 1960s b Mil on Friedman, he fo nder of mone arism , for hich he recei ed he Nobel Pri e. (Edm nd Phelps, ano her Nobel Pri e inner, also independen l de eloped his concep .) The na ral ra e concep is a reflec ion of he mone aris model, hich ie s he econom as a s able s s em ha a oma icall ends o ard long-r n eq ilibri m here here are no recessionar or infla ionar gaps (see Chap er 9, Sec ion 9.3). In his ie , he forces of s ppl and demand ork o alloca e reso rces efficien l , and he mos efficien alloca ion ha is possible is reached hen he econom is a long-r n eq ilibri m. If he labo r marke orked comple el perfec l according o s ppl and demand, nemplo men o ld in fac drop o ero. Ho e er, in he real orld his does no occ r, beca se of ins i ions ha lead o labo r marke imperfec ions: here ill al a s be some people ho canno ins an l find jobs d e o lack of informa ion, b in addi ion, and mos impor an l , people canno find jobs beca se of he presence of labo r marke rigidi ies, incl ding minim m ages, labo r nion ac i i ies and lack of incen i es o ork. In fac , Friedman belie ed (and mone aris economis s con in e o belie e) ha he na ral ra e of nemplo men is ca sed onl b labo r marke rigidi ies. In he long r n, labo r marke rigidi ies can e plain a , incl ding fric ional, seasonal and all of s r c ral nemplo men disc ssed abo e (c clical nemplo men , o ma remember, is ero hen he econom is a longr n eq ilibri m). If people become nemplo ed beca se ind s ries change or mo e, in he long r n in a free compe i i e marke he o ld all respond o marke incen i es and he o ld all find jobs. Therefore, in his ie , in he long r n, all nemplo men arises a a from an imperfec l orking labo r marke . Since he labo r marke ins i ions ha lead o his na ral nemplo men are considered as gi en (fi ed) in an econom , i is reasonable o consider ha he econom has hen all orkers are emplo ed a ab a . I is or h q o ing Nobel Pri e- inning economis Rober Solo once again: W a b a , . 4( , a ,a a a a a a a , a , b , , a ,a a a , a a a , , ) a Friedman as an en h sias ic belie er in he po ers of he free marke o sol e he major economic problems, and he s rongl opposed go ernmen in er en ion. His poli ical con ic ions and al es ndo b edl infl enced his heore ical orien a ions, as ell as his choice of ords. His ideas had an impor an impac on polic -making, especiall d ring he 1970s and 1980s, and his infl ence can s ill be fel o he presen da . He as highl infl en ial in he de elopmen of s ppl -side policies (see Chap er 13). Some economis s cri icise his na ral ra e concep (as ell as all his o her ideas), especiall since he 1990s. James K. Galbrai h, a Ke nesian economis (and son of he famo s economis John Kenne h Galbrai h), ro e he follo ing: Aa , .I a b ab a a a b , a a , a a a a ! . . . [E a b ] b .W , a a . Sa a a , a ... 5 In addi ion o being diffic l o es ima e, he na ral ra e of nemplo men is also imprecise as o i s meaning. In his e , e follo he prac ice of mos e books in sing he erm na ral ra e of nemplo men o refer o he s m of s r c ral, fric ional and seasonal nemplo men . This is a con enien a o make a dis inc ion be een c clical and all o her pes of nemplo men . This does no pres ppose ha i is eas or e en possible o ac all meas re an pe of nemplo men indi id all . As no ed in he e , in he real orld i is er diffic l o dis ing ish be een he differen kinds of nemplo men . We end i h a q es ion. Wh do economis s bo her o meas re he na ral ra e of nemplo men and h is his so impor an ? We ill re rn o his q es ion in he Theor of kno ledge 10.2 a he end of his chap er (a HL). Thinking points Do he erms na ral ra e of nemplo men and f ll emplo men ha e a norma i e aspec ? Wha do he s gges in erms of go ernmen polic ac ion (or inac ion) o red ce he ra e of nemplo men ? Can he se of lang age o reflec an nderl ing poli ical ideolog in erfere scien ific me hod? i h he se of he Do o agree i h Friedman (and o her economis s) ha all non-c clical nemplo men can be e plained in erms of labo r marke ins i ions ha crea e rigidi ies in he labo r marke ? 1 This poin appears as AO2 in he s llab s, ho e er i becomes AO3 in he poin en i led Rela i e cos s of nemplo men ers s infla ion considered la er in his chap er. 2 Source: Robo s ' o replace p o 20 million fac or jobs' b 2030 3 Some economis s make se of a differen pe of labo r marke diagram, hich sho s o labo r s ppl c r es: one for he labo r force, and ano her represen ing he illingness of orkers o ake on jobs a differen age le els; he hori on al difference be een he o s ppl c r es a he marke clearing age represen s na ral nemplo men (of hich s r c ral is he mos impor an ). This diagram presen s na ral (hence s r c ral) nemplo men as being holl ol n ar ; jobs e is , b orkers choose no o ake hem beca se he do no an hem. This is a highl inacc ra e represen a ion of s r c ral nemplo men , hich is ha people an o ork b canno find jobs. 4 Rober M. Solo (1996) Science and ideolog E , Cambridge Uni ersi Press. 5 James K. Galbrai h (1996) The s rrender of economic polic , in T in economics, in D. M. Ha sman, T A a P P , March April. 10.2 Low and stable rate of inflation LEARNING OBJECTIVES Af e d ing hi ec i n ill be able : define all he e m a ea ing in orange bold in he e (AO1) di ing i h be een infla i n, di infla i n and defla i n (AO2) e lain h he infla i n a e i mea calc la e a eigh ed ice inde ed ing ing a c n me an i ie ice inde (AO2) cha ed a eigh (HL nl ) (AO4) calc la e he a e f infla i n (AO4) e lain he limi a i n e lain he ca e d a diag am ill f he CPI in mea f infla i n: demanda ing demand- ing infla i n (AO2) ll and c ll and c - - h (AO2) h infla i n (AO4) e lain and di c he c f infla i n incl ding edi ib i e effec , nce ain , a ing, e c m e i i ene , ec n mic g h, inefficienc in e ce all ca i n (AO3)6 e lain he ca e d a diag am ill f defla i n: dec ea e in AD and inc ea e in SRAS (AO2) a ing defla i n (AO4) e lain he c f defla i n incl ding edi ib i e effec , nce ain , defe ed c n m i n, high le el f c clical nem l men , bank cie , eal al e f deb , inefficienc in e ce all ca i n, ineffec i ene f lic (AO2) Inflation, disinflation and deflation Inflation i defined a a ained inc ea e in he gene al ice le el. When e eak f he gene al ice le el e efe an a e age f ice f g d and e ice in he en i e ec n m , n he ice f an ne a ic la g d e ice. S ained mean ha he gene al ice le el m inc ea e a ne le el and n fall back again i e i l e le el. F he , an inc ea e in he gene al ice le el d e n nece a il mean ha ice f all g d and e ice a e inc ea ing; ice f me g d and e ice ma be c n an e en falling, hile he a e inc ea ing. The e ence f infla i n indica e ha ice f g d and e ice a e inc ea ing on a erage. Deflation i defined a a ained dec ea e in he gene al ice le el. A in he ca e f infla i n, defla i n efe an a e age f ice ; i i likel be ne en, i h me ice c n an e en inc ea ing. Infla i n i fa m e c mm n han defla i n; in fac , ince he 1930 ( he e i d f he G ea De e i n), m ec n mie a nd he ld ha e been e e iencing a i ing ice le el, infla i n. S den me ime c nf e he diffe ence be een change in he ice le el and change in he a e f infla i n. In di c i n f he AD-AS m del, e ha e f e en l een inc ea e in he ice le el; he e indica e infla i n. A change in he a e f infla i n, b c n a , efe a change in h fa he ice le el i i ing. If he ice le el inc ea e b 5% in ne ea and hen inc ea e b 7% he ne ea , hi e e en an increase in the rate of inflation. If he ice le el inc ea e b 10% in ne ea and b 7% he ne ea , hi e e en a decrease in the rate of inflation, and i called disinflation. Di infla i n he ef e cc hen infla i n cc a a l e a e. Y m al be ca ef l n c nf e a fall in he a e f infla i n, di infla i n, i h a fall in he ice le el, defla i n. A fall in he a e f infla i n, ch a f m 10% 7%, mean ha he ice le el i inc ea ing a a l e a e, hence i di infla i n. A fall in he ice le el indica e ha defla i n i cc ing. Defla i n can be h gh f a nega i e infla i n. F he ice le el i falling a he a e f 2%. e am le, defla i n f 2% mean ha Measuring inflation and deflation The consumer price inde Mea e f infla i n (and defla i n) a e b ained b e f ice indice (indices i he l al f inde ). A ice inde i a mea e f a e age ice in ne e i d ela i e a e age ice in a efe ence e i d called a ba e e i d. One f he m c mm nl ed ice indice mea e infla i n i he c n me ice inde (CPI). The c n me ice inde (CPI) i a mea e f he c f li ing, he c f g d and e ice cha ed b he ical h eh ld in an ec n m . I i c n c ed b a a i ical e ice in each c n , hich c ea e a h he ical ba ke c n aining h and f g d and e ice ha a e c n med b he ical h eh ld in he c e f a ea . The al e f hi ba ke i calc la ed f a a ic la ea (called a ba e ea ); hi i d ne b m l i l ing ice ime an i f each g d and e ice in he ba ke , and adding b ain he al al e f he ba ke . The al e f the same basket f g d and e ice i hen calc la ed f b e en ea . The e l i a e ie f n mbe ha h he al e f he same basket f g d and e ice f diffe en ea . The CPI i hen c n c ed h h he al e f he ba ke change f m ea ea b c m a ing i al e i h he ba e ea . Once he c n me ice inde i c n c ed, infla i n and defla i n can be e e ed a a e cen age change f he inde f m ne ea he he , hich i im l a mea e f the percentage change in the alue of the basket from one ear to another. Since he al e f he ba ke change f m ne e i d an he beca e f change in he ice f he g d in he ba ke , he e e cen age change eflec change in he a e age ice le el. A i ing ice inde indica e infla i n; a falling ice inde indica e defla i n. CPI and a e f change in he ice le el a e al calc la ed n a m n hl ba i and a a e l ba i . The consumer price inde (CPI) i a mea e f he c f li ing f he ical h c m a e he al e f a ba ke f g d and e ice in ne ea i h he al e f he a ba e ea . Infla i n (and defla i n) a e mea ed a a e cen age change in he al e f m ne ea an he . A i i e e cen age change indica e infla i n. A nega i e change indica e defla i n. eh ld, and ame ba ke in f he ba ke e cen age Constructing a weighted price inde (HL onl ) We ill c n c a c n me ice inde (CPI) f a im le ec n m he e c n me icall c n me h ee g d and e ice : b ge , m ie icke and hai c , h n in c l mn 1 f Table 10.1. C l mn 2 gi e he an i ie f each ha he ical h eh ld b in a ea ; he e a e he eights. N e ha a weighted price inde i a ice inde ha eigh he a i g d and 7 e ice acc ding hei ela i e im ance in c n me ending. T c n c a CPI, e f ll he e e : 1 Decide hich f he ea ill be he ba e ea ; e ch e 2017. 2 U e he ice f each g d and e ice in he ba e ea (2017), calc la e i ba e ea al e (m l i l an i in c l mn 2 b 2017 ice in c l mn 3); he e al e a ea in c l mn 4. 3 Add all al e in c l mn 4 ge he a ea ing a he b m f c l mn 4. 4 U e he ice f each g d and e ice in 2018 calc la e i 2018 al e (m l i l he n mbe f ni in he ba ke (c l mn 2) b 2018 ice (c l mn 5)); hen d he ame ing 2019 ice (c l mn 7); he e l ing al e a ea in c l mn 6 f 2018 and c l mn 8 f 2019. al al e f he ba ke in he ba e ea ; hi i $756, Add he al e in c l mn 6 b ain he al al e f he ba ke in 2018; hi i $798 a ea ing a he b m f c l mn 6; d he ame find he al e f he ba ke in 2019, hich i $900, a ea ing a he b m f c l mn 8. 5 We n ha : ha e all he inf ma i n e need c n c ice inde f 2017, 2018 and 2019. N e price inde for a specific ear = al e f ba ke in a The ef e, he ecific ea al e f ame ba ke in ba e ea ice inde n mbe f 100 2017, 2018 and 2019 a e: ice inde f 2017= 756 756 100=1.00 100 ice inde f 2018= 798 756 100=1.055 100 = 105.0 ice inde f 2019= 900 756 100=1.190 100 = 119.0 N e ha he ice inde f = 100.0 he ba e ea i al a e al 100. 1 2 3 4 5 6 7 8 Good and services Quantit (number of units) in basket (weights) Prices of basket goods and services in base ear (2017) Value of basket goods and services in base ear (2017) Prices of basket goods and services in 2018 Value of basket goods and services in 2018 Prices of basket goods and services in 2019 Value of basket goods and services in 2019 Burgers 37 $3 $111 $4 $148 $5 $185 Movie tickets 25 $15 $375 $14 $350 $16 $400 Haircuts 15 $18 $270 $20 $300 $21 $315 $756 Total value of basket Table 10.1: C n c ing a h he ical $798 $900 ice inde T c n c a eigh ed ice inde , (i) find he al e f he ba ke in c en ice f each ea ; (ii) di ide he al e f he ba ke f each ea b he al e f he ba ke in he ba e ea and m l i l b 100. Thi ill gi e he ice inde n mbe f each ea . In he eal ld, calc la i n f ice indice a e c m lica ed a he in l e c llec ing ice da a n h and f g d and e ice and ca ing all nece a c m a i n . Thi i d ne b eciali ed a i ical e ice in e e c n . Using a weighted price inde (the CPI) to calculate the rate of inflation A ice inde can be ed calc la e he a e f infla i n. S inde (i i ac all he ne calc la ed ab e f HL). The hi d e e a e gi en he f ll ing ice al h he al e f he ba ke f each f he ea . Year 2017 C n me ice inde Val e f ba ke 2018 2019 100.0 105.5 119.0 $756 $798 $900 The a e f infla i n i he e cen age change in he ice inde . I i al gi en b he e cen age change in he al e f he ba ke . (Thi f ll f m he fac ha he ice inde i calc la ed f m he al e f he ba ke .) The e cen age change in a a iable A i calc la ed b he f ll ing: % change in A= final al e f A ini ial al e f A ini ial al e f A 100 (See Q an i a i e echni e cha e in he 'Digi al c inf ma i n.) T calc la e he e cen age change in he in ice inde f m 2017 2018: eb k: E ice le el f m 2017 a ma e ial' ec i n f m e 2018, e ha e he e cen age change = 105.5 100.0 100.0 100=5.5% In fac , e did n need d hi calc la i n: e can im l ince 105.5 100.0 = 5.5%. ead he infla i n a e f m he When he ice le el i e en ed a a ice inde , he a e f infla i n i e al an ea min he inde n mbe f he ba e ea ( hich i al a 100). ice inde , he inde n mbe f The ef e, i f ll ha he a e f infla i n in he e i d 2017 2019 i 119.0 100.0 = 19.0%. H e e , i i nl ible ead ff he a e f infla i n f m a ice inde in hi im le a in h e ca e in l ing a e cen age change in he ice le el relati e to the base ear, h e ice inde n mbe i e al 100.8 In he ca e , e m e he f m la ab e calc la e he a e f infla i n. F e am le, find he a e f infla i n in 2018 2019: % change in ice inde in 2018 2019 = 119.0 105.0 105.0 100=12.8% We c ld ha e f ba ke : nd he ame a e f infla i n b calc la ing he e cen age change in he al e f he % change in al e f he ba ke in 2017 2018 = 798 756 756 100=5.5% % change in al e f he ba ke in 2018 2019 = 900 798 798 100=12.8% . We can ee ha he e e f he c n me ice inde . e cen age a e he ame a h e calc la ed b N e ha a ice inde i h inc ea ing al e e ime ( ch a he e am le ab e) indica e infla i n. Dec ea ing al e e ime indica e defla i n. Al , n e ha he fi ea in a ice inde need n be he ba e ea . F e am le, e e ha e he f ll ing ice inde : 2000 2001 2002 2003 2004 97.5 100.0 107.3 109.7 107.8 The ba e ea i 2001, f hich he ice inde i 100. Thi ice inde indica e ha infla i n ha cc ed in 2000 2001, 2001 2002, and 2002 2003, b deflation ha cc ed in 2003 2004. Calculating real income (Supplementar material) In Cha e 8, e lea ned h calc la e eal GDP f m n minal GDP ing he GDP defla n e he CPI calc la e eal inc me ( f c n me , en i ne , he cial g ): . We can eal inc me = n minal inc me CPI 100 Clea l , if n minal inc me inc ea e b he ame e cen age a he ice le el (mea ed b he CPI), eal inc me emain nchanged. The CPI i , in fac , e ef l f calc la ing adj men ha m be made n minal inc me ( f age-ea ne , en i ne , e c.) in de f he e g main ain a c n an inc ea ing eal inc me. A word of caution Since he CPI c m a e ice le el ba ed n g d and e ice in a ecific ba ke , i nl make en e calc la e infla i n a e f m a ice inde c n c ed b e f he ame ba ke . F he , i i n ible make c m a i n f ice le el (i.e. calc la e a e f infla i n) ac ea b e f ice indice ha ha e a diffe en ba e ea , e en if he ba ke f g d and e ice i he ame. The ef e, f c m a i n f inde n mbe be meaningf l, he inde n mbe m be calc la ed ing he ame ba e ea , and f he ame ba ke f g d and e ice . Comparing the CPI with the GDP deflator (Supplementar material) If ld like lea n ab he diffe ence be een he CPI and he GDP defla , an he ice inde e di c ed in Cha e 8, ma ead ab hi in he 'Digi al c eb k: E a ma e ial' ec i n. TEST YOUR UNDERSTANDING 10.3 1 De c ibe he meaning f he c n me c n c ed. 2 a Di ing i h be een infla i n, defla i n and di infla i n, and ill a ing each f he e. b E lain, ing e am le , he diffe ence be een an inc ea e in he inc ea e in he a e f infla i n. 3 C n ide he f ll 2018: Year ing ice inde 2014 ihc e 2015 97 CPI ice inde (CPI) and e lain he nding al e 2016 95 hich i i ide n me ical e am le ice le el and an f he ba ke f 2017 100 ef he e i d 2014- 2018 105 107 a Iden if he ba e ea . b Calc la e he a e f infla i n in he e i d 2016 2017, and 2016 2018 i h e cen age change f m la. c Calc la e he a e f infla i n/defla i n in 2014 2015, 2015 2016, and 2017 2018 CPI. d Iden if e O line he he di infla i n cc he e i d f ime hen defla i n cc an e ed a an 4 O line h i i im h eh ld. eigh 5 (HL nl ) U ing he da a f m he able, f ing he ing he ed. ime. he g d and e ice c n med b he ical a c n c a c n me b Iden if c Calc la e he a e f infla i n/defla i n f d Iden if he ea c ncl i n . hen infla i n/defla i n/di infla i n cc e C n f Calc la e he a e f infla i n/defla i n f he ame h ee- ea g C m a e he a e be he ame!). f infla i n/defla i n f h E lain he he n i ld i make en e c m a e an inde n mbe f m he fi ice inde i h an inde n mbe f m he ec nd ice inde . he eigh c a ne Good/ service ice inde ae ice inde ing 2016 a he ba e ea . ing. he ea 2015 2016, 2016 2017, 2017 2018. ed, and e lain ing 2017 a he ba e ea . nd e i d a in ing he e i n (c). ice indice ( he h Quantit in basket Price per unit in 2015 ( ) Price per unit in 2016 ( ) Price per unit in 2017 ( ) Price per unit in 2018 ( ) Pi a 25 7 6 7 6 M ie icke 9 15 17 18 18 B ide 47 2 4 4 3 ld Problems with the consumer price inde (CPI) Different rates of inflation for different income earners. The a e f infla i n calc la ed b e f he CPI eflec he change in a e age ice f g d and e ice incl ded in he ba ke . H e e , diffe en c n me ha e diffe en c n m i n a e n de ending n hei inc me le el , and he e ma diffe f m ha i incl ded in he ba ke . Thi mean he face diffe en a e f infla i n han ha i calc la ed n he ba i f he CPI ba ke . Different rates of inflation depending on regional or cultural factors. E ac l he ame idea a ab e a lie c n me g h e cha e diffe f m he ical h eh ld c n m i n a e n , beca e f a ia i n in a e d e c l al and egi nal fac . Changes in consumption patterns due to consumer substitutions when relative prices change. Each g d and e ice incl ded in he ba ke i eigh ed (m l i lied b he n mbe f ni f he g d e ice cha ed b he ical h eh ld e a ea ). H e e , a me g d and e ice bec me chea e m e e en i e e ime, c n me make b i i n , b ing m e ni f he chea e g d and le f he m e e en i e ne . Thi e l in changing eigh , b beca e he eigh in he ba ke a e fi ed, he change in c n m i n a e n cann be acc n ed f in he CPI. The ef e, he CPI gi e a mi leading im e i n f he deg ee f infla i n, all e a ing i . Changes in c n ie , c and e ice end e consumption patterns due to increasing use of discount stores and sales. In man n me inc ea ingl make e f di c n e and ale , h b ing me g d a l e ice han h e ed in CPI calc la i n . Thi i an he ea n h he CPI a e infla i n. Changes in consumption patterns due to introduction of new products. In hi ca e, , a fi ed ba ke f g d and e ice cann acc n f ne d c in d ced in he ma ke , a ell a lde d c ha bec me le la a e i hd a n (c n ide f e am le he e lacemen f DVD b n-demand e ice ch a Ne fli ). Changes in product qualit . The CPI cann acc n f ali change e ime. International comparisons. The CPI f diffe en c n ie diffe f m each he i h e ec he e f g d and e ice incl ded in he ba ke , he eigh ed and me h d f calc la i n. Thi limi he c m a abili f CPI and infla i n a e f m c n c n . T add e hi blem, he E ean Uni n (EU) ha de i ed a Ha m ni ed Inde f C n me P ice (HICP). The HICP de e mine c n i en and c m a ible le ha m be f ll ed b EU c n ie in 9 de calc la e CPI ha a e c n i en i h each he . Comparabilit over time. Vi all all c n ie a nd he ld e i dicall e i e hei CPI ba ke and change he ba e ea ( all ab e e en ea ) deal i h man f he blem n ed ab e. In man c n ie he eigh f g d and e ice a e changed a f en a e e ea . Thi mean ha he ea ice inde n mbe a e c m a able e h e i d f ime, e l nge e i d c m a abili i le ened beca e f c m la i e change in he ba ke f g d and e ice . The core rate of inflation (Supplementar material) The e a e ce ain g d , n abl f d and ene g d c ( ch a il) ha ha e highl la ile ice (meaning he fl c a e idel e h e i d f ime). Rea n f ice la ili incl de ide ing in l demand, ca ing la ge and ab ice change . When ch g d a e incl ded in he CPI, he ma gi e i e mi leading im e i n ega ding he a e f infla i n. T deal i h hi blem, ec n mi mea e a core rate of inflation, hich all i d ne b c n c ing a CPI ha d e n incl de f d and ene g d c i h highl la ile ice . TEST YOUR UNDERSTANDING 10.4 1 E lain h he CPI ma n be an acc a e mea e f he a e f infla i n. 2 (O i nal) De c ibe he meaning f a c e a e f infla i n and h hi i calc la ed. Causes of inflation We ill e amine ca e f infla i n: demand- ll infla i n and c - h infla i n. Demand-pull inflation Demand- ll infla i n i ca ed b inc ea e in agg ega e demand, in n b gh ab b change in an f he de e minan f agg ega e demand ( ee Cha e 9, Sec i n 9.1). A me he ec n m i ini iall a f ll em l men e ilib i m, d cing en ial GDP, h n a Y in Fig e 10.5(a) and (b). The ec n m e e ience an inc ea e in agg ega e demand a ea ing a a igh a d hif f he AD c e f m AD1 AD2 in b h diag am . The im ac n he ec n m i inc ea e he ice le el f m Pl1 Pl2, and inc ea e he e ilib i m le el f eal GDP f m Y Yinfl. The inc ea e in he ice le el f m Pl1 Pl2 d e he inc ea e in agg ega e demand i kn n a demand- ll infla i n. Figure 10.5: Demand- ll infla i n N e ha demand- ll infla i n i a cia ed i h an infla i na ga : eal GDP i g ea e han f ll em l men GDP, and nem l men fall a le el bel he na al a e f nem l men . The demand f lab i la ge ha me ke h ae c all , f ic i nall ea nall nem l ed em a il find j b . Demand-pull inflation in l e an e ce f agg ega e demand e aggregate suppl a he f ll em l men le el f , and i ca ed b an inc ea e in agg ega e demand. I i h n in he ADAS m del a a igh a d hif in he AD c e. Cost-push inflation C - h infla i n i ca ed b inc ea e in c f ec n m i ini iall a he f ll em l men le el f inc ea e in c f d c i n. The SRAS c e hif f he ice le el f m Pl1 Pl2, and a fall in he e ilib i inc ea e in he ice le el d e he fall in SRAS i kn d ci n l - ide h ck . A me he , Y in Fig e 10.6, and e he e i an m SRAS1 SRAS2, leading an inc