Economics for the IB Diploma
Ellie Tragakes
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Contents
Preface
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Acknowledgments
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Part 1 Introduction to Economics
Chapter 1 Fundamental concepts in Economics
Objectives
1.1 Key concepts in Economics
Defining Economics
Scarcity and choice
Consumer choice and utility
Scarcity, choice and opportunity cost: the economic perspective
Free and economic goods
The factors of production
Understanding the economic world by use of models
The circular flow model
Microeconomics and macroeconomics
Ceteris paribus
Positive and normative concepts
Economic growth, economic development and sustainable development
Economic growth
Economic development
Sustainable development
1.2 The production possibilities model
The production possibilities curve (frontier)
Introducing the production possibilities curve
The production possibilities curve and scarcity, choice and opportunity cost
The shape of the production possibilities curve
Shifts of the production possibilities curve (frontier)
Applications of the production possibilities model
Economic growth and economic development
Environmental issues
Present choices and future growth possibilities
1.3 Basic economic questions, rationing systems and the mixed market economy
Three basic economic questions: resource allocation and output/income distribution
How the basic economic questions are answered by market and command economies
Characteristics of market and command economies
Evaluating the market economy
Key advantages
Key limitations
Evaluating the centrally planned (command) economy
The mixed market economy
Economies in transition: moving towards the mixed market
Eastern Europe and the former Soviet Union
China
Questions for review
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Part 2 Microeconomics
Chapter 2 Markets
Objectives
2.1 Introduction to markets and market structures
Markets
Firms, industries and market structures
Perfect competition (or pure competition)
Monopoly
Monopolistic competition
Oligopoly
Market structure, competition and market power
2.2 Demand, supply and price determination
Demand
Individual demand
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The law of demand: why the demand curve slopes downward
Market demand
Determinants of demand
Movement along a demand curve and shift of the demand curve
Exceptions to the law of demand (higher level topic)
Veblen goods
Giffen goods
The role of expectations
Supply
Individual supply
The law of supply: why the supply curve slopes upward
Market supply
The vertical supply curve
Determinants of supply
Movement along a supply curve and shift of the supply curve
Market equilibrium: demand and supply
Shortages and surpluses
Market equilibrium
Changes in market equilibrium
Free and economic goods revisited
2.3 Prices and efficiency in the market economy
The role of prices in markets
Price rationing and the invisible hand of the market
Prices as signals and incentives
Economic efficiency and the market economy
Productive (or technical) efficiency: how to produce
Allocative efficiency: what to produce
Economic efficiency: maximizing consumer and producer surplus
A word of caution
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overnment intervention in the market: price controls and market disequilibrium
Price ceilings: setting a legal maximum price
What is a price ceiling?
Consequences of price ceilings
Examples of price ceilings
Price floors: setting a legal minimum price
What is a price floor?
Consequences of price floors
Examples of price floors
Setting fixed prices
Commodity agreements and buffer stock schemes
Questions for review
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Chapter 3 Elasticities
Objectives
3.1 Price elasticity of demand (PED)
Determinants of the price elasticity of demand
Definition and formula for the price elasticity of demand
The formula for the PED
The sign of the PED
The use of percentages
Calculating the PED
Interpreting the price elasticity of demand
The range of values for the PED
Variable PED and the straight-line demand curve
PED and the relative steepness of the demand curve (supplementary material)
Applications of the price elasticity of demand
PED and total revenue
PED and firm pricing decisions
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PED and price discrimination (higher level topic)
PED and excise taxes
PED and short-term price instability of agricultural products
3.2 Cross-elasticity of demand (CED)
Definition and formula for the cross-elasticity of demand
Interpreting the cross-elasticity of demand
Positive CED: substitutes
Negative CED: complements
Zero CED: unrelated products
Applications of the cross-elasticity of demand
Substitute goods
Complementary goods
3.3 Income elasticity of demand (YED)
Definition and formula for income elasticity of demand
Interpreting the income elasticity of demand
The sign of the income elasticity of demand (normal or inferior goods)
The value of the income elasticity of demand
Determinants of the income elasticity of demand
Applications of the income elasticity of demand
YED and the rate of expansion of industries
YED and sectoral change in an economy
YED and long-term impacts on agricultural and other primary product prices
3.4 Price elasticity of supply (PES)
Definition and formula for the price elasticity of supply
Interpreting the price elasticity of supply
The range of values for the PES
Determinants of the price elasticity of supply
Length of time
Spare capacity of firms
Applications of the price elasticity of supply
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PES and short-term price instability of agricultural products
Short-run and long-run price elasticities of supply
3.5 Elasticities of demand and supply and incidence of taxes and subsidies (higher level topic)
Indirect taxes: flat rate and ad valorem
The incidence of indirect taxes and subsidies on consumers and producers
The incidence of indirect taxes
The incidence of subsidies
Elasticity of demand and supply and the incidence of indirect taxes
The case of demand elasticities
The case of supply elasticities
Questions for review
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Chapter 4 T
heory of the firm I: costs, revenues and profits (higher level topic)
Objectives
4.1 Costs
Introduction to costs of production
Accounting, implicit and economic costs
The short run and the long run
Fixed, variable and total costs
Average costs
Marginal cost
Costs of production in the short run
Total product, marginal product and average product
The relationship between the marginal and average product curves
Generalized product curves
Law of diminishing marginal returns
Short-run costs of production: deriving the short-run cost curves
The law of diminishing marginal returns and the shape of the cost curves
Shifts in the cost curves
Costs of production in the long run
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Average costs in the long run
Long-run average total cost curve
Economies and diseconomies of scale
Minimum efficient scale and the structure of industries (supplementary material)
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4.2 Revenues and profits
Revenues
Profits
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Economic profit versus accounting profit
Normal profit
4.3 Goals of firms
Profit maximization
Profit maximization based on the total revenue and cost approach
Profit maximization based on the marginal revenue and cost approach
Evaluating profit maximization as the firm’s main goal
Additional firm goals
Revenue maximization
Growth maximization
Managerial utility maximization
Satisficing firm behaviour
Ethical and environmental concerns
Questions for review
Chapter 5 Theory of the firm II: market structures (higher level topic)
Objectives
5.1 Perfect competition
Assumptions of the model
Demand and revenue curves under perfect competition
The demand curve facing the firm
The firm’s revenue curves
Profit maximization in the short run
Short-run profit maximization based on the total revenue and cost approach
Short-run profit maximization based on the marginal revenue and cost approach
The firm’s short-run supply curve
Short-run equilibrium under perfect competition
Perfect competition in the long run
Role of economic (abnormal) profits and losses in adjustment to long-run equilibrium
Changes in demand and adjustment to long-run equilibrium
Changes in technology or resource prices, and adjustment to long-run equilibrium
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Allocative and productive (technical) efficiency
Allocative efficiency
Productive efficiency
Efficiency and perfect competition in the long run
Efficiency and perfect competition in the short run
Evaluating perfect competition
Insights provided by the model
Limitations of the model
5.2 Monopoly
Assumptions of the model
Barriers to entry
Economies of scale
Natural monopoly
Legal barriers
Control of essential resources
Aggressive tactics
The demand and revenue curves under monopoly
The demand curve facing the monopolist
The monopolist’s revenue curves
The monopolist’s output and price elasticity of demand
Profit maximization by the monopolist
Profit maximization based on the total revenue and cost approach
Profit maximization based on the marginal revenue and cost approach
Revenue maximization by the monopolist
Evaluating monopoly and comparing with perfect competition
Criticisms of monopoly
Benefits of monopoly
Monopoly and government regulation
Perfect competition and monopoly as guides to understanding the real world
5.3 Monopolistic competition
Assumptions of the model
Product differentiation and the demand curve
Elements of competition and monopoly
The roles of price and non-price competition
Profit maximization
Economic profit or loss in the short run
Normal profit in the long run
Criticisms of the model
Efficiency in monopolistic competition
Allocative and productive inefficiency
Excess capacity
Comparison of monopolistic competition with other market structures
Monopolistic competition and perfect competition
Monopolistic competition and monopoly
5.4 Oligopoly
Assumptions of oligopoly
Collusive oligopoly
Formal collusion: cartels
Obstacles to forming and maintaining cartels
Informal collusion: price leadership and other approaches
Non-collusive oligopoly: the kinked demand curve
The role of non-price competition in oligopoly
Evaluating oligopoly
Criticisms of oligopoly
Benefits of oligopoly
Advantages and disadvantages of advertising (supplementary material)
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5.5 The theory of contestable markets
5.6 Price discrimination
Definition and conditions for price discrimination
The single-price firm versus the price discriminating firm
Conditions for price discrimination
Types of price discrimination
First degree: discrimination among individual consumers
Second degree: discrimination among quantities
Third degree: discrimination among consumer groups
Summary of advantages and disadvantages of price discrimination
From the firm’s perspective
From the consumer’s perspective
From a social perspective
Questions for review
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Chapter 6 Market failure
Objectives
6.1 Market failure and allocative inefficiency
6.2 Externalities
Diverging private and social benefits and costs
Negative production externalities (spillover costs)
Illustrating negative production externalities
Correcting negative production externalities
Evaluating alternative policies
Negative consumption externalities (spillover costs)
Illustrating negative consumption externalities
Correcting negative consumption externalities
Evaluating alternative policies
Environmental concerns and sustainable development
Environmental concerns and negative externalities
The meaning of sustainable development
Addressing the overuse of open access resources
Positive production externalities (spillover benefits)
Illustrating positive production externalities
Correcting positive production externalities
Positive consumption externalities (spillover benefits)
Illustrating positive consumption externalities
Correcting positive consumption externalities
Evaluating measures to correct spillover benefits
6.3 Merit goods, demerit goods and public goods
Merit and demerit goods
Public goods
Public goods versus private goods
Public goods and the free rider problem
Public goods that are not ‘pure’
Correcting the market’s failure to provide public goods
6.4 Monopoly power
6.5 Additional failures (supplementary material)
Imperfect information and information asymmetries
Coordination failures
Weak or missing market institutions
Macroeconomic objectives
The problem of government failure (policy failure)
Questions for review
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Part 3 Macroeconomics
Chapter 7 Macroeconomic concepts and measurement
Objectives
7.1 Measuring national income and output
The circular flow model revisited
The simple circular flow of income
Adding leakages and injections
National income accounting
The expenditure method
The income method
The output method
Key distinctions relating to measures of the value of output
Distinction between gross and net
Distinction between nominal and real
Calculating nominal and real GDP
Distinction between total and per capita
Distinction between domestic and national: GDP versus GNP
7.2 Concepts and measurement of economic growth and economic development
Economic growth
Defining and calculating economic growth
The sources of economic growth
The significance of economic growth
Economic development
Distinguishing between developing and developed countries
Defining economic development
Relating economic growth to economic development
Limitations of the GDP measure in international welfare comparisons
Why GDP figures understate welfare (or why true welfare is greater than indicated by GDP per capita)
Why GDP figures overstate welfare (or why true welfare is smaller than indicated by GDP per capita)
Why GDP figures understate or overstate welfare (or why true welfare may be greater or smaller
than indicated by GDP per capita)
Purchasing power parities and welfare comparisons across countries
7.3 Measuring economic development
The complexities of measuring economic development
Individual indicators
World Development Indicators (World Bank)
Millennium Development Goals and indicators
Examples of individual indicators
Health indicators
Income poverty
Income distribution
Literacy, improved water source and improved sanitation
Demographic indicators
Relative importance of primary, secondary and tertiary sectors
Composite indicators
The Human Development Index
Other composite indicators
Questions for review
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Chapter 8 Aggregate demand and aggregate supply
Objectives
8.1 The business (trade) cycle: economic fluctuations
Understanding the business (trade) cycle
The phases of the business (trade) cycle
The relationship between real GDP and unemployment
Actual and potential GDP
Why we study the business (trade) cycle
8.2 The aggregate demand and aggregate supply model in the short run
Introducing the aggregate demand and aggregate supply (AD-AS) model
Aggregate demand and the aggregate demand curve
Defining aggregate demand and the aggregate demand curve
The downward slope of the aggregate demand curve (supplementary material)
Changes in aggregate demand (shifts in the AD curve)
Aggregate supply and the short-run aggregate supply curve
The short run and long run in macroeconomics
Defining aggregate supply and the short-run aggregate supply curve
Changes in short-run aggregate supply (shifts in the SRAS curve)
Macroeconomic equilibrium in the short run
Short-run equilibrium level of prices and output
Changes in short-run equilibrium
Recessionary (deflationary) gaps, inflationary gaps and short-run full employment equilibrium
Shifts in AD or SRAS: possible causes of the business cycle
8.3 Macroeconomic controversies: the neoclassical perspective
The AD-AS model in the long run
Defining the long-run aggregate supply curve and long-run macroeconomic equilibrium
Why the LRAS curve is vertical
Why the LRAS curve is situated at the level of potential GDP (or why inflationary and
deflationary gaps cannot persist in the long run)
Why in the long run aggregate demand influences only the price level, leaving real GDP unchanged
Changes in long-run aggregate supply (shifts in the LRAS curve)
Economic growth in the AD-AS model
The relationship between the SRAS and LRAS curves
8.4 Macroeconomic controversies: the Keynesian perspective
Getting stuck in the short run
Wage and price downward inflexibility
The inability of the economy to move into the long run
The shape of the Keynesian aggregate supply curve
The three short-run equilibrium states of the economy in the Keynesian perspective
Some key features of the Keynesian perspective
Recessionary gaps can persist over long periods of time
Increases in aggregate demand need not cause increases in the price level
Illustrating economic growth in the Keynesian perspective
8.5 Some final observations
Illustrating the neoclassical and Keynesian perspectives
Policy implications of the neoclassical and Keynesian perspectives
The business cycle and government policy in the neoclassical perspective
The business cycle and government policy in the Keynesian perspective
The mainstream economic perspective
Questions for review
Chapter 9 Demand-side and supply-side policies
Objectives
9.1 Demand-side policies: shifts in the aggregate demand curve
Objectives of demand-side policies
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Fiscal policy
Background to government finance
Expansionary fiscal policy
Contractionary fiscal policy
Monetary policy
Determination of the rate of interest
Changes in interest rates and aggregate demand
Expansionary (easy money) policy
Contractionary (tight money) policy
Strengths and weaknesses of demand-side policies for short-term stabilization
Strengths of fiscal policy
Weaknesses of fiscal policy
Strengths of monetary policy
Weaknesses of monetary policy
Inability of fiscal and monetary policies to address supply-side causes of economic contractions
Fiscal or monetary policy?
Discretionary policy or a monetary rule? (supplementary material)
Demand-side policies and long-term economic growth
9.2 Supply-side policies: shifts in the aggregate supply curve
Objectives of supply-side policies
Market-oriented supply-side policies
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The theoretical justification of market-oriented supply-side policies
Reducing the size of the government sector and increasing competition
Strengths and weaknesses of these policies
Improving incentives by lowering taxes
Strengths and weaknesses of these policies
Making the labour market more responsive to supply and demand
Strengths and weaknesses of these policies
Liberalizing (freeing up) international trade and capital flows
Interventionist supply-side policies
Interactions between demand-side and supply-side policies
9.3 The multiplier, accelerator and crowding-out effects (higher level topics)
The multiplier effect
Defining the multiplier effect
Calculating the multiplier
The multiplier and aggregate demand
The multiplier and fiscal policy
The multiplier in the real world: the role of leakages and the price level
The accelerator theory
Interactions between the multiplier and accelerator
The crowding-out effect
Questions for review
Chapter 10 Unemployment and inflation
Objectives
10.1 Unemployment
Definitions
Full employment
Unemployment and underemployment
The unemployment rate
Difficulties in measuring unemployment
The costs of unemployment
Economic costs
Non-economic costs
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Natural rate of unemployment: structural, frictional and seasonal unemployment
Structural unemployment
Frictional unemployment
Seasonal unemployment
The natural rate of unemployment in relation to the AD-AS model
Unemployment in a recessionary gap: real wage and cyclical unemployment
Real wage unemployment
Cyclical unemployment
Summary of the five types of unemployment in relation to the AD-AS model
10.2 Inflation and deflation
Introduction to inflation and deflation
Definitions
Distinguishing between changes in the price level and changes in the rate of inflation
Causes of inflation
Demand-pull inflation
Cost-push inflation
Excessive growth in the money supply
Consequences and costs of inflation
The relationship between inflation, purchasing power and nominal and real income
Costs of inflation
Costs of hyperinflation
Causes of deflation
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Why deflation occurs rarely in the real world
Causes of deflation
Costs of deflation
10.3 Measuring inflation (higher level topic)
Measurement of inflation and price indexes
Price index using a base year basket of goods and services (CPI)
Using the consumer price index to calculate the rate of inflation
A word of caution
Price index using current output (the GDP deflator) (supplementary material)
Using the GDP deflator to calculate the rate of inflation
Problems with measuring inflation
Problems with the consumer price index (CPI)
Problems with the GDP deflator (supplementary material)
10.4 The Phillips curve, the NRU and the NAIRU (higher level topics)
The relationship between inflation and unemployment
The breakdown in the relationship
Distinguishing between the short-run and long-run Phillips curves
The short-run Phillips curve
The long-run Phillips curve
The natural rate of unemployment (NRU) and the non-accelerating inflation rate of
unemployment (NAIRU)
The NAIRU and the natural rate of unemployment (NRU)
The NAIRU and the NRU: building a consensus view of the inflation–unemployment relationship
Questions for review
Chapter 11 Distribution of income
Objectives
11.1 Income distribution and redistribution
The meaning of income distribution and redistribution
Methods that can be used to redistribute income and output
Transfer payments
Subsidized provision of merit goods
Government intervention in markets
Taxation
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11.2 The role of taxation in income redistribution
Direct and indirect taxation
Direct taxes
Indirect taxes
The ability-to-pay principle
Proportional, progressive and regressive taxation
Understanding the principles of proportional, progressive and regressive taxation
Progressivity and personal income taxes
Other types of taxes
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Why income redistribution is a controversial issue: an evaluation
11.3 M
easuring income inequalities: the Lorenz curve and Gini coefficient (higher level topic)
Presenting some data on income distribution
The Lorenz curve and Gini coefficient
Lorenz curve
The Gini coefficient
Using Lorenz curves to illustrate income redistribution
Income distribution and the level of economic development
11.4 The Laffer curve (higher level topic)
Understanding the Laffer curve
Evaluating the Laffer curve
Questions for review
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Part 4 International economics
Chapter 12 International trade
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Objectives
12.1 International trade theory
The benefits of trade
Absolute and comparative advantage (higher level topic)
The theory of absolute advantage
The theory of comparative advantage
PPCs, absolute advantage and comparative advantage
Absolute advantage as a special case of comparative advantage
The sources of comparative advantage
Evaluating the theory of comparative advantage
12.2 International trade policy: free trade and protectionism
Defining free trade and protectionism
Free trade versus protectionism
Using diagrams to illustrate international trade
Tariffs
Tariffs and their impacts
The impacts of tariffs on consumer and producer surplus
Import quotas
Import quotas and their impacts
The impacts of quotas on consumer and producer surplus
Subsidies
Production subsidies and their impacts
Export subsidies and their impacts (supplementary material)
Voluntary export restraints
Administrative and technical regulations
Administrative regulations
Health, safety and environmental standards
Summary of arguments against protectionism
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Arguments for protectionism
Qualified arguments
Questionable arguments
Incorrect arguments
12.3 Economic integration
Trading blocs
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Free trade area
Customs union
Common market
Economic and monetary union
Advantages and disadvantages of trading blocs
Trade creation and trade diversion (higher level topic)
Trade creation and its impacts
Trade diversion and its impacts
The impacts of trade creation and diversion on consumer and producer surplus
(supplementary material)
Obstacles to achieving economic integration (higher level topic)
Reluctance to surrender political and economic sovereignty
Globalization
12.4 World Trade Organization
Brief history
WTO objectives
Evaluating the WTO
Potential benefits
Evaluating the Uruguay Round
The Doha Development Round: inability to reach agreement
Questions for review
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Chapter 13 Balance of payments and exchange rates
Objectives
13.1 The balance of payments
Introducing the balance of payments and foreign exchange
The balance of payments
Demand and supply of foreign exchange
Relating the demand and supply of a currency to the balance of payments
Understanding the balance of payments
The current account
The capital account
The financial account
A clarification concerning the capital account and the financial account
The meaning of ‘balance’ in the balance of payments
The statistical discrepancy
Understanding the balance of payments from a different perspective
13.2 Exchange rates
Exchange rates
Exchange rates in a floating (flexible) exchange rate system
The exchange rate as the ‘price’ of a currency
The equilibrium exchange rate
Exchange rate changes: appreciation and depreciation
Causes of changes in exchange rates
The significance of depreciating and appreciating currencies for a country’s exports and imports
Relating exchange rates to the balance of payments
Exchange rates in a fixed exchange rate system
Understanding fixed exchange rates
How fixed exchange rates can be maintained
Changing the fixed exchange rate
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Exchange rates in a managed float
Understanding managed exchange rates
Pegging exchange rates
The problem of overvalued or undervalued currencies
Overvalued currencies
Undervalued currencies
Monetary policy and conflicting objectives in an open economy
13.3 Topics on exchange rates (higher level topics)
Advantages and disadvantages of fixed and floating exchange rates
Advantages of fixed exchange rates
Disadvantages of fixed exchange rates
Advantages of floating (flexible) exchange rates
Disadvantages of floating (flexible) exchange rates
Evaluating the managed float (managed exchange rates)
Advantages and disadvantages of single currencies/monetary integration
Arguments in favour of a single currency
Arguments against a single currency
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Adjustment mechanisms within European Monetary Union (EMU) countries
Purchasing power parity (PPP) theory
Understanding PPP theory
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Why PPP theory does not work in practice
13.4 Topics on the balance of payments
Consequences of persistent current account deficits and financial account surpluses
Persistent current account deficits financed by loans
Persistent current account deficits financed by the sale of domestic assets
Consequences of persistent current account surpluses and financial account deficits
Methods to correct persistent current account deficits
Marshall-Lerner condition and J-curve (higher level topic)
Marshall–Lerner condition
J-curve
Questions for review
Chapter 14 Terms of trade
Objectives
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HL
14.1 Understanding the terms of trade
Defining the terms of trade
Measurement of the terms of trade (higher level topic)
Causes of changes in the terms of trade (higher level topic)
14.2 Consequences of changes in the terms of trade
The terms of trade and the balance of trade
How the terms of trade and the balance of trade are related to each other
The role of price elasticities of demand for exports and imports (higher level topic)
Consequences of changes in the terms of trade for the balance of trade
Changes in demand for an export product
Increases in supply of an export product: impacts of deteriorating terms of trade
Decreases in supply of an export product: impacts of improving terms of trade
Changes in exchange rates
Consequences of long-term changes in the terms of trade for the domestic economy
Long-term deterioration in the terms of trade in developing countries
Causes of deteriorating terms of trade in developing countries
Impacts of deteriorating terms of trade in developing countries
Short-term changes in terms of trade: terms of trade volatility and commodity booms
(supplementary material)
Causes of commodity booms and terms of trade volatility
Impacts of terms of trade volatility and commodity booms
Questions for review
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Part 5 Economic development
Chapter 15 Sources of economic growth and development
Objectives
15.1 F
actors of production and technology as sources of economic growth and development
Some distinctions relating to the factors of production
Expanding the meaning of ‘capital’
Capital, investment and saving
Physical capital and technological factors
Physical capital, technology and economic growth
Physical capital, technology and economic development
Human resources (human capital)
Human resources and economic growth
Human resources and economic development
Natural resources (natural capital)
Natural resources and economic growth
Natural resources and economic development
15.2 T
he role of institutional factors in the development of human capital and technology
The development of human capital: education and health services
The contribution of education and health services to human capital formation
Benefits of education and good levels of health for the individual
Spillover benefits (positive externalities) of education
Spillover benefits (positive externalities) of health
The importance of elementary education and universal literacy
Research and development, technological change and innovation (supplementary material)
Questions for review
Chapter 16 Barriers to economic growth and development
Objectives
16.1 Domestic barriers to growth and development
The poverty cycle (trap)
Understanding the poverty cycle
How poverty is perpetuated across generations
Breaking out of the poverty cycle
Banking and credit
The importance of banking and credit in economic growth and development
Exclusion of the poor from access to credit
Infrastructure
The importance of infrastructure
Infrastructure and economic growth
Infrastructure and economic development
Lack of infrastructure as a barrier to growth and development
Ineffective taxation structures
Low levels of revenues
Inequities in tax systems
Negative impacts on resource allocation
Lack of property rights
Property rights and investment
Property rights and access to credit
Property rights and benefits for non-owners
Inequalities in income distribution
The informal economy (informal sector)
Definition and characteristics of the informal economy (sector)
The size of the informal economy
The failure of the formal sector to provide enough employment opportunities
The role of the informal sector in growth and development
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Political stability
Corruption
Social and cultural barriers
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Culture and tradition in early theories of growth and development
Cultural factors as obstacles to growth and development
Gender inequalities
Consequences of gender inequality: deprivations faced by women and girls
Spillover benefits (positive externalities) of reducing gender inequalities and deprivations
faced by women
Population growth and the demographic trap (supplementary material)
The challenges of population growth
The vicious cycle of poverty and population growth: the demographic trap
Breaking out of the demographic trap
16.2 International trade barriers
Too much dependence on primary products and a narrow range of exports
The importance of the primary sector in developing countries
Consequences of too much dependence on primary products
Protectionism
Tariff barriers
Agricultural trade and rich country subsidies
Other non-tariff barriers: the ‘new protectionism’
16.3 International financial barriers
Developing country indebtedness
Explaining indebtedness
Brief history of the debt problem (supplementary material)
Consequences of high indebtedness
Consequences of some policies intended to address high indebtedness in developing countries
Capital flight
Non-convertible currencies
Defining convertibility and non-convertibility
Non-convertibility for current account transactions
Non-convertibility for financial account transactions
Conditions that should be met before adopting full currency convertibility
Currency convertibility and financial crises
Questions for review
Chapter 17 Growth models and international trade and growth strategies
Objectives
17.1 Early growth models and strategies
The Harrod–Domar growth model
The model
Policy implications
Criticisms of the model
The structural change/dual sector model
The model
Criticisms of the model
Policy implications and policy impacts
17.2 International trade and growth strategies
Import substitution/inward orientation with strong government intervention
The rationale of import substitution
Import-substitution policies and consequences
Export-led growth/outward orientation with strong government intervention
The experience of export promotion
Factors behind the success of export promotion over import substitution
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Export-led growth strategies with market liberalization: the Washington Consensus
The Washington Consensus
The impacts of economic and trade liberalization
Export-led growth strategies with selective government intervention: the New Development
Consensus
Evaluating the roles of inward-oriented and outward-oriented strategies in international
trade and economic growth and development
How an outward orientation to international trade can contribute to growth and development
Obstacles to achieving growth and development through an outward orientation
Can developing countries imitate the trade and growth strategies of the Asian Tigers?
