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:
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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)
,
,
,
,
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(AO2)
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TEST YOUR UNDERSTANDING 7.1
,
1
E
,
.
2
D
3
I
.
.
N
b
T
Ea
E a
Ma
c
D
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(
,
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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)
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K
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,
(
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.
,
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;
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C
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(
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A
)
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K
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GDP. (I
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A
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,
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;
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),
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GDP
A
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.T
AD
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,
,
,
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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
Redistribution, inequality and growth
27
Warning! Inequality may be hazardous to your growth
28
Causes and Consequences of Income Inequality : A Global Perspective
29
Causes and Consequences of Income Inequality: A Global Perspective
30
Causes and Consequences of Income Inequality: A Global Perspective
31
Income Inequality
12.5 Policies to reduce income and ealth
inequalities and povert
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
di ing i h be een
g e i e,
(AO1)
i nal and eg e i e a e (AO2)
di ing i h be een (AO2)
di ec a e
e nal inc me
c
a e inc me
eal h
indi ec a e
calc la e he am n
(HL nl ) (AO4)
calc la e
f indi ec a
al and a e age a
a e f m da a
e lain a e age and ma ginal a
e al a e he
(AO3)
le f diffe en
e lain and e al a e f
(AO3)
licie
an fe
a ge ed
he
aid f m an am n
f e endi
e, gi en he indi ec a
ae
ided (HL nl ) (AO4)
a e (HL nl ) (AO2)
e
f a e in ed cing inc me and
licie
ed ce ine ali ie
ed ce inc me and
f
ni
eal h ine ali ie and
eal h ine ali ie and
e
e
incl ding
ch a in e men in h man ca i al
a men
ending n g
d and e ice
ni e al ba ic inc me
licie
ed ce di c imina i n
minim m age
Ta ation policies to reduce income and ealth inequalities and
povert
Inc me and eal h ine ali ie and
e a e ha e een a e maj gl bal c nce n . T make ma e
e inc me and eal h ine ali ie a e inc ea ing in man c n ie a nd he
ld. In hi ec i n e
ill c n ide a n mbe f lic
l g e nmen can e
m e e i ( a g ea e deg ee f inc me
eal h e ali ) and alle ia i n f
e .
The role of ta ation in promoting (or orsening) equit (income
redistribution)
One f he m
ine ali ie b
im
an in men f inc me and eal h edi ib i n i a a i n, beca e i can l
aking m e a e f m he ich han f m he
.
e
Ta e a e he m im
an
ce f g e nmen e en e , and
ide he f nd f man
e , ch
a
blic g d , an fe a men and me i g d , c ec ing e e nali ie ,
iding b idie , changing he
all ca i n f e
ce , changing he di ib i n f inc me, and man m e.
The e a e
e
b ad ca eg ie
f a e , di ec a e and indi ec a e .
Direct ta es
Direct ta es a e a e aid di ec l
kind f di ec a e incl de he f ll
he g
ing:
e nmen a a h i ie b
he a a e . The m
Personal income ta es. Thi i he m im
an
ce f g e nmen a e en e
(e eciall de el ed c n ie ), and in l e a e aid b h eh ld
indi id
The a e aid n all f m f inc me, incl ding age , en al inc me, in e e inc
( hich a e inc me f m ne hi f ha e in a c m an , and a e he ef e inc me f
im
an
in man c n ie
al in h eh ld .
me and di idend
m
fi ).
Corporate income ta es. C
a i n a e b ine e (fi m ) ha ha e f med a legal b d called a
c
a i n ha i legall e a a e f m i
ne . C
a e inc me a e a e a e n he
fi f
c
ai n .
Wealth ta es. The e a e a e
ba ed n he al e f
e
n he ne hi f a e . T c mm n eal h a e a e propert ta es,
ned, and inheritance ta es, ba ed n he al e f
e inhe i ed.