ea e in m le el f eal GDP f m Y Y ec. The n a c - h infla i n. C - h infla i n i anal ed nl b mean f he m ne a i /ne cla ical AD-AS m del. The Ke ne ian m del i n e i ed deal i h h - e m fl c a i n f agg ega e l . Ke ne a c nce ned i h h ing he im ance f aggregate demand in ca ing h - e m fl c a i n . The le el Y ec, h gh indica ing a ece i n, i n called a ece i na /defla i na ga , beca e ga ( he he ece i na infla i na ) can nl be ca ed b li le m ch agg ega e demand ( ee Cha e 9, f n e 4). Figure 10.6: C - h infla i n In Cha e 9, e a ha a dec ea e in SRAS e a ecial e f blem beca e i lead b h infla i n and a fall in eal GDP ( i h m e nem l men ; ee Sec i n 9.3). The e ence f b h infla i n and nem l men i called stagflation, a c mbina i n f he d agna i n and infla i n . Thi h ld be c n a ed i h an inc ea e in agg ega e demand leading demand- ll infla i n, hich e l in a highe ice le el b an increase in eal GDP ( i h le nem l men ). C - h infla i n, agfla i n, i m e diffic l deal i h effec i el , a e ill di c e in Cha e 13. Cost-push inflation i ca ed b a fall in agg ega e l , in n e l ing f m inc ea e in age ice f he in , h n in he AD-AS m del a lef a d hif f he AS c e. TEST YOUR UNDERSTANDING 10.5 1 U ing a ia e diag am , e lain he diffe ence be een demand- 2 O line h c 3 U ing diag am , h he effec n he i i c - h demand- ll infla i n. - h infla i n i en iall m e e i Real GDP in f eign c n ie ha ade i h demand f c n e . b B ine e a e ending. c An inc ea e in h d A c n imi ic ha a ece i n i ab ing dden inc ea e in he han demand- ice le el f he f ll a ll and c - h infla i n. ll infla i n, ing e en , and e lain he he inc ea e , leading end, and inc ea ed inc ea e in e men ice make c n me inc ea e hei c n m i n e endi ice f il, a ke in in d c i n, cc e. . REAL WORLD FOCUS 10.2 Rising inflation in Pakistan The c n me ice inde in Paki an ha nea l i led in he c e f ne ea , i ing f m 3.2% in Ma ch 2018 9.4% a ea la e , eaching he highe infla i n a e in e en ea . Thi ha been he e l f a mi f demand- ll and c - h fac . The c e a e f infla i n, hich e cl de f d and ene g ice , i nl ligh l l e a 8.5%. Inc ea e in ene g ice and i ing c f d c i n, ha e been e n ible f c - h infla i n. Demand ll infla i n ha been he e l f inc ea ing demand, i elf he e l f an inc ea e in he l f m ne . I i e ec ed ha infla i n ill n i e f he d ble digi . Source: Business Recorder Figure 10.7: Ka achi, Paki an. Em e h Ma ke B ilding, nded b n me ma ke Appl ing our skills 1 2 E lain he meaning and a c n me b c e infla i n a e. e f he ice inde (CPI), U ing diag am , e lain ha fac Paki an. ha e e l ed in c - h and demand- ll infla i n in Costs of a high rate of inflation Infla i n, and e eciall a high a e f infla i n, e blem f an ec n m , beca e i affec a ic la la i n g e eciall ngl , a ell a he ec n m a a h le. and The relationship between inflation, purchasing power and nominal and real income T nde and h blem can a i e, le c n ide e , and n minal and eal inc me. P cha ing can be b gh i h m ne . Imagine ha e 60 n minal inc me . When he ice i 20 e hi , e hi , can nl b hi . Y m ne , he cha ing e f he 60, ha hi m ne Real inc me i he ame a cha ing e ;i ice i e, and inc ea e a ice fall. he ela i n hi be een infla i n and cha ing e efe he an i f g d and e ice ha end n hi . Y can hink f hi a can b h ee hi . If he ice inc ea e 30 n minal inc me f 60 ha n changed, e can b , ha fallen d e he inc ea e in ice. efe ha m ne can b : i dec ea e a Change in eal inc me, m ne inc me and he gene al f ll ing a : % change in eal inc me ( cha ing ice le el ( he a e f infla i n) ice le el a e ela ed each he in he e ) = % change in n minal inc me % change in he The e ela i n hi ill a e me im an in . Infla i n lead a fall in eal inc me, cha ing e , nl if n minal inc me i c n an , if n minal inc me inc ea e m e l l han he ice le el. Sa he e i a 5% inc ea e in he ice le el, hich i a 5% a e f infla i n. H ill eal inc me be affec ed? If n minal inc me al inc ea e b 5%, eal inc me, cha ing e , emain nchanged. The ef e, f , infla i n i n a blem. If, h e e , n minal inc me emain c n an inc ea e b le han 5%, eal inc me fall , and ill be e ff ince he cha ing e f inc me i ed ced. Costs of inflation Redistribution effects Infla i n edi ib e inc me a a f m ce ain g in he ec n m and Redi ib i n a i e in i a i n he e ce ain g l e me cha ing ff, hile he g gain cha ing e and bec me be e ff. G incl de: a d he g . e and bec me e h l e f m infla i n People who receive fi ed incomes or wages. When indi id al ecei e an inc me fi ed c n an , a he gene al ice le el inc ea e he bec me e ff. Thi cc ke ha e age c n ac fi ing hei en i ne age age ha i hen: e a e i d f ime ecei e fi ed en i n landl d ecei e fi ed en al inc me indi id al ecei e fi ed elfa e a men . People who receive incomes or wages that increase less rapidl than the rate of inflation. When indi id al inc me d n kee i h a i ing ice le el (d n inc ea e a fa a he ice le el), a fall in hei eal inc me e l and he he ef e bec me e ff. The e g ma incl de all h e n ed ab e l an he kind f inc me ecei e h e inc me i n inc ea ing a a idl a he ice le el. Holders of cash. A he fall . ice le el inc ea e , he eal al e cha ing e f an ca h held Savers. Pe le h a e m ne ma bec me e ff a a e l f infla i n. In de main ain he eal al e f hei a ing , a e m ecei e a a e f in e e ha i a lea e al he a e f infla i n. S e de i $1000 in a bank acc n ha a n in e e . If he e i infla i n, he eal al e f a ing ill fall. H e e , ma be able ec he cha ing e f a ing . Sa he a e f infla i n i 5% e ea . If ecei e in e e n de i a he a e f 5% e ea , ha ill l e h gh infla i n ill be e ac l ma ched b ha gain h gh in e e inc me. In hi ca e, he eal al e ( cha ing e) f a ing emain naffec ed. In gene al, a e h ecei e a a e f in e e n hei a ing l han he a e f infla i n ffe a fall in he eal al e ( cha ing e ) f hei a ing . e Lenders (creditors). Pe le ( financial in i i n ch a bank ) h lend m ne ma be e ff d e infla i n. A me lend f iend 100 f ne ea (and d n cha ge in e e ). If in he c e f he ea he e i an inc ea e in he ice le el (infla i n), he eal al e f he 100 ill ge back f m f iend a he end f he ea ill ha e fallen. If cha ged f iend a a e f in e e e al he a e f infla i n, hen he eal al e f l an f iend ill be e ac l main ained. In gene al, lending a a l e in e e a e han he a e f infla i n make he lende (c edi ) e ff a he end f he l an e i d. G h gain f m infla i n incl de: Borrowers (debtors). In he e am le ab e, f iend h b ed 100 f m benefi ince he 100 aid back af e ne ea i h le han ne ea ag . If had cha ged in e e , f iend ( he b e) ld benefi a l ng a he a e f in e e i l e han he a e f infla i n. In gene al, b ing a a l e in e e a e han he a e f infla i n make he b e (deb ) be e ff a he end f he l an e i d. Pa ers of fi ed incomes or wages. A l ng a n minal age , en i n , en , elfa e a men , e c., a e fi ed hile he e i infla i n, he a e ( he he he a e fi m , he g e nmen , a e f en , e c.) benefi a he eal al e f hei a men fall d e infla i n. Pa ers of incomes or wages that increase less rapidl than the rate of inflation. A l ng a inc me f an kind inc ea e le a idl han he a e f infla i n, he a e f he e inc me benefi d e he falling eal al e f hei a men . Uncertaint Inabili acc a el edic ha infla i n ill be in he f e mean ha e le cann edic f e change in cha ing e ( f inc me, eal h, l an and an hing el e ha i mea ed in e m f m ne ). Thi ca e nce ain am ng ec n mic deci i n-make . Fi m , in a ic la , bec me m e ca i ab making f e lan nde nce ain ab f e ice le el , beca e he a e nable make acc a e f eca fc and e en e . Thei nce ain lead hem make fe e in e men , hich ma lead l e ec n mic g h. Effects on saving We a ab e ha hen he e i infla i n, a e l e if he ecei e n in e e n hei a ing if he a e f in e e n hei a ing i l e han he a e f infla i n. The ef e, infla i n l e he incen i e a e. F he , if he a e f infla i n i high, e le ma end m e n in de a id highe ice in he f e, in hich ca e he effec ma be f he l e a ing. International (e port) competitiveness When he ice le el in a c n inc ea e m e a idl han he ice le el in he c n ie i h hich i ade , i e bec me m e e en i e f eign b e , hile im bec me chea e d me ic b e . The c n in e na i nal c m e i i ene , i abili c m e e i h f eign c n ie , i ed ced. The e l i ha he an i fe fall , and he an i f im inc ea e . Thi in n ma c ea e diffic l ie f he c n balance f a men ( ee Cha e 16). Effects on economic growth High infla i n d e n fa ec n mic g h. A e ha e een ab e, am ng he c n e ence f infla i n a e nce ain am ng fi m , hich ca e in e men fall; in addi i n l e a ing mean ha he e a e le f nd a ailable f in e men . The e fac lead d in in e men , hich i a c m nen f agg ega e demand, he ef e a fall in agg ega e demand. M e e , e ha e al een ha infla i n lead l e e and highe im , b h c n ib ing a fall in ne e , hich al ca e a fall in agg ega e demand. Falling agg ega e demand lead l e eal GDP. Effects on resource allocation A ice ice he di e di c ed in Cha e 2, he ice mechani m la an im an le in e ce all ca i n. If a e i ing a idl , he ignalling and incen i e f nc i n d n k effec i el . The ea n i ha d n inc ea e in he ame i n f all d c , he i e m e f me d c han f , meaning ha he ignal and incen i e he ide f c n me and d ce bec me ed and he ef e inacc a e. The e l i ha all ca i e inefficienc i inc ea ed. Social and personal costs that are unequall distributed In ie f he edi ib i n effec f infla i n, e ha e een ha e le n fi ed inc me ffe l e a hei inc me l e i cha ing e . Thi f en incl de en i ne , nem l ed e le ecei ing nem l men benefi , and al ke h e age a e ei he fi ed d n i e a fa a he a e f infla i n. In addi i n, e le n l inc me a e n in ii n lace hei a ing in a e ha d n l e hei al e i h infla i n, ch a eal e a e, ck in he ck ma ke , g ld e en je elle . F he , i ing ice f nece i ie ch a f d and ene g needed f hea ing can c dee l in he inc me f l e inc me e le. The ef e i i likel ha e le n l inc me a e m e e i l affec ed b high a e f infla i n han e le n highe inc me . Consequences of h perinflation H e infla i n c n i f e high a e f infla i n. I i defined a cc ing hen he ice le el inc ea e b m e han 50% e m n h, h gh i can each h and e en milli n f e cen age in e ea . One f he m d ama ic h e infla i n in hi cc ed in Ge man af e he Fi W ld Wa , hen he ice le el in 1924 a m e han 100 illi n ime highe han in 1914. In m e ecen ea , man h e infla i n ha e been c ncen a ed in La in Ame ica f m he mid-1980 he ea l 1990 , and in ea e n E ean and f me S ie Uni n c n ie in he ea l 1990 f ll ing he c lla e f he S ie Uni n. Peak ann al a e f infla i n came ab 7500% in Pe in 1990; 3080% in A gen ina in 1989; 2950% in B a il in 1990; 1735% in R ia in 1992; 4735% in Uk aine in 1995; and 1060% in B lga ia in 1997. One f he m ei ca e f h e infla i n cc ed in Zimbab e, he e he a e f infla i n en f m e 1000% in 2006, 12 000% in 2007, and e 11 milli n % ( n an ann al ba i ) in he mme f 2008. In Vene ela in 2018 infla i n a an e ima ed 80 000%. H e infla i n e l f m e he ice le el. H e infla i n l . ignifican inc ea e in he cc hen g e nmen e l f m ne , hich im ac di ec l n in ing m ne , he eb inc ea ing i H e infla i n ha e i nega i e c n e ence , e and ab e h e di c ed ab e, beca e m ne l e i al e e a idl . C n me inc ea e hei ending benefi f m he c en ice bef e he inc ea e in he f e, he eb feeding agg ega e demand, hich ca e demand- ll infla i n. W ke demand highe n minal age main ain he eal al e f hei c en and f e inc me , he eb feeding c - h infla i n. The ef e, an inflationar spiral i c ea ed (a ce he e infla i n e in m i n a e ie f e en ha en he infla i n). Se i h e infla i n e l in a ma i e di i n f ec n mic ac i i : b ine e in e ing in d c i e ac i i ie and in e in ead in a e ha a e belie ed main ain hei al e a ice i e (g ld, eal e a e je el ); fi m al i hh ld g d f m ale in he ma ke ha he can ell hem la e a highe ice ; lende (c edi ) ffe ma i e l e a he eal al e f deb fall d ama icall . A he e eme, m ne l e i al e al ge he and e le e ba e ( he di ec e change f g d e ice , elimina ing he need f m ne ), hich in i elf make d c i n and e change e emel diffic l . Se i h e infla i n can al lead li ical and cial n e . What is an appropriate rate of inflation? M e g e nmen efe a lo and stable rate of inflation, n a e a e f infla i n. The ea n h a a e f infla i n, meaning a c n an ice le el, i n efe ed i ha hi c me dange l cl e defla i n, hich a e ill ee bel can ca e e i blem f an ec n m . The e i n ne a ic la a e f infla i n ha i ideal, b man g e nmen ld like ee hi in he ange f ab 2 3% e ea . Le han 2% migh be c n ide ed a c ming cl e defla i n; m e han 4% i een a being high. TEST YOUR UNDERSTANDING 10.6 1 U ing a n me ical e am le, e lain he ela i n hi be een infla i n and 2 E lain ha ha en i ai n : 3 eal inc me ( cha ing e ) in each f he f ll a n minal inc me inc ea e b 5% and he a e f infla i n i 8%, b n minal inc me fall b 10%, and he a e f infla i n i 3%, and c n minal inc me inc ea e b 7% and he a e f infla i n i 7%. a Infla i n e l in edi ib i n f cha ing h i likel l e f m he edi ib i n effec b Iden if and e lain edi ib i n). me cha ing e . E lain h i likel f infla i n. he nega i e c n e ence e. ing gain and f infla i n ( he han Causes of deflation Wh deflation occurs rarel in the real world Defla i n, a falling ice le el n a e age, i n a c mm n hen men n. Whe ea i i f en he ca e ha he ice f a a ic la g d e ice ma fall e ime, i i a e ee he gene al ice le el f an ec n m falling. The e a e e e al fac ha acc n f hi : Wages of workers do not ordinaril fall. Thi mean i i diffic l f fi m hei d c , a hi ld c in hei fi , e eciall ince age i n f fi m c f d c i n. The e a e e e al ea n h age (lab c n ac , minim m age legi la i n, ke and ni n e i ance fai ne , fea f nega i e im ac n ke m ale, e c.) l e he ice f e e en a la ge d n fall ea il age c , idea f Large oligopolistic firms ma fear price wars. If ne fi m l e i ice, hen he ma l hei m e agg e i el in an eff ca e ma ke ha e, and hen all he fi m ill be ff. The ef e, fi m a id c ing hei ice . e e Whe ea defla i n cc a el , i ha a ea ed e i dicall , f e am le in B i ain and he Uni ed S a e in he la e 19 h cen , in he Uni ed S a e d ing he G ea De e i n f he 1930 (1933 1937), and in Ja an f m 1999 2006. In 2003 and again in 2008, he e e e e i c nce n in E e and he Uni ed S a e ha defla i n migh cc . Defla i n i gene all fea ed m e han infla i n f ea n e ill di c e bel . Causes of deflation We can make a di inc i n be een ca e f defla i n: dec ea e in agg ega e demand and inc ea e in agg ega e l . The e can be een in Fig e 10.8. In Fig e 10.8(a) a dec ea e in agg ega e demand (f e am le, d e b ine e imi m) ca e he AD c e hif f m AD1 AD2. Whe ea he AD-AS m del edic a d in he ice le el, defla i n, hi i nlikel cc e a h e i d f ime f he ea n di c ed ab e, acc n ing f he highl inf e en cc ence f defla i n.10 H e e , if l agg ega e demand e i e a l ng e i d, he ice le el fall Pl2. Thi i me ime efe ed a bad defla i n beca e i i a cia ed i h ece i n, falling inc me and ince eal GDP fall f m Y1 Y2, and c clical nem l men . The e a e he ci c m ance ha cha ac e i ed he defla i n f he G ea De e i n d ing he 1930 and, m e ecen l , in Ja an. Fig e 10.8(b) h a igh a d hif f he SRAS c e, i h he AD c e c n an , hich gi e i e a ne in f e ilib i m ha cc a a l e ice le el. Thi i me ime efe ed a g d defla i n beca e i i a cia ed i h ec n mic e an i n ince eal GDP inc ea e f m Y1 Y2, i ing inc me and , inc ea ing em l men and ec n mic g h. S me ec n mi a g e ha i a nde ch ci c m ance ha he defla i n f B i ain and he Uni ed S a e in he la e 19 h cen cc ed. H e e , i m be e ed ha hile i ma be ible make a he e ical di inc i n be een g d and bad defla i n, no deflation is e er good. We ill di c e he ea n f hi in he f ll ing age , he e e ill ee ha defla i n di c age ending, ca ing agg ega e demand fall ega dle f he ca e f defla i n. Defla i n i he ef e c n ide ed b ec n mi be a g ea e h ea han infla i n. Figure 10.8: Ca e f defla i n Costs of deflation Redistribution effects The edi ib i n effec f defla i n a e he i e f h e f infla i n: i h a falling ice le el, indi id al n fi ed inc me , h lde f ca h, a e and lende (c edi ) all gain a he eal al e f hei inc me h lding inc ea e . B c n a , b e (deb ) and a e f indi id al i h fi ed inc me l e i h a falling ice le el, a he m a m ha ha e an inc ea ing eal al e. Increase in the real value of debt In ie f he ab e, he eal al e f deb inc ea e . If h ld $1000 and he ice le el fall , hi mean ha he cha ing e f m ne inc ea e beca e can b m e hing i h ha am n . In j he ame a if e hi $1000, i eal al e in e m f i cha ing e inc ea e hen he ice le el fall . Uncertaint Defla i n, like infla i n, c ea e nce ain e en e d e declining ice le el . f fi m , hich a e nable f eca hei c and Deferred consumption, high and increasing c clical unemplo ment: risk of a deflationar spiral Deferred consumption mean ha c n me ne ending. C n me ne making cha e hen he ee falling ice a he e ec ha ice ill c n in e fall. The ef e, defla i n di c age ending. Defla i n al di c age b ing b b h c n me and fi m , beca e he eal al e f deb inc ea e a he ice le el fall . The e l i ha c n me and b ine ending fall , ca ing agg ega e demand fall. Falling AD e l in l e eal GDP i h c clical nem l men , and al ca e he ice le el fall f he . Thi in n gi e i e f he nemen f ending, AD fall f he , nem l men inc ea e f he , inc me and ice fall f he , defla i na e e inc ea e f he , and n in a d n a d i al. Thi i kn n a a defla i na i al, h n in Fig e 10.9. Risk of bankruptcies and a financial crisis A e a ab e, defla i n e l in an inc ea e in he eal al e f deb . If he ec n m i in ece i n, and inc me a e falling hile he eal al e f deb i inc ea ing, he e l ill m likel be bank cie f fi m and c n me h a e nable a back hei deb . If ch bank cie bec me ide ead, bank and financial in i i n ill be affec ed, and a la ge i k f a maj financial cii aie. Figure 10.9: Defla i na i al Inefficient resource allocation A e a ea lie , high a e f infla i n lead inefficien e ce all ca i n beca e he ignalling and incen i e f nc i n f ice a e nable k effec i el . In defla i n, ice f all g d and e ice d n fall nif ml , i h he e l ha he ice ignal and incen i e ge di ed, leading e ce mi all ca i n. Polic ineffectiveness Once a defla i n e in, i ma be diffic l f lic make deal i h i . One ea n i ha hen e le e ec a i n f a falling ice le el bec me ell e abli hed, and he ge ed ending le in e ec a i n f falling ice , i ma be diffic l f hem change hei mind e . An he e im an ea n i ha e an i na m ne a lic ( be di c ed in Cha e 13) ma bec me ineffec i e. Thi m ne a lic in l e dec ea e in he a e f in e e in de enc age m e b ing and ending b c n me and fi m , h e e nce in e e a e a ach e he cann c n in e fall. The ef e, m ne a lic cann be elied n l e he blem. Summing up deflation High c clical nem l men , ge he i h he i k f a defla i na he ecial and en iall e i dange f defla i n. The e a e l i n he blem f defla i n. i al and a financial c i i , e eal ened b he diffic l ie f finding Y can n ee h g e nmen efe a lo and stable rate of inflation, i h a a ge a e f a 2% e ea , hich i fficien l ab e e a n be cl e defla i n. nd In addi i n, can ee h he di inc i n be een g d and bad defla i n i ac all meaningle , beca e nce defla i n e in i d e n ma e h i igina ed ince a defla i na i al ma e l e en f m g d defla i n. A positive effect of deflation In i e f all he nega i e f defla i n, he e i ne i i e effec h men i ning. While infla i n h in e na i nal c m e i i ene , defla i n b ing benefi . A l e ice le el mean ha e ma inc ea e a f eigne n efe b ing f m he c n i h l e ice hile im ma fall a d me ic c n me efe he l e - ice d me icall d ced g d . The ef e ne e (X M) inc ea e, ing an ad e e n agg ega e demand and eal GDP. H e e , hi ii e effec i n en gh c n e ac all he i k and dange f defla i n. TEST YOUR UNDERSTANDING 10.7 1 O line h defla i n cc 2 E lain ha ha en i ai n : a el in he eal eal inc me ( cha ing e ) in each f he f ll a n minal inc me inc ea e b 5% and he a e f defla i n i 3%, b n minal inc me fall b 10%, and he a e f defla i n i 2%, and c n minal inc me fall b 3% and he a e f defla i n i 4%. (Y defla i n a nega i e infla i n.) 3 U ing diag am , e lain 4 a E lain b E lain h defla i n ma be e eciall 6 ld. O line h a l ible ca e me nega i e c n e ence ,b ab f defla i n. f defla i n. ei f an ec n m . e e , a e f infla i n i de i able. h ing ld hink f 6 Thi in a ea a AO2 in he llab , h e e i bec me AO3 in he nem l men e infla i n c n ide ed la e in hi cha e . 7 In he eal each g d 8 N e ha e can nl e hi le f ea after he ba e ea and n bef e. F e am le, if he CPI i 92 in 2007 and 100 in 2008, e cann a he e i an 8% inc ea e in he ice le el in he e i d 2007 2008. T c n ince elf, d he calc la i n. Y ill find ha he a e f infla i n i 8.7%. 9 The HICP d e n de e mine a nif m ba ke f all c n ie ( hi i d ne in ec gni i n f he in n ed ab e ha diffe en egi n /c n ie ha e diffe en c n m i n a e n d e di e e a e , c l al fac and inc me le el ). The HICP cceed a la ge e en in e l ing he c m a abili blem, and he ea i i n in ended e lace na i nal CPI , i i ed in all ca e he e c m a i n ac c n ie need be made. The HICP i calc la ed b all E ean Uni n c n ie l Iceland and N a . The fi ba e ea be ed a 1996, and he inde began being calc la ed f m Jan a 1997. 10 The inf e en ld, he eigh ed c n c he CPI a e ba ed n he e ice n a e age, a he han n he an i f each g d cc ence f defla i n ill be e lained b in en i led Rela i e c i n f c n me e ice c n med. he a che effec , be di c f ending n ed in Cha e 13. 