Evaluating the roles of market-led and interventionist strategies in international trade and
economic growth and development
Two responses to developing country trade problems: fair trade organizations and
commodity agreements
Fair trade organizations
Commodity agreements
Questions for review
Chapter 18 S
trategies focusing on the savings, foreign exchange
and technology constraints
Objectives
18.1 Overview of foreign sources of finance
Foreign aid: concessional loans and grants
Non-concessional lending
Private investment
18.2 Foreign aid: concessional financial flows
Public aid: Official Development Assistance (ODA)
Bilateral and multilateral aid
Donor motives for providing aid
Factors that limit the effectiveness of aid
The quantity of aid and poverty alleviation
Evaluating the aid/trade controversy
Arguments supporting the ‘trade, not aid’ perspective
Arguments supporting the ‘trade and aid’ perspective
Arguments supporting the ‘aid for trade’ perspective
Private (civil society) aid: non-governmental organizations (NGOs)
Understanding the role of NGOs in development
Evaluating the role of NGOs in developing countries
18.3 Non-concessional financial flows: public and private lending
Organizations involved in multilateral (public) lending
The World Bank
World Bank activities
Evaluating the role of the World Bank
The International Monetary Fund
Activities of the International Monetary Fund
Evaluating the role of the International Monetary Fund
Private-sector bank (commercial bank) lending
18.4 Private investment
Foreign direct investment: the role of multinational (transnational) corporations
The scope and growth of multinational corporations
Geographical distribution of foreign direct investment
Country characteristics that attract multinational corporations
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Evaluating foreign direct investment and multinational corporations in developing countries
Potential benefits of multinational corporations (MNCs) for host developing countries
Potential costs of multinational corporations (MNCs) to the host developing country
Measures to increase MNC responsiveness to developing country needs (supplementary material)
Foreign portfolio investment (supplementary material)
18.5 Confronting poverty: micro-credit schemes
The importance of access to credit by poor people
Micro-credit schemes
Muhammad Yunus, the Grameen Bank, and the 2006 Nobel Prize for Peace
Controversial issues in micro-credit
Questions for review
Chapter 19 Consequences of economic growth
Objectives
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19.1 Economic growth and income distribution
The development of thinking on economic growth and income distribution
Why is income inequality increasing in many countries?
Policies to achieve a more equitable distribution of income
19.2 Economic growth, environmental externalities and sustainable development
Distinguishing between the pollution of affluence and the pollution of poverty
Negative environmental impacts of increasing economic activity
Social costs of environmental degradation
Economic growth and sustainable development: conflicting or compatible objectives?
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Economic growth and sustainability over the long term
Economic growth and sustainability: taking a short-term perspective
Strategies for sustainable development
Sustainable development: developing a strategy framework
Policies within a strategy for sustainable development
Green accounting methods (supplementary material)
Questions for review
Content from the CD-ROM accompanying the print book
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Introduction to the CD-ROM
Answers to select questions for review
1 Fundamental concepts in Economics
2 Markets
3 Elasticities
4 Theory of the firm I
5 Theory of the firm II
6 Market failure
7 Macroeconomic concepts and measurement
8 Aggregate demand and aggregate supply
9 Demand-side and supply-side policies
10 Unemployment and inflation
11 Distribution of income
12 International trade
13 Balance of payments and exchange rates
14 Terms of trade
15 Sources of economic growth and development
16 Barriers to economic growth and development
17 Growth model and international trade and growth strategies
18 Strategies focusing on the savings, foreign exchange and technology constraints
19 Consequences of economic growth
Case studies and data response questions and answers
Preparing for evaluation questions in Standard level Paper 1 and Higher level Paper 1
The Nobel Prize in Economics
Glossary
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Index
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Contents xix
For Alexios and Alkeos
Preface
Economics is a relatively new social science that touches upon many aspects of our lives and has
important effects on the well-being of all people around the world. Studying it as a scientific discipline
allows us to organize the way we think about the numerous economic problems faced by our own and
other societies, and helps us make informed and responsible choices.
Economics for the IB Diploma has been written for students of Economics in the International
Baccalaureate (IB) Diploma Programme. It covers the entire IB Economics syllabus at both standard and
higher levels. Each of the five parts of the book corresponds to one of the five sections of the syllabus,
and the chapters within each part correspond closely to the syllabus subsections. The book supposes
no prior knowledge of Economics from the student. Every section and subsection begins with a simple
presentation that gradually progresses to a more advanced level, enabling the student to gradually master
complex topics. The book fully covers the needs of the IB Economics student, in terms of both breadth
and depth of coverage of all items in the syllabus.
Note to the reader about the book
The book contains the following main features:
· Learning outcomes At the beginning of each chapter, there is a bulleted list of objectives indicating
what you should have learnt and what you should be able to do after studying the chapter.
· Standard level and higher level material The subdivision of the book’s content into two levels is clearly
demarcated. A vertical dashed bar labelled ‘HL’ runs down the margin of all higher level material,
allowing you to easily distinguish higher level from standard level material.
· Key points Material that is especially important, such as important concepts, laws, definitions and
conclusions, is highlighted in a box shaded light blue. This helps you focus on key points of the
chapter, and can facilitate reviewing.
· Use of bullet points There is extensive use of bullet points where there are lists of items relating to a
particular topic. These will help you keep the material well organized in your mind, and can also help
you review.
· Syllabus terms and glossary All syllabus terms are highlighted in blue bold font at their first
appearance in the book so that you can immediately recognize them. (You should note that when a
syllabus term reappears in a later section of the book, it is not highlighted in blue bold.) At the end of
the book, there is a glossary that defines all the syllabus terms. In the glossary, terms that are part of
higher level material are demarcated using the vertical ‘HL’ bar.
· Supplementary material The book includes some material that is not part of the IB Economics syllabus
and that you will not be examined on. Such material is accompanied by the heading ‘supplementary
material’ so that you can readily recognize it. It is included in the book in order to provide a more
rounded view of some topics that are not bounded by the rigid IB syllabus.
· ‘Test your understanding’ questions Each chapter contains a series of ‘Test your understanding’ questions,
which appear at the end of every topic. These questions are concerned very specifically with the
material of the preceding section and can help you review the section’s main points. The questions can
be used as the basis for class discussions or homework assignments. You can also use them for studying
and reviewing on your own. If you can answer these questions, it means you have understood the
important points of the section.
· End-of-chapter questions for review Each chapter ends with a set of review questions. These questions are
broader in scope than the ‘Test your understanding’ questions. Many (though not all) are similar to
IB Economics exam questions. Each is assigned a maximum number of marks, which is intended to
Preface xxi
guide you on how extensive your answer should be. The questions can help you review the chapter
material, but they can also give you practice in answering IB-style exam questions. Answers to selected
questions are provided in the accompanying CD-ROM (in bullet-point form). The corresponding
questions have a CD-ROM icon in the margin. You should attempt to answer these questions on your
own before reading the answers.
Note to the reader about the CD-ROM
The CD-ROM contains the following main features:
· Introduction This explains how the material on the CD-ROM can help you develop the skills you will
need in order to perform well in your IB Economics exams and in your portfolio of commentaries. It is
important that you read this introduction before proceeding to the other CD-ROM files.
· Answers to the end-of-chapter questions for review There is a separate file for each of the book’s 19
chapters, in which a selected number of end-of-chapter questions have been answered (in bullet-point
form). These questions (and their answers) are based on the material presented in the corresponding
chapters and are intended to sharpen your analytical skills and introduce you to evaluation questions.
· Case studies and data-response questions and answers This file contains a series of texts (or ‘case studies’)
on topics of current interest, together with questions and answers, all of which have been modelled
on the data-response questions of Standard level Paper 2 and Higher level Paper 3. These questions
and answers involve definitions, economic theory and analysis, and evaluation, showing how you can
make connections and find relationships between different parts of Economics, thus improving the
quality of your answers.
· Preparing for evaluation questions in Standard level Paper 1 and Higher level Paper 1 This file contains
further evaluation questions together with answers based on material that comes from more than one
chapter of the textbook.
· List of Nobel Prize winners For the interested student, there is also a list of all Nobel Prize winners in
Economics and a brief description of their work, beginning in 1969 when this prize was first awarded.
Acknowledgments
I would like to express my immense gratitude and debt to Julia Tokatlidou for her thorough, detailed
and insightful review of the book and CD-ROM, as well as for her enthusiasm and support. Whatever
merit this book may have would be less were it not for her invaluable contributions. I would also like to
extend my thanks to Ann Bone for her very careful, meticulous editing of the text and her many useful
suggestions. My thanks also go to K.A. Tsokos, for his great help and support, and for the guidance that
his book, Physics for the IB Diploma, provided for me. Finally, I would like to thank Alexios and Alkeos for
their patience, for reading and commenting on chapters of the book, and, above all, for the inspiration
and motivation they gave me to write this book.
Information about the author
Ellie Tragakes received a BA degree in Economics from Columbia University in the USA, a Master’s from
the University of Birmingham in the UK, and a PhD from the University of Maryland in the USA. She
has worked in the areas of economic development of agriculture of less developed countries, financial
services and health systems, in several national and international organizations, including the World
Bank and the World Health Organization. She is a highly experienced teacher and author, with over
forty professional publications. Many of these are in the area of health system financing and reforms
in transition economies, and they have been translated into several languages including Russian and
Chinese. She has been teaching in the Economics Department at the American College of Greece since
1996 and has been a consultant for the World Health Organization since 1992.
xxii
Preface
Acknowledgements
The author and publishers are grateful for the permissions granted to reproduce texts in either the original
or an adapted form. Whilst every effort has been made, it has not always been possible to identify the sources
of all materials used, or to trace all copyright holders. If any omissions are brought to our notice, we will be
happy to include the appropriate acknowledgements on reprinting.
Cover image: Russ Widstrand / Alamy
On occasion, the author has referred the reader to related sources (e.g. books, articles and websites) for
further information. These sources have been acknowledged in footnotes on the appropriate pages.
The author has also referred to selected data from the following sources in some of the tables and graphs:
United Nations Human Development Programme, Human Development Reports, available at
www.undp.org; UN Conference on Trade and Development (UNCTAD), World Investment Reports; World
Bank, World Development Reports and Development Indicators; Organisation for Economic Co-operation
and Development (OECD). These sources have been acknowledged in footnotes on the appropriate pages.
Acknowledgements xxiii
Part 1
Introduction to Economics
Many urgent issues in our world today, such as pollution, economic
growth, improvements in standards of living, unemployment,
inflation, technology, poverty, international trade, taxes, the role
of markets and government, and many more, involve economics.
The objective of economists is to explain, analyse and understand
issues such as these, in the hope of finding ways to deal with them
so as to bring about improvements in the well-being of people
everywhere.
Part 1 of this book is an introduction to the social science of
Economics. We will discover the meaning of Economics, and we
will discuss the important concepts of scarcity, opportunity cost
and choice, which form the basis of the economic perspective
of the world. We will see how economists use models to analyse
economic problems, and we will discover that even very simple
models of the economy can be used to shed light on important
economic issues. In Chapter 1 we will also learn about the
organizing principles of market and command economies, which
will allow us to go on to understand the workings of real-world
economies based on a mix of market and command principles.
Chapter 1
Introduction to Economics
Fundamental concepts
in Economics
This chapter is an introduction to the study of economics. It is also an introduction to many of the
topics that will be explored in depth in later chapters.
OBJECTIVES
After studying this chapter you should be able to:
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·
·
·
·
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·
·
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define Economics as the social science of scarcity and choice
identify the relationships illustrated by the circular flow model
distinguish between macroeconomics and microeconomics, and positive and normative concepts, and
understand why economists use the ceteris paribus assumption
distinguish between economic growth, economic development and sustainable development
use the production possibilities model to analyse a variety of economic issues
explain the concept of opportunity cost in relation to scarcity and choice
identify the three basic economic questions, and their relationship to resource allocation and output/income
distribution
compare and contrast the organizing principles of market and command economies
define transition economies and understand the kinds of reforms they pursue.
1.1 Key concepts in Economics
Defining Economics
The social sciences are academic disciplines that
study human society and social relationships. They
are concerned with discovering general principles
describing how societies function and are organized.
The social sciences include anthropology, economics,
political science, psychology and sociology.
Economics is a social science because its approach
to studying human society is based on the scientific
method. It is a social science because it deals with
human society and behaviour, and particularly those
aspects concerned with how people organize their
2
Part 1: Introduction to Economics
activities and how they behave in order to satisfy
their needs and wants.
Human beings have very many needs and wants.
Some of these are satisfied by physical objects and
others by non-physical activities. All the physical
objects people need and want are called goods (food,
clothing, houses, books, computers, cars, televisions,
refrigerators and so on); the non-physical activities are
called services (education, health care, entertainment,
travel, banking, insurance and many more).
The study of Economics arises because people’s needs
and wants are unlimited. Whereas some individuals
may be satisfied with the goods and services they
have or can buy, most would prefer to have more.
They would like to have 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 within
them to produce or buy all the things they want. Why
is this so? It is because there are not enough resources.
Resources are the inputs used to produce goods and
services wanted by people. They include things like
human labour, machines and factories, and ‘gifts of
nature’ like agricultural land and metals inside the
earth. Resources do not exist in unlimited abundance:
they are scarce, or limited and insufficient in relation
to unlimited uses that people have for them.
Scarcity is a very important concept in Economics. It
arises whenever there is not enough of something in
relation to the need for it. For example, we could say
that food is scarce in poor countries. Or we could say
that clean air is scarce in a polluted city. In Economics,
scarcity is especially important in describing the
condition of insufficient resources, because the
scarcity of resources causes scarcity in goods and
services. Defining scarcity, we can therefore say that:
The conflict between unlimited needs and wants, and
scarce resources has a second important consequence.
Since resources are scarce, it is important to avoid
waste in how they are used. If resources are not used
effectively and are wasted, they will end up producing
less; or they may end up producing goods and services
that people don’t really want or need. Economics must
try to find how best to use scarce resources so that
waste can be avoided. Defining Economics, we can
therefore say that:
Economics is the study of choices leading to the best
possible use of scarce resources in order to best satisfy
unlimited human needs and wants.
As you can see from this definition of Economics,
economists study the world from a social perspective,
with the objective of determining what is in society’s
best interests.
Test your understanding 1.1
1 Think of some of your most important needs
Scarcity is the condition in which available resources
are not enough to produce everything that human
beings need and want.
and wants, and then explain whether these are
satisfied by goods or by services.
2 Define scarcity, and then think of some things
that are (a) scarce, and (b) not scarce.
3 Why is Economics a study of choices?
4 Explain the relationship between scarcity and
It follows that societies face a fundamental problem,
which is the conflict between unlimited human needs
and wants on the one hand, and limited or scarce
resources on the other. The subject of Economics is
how to best resolve this conflict.
The conflict between unlimited needs and wants,
and scarce resources has an important consequence.
Since people can’t have everything they want, they
must make choices. The classic example of a choice
forced on society by resource scarcity is that of ‘guns
or butter’, or more realistically the choice between
producing defence goods (guns, weapons, tanks)
or food: more defence goods mean less food, while
more food means fewer defence goods. Societies
must choose how much of each they want to have.
Note that if there were no resource scarcity, a choice
would not be necessary, since society could produce
as much of each as was desired. But resource scarcity
forces the society to make a choice between available
alternatives. Economics is therefore a study of choices.
the need to avoid waste in the use of resources.
Scarcity and choice
We have seen that the condition of scarcity forces
people and societies to make choices. Let’s have a
closer look at some of the types of choices that must
be made.
Consumer choice and utility
Utility is the benefit or satisfaction that consumers
derive from consuming a good or service. Utility is
a subjective concept – the satisfaction you receive
from buying and using a particular good depends on
your own particular preferences, and is unlikely to be
the same as your friend’s. Consumers, acting in their
best interests, attempt to maximize the utility (i.e.
get the greatest possible utility) from buying a variety
of goods and services. This means that they make
choices about how to spend their income on different
possible purchases of goods and services, so as to buy
Chapter 1: Fundamental concepts in Economics 3
those things that will provide them with the greatest
possible benefit or satisfaction. (Note that if consumers
had an unlimited income, it would not be necessary
for them to make choices between alternative
purchases.) Utility maximization by the consumer is
an example of one of the many kinds of choices that
are studied by economists.
If resources were limitless, no sacrifices would be
necessary, and the opportunity cost of producing
anything would be zero.
Test your understanding 1.2
1 Explain the relationship between scarcity and
choice.
Scarcity, choice and opportunity cost: the
economic perspective
Opportunity cost is defined as the value of the next
best alternative that must be given up or sacrificed in
order to obtain something else. Every time we choose
to do something, we give up something else that we
could have done instead. For example, your decision
to read this book now means that you have given up
a different activity, such as sleeping, watching TV,
reading a novel, or visiting a friend. If your best or
favourite alternative to reading this book is watching
TV, the TV time you have sacrificed is the opportunity
cost of reading this book. Opportunity cost in this
case arises from the fact that time is limited or scarce;
if it were endless, you would never have to sacrifice
any activity in order to do something else – you could
simply watch TV after reading, and your reading time
would not have any opportunity cost; we would say
that your reading time has an opportunity cost of zero.
The concept of opportunity cost, or the value of
the next best alternative that must be sacrificed to
obtain something else, is central to the economic
perspective of the world, and results from the
condition of scarcity that forces a choice between
competing alternatives.
When a consumer chooses to use her $100 to buy
a pair of shoes, she is also choosing not to use this
money to buy books, or CDs, or anything else; if CDs
are her favourite alternative to shoes, the CDs she
sacrificed (did not buy) are the opportunity cost of the
shoes. When a business chooses to use the resources at
its disposal to produce hamburgers, it is also choosing
not to produce hotdogs or pizzas, or anything else;
if hotdogs are the preferred alternative, the hotdogs
sacrificed (not produced) are the opportunity cost
of the hamburgers. Note that if the consumer had
endless amounts of money, she could buy everything
she wanted and the shoes would have no opportunity
cost. Similarly, if the business had endless resources
at its disposal, it could produce hotdogs, pizzas and
a lot of other things in addition to hamburgers, and
the hamburgers would have no opportunity cost.
4
Part 1: Introduction to Economics
2 Define opportunity cost.
3 Think of three choices you have made today,
and describe the opportunity cost of each one.
Free and economic goods
Based on the concept of opportunity cost, we can
make a distinction between free and economic goods
(note that the term ‘good’ is used here in a general
sense to include goods, services and resources):
A free good is any good that is not scarce, and
therefore has a zero opportunity cost. Since it is not
limited by scarcity, it includes anything that can
be obtained without sacrificing something else. An
economic good is any good that is scarce, either
because it is a naturally occurring scarce resource
(such as oil, gold, coal, forests, lakes), or because it
is produced by scarce resources. All economic goods
have an opportunity cost greater than zero.
Free goods are rare. Sometimes a good can be a free
good in certain situations and an economic good in
others. For example, arable land in America before
European colonizers arrived was a free good because it
was so abundant; as the colonizers grew in numbers it
became increasingly scarce and therefore an economic
good. Salt used to be a free good and has become
an economic good. Oxygen in the open unpolluted
countryside can be a free good; in a room with no
windows that is crowded with people it becomes an
economic good. Unobstructed sunshine is also a free
good in many situations.
It is important to distinguish free goods from goods or
resources that are available free of charge to their users.
There are two categories of goods that are available
free of charge, but which do have opportunity costs
and are therefore economic goods (both of these will
be studied in Chapter 6):
· goods provided by the government, such as the
road system, public parks and playgrounds, free
education, free health care services; all these are
economic goods produced by scarce resources, and
are paid for out of tax revenues
· certain natural resources, such as clean air, forests,
rivers, lakes and wildlife, that are not owned by
anyone (they are called ‘open access resources’);
these are also economic goods because they are
scarce (they are not unlimited), and are becoming
increasingly scarce due to overuse and depletion.
opportunities for opening and running a business.