The e en e c llec ed f m all f he ab e f m
finance a b ad a ie
f g e nmen e endi
di ec a a i n:
f a a i n i aid in he g e nmen b dge and i
e . In c n a
he e, he e i an addi i nal f m f
ed
Social insurance (social securit ) contributions or pa roll ta es. The e a e a e aid b
ke and
hei em l e ( h a n behalf f hei em l ee ). The e en e f m he e a e a e n
aid in
he g e nmen b dge , b a he in
ecific f nd , and a e ed
finance ecific e endi e ,
ch a en i n , cial in ance and heal h ca e (in me c n ie ).
Indirect ta es
Indirect ta es a e a e n ending n g d and e ice , di c ed in Cha e 4 and 5. The a e called
indi ec beca e, hile c n me a e he l ima e a e f a a f he e a e , he a indi ec l h gh
he
lie f he g d
e ice
cha ed ( he
lie ma be he
d ce , he e aile , gene all
he elle ). The m im
an kind f indi ec a e incl de he f ll ing:
General e penditure ta es, also kno n as sales ta es. The e a e a e n ending
ale f g d
and e ice . In he Uni ed S a e ( he e he a e kn n a ale a e ), he a e a fi ed e cen age f
he e ail ice f g d and e ice . The c e nding a
ed in he E
ean Uni n and man
he
c n ie a nd he
ld i he al e added a (VAT). VAT diffe f m a ale a in ha i i a a
aid n he al e added b each
d ce in he
d ci n
ce .32 In ac ice, man c n ie ha
e he VAT a ell a a e in he Uni ed S a e e em
e cl de ce ain g d and e ice f m
a men f a e n he g nd f e i (f e am le, g d and e ice like f d, ha mace ical ,
en n h ing, and he ); in me ca e he e ma be diffe en a e f diffe en
e f g d and
e ice n he g nd f e i .
E cise ta es. In c n a
e endi e/ ale a e , e ci e a e a e a e
e ice , ch a ciga e e and e l (ga line). (See Cha e 4 and 5.)
aid n
ecific g
d and
Customs duties, also kno n as tariffs. C
m d ie
a iff a e a
e f a a lied n im
f
f eign g d in a c n . The e a e
main ea n h g e nmen le
a iff . One i
kee
im
f he c n b making hem m e e en i e c n me , and he he i
ai e a
e en e . We ill d a iff in Cha e 14.
Proportional ta ation
Progressive ta ation
Regressive
ta ation
Income
Ta rate
(proportional)
Amount
of ta
Ta rate
(mildl
progressive)
Amount
of ta
Ta rate
(strongl
progressive)
Amount
of ta
Ta
rate
Amount
of ta
10 000
15%
1500
15%
1500
15%
1500
15%
1500
20 000
15%
3000
20%
4000
25%
5000
10%
2000
30 000
15%
4500
25%
7500
40%
12 000
5%
1500
Table 12.7: P g e i e,
i nal and eg e i e a a i n
Ta
em a en m l f m c n
c n a nd he
ld, and he e a e n
c n ie ha
ha e he ame a
em. While m c n ie ha e a mi f di ec and indi ec a e , he a
i h ega d
he deg ee f eliance n each f he e, a ell a n he a ic la mi f
e f a e i hin each g
.
In addi i n, he can a en m l i h e ec
a a e and man
he echnical de ail .
Understanding the principles of proportional, progressive and
regressive ta ation
Ta e can be defined a being
i nal,
ge i e
eg e i e acc ding
he ela i n hi be een
inc me and he f ac i n f inc me aid a a . The f ac i n f inc me aid a a , in e cen age e m , i
efe ed a a ta rate.
Proportional ta ation: a inc me inc ea e , he f ac i n f inc me aid a a e emain c n an ; he e
i a c n an a a e.