10.3 E LEARNING OBJEC I ES Af er s d ing his sec ion o ill be able o: define all he erms appearing in disc ss he rela i e cos s of nemplo men disc ss he po en ial conflic be een lo in he e (AO1) ers s infla ion (AO3) nemplo men and lo infla ion (AO2)11 disc ss he rade-off be een nemplo men and infla ion: he shor -r n and long-r n Phillips c r es (HL onl ) (AO3) dra diagrams sing he AD-AS model and sho ing he shor -r n and long-r n Phillips c r es (HL onl ) (AO4) In Sec ions 10.1 and 10.2 abo e, e disco ered ha bo h nemplo men and infla ion ha e a n mber of cos s. Yo sho ld be able o iden if ha hese are and disc ss hem. D ring he 1970s, a ell-kno n U.S. economis , Ar h r Ok n, crea ed a miser inde hich consis s of he s m of he nemplo men ra e and he infla ion ra e of a co n r . The higher he inde , he grea er he miser of a pop la ion. Ho e er, he miser inde does no dis ing ish be een he separa e effec s of nemplo men and infla ion on he ell-being, or lack of ell-being, of a pop la ion. Can e sa an hing abo hich of he o con rib es more o miser , or has grea er cos s? From a p rel economic perspec i e, i is diffic l o generalise abo hich of he o is less desirable, as his is likel o depend on he par ic lar circ ms ances of he econom being considered, as ell as on ho high is he nemplo men ers s ho high is he infla ion. In addi ion o he economic cos s, e ha e seen ha bo h nemplo men and infla ion ha e personal and social cos s, o er and abo e he economic ones. A n mber of s dies ha ha e e amined he effec s of nemplo men ers s infla ion on ell-being concl de ha , be een he o, nemplo men has a s ronger nega i e impac . According o one s ch s d ha meas red he loss of ell-being, i as fo nd ha bo h nemplo men and infla ion increase nhappiness.12 The s d as based on a er large E ropean da ase for he period 1975 2013, hich incl ded periods of high infla ion as ell as periods of high nemplo men . I as fo nd ha nemplo men increases nhappiness far more han infla ion. Specificall a i c ea e f e e ce age i i em l me l e ell-bei g ea l i ime m e ha a e e ce age i i c ea e i i fla i . Unemplo men lo ers he happiness of no onl he nemplo ed b also he people aro nd hem, i h omen and he elderl being rela i el more affec ed. This is perhaps hardl s rprising as he loss of a job leading o nemplo men and herefore loss of income has po en iall er serio s financial, personal and social effec s on he nemplo ed indi id als and heir families. There are a n mber of po en ial conflic s be een macroeconomic objec i es, hich e ill s d in Chap er 11. One of hese conflic s is be een he objec i es of lo nemplo men and lo infla ion. This can be nders ood b se of he Ke nesian AD-AS model, sho n again in Fig re 10.10. When here is a defla ionar gap and he econom is in recession s ch as a o p le el Y1 or Y2, he ra e of infla ion is lo ( he price le el is cons an ) b here is high c clical nemplo men . As aggrega e demand increases and he econom approaches po en ial o p , Yp, he price le el begins o rise hile c clical nemplo men falls. As aggrega e demand con in es o increase, he price le el increases e en fas er, hile nemplo men con in es o fall. If aggrega e demand increases f r her res l ing in an infla ionar gap s ch as a Y4, nemplo men falls o a le el ha is e en lo er han he na ral ra e, since some of he s r c rall , seasonall and fric ionall nemplo ed ill no find emplo men (see Fig re 10.4 for an e plana ion). The reason behind he increasing infla ionar press res is ha as aggrega e demand increases, reso rces are sed more f ll , gi ing rise o bo lenecks ha res l in higher ages and o her reso rce prices. This process gi es rise o higher prod c prices and hence a rising price le el. F 10.10: Ke nesian model sho ing increasing price le el i h decreasing nemplo men I can herefore be concl ded ha i ma be diffic l o achie e bo h a lo ra e of infla ion and a lo nemplo men ra e a he same ime. - (HL ) P The P is concerned i h he rela ionship be een nemplo men and infla ion. In he la e 1950s, a Ne Zealand economis A.W. Phillips p blished a s d sho ing ha here appeared o be a long- erm nega i e rela ionship be een he nemplo men ra e and he ra e of change in nominal (mone ) ages; his rela ionship as la er e ended b economis s o appl o he rela ionship be een nemplo men and infla ion. The rela ionship sho ed ha he lo er he ra e of infla ion, he higher he nemplo men ra e; and he higher he ra e of infla ion, he lo er he nemplo men ra e. This rela ionship is sho n in Fig re 10.11(a), here he nemplo men ra e is meas red along he hori on al a is, and he ra e of infla ion along he er ical a is. (No e ha he er ical a is does no meas re he price le el, as in he AD-AS model.) The Phillips c r e s gges s ha if here is a cons an nega i e rela ionship be een he o ariables, hen e er econom faces a rade-off be een infla ion and nemplo men : i can choose be een a rela i el lo ra e of infla ion and a higher nemplo men ra e, s ch as poin a on he c r e, or a higher ra e of infla ion and a lo er nemplo men ra e, s ch as poin d. Whereas, ideall , i o ld be preferable for an econom o ha e lo infla ion and lo nemplo men , s ch as poin e, his is no possible according o he heor of he Phillips c r e, as he onl achie able poin s are hose on (or close o) he c r e. The reasoning behind he shape of he c r e can be ill s ra ed b se of he AD-AS model, sho n in Fig re 10.11(b). Ass me a fi ed, p ard-sloping SRAS c r e, and imagine a s ccession of aggrega e demand increases ( hich co ld be ca sed b an of he fac ors e are familiar i h from Chap er 9 (Table 9.1)). As aggrega e demand shif s from AD1 o AD2, he price le el rises from Pl1 o Pl2, he le el of real GDP increases from Y1 o Y2, and he le el of nemplo men correspondingl falls. The same process is repea ed as aggrega e demand increases from AD2 o AD3, and hen o AD4, and so on. Wi h e er increase in aggrega e demand, e ha e an increase in he price le el and a fall in nemplo men . I follo s, hen, ha e can simpl hink of each poin on he Phillips c r e (s ch as a, b, c or d) as corresponding o he poin of in ersec ion of SRAS i h a differen AD c r e (a, b, c or d). The choice of here o be on he Phillips c r e in par (a) h s corresponds o a choice of AD c r e in par (b) of he fig re.13 F 10.11: The shor -r n Phillips c r e : D ring he 1960s, man economis s came o belie e ha he Phillips c r e did offer he possibili of choice be een infla ion and nemplo men . A ha ime aggrega e s ppl as rela i el s able, and major changes in economic ac i i ere ca sed b s ings in aggrega e demand. Mos economis s a he ime ere er s rongl infl enced b Ke nesian hinking, belie ing ha demand-side policies (see Chap er 13) ere er impor an in infl encing he le el of economic ac i i and real GDP. The Phillips c r e appeared o offer go ernmen s he possibili of sing demand-side policies o choose be een ario s al erna i es. High aggrega e demand o ld lead o lo nemplo men and higher infla ion, hile lo aggrega e demand o ld lead o higher nemplo men and lo er infla ion. E en s of he 1970s and 1980s pse his line of hinking, and he s able rela ionship be een infla ion and nemplo men ha as s gges ed b he Phillips c r e appeared o break do n. Whereas i had been s pposed ha aggrega e s ppl co ld remain s able o er long periods of ime, a n mber of aggrega e s ppl shocks led o a period of agfla i , a erm coined a he ime o refer o he ne phenomenon of s agna ion (or recession) i h nemplo men and infla ion sim l aneo sl . The mos impor an of he s ppl shocks in ol ed he oil price increases bro gh on b he ac ions of OPEC (Organi a ion of he Pe role m E por ing Co n ries), hich res ric ed he global s ppl of oil. Ano her s ppl shock in ol ed food price increases res l ing from orld ide crop fail res, res ric ing he global s ppl of food. The impac s of hese e en s on he Phillips c r e and on he SRAS c r e are sho n in Fig res 10.12(a) and (b). In par (b), e see ha as he s ppl shocks ca se he SRAS c r e o shif lef ard from SRAS1 o SRAS2 and hen o SRAS3, he res l is higher price le els (from Pl1 o Pl2 and Pl3) and lo er le els of GDP (from Y1 o Y2 and Y3), signif ing increases in nemplo men . In o her ords, decreases in SRAS ( i h AD cons an ) res l in higher price le els and higher nemplo men . This phenomenon is inconsis en i h he logic of he Phillips c r e, and as in erpre ed o in ol e a d hif i he Philli c e, hich n il hen as ho gh o be s able and cons an . The o ard Phillips c r e shif s appear in par (a), indica ing ha higher ra es of infla ion are associa ed i h higher ra es of nemplo men ; he mo e from poin a o b and c in par (a) correspond o poin s a, b and c in par (b). F 10.12: S agfla ion: o - ard shif s of he shor -r n Phillips c r e d e o decreasing SRAS P In he la e 1970s, he Nobel Pri e- inning, mone aris economis Mil on Friedman a acked he idea of a s able nega i e rela ionship be een infla ion and nemplo men , and arg ed ha here is onl a emporar rade-off be een infla ion and nemplo men , no a permanen one. Friedman made a dis inc ion be een a shor -r n Phillips c r e and a long-r n Phillips c r e. The shor -r n Phillips c r e is ha e ha e considered in Fig re 10.11(a), hich e can see once again in Fig re 10.13(a), represen ed b SRPC1 and SRPC2. According o Mil on Friedman, in he long r n, his nega i e rela ionship no longer holds. Ins ead, he long-r n Phillips c r e is er ical a he le el of f ll emplo men , or here nemplo men eq als he a al a e f em l me . (In fac , he na ral ra e of nemplo men is a concep firs in rod ced b Mil on Friedman.) The longr n Phillips c r e is LRPC in Fig re 10.13(a). Wh is he long-r n Phillips c r e er ical a he econom s na ral ra e of nemplo men ? The ans er is q i e simple: i is so for he same reasons ha he LRAS c r e is er ical a he le el of real GDP corresponding o he na ral ra e of nemplo men ( his as e plained in Chap er 9, Sec ion 9.3). Consider Fig re 10.13, and s ppose he econom is ini iall a poin a in bo h par s. (No e ha Fig re 10.13(b) is he same as Fig re 9.8(b) in Chap er 9.) In par (b), poin a indica es ha he econom is a a poin of long-r n eq ilibri m on AD1, SRAS1 and he LRAS c r e, i h real GDP eq al o po en ial GDP sho n b Yp. A Yp, nemplo men is eq al o he na ral ra e of nemplo men , hich e ass me o be 5%. In par (a), poin a indica es ha he econom is on a shor -r n Phillips c r e, SRPC1, here i is e periencing a ra e of infla ion of 5% and an nemplo men ra e of 5%, or he na ral ra e of nemplo men . F 10.13: The shor -r n and long-r n Phillips c r es S ppose here occ rs an increase in aggrega e demand, so ha he AD c r e in par (b) shif s from AD1 o AD2. In he shor r n he econom mo es o poin b on he SRAS1 c r e, corresponding o a higher price le el, Pl2, increased real GDP, Yinfl, and lo er nemplo men ( nemplo men falls belo he na ral ra e). This corresponds o poin b on he SRPC1 in par (a), here here is a higher infla ion ra e of 7% and lo er nemplo men ra e a 3%. The econom mo ed o poin b in he shor r n, beca se in he shor r n ages are cons an ; i h he price le el increasing, firm profi abili increases, o p increases and nemplo men falls. B in he long r n, poin b canno be a poin of eq ilibri m, beca se, as e kno from Chap er 9, ages ill rise o mee he increases in he price le el, ca sing he SRAS c r e o shif lef ard from SRAS1 o SRAS2, here i in ersec s AD2 a a poin on he LRAS c r e, or poin c. Poin c in par (b) is associa ed i h a higher price le el Pl3, b real GDP has fallen back o Yp, and he ra e of nemplo men has re rned o he na ral ra e. In par (a), hese changes mean he econom has mo ed o poin c, here he shor -r n Phillips c r e has shif ed o he righ o SRPC2 (remember, hen he SRAS c r e shif s lef ard i h a cons an AD c r e, he SRPC c r e shif s righ ard, as e sa in Fig re 10.12). A poin c, here is a higher ra e of infla ion, no s anding a 9%, and nemplo men has climbed back p o 5%, or he na ral ra e. The er ical line connec ing a and c is he long-r n Phillips c r e (LRPC), si a ed a he na ral ra e of nemplo men .14 Since he na ral ra e of nemplo men occ rs a long-r n eq ilibri m, i is also kno n as e ilib i m em l me . The shor -r n Phillips c r e is a ool preferred b Ke nesian economis s, ho see in his he possibili of sing policies ha foc s on infl encing aggrega e demand o make choices abo he ra e of infla ion and he ra e of nemplo men (and herefore he le el of real GDP). B con ras , he long-r n Phillips c r e is an anal ical ool preferred b mone aris /ne classical economis s, ho are highl skep ical abo he effec i eness of demand-side policies, and ho se i o sho ha e pansionar demand-side policies are more likel o res l in infla ion han o infl ence nemplo men and real GDP. These economis s prefer policies ha foc s on infl encing aggrega e s ppl . We ill come back o hese iss es in Chap er 13. According o he P in Fig re 10.11(a), here is a nega i e rela ionship be een he ra e of infla ion and he nemplo men ra e, s gges ing ha in he shor r n polic makers can choose be een he compe ing al erna i es of lo infla ion or lo nemplo men b sing policies ha affec aggrega e demand. The P is er ical a he na ral ra e of nemplo men , indica ing ha nemplo men is independen of he ra e of infla ion, and ha polic -makers do no ha e a choice be een he o compe ing al erna i es. In he long r n, he onl impac of an increase in aggrega e demand is o increase he ra e of infla ion, hile he le el of real o p and nemplo men remain nchanged a he na ral ra e of nemplo men . - P In he ears follo ing he global financial crisis, he shor -r n rela ionship be een infla ion and nemplo men sho n in Fig re 10.11(a) came o be q es ioned again. Man economis s aro nd he orld began o arg e ha his rela ionship has broken do n. The reason is ha hile nemplo men has fallen o er lo le els, infla ion has no been increasing as he Phillips c r e o ld predic . A n mber of arg men s ha e been p for ard r ing o e plain his. According o one, rising global compe i ion makes i diffic l for firms o raise prices e en as nemplo men falls. According o ano her, ages ha e no been rising in man economicall more de eloped co n ries, herefore here has no been a s rong p ard press re on prices. Reasons h ages ha e no been rising incl de di erse fac ors like he decline of labo r nions, echnolog , and globalisa ion. S ill o her economis s arg e ha o er he pas se en decades hen he Phillips c r e began o be sed as a basis for polic , here ha e been se eral occasions hen he rela ionship be een infla ion and nemplo men became ns able, as ho gh i ere aking a break from he normal pa ern; his co ld again be a emporar break before he normal pa ern res mes again. A deba e has emerged, i h some economis s arg ing ha here is no longer an Phillips c r e, hile o hers are s gges ing ha i is onl a ma er of ime before he infla ion and nemplo men rela ionship raced o in Fig re 10.11(a) emerges once again. ES 1 2 O R NDERS ANDING 10.8 E plain h here ma be a conflic be een he goals of lo infla ion. (HL onl ) nemplo men and lo Using he concep of he shor -r n Phillips c r e and he AD-AS model, e plain h man economis s d ring he 1960s considered ha polic -makers had a choice be een lo infla ion and high nemplo men , or high infla ion and lo nemplo men . Iden if he e en s of he 1970s and 1980s ha made economis s belie e ha he shor r n rela ionship be een infla ion and nemplo men as ns able (no fi ed and permanen ). E plain, sing diagrams and he concep of s agfla ion, he rela ionship be een shif s in he SRAS c r e and he posi ion of he shor -r n Phillips c r e. 3 Using one or more diagrams, sho ho shor -r n Phillips c r e. he long-r n Phillips c r e differs from he O line ha he long-r n Phillips c r e ells s abo he rela ionship be een he ra e of infla ion and he ra e of nemplo men in he long r n. 4 O line he rela ionship be een he long-r n Phillips c r e and he na ral ra e of nemplo men , and he long-r n Phillips c r e and he f ll emplo men le el of o p . 5 According o he heor of he Phillips c r e, e plain ha ill happen o he ra e of infla ion, he ra e of nemplo men and real GDP if polic -makers a emp o increase aggrega e demand in order o increase he le el of real GDP in he shor r n, and in he long r n. 6 Using an AD-AS diagram, e plain h he long-r n Phillips c r e is er ical. HEOR OF KNO LEDGE 10.2 C : We re rn o he q es ion posed a he end of he Theor of kno ledge 10.1 earlier in his chap er: ha is so impor an abo meas ring he na ral ra e of nemplo men ? In addi ion, ho ma he choice of polic goals be affec ed b he general poli ical mood and ideolog of socie ies and heir go ernmen s? Based on he Phillips c r e anal sis, e can easil ans er he firs q es ion. If he ac al ra e of nemplo men is abo e he na ral ra e, polic -makers can se demand-side policies o increase aggrega e demand, i ho fearing infla ion. If, ho e er, ac al nemplo men is a or belo he na ral ra e, an increase in aggrega e demand onl emporaril lo ers nemplo men , as his ill go back o he na ral ra e once ages ha e adj s ed, onl a a higher price le el (see Fig re 10.13). In he long r n, he increase in aggrega e demand onl crea es infla ion. Therefore, kno ing he na ral ra e is impor an as a g ide o polic -makers. Ho e er, if he na ral ra e changes of en, and canno e en be acc ra el es ima ed, here ma be serio s do b s abo ho reliable i is as he basis for g iding polic . Ye , since he 1970s, Friedman s hinking has been highl infl en ial in crea ing a polic approach in man co n ries ha foc ses on keeping infla ion lo , e en if nemplo men is high. The arg men is ha i ce dema d- ide licie cha ge agg ega e dema d ca l e em l me a a , lic h ld f c kee i g i fla i l . Man economis s disagree i h his perspec i e. According o Nobel Pri e- inning economis Joseph S igli : P licie ha f c e cl i el i fla i a e mi g ided . . . A a ac ical ma e , . . . he ela i hi be ee em l me a d i fla i i highl able. I i i all im ible di ce he ela i hi f m he da a e ce i a fe i la ed e i d . [P lic -make ] face c ide able ce ai ab he le el f he [ a al a e f em l me ]. Th , he ill face a ade- ff be ee hi g em l me l , a d e i g ff a e i de f i fla i , a d hi g ha d e gh e l i g i a ece a a e f e ce . H e ie he e i k de e d he c f d i g mi ake . . . The eigh f he e ide ce i dica e ha he c f d i g he mi ake f hi g em l me d fa i i elf e l . . . I hi ie , [ lic -make ] h ld agg e i el el em l me , il i i h ha i fla i i i i g. B c a , i fla i ha k 15 a g e ha i fla i m be a acked [ e e i el ] . . . [T]hi a ce i a ma e f eligi , ec mic cie ce. The e i im l li le em i ical e ide ce ha i fla i , a he l m de a e a e ha ha e e ailed i ece decade , ha a ig ifica ha mf l eal effec , em l me , g h he di ib i f i c me. N i he e e ide ce ha i fla i , h ld i i c ea e ligh l , ca be e e ed a a ela i el mi c ... The ie [ ha hi g ca be d e ab em l me ] bel mac ec mic ha a me . . . e fec l c m e i i e ma ke . ie ] a e al a efficie , he e i eed f g e me i e ma e f hi ie , he c f ed i h he eali f aie l beca e f g e me -im ed igidi ie a d ade ih ei he , he e ld, he claim, be em l me . 16 g a ch l f m de . . Beca e ma ke [i hi e i . M e [da ge l ], em l me , a g e ha i i . I hei ideal ld The idea ha con rol of infla ion is more impor an han keeping nemplo men lo is poli icall conser a i e, and is of en embraced b people ho belie e in he s periori of free marke s o er go ernmen in er en ion o sol e economic problems. Less conser a i e economis s and orkers ho ha e onl heir job o rel on as a so rce of income, end o prefer lo nemplo men o er lo infla ion (pro ided of co rse ha infla ion is modera e and does no ge o of hand). The also end o fa o r some in er en ion in marke s aiming o keep nemplo men lo . The na ral ra e concep , fa o ring lo infla ion o er lo nemplo men , became a rac i e o polic -makers for o reasons. One as ha beca se of s agfla ion, i forced economis s o q es ion he Ke nesian se of demand-side policies o deal i h economic fl c a ions. The second, and er impor an reason, as ha since he la e 1970s, here occ rred a shif in he general poli ical mood a a f m g e me i e e i a d a d he ma ke (par ic larl in he Uni ed S a es and Uni ed Kingdom); he na ral ra e concep i h i s s rong free-marke orien a ion, offered i self as an appealing heore ical approach o polic -making. I s free-marke recommenda ions, incl ding abolishing or red cing minim m ages and red cing labo r nion po er, ere a rac i e o polic makers ho opposed in er en ion in marke s. Therefore, he na ral ra e concep as con enien l adop ed as a g ide o polic , placing a grea er emphasis on con rolling infla ion ra her han red cing nemplo men . Wha does S igli mean hen he sa s he perspec i e of infla ion ha ks is a ma er of religion, no economic science ? On he basis of ha kno ledge cri eria ha e socie ies made a consis en choice o er man o make a priori of lo infla ion o er lo nemplo men ? ears Wh do man economis s consider he polic choice be een lo infla ion and lo nemplo men o be a ba le be een conser a i e and non-conser a i e economis s? INQ IR AND REFLEC ION The follo ing q es ions ill help o reflec on o r learning and enhance o r nders anding of ke opics in his chap er. The are s gges ions for inq iries ha o can nder ake on o r o n or in gro ps in order o re ise he learning objec i es of his chap er. 1 Research and find da a on nemplo men o er a period of abo en ears in selec ed co n ries o are in eres ed in, and r o find a co n r ha has e perienced significan fl c a ions in i s nemplo men ra e. Tr o find informa ion on he ca ses of he fl c a ions, specificall ha are he fac ors ha ha e led o increases or decreases o er he ears? Is i possible o come o an concl sions abo he her c clical fl c a ions ( he b siness c cle) ha e pla ed a role in nemplo men in hese fl c a ions? Tr o find an e ample of s r c ral nemplo men , sing he ca ses of s r c ral nemplo men o ha e learned abo in his chap er. 2 Research and find da a on infla ion o er a period of abo en ears in he co n r o li e in or a co n r o are in eres ed in. Yo are likel o find al erna ing rising or falling infla ion ra es. Tr o disco er he ca ses of rising infla ion or disinfla ion. See if o can de ermine he her hese are demand-p ll or cos -p sh fac ors. 3 (HL onl ) In he e abo e i as no ed ha he shor -r n Phillips c r e has come o be q es ioned b man economis s, ho gh man o hers arg e ha i is onl a ma er of ime before he familiar in erse rela ionship be een infla ion and nemplo men res mes. Research he mos recen ri ings on he Phillips c r e, in order o disco er if and ho he deba e has been resol ed. De ermine he her nemplo men and infla ion are displa ing he rela ionship sho n b he shor -r n Phillips c r e, and if he are no e amine he reasons p for ard o e plain his. E S Q Yo can find q es ions in he s le of IB e ams in he 'Digi al co rsebook: E ra ma erial' sec ion. 11 No e ha his b lle poin as macroeconomic objec i e'. ell as he ne o come from he s llab s sec ion Po en ial conflic be een 12 The Happiness Trade-Off be een Unemplo men and Infla ion 13 The correspondence be een Fig re 10.11(a) and (b) is no en irel acc ra e. The er ical a is of par (a) meas res he ra e of infla ion, or he percen age increase in he price le el. The er ical a is of par (b) meas res he price le el, hich is er differen from he ra e of infla ion. There can be increases in he price le el i h no increase in he ra e of infla ion and e en i h a decrease in he ra e of infla ion (or disinfla ion; for e ample, he ra e of infla ion increases b 5% in 2000 and b 3% in 2001). The s ccession of AD c r es in par (b), leading o increasingl larger rises in he price le el, has been dra n i h his poin in mind, e en ho gh i is s ill no acc ra e. 14 This same arg men is of en made in erms of ac al and e pec ed ra es of infla ion. Le s ass me ha hen he econom is ini iall a poin a, nominal ages are se on he e pec a ion ha he ra e of infla ion ill be 5%, and herefore nominal ages ha e been agreed i h emplo ers o increase b 5% so as o main ain a cons an real age. Le s sa ha he increase in aggrega e demand, ho e er, in ac al fac gi es rise o an infla ion ra e of 7%. Real ages decline as a res l , firm profi abili increases, real GDP increases as he econom mo es p ard along SRAS1, and nemplo men falls belo he na ral ra e o 3%. Th s e ha e he mo emen from poin a o poin b on SRAS1 and on SRPC1. In he long r n, he econom mo es o poin c beca se nominal ages adj s o ac al ra es of infla ion, i h he res l ha real ages increase o heir pre io s le el, firm profi abili falls o i s original le el, real GDP falls o Yp, and nemplo men climbs back o he na ral ra e of 5%. The onl difference from he ini ial eq ilibri m is ha here is no a higher ra e of infla ion, of 9%. In he long r n, hen he ac al ra e of infla ion is eq al o he e pec ed ra e of infla ion, nominal ages increase in line i h he ac al ra e of infla ion, real ages remain cons an , and he rade-off be een infla ion and nemplo men disappears. 