Entrepreneurship organizes the other three factors
of production and takes on the risks of success or
failure of a business.
Owners of factors of production receive a payment for
providing their resources to the production process:
· Rent is payment to owners of land resources who
supply their land to the production process.
Test your understanding 1.3
1 Explain the difference between a free good and
an economic good.
2 Are any of the following goods ‘free goods’?
Explain why or why not: (a) public parks;
(b) sand in the Sahara desert; (c) garbage
collection; (d) free health care services;
(e) wildlife.
3 Why do you think free goods are rare?
The factors of production
Resources, or all inputs used to produce goods and
services, are alternatively known as factors of
production. Factors of production are grouped under
four broad categories:
· Land includes all natural resources, including all
agricultural and non-agricultural land, as well as
everything that is under or above the land, such as
minerals, oil reserves, underground water, forests,
rivers and lakes. Natural resources are also called
‘gifts of nature’.
· Labour includes the physical and mental effort
that people contribute to the production of goods
and services. The efforts of a teacher, a construction
worker, an economist, a doctor, a taxi driver or a
plumber all contribute to producing goods and
services, and are all examples of labour.
· Capital, also known as physical capital, is a
man-made factor of production that is used in the
production process to produce goods and services.
Examples of physical capital include machinery,
tools, factories, buildings, road systems, airports,
harbours, electricity generators and telephone
supply lines. Physical capital is also referred to as a
capital good or investment good.
· Entrepreneurship/management is a special
human skill possessed by some people, involving
the ability to innovate by developing new ways of
doing things, to take business risks and to seek new
· Wage is a payment to those who provide labour;
this includes all wages and salaries, as well as
supplements (such as bonuses and commissions).
· Interest is a payment to owners of capital
resources.
· Profit is payment to owners of entrepreneurship.
The payments to the factors of production are usually
expressed as payment for the amount of time they are
used. For example, they can be expressed as rent per
month; wage per hour or salary per month; interest
per year; profit per year, and so on.
Test your understanding 1.4
1 Why do you think resources are also called
‘factors of production’?
2 What are the factors of production? What
kind of payments do their owners receive for
supplying them in the economy?
3 How does physical capital differ from the other
three factors of production?
4 Why is entrepreneurship considered to be a
factor of production separate from labour?
Understanding the economic world by use of
models
Everyone is familiar with the idea of a model. As
children many of us played with paper airplanes,
which are models of real airplanes. In chemistry
at school, we studied molecules and atoms, which
are models of what matter is made of. Models are a
simplified representation of something in the real
world, and are used extensively by scientists and
social scientists in their efforts to understand and
explain real-world situations. Models represent only
the important aspects of the real world that is being
investigated, ignoring unnecessary details, thereby
allowing scientists and social scientists to focus on
important relationships.
Chapter 1: Fundamental concepts in Economics 5
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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.
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Whereas sciences like biology, chemistry and
physics offer the possibility to construct threedimensional 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 key variables. In more advanced
Economics (beyond the scope of this course), models
are illustrated by use of mathematical equations.
To construct a model, economists select particular
variables and make assumptions about how these
are interrelated. Different models illustrate different
aspects of the economic world. Some models may be
better than others in their ability to explain economic
phenomena, and as we will see in later chapters,
economists sometimes disagree about which model
can offer a better explanation of some aspect of the
real world.
firms
(businesses)
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In our study of Economics, we will encounter a variety
of economic models and will make extensive use of
diagrams. We now turn to a very simple model of the
economy.
The circular flow model
The circular flow model is a very simple model
that illustrates a number of economic concepts and
relationships. The simplest version of this model
is shown in the diagram in Figure 1.1. The model
assumes that households (or consumers) and firms
(or businesses) are the main decision-makers in
the economy; both are shown in square boxes.
Households and firms are linked together through two
kinds of markets, shown in diamonds. A market, in
Economics, is any arrangement that allows buyers and
sellers to conduct their buying and selling activities
(we will study markets in detail in Chapter 2).
Households or consumers (we use these terms
interchangeably) are owners of the factors
of production (land, labour, capital and
entrepreneurship), which they sell to firms in resource
markets. Firms buy the factors of production in
resource markets and use them to produce goods
6
Part 1: Introduction to Economics
go
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Models are very closely related to theories. A theory is
a generalization or simplification about the real world
that shows how particular variables are interrelated,
and attempts to explain real-world phenomena.
Models are sometimes built on the basis of wellestablished theories. In some contexts, economists use
the terms ‘model’ and ‘theory’ interchangeably.
d
goo
ic
rv
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s an
Figure 1.1 The simple circular flow model.
In the counterclockwise direction, there is a flow of
money used as payments for sales and purchases.
When households sell their factors of production to
firms, they receive payments taking the form of rent
(for land), wages (for labour), interest (for capital)
and profit (for entrepreneurship). These payments
constitute the income of households. The payments
that households make to buy goods and services are
household expenditures (or simply household or
consumer spending). The payments that firms make
to buy factors of production represent their costs,
and the payments they receive by selling goods and
services are their revenues.
The circular flow model provides a visual
representation of some key aspects of an economy
relying on markets. It shows how production of
goods and services and consumption of these are
linked together through the economic decisions made
by households and firms. These decisions involve
choices, necessitated by the condition of scarcity.
Test your understanding 1.5
1 The circular flow model represents a
simplification of the real world. Can you think
of some important features of the real world that
this model ignores?
2 What are the two kinds of markets shown in the
circular flow model? Can you provide examples
of what is exchanged (bought and sold) in each
of these?
3 What are the two flows shown in the circular
flow model?
4 The circular flow model shows that households
and firms are both buyers and sellers
simultaneously. How is this possible?
Microeconomics and macroeconomics
Economics is studied on two levels. Microeconomics
examines the behaviour of individual decisionmaking units in the economy. The two key groups
of decision-makers are consumers (or households)
and firms (or businesses), introduced in the circular
flow model. Microeconomics is concerned with how
these decision-makers behave, how they make choices
and how their interactions in markets determine
the prices of individual goods and services (in
product markets), and prices of individual factors of
production (in resource markets). As the circular flow
model illustrates, consumers choose what particular
goods and services and what quantities of these they
wish to buy, and they also choose the quantities of
factors of production that they wish to sell to firms.
Firms, on the other hand, choose the quantities of
factors of production they wish to buy, and they also
choose what particular goods and services and what
quantities of these to produce and sell to consumers.
These countless decisions are coordinated through the
operation of product and resource markets that we will
study in the chapters on microeconomics.
Macroeconomics examines the economy as a
whole to obtain a broad or overall picture, by use
of aggregates, which are wholes or collections of
many individual units, such as the sum of consumer
behaviours and the sum of firm behaviours, and
total income and output of the entire economy, as
well as total employment and the general price level
(as opposed to prices of individual goods, services
and resources). In terms of the circular flow model,
macroeconomics is concerned with the overall size of
output and income flows, as well as with explaining
how their size is determined.
Test your understanding 1.6
Which of the following topics are studied in
microeconomics and which in macroeconomics?
(a) Total household spending increased by
1.5% in 2006.
(b) Unemployment fell to 4% in 2005.
(c) The price of petrol (gasoline) increased due
to the government’s decision to increase
taxes.
(d) The economy’s total output has been
declining over the last two years.
(e) As firms are showing a greater interest in
hiring skilled labour, there has resulted an
increase in average wage rates received by
skilled workers.
Ceteris paribus
When we try to understand the relationship between
two or more variables in the context of economic
models, we must assume that everything else, other
than the variables we are studying, does not change.
We do this by use of 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.
Consider the simple circular flow model, and suppose
that households decide to save (not spend) a portion
of the income they receive from selling their factors
of production. What will happen to household
spending on goods and services? We might think that
household spending will fall by an amount equal to
savings. But will this necessarily happen? The answer
is no, it may not, if other things happen at the same
time that also affect household spending. For example,
let’s say that at the same time that households decide
to start saving, they also decide to work longer
hours (sell more of their labour in the labour market
to firms) in order to increase their income. If they
succeed, their longer working hours will have the
effect of increasing their income and therefore their
spending, at the same time that their saving will have
the effect of lowering their spending. We have no idea
what will happen on balance.
Chapter 1: Fundamental concepts in Economics 7
If we want to study the relationship between
household saving and spending, we can do it by
assuming that all other things that could affect
spending are constant and unchanging. More
formally, we could say that we are examining the
impact of the decision to save on household spending,
ceteris paribus. This means simply that we are studying
the relationship between saving and spending on
the assumption that nothing else happens that can
influence this relationship. By eliminating all other
possible interferences, we isolate the impact of saving
on spending, so we can study it alone.
In the real world all the variables that can affect
household spending 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 models
and theories.
Test your understanding 1.7
Consider the statement, ‘If you increase
your consumption of calories, you will put
on weight.’ Do you think this statement is
necessarily true? Why or why not? How could
you rephrase the statement to make it more
accurate?
Positive and normative concepts
Economists think about the economic world in two
different ways: one way tries to describe and explain
how things in the economy actually work, and the
other deals with how things ought to work.
The first of these is based on positive statements,
which are about something that is, was or will be.
Positive statements are used in several ways:
· They may describe something (e.g. the
unemployment rate is 5%; industrial output grew by
3%).
· They may be statements in a theory (e.g. an increase
in price leads to a decrease in quantity bought).
· They may be about a cause-and-effect relationship
(if the government increases spending,
unemployment will fall).
8
Part 1: Introduction to Economics
The second way of thinking about the economic
world, dealing with how things ought to work, is
based on normative statements, which are about
what ought to be. These are subjective statements
about what should happen. Examples include the
following: the unemployment rate should be lower;
health care should be available free of charge; extreme
poverty should be eradicated.
Positive statements may be true or they may be false.
For example, we may say that the unemployment
rate is 5%; if in fact the unemployment rate is 5%
this statement is true; but if the unemployment rate
is actually 7%, the statement is false. Normative
statements, by contrast, cannot be true or false. They
can only be assessed relative to beliefs and value
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.
Positive statements play an important role in
economics because they are used to describe economic
events and to construct theories and models that try
to explain these events. Normative statements are
important because they form the basis of economic
policy-making. Economic policies are government
actions that try to solve economic problems. When
a government formulates a policy to lower the
unemployment rate, this is based on a belief that
the unemployment rate is too high, and the value
judgement that high unemployment is not a good
thing. If a government pursues a policy to make
health care available free of charge, this is based on a
belief that people should not have to pay for receiving
health care services.
Positive and normative statements, while distinct,
often work together in economics. 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 provides guidance to policy-makers on how
to achieve their economic goals.
Test your understanding 1.8
Which of the following are positive statements
and which are normative?
(a)
(b)
(c)
(d)
It is raining today.
It is too humid today.
Economics is a study of choices.
Economics should be concerned with how
to reduce poverty.
(e) If household saving increases, ceteris paribus,
there will be a fall in household spending.
(f) Households save too little of their income.
Economic growth, economic development and
sustainable development
Economic growth, economic development and
sustainable development are three distinct but closely
related concepts.
Economic growth can be expressed as a percentage
change in real GDP over a specified period of time. (As
we will see in Chapter 7, ‘real’ means that the measure
of GDP accounts for changes only in quantities of
goods and services produced, and ignores changes in
prices.) For example, China’s real GDP increased by
9.1% in 2004; this means that the real value of output
produced within China in the course of the year 2004
grew by 9.1%. ‘Real GDP per capita’ considers the GDP
of a country divided by that country’s population, in
other words, real GDP per person. We will study these
concepts in more detail in Chapter 7.
Test your understanding 1.9
1 How would you use the circular flow model to
explain economic growth?
2 In Egypt, real GDP grew by 3.1% in 2004, yet
real GDP per capita in the course of the same
year grew by 1.3%. What do you think accounts
for the difference between the two growth rates?
Economic growth
All economies produce some output, which includes
all goods and services produced for consumers, as well
as all capital goods (physical capital). Over time, the
quantity of output that is produced in a given period
of time (say a year) changes.
When the quantity of output produced by an
economy over a period of time increases, there is
economic growth; if it decreases there is economic
contraction or negative economic growth.
In the circular flow model, economic growth would
be illustrated by an increase in the size of the flows of
goods and services moving from firms to households,
as well as in flows of resources. At the same time,
growth would also appear as an increase in the money
flows, including household incomes and expenditures.
A contraction, on the other hand, would be shown by
a reduction in the size of the flows.
To have a clear picture of how much output is being
produced and how this changes over time, we must
be able to measure the quantity of output. Common
measurements of output include GDP (gross domestic
product) and GDP per capita (GDP per person). GDP
measures the value of all goods and services produced
within the boundaries of a particular country over a
particular time period, typically a year.
Economic development
There are enormous differences between countries
in the volume of output (or GDP) per capita that
they produce and in their levels of income. Whereas
countries are commonly referred to as being ‘rich’
or ‘poor’, economists try to classify them in a more
precise way. The World Bank (this is an international
financial institution that lends to developing
countries in order to assist them in their development
efforts) divides them into four groups according to
their level of GDP per capita; these groups are: low
income economies, lower middle income economies,
upper middle income economies and high income
economies. The first three groups comprise the less
developed countries (LDCs) or developing countries,
while high income economies are known as more
developed countries (MDCs).
Economic development refers to raising the
standard of living and well-being of people,
particularly in less developed countries (LDCs). It
involves increasing income levels and reducing
poverty, reducing income inequalities and
unemployment, and increasing provision of, and
access to, basic goods and services such as food
and shelter, sanitation, education and health care
services.
Chapter 1: Fundamental concepts in Economics 9
Economic development must be sharply distinguished
from economic growth. Economic growth involves
increases in the volume of output produced. This is
an essential prerequisite for economic development
to occur; however it does not by itself ensure that
development will take place. There may, for example,
be growth in the volume of output produced, but
this may not result in a reduction in poverty of lower
income groups, or in the provision of increased social
services such as education and health care, or in less
income inequality and greater employment.
It follows, then, that measures of growth such as
changes in real GDP and real GDP per capita over time,
though used extensively, are not fully appropriate
as measures of economic development. Measures of
economic growth cannot take into account all of the
above dimensions that development involves. Because
of these many dimensions, it follows, too, that the
division of countries into LDCs and MDCs on the
basis of their GDP per capita can be misleading. Some
countries may be more advanced than others with
respect to the provision of basic social services, or
with respect to literacy of the population, or income
distribution, or other factors, and yet they may have
relatively low GDPs per capita. These issues will be
explored at length in Chapter 7 and in Part 5 of this
book.
Test your understanding 1.10
Which country do you think is more
‘developed’: that with a higher GDP per capita
and low provision of social services (such as
health care services and sanitation), or that with
a lower GDP per capita and higher provision of
social services?
Sustainable development
Economic growth and economic development in
many countries are often achieved at the expense
of the natural environment and natural resources.
There may be growth in output, or there may be a
general improvement in the standard of living of the
population, but these very often result in increased air
and water pollution, and the destruction or depletion
of forests, wildlife and the ozone layer, among many
other natural resources. Growing awareness of this
1
Brundtland Commission (World Commission on Environment and
Development), Our Common Future (Oxford University Press, 1987).
10
Part 1: Introduction to Economics
issue in virtually all countries of the world has given
rise to the concept of sustainable development:
Sustainable development is defined as
‘development which meets the needs of the
present without compromising the ability of future
generations to meet their own needs’.1
What this says in effect is that as societies make efforts
to grow and develop, they should take care not to
leave behind fewer or lower quality resources available
for use by future generations.
The World Bank has expanded this definition to
mean growth and development that do not give rise
to environmental degradation, and which if possible
include improvements in environmental quality. Both
this and the previous definition suggest that there
are close interconnections between the economy and
the environment, and that growth and development
efforts in the present should take into account
the needs of future generations. This can only be
accomplished by pursuing activities that preserve
and even improve the quality of the natural
environment. Sustainable development will be
discussed in Chapters 6 and 19.
Test your understanding 1.11
Consider the following: ‘But just as the speed
and scale of China’s rise as an economic
power have no clear parallel in history, so its
pollution problem has shattered all precedents.
Environmental degradation is now so severe
that pollution poses not only a major long-term
burden on the Chinese public but also an acute
political challenge to the ruling Communist
Party’.
(a) In your opinion, is China achieving
sustainable development?
(b) What can you conclude about China’s rapid
economic growth and its impacts on future
generations?
(c) Why do you think the ruling party is being
challenged?
1.2 The production possibilities model
The production possibilities model is a simple model
of the economy illustrating the concepts of scarcity,
choice and opportunity cost, as well as the concept of
efficiency to be introduced in this section.
The production possibilities curve (frontier)
Introducing the production possibilities
curve
Let’s consider a very 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 1.1 shows the
combinations of the two goods that this economy
can produce with the resources and technology at its
disposal. Figure 1.2 plots the data of Table 1.1: the
quantity of microwave ovens is plotted on the vertical
axis, and the quantity of computers on the horizontal
axis.
Table 1.1
Combinations of microwave ovens and computers.
Point
Microwave ovens
Computers
A
40
0
B
35
17
C
26
25
D
15
31
E
0
33
40
A
B
35
microwave ovens
30
G
In order for the economy to produce the greatest
possible output, in other words somewhere on the
PPC, two conditions must be met:
· All resources must be fully employed: 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 is capable of
producing.
· All resources must be used efficiently: specifically, there
must be productive efficiency. The term ‘efficiency’
in a general sense means that resources are being
used in the best possible way. (If they are not used in
the best possible way, we say there is ‘inefficiency’.)
Productive efficiency 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 that could have been used
to produce something else instead, and it would not
be producing the maximum that it can produce.
C
25
20
F
15
The production possibilities curve (or frontier)
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 productive efficiency.
D
10
5
0
If all of the economy’s available resources are used to
produce microwave ovens, the economy will produce
40 microwave ovens and 0 computers, as shown by
point A. If on the other hand all resources are used
to produce computers, the economy will produce 33
computers and 0 microwave ovens; this is shown by
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. 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 production
possibilities curve (PPC) or production possibilities
frontier (PPF).
5
10
15
20 25
computers
Figure 1.2 Production possibilities curve.
E
30 35
40
What would happen if either of the two conditions
(full employment and productive 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.
Chapter 1: Fundamental concepts in Economics 11
Yet it has the resources and the technology to
increase production of both goods, by eliminating
unemployment of resources and/or using resources
more efficiently. If it uses its resources fully and
efficiently it could, for example, move to point C and
produce 26 microwave ovens and 25 computers. In
fact, as we will see in more detail in later chapters, in
the real world no economy ever produces on its PPC.
An economy’s actual output, 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 productive inefficiency. The greater the
unemployment or the productive inefficiency,
the further away is the point of production from
the PPC.
The production possibilities curve and
scarcity, choice and opportunity cost
The production possibilities model is very useful
for illustrating the concepts of scarcity, choice and
opportunity cost:
· The condition of scarcity does not allow the economy to
produce outside its PPC With its fixed quantity and
quality of resources and technology, the economy
cannot move to any point outside the PPC, such as
G, because it doesn’t have enough resources (there is
resource scarcity).
· The condition of scarcity forces the economy to make
a choice about what particular combination of goods
it wishes to produce Assuming it could achieve full
employment and productive efficiency, it must
decide at which particular point on the PPC it
wishes to produce. (In the real world, the choice
would involve a point inside the PPC.)
· The condition of scarcity means that choices involve
opportunity costs 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 necessarily 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
12
Part 1: Introduction to Economics
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 productive efficiency).
The shape of the production possibilities
curve
In Figure 1.3(a) the PPC’s shape is similar to that of
Figure 1.2, while in Figure 1.3(b) it is a straight line.
When the PPC bends outward and to the right, as in
panel (a), opportunity costs change as the economy
moves from one point on the PPF to another. In
Figure 1.3(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 specialization 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 will be
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 panel (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
specialized factors of production to produce them. As
we can see in Figure 1.3(b), for each additional unit of
volleyballs produced, the opportunity cost, or sacrifice
of basketballs, does not change.
(a) Increasing opportunity costs.
basketballs
microwave ovens
(b) Constant opportunity costs.
computers
volleyballs
Figure 1.3 Production possibilities curve with increasing and constant opportunity costs.
Test your understanding 1.12
1 Consider the production possibilities data
in Table 1.1 and Figure 1.2. If the economy
is initially at point A and moves to point B,
computer production will increase by 17 units.
(a) What is the opportunity cost of the increase
in computer production? (b) If the economy
moves from D to C, what will be the gain and
what will be its opportunity cost? (c) If it moves
from point C to B, what will be the gain and
what will be its opportunity cost?
2 Use the concept of opportunity cost to explain
why the following two statements have the
same meaning: (a) productive efficiency
means producing by use of the fewest possible
resources; (b) productive efficiency means
producing at the lowest possible cost.
3 (a) Distinguish between actual output and
output that occurs on the PPC. (b) Why is
an economy’s actual output most likely to be
located somewhere inside its PPC?
4 Say an economy is initially at point F, producing
15 microwave ovens and 12 computers
(Figure 1.2). 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?
5 Consider the statement, ‘The opportunity cost
of computers in terms of microwave ovens
depends on the quantity of each that is being
produced.’ Is this statement true or false? Explain
why. (Hint: consider the shape of the production
possibilities curve, and what this means.)
Shifts of the production possibilities curve
(frontier)
If the production possibilities curve shifts outward
and to the right, this means that there has occurred
an increase in the economy’s production possibilities,
or what the economy is capable of producing; the
economy has the possibility to produce more of both
goods (X and Y), as shown in Figure 1.4(a) (page 14).
An increase in production possibilities can result from
any of the following:
· an increase in the quantity of resources (factors of
production) in the economy; with more resources,
the economy can produce greater quantity of
output
· an improvement in resource quality; if the quality
of the resources improves (such as for example,
through more highly educated labour), then the
economy can produce more output
· a new and improved technology used to produce
the goods; improvements in technology, or
methods of production, allow the economy to
produce a greater amount of output.
An inward (leftward) shift represents a decrease in the
economy’s production possibilities, i.e. less of the two
goods can be produced, as shown in Figure 1.4(b). This
can result from a decrease in the quantity of resources,
deterioration in resource quality, or use of a less
productive technology.
6 If you were asked to draw a PPC illustrating the
possible choices between consuming two free
goods, what would you say?
Chapter 1: Fundamental concepts in Economics 13
(b) Decrease in production possibilities.
good Y
good Y
B
A
0
(c) Non-parallel shifts of the PPC.
good Y
(a) Increase in production possibilities.
PPC1
PPC2
good X
0
PPC2
PPC1
good X
0
PPC1
PPC2
good X
Figure 1.4 Shifts of the production possibilities curve.
An outward or inward shift need not be parallel, as
shown in Figure 1.4(c). For example, a technological
change favouring the production of one good
(good X) will increase the production of that
good proportionately more. Similarly, an influx of
unskilled workers into a country will result in a larger
proportionate increase in the production of goods
using relatively more unskilled labour.
Test your understanding 1.13
1 Can you think of two reasons why the model we
have been considering in this section is called
the ‘production possibilities’ model? (Hint:
consider (a) the necessity of making a choice,
and (b) the consequences of unemployment and
productive inefficiency.)