Progressive ta ation: a inc me inc ea e , he f ac i n f inc me aid a
inc ea ing a a e.
a e inc ea e ; he e i an
Regressive ta ation: a inc me inc ea e , he f ac i n f inc me aid a
dec ea ing a a e.
a e dec ea e ; he e i a
The e ela i n hi a e ill a ed in he n me ical e am le a ea ing in Table 12.7. The able h
h ee
ible inc me le el , and f
h
he ical a a i n
em i h diffe ing a a e . In each ca e, he
am n f a i calc la ed b m l i l ing he am n f inc me ime he c e nding a a e. In he ca e
f
i nal a a i n, he a a e emain c n an (a 15%) f all inc me le el ; he ef e, he am n f
a aid inc ea e in he ame
i n a inc me. In he ca e f
g e i e a a i n,
e am le a e
e en ed. In b h, he a a e inc ea e a inc me inc ea e ; a a e l , he am n f a aid inc ea e
m e han in
i n inc me. The fi e am le i mildl
g e i e , meaning ha he a a e
inc ea e l l a inc me inc ea e . In he
ngl
g e i e e am le, he a a e inc ea e m ch m e
a idl .
Ign ing eg e i e a a i n f he m men , le c m a e he am n f a aid in he ca e f
i nal,
mildl
g e i e and
ngl
g e i e a a i n. In all h ee ca e , a inc me inc ea e , he am n f a
aid bec me la ge . Which f he h ee i he m
fai ? (All h ee a i f he inci le f e ical e i ,
acc ding
hich h e i h g ea e inc me h ld a a la ge a han h e i h le inc me; ee The
f kn ledge fea e 12.2.) Thi i im
ible an e ing ec n mic ea ning, beca e fai ne i a
n ma i e e i n ha de end n al e j dgmen .
The nl hing ha can be aid i h ce ain i ha he m e
g e i ea a
em, he m e e al ( le
ne al) he af e - a di ib i n f inc me bec me . We can ee h b e amining he fig e in he able.
In all h ee a a i n
em , he a a e face he ame a a e and he ame am n f a f inc me f
10 000. H e e , a inc me inc ea e
20 000 and hen
30 000, he am n f a aid inc ea e
m e a idl in he mildl
ge i e
em and e en m e a idl in he
ngl
ge i e
em. B
h inking he diffe ence be een he high and l inc me le el ,
g e i e a a i n achie e a m e e al
inc me di ib i n han
i nal a a i n; and he m e
g e i e he a
em, he g ea e he
inc me e ali achie ed.
In eg e i e a a i n, he a a e dec ea e a inc me inc ea e ; he
inc me i e . Reg e i e a a i n he ef e make inc me di ib i n le
i n f inc me aid in a fall a
e al.
Wh indirect ta es are regressive
Al h gh
g e i e,
i nal and eg e i e a a i n a e defined ela i e inc me, he d n a l
j
inc me a e , b
all
e f a e , he he di ec
indi ec . Thi i beca e a e a e aid
f
inc me, and can he ef e be c m a ed i h inc me. T ee he he a a i
g e i e,
i nal
eg e i e, i can be calc la ed a a f ac i n f he inc me
f hich i i aid. F e am le, c
ae
inc me a e a e
all
i nal. S cial in ance c n ib i n a e al
ke and hei em l e ). Indi ec a e ( f all
e ) a e eg e i e.
all
i nal (f
b h
T ee h indi ec a e a e eg e i e, c n ide
indi id al , XX and XY. Each ne b
a ca f $10
000 ( i h
a ), n hich he e i an indi ec a (VAT,
ale a ,
a iff) f 10%, am n ing $1000.
Indi id al XY ha an ann al inc me f $10 000 and indi id al XX ha an ann al inc me f $20 000. The
$1000 f a i 10% f indi id al XY inc me, and i i 5% f indi id al XX inc me. In he
d ,a
inc me inc ea e f m $10 000 $20 000, he f ac i n f inc me aid n he indi ec a dec ea e f m
10% 5%. Thi i he defini i n f eg e i e a a i n. Since all indi ec a e
k n he ame inci le,
e can c ncl de ha indi ec a e a e eg e i e. It follo s that indirect ta es are inconsistent ith the
objective of a more equal distribution of income.
In he eal
ld, me g d and e ice c n ide ed be nece i ie , ch a f d and medicine , ma be
e em ed f m gene al e endi e
ale a e . Thi make indi ec a e
me ha le eg e i e, h gh
he emain eg e i e e all.