15 Infla ion ha ks are polic -makers con rolled. 16 Joseph S igli (2006) The Phelps Fac or, Projec S ndica e. ho belie e ha infla ion has highl nega i e effec s and sho ld be C a e 11 Mac ec Ec Bef e cg c b ec , a ab e e e e II: f deb a 1 We have seen that countries tend to achieve economic growth over a period of time. What do ou think might be some positive and negative consequences of economic growth? 2 Governments sometimes accumulate debt in order to achieve their economic objectives. What might be some problems faced b countries with high levels of debt? In this chapter we will stud two more important macroeconomic objectives: economic growth and sustainable level of debt. 11.1 E LEARNING OBJEC I E Af e d ing hi ec ion o ill be able o: define all he e m appea ing in e plain ho - e m g o ac al g o in he e (AO1) h in e m of (AO2) h in he PPC model he ole of agg ega e demand in he AD-AS model e plain long- e m g o h in e m of (AO2) hif in he PPC ill a ing g o h in p od c ion po ibili ie he ole of LRAS in he AD-AS model d a diag am of he PPC model ho ing ac al g o (AO4) d a diag am of he AD-AS model ill h and g o h in p od c ion po ibili ie a ing (AO4) inc ea e in AD o ho inc ea e in eal o p inc ea e in LRAS o ho inc ea e in f ll emplo men o p e plain ho economic g o calc la e he a e of g o di c h i mea ed (AO2) h f om da a (AO4) he con e ence of g o h incl ding i impac on (AO3) li ing anda d he en i onmen income di ib ion Yo e e in od ced o ec ic g h in Chap e 1 in connec ion i h he p od c ion po ibili ie model. I a al o b iefl di c ed in Chap e 9 in connec ion i h he AD- AS model. Economic g o h efe o an inc ea e in eal GDP, o he eal an i o e a pe iod of ime ( picall a ea ), and i all e p e ed a : of good and e ice p od ced a pe cen age change in eal GDP o e a pe iod of ime, o a pe cen age change in eal GDP e ca i a o e a pe iod of ime. The di inc ion be een g o h in eal GDP and eal GDP e ca i a i impo an beca e he o mea e a e e likel o be diffe en . Whe ea eal GDP mea e he o al o p p od ced in an econom , eal GDP e ca i a mea e o al o p pe pe on. Real GDP e ca i a i a be e indica o of he anda d of li ing of a pop la ion, ince i mea e he amo n of eal GDP co e ponding o each pe on on a e age. No e ha economic g o h i mea ed a he pe cen age change in ea a oppo ed o i a GDP. The eal fig e elimina e he impac of p ice change , h pe mi ing meaningf l compa i on of le el of o p o e ime. C C The fo m la fo calc la ing pe cen age change in eal GDP i he follo ing: % change in eal GDP = final al e of eal GDP ini ial al e of eal GDP ini ial al e of eal GDP 100 Fo mo e info ma ion on pe cen age change , ee Q an a i i e echni e chap e in he 'Digi al co ebook: E a ma e ial' ec ion. If an econom had eal GDP of $75.3 billion in 2017 and $81.7 in 2018, b ho m ch did eal GDP g o in 2017 2018? U ing he fo m la abo e e find % change in eal GDP=81.7-75.375.3 100=6.475.3 100=8.5% The iden ical fo m la i of co e ed o calc la e he pe cen age change in eal GDP e ca i a. S ppo e an econom ha eal GDP e ca i a of $1402 in 2017, $1457 in 2018 and $1410 in 2019. B ho m ch did eal GDP e ca i a g o in 2017 2018 and in 2018 2019? 2017 2018 change in eal GDP e ca i a = 1457 1402 1402 100 = 55 1402 100=3.9% 2018 2019 change in eal GDP e ca i a = 1410 1457 1457 100 = 47 1457 100= 3.2% No e ha in he econd pe iod, economic g o R h a nega i e. GDP GDP S ppo e eal GDP i g o ing in a h po he ical econom , o i ha a po i i e g o h a e. Doe hi mean i al o ha po i i e e ca i a GDP g o h? The an e depend on ho fa he pop la ion i g o ing. If eal GDP i g o ing fa e han he pop la ion, hen he amo n of eal GDP ha co e pond o each pe on on a e age inc ea e , e l ing in po i i e g o h in eal GDP e ca i a. If, on he o he hand, he pop la ion i g o ing fa e han eal GDP, hen he amo n of GDP pe pe on on a e age dec ea e , and he g o h a e of eal GDP e ca i a i nega i e. If e kno he pe cen age change in eal GDP and he pe cen age change in he pop la ion, e can find he pe cen age change in eal GDP e ca i a in a e imple a : % change in eal GDP e ca i a = % change in eal GDP % change in pop la ion Fo e ample, if eal GDP g e b 2% in a ea , and he pop la ion g e b 1.5%, hen eal GDP e ca i a g o h a 0.5%. If, ho e e , he pop la ion g e b 2.5%, hen he % change in eal GDP e ca i a a 0.5%, indica ing ha o p pe pe on fell. Economic g o h a e achie ed b co n ie a o nd he o ld a idel . While ome co n ie e pe ience apid g o h, o he g o m ch mo e lo l , hile o he con ac fo a pe iod of ime. Thi can be een in Table 11.1, ho ing a e age ann al g o h a e of eal GDP fo e e al co n ie fo he pe iod 2013 2018. A 2013 2018 E GDP 9.40 (%) B 6.72 I 5.51 2.71 J 1.25 A 0.15 E 4.81 : Li fc ie b ea GDP g 11.1: Real GDP pe cen age g o h ae h Diffe ing g o h a e ha e eno mo implica ion fo a co n economic pe fo mance o e long pe iod of ime. Le con ide ha o ld happen o eal GDP of h ee h po he ical economie ha g o a diffe en a e o e a pe iod of fi e ea (a in he able). Imagine ha each econom a o in he ea 2015 i h a eal GDP of $1000. The fi one g o fo fi e ea a he high ann al a e of 9.40%; he econd co n g o a he lo a e age ann al a e of 0.15 %; and he hi d co n con ac a he ann al a e of 4.81% (nega i e g o h). The e l a e p e en ed in Table 11.2. The co n he co n 0.15% pe ha g o a 9.40% pe ea fo fi e ea end p i h a eal GDP ha i do ble ha of i h he nega i e g o h a e of 4.81%. The co n ha g o a he lo a e age a e of ea onl add $8 o i GDP. 2015 GDP A 2020 GDP $1000 9.40% $1567 $1000 0.15% $1008 $1000 4.81% $782 11.2: G o h of eal GDP in h po he ical economie The la ge c m la i e impac ha a e of g o h ha e on le el of eal GDP e plain a o nd he o ld foc ongl on policie in ended o inc ea e hei g o h. E O R NDER h go e nmen ANDING 11.1 1 De c ibe he meaning of economic g o h and e plain i 2 When e calc la e economic g o GDP. 3 E plain he ad an age of calc la ing g o of eal GDP. 4 S ppo e an econom had eal GDP e ca i a of 1579 in 2017, 1611 in 2018 and 1597 in 2019. Find he a e of economic g o h h, o line he he ignificance o e a pe iod of ea . e ho ld e nominal o eal al e of h of eal GDP in e ca i a e m a he han g o in 2017 2018, and in 2018 2019. S a e hen he econom e pe ienced nega i e g o 5 O line ho i i po ible ha a co n nega i e eal GDP e ca i a g o h. h. can ha e po i i e eal GDP g o h and e ha e h 6 S ppo e ha an econom eal GDP g e b 2.2% in 2007, and i pop la ion g e b 1.5% d ing he ame ea . Calc la e b ho m ch i eal GDP e ca i a g e . - - We ill no make a di inc ion be een , hich ake place o e ela i el pe iod of ime, and , hich need a long ime o ake effec . Man of he idea ha ill be di c ed in hi ec ion ha e been died in p e io m ch of ha o ill ead abo in hi ec ion ill be a e ie fo o . ho chap e , and o AD-AS In he AD-AS model, economic g o h, o inc ea e in eal GDP, occ inc ea e in agg ega e demand, hich i efe ed o a inc ea e in ho - n agg ega e go h inc ea e in long- n agg ega e - a a e l of: ho - e m g o ppl ( ho gh hi i fa le common), al o a ppl , efe ed o a long- e m g o : h pe of ho - e m h. (AD) Fig e 11.1 ho ho - e m g o h in he mone a i /ne cla ical model. I can be ca ed b inc ea e in agg ega e demand, ill a ed in pa (a) b he igh a d hif of he AD c e f om AD1 o AD2, e l ing in a eal GDP inc ea e f om Y1 o Y2. No e ha h - e ec ic g hd e i e a i c ea e i e ia , and he efo e he e i no igh a d hif of he LRAS c e. In he Ke ne ian model, ho - e m economic g o h can be een in Fig e 11.1(b), he e cce i e inc ea e in agg ega e demand f om AD1 o AD2 o AD3 and AD4 e l in g o h of eal GDP f om Y1 o Y2 o Y3 and Y4. No e ha he e, oo, h - e ec ic g hd e i e a i c ea e i e ia , and hence no igh a d hif of he AS c e. Thi pe of ho - e m g o h can be ca ed b an of he fac o ha can ca e inc ea e in agg ega e demand (AD) ha o died in Chap e 9, Sec ion De e i a f agg ega e de a d. AD can inc ea e a a e l of an inc ea e in an one o mo e of he componen of AD, hich a e con mp ion (C), in e men (I), go e nmen pending (G) and ne e po (X M). - : - ( RA ) Sho - e m g o h can al o be ca ed b inc ea e in ho - n agg ega e ppl , o a igh a d hif of he SRAS c e f om SRAS1 o SRAS2 in Fig e 11.1(c), ca ing eal GDP o inc ea e f om Y1 o Y2. The ca e of hi pe of g o h incl de he fac o ha can inc ea e ho n agg ega e ppl (SRAS) ha o died in Chap e 9, Sec ion Cha ge i h agg ega e : fall in p ice of fac o of p od c ion (labo and non-labo e o ce ), inc ea e in b idie , o po i i e ppl hock . I h d be ed, h e e , ha h - e agg ega e de a d a he ha i h - L AS - : ec ic g agg ega e - h i affec ed fa . e b i c ea e i (LRAS) K In Chap e 9, Sec ion Shif i g agg ega e c e e he g e , o lea ned abo a n mbe of fac o ha affec he po i ion of he LRAS and Ke ne ian AS c e , ca ing he e c e o hif o he igh . Since he e all need an e ended pe iod of ime o ake effec , hei effec on he econom a e efe ed o a g- e g h. Bo h of he e a e ho n in Fig e 11.2, hich i he ame a Fig e 9.13. F 11.1: Sho - e m g o h A o ma ecall, he e fac o incl de inc ea e in he an i and imp o emen in he ali of fac o of p od c ion, echnological change, imp o emen in efficienc and in i ional change . F go 11.2: Inc ea ing po en ial o p , hif h in agg ega e ppl c e and long- e m economic AD-AS , In Chap e 9 e a ha infla iona and defla iona gap co e pond o he p a d and do n a d pha e of he b ine c cle in od ced in Chap e 8, Fig e 8.4 and 8.5. We al o a ha hen he e i no infla iona o defla iona gap, he econom p od ce a i f ll emplo men le el of o p , o po en ial GDP. I i no imple o ee he connec ion be een economic g o h and he b ine c cle. Sho - e m g o h i ho n in he e pan ion pha e of he b ine c cle, hen eal GDP i inc ea ing o e ime, ho gh hi i follo ed b a con ac ion, o a pe iod of dec ea ing eal GDP. The con ac ion ill a e i a ion he e he e i nega i e g o h. The p a d pha e of he b ine c cle a e ca ed mainl b inc ea e in agg ega e demand, and o a le e e en b inc ea e in ho - n agg ega e ppl . Simila l he do n a d pha e , ill a ing nega i e g o h, a e ca ed b dec ea ing agg ega e demand and o a le e e en dec ea ing ho - n agg ega e ppl . On he o he hand, o e long pe iod b ine c cle diag am, ho ing an econom eal GDP i g o ing o e efe ed o a e ia ; hi i i a ed, and he po en ial o p e of ime, mo economie e pe ience po i i e economic g o h. The p a d- loping, long- e m g o h end, indica e ha he ime. The long- e m g o h end, o ma emembe , a none o he han he eal GDP le el a hich he LRAS c e i ee in he Ke ne ian model. Sho - e m g o h ca ed mainl b inc ea e in agg ega e demand (and o a le e e en inc ea e in ho - n agg ega e ppl ) co e pond o e pan ion of eal GDP in he b ine c cle diag am. Long- e m g o h ca ed b igh a d hif ing LRAS o Ke ne ian AS c e ha ho inc ea e in po en ial o p co e pond o he long- e m g o h end in he b ine c cle diag am. Fig e 11.3 ill a e ho mac oeconomic e ilib i m change o e he long e m hen po en ial o p i inc ea ing. Y1 and Y2, hich a e he long- n e ilib i m poin of pa (a) and he Ke ne ian e ilib i m poin of pa (b) co e pond o poin in he b ine c cle diag am he e ac al o p i e al o po en ial o p . The e a e he poin of in e ec ion of he c e ho ing ac al GDP and po en ial GDP. The long- e m g o h end of he b ine c cle diag am impl ace o he inc ea e in po en ial o p ho n in he AD- AS model . F 11.3: Long- e m economic g o econom h: achie ing po en ial (f ll emplo men ) o p in a g o ing In he eal o ld, i i e diffic l o e amine economic ac i i and a i e a acc a e concl abo ha pa of g o h i d e o ho - e m fl c a ion of he b ine c cle and ha pa in po en ial o p . Ho e e , economi con in o l make effo o mea e po en ial o p g o h, beca e ha ing e ima e of he e can help go e nmen fo m la e app op ia e policie he mac oeconom in he de i ed di ec ion . ion og o h and i o g ide Thi model a in od ced in Chap e 1 (Sec ion I d ci g he d ci ibi i ie de ). I i gge ed ha o e ead hi ec ion a i i highl ele an o he di c ion of g o h belo . - : Yo ma emembe ha he p od c ion po ibili ie c e (PPC) ho combina ion of ma im m o p ha can be p od ced b an econom i h fi ed e o ce and echnolog , ided he e i f a i e e f e ce a d efficie c i d c i . Ma im m emplo men in hi model doe no mean f ll emplo men a in AD- AS model ; i mean ha all e o ce a e emplo ed o he f lle e en and he e i e o nemplo men . In Chap e 1, e lea ned ha i i highl nlikel fo an econom o be p od cing on i PPC, a hi p e ppo e f ll o ma im m emplo men of all e o ce and efficienc , hich canno be achie ed in he eal o ld. An co n i he efo e mo likel o be p od cing a a poin in ide i PPC. I can mo e clo e o i PPC and i c ea e he ac a a i f i d ce b ed ci g e e b i i g he efficie c f e ce e. In Fig e 11.4(a), hich i he ame a Fig e 1.3(a) in Chap e 1, he mo emen f om poin A o poin B ho g o h of ac al o p . We efe o hi a ac a g h, hich i a kind of h - e g h, beca e i can occ o e ho pe iod of ime. L - : I i clea f om Fig e 11.4(a) ha ed c ion of nemplo men and inefficiencie can onl e l in a limi ed amo n of economic g o h. The p e ence of he PPC e an ppe bo nd o ho m ch mo e o p can be p od ced. The onl a o p od ce mo e o p be ond he limi c ea ed b he PPC i if he PPC hif o a d a in Fig e 11.4(b), allo ing mo e of bo h g o p of good ( i i a g d and c e g d ), o be p od ced. The hif f om PPC1 o PPC2 o PPC3, called g hi d ci ibi i ie , a e efe ed o a g- e g h, beca e i i likel o occ o e long pe iod of ime. In Fig e 11.4(b), oge he i h he g o h in p od c ion po ibili ie he e i al o ac al g o h ho n b he o a d mo emen of he econom ac al o p , f om A o B o C. A o lea ned in Chap e 1, he fac o p od c ion po ibili ie a e: inc ea e in he an i ha lead o o a d hif of he PPC, o inc ea e in of e o ce (fac o of p od c ion) in he econom imp o emen in he ali of e o ce (fo e ample, h o gh mo e ed ca ed labo , o imp o ed ph ical capi al h o gh echnological change). A p od c ion po ibili ie g o , effo m be made o keep nemplo men a lo le el and ed ce inefficiencie o en e ha ac al o p g o along i h p od c ion po ibili ie , a in Fig e 11.4(b). Fo e ample, if he i e of he labo fo ce inc ea e , hi ill no lead o ac al g o h if m ch of hi labo emain nemplo ed, in hi ca e he econom co ld emain ck a poin A e en a PPC1 hif o PPC2. Simila l , he di co e of majo oil e e e ma no lead o ac al g o h if he e e e e emain ne ploi ed, o if hei e ploi a ion i nde aken inefficien l . A o ma emembe f om Chap e 1, he PPC can al o hif in a d, indica ing a dec ea e in p od c ion po ibili ie . Thi mean ha le of he o good i being p od ced, a ho n in Fig e 11.4(c). Thi e l f om a dec ea e in he an i of e o ce o o ening of e o ce ali . I ep e en he ca e of nega i e g o h. F 11.4: U ing he p od c ion po ibili ie model o ill a e economic g o h Ac al g o h i ho e -g h, beca e i can occ o e ho pe iod of ime and i d e o ed c ion in nemplo men o inefficienc in p od c ion. G o h in p od c ion po ibili ie i ge g h, beca e i all e i e long pe iod of ime and i d e o inc ea e in an i o imp o emen in ali of fac o of p od c ion. Table 11.3 p o ide a mma of he fac o ha ca e ho - e m and long- e m g o h in he o model . We can ee ha he a e in ome e pec imila ega ding he ca e of g o h. In he PPC model, ed c ion of nemplo men i a ke ca e of ac al g o h o e he ho e m. In he AD- AS model, inc ea e in AD o SRAS bo h in ol e ed c ion in nemplo men , ince i i no po ible o p od ce a la ge amo n of eal GDP i ho mo e labo being hi ed, hich lead o a fall in nemplo men . The efo e, in bo h model fall in nemplo men a e a majo fac o behind g o h. Rega ding long- e m g o h, e can ee ha he fi h ee ca e of g o h ha a e li ed a e common o bo h model . The imila i ie be een he o model a e ha dl p i ing ince bo h ill a e economic g o h. On he o he hand i i al o no p i ing ha he e a e ome diffe ence be een he o model . The o AS c e a e in ended o ho he ela ion hip be een he p ice le el and eal GDP. The p od c ion po ibili ie model doe no deal i h he p ice le el, i i be e i ed o ill a e he p inciple of e o ce ca ci and oppo ni co of economic choice . AD-AS - PPC inc ea e in AD ed c ion nemplo men inc ea e in SRAS (le impo an ) L - imp o emen efficienc inc ea ed e o ce an i imp o ed e o ce ali in in echnological change imp o emen efficienc in i 11.3: Fac o E 1 ha ca e economic g o O R NDER in ional change h ANDING 11.2 U ing diag am( ), e plain he diffe ence be een an inc ea e in ac al o p p od c ion po ibili ie . U ing e ample iden if he ca e of each. and an inc ea e in 2 U ing diag am , e plain he diffe ence be een long- e m economic g o economic g o h d e o economic fl c a ion . U ing e ample , iden if he ca e of each. O line ho po en ial o p 3 h and ho - e m change / doe no change in each ca e. U e he p od c ion po ibili ie model and diag am o ho ho he follo ing can e l in economic g o h (po i i e o nega i e), di ing i hing be een PPC hif and mo emen of a poin clo e o o f he f om a gi en PPC: a di co e of ne oil e e e , a fall in na al nemplo men , an inc ea e in c clical nemplo men , an imp o emen in le el of heal h of he pop la ion, an imp o emen in efficienc in p od c ion, he ide p ead e of a ne a iolen conflic de o echnolog , a po ion of a co n fac o ie , machine and oad em, la ge c in go e nmen pending on ed ca ion and heal h ca e lo e le el of ed ca ion and heal h in a pop la ion, an inc ea e in he an i of capi al good , an imp o emen in he le el of ed ca ion and kill of o ke , and ind ial poll ion de o he en i onmen . ( ) , To nde and h inc ea e in e o ce an i ie and imp o emen in e o ce ali incl ding echnological change ca e long- e m g o h in bo h model , e ill e he e panded meaning of ca i a , in od ced in Chap e 1, Sec ion Re ce a fac f d c i . Capi al gene all efe e o ce ha can p od ce a f e eam of benefi . Thi f e eam of benefi a i e f om in e men , o pending nde aken o c ea e ha eam of benefi . o Th ee of he fo fac o of p od c ion: land, o na al e o ce ; labo , o h man e o ce ; and ph ical capi al, can be in e p e ed a a pe of capi al : Ph ica ca i a ,al o efe ed o a capi al good i he anda d pe of capi al; a e kno f om Chap e 8 i e l f om in e men , o pending o p od ce machine , e ipmen , oad , e c. H a ca i a efe o he kill , abili ie , kno ledge and le el of heal h of o ke . H man capi al e l f om in e men , o pending on ed ca ion, aining, p o i ion of heal h ca e e ice , clean a e pplie , good n i ion, and gene all an hing ha affec le el of ed ca ion and heal h. Na a ca i a incl de e e hing ha adi ionall fall i hin land , o na al e o ce . I incl de e e hing nde he land (mine al depo i , me al , oil, na al ga , e c.) pl e e hing on he land ( i e , lake , ocean , fo e , oil , e c.), pl a co n o e all na al en i onmen and eco em (ai , ildlife, biodi e i , clima e, o one la e , and o on). Whe ea land and na al capi al incl de he ame hing , he e i an impo an diffe ence in ho he o e m a e in e p e ed. Land i a med o be gi en b na e and doe no change. Na al capi al doe change, beca e i can be de o ed (b c ing do n fo e , poll ing he ai and a e , deple ing fi h). I can al o be imp o ed (b plan ing mo e fo e , imp o ing oil ali ). Main aining na al capi al and imp o ing i ali depend on in e men ha aim o p e e e and imp o e na al e o ce an i and ali . B e panding he meaning of capi al , e ha e e ended he meaning of in e men h ee fac o of p od c ion li ed abo e: o appl o all F ph ical capi al i ela ed o in e men in ph ical capi al labo i ela ed o in e men in h man capi al = h man e o ce land = na al e o ce i ela ed o in e men in na al capi al In e men can be nde aken b he p i a e ec o (fi m o p i a e indi id al ) o b ( he go e nmen ).1 I e e i c cia b i di g ca i a f a e. We ill no ee ho in e men in he h ee pe of capi al lead o economic g o he p blic ec o h. P , An inc ea e in he e ipmen , oad a i f h ica ca i a in ol e an inc ea e in he n mbe of machine , ool , em , po , e c. a ailable in an econom . An imp o emen in he a i f h ica ca i a depend on echnological ad ance , hich lead o ne and be e machine , ool and e ipmen . Technological ad ance a e all inco po a ed in o ne capi al good ; fo e ample, a ne comp e ha i fa e and mo e po e f l inco po a e i hin i he ne echnolog ha make i fa e and mo e po e f l. When a echnological ad ance i inco po a ed in o a capi al good, i i efe ed o a being e b died in he ne capi al. The efo e, imp o ed capi al good a e capi al good ha embod a ne echnolog . U e of capi al good embod ing ne echnologie lead o a la ge an i of o p p od ced; fo e ample, he e of a mo e po e f l comp e allo a o ke o p od ce mo e o p . Inc ea e in he an i and imp o emen in he ali of ph ical capi al, a i ing f om in e men in ph ical capi al and ne echnolog , a e among he mo impo an o ce of economic g o h o e long pe iod of ime. H , The an i of labo can ome ime be an impo an o ce of economic g o h; fo e ample, he infl of fo eign o ke in o Ge man in he 1960 and 1970 pla ed an impo an ole in p omo ing i g o h. Ho e e , man co n ie (e peciall le de eloped one ) ome ime face high le el of nemplo men and nde emplo men . The efo e, inc ea e in he an i of labo ma no al a be a o ce of g o h. Fa mo e impo an han inc ea e in he an i of labo i imp o emen in he ali of labo , de e mined b kill , abili ie , kno ledge and le el of heal h of he o kfo ce. Imp o ed labo ali i he e l of in e men in h man capi al, incl ding pending on ed ca ion, b ilding chool , p o iding meal fo choolchild en and p o iding oca ional aining; a ell a pending o p o ide medical e ice , imm ni a ion, and en ing acce b he o e all pop la ion o heal h ca e e ice , oge he i h he p o i ion of ani a ion and clean a e pplie , and keeping he en i onmen npoll ed. Highe le el of kill , kno ledge and heal h, e l ing f om in e men in h man capi al, a e a e impo an o ce of economic g o h beca e a highl killed, ell-ed ca ed and heal h labo fo ce i mo e p od c i