2 How would you illustrate each of the following
An outward shift of the PPC, or an increase in
production possibilities, may signify economic
growth, involving increases in the volume of output
produced over time, because the economy becomes
capable of producing more of both goods. By contrast,
an inward shift of the PPC may signify economic
contraction or negative economic growth, as the
economy’s production possibilities are reduced.
However, an increase in production possibilities only
means that the economy is capable of producing a
greater volume of output; it does not mean that the
economy will actually produce more output.
An economy’s actual output could, for example,
remain stuck at point A in Figure 1.4(a) even as the
PPC shifts from PPC1 to PPC2, though this is not
very likely. The most likely result of an increase in
production possibilities is that the economy’s actual
output will move from a point like A inside PPC1 to
point B inside PPC2, because of unemployment of
resources and some productive inefficiency. We will
examine these points more carefully in Chapter 7.
14
Part 1: Introduction to Economics
events by use of a PPC model? (Hint: remember
the difference between a shift of the PPC and a
movement from one point to another.)
(a) A violent conflict destroys a portion of a
country’s factories, machines and road
system.
(b) A nationwide public health campaign
improves the general level of health of the
population.
(c) There is an increase in unemployment of
resources.
(d) There is a widespread introduction of a new
technology of production.
(e) There is large emigration (departure) of
working age people to another country.
(f) There is an increase in the quantity of
capital goods.
(g) There is an improvement in the level of
education and skills of workers.
(h) There is an improvement in productive
efficiency.
3 We have studied two very different models,
both of which can illustrate economic growth:
the circular flow model and the production
possibilities model. Which of the two do you
think is better suited to explaining the causes
of economic growth? Why? Which of the two
offers a better illustration of the role of markets
in the economy?
Applications of the production possibilities
model
Economic growth, as you may remember, involves
an increase in the volume of output produced,
or an increase in volume of output produced per
person (per capita). Economic development involves
improvements in the general standard of living of the
population, which can come about from increased
provision of services such as health care, education,
clean water supplies and improved sanitation facilities.
Such services can collectively be termed ‘merit goods’
(they will be discussed in Chapter 6). The production
possibilities model can be used to illustrate an
economy’s choice between economic growth without
economic development, and economic growth with
economic development.
This is shown in Figure 1.5, where the vertical
axis measures industrial goods production and the
horizontal axis represents merit goods production.
Assume that a country is initially at point A on PPC1.
A rightward shift of its production possibilities frontier
to PPC2 shows an increase in production possibilities.
The country can choose to move to point B or point
C on PPC2. (We are assuming for simplicity that the
economy is producing at some point on its PPC.) Both
moves indicate that economic growth has occurred,
because in both cases the economy is capable of
producing a greater volume of output. Moving to
point B indicates growth without development,
because the country has chosen to use its increased
productive capacity to produce relatively more
industrial goods compared to merit goods. Moving to
point C shows growth with development, since the
country has made a choice to place a relatively greater
emphasis on the production of merit goods rather
than industrial goods.
Note that the production possibilities model can
illustrate that economic development is occurring
only with respect to increased merit goods production,
which is only one aspect of development. It cannot
illustrate other aspects of development (such as
poverty reduction, improved income distribution,
improved employment opportunities, and others to be
discussed in Chapter 7 and Part 5).
industrial goods
Economic growth and economic
development
B
C
A
D
0
PPC2
PPC1
merit goods
Figure 1.5 Economic growth and economic development.
Economics for the IB Diploma
Figure 1.5
Environmental
issues
Mac/eps/Illustrator Col s/s
The production
Text: Agendapossibilities model can be used
to illustrate
choices between any two competing
emcdesign
Studio:
& ZabranskyAs an example, we
or confl
ictingPeters
alternatives.
will consider choices that have impacts on the
environment. Consider the consequences of fishing
activities on marine resources. In Figure 1.6, the
vertical axis measures the size of the fish harvest in the
fishing industry, and the horizontal axis the quality
of marine resources. The greater the fish harvest, the
lower the quality of marine resources, i.e. the greater
the environmental damage (destruction of reefs,
lower survival of young fish, disruption of the marine
ecosystem and so on). On the other hand, efforts
to preserve the quality of marine resources, such as
moving from point A to B, involve restrictions on
fishing activities and a lower fish harvest.
A
fish harvest
The production possibilities model is a useful tool that
can be used to analyse numerous situations involving
choices between competing alternatives. The following
examples illustrate some of the kinds of choices faced
by economies.
0
B
quality of marine resources
Figure 1.6 Fishing and the quality of marine resources.
Economics for the IB Diploma
Figure 1.6
Mac/eps/Illustrator
Col s/s concepts in Economics
Chapter 1: Fundamental
Text: Agenda
emcdesign
Studio: Peters & Zabransky
15
Choices made by an economy in the present can affect
the position of its production possibilities curve in
the future. Consider two economies that we will call
Country A and Country B, with identical resources and
technologies in the present, and therefore identical
PPCs; these are shown as PPCp in Figure 1.7 for both
Country A and Country B. Each country must make
a choice in the present concerning what quantity of
consumer goods and what quantity of capital goods to
produce, that is, each must choose where it wants to
be on its PPCp. Consumer goods are goods purchased
by consumers that satisfy immediate needs and
wants; they represent consumption in the present (for
example, food, clothing, books, DVD players, cars and
so on). Capital goods, as we know from Section 1.1,
are one of the factors of production; they are the one
factor that is man-made or produced, and includes
factories, machines, tools, buildings, airports and so on.
Country A chooses to produce relatively more
consumer goods in the present (point X), while
Country B chooses to produce relatively more capital
goods in the present (point Y). What will be the future
consequences of each country’s present choice? PPCf,
showing the future PPC for both countries, indicates
that Country B expects to experience a larger PPC
shift. Why is this so? Remember from our earlier
discussion on shifts in the PPC that any increase in the
quantity of a factor of production leads to an outward
shift of this curve, and therefore an increase in the
economy’s production possibilities. Country B expects
a larger shift because it accumulates a larger quantity
of capital goods, thus increasing its production
possibilities relatively more than Country A. Country
B’s larger PPC shift in the future PPC means that it has
possibilities to experience greater economic growth
than country A.
16
Part 1: Introduction to Economics
Country A
consumer goods
Present choices and future growth
possibilities
(In Part 5, we will discover that a number of countries
in the 1950s and 1960s tried to achieve rapid
economic growth by accumulating large quantities
of capital goods; however they were not as successful
in actually achieving high rates of economic growth
as was hoped. We will study their experiences more
carefully in Chapter 17.).
X
PPCp
0
PPCf
capital goods
Country B
consumer goods
Societies must therefore make a choice between the
two conflicting objectives: greater fish harvest or
maintenance of marine resource quality. Each of these
has an opportunity cost: sacrificed fish harvest is the
opportunity cost of marine resource preservation.
Sacrificed marine resource quality (including young
fish survival, reef preservation and so on) is the
opportunity cost of greater than sustainable fishing
activities. Note that marine source quality conflicts
with the size of the fish harvest (the more there is of
one, the less there is of the other) because of resource
scarcity. If resources were not scarce, it would be
possible to fish any quantity of fish, and there would
be no damage to the quality of the environment.
0
Y
PPCp
PPCf
capital goods
Figure 1.7 Present choices and future growth.
1.3 Basic economic questions, rationing
systems and the mixed market
economy
Three basic economic questions: resource
allocation and output/income distribution
Scarcity forces every economy in the world, regardless
of its form of organization or its level of economic
development, to address three basic questions:
· What to produce: all economies must choose what
particular goods and services and what quantities of
these they wish to produce.
· How to produce: all economies must make choices
on how to use their resources in order to produce
goods and services. Goods and services can be
produced by use of different combinations of factors
of production (for example, relatively more labour
with less capital, or relatively more capital with less
labour), by using different skill levels of labour, and
by using different technologies.
· For whom to produce: all economies must make
choices about how the goods and services produced
are to be distributed among the population. Should
everyone 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 equally?
The first two of these questions, what to produce and
how to produce, are about resource allocation, while
the third is about the distribution of income (or
output). Let’s see what these mean.
Resource allocation refers to assigning available
resources, or factors of production, to specific
uses chosen among many possible and competing
alternatives, and involves answering the what to
produce and how to produce questions.
When an economy makes a choice about what
goods and services to produce, it is also making
a decision to assign resources to the production
of those goods and services. Consider an example
provided by the production possibilities model in
Table 1.1 and Figure 1.2. If the economy is initially at
point B, it has allocated all its resources to produce
35 microwave ovens and 17 computers. If it wants
to move to point C, where it reduces microwave
oven production to 26 units and increases computer
production to 25 units, it must take some resources
out of microwave oven production and move them
into computer production; this is called a reallocation
of resources: the economy has reassigned resources to
the production of a different combination of the two
goods. If the economy assigns too many resources to
the production of a good or service relative to what
is socially desirable, in other words if too much of a
good or service is produced, this is referred to as an
overallocation of resources to the good or service.
If too few resources are assigned to what is socially
desirable, there is an underallocation of resources to
the good or service.
When the economy makes a choice about how
to produce its goods and services, it is making a
decision about which particular resources and in what
quantities these are to be assigned to the production
of the goods and services; in other words, it is once
again allocating types and quantities of resources
to its production. Here, too, if a decision is made to
change the particular combinations and quantities of
resources used in producing goods and services, there
will result a reallocation of resources.
The distribution of income (or output) is
concerned with how much income different
individuals or different groups in the population will
receive, and involves answering the for whom to
produce question.
The distribution of income and of output may be
considered together because the amount of goods and
services that households can have is closely related
to what they are able to buy, which in turn is related
to their income level. You can see this in the circular
flow model (Figure 1.1), where households receive
income by selling the factors of production they own,
and use this income to buy goods and services. When
the distribution of income or output changes so that
different social groups now receive more, or less,
income and output than previously, this is referred to
as redistribution.
In the real world the situation is more complicated
because governments (not shown in the simple
circular flow model) often intervene in the economy
to influence both the allocation of resources and the
distribution of income and output. We will study the
role of governments in later chapters.
Test your understanding 1.14
1 What are the three basic economic questions
that must be addressed by any economy?
2 Explain the relationship between the three
basic economic questions, and the allocation
of resources and the distribution of income or
output.
(...continued)
Chapter 1: Fundamental concepts in Economics 17
Test your understanding 1.14
(...continued)
3 Consider the following, and identify each one
as referring to output/income distribution
or redistribution; or to resource allocation,
reallocation, overallocation or underallocation
(note that there may be more than one answer):
(a) Evidence suggests that over the last two
decades in many countries around the
world the rich are getting richer and the
poor are getting poorer.
(b) In Brazil, the richest 10% of the population
receive 48% of total income.
(c) Whereas rich countries typically spend
8–12% of their GDP on providing health
care services to their populations, many
poor countries spend as little as 2–3% of
GDP.
(d) Many developing countries devote a
significant proportion of their government
budget funds for education to spending
on university level education, while a
substantial proportion of their population
remains illiterate.
(e) If countries around the world spent less
on defence, they would be in a position
to expand provision of social services,
including health care and education.
(f) Pharmaceutical companies spend most
of their research funds on developing
medicines to treat diseases that are
common in rich countries, while ignoring
the treatment of diseases that are common
in poor countries.
How the basic economic questions are
answered by market and centrally planned
(command) economies
Countries around the world differ enormously in the
ways they make allocation and distribution decisions.
At the heart of their differences lie the methods
used to make and coordinate the choices demanded
by the what, how and for whom questions. There
are two main methods that can be used to make
and coordinate choices: the market (also known as
‘free market’) method and the central planning (or
command) method.
These two methods can be thought of as two ‘ideal
types’ of economies. An ‘ideal type’ is an abstract idea
that does not claim to represent the real world, but
18
Part 1: Introduction to Economics
rather contains some characteristics that serve as a
standard for comparison of real-world situations. (Note
that an ideal type is not ‘ideal’ in the sense of perfect
or excellent.) No actual economy is or ever was a pure
market or pure centrally planned (command) type of
economy. Real-world economies combine markets and
commands in many different ways, and each country
is unique in the ways they combine them.
The ideal-type market and centrally planned
(command) economies are distinguished from each
other on the basis of three criteria:
· Resource ownership: public or private sector Ownership
of society’s resources can be ‘public’ or ‘private’.
The public sector refers to the parts of the
economy 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 economy that are under the ownership of
private individuals or groups of individuals; these
include consumers (households), firms (businesses)
and resource owners, as well as organizations such
as NGOs (non-governmental organizations) and
interest groups (for example, consumer protection
organizations). The market economy has private
sector resource ownership, and the centrally
planned (command) economy has public sector
resource ownership.
· Economic decision-making Economic decisions and
choices regarding the what, how and for whom
questions can be made by the public sector, i.e.
the government, or by the private sector. There
many private decision-makers, as noted above,
but the most important of these are consumers
(households), firms (businesses) and resource
owners. The market economy has private sector
economic decision-making and the centrally
planned (command) economy has public sector
economic decision-making.
· Rationing systems The term rationing can be
defined as a method used to apportion or divide
something up between its interested users. In
Economics it refers to the method used to make
resource allocation and output/income distribution
decisions. There are two categories of rationing
systems: price rationing and non-price rationing:
❍
The market economy 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 centrally planned (command) economy
uses non-price rationing to make resource
allocation and output/income distribution
decisions. This means that all decisions relating
to what will be produced, how it will be produced
and who will receive the output are made by 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 authority and
makes economic decisions by commands.
Both price rationing and non-price rationing will
become much clearer to you after you have studied
Chapter 2.
The market economy is illustrated by the circular flow
model (Figure 1.1). This model shows households and
firms (the private sector) to be owners of resources, as
well as economic decision-makers who make buying
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 centrally planned (command) economy is
characterized by the absence of markets or the limited
operation of markets. As owner of resources and
economic decision-maker, the government makes all
allocation and distribution decisions through nonprice rationing. This is called a ‘centrally planned’
economy because the government bases all economic
decisions on economic plans. It is also known as
a ‘command’ economy because the government
authority directs and coordinates economic decisions
through commands.
In the real world, virtually all economies combine
elements of both markets and commands. Differences
between actual economies lie mainly in the ways the
two are combined and in the degrees to which one
Table 1.2
predominates. For this reason, most economies in the
world today are called mixed economies. Over the
past 30 or so years, most economies around the world
have been basing their economies increasingly on
the market, and correspondingly less on commands.
Countries that tend to rely relatively more on the
market are called mixed market economies. Table 1.2
provides a summary of the three criteria as they apply
to each type of economy.
The market economy, also known as free
market economy is based on private ownership
of resources and private decision-making, and relies
on prices determined in free markets and price
rationing to coordinate choices that allocate resources
and distribute income/output. The centrally
planned economy based on central planning
(or commands) is based on government (public)
ownership of resources and government decisionmaking, and relies on commands and non-price
rationing techniques to coordinate choices that
allocate resources and distribute income/output.
The mixed economy relies on a mix of public and
private resource ownership and decision-making, and
price and non-price rationing.
Characteristics of market and centrally
planned (command) economies
(You may find that some of the concepts and ideas
introduced in the remaining part of this chapter are
difficult to understand at this point. However, they
will become very clear to you after you have read
Chapters 2, 3 and 6 on Microeconomics. You will
therefore be reminded to reread and review this part of
the chapter after you have completed Chapter 6.)
Table 1.3 (page 20) uses the same criteria as in Table
1.2 to show the main characteristics of the two idealtype economies in greater detail.
Market, centrally planned (command) and mixed economies.
Criteria
Market economy
Centrally planned
(command) economy
Mixed economy and mixed
market economy
Resource ownership
private sector
public sector
public and private sectors
Economic decision-making
private sector
public sector
public and private sectors
Rationing system
price rationing
non-price rationing
price rationing and non-price
rationing
Chapter 1: Fundamental concepts in Economics 19
Table 1.3
Characteristics of market and command economies.
Criteria
Market economy
Centrally planned (command) economy
Resource
ownership (land
and capital)
Land and capital resources are privately owned (by
consumers and firms); the institution of private
property is established and enforced by the
government.
Land and capital resources are publicly owned (by
the government, or state). The institution of private
property is limited.
Economic
decision-making
Key decision-makers are consumers, firms and
resource owners, all acting in their best self-interest.
Consumers maximize the satisfaction (utility) they
get from buying goods and services, firms maximize
profits, and owners of resources maximize the
income they get from selling their resources: for
example, workers try to maximize wages, owners of
capital maximize interest income, and so on.
All decision-makers have freedom of choice. Firms
are free to use whatever production method
they prefer, and produce and sell whatever good
or service they believe will be most profitable.
Consumers are free to buy those goods and services
that will best satisfy their needs and wants, workers
are free to work at whatever job they prefer, and so
on.
Government planning bodies are the sole decisionmakers. They engage in central planning (also known
state planning). All economic activities are based
on a ‘central plan’ made by the government, that
sets out the economy’s production activities and
makes detailed decisions on what and how much of
each good and service will be produced, and what
resources will be used for production.
Freedom of choice is limited: consumers have some
limited choice, but there is no possibility of choice
by firms and resource (land and capital) owners as
firms and resources are government owned and
managed.
Rationing system
Price rationing is used to ration (apportion)
all resources, goods and services among their
alternative uses.
Prices of all goods, services and resources are
determined in markets.
Prices determined in markets provide all the
information to firms, consumers and resource
owners that is necessary to guide them in their
buying and selling decisions; prices act as signals and
incentives.
Non-price rationing is used to ration (apportion)
all resources, goods and services among their
alternative uses.
Markets and market-determined prices do not exist.
Prices of all goods, services and resources are set
administratively by the government in its central
plan through the command mechanism; these prices
do not act as signals and incentives.
Rationing system
and resource
allocation:
answering the
what and how to
produce questions
Resource allocation is accomplished by price
rationing. Prices established in markets determine
what goods and services will be produced, and
how goods and services will be produced, in other
words by use of what combinations of resources and
technologies.
Resource allocation is accomplished through
non-price rationing. The government’s central plan
determines what goods and services to produce,
as well how to produce (i.e. using what resource
combinations) by use of commands.
Rationing system
and income
distribution:
answering the for
whom question
Income distribution is also accomplished by price
rationing. There are two aspects to this. (i) Prices
established in resource markets determine the
payments that resource owners will receive (i.e. their
income) in exchange for providing their resources
to the production process (i.e. owners of labour
resources receive wages, owners of capital resources
receive interest, etc.). The resource owners use
the income they receive to purchase goods and
services. (ii) Prices established in product markets
determine how much of each good and service will
be purchased by individuals: if an individual is willing
and able to pay the price in order to buy a good, she
or he will get the good.
Income distribution is also accomplished by nonprice rationing. There are two aspects to this. (i)
Incomes are administratively determined for each
worker and paid by the government, who is the
sole employer. (ii) Goods and services (all of which
are produced by government enterprises) are
distributed most commonly by means of waiting in
line (a queue), which works on the first come, first
served principle (those who come last don’t get the
good if it is sold out). Goods that are considered
to be important for the satisfaction of basic needs
(such as staple foods, essential clothing) may be
assigned a low price, whereas luxury goods are
likely to be assigned a high price. Certain goods and
services that are considered to be socially desirable
are provided free of charge (such as education and
health care).
20
Part 1: Introduction to Economics
Test your understanding 1.15
1 What are the basic economic questions that
must be answered by (a) free market economies;
(b) centrally planned economies; (c) mixed
economies?
· Promotion of efficiency The operation of the invisible
hand means that the free and self-interested
behaviour of economic decision-makers linked
together through markets improves society’s welfare
by promoting economic efficiency. The market
mechanism results in two types of efficiency:
❍
2 Use the criteria appearing in Table 1.3 to
compare and contrast the main characteristics
of the market and centrally planned economies.
3 Differences in resource ownership between
market and centrally planned economies
refer only to ‘land’ and ‘capital’. Why do
you think labour and entrepreneurship are
excluded? (Hint: is it possible for labour and
entrepreneurship to be publicly owned?)
4 Why is the command economy also referred to
as a centrally planned economy?
5 Compare and contrast the methods by which
allocation and distribution choices are made
in the market economy and the centrally
planned economy.
❍
Productive efficiency (that we defined in connection
with the production possibilities model) means
that output is produced by use of the fewest
possible resources (or at the lowest possible cost).
When productive efficiency is achieved, the how
to produce question is answered in the best
possible way from society’s point of view, because
there is no waste of resources.
Allocative efficiency means that resources are being
used to produce those goods and services that
are mostly wanted by society. When allocative
efficiency is achieved, the what to produce
question is answered in the best possible way,
because resources are used to produce those goods
and services that result in the greatest possible
benefits for consumers.
6 (a) Define and explain the difference between
price rationing and non-price rationing.
(b) What are the functions of these two
rationing mechanisms? (c) In what kind of
economic system does each one predominate?
When there is both productive and allocative
efficiency, an economy achieves the best possible
allocation of resources, as it answers both the what
to produce and the how to produce questions in the
best possible way from the point of view of what is
in society’s best interests.
Evaluating the market economy
Key advantages
The key advantages of the market economy include
the following:
· Systematic and automatic coordination of individual
decisions: the invisible hand of the market The
market economy gives rise to a systematic and
automatic coordination of innumerable individual
decisions in the absence of any central authority.
In the free market system, the decisions of
individual consumers, firms and resource owners
are coordinated through their interactions in
resource and product markets. There is no one
managing or coordinating these decisions; the
system is decentralized, and markets themselves
are the organizing principle of the economy. This
mechanism was termed ‘the invisible hand’ of
markets by one of the earliest economists, Adam
Smith, in the 18th century.
· The pursuit of self-interest provides incentives that
promote economic growth When all private decisionmakers (consumers, firms and resource owners)
make decisions on the basis of what they believe to
be in their best self-interest (as explained in Table
1.3), this gives rise to incentives for hard work, risktaking and innovation, which lead to higher levels
of output and improved levels of living. The market
system may therefore promote general welfare by
advancing economic growth.
Key limitations
As noted earlier, the market mechanism is an ideal
type that does not and cannot ever exist in the real
world. The advantages noted above can only be
realized under some very strict conditions that are
never met in the real world. In the absence of these
conditions, the market fails to achieve the socially
desirable objectives listed above. The reasons are that:
Chapter 1: Fundamental concepts in Economics 21
· The market can fail to provide certain goods that
are desirable, or can result in the production of
some goods in smaller quantities than are socially
desirable.
· The market can end up producing certain activities
that are socially undesirable (such as the polluting
activities of many firms).
· Large producers/sellers can limit competition, and
produce less output at higher cost, and sell this
output at higher prices than are socially desirable.
· The market is unable to deal effectively with the
issues of unemployment, inflation and economic
growth and development.
· People in vulnerable social groups may receive very
low or no income if they have few or no resources
to sell, or if they are unable to work (i.e. sell their
labour).
· The market cannot operate effectively without a
strong institutional and legal framework that must
be established and enforced by the government,
such as, for example, the institution of private
property and property rights.
Because of these shortcomings, governments
intervene in the market with various policies in order
to improve outcomes in favour of society’s general
welfare. We therefore never see a free market economy
operating in the pure form described above. All the
problems listed here require some form of government
intervention that we will study in later chapters.
Test your understanding 1.16
1 Explain the role of the invisible hand in a market
economy.
2 What is the relationship between allocative and
productive efficiency and resource allocation?