The a
em f i all all c n ie c n i f man diffe en
e f a e . Whe he he e all a
em f a c n i m e
ge i e
eg e i e de end n he mi f a e and a a e , and hei
ela i e im
ance a
ce f g e nmen e en e. F e am le, a c n
ha elie ela i el m e n
g e i e inc me a e i likel
ha e a a
em ha i ela i el m e
g e i e c m a ed a
c n
ha elie ela i el m e n indi ec a e .
The m e
g e i ea a
em, he m e e al i he af e - a di ib i n f inc me c m a ed
he
e- a di ib i n f inc me. Reg e i e a
em end make he di ib i n f inc me le e al.
TEST YOUR UNDERSTANDING 12.5
1
Di ing i h be een di ec and indi ec a e ,
2
Define and e lain,
a a i n.
3
E lain h
4
a
E lain h indi ec a e a e eg e i e.
b
O line he ea n f e cl ding me g d and e ice c n ide ed
a men f indi ec a e ( ch a VAT and ale a e ).
c
De c ibe he im ac hi ha
5
O line h
ing e am le , he diffe ence be een
inc me a e can be
he i
iding e am le
e f
ed
nh
ing a e
l
f each.
i nal,
g e i e and eg e i e
e inc me ine ali ie .
be nece i ie f m
eg e i e he indi ec a e a e.
edi ib e inc me i
a l a n ma i e i
e.
THEORY OF KNOWLEDGE 12.2
Principles of equit for ta ation
E i
if i i
efe
he idea f being fai
j . The de ign f a a
be c n ide ed fai
j . The e a e
main inci le
em e i e
me inci le f e i
f e i in a a i n, e lained bel .
The benefits-received principle
Acc ding
hi inci le, c n me and fi m h ld a a e n g d and e ice
ided b he
g e nmen in acc dance i h he e he make f hem. The idea he e i ha ch g d and e ice
h ld be aid f b hei e in he ame a ha g d and e ice
ided b he ma ke a e aid
f : he a e e a imila f nc i n a ice in he ma ke , and a e en e a e ed
a (a lea a l )
f
i i n f he g d and e ice b he g e nmen . E am le f g d aid f ( a ed) hi a
incl de a k ha ha e admi i n fee , ad and b idge ha cha ge ll , ad and high a financed b
e l (ga line) a e , and blicl financed ch l aid f b
e
a e.
In each ca e, he benefi
inci le i
ed, e en h gh i i n al a he ca e ha he a e f he a i
he ne h immedia el benefi f m he e f he g d
e ice. F e am le,
e
a e
ed
a f
blicl -financed ch l a e ba ed n he a m i n ha e le h li e in a a ic la a ea ill
end hei child en
he l cal ch l; he e l (ga line) a
ed
a f high a c n
c i n and
main enance e
f he high a .
e ha h e h b
e
l (ga line) a e al
h e h
ill benefi f m he
e
The benefi
inci le i c n ide ed fai in he en e ha e le a f benefi he ecei e, and d n
a f benefi ha a e enj ed b
he . H e e , i cann be ed a a gene al inci le f a a i n
f
main ea n . One i ha i i e diffic l , if a all
ible, iden if h ecei e he benefi
f n me
blic g d like na i nal defence, lice
ec i n and he c
em. The he i ha i
d e n all f an edi ib i n, ch a ha
ided b an fe a men .
The abilit -to-pa principle
Acc ding
hi inci le, a e h ld be le ied n indi id al
h eh ld acc ding
hei abili
a a a , in acc dance i h hei inc me
eal h. The abili - - a
inci le i de i ed f m he
idea n di ib i e j ice (fai ne ) f he fam
G eek hil
he A i le, h di ing i hed
be een h i n al and e ical e i . Acc ding
he idea f h i n al e i , e le h a e e al
i h e ec
ce ain cha ac e i ic h ld be ea ed e all . When a lied a a
em, hi mean
ha e le i h imila inc me
eal h ( a imila abili
a ) h ld be a ed b he ame am n .