e han an n killed, ned ca ed and nheal h one: a killed and heal h p od ce mo e o p han a o ke ho i n killed o nheal h . o ke can Inc ea ed an i ie of labo a e nlikel o be a o ce of economic g o h o e long pe iod , b imp o emen in he ali of labo , a i ing f om in e men in h man capi al, a e among he mo impo an o ce of g o h. N , When hinking abo he con ib ion of na al e o ce (na al capi al) o economic g o h, i i ef l o make a di inc ion be een o kind of na al capi al: a ke ab e c di ie (commodi ie ha a e bo gh and old) ch a imbe , mine al , me al , na al ga , coal and oil; and ecological e o ce ch a oil ali , i e , clean ai , biodi e i , he o one la e (and, mo e gene all , common pool e o ce ). Ma ke ab e c di ie ca c ib e g hb a e e e ia . Fo e ample, he Uni ed S a e benefi ed eno mo l f om i la ge ac of good ali ag ic l al land, oil e e e and mine al depo i . Ye he e idence gge ha co n ie do no need o be ich in ma ke able commodi - pe na al e o ce o achie e high a e of g o h. The e a e man economie , ch a I ael, Japan, Hong Kong, Singapo e, So h Ko ea, S i e land, Tai an and o he , ha ha e achie ed high a e of g o h o e long pe iod and ha e a ained high le el of GDP e ca i a, in pi e of p od cing fe , if an , ma ke able commodi ie . C e ce a e c cia i a g- e g h. Long- e m economic g o h depend c i icall on he abili of co n ie o main ain, and if po ible imp o e, en i onmen al ali , and he efo e na al capi al ha incl de common pool e o ce ( ee Chap e 5). En i onmen al de c ion can ha e di ec effec on he amo n of o p p od ced; fo e ample, a fa me o king i h poo e ali oil p od ce le o p ; fi he ie in fi h-deple ed ea ha e a malle ca ch. De pi e hi , i can al o ha e impo an indi ec effec ; fo e ample, o ke ho e heal h i affec ed b en i onmen al poll ion become le p od c i e, and hi in ol e deple ion of h man capi al oge he i h deple ion of na al capi al. Anal ed in e m of he p od c ion po ibili ie model, he e effec in ol e an in a d hif of he PPC d e o fe e and lo e ali en i onmen al and h man e o ce (na al and h man capi al) and he efo e lo e (o e en nega i e) economic g o h in he f e, een in Fig e 11.4(c). The efo e, con in ed economic g o h in he f e e i e in e men in he p e en in na al capi al fo en i onmen al p e e a ion. The con ib ion of e o ce an i ie and ali o economic g o h can be mma i ed in he concep of d c i i , efe ing o he an i of o p p od ced fo each ho of o k of he o king pop la ion. Fo an econom a a hole, p od c i i can be mea ed a eal GDP di ided b he o al n mbe of ho o ked. An imp o emen in p od c i i mean ha o ke become mo e p od c i e: he an i of o p p od ced in an ho of o k inc ea e . Imp o emen in p od c i i lead o economic g o h, beca e each ho of o k no p od ce mo e o p . Wha a e he fac o ha ca e imp o emen in p od c i i ? The a e e ac l he fac o making he mo impo an con ib ion o long- e m economic g o h di c ed abo e. The incl de: inc ea e in an i and imp o emen in ph ical capi al and echnological change) imp o emen in he ali of labo ali E O R NDER e l in igh an i and ali of ecological e o ce a d hif of he LRAS o Ke ne ian AS c e , and o ad ANDING 11.3 1 E plain he ela ion hip be een in e men and ph ical, h man and na 2 Refe ing o land, labo and ph ical capi al, and he concep of capi al a applied o each of he e e o ce , e plain ho each one can con ib e o economic g o h. 3 in ( h o gh in e men in h man capi al) imp o emen in (o a lea main enance of) he ( h o gh in e men in na al capi al). P od c i i imp o emen hif of he PPC. of ph ical capi al ( h o gh in e men al capi al. Define p od c i i . E plain h imp o ed p od c i i Wha a e he mo impo an fac o Sho p od c i i go h i impo an fo economic g o ha e l in p od c i i h. imp o emen ? ing PPC and LRAS diag am . C Economic g o h impac pon man a pec of he econom , and ome of i po ible con e ence a e po i i e hile o he ma be nega i e. I i impo an o no e ha man of he e con e ence , he he po i i e o nega i e, a e no ine i able, b a he f f he a ha g hi ed. I Li i g a da d (o a da d f i i g) efe o le el of income, eal h and con mp ion of good and e ice , incl ding heal h ca e and ed ca ion. If eal GDP of a co n inc ea e fa e han i pop la ion, hen an inc ea e in GDP e ca i a e l . Thi indica e ha he e i a g ea e e ia f e e i c ea e hei c i f g d a d e ice , a d i e hei a da d f i i g. Acco ding o n me o die ca ied o o e man ea , economic g o h i a ocia ed i h imp o emen in anda d of li ing indica o . Thi i ha e o ld e pec , ince g o h p o ide addi ional e o ce allo ing fo imp o emen in li ing anda d . Ho e e , GDP e ca i a o income e ca i a i onl an a e age mea e, and doe no ell ho he inc ea e in income i di ib ed o he he he e i a b oadl di ib ed imp o emen in li ing anda d . The efo e imp o emen a a lo f om co n o co n and f om ime pe iod o ime pe iod, o ha fo a gi en a e of g o h he a e in ome ca e mall and in o he m ch la ge . Wha acco n fo ch diffe ence ? Impo an fac o follo ing: ha allo economic g o h o ha e po i i e effec on anda d of li ing incl de he . The g ea e he ha e of income going o poo e ho ehold , he g ea e he po en ial fo con ib ing o imp o emen in li ing anda d a he poo e ho ehold a e ho e i h he g ea e dep i a ion . If inc ea e in income made po ible b economic g o h b pa he poo e ho ehold , g o h ha limi ed effec on b oadl ha ed imp o emen in li ing anda d . H . The g ea e he ha e of ho ehold income pen on good and e ice a food, ed ca ion and heal h ca e, he g ea e he imp o emen in li ing anda d . . The g ea e hi i , he Chap e 19 on he ole of omen). ch onge he impac ( ee al o G . Thi ela e o he ha e of he go e nmen b dge alloca ed o p io i a ea like ed ca ion, heal h ca e and inf a c e incl ding clean a e pplie and ani a ion; he la ge hi i , he g ea e he po i i e effec of g o h. C (NGO ). Beca e of hei po e o ien a ion and hei gene al effec i ene in eaching poo people, NGO con ib e o inc ea ing he impac of g o h on highe anda d of li ing. A majo d of da a be een 1970 and 2005 fo 111 co n ie b he Uni ed Na ion De elopmen P og amme (UNDP)2 ho ha he g ea e imp o emen in li e ac and life e pec anc ( o componen of he H man De elopmen Inde (HDI); ee Chap e 18) a e cc i g i he fa e g i g ec ie f he d ( he onl o e cep ion being China and Ko ea). Fac o con ib ing o HDI imp o emen a e go e nmen e pan ion of ed ca ion and heal h ca e, oge he i h he in e na ional comm ni con ib ion of accine and an ibio ic . The efo e, hi e ec ic g h ffe he e ia achie e i e e i he e i e e d cc a a ica a a e f ec ic g hb policie o make effec i e e of he e o ce g o h make a ailable. a da d f i i g, e i e app op ia e I E pe ience ho ha g o h, e peciall apid g o h, of en lead o n ainable e o ce e (pa ic la l in he ca e of common pool e o ce ). Fo e ample, e high g o h a e in Ea A ian co n ie ha e been a ocia ed i h e io en i onmen al lo e aking he fo m of e high le el of ban ai poll ion, oil deg ada ion d e o oil e o ion, a e logging and o e g a ing, h ea o biodi e i and e io defo e a ion. Ind iali a ion ba ed on fo il f el i a majo o ce of poll ion (nega i e p od c ion e e nali ie ). Inc ea ing income lead o con mp ion pa e n al o ba ed on g ea e fo il f el con mp ion ( e of ca , ai condi ione , ai a el, e c., c ea ing nega i e con mp ion e e nali ie ). O he ac i i ie , ch a comme cial logging and ag ic l al p ac ice ba ed on a lack of p icing mechani m fo common pool e o ce , e l in hei n ainable e. E pe ience like he e ha e led o he ide p ead belief ha economic g o h and en i onmen al ainabili a e conflic ing objec i e : mo e of one mean le of he o he . Man go e nmen a o nd he o ld ha e ba ed hei policie on hi belief b follo ing he g o no , clean p la e a of hinking, hich a g e ha ince ing e o ce o p e e e he en i onmen ed ce g o h, i i p efe able o p e g o h i h i nega i e effec on he en i onmen , and po pone he clean- p job of en i onmen al p e e a ion fo la e hen income ill be highe . Fo e ample, he in alla ion of poll ion-con ol e ipmen in ol e g ea e co fo fi m , hich ma mean lo e p ofi , lo e in e men and lo e economic g o h. S i ching o en i onmen all o nd ag ic l al p ac ice imila l in ol e co ha ma c in o f e economic g o h p o pec . Se ing limi o defo e a ion fo imbe place e ic ion on he g o h of he imbe ind . The efo e, alloca ing e o ce fo en i onmen al p o ec ion a g abl an la e in o malle inc ea e in o p and hence lo e economic g o h. Ye , hi a of hinking i n o nd fo e e al ea on . One i ha ee i e a da age i i e e ib e; i ill no be po ible o co ec he damage in he f e, and ome e o ce ill be lo fo e e . Fo e ample, lo biodi e i can ne e be eco e ed; lo li e d e o poll ion-ind ced illne e can imila l ne e be eco e ed. A econd i ha i j ifie g e e i ac i he e i e . Go e nmen and polic -make of en ongl a me ha en i onmen al i e ill a oma icall be egained in he f e a income inc ea e i h g o h. Thi i n eali ic, beca e p e e a ion of he en i onmen e i e policie aiming o limi nega i e en i onmen al e e nali ie . A hi d, ela ed ea on i ha i i ha g hi ed. If g o h e ainabili . A fo h ea on i ha de ci f a a e ce be h ea e ed. g h i e f ha i bad f he e i e , b a he he a ep ed diffe en l , i need no conflic i h en i onmen al g h ba ed ai ab e e ce e a ead ch a ide ca e ha he ibi i f c i ed f eg h a Mode n g o h heo ho ha economic g o con i en i h each o he , and ca be cce f he follo ing: h and en i onmen al ainabili a e in fac ed ge he de ce ai c di i , ch a Go e nmen implemen ma ke -ba ed policie ha in e nali e he e e nali ie , h no onl co ec ing hem (a lea in pa ) b al o p o iding incen i e fo ainable e o ce e and p omo ion of g een (o clean ) echnologie ( ee Chap e 5). Go e nmen p e mo e en i onmen al eg la ion change (g een echnologie ). ha enco age poll ion-f ee echnological The e i an inc ea ed empha i on h man capi al in p od c ion ( hich i poll ion-f ee) a oppo ed o ph ical capi al. The e i an inc ea ed empha i on g een in e men , hich p omo e g o h hile no h ing he en i onmen : b ilding p blic an po a ion em ; in e ing in in la ion in home and b ilding ; in e ing in clean echnolog e ea ch and de elopmen (R&D) and clean echnologie . The e a e change in he c e of he econom o a d mo e e ice ( hich end o be poll ion-f ee), oge he i h mo e in e men in he p o ec ion of na al e o ce . A income inc ea e i h economic g o h, mo e e o ce a e made a ailable i h hich go e nmen can p e he abo e kind of policie , enco aging economic g o h a he ame ime ha he enco age ainabili . The efo e, ec ic g ha d ai abi i ca be ed ge he ided g e e ake a ia e ea e e e ai ab e e ce e. Thi i he e meaning behind he concep of ainable de elopmen ( ee Chap e 5). Ho e e , e en nde he be po ible ci c m ance he e all of he abo e condi ion a e f lfilled, mode n g o h heo ie ho ha he e i a a i ae fg h ha i c i e ih e i e a ai abi i , and ha if an econom e ceed hi a e, e o ce e ill become n ainable. The ea on i ha p i of ainabili e p ome e o ce (fo e ample an ipoll ion con ol , co of eg la ion, e c.), and he e e o ce ep e en an oppo ni co in e m of lo economic g o h. No e, ho e e , ha hi onl applie o a lo of a po ion of e high a e of g o h.3 HEOR OF KNO LEDGE 11.1 The appa en conflic be een g o h and ainabili a i e beca e of he a ec ic g hi defi ed. The idea of conflic follo f om he con en ional mea e of economic g o h, aken o be inc ea e in eal GDP e ca i a. Thi in n depend on he defini ion of GDP, hich i he al e of all good and e ice p od ced in a co n in he co e of a ea . A o ma emembe f om Chap e 8, Sec ion E a a i g a i a i c e a i ic , one of he e io limi a ion of he mea e of eal GDP pe capi a i ha i doe no acco n fo nega i e e e nali ie and en i onmen al lo e a i ing f om en i onmen al deg ada ion. Thi limi a ion co ld be co ec ed if co n ie adop ed o he acco n ing me hod ha incl ded en i onmen al deg ada ion in ome fo m ( ch a he OECD Be e Life Inde o he Happ Plane Inde ). If economic g o h a calc la ed in a a ha ook acco n of en i onmen al de c ion a ell a po ible nega i e heal h con e ence of poll ion e o ld find ha in mo co n ie a o nd he o ld economic g o h a e o ld be fa lo e han ho e ba ed on con en ional GDP mea e , and in man ca e o ld be nega i e. Man co n ie o ld find ha hei lo e d e o en i onmen al deg ada ion a e g ea e han hei gain d e o inc ea ed p od c ion of good and e ice . If economic g o h e e edefined o a o ake in o acco n ch lo e , he onl a hen o achie e high a e of g o h o ld be b inc ea ing he p od c ion of good and e ice i ho ca ing en i onmen al de c ion (o ca ing onl mall amo n of en i onmen al de c ion); al e na i el , inc ea e in he p od c ion of good and e ice o ld incl de imp o emen in he ali of en i onmen al e o ce e l ing f om in e men in na al capi al. The p oblem of he conflic be een g o h (con en ionall defined) and ainabili i ela ed o economi ema ic neglec of he fac o of p od c ion land . G o h model in main eam economic ho ho o p inc ea e in ela ion o labo and capi al (in he en e of ph ical capi al), ome ime al o con ide ing h man capi al, hile comple el igno ing land, hich a aken o be an nimpo an fac o ha a pe manen l fi ed in an i and ali . I i onl in ecen ea ha land ha been edefined b en i onmen al economi o con i of na al capi al , hich can be de o ed o imp o ed h o gh in e men a di c g h cc (S pplemen a ma e ial). Ho doe he a e hink of (o define) g o ed abo e in Sec ion Wh ec h affec i ela ion hip o he en i onmen ? Do e ha e a mo al obliga ion o na e and he en i onmen ? I o h ba ed on economic o mo al c i e ia (o bo h)? choice of ho o mea eg o ic If go e nmen began ing al e na i e acco n ing me hod , o ld p od c ion and con mp ion pa e n nece a il change o a o become mo e con i en i h ainabili ? Some migh a g e ha con in o g o h i impo ible beca e i i indefini e g o h. I hi a g men alid? n ainable o achie e I A la ge n mbe of die ha e been ca ied o in e iga ing he ela ion hip be een g o h in GDP e ca i a and income di ib ion in de eloping and de eloped co n ie . The e l ha e been inconcl i e: hile in ome co n ie income di ib ion o ened in he ea l pe iod of g o h and hen imp o ed, in ome o he he oppo i e happened, hile in man o he , income di ib ion did no ho an clea pa e n of change. The e e l lead o he concl ion ha he e i c ea e a i hi be ee g h i GDP e ca i a a d i c e di ib i ; in ead, ha happen o income di ib ion a a co n g o i a eflec ion of pa ic la condi ion in each co n and he kind of g o h policie ha a e p ed. Fo e ample, man co n ie in La in Ame ica had highl ne al income di ib ion o begin i h; income di ib ion in he e co n ie ha ended o emain highl ne al. A n mbe of co n ie in Ea A ia (fo e ample So h Ko ea) had fa mo e e al income di ib ion hen he began hei apid g o h, and hi emained o e en i h apid g o h d ing he 1970 and 1980 . In addi ion, co n ie of Ea A ia placed a ong empha i on he de elopmen of h man capi al, a polic ha pla ed a ke ole in en ing b oad-ba ed pa icipa ion in he benefi of g o h, i h po i i e effec on he e ali of income di ib ion. Ye , income ine ali ie in man co n ie a o nd he o ld ha e been idening o e he pa h ee o o decade . The ha e been g o ing in China, India, Indone ia, Thailand and o he Ea A ian and So h-ea A ian co n ie ha had achie ed g ea e income e ali and ed c ion in po e in hei ea l ea of g o h. R ia and mo o he cen al and ea e n E opean co n ie ha e imila l been e pe iencing ha p i e in income ine ali ie . A n mbe of co n ie in La in Ame ica ha e een g o ing ine ali ie a ell. Almo all OECD4 co n ie al o ho o ening income di ib ion . Some of he e co n ie ha e al o e pe ienced inc ea e in he n mbe of ho ehold belo he po e line. In bo h de eloped and de eloping co n ie , a majo fac o behind inc ea ing income ine ali ie ha been he g o ing e of ma ke -ba ed ppl - ide policie ( ee Chap e 13). Economie in cen al and ea e n E ope and he fo me So ie Union ha an i ioned o ma ke -ba ed em ha e addi ionall been infl enced b he i ch o ma ke economie and he lo of go e nmen p o ec ion of lne able g o p . In de eloping co n ie , income ine ali ie inc ea ed d e o economic and ade libe ali a ion, hich a e ill ee gi e i e o bo h inne and lo e (Chap e 20). While ho e ho can ake ad an age of ne oppo ni ie gain, man become o e off, if he a e le ed ca ed o killed, canno ge c edi , a e geog aphicall i ola ed, ha e no hing o p od ce fo e po , lo e hei job d e o p i a i a ion o ed c ion in he i e of he go e nmen ec o , and o on. In addi ion, income di ib ion in de eloping co n ie can o en a a e l of economic g o h d e o inapp op ia e go e nmen policie , ch a : he in od c ion of capi al- ing (labo - a ing) echnologie in ind end o e ela i el mo e capi al inp in pi e of ela i el ab ndan al and ban nemplo men ( ee Chap e 19) and ag ic l e, hich pplie of labo , c ea ing lo le el of go e nmen in e men in h man capi al, hich nega i el affec people on lo e income and he poo di p opo iona el mo e han eal hie people alloca ing mo e ice and inf a he e mo of he poo li e c e in e men o ban a ea and igno ing he i hin he ban ec o , concen a ing inf a c e and e ice in e men (mode n and highl paid) ec o and igno ing he ban l m . I can he efo e be concl ded ha ec ic g hi i ead de e d e ch he ki d f I ( h i ei he g d icie c ie ad bad f i de al ec o i hin he fo mal i c e di achie eg ib i ; h. ) If o a e in e e ed in hi opic o ma a S pplemen a ma e ial. ead abo i in he 'Digi al co ebook: E a ma e ial' ec ion A We ha e e amined he effec of economic g o impac on economic g o h: h on e e al fac o . No e ha he e fac o can al o L . Economic g o h can be e pec ed o impac on li ing anda d , b imp o ed li ing anda d mea ed a imp o emen in h man capi al o ed ced income ine ali ie a e majo fac o con ib ing o economic g o h ( ee hi chap e on ca e of g o h and Chap e 19). E . Economic g o h ha igno e he effec on he en i onmen lead o en i onmen al n ainabili , b n ainabili al o lead o lo e economic g o h d e o de c ion of common pool e o ce . On he o he hand, economic g o h ba ed on he p inciple of ainable de elopmen lead o en i onmen al p e e a ion, hich in n can be e pec ed o lead o highe economic g o h in he f e. D (e i able), b 19). . Economic g o h can make he di ib ion of income mo e o le e al a mo e e al di ib ion of income ha a po i i e effec on g o h ( ee Chap e The likelihood of a o- a ca ali , he e economic g o h impac pon fac o ch a he abo e, and he e he e fac o in n impac pon economic g o h, ome ime make i diffic l in he eal o ld o de e mine ha ca e ha . E Di c O R NDER ANDING 11.4 he po ible nega i e and po i i e con e ence of economic g o h on li ing anda d , he en i onmen , and income di ib ion. To ha e en can go e nmen make he con e ence lean mo e o a d he po i i e? 1 No e ha in he AD-AS model, p i a e in e men i ca ied o incl ded in he G componen . b fi m (I) and go e nmen in e men i 2 Uni ed Na ion De elopmen P og amme, H man De elopmen Repo 2010. 3 Yo ma be onde ing ha he e a e of g o h a e. I i no po ible o a ach n me ical al e o he e gi en he p e en a e of economi and cien i kno ledge, beca e no eno gh i kno n abo he co and benefi of g o h and en i onmen al ainabili . 4 The OECD i he O gani a ion fo Economic Co-ope a ion and De elopmen , con i ing mo l of de eloped co n ie . 11.2 S ) (HL LEARNING OBJECTI ES Af e d ing hi ec ion o ill be able o: define all he e m appea ing in in he e (AO1) e plain he ela ion hip be een a b dge defici and go e nmen (na ional) deb (AO2) e plain ha go e nmen (na ional) deb i mea e plain he co ed a a pe cen age of GDP (AO2) of a high go e nmen (na ional) deb on he follo ing (AO2) deb e icing co c edi a ing f e a a ion and go e nmen pending T G , al o kno n a ,o blic deb , efe go e nmen o e o lende o ide of he go e nmen i elf. o he amo n of mone ha a H Ag e e b dge i a pe of plan of a co n e en e and e pendi e o e a pe iod of ime ( all a ea ). Mo of he go e nmen e en e come f om a e . I e pendi e con i of pending on n me o i em ch a age of go e nmen emplo ee , p o i ion of me i good , in e men in inf a c e like oad , and an fe pa men o lne able g o p like nemplo men benefi and child b idie . (We ill e amine go e nmen e en e and e pendi e in mo e de ail in Chap e 13.) If a e en e a e eq al o go e nmen e pendi e o e ha pe iod, he go e nmen i aid o ha e a bala ced b dge . Ho e e , in p ac ice, he go e nmen b dge i a el if e e balanced. If e pendi e a e la ge han a e en e , he e i a ; if e pendi e a e malle han a e en e , he e i a . When he e i a b dge defici , he go e nmen finance (pa fo ) he e a e pendi e o e e en e b bo o ing. Thi i imila o pe onal finance: if o pend mo e han o ea n, i i likel ha o bo o o pa fo o e a pending o e o income. Go e nmen e of en ha e defici . The ha e man commi men in e m of hei pending, a he m p o ide heal h ca e, ed ca ion, inf a c e, defen e, and he pa ala ie o hei emplo ee and make an fe pa men . Of en hei commi men a e g ea e han hei e en e , and bo o ing allo hem o con in e o pend i ho ha ing o inc ea e a e . The e i a g ea e need fo bo o ing d ing a ece ion beca e a nemplo men inc ea e , a e en e fall hile go e nmen pending on nemplo men benefi i e ( ee Chap e 10). O e ime, he go e nmen acc m la ion of defici min pl e i efe ed o a g e e deb , o a i al deb o blic deb . In an pa ic la ea , if he go e nmen n a b dge defici , i deb ill become la ge ; if i n a b dge pl , i deb ill become malle . S efe o a le el of deb he e he bo o ing go e nmen ha eno gh e en e o mee i deb obliga ion (pa men of in e e and epa men of he bo o ed amo n ) i ho acc m la ing a ea (o e d e deb pa men ) hile al o allo ing economic g o h o con in e a an accep able le el. H Go e nmen e commonl bo o b i ing bond , hich a e a fo m of deb . When he go e nmen bo o o finance a defici , i i e a ce ifica e called a bond ha p omi e o pa in e e a a io in e al n il a ce ain da e hen he mone i epaid o he bond holde . The holde of he bond i he efo e he lende , and he i e of he bond i he bo o e . Financial in e o , ho ma indi id al , fi m , bank , o an pe of o gani a ion, ha e he incen i e o b bond beca e of he in e e income he ecei e. Some ime co n ie ma al o bo o di ec l f om financial in i ion ( o be di c ed in Chap e 20). The bo o ing ma be f om in e nal o ce , i hin he co n , o f om e e nal o ce , f om o he co n ie . M GDP One of he mo common a o mea e he i e of a co n go e nmen deb i a a ha e of GDP of he bo o ing co n . Thi i efe ed o a he deb - -GDP a i . Table 11.4 ho he le el of deb a a ha e of GDP of elec ed co n ie . The co n la ge go e nmen deb a a ha e of GDP i Japan, follo ed b G eece and I al . i h he Go e nmen deb ha been inc ea ing apidl ince he global financial c i i ha began in 2008, i h he la ge inc ea e gene all occ ing in de eloped co n ie . C High le el of deb ha e a n mbe of di ad an age fo he economie of deb o co n ie . D D efe o he pa men ha m be made in o de o epa he p incipal ( he amo n of he loan) pl