3 Explain the main advantages of the market
economy.
4 Why has there never existed a pure free market
economy in the real world?
Evaluating the centrally planned (command)
economy
The centrally planned or command economy as an
ideal type described above has never existed in the
real world; however, it was approximated during the
20th century by communist countries, which relied
22
Part 1: Introduction to Economics
heavily on central planning of most of their economic
activities. Also, many non-communist less developed
countries adopted some elements of central planning
in the 1950s–1970s in the belief that this would
promote more rapid growth and development (among
them, India, Egypt and many countries in Africa).
The development of central planning historically
was prompted in part by a recognition of the
disadvantages of markets, noted above, which tend to
be even more pronounced in less developed countries.
It was also associated with the ideological principle
that the institution of private property goes against
the interests of the broader population. It was believed
that certain objectives such as rapid economic growth
and development would be better served through
direct administration and government planning of
economic activities. Another important objective was
poverty alleviation through a more equal distribution
of income, as well as provision by the government
of important social services (health care, education)
that would be widely distributed throughout the
population.
However, centrally planned economies have run into
serious difficulties:
· highly inefficient use of resources (productive
inefficiency), due to the extreme technical
difficulties involved in central planning of all
economic activities, and its dependence on very
detailed information – essential for planning
economic activities but not readily available
· absence of incentives for producers since they do
not own resources (land and capital) and have no
price system on which they can base their decisions
· excessive bureaucracy that interferes with achieving
economic objectives effectively
· goods and services produced are unlikely to reflect
society’s preferences as planners do not base
their output decisions on what consumers want
(allocative inefficiency)
· limited variety in the goods and services produced
(allocative inefficiency)
· limited freedom of choice for all non-governmental
economic decision-makers (consumers, producers).
There remain very few countries in the world today
that are still highly centrally planned; these include
North Korea, and to a lesser extent Cuba; most others
have begun to introduce major reforms intended to
strengthen the role of markets.
Test your understanding 1.17
1 What are the main limitations of the centrally
planned economy?
2 What do you think are some of the advantages
that market economies have over planned
economies and central planning of most
economic activities?
The mixed market economy
Virtually all economies are mixed economies, but
increasingly, economies in the world today are
becoming mixed market economies, strongly based
on the market system, with varying degrees and types
of government involvement. There is a mix of private
and public sector ownership and decision-making,
and a mix of price and non-price rationing systems,
but a significant portion of economic activity is
based on the market mechanism with price rationing
playing a more important role in determining
resource allocation and income distribution.
In mixed market economies, public or private sector
ownership and decision-making often go together; for
example, privately owned firms usually make decisions
about what and how they will produce and sell, while
the government makes decisions about economic
activities that fall under its ownership (such as or
public health services, public road systems, public
parks, defence facilities and many others).
However, the government’s decision-making role
in the mixed market economy is not limited to
activities falling under its ownership; it also extends
into private sector activities. For example, the United
States, one of more market-oriented countries in
the world, has a government presence in the form
of government decision-making that affects the
workings of the private sector in such diverse areas as
minimum wage legislation, subsidies for agricultural
products, restrictions on imports, regulation of
private sector activities, anti-monopoly legislation,
tax collection, income redistribution and many
others. All mixed market economies in fact have
government involvement with the private sector that
arises either as a response to the failure of the pure
market mechanism to work well for the reasons noted
earlier, or in response to the demands of politically
powerful interest groups. We will examine government
intervention in the market for both these sets of
reasons extensively in later chapters.
Government involvement in the private sector varies
widely from country to country in extensiveness. For
example, the free market plays a more prominent role
in the United Kingdom and the United States than in
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, Norway 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.
It is important to note that whatever the reasons for
and types of government intervention in the market,
government intervention changes the allocation of
resources and distribution of income and output from
what the market system working on its own would
have achieved.
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 systems, public
road systems and flood control, they do not rely 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 systems, where the government,
through tax financing, undertakes to provide health
care services that are made available to the entire
population free (or nearly free) of charge. Since there
is no price charged to the consumer who receives a
service, some mechanism other than price, i.e. nonprice rationing, must be used to distribute the service
among its users. The most commonly used non-price
mechanism is waiting in line or a waiting period (i.e.
queues).
There have been significant changes over time in the
relative prominence of private versus public sector
activities. During much of the 20th century, many
Chapter 1: Fundamental concepts in Economics 23
countries throughout the world saw significant
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 many 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 popularity
of supply-side economic policies (to be discussed in
Chapters 9 and 17), as well as a recognition of the
limitations of central planning. In China and former
communist countries whose economies used to be
strongly based on central planning, a deliberate choice
was made to move away from planning and towards
a mixed market economy; these economies are called
‘economies in transition’ and will be the topic of the
next section.
Test your understanding 1.18
1 How do mixed market economies differ from
(a) pure market economies and (b) mixed
economies?
Eastern Europe and the former Soviet
Union
Measures designed to achieve a very rapid transition
to a market system have been termed ‘shock therapy’,
and include the following key reforms:
· privatization of state enterprises (firms) and
government property in many areas, including
manufacturing, agriculture, services and housing;
privatization involves the transfer of ownership
from the public sector to the private sector
· reform of the price system, consisting of freeing of
prices so that they become more responsive to
the forces of demand and supply; this involves a
transition from methods of non-price rationing to
price rationing
· promotion of competition by breaking up large state
monopolies; this involves the break-up of large
government-owned firms, or state monopolies, into
a number of smaller privately owned firms that
compete with each other
· opening trade and finance to the international
economy; under central planning countries were for
the most part cut off from the global economy.
2 Can you provide some examples of command
practices in mixed market economies?
3 Why do you think most economies in the world
today are mixed market economies?
Economies in transition: moving towards the
mixed market
The term economy in transition refers to
any country that is making the transition from a
predominantly centrally planned economy towards
a mixed market economy, as for example after the
collapse of communist regimes in eastern Europe and
the former Soviet Union in 1989–90. The countries
in this group include the ones that emerged after the
break-up of the Soviet Union (15) and Yugoslavia (7),
plus the countries of eastern Europe that experienced
a transition to democratic regimes. China, also a
transition economy, has taken a different route by
choosing to introduce market reforms gradually under
the strong direction of its Communist Party.
24
Part 1: Introduction to Economics
The experiences of the various economies in transition
have been highly diverse with respect to how far
they have progressed with these reforms, as well as in
the degree of their success. In the early years many
encountered severe difficulties due to hyperinflation
(very high rates of inflation, or rapid increases in the
general price level) that emerged from the freeing
of prices, and very significant drops in incomes and
output (negative growth over a period of several
years). This followed from the bankruptcy of many
government enterprises because of their inability to
compete in the new environment, rapidly growing
unemployment, the break-up of trade relationships
with former communist-block trade partners and a
highly uncertain environment for economic activity.
In addition, many problems arose from the absence of
appropriate legislative and regulatory measures for the
smooth operation of private sector activities.
Many countries, particularly in eastern Europe, have
succeeded in resolving most of the difficulties, and
are on the road to developing strong mixed market
economies (for example, Czech Republic, Estonia,
Latvia, Lithuania, Hungary, Poland, Slovenia and
others) while some other countries are progressing
more slowly.
China
In contrast to the rapid reforms undertaken by the
countries of the former Soviet Union and eastern
Europe, China has pursued a more gradual approach
to reform, occurring in several steps:
· Reform of agriculture Beginning in 1978, agricultural
reform consisted of abolishing the commune
system. Under the commune system, farmers had to
sell all their output to the government at low fixed
prices. Since their income depended on the overall
commune output and not on the output produced
by each individual farmer, the system deprived
farmers of the incentive to work harder and increase
output. The commune system was replaced by
farming on individual leased plots of land, with
the right to sell a portion of agricultural output in
markets; this gave an enormous boost to agricultural
production.
· Freedom of farmers to leave the farm Since the
1980s, farmers have been permitted to seek work
in township and village industrial enterprises,
providing a boost to the industrial sector that used
labour-intensive production techniques (the term
‘labour intensive’ refers to production methods that
use a relatively large proportion of labour compared
to other factors of production. We will return to this
concept in Chapter 15).
· Establishment of special economic zones or special
free-trade zones Beginning in the 1980s, private
ownership, foreign investment and international
trade were permitted in special economic zones
established for this purpose; this marked the
beginning of China’s boom in exports of textiles,
clothing, footwear, toys and plastics.
· Greater freedom granted to state-owned enterprises
Beginning in the 1980s, state-owned enterprises
were permitted to determine what quantities
of output to produce, to make decisions on
employment, to sell a portion of output in markets,
and to retain a large portion of profits (as opposed
to the previous practice of transferring their profits
to the central government); while granting state
enterprises greater authority, this reform has stopped
short of privatizing them.
China has attracted a deal of attention around the
world, because it has succeeded in achieving very
rapid economic growth over many years. However,
the Chinese economy is not without problems, which
include:
· Incomplete property rights Property rights (or
ownership rights) are the rights of an owner over
property, and are established by law. If there are
no clear property rights, a market economy cannot
function properly as there is uncertainty and risk
associated with undertaking activities relating to the
‘property’. For example, it is risky to build a house
or a factory on a piece of land whose ownership has
not been legally secured.
· Financial indebtedness of state-owned enterprises Many
government-owned enterprises operate inefficiently
and have contributed to a huge government debt
that some fear may lead to a financial crisis.
· Periodic inflation The Chinese economy every now
and then experiences high rates of inflation (a
rapidly rising general price level).
· Lack of integration in the global economy The
Chinese economy is not yet fully integrated in the
international finance system.
· Uneven economic growth and development by
geographical region Some regions experience far
greater economic growth and development while
other regions lag significantly behind; this is a
serious problem as the benefits of growth and
development are not shared equally throughout the
population.
· Serious environmental degradation China’s growth is
environmentally unsustainable; it is occurring at
the expense of the natural environment, which has
been severely neglected by the public sector (the
government) and the private sector.
Test your understanding 1.19
1 (a) What are ‘economies in transition’?
(b) What are their economic objectives and
what principal reforms are they pursuing?
2 Based on the experiences of transition
economies, what are some of the problems
that can be encountered when moving from a
centrally planned to a mixed market economy?
3 What are some of the ways that China’s
approach to transition differs from the approach
followed by eastern Europe and the former
Soviet Union?
4 Why do you think secure property rights are an
important feature of a mixed market economy?
Chapter 1: Fundamental concepts in Economics 25
Questions for
review
1.1
[10 marks] (a) It has been said that if there were
no scarcity, there would be no social science of
economics. Do you agree with this statement?
Explain why or why not. (b) Using examples,
explain the fundamental problem of Economics.
1.2
[15 marks] Assuming that a simple hypothetical
economy produces two goods, use appropriate
diagrams to answer the following: (a) How
likely is it that the economy’s actual output
will be located at some point on its production
possibilities curve? Explain. (b) If the economy
produces at a point inside the curve, what must it
do if it wants to increase its actual production of
both goods? (Use the concepts of full employment
and productive efficiency in your answer.)
(c) What is the opportunity cost of moving from a
point inside the PPC to a point closer to the PPC?
(d) What is the opportunity cost of moving from
one point on the PPC to another point on the
PPC? (e) Explain why your answers to questions
(c) and (d) are different. (f) Can the economy
produce at a point outside its PPC? Why or why
not?
1.3
[10 marks] Define opportunity cost, and use the
production possibilities model to explain how it is
related to the concepts of scarcity and choice.
1.4
[10 marks] Do you think the production
possibilities model can be useful in explaining the
concept of a free good? Explain why or why not.
1.5
[10 marks] A hypothetical country discovers oil
within its territory. (a) Show the impact of this
discovery diagrammatically using the production
possibilities model. (b) Using your diagram of
part (a), show the possible choices that can be
made between (i) growth without economic
development, (ii) growth with economic
development.
1.6
[10 marks] A number of countries (such as the
former Soviet Union and India) during the 1950s
and 1960s directed a relatively large proportion
of their resources to heavy industries involved in
capital goods production, while they tended to
neglect consumer goods production. Explain
the reasoning behind their choice by use of the
production possibilities model.
26
Part 1: Introduction to Economics
1.7
[20 marks] (a) What are the three basic economic
questions that must be answered by all economies
regardless of their form of organization?
(b) Explain the concepts of resource allocation
and income/output distribution. (c) How
do resource allocation and income/output
distribution relate to the three basic economic
questions? (d) Compare and contrast how
resource allocation and output/income
distribution are achieved in market and centrally
planned economies.
Part 2
Microeconomics
Microeconomics is concerned with the behaviour of consumers,
firms and resource owners, who are the most important economic
decision-makers in a market economy. We will study the model
of demand and supply, which forms the basis of the market
economy and is one of the most important analytical tools in
microeconomics. We will learn about the benefits of free markets,
and we will also examine some of their imperfections. We will also
examine the role of governments in a variety of situations. We will
see what effects governments have when they interfere in markets,
as well as how they can help achieve better social outcomes when
markets fail to perform well.
In addition, Part 2 will also be concerned with market or
industry structures (at higher level). We will learn about a variety
of ways in which real-world industries are organized, and their
advantages and disadvantages from the perspectives of consumers,
firms and societies.
The tools that we will develop in microeconomics are very
important, because they provide many insights into the workings
of the market economy, and into the effects of different types
of government intervention. But, in addition, these tools are
important because they form the basis of additional topics that
we will study in later parts of this book, particularly in the area of
international economics.
Chapter 2
Microeconomics
Markets
In this chapter we examine what lies at the heart of every market-based economy: the forces of demand
and supply. We will also study what happens in an economy when governments interfere with these forces.
OBJECTIVES
After studying this chapter you should be able to:
·
·
·
·
·
·
·
·
·
·
explain the basic differences between the four different market structures
explain the factors that influence demand
identify exceptions to the law of demand (higher level topic)
explain the factors that influence supply
understand the behaviour of buyers and sellers, and explain how demand and supply interact in competitive
markets to determine equilibrium price and quantity
analyse the effects of changes in demand and supply and predict changes in equilibrium prices and quantities
explain the rationing function of prices in competitive markets, and their role in resource allocation and output/
income distribution
explain the significance of allocative and productive efficiency in the market economy
analyse the consequences of price ceilings and price floors
analyse how buffer stock schemes are intended to work.
2.1 Introduction to markets and
market structures
Markets
A market originally was a place where people gathered
to buy and sell goods. Such markets still exist today,
for example cattle markets, fish markets, fruit and
vegetable markets, flea markets, involving a physical
meeting place where buyers and sellers meet face to
face.
The term market has since evolved to include any
kind of arrangement where buyers and sellers of a
particular good, service or resource are linked together
to carry out an exchange.
The market may be in a specific place (such as a
vegetable market), or it may involve many different
28
Part 2: Microeconomics
places (such as the oil market). Buyers and sellers
may meet (say, in a shop), or they may never meet,
communicating by fax, phone, internet, classified ads,
or any other method which allows them to convey
information about price, quantity and quality.
A market can be local, where the buyers and sellers
originate from a local area; it may be national, in
which case the buyers and sellers are from anywhere
within a country; or it may be international, with
buyers and sellers from anywhere in the world. For
example, small neighbourhood bakeries produce
and sell bread and other baked goods for the local
community – this is a local market. Local takeaway
restaurants also produce for the local market. The
labour market, on the other hand, tends to be mostly
a national market. By contrast, the world oil market
includes oil producers in different countries, and
buyers of oil virtually everywhere in the world, as
well as wholesalers, retailers and other intermediaries
involved in buying and selling oil around the world.
Goods and services are sold in product markets,
while resources (or factors of production) are sold in
resource markets (or factor markets). As we know
from the circular flow model (Chapter 1, page 6),
households (or consumers) are buyers of goods and
services in product markets and sellers of factors of
production in resource markets; firms (or businesses)
are buyers of factors of production in resource markets
and sellers of goods and services in product markets.
· how easy or difficult it is for new firms to enter the
industry and begin producing, which depends on
the degree to which there are barriers to entry in
the industry; barriers to entry include anything that
can prevent a firm from entering an industry and
beginning production.
Perfect competition (or pure competition)
Test your understanding 2.1
Perfect competition has the following
characteristics:
1 What is a market?
· There is a very large number of firms in the industry.
· Each firm has no control over the price at which
2 Can you think of more examples of local,
national and international markets?
Firms, industries and market structures
A firm (or business) is an organization that
employs factors of production to produce and sell
a good or service. A group of one or more firms
producing identical or similar products (goods or
services) is called an industry. For example, the car
industry consists of a number of firms that are car
manufacturers (Ford, Honda, Mercedes, etc.); the shoe
industry consists of firms that are shoe manufacturers;
the banking industry consists of firms that provide
banking services (banks); the agricultural industry
consists of firms that produce agricultural products
(farms). There are many kinds of industries with
various characteristics, which economists analyse by
use of models called market structures. A market
structure describes characteristics of a market
organization that determine the behaviour of firms
within an industry. There are four market structures
identified by economists:
· perfect competition (also known as pure
competition)
· monopoly
· monopolistic competition
· oligopoly.
Market structures can be defined on the basis of four
main characteristics:
· the number of firms in the industry
· the ability of the firm to control the price at which
the good is sold in the market
· the type of product, in particular how similar or
different are the goods or services produced by firms
in the industry
it sells its product; because of the large number of
firms, each firm’s output is a very small fraction
of the total output of the industry so it cannot
influence price.
· All the firms in the industry sell a standardized
or identical (undifferentiated) product; from the
consumers’ point of view it makes no difference
from which firm they buy the product, as it is
exactly the same in all firms; there are no brand
names.
· There are no barriers to entry into the industry; any
firm that would like to enter the industry and begin
producing and selling the good or service can do so
freely.
Examples of perfect competition include the
international markets for agricultural commodities
such as wheat, rice, corn and livestock, other
commodities like silver and gold, stock and bond
markets, and the foreign exchange market (in which
currencies of different countries are bought and sold).
In all these cases, each firm is so small relative to the
total number of firms that it is impossible for any
one of them to have any control over the price of
the item being sold. Further, the product sold by all
firms is identical, and any new firm is free to enter
the industry. Note that perfect competition occurs
mostly in international markets and sometimes in
national ones. Perfectly competitive markets are not
encountered frequently in the real world.
Monopoly
Monopoly has the following characteristics:
· There is a single firm in the industry.
· The firm has significant control over the price at
which its product is sold in the market.
· The firm produces and sells a unique good or
service, which cannot be purchased elsewhere.
Chapter 2: Markets 29
· There are high barriers to entry in the industry; if a
new firm would like to enter the industry, it cannot
do so. (The reasons for this are examined in Chapter
5 at higher level.)
Examples of monopolies include telephone, water
and electricity companies in areas where they operate
as a single supplier. These may be local areas, in
which case the firm is a local monopoly, or it may
involve a national market if it covers all residents of
a country. A postal service is another example of a
monopoly with a national market. On the other hand,
Microsoft Corporation is a monopoly in the market
for Windows®, which is an international market. In all
these cases, there is a single firm providing the entire,
or at least the greatest part of the market, whether this
is local, national or international; the consumer has
no choice but to purchase the good or service from
this firm; and it is extremely difficult for other firms
to enter the industry. Since a monopolist is the sole
producer in an industry, it has significant control over
the price at which it sells its good or service. Like firms
in perfect competition, monopolies are not frequently
encountered in the real world.
Monopolistic competition
Monopolistic competition has the following
characteristics:
· There is a fairly large number of firms in the
industry (but not as large as in perfect competition).
· Each firm has a substantial amount of control over
the price at which its product is sold.
· There is product differentiation; this means that
each firm in the industry tries to make its product
different from those of the other firms in the
industry; these differences may be in the many
different characteristics of the product, the quality,
the servicing or the packaging.
· There are very low barriers to entry in the industry;
any new firm can easily enter the industry and begin
producing and selling the good or service.
Examples of monopolistic competition include the
shoe, clothing, detergent, computer, publishing,
furniture and restaurant industries. Monopolistic
competition is like perfect competition in that there
are many firms in the industry. It differs from perfect
competition mainly because of product differentiation.
By trying to make its good or service different from
any other, each firm tries to be like a little monopoly.
30
Part 2: Microeconomics
This is possible because each firm is the only producer
of that particular version of the product. For example,
Nike is a monopolist of Nike shoes, and Reebok is
a monopolist of Reebok shoes. Monopolistically
competitive firms use product differentiation in
order gain some control over the price at which their
products are sold. However, the existence of other
similar products (in the example here, other brands
of shoes) limits the degree of its power to control the
market prices. Monopolistic competition occurs in
local, national and international markets.
Oligopoly
Oligopoly has the following characteristics:
· There is a small number of large firms in the
industry.
· Firms have significant control over price, but this
occurs only when they recognize that because of
their small number their actions are interdependent.
· The products may be either differentiated or
undifferentiated.
· There are high barriers to entry; it is not easy for a
new firm to enter and begin producing and selling
in the industry.
Examples of oligopolies include the car industry,
airlines, electrical appliances, electronic
equipment (differentiated products) and the steel,
aluminium, copper, cement industries (identical or
undifferentiated products). They often operate in
international markets, and sometimes in national
ones. There are different kinds of oligopolies: there
might be one dominant firm in the industry in terms
of size and its share of the market coexisting with
several other smaller firms; or there might be a group
of dominant firms alongside a number of smaller
firms. Oligopolies have significant control over price.
A feature of oligopolies that makes them different
from the other three market structures is that because
of their small number in the industry, the firms are
interdependent: the behaviour of one firm affects the
behaviour of the others. As a result they engage in
actions unlike those of firms in the other three market
structures in an effort to exercise control over price.
Most industries in the real world are monopolistically
competitive or oligopolistic. Table 2.1 summarizes
the main characteristics of each of the four market
structures.
Table 2.1
Characteristics of market structures.
Perfect
competition
Monopoly
Monopolistic
competition
Oligopoly
Number of firms
Market power/control
over price
Type of product
Barriers to entry
into the industry
Examples
very many
none
undifferentiated/
standardized
none
agriculture
one, large
very significant
one product
with no close
substitutes
high
public utilities
relatively many,
relatively small
some
differentiated
very low
restaurants, CDs,
computer games,
books, furniture
few large
significant
differentiated or
undifferentiated
high
steel, aluminium,
cars, household
appliances
Test your understanding 2.2
1 What are the four market structures? Define
them on the basis of their key characteristics.
2 Can you think of examples of industries that are
(a) perfectly competitive
(b) monopolistic
(c) monopolistically competitive
(d) oligopolistic?
Market structure, competition and market
power
Competition is generally understood to be a process
in which rivals compete in order to achieve some
objective. For example, firms may compete with each
other over who will sell the most output, consumers
may compete over who will buy a scarce product,
workers compete over who will get the best jobs with
the highest salaries, countries compete over which
will capture the biggest export markets, and so on. But
beyond this everyday sense, the term ‘competition’
in economics is meaningful in the context of market
structures.
Competition occurs when there are many buyers
and sellers acting independently, so that no one has
the ability to influence the price at which the product
is sold in the market. By contrast, market power, also
known as monopoly power, refers to the control
that a firm has over the price of the product it sells in
the market. The greater the market power, the greater
is the control over price. It follows that the greater
the degree of competition in an industry, the less the
market power of firms, and the weaker is each firm’s
control over the price that prevails in the market.
Figure 2.1 (page 32) shows how the four market
structures relate to each other in these respects.