Acc ding
he idea f e ical e i , e le h a e ne al i h e ec
ce ain cha ac e i ic
h ld be ea ed ne all , and in
i n
hei ine ali ie . In a a
em, ince man e le a e
ne al i h e ec
inc me and eal h (abili
a ), h e i h g ea e inc me and eal h h ld
a a la ge a han h e i h le inc me and eal h. If a a
em i de igned i h he e idea in
mind, he di ib i n f inc me ill bec me m e e al ( le
ne al).
The abili - - a
inci le i c n ide ed fai beca e e le i h highe inc me a m e a han
e le i h l e inc me . I al hel
l e he
blem f edi ib i n h gh ch me h d a
an fe a men . Whe ea i i idel acce ed, and i
ed in m c n ie a he ba i f de igning
inc me a
em , in ac ice i i e diffic l
each ag eemen ab
h
he c nce
f e ical
and h i n al e i h ld be in e e ed. E en if i i ag eed ha he ich h ld a m e han he
,
he e i n i , h m ch m e? Thi i a highl c n
e ial e i n, and he an e de end e
m ch n li ical belief and al e
em (n ma i e i e ).
Thinking points
D
hink i i im
acce ed b he membe
an f a a
f a cie ?
em
be ba ed n a
E amine he benefi - ecei ed and he abili - - a
d
hink i m e fai ? H
ld
j if
D he e le f a cie
e i
inci le f he a
ha e a m al bliga i n
em?
inci le f e i
inci le f m he e
a g men ?
a
ha i gene all
ec i e f e i . Which
a e ? Wha if he d n
ag ee
i h he
Achieving progressivit through proportional ta ation
(Supplementar material)
If
S
a e in e e ed
can ead ab
lemen a ma e ial.
hi in he 'Digi al c
eb
k: E
a ma e ial' ec i n a
Calculations of direct and indirect ta es (HL onl )
Ho to calculate total income ta es and average ta rates
T ee h inc me a e a e calc la ed in he eal
ld, e ill make a di inc i n be een ma ginal and
a e age a a e . A marginal ta rate i defined a he a a e aid n addi i nal inc me,
n he la
am n f a aid, e e ed a a e cen age. An average ta rate i a aid di ided b
al inc me,
al e e ed a a e cen age. All he a a e a ea ing in Table 12.7 a e a e age a a e .
In he eal
ld, inc me a e in a
ge i e a
em a e calc la ed ing cce
inc me and a l ing a diffe en a a e each la e . The la e f inc me a e called
c e nding a a e a e he ma ginal a a e . A n me ical e am le ill hel
C l mn 1 f Table 12.8 h
a b acke ( he la e f inc me) in a h
he ical ec
2 gi e
he ma ginal a a e ha a lie
each b acke .
i e la e f
a b acke , and he
nde and hi .
n m , and c l mn
S
e e an
calc la e he am n f inc me a aid n an ann al inc me f $59 000. The al a
aid ill be 0 f he fi $10 000 f hi inc me; 9% n inc me be een $10 001 and $25 000; 22% n
inc me be een $25 001 and $55 000; and finall 40% n inc me be een $55 001 and $59 000. We
calc la e he al a aid a f ll
.
(0 $10 000) +(0.09
$9550
$15 000) + (0.22
Wha i he a e age a
a e cen age,
$9550 $59 000 =0.162,
aef
$30 000) + (0.40
he inc me f $59 000? I i
$4000) = 0 + $1350 + $6600 + $1600 =
al a
aid di ided b inc me e
e ed a
16.2%
U ing he inf ma i n in Table 12.8, le
n
calc la e he inc me a
aid n inc me f $175 000.
(0 $10 000) + (0.09 $15 000) + (0.22 $30 000 +
(0.40 $60 000) + (0.55 $60 000) = 0 + $1350 + $6600 + $24 000 + $33 000 = $64 950 = inc me a
aid
The a e age a
a e n inc me f $175 000 i 37.1%
i.e. $64 950 $175 000 =0.371,
37.1%
C m a ing he a e age a a e f inc me f $59 000 (16.2%)