in e e pa men . La ge deb e ice pa men ha e majo oppo ni co beca e he go e nmen ha fe e e o ce o pend on ocial e ice (heal h, ed ca ion, e c.) and inf a c e. In addi ion, he po ion of he deb ha i f om e e nal (fo eign) lende m be epaid in fo eign e change (fo eign c encie ). Thi mean ha he go e nmen i fo ced o e e po ea ning fo deb e icing, e l ing in le fo eign e change o pa fo impo of needed capi al eq ipmen , o he p od c ion inp and good and e ice gene all . The fo egone impo a e an addi ional oppo ni co i h nega i e con eq ence fo economic g o h. (Thi ill become clea e o o ha e died Chap e 16.) P A c edi a ing i an a e men of he abili of a bo o e o pa back loan , all ca ied o b agencie ha a e q alified o do hi . (E ample of ch agencie incl de S anda d & Poo , Fi ch Ra ing , and Mood .) A high c edi a ing ecei ed b a go e nmen mean ha i i e pec ed o be able o pa back i loan in f ll and on ime i ho diffic l ie . A lo c edi a ing mean ha i i e pec ed ha he go e nmen ma ha e diffic l ie e icing i deb . Thi make i mo e diffic l fo he bo o ing go e nmen o find financial in e o illing o lend (b b ing he go e nmen bond ) a ell a mo e diffic l o bo o f om financial in i ion . If a go e nmen ha a high le el of deb , ho n b a high deb - o-GDP a io, i i likel o ecei e a lo e c edi a ing, c ea ing diffic l ie fo he go e nmen abili o bo o in he f e. Thi of en fo ce he bo o ing go e nmen o offe highe in e e a e o financial in e o in o de o ind ce hem o b he bond (in o he o d o lend), hich inc ea e he deb e icing co o he go e nmen . C Japan D - -GDP % 2018 234.2 C Zimbab e D - -GDP % 2018 72.6 G eece 181.8 Angola 71.6 I al 127.5 Zambia 68.0 Uni ed S a e 109.5 India 67.3 Gambia 105.2 Sie a Leone 64.0 F ance 96.2 China 54.4 B a il 90.2 Came oon 34.1 Canada 83.8 Chile 24.6 Uni ed Kingdom 85.9 B lga ia 22.8 S T : Deb GDP Ra i b C 2020 11.4: Deb - o-GDP a io in elec ed co n ie I If a go e nmen an o dec ea e he i e of i deb , i m ha e b dge pl e a he han b dge defici . A b dge pl a e ha e een abo e mean ha go e nmen e en e a e g ea e han go e nmen pending. Thi e a amo n of e en e o e and abo e pending can be ed o pa back a po ion of he deb , hich ill o k o ed ce i o e all i e. Ho e e , hi ma c ea e e io diffic l ie fo he go e nmen . In o de o achie e b dge pl e , i m ei he inc ea e a e , o i m dec ea e pending. Bo h of he e a e poli icall npop la . B mo e e io han he poli ical con eq ence a e he economic con eq ence of inc ea ed a e o lo e go e nmen pending. A o ma emembe f om Chap e 9, inc ea ed a e on con me income ed ce con mp ion pending (C) hile inc ea ed a e on b ine p ofi ed ce in e men pending (I). Red c ion in bo h C and I ca e agg ega e demand o fall, e l ing in lo e eal GDP. A he ame ime, dec ea e in go e nmen pending al o ca e agg ega e demand o fall, e e ing a f he do n a d p h on eal GDP. The e l i ha a he go e nmen ie o achie e a b dge pl , i ca e eal GDP o fall, c ea ing a ece ion o a defla iona gap (nega i e g o h). Wha happen hen o he deb - o-GDP a io? I ac all inc ea e ! The go e nmen can hen end p being o e off in e m of he i e of i deb ela i e o GDP. B he o doe no end he e. Once he ece ion begin , c clical nemplo men inc ea e , and income fall, hich mean ha he go e nmen a e en e fall. A he ame ime, he go e nmen pending on nemplo men benefi inc ea e. The fall in a e en e and inc ea e in go e nmen e pendi e happen a he ame ime ha he go e nmen i ing o inc ea e i a e en e and ed ce i e pendi e . A a e l he go e nmen i conf on ed b a i a ion he e o achie e a b dge pl i m inc ea e a e e en mo e and c pending e en mo e, c ea ing a icio ci cle of f he dec ea e in agg ega e demand and falling eal GDP. Thi i ha happened in he ca e of G eece, hich a Table 11.4 ho ha he econd highe deb o-GDP a io in he o ld ( ee Real o ld foc 11.1 and 17.1, Chap e 17). In fac , a co n deb - o-GDP a io can be ed ced in ano he , fa mo e logical a . Ve impl , hi can be done h o gh economic g o h hich a e kno in ol e highe eal GDP. A GDP inc ea e , he deb - o-GDP a io fall . Fo e ample, he Uni ed S a e af e he Second Wo ld Wa had he e high deb - o-GDP a io of 122%. Wi hin en ea hi had been c in half d e o economic g o h, i ho he go e nmen ha ing paid back i deb . I Go e nmen deb i likel o inc ea e ineq ali in income di ib ion. B e of go e nmen bond , ho a e he lende o he go e nmen , end o be highe income people. When he go e nmen pa hem in e e , i doe o h o gh a e en e . The efo e he e i a an fe of income a a f om lo e income a pa e and o a d highe income bond holde . L Fea ha a go e nmen ma be nable o e ice i deb c ea e nce ain ega ding economic condi ion and ca e a a p i a e in e o , bo h dome ic and fo eign. E en if in e men doe ake place, i i mo e likel o in ol e ho - e m in e men p ojec i h q ick e n , a he han longe - e m one i h g ea e po en ial o ppo economic g o h. P A le el of deb i e, he e come a poin he e he le el of deb canno be ained: ne deb eq i e highe deb e ice pa men , hich eq i e mo e fo eign bo o ing, hich lead o mo e deb e icing pa men , and o on, in a elf- einfo cing pi al in hich he co n i apped. Thi ha been e med he deb ap , in ol ing a i a ion he e a co n m keep on aking o ne loan in o de o pa back he old one . Man co n ie , pa ic la l in La in Ame ica and bSaha an Af ica, e e ca gh in a deb ap d ing he 1980 and G eece ha been ca gh in one in mo e ecen ea . L The abo e fac o ma o k o lo e economic g o h in co n ie i h high le el of deb , d e o lo e go e nmen pending, inc ea ed a e , ed ced in e men and fe e impo of capi al good . TEST OUR UNDERSTANDING 11.5 1 E plain he meaning of go e nmen deb in ela ion o b dge 2 Di c REAL ome of he co pl e and defici . of a high le el of go e nmen deb . ORLD FOCUS 11.1 A The polic of inc ea ing a e and ed cing go e nmen pending o deal i h b dge defici and go e nmen deb i kno n a a e i . A e ill di co e in Chap e 13 i i ell kno n ha a e i i likel o lead o ece ion. Ho e e , in pi e of ha he e i a majo deba e among economi abo he he hi i he app op ia e polic o deal i h defici and deb . When he financial c i i of 2008 occ ed, man e o one co n ie fea ed a deb c i i , in hich hei pending o pa back deb o ld be oo high, in o he o d he fea ed hei deb o ld become n ainable. G eece in fac did face a e io deb c i i ( ee Real o ld foc 17.1, Chap e 17). The he efo e began a polic of a e i . Ye acco ding o n me o die , incl ding o b The In i e of In e na ional Finance and O fo d Economic , he a e i polic led o lo e GDP g o h in he ea follo ing he c i i . Thi in ol ed ed c ion of bo h ac al GDP a ell a po en ial GDP. In e m of he b ine c cle diag am in Fig e 8.4 (Chap e 8) hi ha mean malle e pan ion of ac al o p and a fla e long- e m g o h end ho ing po en ial GDP. I a like le ing ai o of a bo ncing ball. I abili o bo nce back go o e he mo e i a defla ed. 5 I i e ima ed ha in he en ea ince 2008, E ope lo an econom he i e of Spain, i h a GDP of $1.3 illion and 19 million emplo ed people. Mo eo e , he deb i e a no ol ed. In ead, h o gh lo e eal GDP g o a inc ea ed a he han ed ced. Acco ding o he Ha a d B ine Re ie h, he deb b den E eg e e e eciall h e i ggli g S he E ea c ie (S ai , G eece, P gal) i ched d a a icall a d a e i i he ea 2010-2014. M e e ag ee ha he e licie had ch da agi g a d e i e ega i e effec g h ha he e e elf-defea i g. G e e e e ed ci g e di g i de bi g hei deb le el de c l. B GDP fell ch ha he ac al effec a h he a i f deb GDP. A a e l , deb beca e e e le ai able ha bef e he a e i ea e e e i le e ed. F 11.5: Mad id, Spain. P o e o in he Ma ch fo digni in 2014, p o e ing again go e nmen ' a e i p og amme and he ocial and economic c i i he S : B i e I ide Ha a d B i e Re ie A 1 U e a b ine c cle diag am o ho ho a ei affec ed ho - e m fl c a ion , and he long- e m g o 2 5 h end of e o one economie . Al ho gh a goal of a e i i o ed ce he deb - o-GDP a io, e plain ho he oppo i e effec in he e o one. E ope ha made a poli ical deci ion o go in o ece ion hi polic had 11.3 P b c a c c b ac c c LEARNING OBJECTIVES After studying this section you will be able to: • define all the terms appearing in • discuss the trade-off between inflation and unemployment based on: (HL only) • a b in the text (AO1) • the short-run and long-run Phillips curves (AO3) • AD-AS diagrams (AO4) • Phillips curve diagrams (AO4) discuss the potential conflict between (AO3) • low unemployment and low inflation • high economic growth and low inflation • high economic growth and environmental sustainability • high economic growth and equity in income distribution L a a The trade-off based on the Phillips curve (HL only) and the potential conflict between low unemployment and low inflation were discussed in Chapter 10, Section The c f c be ee e e a d fa . The discussion came at the end of the discussion of low unemployment and low inflation which were the two macroeconomic objectives discussed in Chapter 10. H c c a a This topic was introduced above under C e e ce f ec cg h. We can now discuss this further by referring to the distinction between demand-pull and cost-push inflation. D a - a a c c Demand-pull inflation is caused by increases in aggregate demand. This can be shown both by use of the monetarist-new classical model and the Keynesian model as a rightward shift in the AD curve, shown in Figure 10.5 (Chapter 10). In the Keynesian model, as long as AD increases along the horizontal portion of the AS curve, there is economic growth with no inflation. Therefore as long as the economy is operating in a deflationary gap, below potential output, there is no conflict between low inflation and economic growth as growth can occur with no inflationary pressures. The same is not true in the monetarist/new classical model, as here when the economy is in a deflationary gap, an increase in aggregate demand will result in both economic growth and an increase in the price level, suggesting a possible conflict. However, as the economy approaches potential output, inflationary pressures appear also in the Keynesian model due to resource bottlenecks, suggesting the emergence of a conflict between economic growth and low inflation in this model as well. The only way that further increases in aggregate demand will not be inflationary, in the context of both models, is if at the same time that aggregate demand is increasing there is an increase in long-run aggregate supply (LRAS) or Keynesian AS, shown by rightward shifts in these two curves as in Figure 11.3. We can see in this figure that as AD increases by the same amount as the AS curves, increases in real GDP are not accompanied by a higher price level. The reason is that as the economy s total demand for real GDP increases, there is a corresponding increase in the economy s ability to supply that real GDP. But if AD increases faster than LRAS or Keynesian AS, then increases in real GDP or economic growth will result in inflation. C - a This is caused by decreases in short-run aggregate supply due to such factors as higher prices of factors of production. As Figure 10.6 (Chapter 10) shows, the leftward shift in the SRAS curve leads to a higher price level and a fall in real GDP, or negative economic growth, also known as s agf a . Therefore, with cost-push inflation it is not possible to have positive economic growth at the same time as the price level is rising. H c c a a a ab This topic was explored above under C e e ce f ec cg h, where it was concluded that economic growth and environmental sustainability can be pursued together provided governments take appropriate measures to ensure sustainable resource use. This is the meaning behind the concept of a ab e de e e . H c c a c b This topic was also explored under C e e ce f ec cg h. It was concluded that economic growth is neither good nor bad for income distribution; this instead depends very much on the kinds of policies countries adopt in order to achieve and handle growth. TEST YOUR UNDERSTANDING 11.6 Using your knowledge of economics and the information provided in this chapter and Chapter 10, discuss the extent to which there may be a conflict between: a low unemployment and low inflation b high economic growth and low inflation c high economic growth and environmental sustainability high economic growth and equity in income distribution. INQUIRY AND REFLECTION The following questions will help you reflect on your learning and enhance your understanding of key topics in this chapter. They are suggestions for inquiries that you can undertake on your own or in groups in order to revise the learning objectives of this chapter. 1 Select a country you are interested in. Examine possible conflicts between its growth and environmental sustainability. Investigate whether any measures are being taken to deal with the environment. 2 There are some developed countries with high debt-to-GDP ratios. Research such a country of your choice. Does a large ratio always mean the country is struggling? Why can some developed countries (such as the United States) maintain high debt-to-GDP ratios while others suffer immensely? EXAM STYLE QUESTIONS You can find questions in the style of IB exams in the 'Digital coursebook: Extra material' section. Chapter 12 Economics of inequalit and povert BEFORE YOU START In most societies, we see that there are some people who have high incomes and accumulate a lot of wealth while others have ver little. What do ou think might be some reasons for such extreme differences in income and wealth? What, if an thing, do ou think governments should do to reduce extreme inequalities in income and wealth? Povert and inequalities in income and wealth are major issues in countries around the world. While povert is more prominent in developing countries, it is present in rich countries as well. This chapter will discuss causes and consequences of povert and inequalit , their measurement and policies to tackle them. 12.1 I LEARNING OBJECTI ES After stud ing this section ou ill be able to: define all the terms appearing in in the te t (AO1) e plain the relationship bet een equit and equalit (AO2) e plain economic inequalit as (AO2) unequal distribution of income unequal distribution of ealth use the Loren cur e and Gini coefficient (inde ) to measure economic inequalit (AO2) dra Loren cur es to sho the distribution of income and changes in the distribution of income (redistribution) (AO4) construct a Loren cur e based on income quintile data (HL onl ) (AO4) T We encountered the concepts of equit and equalit in Chapter 1 (see Section 1.4). As eq i in ol es fairness, something is eq i able if it is fair. This is a normati e concept because different people ha e different ideas and beliefs about hat is fair. On the other hand eq ali or the idea of being the same is a positi e concept because something ma be equal or unequal on the basis of some measure. The concepts of equit and equalit are used in economics mainl to describe the distribution of income and/or ealth. As e kno from our stud of the circular flo model (Chapters 1 and 8), income is the mone recei ed b o ners of factors of production. Weal h, on the other hand, refers to the mone , assets or things of alue that people o n, such as sa ings deposits (mone sa ed in a bank); stocks in the stock market; bonds; land, houses and other propert ; aluable paintings or je ellr , and so on. While equit differs from equalit , it is usuall interpreted to mean equalit . Therefore the e pressions a more equitable or more equal distribution of income or ealth usuall mean the same thing. Both e pressions are correct, pro ided it is understood that in these cases, eq i i in e p e ed a g ea e eq ali (o le ineq ali ). The reason that equit is most often interpreted in this a is that there is a idel shared belief around the orld that highl unequal distributions of income are unfair. Therefore go ernments around the orld usuall ha e in place policies that tr to reduce income inequalities. E T E refers to the degree that people in a population differ in their abilit to satisf their economic needs; it means inequalit in li ing conditions that arise due to monetar factors. There are man sources of economic inequalit , including income and ealth, education, health, nutrition, gender and more, but economists focus on inequalities that result mainl from diffe ence in income and eal h. Income ineq ali arises from diffe ence in ho e enl income is distributed in a population. Income includes the mone that people recei e from their emplo ment as ell as other sources including interest from sa ings accounts and holdings of bonds, di idends from shares (stocks) in the stock market, rents from propert that is o ned and rented out, pensions or go ernment benefits. Weal h ineq ali arises from differences in the amount of ealth people o n, hich as noted abo e refers to the mone or things of monetar alue including sa ings, stocks, land, houses, and more. Both income and ealth are generall distributed unequall , so that some groups ha e much more income and/or ealth than other groups. This applies both to populations ithin countries, as ell as across countries. H Table 12.1 presents data on income distribution of selected countries around the orld. The data sho ho income is distributed b q in ile of the population. A is a 20% portion of a countr s population; e can di ide a population into fi e quintiles, ranging from the lo est (the poorest 20% of the population) to the highest (the richest 20%). If income ere completel equall distributed, e er one ould recei e e actl the same income, so e er quintile ould recei e 20% of income. Ho e er, in the real orld this is a irtual impossibilit . In all countries in the orld, the presence of inequalities in income distribution means that the poorest quintile of the population recei es less than 20% of income, and the richest quintile more than 20%. This can be seen in Table 12.1. For e ample, in Bra il the lo est quintile recei es 3.2% of income and the highest quintile 57.8%. In Belarus, the lo est quintile recei es 9.9% and the highest quintile 35.5%. The higher the percentage share of income recei ed b the poorest quintile, and the lo er the percentage share recei ed b the highest quintile, the more equal the distribution of income. Therefore, income distribution in Belarus is more equal than in Bra il. Income shares can also be sho n b decile , hich are 10% portions of the population (there are ten deciles) as ell as q a ile , or 25% portions of the population (there are four quartiles). Sometimes income shares are broken do n into 1% particularl for the top, or e en the top 0.1%. T L AL is used to sho the degree of income inequalit in an econom . Named after an American economist Ma Otto Loren , ho de ised this measure of income inequalit in 1905, it is a isual representation of the kind of income distribution data in Table 12.1. To construct a Loren cur e, e dra a square bo , as in Figure 12.1 here the ertical a is measures the total amount of income in an econom in cumulati e percentages (therefore it runs from 0 to 100%), and the hori ontal a is plots the total population in the econom , also in cumulati e percentages (from 0 to 100%). ( Cumulati e means that 20 represents the poorest 20% of the population, 40 represents the poorest 40%, and so on.) The diagonal line in the diagram represents perfect equalit , as it sho s that if income ere perfectl equall distributed, 20% of the population ould recei e 20% of income, 40% ould recei e 40% of income, and so on. The Loren cur e plots the ac al ela ion hip bet een percentages of the population and the shares of income the recei e. C P 20% S 20% T 20% F 20% R 20% G Australia 2014 6.8 12.0 16.1 22.1 43.0 0.36 Belarus 2017 9.9 14.2 17.9 22.5 35.5 0.25 Boli ia 2017 4.1 9.5 15.0 22.8 48.5 0.44 Bra il 2017 3.2 7.4 12.2 19.5 57.8 0.53 China 2015 6.4 10.6 15.3 22.3 45.4 0.39 Denmark 2015 9.4 13.9 17.2 21.8 37.7 0.28 S. Africa 2014 2.4 4.8 8.2 16.5 68.2 0.63 United Kingdom 2015 7.5 12.2 16.8 23.0 40.6 0.33 United States 2016 5.0 10.2 15.3 22.6 46.9 0.42 S : Da aBank T .camb idge.o g/link /ecib d8050 12.1: Distribution of income b quintiles and gini coefficients in selected countries In general, the closer a Loren cur e is to the diagonal representing perfect income equalit , the greater is the equalit in income distribution. As e can see in Figure 12.1, Belarus clearl has greater income equalit than Bra il. F 12.1: Loren cur es: Belarus achie es greater income equalit than Bra il H (HL L ) Figure 12.1 plots t o Loren cur es, one for Bra il, and one for Belarus (based on the data in Table 12.1). In the case of Bra il, the poorest 20% of the population recei e 3.2% of income; this is sho n b point a. Point b on Bra il s cur e is obtained b adding the 3.2% of income of the poorest quintile to the 7.4% of income recei ed b the second quintile, gi ing 10.6%, or the cumulati e income of the bottom 40% of the population. Similarl , point c is obtained b adding the percentages of income recei ed b the bottom three quintiles, gi ing 22.8% of income, and finall to find point d e add the incomes of the bottom four quintiles, getting 42.3% of income for 80% of the population. When these points are joined together starting from 0 and going up to 100% of the population, e obtain Bra il s Loren cur e. Points e, f, g and h on Belarus cur e are calculated and plotted in e actl the same a . As e pected Bra il s Loren cur e is further a a from the line of perfect equalit indicating greater income inequalit . Note that to plot a Loren cur e, e could use income distribution figures that di ide the population into ten deciles (or tenths), or an other con enient subdi ision. T G The G (or G ), named after Corrado Gini, an Italian statistician, is a summar measure of the information contained in the Loren cur e of an econom . It is defined as Gini coefficient = area bet een diagonal and Loren cur e entire area under diagonal = A A+B Where A and B represent the areas sho n in Figure 12.2. The Gini coefficient has a alue bet een 0 and 1. If there ere perfect income equalit , the coefficient ould be ero, since the numerator of the ratio ould be ero. The larger the Gini coefficient, and the closer it is to 1, the greater is the income inequalit , since the further a a is the Loren cur e from the diagonal. (A perfectl unequal income distribution ould be here a single household recei es all the income of the econom , and the numerator ould be equal to the entire area under the diagonal, making the Gini coefficient equal to 1.) Note that some publications e press Gini coefficients as a percentage rather than a decimal. For e ample, a coefficient of 0.27 ould appear as 27.0. This does not in an a change in the meaning of the Gini coefficient, hich in this method of e pression has a alue ranging bet een 0 and 100. F 12.2: Deri ing the Gini coefficient from a Loren cur e The last column in Table 12.1 sho s Gini coefficients that correspond to each of the income distributions. Belarus Gini coefficient of 0.25 and Bra il s of 0.53 clearl indicate that Belarus has a relati el more equal income distribution. The Gini coefficien is a summar measure of income inequalit . In a Lo en diag am it is the ratio of the area bet een the diagonal and the Loren cur e, to the total area under the diagonal. It has a alue bet een 0 and 1; the closer the alue is to 0, the greater the income equalit ; the closer the alue is to 1, the greater the income inequalit . E er thing that has been said abo e about measurement of income inequalit applies also to ealth inequalit . The three methods discussed abo e, namel (i) quintiles (or deciles or quartiles), (ii) Loren cur es, and (iii) Gini coefficients can be used in e actl the same a to sho the e tent of ealth inequalit . The distribution of ealth is generall far more unequal than the distribution of income in most countries in the orld. On a erage, Gini coefficients in the case of ealth distribution are roughl double the si e of the Gini coefficients of income distribution. This is sho n in Figure 12.3. We can see here that de eloped countries on the hole ha e slightl lo er ealth and income inequalit than emerging market economies, but in both groups ealth inequalit is far greater than income inequalit . Reasons behind greater ealth inequalit include the follo ing: Limited gro th in ages makes it difficult for lo -income and middle-income people to sa e and accumulate ealth. High-income people tend to consume a smaller fraction of their income than lo er-income people therefore ha e greater possibilities of sa ing and accumulating ealth. Income and ealth inequalities feed on each other. The greater the income, the more possibilities for accumulating ealth, but man t pes of ealth (stocks, bonds, real estate) lead to e en more income and hence e en more possibilities for accumulating more ealth. For e ample, in the United States, in 2015 the share of income that came from ealth for the richest 1% of the population as nearl 60%, hile the share of income coming from ealth for the bo om half (or 50%) of the population as about 5%.1 F 12.3: Income and ealth inequalit in ad anced economies* and emerging market economies** * Ad anced economies include de eloped countries ** Emerging market economies include Argentina, Bra il, China, India, Indonesia, Me ico, Pakistan, Thailand and Turke S : In e na ional Mone a F nd L Later in this chapter, e ill consider methods go ernments can use to redistribute income and ealth, to make their distribution more equal. Graphicall , this appears as a shift of a countr s Loren cur e closer to the diagonal line, and is reflected in a lo er Gini coefficient. Figure 12.4 sho s ho a Loren cur e shifts to ards the diagonal after the go ernment pursues policies to redistribute income or ealth to reduce the degree of economic inequalit in the econom . F 12.4: Loren cur es and income redistribution TEST O R NDERSTANDING 12.1 1 Outline the meaning of equit and equalit and ho the relate to each other. 