Moving from left to right, there is less competition,
more market power and greater control over price. At
one extreme of the four market structures is perfect
competition, which is completely (or perfectly)
competitive, where firms have no market power and
no control over price. At the opposite extreme lies
monopoly, where a single seller faces no competition,
has significant market power, and therefore significant
control over price. In between the two extremes
lie monopolistic competition and oligopoly. In
monopolistic competition there is a substantial degree
of competition between firms, but in trying to create
some monopoly power for the particular version
of their product, firms end up having substantial
influence over the price that prevails in the market for
their own particular product. Oligopolistic firms, on
the other hand, usually go to great lengths to try to
limit the competition between them, and this results
in significant control over price.
Chapter 2: Markets 31
Perfect
competition
Monopolistic
competition
Oligopoly
most competition
least (zero) competition
zero market power
most market power
zero control over
market price
Figure 2.1
Monopoly
significant control
over market price
Market structure, competition and market power.
The different market structures, and their varying
degrees of competition, market power and control
over price are important issues because each one
affects the allocation of resources and the efficiency
of resource use differently. Each structure has its own
particular advantages and disadvantages. Of the four
market structures, perfect competition gives rise to
highly desirable outcomes from a social point of view.
It usually results in larger quantities of output, and
products are sold at lower prices. It can give rise to an
allocation of resources which best satisfies the needs
and wants of consumers, and it can also minimize
waste in the use of resources, by ensuring that they
are used in the most efficient way. The greater the
degree of competition, understood to mean the
inability of economic decision-makers to control price,
the closer is an economy to realizing these desirable
results. The model of perfect competition is therefore
studied extensively, even though in the real world
most markets are not perfectly competitive. Perfect
competition provides a standard for comparison of
other market structures with an ideal. In addition, a
study of perfect competition offers important insights
into the workings of mixed market economies,
discussed in Chapter 1, page 23.
Test your understanding 2.3
2.2 Demand, supply and price
determination
We now turn to a study of a competitive market. We
are interested in seeing how the independent actions
of numerous buyers and sellers, none of whom
individually have any control over price, interact in
markets where prices are determined.
Demand
Demand is concerned with the behaviour of buyers.
Consumers (or households) are buyers of goods and
services in product markets, whereas firms are buyers
of factors of production in resource markets (recall
the circular flow model). In our analysis of demand
and supply we will focus mainly on product markets
and therefore on the behaviour of consumers as
buyers (though the same general principles described
here apply also to the behaviour of firms as buyers in
resource markets).
Individual demand
Consumers buy goods and services in product markets.
As buyers, they are demanders of those items they
wish to buy.
1 What is the meaning of ‘competition’ in
Economics?
2 Explain the relationship between competition
and market power, and show how the four
market structures relate to each other with
respect to these features.
The demand of an individual consumer indicates the
various quantities of a good (or service) the consumer
is willing and able to buy at different possible prices
during a particular time period, ceteris paribus (all
other things equal).
3 Why are competitive markets studied
extensively?
32
Part 2: Microeconomics
A consumer’s demand for a good can be presented as
a demand schedule, which is a table listing quantity
demanded at various prices. Table 2.2 shows a
consumer’s demand schedule for chocolate bars. When
the price of chocolate bars is $5, the consumer is
willing and able to buy two chocolate bars in a week.
Quantity of
chocolate bars
demanded
(per week)
5
2
4
4
3
6
2
8
1
10
(a) Demand curve for an individual consumer.
(b) Willingness to pay and marginal benefit.
5
5
4
3
2
1
D
0
2 4 6 8 10
quantity of chocolate bars (per week)
willingness to pay ($)
Price of
chocolate bars
($)
price of chocolate bars ($)
Table 2.2 Demand schedule for a consumer.
4
3
2
1
D = MB
0
2 4 6 8 10
quantity of chocolate bars (per week)
Figure 2.2 Demand, willingness to pay and marginal benefit.
When the price is $4, the consumer is willing and able
to buy four chocolate bars in a week, and so on.
‘Willing’ means the consumer wants to buy the good;
‘able’ means that the consumer can afford to buy it.
(You may want to buy a Ferrari, but can you afford
it? If not, your desire to buy one will not show up as
demand for Ferraris.)
Ceteris paribus means that all things other than
price that can affect how much the consumer is
willing and able to buy are assumed to be constant
and unchanging. In fact, the consumer’s demand is
affected not only by price, but also by many other
things, such as the consumer’s income and tastes,
and the prices of related goods. For the moment, we
put all those other things aside and concentrate only
on the relationship between the quantity of a good
the consumer is willing and able to buy, and its price.
Later we will also consider the effects of all those other
influences on the consumer’s demand.
The information contained in the demand schedule
can be plotted as a graph, shown in Figure 2.2(a).
In the graph, the price of chocolate bars is plotted
on the vertical axis and quantity of chocolate bars
on the horizontal axis. The curve in Figure 2.2(a) is
a demand curve. (Note that even though this is a
straight line, it is referred to as a ‘curve’.)
The demand schedule and the demand curve do not
tell us anything about how many chocolate bars
the consumer will actually buy, and what price the
consumer will pay. This information will be given
to us later through the interaction of demand with
supply. The demand information alone only tells us
how many chocolate bars the consumer would be
prepared to buy if the price were $5, or $4, and so on.
The law of demand: why the demand
curve slopes downward
The demand curve plotted in Figure 2.2(a) illustrates
a very important relationship: as the price of a good
falls, the quantity of the good demanded increases.
When two variables change in opposite directions (so
that as one falls the other increases) they are said to
have an ‘inverse’ or ‘indirect’relationship. The inverse
relationship between the two variables, price and
quantity demanded, is known as the ‘law of demand’.
According to the law of demand, there is an
inverse relationship between the quantity of a good
demanded over a particular time period and its price,
ceteris paribus: as the price of the good increases, the
quantity of the good demanded falls; as the price falls,
the quantity demanded increases, all other things
equal.
The law of demand is most likely to be consistent with
your experience. The higher the price of a good, the
less of it you are probably willing and able to buy; as
the price falls, the good becomes more affordable, and
you are likely to want and be able to buy more of it.
Chapter 2: Markets 33
What is the economic reasoning behind this
relationship? As you may remember from Chapter 1,
page 3, consumers buy goods and services because
these provide them with some benefit, or satisfaction,
also known as utility (we are using these words
interchangeably). The greater the quantity of a good
consumed, the greater the benefit derived. However, as
the quantity of a good consumed increases, the extra
benefit provided by each additional unit does not
increase by a constant amount; rather it increases by
less and less. Consider the following example. Imagine
you are thirsty and would like to drink a soft drink.
You buy one soft drink, which provides you with a
certain amount of benefit. You are still thirsty, so you
buy a second. Whereas you will enjoy your second soft
drink, you will most likely enjoy it less than you had
enjoyed the first; in other words the second soft drink
provides you with less benefit than the first. If you buy
a third, you will get even less benefit than from the
second, and so on with each additional soft drink. The
extra benefit that you get from each additional unit
of something you buy is called the marginal benefit
(marginal means extra or additional). This example
illustrates a general principle:
As the quantity of a good consumed increases, the
marginal (or additional) benefit it provides to the
consumer decreases. This principle is known as the
law of diminishing marginal utility.
Remember now the definition of the demand curve:
it shows the quantity of a good a consumer is willing
and able to buy at different prices (ceteris paribus).
Another way of saying the same thing is to say that
the demand curve shows what price the consumer is
willing to pay in order to get different quantities of
the good. The consumer’s willingness to pay is the
amount she or he is willing to spend in order to get a
unit of the good. It is determined by what the good is
worth to the consumer, which is the marginal benefit.
You can see this in Figure 2.2(b), which is exactly the
same as Figure 2.2(a), except that the vertical axis now
shows the consumer’s willingness to pay for the good,
and the demand curve is labelled MB (for marginal
benefit). Figure 2.2(b) shows that willingness to pay
for an additional unit of a good falls as the number
of units bought increase. The reason behind falling
willingness to pay is decreasing marginal benefit. It
follows then that:
34
Part 2: Microeconomics
The explanation for the shape of the demand curve
can be found in the principle of decreasing marginal
benefit: since marginal benefit falls as quantity
consumed increases, the consumer’s willingness to
pay also falls as the quantity increases.
Note that different consumers have a different
willingness to pay for a good, because they have
different preferences (likes and dislikes), and therefore
derive different marginal benefits from consumption
of a good. This is reflected in different demands (or
demand curves) for different consumers.
Market demand
So far we have considered the demand for a good of
one individual consumer. Market demand indicates
the total quantities in the market for the good
consumers are willing and able to buy at different
prices (during a particular period of time, all other
things equal). Market demand is the sum of all
individual demands for that good. Figure 2.3 shows
how the quantity demanded by Consumer A is added
to the quantity demanded by Consumer B, and so on
until all the quantities demanded by 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, and
therefore different marginal benefits and willingness to
pay.) For example, at the price of $4, we add the 4 bars
demanded by Consumer A to the 5 bars demanded by
Consumer B, and so on to all the quantities demanded
by other consumers, to arrive at the sum of 6000
chocolate bars per week. This sum is a point on the
market demand curve Dm. When we add individual
demands in this way for each of the possible prices, we
derive the entire market demand curve Dm, showing
the total demand in the chocolate bar market.
Market demand is the sum of all individual demands
for a good. The market demand curve illustrates the
law of demand, shown by an inverse relationship
between price and quantity demanded. The market
demand curve can also be considered as the sum of
consumers’ marginal benefits.
price of chocolate bars ($)
(a) Demand of Consumer A.
(b) Demand of Consumer B.
(c) Market demand.
P($)
P($)
5
5
5
4
4
+
3
+
3
2
2
1
DA
1
0
2 4 6 8 10 12
quantity of chocolate
bars
0
demands
of other
consumers
in the
market
4
=
3
2
1
DB
0
2 4 6 8 10 12
quantity of chocolate
bars
Dm
2 4 6 8 10 12
quantity of chocolate bars
(thousands)
Figure 2.3 Market demand as the sum of individual demands.
Determinants of demand
The determinants of demand are the variables
other than price that can influence demand. They are
the variables that were assumed to be constant and
unchanging when the relationship between price and
quantity demanded was being examined, by use of
the ceteris paribus assumption. We will now see what
happens to the demand curve when these variables
change.
Changes in the determinants of demand cause shifts
in the demand curve. This means that the entire
demand curve moves to the right or to the left. In
Figure 2.4, note that the vertical axis is labelled
‘P’, which stands for price, and the horizontal axis
is labelled ‘Q’, standing for quantity. (This is the
standard labelling practice we will be following from
now on.) Let’s say that the original demand curve is
given by D1. If price is P1, then the demand curve D1
indicates that quantity Q1 will be demanded. What
happens if the demand curve now shifts to the right,
to D2? As we can see in the figure, at the same price P1,
a larger quantity, Q2, will be demanded. If on the other
hand the demand curve shifts to the left, from D1 to
D3, then a smaller quantity, Q3, will be demanded at
the same price P1.
A rightward shift of the demand curve indicates that
more is demanded for a given price; a leftward shift of
the demand curve indicates that less is demanded for
a given price. A rightward shift of the curve is called
an increase in demand; a leftward shift is called a
decrease in demand.
P
decrease
in demand
increase
in demand
P1
D3
0
Q3
D1
Q1
D2
Q2
Q
Figure 2.4 Shifts in the demand curve.
The determinants of market demand include:
· The number of buyers If there is an increase in the
number of buyers (demanders), demand increases
and therefore the market demand curve shifts to the
right; if the number of buyers decreases, demand
decreases and the curve shifts to the left. This
follows simply from the fact that market demand is
the sum of all individual demands.
· Tastes If 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.
· Income in the case of normal goods When demand
for a good increases in response to an increase in
consumer income, the good is a normal good
Chapter 2: Markets 35
(a good is normal if the demand for it varies directly
with income). Most goods are normal goods.
Therefore an increase in income will give rise to a
rightward shift in the demand curve when the good
is normal, and a decrease in income will give rise to
a leftward shift.
· Income in the case of inferior goods While most goods
are normal, there are some goods the demand for
which falls as consumer income increases; the
good is then an inferior good (a good is inferior
if the demand for it varies inversely with income).
Examples of inferior goods are used clothes,
used cars, and bus tickets. As income increases,
consumers switch to more expensive alternatives
(new clothes, new cars, and cars or aeroplanes rather
than travelling by bus), and so the demand for the
inferior goods falls. Thus an increase in income will
give rise to a leftward shift in the demand curve
for an inferior good, and a decrease in income will
produce a rightward shift.
· Prices of substitute goods Two goods are substitutes
if they satisfy a similar need. An example of
substitute goods is Coca-Cola® and Pepsi-Cola®. A
fall in the price of one (say Coca-Cola®) will result in
a fall in the demand for the other (Pepsi-Cola®). The
reason is that as the price of Coca-Cola® falls, some
consumers will switch from Pepsi® to Coca-Cola®,
and so the demand for Pepsi® will fall. On the other
hand, if there is an increase in the price of CocaCola®, there will result an increase in the demand
for Pepsi® as some consumers switch away from
Coca-Cola® and towards Pepsi®. Therefore for any
two substitute goods X and Y, a decrease in the price
of X will produce a leftward shift in the demand for
Y, while an increase in the price of X will produce a
rightward 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 (they both
increase or they both decrease). Other examples of
substitute goods are oranges and apples, Cadbury
and Nestlé chocolate, and milk and yoghurt.
· Prices of complementary goods Two goods are
complements (complementary goods) if
they tend to be used together. An example of
complementary goods is CDs and CD players. In
this case, a fall in the price of one (say CD players)
will give rise to an increase in the demand for the
other (CDs). This is because the fall in the price of
CD players leads to a bigger quantity of CD players
being purchased, and therefore the demand for CDs
will increase. Therefore, for any two complementary
goods X and Y, a fall in the price of X will lead
to a rightward shift in the demand for Y, and an
increase in the price of X will lead to a leftward shift
36
Part 2: Microeconomics
in the demand for Y. In the case of complementary
goods, the price of X and the demand for Y change
in opposite directions (as one increases, the other
decreases). More examples of complementary goods
are computers and computer software, DVD players
and DVDs, tennis shoes and tennis rackets, and
ping-pong balls and ping-pong rackets. Note that
most goods are not related to each other; these are
called independent goods. For example, pencils and
apples, cars and ice cream, telephones and books
are unrelated to one another, and the change in
the price of one will have little or no effect on the
demand for the other.
· Expectations of future income If consumers expect
that their future income will increase, their demand
for a good in the present will be likely to increase
(rightward shift in the demand curve); if they expect
their income to fall in the future, their demand for
a good in the present will be likely to fall (a leftward
shift in the demand curve).
· Expectations of future price changes If consumers
expect that the price of a good will increase in the
future, they will probably demand more of it in
the present in order to take advantage of the lower
present price, and so demand will shift to the right;
if they expect that the price will fall in the future,
they will demand less of it in the present, as they
will postpone their purchases for the future, and so
demand in the present shifts to the left.
Movement along a demand curve and
shift of the demand curve
It is important to distinguish between movements
on or along a demand curve, and shifts of a demand
curve. Whenever the price of a good changes, ceteris
paribus, it gives rise to a movement along the demand
curve. In Figure 2.5(a), if the price falls from P1 to P2,
the quantity 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
quantity demanded. Conversely, an increase in price
would give rise to a decrease in quantity demanded.
By contrast, any change in one or more determinants
of demand gives rise to a shift in the whole demand
curve, as shown in Figure 2.5(b); this is called a
change in demand. Let’s say, for example, that there
is an increase in the number of buyers. We know
that the demand curve will shift rightward (from D1
to D2); this is called an increase in demand, shown
in Figure 2.5(b). A decrease in the number of buyers
would cause a leftward shift of the demand curve
(from D1 to D3); this is called a decrease in demand.
To summarize:
Test your understanding 2.4
(a) A movement along the demand curve,
caused by a change in price, is called a
‘change in quantity demanded’.
1 (a) Define ‘demand’. (b) What is the law
of demand? (c) Show the law of demand
graphically. (d) What is the relationship
between individual demand and market
demand? (e) Distinguish between a ‘change in
demand’ and a ‘change in quantity demanded’
and explain the cause or causes of each.
(f) What are the determinants of demand?
2 Explain why a consumer’s willingness to pay for
an additional unit of a good falls as the quantity
purchased increases.
P
A
P1
change in
quantity
demanded
B
P2
D
0
Q1
3 Using appropriate diagrams, show the impact
Q2
of each of the following on the demand curve
for product A, and explain what happens to
demand in each case:
Q
(b) A shift of a demand curve, caused by a
change in a determinant of demand, is
called a ‘change in demand’.
P
change in demand
decrease
in D
increase
in D
D2
D3
0
D1
Q
Figure 2.5 Movement along and shift of a demand curve.
Any change in price produces a change in quantity
demanded, shown as a movement on the demand
curve. Any change in a determinant of demand
(other than price) produces a change in demand,
represented by a shift of the whole demand curve.
HL
(a) the number of consumers in the market for
product A increases
(b) consumer income increases and product A
is an inferior good
(c) consumer income decreases and product A
is a normal good
(d) consumers expect a drop in their future
income
(e) a news report claims that use of product A
has harmful effects on health
(f) the price of substitute good B falls
(g) the price of complementary good B
increases.
Exceptions to the law of demand
(higher level topic)
The law of demand states that there is an inverse
relationship between the price of a good and quantity
of the good demanded, all other things equal.
However, in the situations described below, this law
does not hold.
HL
Veblen goods
Veblen goods are goods whose demand curve is
upward sloping due to ostentation (defined as a
pretentious display of wealth) or a belief that a lower
price of a good means lower quality. Veblen goods
are named after Thorstein Veblen, who explained
this phenomenon in his book The Theory of the
Leisure Class in 1899. They are alternatively known as
‘ostentatious goods’, or ‘conspicuous consumption’
goods. In such a demand curve there is a positive
(direct) relationship between price and quantity
demanded, as shown in Figure 2.6(b). In the case
of Veblen goods, a consumer derives more utility
(satisfaction) from the desire to impress other people
than from consumption of the good itself. As price
increases, the good becomes more attractive because
the consumer associates possession of the good with
increased social status. Therefore quantity demanded
Chapter 2: Markets 37
Giffen goods
HL
(a) The law of demand.
P
D
0
Q
(b) Violation of the law of demand.
P
D
0
Q
Figure 2.6 The law of demand and violations of the law of demand.
increases as price increases, while quantity demanded
falls as price falls. Examples of Veblen goods may
include diamonds, mink coats and luxury cars (such as
Rolls-Royces).
Consumers displaying this kind of behaviour are more
likely to be higher income individuals purchasing
items in the luxury market. The upward sloping
demand curve is likely to be an individual demand
curve, or a demand curve for a group of high income
consumers. It is far less likely to be a market demand
curve that includes all consumers, as the market
demand curve is the sum of all individual demands,
and therefore also includes the demand of lower
income individuals whose behaviour is consistent with
the law of demand (shown in Figure 2.6(a)). In fact,
the existence of an upward-sloping market demand
curve has never been established by economists for
any good.
1
To understand what this means, consider the following simple example.
Say you have $12 and you want to buy some pencils. When the price is $4
per pencil, you can buy 3 pencils. Suppose then that the price of pencils
falls to $3 per pencil. You can now buy 4 pencils. The sum of money at
38
Part 2: Microeconomics
In Economics, there is often more than one way to
explain something. The law of demand, for example,
has more than one explanation of why price and
quantity demanded are inversely related to each
other. Earlier in this chapter (page 33), we saw that
the declining marginal benefit that a consumer enjoys
by consuming additional units of a good explains the
downward-sloping demand curve (the law of demand).
Now we will consider a different explanation for the
downward-sloping demand curve, which will help
us understand a special category of goods for which
the law of demand may not hold. (Note that the two
explanations of the law of demand, though different,
are entirely consistent with each other.)
Recall that demand shows the relationship between
the price of a good and quantity of the good
demanded, all other things equal. As we know,
any price change produces a change in quantity
demanded, shown as a movement along the demand
curve. We will now see that the total effect of a price
change on quantity demanded can be broken down
into two separate effects: the substitution effect and
the income effect, with the total effect of a price
change being the sum of the two effects.
· The substitution effect Say there is a price decrease;
the consumer substitutes more of the now less
expensive good for other similar products that have
become relatively more expensive. The result is that
quantity of the good demanded increases. There is
always an inverse relationship between price and
quantity demanded as a result of the substitution
effect: as price increases, quantity demanded falls; as
price decreases, quantity demanded increases.
· The income effect Consider again the price decrease;
a fall in the price of the good means that the
consumer’s real income (or purchasing power) has
increased.1 There are two possible impacts on how
much of the good will be demanded, depending on
whether it is normal or inferior:
m
If the good is normal, as real income increases,
quantity demanded of the good increases. In
this case, the income effect gives rise to an
inverse relationship between price and quantity
demanded; as price falls, quantity demanded
increases.
your disposal ($12) has not changed, and yet the ‘purchasing power’ of
$12, or what your money can buy, has increased as a result of the fall in
the price of pencils. ‘Real income’ is the same as ‘purchasing power’; it
increases as prices fall, and it decreases as prices rise.
HL
m
If the good is inferior, as real income increases,
quantity demanded of the good falls. The income
effect now gives rise to a direct relationship
between price and quantity demanded; as price
falls, quantity demanded falls.
When a good is normal, the income effect and the
substitution effect reinforce each other: both lead to
an inverse relationship between price and quantity
demanded, and there results the standard downward
sloping demand curve, indicating that the law of
demand holds.
If on the other hand a good is inferior, there are two
possibilities:
· If the income effect is smaller than the substitution
Giffen goods are very rare; in fact some economists
claim they may not even exist at all. They were named
after Sir Robert Giffen, a 19th century economist who
observed increased consumption of bread by lower
income people as the price of bread increased. The
explanation provided by Sir Robert Giffen was that as
the price of bread increased, poor people’s real income
fell. As bread consumption made up a large proportion
of household expenditures, an increase in the price
of bread could make a perceptible difference in
households’ real income. Bread was an inferior good,
therefore the fall in real income led to an increase in
the demand for bread. The income effect was larger
than the substitution effect, and thus the overall effect
of the increase in the price of bread was to increase
bread consumption.
effect, there results a downward-sloping demand
curve so that the law of demand holds; the good is
inferior but not Giffen.
ct
ffe
ee
om
inc
effect, there results an upward-sloping demand
curve; the law of demand does not hold and the
good is a Giffen good.
substitution
effect
price
quantity
demanded
inc
om
rm e ef
fe
al
go ct
od
· If the income effect is greater than the substitution
no
HL
These relationships will become clearer if you carefully
study Figure 2.7. (Note that upward-pointing arrows
signify an increase, and downward-pointing arrows
signify a decrease.) Figure 2.8 shows the demand
curves that correspond to each kind of good.
real
income
For an inferior good,
if income effect < substitution
effect, the good is not Giffen,
ct
ffe
e e ood
om r g
inc erio
inf
A Giffen good is a kind of inferior good whose
demand curve is upward sloping because the income
effect of a price change is greater than the substitution
effect.
quantity
demanded
if income effect > substitution
effect, the good is Giffen.
Figure 2.7 Normal, inferior and Giffen goods.