2 Using e amples, e plain the meaning of economic inequalit . 3 Outline the meaning of quintiles, and ho 4 List the countries in Table 12.1 in order of increasing income inequalit and e plain our reasoning. 5 e use them to measure income distribution. Define the Gini coefficient. Using a diagram, describe ho e deri e it from a Loren cur e diagram. State its possible range of alues. Outline ho 6 e interpret its possible alues ith regard to income equalit /inequalit . Choose an t o countries from Table 12.1 and dra their Loren cur es in a single diagram (HL students should plot the Loren cur es). Outline ho ou use our Loren cur e to determine hich countr has a more equal distribution of income. Describe ho ou can use the corresponding Gini coefficients to compare the income distributions of the t o countries. 7 Outline ho redistribution of income changes the position of a countr s Loren cur e. Describe ho redistribution ould be reflected in a Gini coefficient. (Make sure ou distinguish bet een redistribution that increases or decreases income equalit .) 8 Describe the methods that can be used to measure ealth inequalit . REAL ORLD FOC S 12.1 T Trends in ealth concentration In the United States, ealth concentration had peaked in 1929 hen the top 0.1% of the population o ned nearl 25% of ealth. It then began to fall steadil , reaching a lo in 1978 hen the top 0.1% o ned 7% of ealth. Since then it has been steadil climbing again. In the period before 2020 the richest 0.1% o ned o er 20%, hile the richest 1% o ned 40% of ealth.2 Moreo er, the three richest Americans held more ealth than the bottom 50% of the population of the United States.3 In England ( hich is part of the United Kingdom) less than 1% of the population o ns half of England s land. This includes about 25 000 lando ners, consisting mainl of the aristocrac and corporations. B contrast, all of England s homeo ners (in a population of about 55 million people) o n 5% of the land.4 High ealth concentration e ists on a global le el as ell, here ealth inequalit is also gro ing. It is estimated that the richest 1% of the global population o ns half of the orld s ealth.5 The top 10% of the combined populations of China, Europe and the US o n more than 70% of ealth, hile the bottom 50% o ns less than 2% of ealth. If countries in Latin America, Africa and the rest of Asia ere included, ealth concentration ould be e en greater as in most countries the share of ealth o ned b the bottom 50% is close to ero.6 If trends in ealth accumulation that began in 2008 ith the Global Financial Crisis continue, the orld s richest 1% ill control t o-thirds of the orld s ealth b 2030. Since 2008, the ealth of the richest 1% has been gro ing at about 6% per ear, compared to 3% per ear for the remaining 99%.7 F 12.5: Bel Air Los Angeles, USA. Neighborhood ith mansions and golf course A 1 Dra Loren cur es to illustrate the changes obser ed in ealth distribution in the United States from the earl 20th centur up to the present. 2 Dra Loren cur es to illustrate the change in global ealth distribution since 2008. 1 Wealth inequalit is e en orse than income inequalit 2 Global Wealth Inequalit 3 The 3 Richest Americans Hold More Wealth Than Bottom 50% Of The Countr , Stud Finds 4 Half of England is o ned b less than 1% of the population 5 Causes and Consequences of Income Inequalit : A Global Perspecti e 6 Global Wealth Inequalit 7 Richest 1% on target to o n t o-thirds of all ealth b 2030 12.2 P LEA NING OBJEC I E Af e d ing hi ec ion o ill be able o: define all he e m appea ing in in he e (AO1) e plain he diffe ence be een ab ol e and ela i e po e e plain ho po e i mea ed (AO2) ing (AO2) ingle indica o incl ding in e na ional po e line minim m income anda d compo i e indica o incl ding he M l idimen ional Po e e plain diffic l ie in mea Inde (MPI) ing po e (AO2) P efe o an inabili o a i f minim m con mp ion need . Be ond hi gene al defini ion, he e a e o diffe en pe pec i e on ho be o define po e : in an ab ol e en e and in a ela i e en e. A A efe o a i a ion he e a pe on o famil doe no ha e eno gh income o mee ba ic h man need . Mea e of begin b defining a minim m income le el called a . Acco ding o he OECD, a po e line i : An income le el ha i con ide ed minimall fficien o ain a famil in e m of food, ho ing, clo hing, medical need and o on. 8 Mo co n ie ha e a na ional po e line, de e mined b go e nmen a ho i ie a an app op ia e amo n of income eq i ed o a i f minim m need . In addi ion, he Wo ld Bank (an in e na ional o gani a ion ha lend o de eloping co n ie fo de elopmen p po e ; ee Chap e 20) ha de e mined an in e na ional po e line o be: li ing on le han $1.90 a da , hich i defined a adj ed o ake infla ion in o acco n ; hi fig e i pe iodicall Once a po e line ha been de e mined, he amo n of po e i fo nd b aking he pe cen age of a pop la ion (o he n mbe of indi id al ) ho e income fall belo he po e line. Da a on e eme po e in elec ed co n ie a o nd he o ld, compiled b he Wo ld Bank, appea in Table 12.2. No e ha he able incl de de eloped co n ie a ell a de eloping one . In a majo d on global po e in 2018, he Wo ld Bank concl ded ha he e ha been ignifican p og e in ed cing e eme po e , hich fell f om 36% of he global pop la ion in 1990 o 10% in 2015. Acco ding o he Bank, he g ea e p og e a made in Ea A ia and So h A ia, hile bSaha an Af ica ho ed a m ch lo e pace of po e ed c ion. C P % C P % Iceland 0 India 13.4 Po gal 0.1 Banglade h 15.2 No a 0.2 So h Af ica 18.9 I eland 0.2 E hiopia 27.0 Uni ed Kingdom 0.2 Chad 34.1 A 0.5 Tan ania 40.7 China 0.7 R anda 51.5 B a il 3.4 Mo ambiq e 62.2 Philippine 8.3 Cen al Af ican Rep blic 77.7 alia :P 12.2: E T :T eme po e P P (li ing on le han $1.90 pe da ) in elec ed co n ie , 2015 A no ed abo e, in addi ion o he Wo ld Bank line, bo h de eloped and de eloping co n ie al o ha e na ional po e line . The e a e all e a a highe income le el han ha of he Wo ld Bank, o ha a la ge pe cen age of people a e con ide ed poo b na ional anda d . The Wo ld Bank ha been c i ici ed on he g o nd ha i in e na ional po e line of $1.90 pe da i oo lo o be meaningf l in e m of po e ed c ion.9 Fo e ample, in So h Af ica he Bank in e na ional po e line p 18.9% of he pop la ion belo he po e line, hile acco ding o he So h Af ican go e nmen po e line 55% of he pop la ion a e poo .10 In ackno ledgemen of hi poin he Wo ld Bank p e en o mo e po e line : li ing on le han $3.20 a da i a po e line fo lo e -middle-income co n ie li ing on le han $5.50 a da i a po e line fo Nea l half of he o ld pop la ion li e belo ppe -middle-income co n ie .11 he po e line of $5.50 pe da .12 In addi ion, in ecogni ion of he limi a ion of in e na ional po e line , he Wo ld Bank ha p opo ed a mea e of po e ha ake in o acco n dimen ion of po e in addi ion o income, o be di c ed belo . i a concep ha compa e he income of indi id al o ho ehold in a ocie ih . I i clo el ela ed o ho eq all o neq all ocie income i di ib ed among i o al pop la ion. If income e e eq all di ib ed, he e o ld be no ela i e po e , ince no one o ld be poo ela i e o omeone el e. In gene al, he mo e neq al he di ib ion of income, he g ea e i he deg ee of ela i e po e . median13 income The idea behind ela i e po e i ha po e i m ch mo e han being nable o affo d a minim m of ba ic good and e ice . E en ho gh people ma be able o b ba ic nece i ie , he a e ill poo if he canno affo d good and e ice and a life le ha a e pical in a ocie . The mea emen of ha i pical i ba ed on a anda d de e mined b he median income le el. If people income fall fa belo hi median le el, he a e con ide ed poo . Mea emen of ela i e po e in ol e pecif ing a pa ic la pe cen age of median income belo hich he e i po e . Of en hi i aken o be 50%. Fo e ample, a he median ann al famil income in an econom i $20 000. Taking 50% of hi , e ha e $10 000. An famil ho e ann al income fall belo $10 000 i con ide ed poo (in ela i e e m ). Table 12.3 p e en da a on ela i e po e in ome de eloped co n ie . C % C % of pop la ion li ing belo 50% of median income (2017 o la e a ailable) 50% (2017 ) Iceland 5.4 Ge man 10.4 Denma k 5.5 Uni ed Kingdom 11.1 Ne he land 8.3 A 12.1 No 8.4 Canada 12.4 Belgi m 9.7 G eece 14.4 I eland 9.8 La ia 16.9 H nga 10.1 Uni ed S a e 17.8 a alia :P 12.3: Rela i e po e in economicall mo e de eloped co n ie , 2017 Whe ea he di c ion abo e ha been in e m of po e a e , i i impo an o no e ha po e a e diffe idel among ocial g o p in a ocie . In gene al, olde people, child en, inglepa en ho ehold , omen, and acial and e hnic g o p ha ffe di c imina ion, face highe po e a e han na ional a e age . Thi applie o mo co n ie in he o ld, bo h mo e and le de eloped. Table 12.4 ho ho po e a e a in he Uni ed S a e b ace and b age fo each ace. 18 % 18 64 % 65 % Black 28.8 18.3 19.3 Hi panic 24.7 15.0 17.0 A ian 11.1 9.5 10.8 Whi e 10.5 8.6 7.0 12.4: Uni ed S a e po e ae b ace and age, 201714 While he di c ion he e i abo ineq ali b ocial g o p in po e , i migh be no ed ha he e i ineq ali b ocial g o p in eal h a ell. The e i a la ge acial gap in eal h in he Uni ed S a e , hich i o ening a Black eal h i dec ea ing hile Whi e eal h i inc ea ing. Acco ding o p ojec ion , in 2020, Whi e ho ehold ill o n 86 ime mo e eal h han Black ho ehold . If p e en end con in e, in 2053 Black median eal h ill ha e hi e o, hile Whi e median eal h ill inc ea e o $137 000.15 The e de elopmen indica e ha Black ho ehold on a e age a e a i k of becoming impo e i hed. Bo h ab ol e and ela i e po e mea e , on a na ional le el and fo pa ic la ocial g o p , a e e ef l o go e nmen a g ide o policie p o iding income ppo ( ch a an fe pa men ; ee Sec ion 12.5) a ell a mea e in ended o comba po e . M M (MIS) efe o a me hod o mea e po e de eloped b he Jo eph Ro n ee Fo nda ion in he UK. The me hod con i of ongoing e ea ch on ha people in a pop la ion belie e a e he e en ial fo a minim m accep able anda d of li ing ha allo people o pa icipa e in ocie . The MIS hen p od ce b dge fo a ba ke of good incl ding n me o e en ial i em like food, clo hing, ho ing, childca e, f el co and ocial and c l al pa icipa ion, eq i ed b ho ehold in o de o achie e he minim m anda d of li ing. Ba ed on hi info ma ion i calc la e he minim m income ha i eq i ed fo diffe en famil pe (acco ding o n mbe of people, age , geog aphical a ea , e c.) o be able o b he e en ial in he ba ke . The MIS e eal impo an info ma ion abo : he n mbe of people li ing belo he minim m income eq i ed o b he e en ial he ela i e con ib ion of each i em in he ba ke o ho ehold abili ie o achie e MIS ho he e change o e ime. Thi info ma ion can be helpf l o go e nmen a a g ide o making policie o deal i h po e . Calc la ion of he MIS began in he UK in 2008. Se e al co n ie ha e been cond c ing pilo (e pe imen al) die i h he MIS incl ding F ance, I eland, Japan, Me ico, Po gal, Singapo e, So h Af ica and Thailand. C Compo i e indica o a e mea e of comple phenomena ha canno ea il be de c ibed b a ingle indica o . The he efo e o cap e mo e han one dimen ion of he i e in q e ion. We ill d compo i e indica o in g ea e de ail in Chap e 18. M P I (MPI) The M P I (MPI) a de eloped in 2010 b he Uni ed Na ion De elopmen P og amme and he O fo d Po e and H man De elopmen Ini ia i e. I mea e po e in h ee dimen ion : heal h, ed ca ion and li ing anda d . Each of he e dimen ion i in ended o eflec (e en ial hing ha people do no ha e) mea ed b he follo ing en indica o : Heal h i mea ed b child mo ali n i ion Ed ca ion i mea ed b ea of chooling chool a endance HEO Li ing anda d a e mea cooking f el ani a ion d inking a e elec ici ho ing a e ed b OF KNO LEDGE 12.1 A The concep of ab ol e and ela i e po e ha e diffe en implica ion fo he meaning of po e . The concep of ab ol e po e , ba ed on an ab ol e po e line ha doe no change o e ime (e cep fo adj men fo infla ion), gge ha i h economic g o h e e one ill e en all i e abo e he po e line. The efo e, man co n ie ha e pe ience long- e m g o h ha e been eeing falling ab ol e po e a e . The ela i e po e line, b con a , change con an l o e ime a income g o , and he poo a e ho e ho canno keep p i h i ing a e age/median income . Rela i e po e ha ac all been in man co n ie o e ecen decade , d e o income ineq ali ie . The follo ing famo pa age, i en b Adam Smi h ( he Fa he of Economic ) in he 18 h cen in hi cla ic book, T N , offe an e plana ion of he diffe ence be een he o meaning of po e , b efe ing o he meaning he a ache o nece a ie : B I , , , , .T . B . A G R , ,I , , , , , , E , - , , , , . . . Unde nece a ie he efo e, I comp ehend, no onl ho e hing hich na e, b ho e hing hich e abli hed le of decenc ha e ende ed nece a o he lo e ank of people. 16 Acco ding o Adam Smi h, a pe on ho ha he ba ic nece i ie of life eq i ed fo ph ical i al b doe no ha e a linen hi i ela i el poo , b no ab ol el poo . One ho doe no e en ha e he ba ic nece i ie of life i ab ol el poo (and, of co e, al o ela i el poo ). A no ed in he e , mea e of po e a e impo an beca e he fo m he ba i fo an i-po e p og amme ch a an fe pa men . Diffe en co n ie e diffe en mea e fo hi p po e. Fo e ample, in he Uni ed S a e he official po e mea e ed o de e mine eligibili fo go e nmen a i ance i an ab ol e one; in he E opean Union, he official po e mea e i a ela i e one ( ho gh bo h calc la e ab ol e and ela i e po e a e ). Doe ocie ha e a mo al obliga ion o help he poo ? Adam Smi h iden ifie nece a ie o be ho e hing hich e abli hed le of decenc ha e ende ed nece a . Wo ld he define po e in he ab ol e o in he ela i e en e? Wha kind of c i e ia a e impo an fo making a choice be een ab ol e and ela i e po e a he ba i fo an i-po e p og amme ( ocial cien ific, e hical o o he )? A ocie choice be een an ab ol e o ela i e po e mea e a he ba i fo polic e on ome p inciple of eq i . Wha do o hink migh be an eq i p inciple fo he US e of ab ol e po e and fo he EU e of ela i e po e ? Ho do he eq i p inciple diffe f om each o he ? A hi li of indica o ho , he MPI goe be ond con ide ing po e olel in e m of , con ide ing in ead a a ie of a ea in hich poo people e pe ience . The empha i on dep i a ion a in od ced b he Nobel P i e inning Indian economi Ama a Sen ( ee Chap e 18). The MPI i ed a a mea e of po e in de eloping co n ie ( he e ill be died in Chap e 18 20). I incl de 105 co n ie (a of 2019) co e ing 5.7 billion people o 77% of he o ld pop la ion. Each co n ecei e an MPI al e f om 0 o 1, he e he highe he MPI al e he g ea e he po e . In o de o be co n ed a , people m be dep i ed in a lea one- hi d of he indica o li ed abo e. Info ma ion i p o ided on he n mbe of people and he pe cen age of he o al pop la ion ho a e poo in each co n . An impo an ad an age of he MPI i ha i can be b oken do n b indica o o ha fo each co n i i po ible o de e mine hich indica o make he mo impo an con ib ion o po e . Fo e ample, Tajiki an and Pe ha e imila MPI , hich a e 0.049 fo Tajiki an and 0.052 fo Pe . B in Pe 18% of po e i d e o dep i a ion in ea of chooling hile in Tajiki an onl 1% of po e i d e o hi indica o . B con a , in Tajiki an 35% of po e come f om maln i ion hile in Pe i i abo 18%.17 Table 12.5 ho ha nea l one-q a e of he pop la ion of he 105 co n ie li e in m l idimen ional po e . Mo of he o ld MPI poo , o 89%, li e in So h A ia o b-Saha an Af ica. D MPI N % ( ) * Ea e n E ope and Cen al A ia 0.009 3.5 2.4% Ea A ia and he Pacific 0.025 117.7 5.9% La in Ame ica and he Ca ibbean 0.033 30.7 7.7% A ab S a e 0.098 65.7 19.2% So h A ia 0.143 545.9 31.3% S b-Saha an Af ica 0.317 559.4 57.7% Global MPI De eloping egion 0.115 1.33 billion 23.2% * Poo people a e defined o ho e ho a e dep i ed in one- hi d o mo e of he indica o :G M P 12.5: M l idimen ional po e I b 2018 egion 2018 While he MPI con ide po e in de eloping co n ie , a e ha e een he e i po e co n ie a ell. Acco ding o he Uni ed Na ion De elopmen P og amme: D A D 633 000 in de eloped . 11 (OECD18) O S 284 000 E C 2014. A 2012 ...A 15 G 15 29 . H . T OECD 53.8 , . M , 19 P I MPI) B The Wo ld Bank ( ee Chap e 20) i in he p oce of de eloping ano he MPI. A no ed b he Bank, he anda d mone a mea e of po e doe no cap e impo an a pec of ell-being, ch a acce o heal h ca e o a ec e comm ni . I he efo e p opo e a ne MPI o complemen ha of he UNDP and O fo d b incl ding a mone a indica o (income ) a ell a ome addi ional indica o . The Wo ld Bank p opo ed indica o a e ho n in Table 12.6. Income pe capi a Elec ici Child chool en olmen Co e age of ke heal h e ice Ad l chool a ainmen Malno i hmen (child and ad l ) Limi ed- anda d d inking a e Incidence of c ime Limi ed- anda d ani a ion Incidence of na :O K R al di a e 12.6: Wo ld bank p opo ed indica o fo M l idimen ional Po e Inde D The mea emen of po e i a challenging a k fo e e al ea on . P A e ha e een he e a e diffe en mea e of po e , depending on ho hi i in e p e ed. The e i he di inc ion be een ab ol e po e and ela i e po e , hich gi e i e o e diffe en e ima e on he e en of po e . In addi ion, he e i po e mea ed on he ba i of income, a ell a po e mea ed on he ba i of dep i a ion in a n mbe of diffe en non-mone a a ea , kno n a m l idimen ional po e . All he e a e no con i en i h each o he . M Of en, a e ha e een, po e i mea ed on he ba i of income of a ho ehold. Ho e e , people al o ha e ome eal h o le e o g ea e deg ee , o he ma ha e ome a ing , on hich he can fall back in ha d ime . Income mea e of po e do no ake eal h o a ing in o con ide a ion. In ome ca e po e i mea ed b e of ho ehold e . Thi ai e e e al i e: he info ma ion p o ided b he ho ehold ha a e e ed i bjec i e, o ha diffe en people ma ha e diffe en opinion abo hei economic i a ion ch e do no incl de homele people and people in in i ion affec ed b po e , e l ing in nde e ima e of he e en of po e ho a e m ch mo e income fig e ma be nde a ed in ca e he e he e i f eelance o k o income f om in e men , e l ing in o e e ima e of po e . U ban a ea all ha e a highe co of li ing han al a ea , o na ional po e e cl de man poo in ban a ea ho canno affo d nece i ie like food, ho ing. line of en Po e line ell ho man people (o he pe cen age of people) fall belo he po e line, b do no p o ide an info ma ion on ho m ch he fall belo he po e line. In one ca e he majo i of poo ma be belo b clo e o he po e line, he ea in ano he he ma be fa belo . Clea l he e i g ea e po e in he econd ca e han in he fi . O Depending on pa ic la goal of go e nmen , he na ional po e o e e ima ed o nde e ima ed. line (fo ab ol e po e ) ma be O e e ima ion e l in a la ge p opo ion of a pop la ion ho e income fall belo hi line. Thi can be ed b go e nmen o a g e in fa o of ecei ing mo e fo eign aid o m l ila e al a i ance ( ee Chap e 20). Unde e ima ion e l in a malle p opo ion of a pop la ion i h an income belo hi minim m. Thi can be ed b go e nmen fo m la ing na ional a egie fo po e ed c ion, in he e en ha he o ld like o pend le on po e ed c ion han on o he ac i i ie demanding go e nmen f nding. E 1 O NDE ANDING 12.2 E plain he diffe ence be een ab ol e and ela i e po e O line he he i make en e o compa e po e a e mea ing ela i e po e . 2 Di ing i h be een po e . a e mea ing ab ol e po e line and minim m income anda d a mea e of po e ih . 3 The Wo ld Bank lend o de eloping co n ie fo de elopmen p po e . O line he he o hink i make en e o e he Wo ld Bank defini ion of ab ol e po e o mea e po e in de eloped co n ie . 4 U ing e ample , e plain po ible ad an age of compo i e indica o o e ingle indica o a mea e of po e . 5 Di c diffic l ie o nding effo of S a i ical Te m , Po e o mea e po e . 8 OECD, Glo a Line. 9 Wh he Wo ld Bank i aking a ide-angle ie of po e 10 Wh he Wo ld Bank op imi m abo 11 Lo e -middle-income co n ie ha e a pe capi a GNI of $996 $3895 hile ppe -middle-income co n ie ha e a pe capi a GNI of $3896 $12 055 Ne co n cla ifica ion b income le el: 2018-2019 12 Nea l Half he Wo ld Li e on Le 13 The median i he n mbe ha i in he middle of a e ie of n mbe . The efo e, he median income i ha income ha lie in he middle of all income le el , o ha half of income le el a e g ea e and half a e lo e . No e ha he median i diffe en f om he a e age o mean. 14 Hi o ical Po e 15 Repo : The Road o Ze o Weal h 16 Adam Smi h (1937) An Enq i in o he Na e and Ca e of he Weal h of Na ion , Ne Lib a , pp. 821 2 (Book V, Chap e II, Pa II, A icle 4 h). 17 Global M l idimen ional Po e 18 The OECD incl de 36 co n ie mo of hich a e de eloped. 19 H man De elopmen Repo 2016 global po e mi e he poin han $5.50 a Da Table : People and Familie - 1959 o 2018 Inde 2018 Yo k, Mode n 12.3 C LEARNING OBJECTIVES After stud ing this section ou ill be able to: define all the terms appearing in in the te t (AO1) e plain causes of economic inequalit and povert including (AO2) inequalit of opportunit different levels of resource o nership different levels of human capital discrimination (race, gender and others) unequal status and po er government ta and benefits policies globalisation technological change market-based suppl -side policies Economic inequalit and povert have similar and overlapping causes. The societies that have the most equal distributions of income also tend to have lo er levels of povert (mainl in Nordic countries). The reason is that policies that favour greater income equalit overlap ith those that reduce povert . We ill e amine such policies later in this chapter. I O can be defined as a set of circumstances that makes it possible for someone to do something. To understand ine ali f ni , it is useful to compare and contrast it ith ec n mic ine ali . Economic inequalit is concerned ith inequalities in standards of living that arise from monetar factors like income and ealth. As such it is concerned ith inequalities in c me in anda d li ing arising from income and ealth differences. f Inequalit of opportunit is concerned ith inequalities in en ial c me in anda d f li ing that arise from circumstances that are be nd ne c n l. The World Bank terms it the lotter of birth .20 Important circumstances that affect life opportunities and are be ond one s control include such factors as: parents level of education and occupation parents level of income place of birth gender race and ethnicit . There ould be equalit of opportunit if ever one began life from a situation here all factors like the above ere equal. In such a h pothetical situation, inequalities in c me ould be due to circumstances over hich people have control, such as effort in school, effort on the job and hard ork. Yet in the real orld, it is apparent that large and gro ing economic inequalities cannot be e plained b differences in circumstances over hich people have control, such as effort and hard ork. For this reason, economists have recentl taken a strong interest in stud ing the factors that give rise to inequalit of opportunit , and the e tent to hich inequalit of opportunit contributes to economic inequalit . An earl stud of si Latin American countries found that circumstances over hich people have no control (father s occupation, parents education, and region of birth) contributed to economic inequalit from at least 25% in Columbia to at least 51% in Guatemala.21 A larger stud of 41 countries found that circumstances contributed 4% in Nor a and 40% in Mali.22 A more detailed stud of the United Kingdom and the United States found that such circumstances as parent s education, time spent ith parents, race and childhood behavioural problems are responsible for 31% of inequalit in the United Kingdom and 45% in the United States.23 D Human capital refers to the skills, education and good health that people possess (see Chapter 11). Lo levels of education and skills translate into lo incomes because there is generall a positive (direct) relationship bet een skill/educational attainment and income levels. Poor levels of health also lead to lo incomes because an unhealth person is likel to be less productive and therefore more poorl paid. Unskilled people ma rel on the minimum age, hich ma be insufficient to support a famil . D Some people inherit, or accumulate through savings from ver high incomes, financial capital (cash, stocks and bonds) or other forms of propert (such as agricultural land or a home), hich gives them both an income advantage as ell as increased ealth. Yet man others have no resources to rel on other than their labour, hich for numerous reasons (such as lo levels of human capital, discrimination and others) ma not provide them ith an adequate income. People on lo incomes often do not o n a home and therefore have to pa rent, hich ma take up a substantial portion of their income ithout building up their ealth (unlike home-o ners graduall pa ing off a mortgage). Lo incomes ma mean poor housing, affecting health and further lo ering one s income potential, and ma even lead to homelessness. REAL WORLD FOCUS 12.2 I On average, children from rich and middle-income families are more likel to do better at school, go to universit and have higher incomes as adults. The advantages of children from higher-income families begin from a ver oung age, as a result of better nutrition and famil spending on activities that involve books and a variet of non-school educational activities. According to a stud about the United States, spending per child on education in the poorest fifth of the population increased b about 55% bet een the mid-1970s and the mid-2000s, hile it rose b 155% for the richest fifth over the same period. This, together ith additional advantages enjo ed b children of richer families (spending on non-school activities), is increasing the gap in educational attainment bet een rich and poor. School s stems can often reinforce these trends. For e ample, schools ith children from disadvantaged families often find it difficult to attract qualified teachers, ith the result that disadvantaged children receive lo er qualit education. In all OECD countries, children of parents ho did not attend universit are themselves less likel to go to universit . On average, the proportion of universit students of parents ho did not themselves attend is about half of hat it ould have been if all social groups ere proportionall represented. Since people ith lo er levels of educational attainment have lo er levels of income compared to those ho are more educated, it follo s that inequalit of opportunit in education contributes to income inequalit . Moreover, the problem is intergenerational, since inequalities are transferred from generation to generation. F 12.6: Ethiopia. Children in school ith alls made of cla and stra , ith no light or electricit A stud at the London School of Economics has found that the advantages offered b high-income families can persist for more than half a millennium. UK students ith names of prominent families could be traced back to the Normans ho invaded England in the 11th centur , and attended the e clusive universities of O ford and Cambridge. B contrast, students ith lo er status surnames attended these universities ith far less consistenc . Some researchers also argue that such intergenerational advantages last longer in more unequal societies. S : Keele , B. (2015), Income Inequalit : The Gap bet een Rich and Poor, OECD Insights, OECD Publishing, Paris A Based on our e perience ou ma be able to identif individuals or groups of individuals ho face unequal opportunities. Identif ho their opportunities differ based on differing circumstances that are be ond their control. Describe some advantages or disadvantages the face due to differing opportunities. D Discrimination is a serious problem both for the individuals involved as ell as for the job market. Some social groups (racial and ethnic groups, omen) often face discrimination in the job market, ith the result that the ma receive lo er ages than others for the same ork, or ma find greater difficult finding ork than the orker ho does not face discrimination. The often live in poor qualit environments and have less access to social services. For e ample, omen are at higher risk of povert because the are less likel than men to be in paid emplo ment, often do unpaid caring ork, the often receive lo er pa for the same job, and have lo er pensions. U S a refers to one s social or professional position in a societ . It ma be due to level of education, or level of income and ealth, or some form of social arrangement (as in an aristocrac ). Status is often closel related to po er, as individuals or groups ith a high status are also often able to control and influence other people or events. Large inequalities in status can affect economic inequalit because people in positions of po er ma sometimes use this to influence government policies favouring their o n interests and hence protecting their incomes and ealth, rather than policies that favour redistribution (to be discussed belo . See Real orld focus 12.4.). G People on lo incomes must often rel heavil on transfer pa ments (see belo ) and social services and merit goods (health care, education, housing) provided or subsidised b the government, as their incomes are insufficient to purchase these in the market. If these are limited or are reduced b the government, people on lo incomes ma be forced into povert b having to purchase these in the market. In addition, government ta policies pla a cruciall important role in determining income and ealth distribution. (We ill stud these later in this chapter.) Ta policies that favour the rich and do not favour redistribution contribute to increasing income and ealth inequalities and povert . In man countries, particularl developed ones, changing ta policies have contributed to idening income inequalities (see the discussion later in this chapter). T While the development of ne technologies contributes greatl to improving labour productivit (output per orker; see Chapter 11) and therefore to promoting economic gro th, in recent ears it has contributed to greater inequalit . The reason is that it has eliminated some jobs b replacing human labour b machines (automation). For e ample, jobs in packaging or manufacturing that require a lot of repetitive ork have been replaced b machines that can complete the ork faster and more effectivel . The result is that ages of lo -skill labour hose jobs are being eliminated do not rise much. At the same time, ne technologies have created demand for ne higher-level skills, meaning that ages of such orkers rise faster than those of lo -skill orkers. As a result, income differences bet een higherskill and lo er-skill labour are increasing. Another related factor is that technological change that leads to the replacement of labour b capital (ne machines) means that there is an increase in incomes of o ners of capital. This results in gro ing income inequalit bet een orkers hose income comes from their labour and the o ners of capital ho invest in ne machines. G G contributes to the above process. It refers to economic integration on a global scale, involving increasing interconnectedness throughout the orld in man areas (trade, finance, investment, people, technolog , ideas, kno ledge, communications and culture). Increased foreign direct investment (FDI, involving investments b multinational corporations; see Chapter 20) from developed economies increase income inequalities in both developed and developing economies because FDI tends to involve greater demand for skilled rather than unskilled orkers, increasing the income differences bet een the t o. In addition, developed economies sometimes offshore certain jobs (relocating them to other countries ith lo er labour costs), resulting in a lo er domestic demand for certain skills. M - - These policies ill be studied at length in Chapters 13 and 20, here e ill see that in some cases the lead to greater unemplo ment, or lo er incomes for lo er-skilled orkers, and hence to increased income inequalities and povert . The have been increasingl used in man countries around the orld since the 1980s. Policies such as discouraging trade unions and reduction of the bargaining po er of labour, reduction of the minimum age, and reductions in emplo ment protection have been found to contribute significantl to increasing inequalities.24 H (HL ) Some large firms ith market po er have been able to earn ver high and increasing abnormal profits hich transfer income and ealth a a from consumers ho have to pa higher prices and to ard the o ners of the firms (see Chapter 7, Section E al a ing m n l and c m a ing i h e fec c m e i i n). I Certain occupations, in particular e ecutives and professionals in the financial sector and non-financial e ecutives have been enjo ing huge increases in pa . In the United States, the ratio of pa of CEOs to pa of the average orker increased from 20 to 1 in 1965 to 300 to 1 in 2013.25 U An unemplo ed individual receives no income but ma receive some unemplo ment benefits; ho ever; these are generall lo relative to income received for ork, and in most countries are onl provided for limited periods. If unemplo ment is long term (such as ith structural unemplo ment), then an individual or famil is more likel to become poor. The risk of falling into povert is far greater in single-parent households here the parent is unemplo ed, or if both heads of a household are unemplo ed over long periods. G Some people ma live in remote, isolated geographical regions, ith limited possibilities for emplo ment, and ith limited possibilities to relocate (move) to other more economicall active regions (due to povert , age, or lack of communication and lack of marketable skills); this problem ma be especiall significant in some rural areas in developing countries. A Older people ma receive pensions that are barel enough to cover minimum needs, and in man countries (particularl developing ones) ma receive no pension at all if the have been living and orking in the informal econom (outside the legall registered econom ; see Chapter 19). P Povert itself ma become a cause of further povert . If people do not have access to essential services such as health care, education and housing, a self-perpetuating c cle ma be set into motion here lo incomes lead to lo human capital, and further to lo incomes. This is part of the povert c cle , to be studied in Chapter 19. TEST YOUR UNDERSTANDING 12.3 1 E plain the meaning of inequalit of opportunit and using e amples discuss ho it contributes to economic inequalit and povert . 2 Identif some further causes of economic inequalit and povert , e plaining in each case ho inequalit or povert are created or orsened. 20 The Data Minute: What is Inequalit of Opportunit ? 21 The Measurement of Inequalit of Opportunit : Theor and an Application to Latin America 22 Inequalit of Opportunit , Income Inequalit and Economic Mobilit 23 Inequalit of Opportunit : Ne Measurements Reveal the Consequences of Unequal Life Chances 24 Causes and Consequences of Income Inequalit : A Global Perspective 25 Inequalit and Economic Gro th 12.4 The i ac fi c e a d eal h i e ali LEARNING OBJECTIVES After studying this section you will be able to: evaluate the impact of income and wealth inequality on (AO3) economic growth standards of living social stability Ec ic g h In Chapter 11 we examined the impact of economic growth on income distribution. Now we look at the impact of income (and wealth) distribution on growth. There is increasing evidence that high levels of inequality are not good for economic growth. A number of studies confirm this point. For example, a study by the International Monetary Fund (IMF) concludes that lower inequality is linked with faster and more sustained growth, while policies that redistribute income do not generally have negative effects on growth.26 Another study by the IMF found that periods of growth were more likely to come to an end in countries that have more unequal income distributions.27 Yet another study by the IMF based on data from 159 developed and developing countries finds that increases in the share of income of the poor and middle class works to increase growth, whereas an increasing share of the top 20% results in lower growth.28 According to the study if the income share of the top 20% (the rich) increases, then GDP growth actually declines over the medium term while an increase in the income share of the bottom 20% (the poor) is associated with higher GDP growth . Reasons why inequality leads to lower growth include the following: Greater inequality lowers growth by reducing the ability of lower income households to invest in human and physical capital. For example it leads to lower spending on education, with poor children going to lower-quality schools, which in turn makes it more difficult for them to continue to university. This results in lower labour productivity (output per worker) hence lower growth. Countries with higher levels of income inequality have higher levels of inequality of opportunity in education, which is transferred from generation to generation so that children of low-income families are likely to also have low incomes (see also Real world focus 12.2). High income inequality may lead to lower growth because the wealthy spend a lower fraction of their incomes than middle income and lower income groups.29 But the higher savings of higher income groups often leave the country as financial investments abroad, thus reducing resources available for domestic investments. The concentration of income and wealth in a few hands results in significant political control and the ability of powerful groups to influence government policies for their own benefit, even though these policies may go against the interests of the whole population. For example, it is considered that the period of higher inequality in developed countries gave rise to activities that led to the global financial crisis of 2008 (such as financial institutions extending too much credit, and reduced government regulation) which greatly reduced rates of growth.30 Significant political control by the rich may also result in less government provision of essential merit goods (education, health care, infrastructure, etc.) which works against the interests of lower income groups and also works against growth. For example, spending on education increases the income-earning potential of the poor, but also leads to greater economic growth by increasing human capital. An improved income distribution increases the demand for locally produced goods and services, thus encouraging local production and promoting local employment and investment. With high income inequalities, these potential benefits are lost. This is especially relevant to developing countries. Highly unequal income distributions mean that the poor are unable to obtain credit, because they have no collateral as they have no wealth, meaning fewer investments for people on lower incomes, leading to lower growth and development. Also, opportunities to pay for education and health care through borrowing are reduced, leading to lower human capital and lower growth and development. A more equal distribution of income leads to greater political stability; highly unequal distributions can lead to social dissatisfaction, unrest and political instability, resulting in lower growth. L li i g a da d This is an obvious consequence arising from low incomes. Low living standards are associated with greater levels of psychological stress, substance abuse, poor nutrition and poor levels of health, all leading to poorer job and income-earning prospects. Low living standards are also a consequence of the factors below: Lac f acce hea h ca e a d ed ca i . Reduced ability to access health care and education leads to lower human capital formation, lower productivity and lower incomes, possibly resulting in the selfperpetuating poverty cycle noted above (see Chapter 19). Highe i fa , chi d a d a e a a i . The inability to access needed health care services, as well as poor nutrition for mothers and children lead to large numbers of unnecessary deaths among infants, children and women due to pregnancy-related causes. Highe e e f e e ab e di ea e . Poor hygiene and nutrition make both children and adults more prone to illnesses. S cia be . These include higher crime rates, drug use, family breakdowns and homelessness. I abi i ea i e e f e ia . Due to all of the above people in very low income groups are unable to realise their full potential, leading to a waste of human talent, and in addition to the personal costs, may result in lower economic growth (by adversely affecting the economy s PPC or L A curve). S cial a d li ical abili High income and wealth inequalities create societies that are polarised and divided, consisting of social groups with different interests that make interactions between them difficult. This leads to a reduced sense of social solidarity and trust in the system, while at the same time the groups at the top begin to feel entitled (that they have rights over others). The groups at the top begin to have a stronger political influence. The result is that economic inequality leads to political inequality. But those groups at the top with political power influence economic policies (such as tax and social benefits and merit goods policies) in their favour, so that economic inequality becomes even greater. They also influence the political rules of system in order to increase their political power. This results in a vicious circle of greater economic inequality and political inequality.31 Growing inequalities increasingly give rise to the feeling that people at or close to the bottom are socially inferior, giving rise to a pronounced sense of dissatisfaction which may eventually pave the way for social instability with possible social conflicts. Governments may further polarise society by serving the interests of their supporters such as lobbyists or big money donors at the expense of the interests of the whole of society. As divisions between social groups widen, it becomes more and more difficult to reach consensus on important challenges. TEST YOUR UNDERSTANDING 12.4 1 Discuss some of the reasons why high economic inequality is not good for growth. 2 Evaluate the impact of income and wealth inequality on a living standards, and b social stability. 26 Redistr