(a) Normal good or inferior good that is not Giffen.
P
(b) Giffen good.
P
D
D
0
Q
0
Q
Figure 2.8 Demand curves: normal, inferior and Giffen goods.
Chapter 2: Markets 39
HL
HL
The role of expectations
If the price of a good falls, and the consumer expects
it to fall further, she or he may postpone purchases for
the future when the price will be lower, and therefore
quantity demanded can fall; there results a positive
relationship between price and quantity demanded.
If the price of a good increases and the consumer
expects it to increase further, s/he may increase
quantity demanded in the present to take advantage
of the current lower price. Once again there may result
a positive relationship between price and quantity
demanded.
Test your understanding 2.5
1 (a) What are Veblen goods? (b) How might they
violate the law of demand? (c) Explain why a
violation of the law of demand in the case of a
Veblen good is more likely to involve individual
demand than market demand.
2 (a) Explain the substitution effect of a
price change; what does it tell us about the
relationship between the price of a good and
quantity demanded? (b) Explain the income
effect of a price change; what does it tell us about
the price of a good and quantity demanded in
the case of (i) normal goods, and (ii) inferior
goods? (c) How can we use these concepts to
explain the possibility of an upward-sloping
demand curve in the case of Giffen goods?
(d) When does an inferior good not violate the
law of demand? (e) Do you think that most
inferior goods are Giffen or not Giffen goods?
Explain.
3 How can expectations lead to an upward-sloping
demand curve?
The supply of an individual firm indicates the
various quantities of a good (or service) the firm is
willing and able to produce and supply to the market
for sale at different possible prices, during a particular
time period, ceteris paribus (all other things equal).
A firm’s supply of a good can be presented as a supply
schedule, which is a table showing the various
quantities of a good the firm is willing and able to
produce and supply at various prices. Table 2.3 shows
a firm’s supply schedule for chocolate bars. The same
information appears as a graph in Figure 2.9, where
price is plotted on the vertical axis and quantity
supplied on the horizontal axis. The line appearing in
the diagram is the supply curve of the firm. If the
price is $4, the firm supplies 500 chocolate bars in the
course of a week; if price were $3, then the firm would
supply 400 chocolate bars, and so on.
Just as in the case of demand, where price is only
one thing that determines how much is demanded,
so in the case of supply, price is only one thing that
influences how much the firm will supply to the
market; hence the ceteris paribus assumption. For the
moment, we will ignore other possible influences on
supply, and focus only on the relationship between
price and quantity.
The supply schedule and the supply curve do not tell
us anything about how many chocolate bars the firm
will actually supply to the market, and what price the
firm will receive. The supply information alone tells us
how many chocolate bars the firm would be prepared
to produce and sell if the price were $5, or $4, and so
on.
Table 2.3 Supply schedule for a firm.
Supply
Supply is concerned with the behaviour of sellers,
which include firms in the product markets and
households in the resource markets. In line with
our focus on product markets, we will consider the
behaviour of firms as sellers (though the same general
principles also apply to consumers as sellers of factors
of production in resource markets).
Individual supply
Firms produce goods and services, and they supply
them to the product markets for sale. As sellers,
therefore, they are suppliers of goods and services.
40
Part 2: Microeconomics
Price of
chocolate bars ($)
Quantity of chocolate bars
supplied (per week)
5
600
4
500
3
400
2
300
1
200
S
price of chocolate bars ($)
5
4
3
2
1
0
What is the economic reasoning behind the law of
supply? Higher prices generally mean that the firm’s
profits increase, and so the firm faces an incentive
to produce more output. Lower prices mean lower
profitability, and so the incentive facing the firm
is to produce less. Therefore, there results a direct
relationship between price and quantity supplied: the
higher the price, the greater the quantity supplied by
the firm.
Market supply
100 200 300 400 500 600
quantity of chocolate bars (per week)
Figure 2.9 Supply curve for a firm.
The law of supply: why the supply curve
slopes upward
The supply curve shown in Figure 2.9 illustrates a very
important relationship: as price increases, quantity
supplied also increases. When two variables change
in the same direction (as one increases the other also
increases), they are said to have a ‘positive’ or ‘direct’
relationship. The direct relationship between the two
variables, price and quantity supplied, is summarized
in the ‘law of supply’.
The market supply indicates the total quantities of a
good that firms are willing and able to supply in the
market at different possible prices, and is given by the
sum of all individual supplies of that good. Figure 2.10
provides an example where at each price, the quantity
supplied by Firm A is added to the quantity supplied
by Firm B, and so on until all the quantities supplied
by all firms producing chocolate bars are added up.
For example, at the price of $3, Firm A supplies 400
bars per week and Firm B supplies 300 bars. If we add
up these quantities together with all the quantities
supplied by other firms, we obtain 8000 bars per
week, which is a point on the market supply curve
Sm, corresponding to the price of $3. When the firm
supplies are added up this way for each possible price,
we derive the market supply curve, Sm.
According to the law of supply, there is a direct
relationship between the quantity of a good supplied
over a particular time period and its price, ceteris
paribus: as the price of the good increases, the
quantity of the good supplied also increases; as the
price falls the quantity supplied also falls, all other
things equal.
price of chocolate bars ($)
(a) Supply of Firm A.
Market supply is the sum of all individual firms’
supplies for a good. The market supply curve
illustrates the law of supply, shown by a direct
relationship between price and quantity supplied.
(b) Supply of Firm B.
(c) Market supply.
P$
SA
5
4
3
+ 3
2
2
1
1
200
400
600
quantity of chocolate
bars
SB
5
4
0
P$
0
Sm
5
+
supplies
of other
firms in
the market
4
= 3
2
1
200
400
600
quantity of chocolate
bars
0
2 4 6 8 10 12
quantity of chocolate
bars (thousands)
Figure 2.10 Market supply as the sum of individual supplies.
Chapter 2: Markets 41
The vertical supply curve
Determinants of supply
Under certain special circumstances, the supply curve,
rather than slope upward, is vertical at some particular
fixed quantity, as in Figure 2.11. A vertical supply
curve tells us that even as price increases, the quantity
supplied cannot increase; it remains constant. The
quantity supplied is independent of price (it does not
depend on price). There are two reasons why this may
occur:
We now turn to the determinants of supply, or
the factors other than price that can influence supply.
Changes in the determinants of supply cause shifts in
the supply curve. A rightward shift means that for a
given price, supply increases, i.e. more will be supplied;
a leftward shift means that for a given price, supply
decreases, and less will be supplied. As Figure 2.12(b)
shows, when supply is S1, quantity Q1 will be supplied
at price P1. If there is an increase in supply to S2, at the
same price P1 then Q2 quantity is supplied. If supply
falls to S3, then Q3 quantity is supplied at the same
price P1.
P
0
S
A rightward shift of the supply curve indicates that
more is supplied for a given price; a leftward shift of
the supply curve indicates that less is supplied for a
given price. A rightward shift of the curve is called
an increase in supply; a leftward shift is called a
decrease in supply.
Q
theatre tickets for one
show OR Stradivarius violins
Figure 2.11 The vertical supply curve.
· There is a fixed quantity of the good supplied
because there is no time to produce more of it. For
example, there is a fixed quantity of theatre tickets
in a given theatre, because there is a fixed number of
seats. No matter how high the price, it is not possible
to increase the number of seats in a short period of
time (we will see more of this in Chapter 3).
· There is a fixed quantity of the good because there
is no possibility of ever producing more of it. This
is the case with original antiques (for example,
Stradivarius violins) and original paintings and
sculptures of famous artists. It may be possible to
make reproductions, but it is not possible to make
more originals. The supply curve is therefore vertical
at the fixed quantity of the good that exists.
(a) A movement along the supply curve, caused by a change
in price, is called a ‘change in quantity supplied’.
P
0
firms producing the good in question increases
supply and gives rise to a rightward shift in the
supply curve; a decrease in the number of firms
decreases supply and produces a leftward shift. This
follows from the fact that market supply is the sum
of all individual supplies.
· Resource prices and costs of production The firm buys
various resources (factors of production) that it uses
to produce its product. If the price of one or more
resource rises, production becomes less profitable and
the firm produces less; the supply curve shifts to the
left. If one or more resource prices fall, production
(b) A shift of a supply curve, caused by a change in a
determinant of supply, is called a ‘change in supply’.
A
Q1
change in
quantity
supplied
Q2
P1
Q
Part 2: Microeconomics
0
S1
S3
B
Figure 2.12 Movements along and shifts in the supply curve.
42
· The number of firms An increase in the number of
P
S
P2
P1
The determinants of market supply include the
following:
Q3
decrease
in supply
increase
in supply
Q1
Q2
S2
Q
becomes more profitable and the firm will produce
more; the supply curve shifts to the right. Resource
prices are important in determining the firm’s costs
of production. In general, when costs of production
increase, production becomes less profitable, and so
supply falls (the supply curve shifts to the left) and
when costs decrease, supply increases (the supply
curve shifts to the right).
· Technology A new improved technology lowers
costs of production, thus making production more
profitable. Supply increases and the supply curve
shifts to the right. In the (unlikely) event that a
firm employs a less productive technology, costs
of production increase and the supply curve shifts
leftward.
· Prices of other goods the firm can produce Suppose a
farmer grows wheat. If the price of another product,
say corn, increases, the farmer may switch to corn
production, which is now more profitable; this
results in a fall in wheat supply: the supply curve
shifts to the left. If the price of corn falls, corn
producers may switch to growing wheat, as this is
now more profitable; the supply of wheat increases
and the supply curve shifts to the right. Therefore
the supply curve of a good can shift in response to
changes in the prices of other goods that the firm
can produce.
· Producer (firm) expectations If firms expect the price
of their product to rise, they may withhold some of
their current supply from the market (i.e. not offer
it for sale), with the expectation that they will be
able to sell it at the higher price in the future; in this
case there will result a fall in supply in the present,
and hence a leftward shift in the supply curve. If the
expectation is that the price of their product will
fall, they will increase their supply in order to take
advantage of the current higher price, and hence
there will be a rightward shift in the supply curve.
· Taxes Firms treat taxes as if they were costs of
production. Therefore the imposition of a new
tax or the increase of an existing tax represents
an increase in production costs, so supply will
fall and the supply curve will shift to the left. The
elimination of a tax or a decrease in an existing tax
represent a fall in production costs; supply increases
and the supply curve shifts to the right.
· Subsidies A subsidy is a payment made to the firm
by the government, and so has the opposite effect
of a tax. (Subsidies may be given in order to increase
the incomes of producers or to encourage an
increase in the production of the good produced.)
The introduction of a subsidy or an increase in an
existing subsidy is equivalent to a fall in production
costs, and will give rise to a rightward shift in the
supply curve, while the elimination of a subsidy or a
decrease in a subsidy will give rise to a leftward shift
in the supply curve.
· Supply shocks Supply shocks are sudden events that
have an impact on supply, such as unusual weather,
war or cuts in major input supplies (for example,
imports of oil). An adverse supply shock, such as
unusually bad weather that affects agricultural
output, or a cut in oil supplies, will result in a
decrease in supply and leftward shift in the supply
curve. A beneficial supply shock (such as unusually
good weather) results in an increase in supply and a
rightward shift in the supply curve.
Movement along a supply curve and shift
of the supply curve
Just as in the case of the demand curve, so in the
case of the supply curve we distinguish between
movements along the curve and shifts of the entire
curve. Movements along a supply curve can occur
only as a result of changes in price. In Figure 2.12(a),
as price increases from P1 to P2, quantity supplied
increases from Q1 to Q2. There has been a movement
along the supply curve from A to B. This is called
change in quantity supplied.
If there is a change in one more determinant of
supply, supply will increase or decrease, and the entire
curve will shift to the right or to the left, as in Figure
2.12(b). This is called a change in supply.
Any change in price produces a change in quantity
supplied, shown as a movement on the supply curve.
Any change in a determinant of supply (other than
price) produces a change in supply, represented by a
shift of the whole supply curve.
Test your understanding 2.6
1 (a) Define ‘supply’. (b) What is the law of
supply? (c) Show the law of supply graphically.
(d) What is the relationship between individual
supply and market supply? (e) Distinguish
between a ‘change in supply’ and a ‘change
in quantity supplied’ and explain the cause or
causes of each. (f) What are the determinants of
supply?
2 What are some examples of goods with a
vertical supply curve?
(...continued)
Chapter 2: Markets 43
(...continued)
3 Using appropriate diagrams, show the impact
of each of the following on the supply curve of
product A, and explain what happens to supply
in each case:
(a) the number of firms in the industry
producing product A decreases
(b) the price of oil, a key input in the
production of product A, increases
(c) firms expect that the price of product A will
fall in the future
(d) the government grants a subsidy on each
unit of A produced
(e) a war causes disruption of imports of inputs
used in the production of A
(f) the price of product B increases, and B is a
substitute in production
(g) a new technology is adopted by firms in the
industry producing A.
Market equilibrium: demand and supply
The market demand and market supply for chocolate
bars that we have considered separately above show
the quantities that consumers and firms are willing
and able to buy and sell at each price; not how much
they actually buy and sell. We will now put market
demand and market supply together to find out how
these interact to determine what actually happens in
the market for chocolate bars.
Shortages and surpluses
Figure 2.13 presents the same market demand and
supply curves that appeared in Figures 2.3 and 2.10.
The same information appears as a demand schedule
and a supply schedule in Table 2.4.
Table 2.4 Market demand and supply schedules for chocolate bars.
Price of chocolate
bars
($)
Quantity of
chocolate bars
demanded
(per week)
Quantity of
chocolate bars
supplied
(per week)
5
4,000
12,000
4
6,000
10,000
3
8,000
8,000
2
10,000
6,000
1
12,000
4,000
44
Part 2: Microeconomics
price of chocolate bars ($)
Test your understanding 2.6
S
5
surplus
4
3
equilibrium
price
market equilibrium
2
shortage
1
D
equilibrium quantity
0
2
4
6
8
10
12
quantity of chocolate bars (thousands)
Figure 2.13 Equilibrium in the chocolate bar market.
In both Table 2.4 and Figure 2.13 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 a
surplus of chocolate bars, or excess quantity
supplied, of 4000 bars (= 10,000 – 6000). At the
even higher price of $5, there is a larger surplus
of 8000 bars.
Let’s say that 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? When the producers see that they
have unsold output of 8000 bars, they will lower
their price in order 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.
At a lower than equilibrium price, say $2, quantity
demanded (10,000 bars) is larger than quantity
supplied (6000 bars). There is now a shortage of
chocolate bars, or excess quantity demanded of 4000
bars (10,000 − 6000). If price were even lower, at $1,
the shortage would be larger, at 8000 bars. Say that
the price is initially $1. Chocolate 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 all the chocolate bars
will be quickly sold out, and so begin to raise the price.
As they do so, the quantity of bars demanded begins
to fall and the quantity supplied begins to increase.
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.
If quantity demanded of a good is smaller than
quantity supplied, the difference between the two is
called a shortage; if quantity demanded of a good is
larger than quantity supplied, the difference is called
a surplus. The existence of a shortage or a surplus 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 a shortage, price will rise; in
the event of a surplus, price will fall.
Market equilibrium
Equilibrium 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
market equilibrium; 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 that prevails in
market equilibrium is the equilibrium price, and
the quantity is the equilibrium quantity. At the
equilibrium price, the quantity that consumers are
willing and able to buy is exactly equal to the quantity
that firms are willing and able to sell. The buyers
and sellers are satisfied, and there is no pressure on
the price to change. This price is also known as the
market-clearing price, or simply market price.
In the market for chocolate bars considered in Figure
2.13, the equilibrium price is $3 per chocolate bar,
and the equilibrium quantity is 8000 bars. At any
price other than the equilibrium price, when there is a
shortage or a surplus, there is market disequilibrium.
At a market disequilibrium, the activities of many
buyers and sellers, through their demand and supply,
as we have seen, force the price to increase or decrease
until it reaches its equilibrium level.
Changes in market equilibrium
Once a price reaches its equilibrium level, consumers
and firms are satisfied and will not engage in any
action to make it change. This presupposes that the
demand and supply curves are fixed; in other words,
that all those factors that can cause shifts in these
curves (the determinants of demand and supply) are
constant and unchanging (recall the ceteris paribus
assumption). If there occurs a change in any of the
determinants of demand or supply, there will result a
shift in the curves, and the market will adjust to a new
equilibrium.
Changes in demand (demand curve shifts)
In Figure 2.14(a) (page 46) the demand curve,
D1, intersects the supply curve, S, to give rise to
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, or an increase in the number
of consumers, will produce a rightward shift in the
demand curve to D2. There will result a new, higher
equilibrium price, P2, and greater equilibrium
quantity, Q2, given by the intersection of D2 with S.
On the other hand, a decrease in demand, shown in
Figure 2.14(b), which could arise from a decrease
in the number of consumers, or a fall in consumer
income in the case of a normal good, will give rise to
a leftward shift in the demand curve from D1 to D3,
and a fall in both the equilibrium price to P3, and the
equilibrium quantity to Q3.
Changes in supply (supply curve shifts)
We now consider supply curve shifts that can arise
from changes in the determinants of supply. In
Figure 2.15(a), the initial equilibrium is given by the
intersection of D with S1, giving rise to equilibrium
price and quantity P1 and Q1. An increase in supply,
which could be caused for example by an increase
in the number of firms in the industry, will shift the
supply curve to S2 and give rise to a lower equilibrium
price, P2, but a higher equilibrium quantity, Q2. A
decrease in supply as shown in Figure 2.15(b), caused
for example by a fall in the number of firms in the
industry, will shift the supply curve to S3, and the
new equilibrium will be at a higher price P3 and lower
quantity Q3.
When a market is in equilibrium, quantity demanded
is equal to quantity supplied, and there is no tendency
for the price to change. In a market disequilibrium,
there is a shortage or surplus, and the forces of
demand and supply cause the price to change until
the market reaches equilibrium.
Chapter 2: Markets 45
(a) Increase in demand.
P
(b) Decrease in demand.
initial
equilibrium
P2
S
P
final
equilibrium
P1
P1
final
equilibrium
S
initial
equilibrium
P3
D2
D1
D1
0
Q1
D3
Q2
0
Q
Q3
Q1
Q
Figure 2.14 Changes in demand and the new equilibrium price and quantity.
(a) Increase in supply.
(b) Decrease in supply.
initial
equilibrium
final
equilibrium
S1
P
P
S2
P1
S1
P3
final
equilibrium
P2
S3
initial
equilibrium
P1
D
0
Q1
Q2
D
0
Q
Q3
Q1
Q
Figure 2.15 Changes in supply and the new equilibrium price and quantity.
Free and economic goods revisited
You may remember from Chapter 1, page 4, that free
goods are goods that are not subject to the condition
of scarcity and have a zero opportunity cost, while
economic goods are subject to scarcity and have an
opportunity cost greater than zero. We are now in a
better position to understand the difference between
the two by use of demand and supply analysis.
Figures 2.16 (a) and (b) show a free and economic
good respectively. A free good is a good for which
the quantity supplied is greater than the quantity
demanded when the price is zero. Supply is so large
relative to demand that there is excess quantity
supplied even at a zero price. An economic good is
a good for which quantity supplied is smaller than
quantity demanded when the price is zero. 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 zero, the good has become an
economic good.
(a) Free good.
(b) Economic good.
P
P
supply
demand
supply
demand
0
Figure 2.16 Free and economic goods.
46
Part 2: Microeconomics
Q
0
Q
Test your understanding 2.7
1 In Figure 2.13, state whether there is a surplus or
shortage, and how large this is if
(a) price is $5 per chocolate bar
(b) price is $4 per chocolate bar
(c) price is $3 per chocolate bar
(d) price is $2 per chocolate bar
(e) price is $1 per chocolate bar
2 Use a demand and supply diagram to:
(a) show equilibrium price and quantity
(b) show disequilibrium prices and quantities
(c) relate disequilibrium prices to shortages and
surpluses
(d) explain the meaning of ‘market equilibrium’
(e) explain the roles of demand and supply in
achieving market equilibrium.
3 Use supply and demand diagrams to illustrate
the following events:
(a) freezing weather destroys the orange crop
and the price of oranges rises
(b) the mass media report on the fat content of
cheese and the price of cheese falls
(c) a new technology of production for
computers is developed and the price of
computers falls
(d) the price of milk increases and the price of
ice cream increases (remember that milk is
an input in ice cream production)
(e) the mass media report on outbreaks of bird
flu and the price of chicken falls.
4 Assuming a competitive market, use demand
and supply diagrams to show the impact on
equilibrium price and equilibrium quantity of
product A that each of the following will have:
(a) consumer income increases, ceteris paribus
(A is a normal good)
(b) consumer income falls, ceteris paribus (A is
an inferior good)
(c) there is an increase in labour costs, all other
things equal
(d) the price of substitute good B falls, all other
things equal
(e) the number of firms in the industry
producing product A increases, ceteris
paribus
(f) a successful advertising campaign
emphasizes the health benefits of product
A, ceteris paribus.
(...continued)
Test your understanding 2.7
(...continued)
5 Use supply and demand diagrams to show how
(a) land in America, which initially was a free
good, became an economic good after colonizers
arrived; (b) deforestation (the cutting of forest
trees) on a massive scale over many decades has
transformed forests from a free good into an
economic good.
2.3 Prices and efficiency in the market
economy
The role of prices in markets
Prices determined by the forces of supply and demand
in competitive markets serve a number of important
functions.
Price rationing and the allocation of
resources
As we know from Chapter 1 (Section 1.3, page 18),
rationing is a method of apportioning or parcelling
out resources among their many competing uses,
as well as apportioning goods and services among
households. The market mechanism uses price
rationing for this purpose, which involves the use of
prices that are freely determined in markets by the
forces of supply and demand. We have learned in this
chapter that when a market operates under conditions
of competition, market demand and market supply,
composed of numerous individual demanders and
numerous individual suppliers, each making his or her
individual choices, determine an equilibrium price and
quantity for a particular good (or service or resource).
At this equilibrium, the buying and selling choices of
all buyers and sellers are satisfied and are in balance.
Now imagine that there exists a market for each
and every good and service produced and for each
and every resource, and that all these markets have
established a market-clearing price. This means that all
decision-makers, whether they are households, firms
or resource owners, having made their buying and
selling choices, are now satisfied since everyone who
was willing and able to buy or sell specific quantities at
different prices has succeeded in doing so!
The market mechanism, through price rationing, is
known as the invisible hand of the market, which
succeeds in coordinating the countless buying and
selling decisions of thousands or millions of decisionmaking units in an economy without any central
Chapter 2: Markets 47
Prices as signals and incentives
How do prices and markets achieve the task of
resource allocation?
in price is also an incentive for producers to increase
the quantity of strawberries supplied; at the higher
price, strawberry production is more profitable, so
producers move along the supply curve from point
A to point C, thereby increasing quantity supplied
from Q1 to Q3. But the new, higher price is a signal and
incentive for consumers: it signals that strawberries
are now more expensive, and it is an incentive for
them to buy fewer strawberries; they therefore move
along the new demand curve from B to C, buying
fewer strawberries than they would have bought at the
original price P1 (Q3 is smaller than Q2). The increase
in the price of strawberries resulted in a reallocation
of resources. More resources are now allocated to
strawberry production. (This has affected the answer
to the what question of resource allocation.)
(a) Adjustment of
price to increased
demand.
The key to the market’s ability to allocate resources
can be found in the role of prices as signals and
as incentives. As signals, prices communicate
information to decision-makers. As incentives,
prices motivate decision-makers to respond to the
information.
As signals and incentives, prices guide resource owners
on what and how much of their resources they will
sell; they guide consumers on what and how much of
goods and services they will buy; and they guide firms
on what and how much of resources they will buy,
and what and how much of goods and services they
will produce and sell.
An example from a product market
Suppose consumers decide they would like to eat
more strawberries because of their health benefits
(a change in tastes that causes the demand curve to
shift); demand increases and the demand curve shifts
to the right from D1 to D2 in Figure 2.17(a). At the
initial price, P1, there results a shortage equal to the
difference between Q2 and Q1: the quantity demanded
Q2, due to the increase in demand to D2, is larger than
quantity supplied, Q1. The price of strawberries will
therefore begin to rise, and will continue to rise until
the shortage has disappeared; this happens at price P2
and quantity Q3, given by the point of intersection of
the supply curve with the new demand curve, D2.
What has happened? The new, higher price signalled
or conveyed information to producers that there
was a shortage in the strawberry market. The increase
48
Part 2: Microeconomics
P
S
C
P2
A
P1
B
shortage
D2
D1
0
(b) Adjustment of the
price of labour to
increased labour
supply.
price of labour (wage)
authority. Prices and markets determine the allocation
of resources (and the distribution of output/income).
The what question of resource allocation is answered
because firms will only produce those goods and
services consumers are willing and able to pay for;
the how question of resource allocation is answered
because firms will use those resources and technologies
in their production process they are willing and able
to pay for. (The for whom question of distribution is
answered because consumers will get those goods and
services they are willing and able to pay for, which
in turn depends on the prices at which they sell their
resources to firms, and therefore their income.)
Q3
Q1
S1
P
W1
W2
Q2 Q
A
S2
surplus
B
C
D
0
Q1 Q3 Q2
quantity of labour
Figure 2.17 Illustrating how price works as a signal and incentive.
An example from a resource market
Consider another example, this time from the labour
market (one of the resource markets). The vertical
axis in Figure 2.17(b) measures the price of labour
(the wage) and the horizontal axis the quantity of
labour. Firms are interested in buying labour services,
and their demand for labour is shown by the demand
curve D. Owners of labour services (workers) supply
their labour in the labour market, and the initial
supply of labour is shown by the supply curve S1.
(The demand curve has the usual downward-sloping
shape, because as the wage falls, firms are prompted
to hire more labour and so the quantity of labour
demanded increases. The supply curve has the usual
upward-sloping shape because the higher the wage,
the more willing workers will be to supply their labour
in the market.)
Assume now that because of immigration (foreign
workers enter the country), the supply of labour
increases, giving rise to a rightward shift in the labour
supply curve, to S2. At the old wage, W1, there will
be a surplus of labour in the market given by the
difference between Q2 and Q1 of labour. The surplus
will cause the wage rate to start falling, and this will
keep falling until the surplus has disappeared. The
new equilibrium wage will be W2, and the equilibrium
quantity of labour Q3, given by the intersection of the
demand for labour, D, with the new supply of labour
curve, S2.
The falling wage has acted as a signal and an
incentive. It signalled to firms that there was a surplus
in the labour market, and it has provided them with
an incentive to hire a bigger quantity of labour to
which they responded by moving along the labour
demand curve from point A to point C, where they
now hire more labour (Q3 is larger than Q1). At the
same time, the lower wage is a signal to workers, and
it provides them with the incentive to move along the
new supply curve, S2, from point B to point C, where
they offer less of their services at the lower wage than
they were willing to offer at the old higher wage (Q3 is
less than Q2). Therefore both firms and workers have
responded to the signals and incentives provided by
prices. This has resulted in a reallocation of labour
resources as firms are now producing output with a
larger quantity of labour. (This has affected the answer
to the how question of resource allocation.)
Test your understanding 2.8
1 What are the key functions of prices in
competitive markets?
2 How are markets related to price rationing?
3 How do prices help answer the how and what
questions of resource allocation?
(...continued)
Test your understanding 2.8
(...continued)
4 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), giving
rise to a new equilibrium price and quantity of
coffee. Explain the role of price as a signal and
as an incentive for consumers and for firms in
reallocating resources.
5 Consider the labour market, and suppose that
the supply of labour falls (due to large-scale
emigration, or departure of workers to another
country), giving rise to a new equilibrium price
and quantity of labour. Explain the role of price
as a signal and as an incentive for workers (the
suppliers of labour) and firms (the demanders of
labour) in reallocating resources.
Economic efficiency and the market economy
Economic efficiency broadly means making the best
possible use of resources. More precisely, economic
efficiency consists of: productive efficiency and
allocative efficiency, achieved in the ideal-type market
economy studied in Chapter 1, page 18.
Productive (or technical) efficiency: how
to produce
As we know from Chapter 1, page 11, an economy
achieves productive efficiency when it produces
at the lowest possible cost; or alternatively by
producing by use of the fewest possible resources.
The competitive market induces firms to produce at
the lowest possible cost. If some firms produced at a
higher cost, they would have to charge a higher price
in order to cover their costs; but then consumers
would prefer the lower price sellers, and the higher
price ones would go out of business.
Productive efficiency in the economy as a whole
means that it is not possible to produce more of one
good without producing less of any other good. To see
this, consider that if production takes place by use of
the fewest possible resources, this must mean that the
economy is producing the maximum it can produce,
in which case it is producing on the production
possibilities curve (PPC). But if it is producing on the
PPC, it is not possible to produce more of one good
without producing less of another good.
Chapter 2: Markets 49
The competitive market achieves productive
efficiency, which involves producing at the lowest
possible cost. When there is productive efficiency, the
economy is producing on its production possibilities
curve, and the ‘how to produce’ question is answered
in the best possible way in the sense that there is no
waste of resources.
Allocative efficiency: what to produce
An economy achieves allocative efficiency when it
produces the combination of goods that are mostly
wanted by society. Alternatively, we can say that
allocative efficiency for the economy as a whole is
achieved when the economy allocates its resources so
that it produces a combination of goods and services
such that it is not possible to make anyone better off
in terms of increasing their benefit from consumption
without making someone else worse off. In other
words, the benefits from consumption are maximized
for the whole of society.
Allocative efficiency is reached when the economy
produces at some specific point on its PPC selected by
society, because it specifies the combination of goods
that society mostly desires.
Economic efficiency: maximizing
consumer and producer surplus
To understand how economic efficiency is achieved by
the competitive market economy, we will study two
new concepts: consumer surplus and producer surplus.
Consumer surplus
Consumer surplus is defined as the highest price
consumers are willing to pay for a good minus the
price actually paid. As you may remember from our
discussion on demand, willingness to pay is the price
that a consumer is willing to pay in order to get a
unit of the good (see Figure 2.2(b)). In a competitive
market, the price actually paid is determined at the
market equilibrium by supply and demand. Consumer
surplus is shown in Figure 2.18 as the shaded area
between the demand (or marginal benefit) curve, and
the equilibrium price Pe. It represents the difference
between total benefits consumer receive and the price
paid to receive them.
P1
P2
P3 consumer
Pe
P4
P5
The competitive market achieves allocative
efficiency, which involves producing the
combination of goods and services mostly wanted by
society. When there is allocative efficiency, the ‘what
to produce’ question is answered in the best possible
way in the sense that scarce resources are used to best
satisfy consumers’ unlimited wants.
Note that if an economy as a whole is achieving
allocative efficiency, it must also be achieving
productive efficiency. Since allocative efficiency
involves being at a point on the PPC, productive
efficiency is necessarily also being achieved, otherwise
the economy would not be on the PPC. When the
economy achieves both productive and allocative
efficiency, the society is said to have achieved
economic efficiency (also known as Pareto efficiency
or Pareto optimality2).
2
This condition is named after Vilfredo Pareto, a 19th century economist.
50
Part 2: Microeconomics
S = MC
at market
equilibrium
MB = MS
surplus
producer
surplus
D = MB
P6
0
Qa Qb
Qe
Q
Figure 2.18 Consumer and producer surplus in a competitive market.
Consumer surplus indicates that whereas many
consumers were willing to pay a higher price to get the
good, they actually received it for less. For example,
many consumers were willing to pay price P2 to get
quantity Qa. Yet they got Qa by paying only the lower
price Pe. The difference between P2 and Pe is consumer
surplus for quantity Qa. Similarly, many consumers
were willing to pay price P3 in order to get quantity Qb,
yet they got it by paying only Pe. Again, the difference
P3 − Pe is consumer surplus for quantity Qb. The same
principle applies to all possible prices between the
highest price P1 and the equilibrium price Pe. This
means that all the consumers who were willing to pay
a higher price than Pe to get the good received some
benefit (or utility) over and above what they actually
paid for the good. This extra benefit is called consumer
surplus.
Producer surplus
Producer surplus is defined as the price received by
firms for selling their good minus the lowest price
that they are willing to accept in order to produce
the good. The lowest price they are willing to accept
represents the firms’ cost of producing an extra unit
of the good (or marginal cost), and is shown by the
supply curve. (The logic behind this is very simple:
the lowest price that the firm is willing to accept
must be just enough to cover its cost of producing
each extra unit; this cost is known as marginal cost,
and will be studied in Chapters 4 and 5.) Producer
surplus is shown diagrammatically as the area above
the firms’ supply curve and below the price received
by firms, Pe, which is determined in the market. As
we can see in Figure 2.18, firms that were willing to
produce quantity Qa for price P5 actually received
price Pe. The difference Pe − P5 is producer surplus for
quantity Pa. Similarly the producer surplus for quantity
Qb is given by the price Pe actually received minus P4
that the firms were willing to accept for producing
Qb. The same principle applies to all possible prices
between the lowest price P6 and the equilibrium price
Pe. Therefore producer surplus is shown by the shaded
area between the equilibrium price Pe and the supply
curve, representing the difference between price
received and marginal cost.
Reinterpreting market equilibrium
As we know, market equilibrium occurs at the point
of intersection of the demand curve and the supply
curve, which is the point where quantity demanded
is equal to quantity supplied. But depending on how
we interpret the demand and supply curves, the point
of market equilibrium can be thought of differently.
If we think of the demand curve as a marginal benefit
(MB) curve, and of the supply curve as a marginal cost
(MC) curve, then the point of market equilibrium is
the point where MB = MC. The equality of MB with
MC tells us that the extra benefit to society of getting
one more unit of the good is equal to the extra cost
to society of producing one more unit of the good.
When this happens, it means that society’s resources
are being used to produce the ‘right’ quantity of the
good; in other words, society has allocated the ‘right’
amount of resources to the production of the good,
3
To understand this, consider that if MB > MC, then society would be
placing a greater value on the good than it costs to produce it, and so
more of it should be produced. If on the other hand MC > MB, then it
would be costing society more to produce the good than the value society
puts on it, and so less should be produced. If MC = MB, then just the
‘right’ quantity of the good is being produced.
and is producing the quantity of the good that is
mostly wanted by society.3 But this is none other than
allocative efficiency in the case of a single market. It
follows then that when MB = MC, which occurs at the
point of competitive market equilibrium, the market is
achieving allocative efficiency.
There is also another way to interpret the demand and
the supply curves. Every point on the demand curve
represents the highest price consumers are willing
to pay for the corresponding quantity of the good,
while every point on the supply curve represents the
lowest price firms are willing to accept to produce the
corresponding quantity of the good. This means that
at the point of competitive market equilibrium, the
highest price that consumers are willing to pay is equal
to the lowest price firms are willing to accept. When
this happens, the sum of consumer and producer
surplus is maximum, or the greatest it can be.4
Putting the above points together, we can conclude
that allocative efficiency is achieved at the point of
competitive market equilibrium, where MB = MC, and
where the sum of consumer and producer surplus is
maximum.
Now we know from the discussion above that when
allocative efficiency is achieved, this means that
productive efficiency has been achieved as well.
In fact, the condition of maximum consumer plus
producer surplus indicates that the economy is
achieving not only allocative but also productive
efficiency. To see why this is so, suppose that firms
in some markets are not producing at the lowest
possible cost, i.e. they are productively inefficient. As
they compete with each other to lower their costs,
resources are transferred from the higher cost firms
to lower cost firms. With lower costs, these firms will
also have a lower minimum price they are willing to
accept for selling their output, and therefore a greater
producer surplus (since producer surplus is the price
firms receive minus the lowest price they are willing
to accept). Producer surplus will continue to increase
as long as resources can be shifted out of higher cost
producers and into lower cost producers, and will
be maximized when all output is produced by firms
producing at the lowest possible cost.
4
To see this, consider what would happen if any quantity less than Qe
were produced in Figure 2.18. If, say, Qb is produced, the highest price
consumers are willing to pay would be greater than the lowest price firms
are willing to accept, and the sum of consumer plus producer surplus
would be smaller, as this sum would then be equal to the shaded area
between the demand and supply curve only up to output Qb. The sum of
consumer plus producer surplus is the greatest it can be, or is maximized,
at the point of market equilibrium.
Chapter 2: Markets 51
Note that so far we have been considering what
happens in one single competitive market. If allocative
and productive efficiency are to be achieved for
the economy as a whole, the condition MB = MC,
indicating maximum consumer plus producer surplus,
must hold in all markets. When this occurs, allocative
and productive efficiency have been achieved for the
economy as a whole. It follows then that economic
efficiency, including both allocative and productive
efficiency, has been attained by the operation of free
markets.
The competitive market ensures that production of a
good will occur at the point where MB = MC (marginal
benefit equals marginal cost), which is also the point
where the sum of consumer plus producer surplus is
maximum. The conditions MB = MC and maximum
consumer plus producer surplus are achieved at the
point of competitive market equilibrium. When MB
= MC, the market is achieving economic efficiency,
which includes both allocative and productive
efficiency, thereby producing the quantity of the good
that is mostly desired by society at the lowest possible
cost. Economic efficiency in the economy as a whole
is achieved when MB = MC in every market.
A word of caution
We have seen that the competitive market economy
offers major advantages, in that through the workings
of the invisible hand coordinating the economic
decisions of individual consumers, firms and resource
owners, it succeeds in achieving allocative and
productive efficiency, thereby addressing the ‘what to
produce’ and ‘how to produce’ questions in the best
possible way from the point of view of society’s
interests. Productive and allocative efficiency are
highly desirable objectives because they indicate that
society is making the best possible use of its scarce
resources. Yet it should be stressed that efficiency can
only arise in the ideal-type market economy, under a
number of very strict and highly unrealistic conditions
that are practically never met in the real world. This
means that in the real world, the market actually fails
with respect to achieving many of the highly desirable
outcomes. We will study market failures and what can
be done to solve the problems they pose in Chapter 6.
Moreover, the competitive market economy is unable
to provide a satisfactory answer to the ‘for whom to
produce’ question, or output and income distribution.
The topic of distribution and what can be done to
improve outcomes will be examined in Chapter 11.
52
Part 2: Microeconomics
These observations do not lessen the significance
of the market’s potential advantages; they only
point out that in the real world, there is a need for
government policies that will counteract the failings of
markets, thus allowing them to realize their potential
advantages (we will study such policies in Chapters 6
and 9–11). There are several reasons why economists
study the market economy extensively, even though
this is not fully achievable in practice. One is that it
provides standards for economic efficiency against
which actual economies, which are less than perfectly
efficient, can be assessed. Another is that it can form
the basis for government policies that try to create
conditions in the real world that will allow actual
economies to come closer to achieving economic
efficiency. A third is that government policies
undertaken for reasons unrelated to efficiency can
themselves be assessed with respect to their efficiency
impacts. We now turn to consider some such policies
and their efficiency impacts in Section 2.4 (page 53).
Test your understanding 2.9
1 Consider whether each of the following
situations involves problems relating to
productive efficiency, or allocative efficiency, or
both. What could be done in each case in order
to improve productive or allocative efficiency?
(a) An economy produces mostly videotape
players, whereas consumers mostly prefer
DVD players.
(b) An economy that has a large labour force
(number of working-age people who are
working or looking for a job) and relatively
small amounts of capital decides to produce
a variety of goods by using production
methods that require large amounts of
capital and relatively small amounts of
labour (hint: think about the ‘how to
produce’ basic question).
(c) A farmer has just purchased a large, modern
tractor and uses it to drive from the farm
to the nearby town in order to buy seeds,
fertilizer and other agricultural inputs
(hint: is the farmer making good use of
the tractor, which is an expensive piece of
equipment, or does the tractor have better
uses on the farm?).
(d) An economy with a temperate zone climate
produces bananas, whereas it could have
been producing apples at a much lower
cost.
(...continued)
Test your understanding 2.9
HL
Price ceilings: setting a legal maximum price
(...continued)
Higher level
What is a price ceiling?
2 (a) Use a demand and supply diagram to
A government may in some situations set a legal
maximum price for a particular good; this is called
a price ceiling. This means that the price that can
be legally charged by sellers of the good must not
be higher than the price ceiling, or maximum price.
Figure 2.19 shows how this works. In panel (a), the
equilibrium price is Pe, determined by the forces of
demand and supply. The price ceiling, Pc, has been set
by the government at a level below the equilibrium
price. At this price, there arises a shortage, because
the quantity demanded, Qd is greater than quantity
supplied, Qs. If the market were free, the forces of
demand and supply would exert an upward pressure
on price until it reached Pe. However, now this cannot
happen, because the price hits the legally set price
ceiling.
illustrate consumer and producer surplus. At
which level of output is their sum maximum?
(b) Explain the condition MB = MC. Use your
diagram to show at which level of output it
occurs. (c) What do the conditions of maximum
consumer plus producer surplus, and MB =
MC tell us about allocative and productive
efficiency?
2.4 Government intervention in the
market: price controls and market
disequilibrium
Demand and supply interact to determine an
equilibrium, market-clearing price and equilibrium
quantity only when they are free to do so, that is,
when there is nothing preventing them from arriving
at a market-clearing price. Sometimes, governments
(as well as private organizations) intervene in markets
in pursuit of particular objectives, thereby preventing
the market from achieving equilibrium. One common
method of intervention in markets involves price
controls.
P
Consequences of price ceilings
· Shortages A price ceiling that is set below the
equilibrium price of a good creates a shortage of the
good. There will be excess quantity demanded, as
not all interested buyers who are willing and able to
buy the good will be able to do so, simply because
at the maximum legal price there isn’t enough of
the good being supplied. In Figure 2.19(a), there is a
shortage equal to the difference between Qd and Qs.
Price controls refer to the setting of prices by
the government (or private organizations) so that
they are unable to adjust to their equilibrium level
determined by demand and supply. Price controls
result in market disequilibrium, and therefore in
shortages or surpluses.
(a) Price ceiling that is
constraining.
Note that in order to have an impact, the price ceiling
must be below the equilibrium price. Figure 2.19(b)
shows a situation where the price ceiling has no
effect on the market, because it is higher than the
equilibrium price: Pc lies above Pe. The market achieves
equilibrium price and quantity (Pe and Qe), and the
price ceiling has no practical impact.
(b) Price ceiling that is
not constraining.
S
P
S
Pc
Pe
Pe
Pc
shortage
0
Qs
Qe
D
Qd
D
Q
0
Qe
Q
Figure 2.19 Price ceilings.
Chapter 2: Markets 53
· Smaller quantity supplied and sold A price ceiling
gives rise to a lower quantity supplied and sold
than what would have prevailed at the equilibrium
price. This can be seen in Figure 2.19(a), where Qs
corresponding to Pc is less than the quantity that
suppliers would sell in the market at price Pe.
· Underallocation of resources to the good and failure
to achieve allocative efficiency Since a lower than
equilibrium price results in a smaller quantity
supplied than the amount that would have prevailed
at equilibrium, this means that too few resources
are being allocated to the production of the good,
resulting in a quantity produced that is smaller than
optimum (or ‘best’). Whereas the optimum quantity
that should be produced would be Qe, actually Qs is
produced. This means that the price ceiling results
in failure to achieve allocative efficiency: consumers
are worse off because less than the optimal amount
of the good is being produced.
· Non-price rationing Once a shortage arises, the price
mechanism is no longer able to achieve its rationing
function. Some of the demanders who want and
are able to buy the good at the maximum price
Pc in Figure 2.19(a) will have to go unsatisfied. At
this price only quantity Qs is being supplied. The
question then arises, how will this quantity be
distributed among all interested buyers? This can
only be done through a mechanism of non-price
rationing (introduced in Chapter 1, pages 18
and 20). Non-price rationing methods include the
following:
m
m
m
waiting in line and the first-come-first-served
principle: those who come first will buy the good
the distribution of coupons to all interested
buyers, so that they can purchase a fixed amount
of the good in a given time period
favouritism: the sellers can sell the good to their
preferred customers.
· Underground (or informal) markets Underground
markets are a special kind of price rationing, as
they are illegal. They involve buying a good at the
maximum price set, and then illegally reselling
it to interested buyers at a price above the legal
maximum. Underground markets can arise when
there exist dissatisfied people who have not
succeeded in buying the good because there wasn’t
enough of it, and are willing to pay more than
the ceiling price to get it. Therefore underground
markets can only arise in situations where there is
a shortage (if there were no shortage, the price of
the good would be at its equilibrium price, and no
one would be interested in paying a higher than
54
Part 2: Microeconomics
equilibrium price for it). Underground markets are
inequitable, and tend also to frustrate the objectives
sought by the price ceiling.
Examples of price ceilings
Rent controls
Rent controls consist of a maximum legal rent on
housing, which is below the market-determined level
of rent (i.e. the market-determined price of rental
housing). It is undertaken by governments in many
cities around the world in order to make housing more
affordable to low income groups. Consequences of
rent controls include the following:
· They result in a shortage of housing, as the quantity
of housing demanded at the legally maximum rent
is greater than the quantity of housing available.
· The quantity of housing available at the legally
maximum rent is lower than if the free market
rent had prevailed, because landlords (owners of
housing) are less willing to make their housing
available for rent at the lower price; this can be seen
in Figure 2.19(a) where at price Pc, the quantity
supplied Qs is lower than the quantity that would
have been supplied at the equilibrium price (Qe).
· There arise long waiting lists of interested tenants
waiting for their turn to secure an apartment.
· There may develop a market for rented units where
tenants sublet their apartments at rents above the
legal maximum (an underground market).
· It becomes unprofitable for landlords to maintain or
renovate their rental units because of the low rent,
with the result that over long periods of time these
become run down.
Setting price ceilings by setting prices
administratively
In former communist countries, most consumer good
prices were set by the government at artificially low
levels, in order to make them affordable to everyone;
there resulted significant shortages and long queues
where consumers commonly spent hours in order to
buy their food and other basic goods. In addition,
there developed underground markets for many goods
and services.
Petrol (gasoline) prices
In the early 1970s, the Organization of Petroleum
Exporting Countries (OPEC) succeeded in significantly
raising the market price of oil by restricting output. In
response, some governments imposed price ceilings on
petrol (gasoline), with the result that there developed
long queues at petrol stations because of the shortage
created by lower than equilibrium prices.
Price floors: setting a legal minimum price
floor gives rise to a lower quantity demanded
and purchased than the amount that would have
prevailed at the equilibrium price. This can be seen
in Figure 2.20(a), where Qs, corresponding to Pf,
is larger than the quantity that would have been
demanded and purchased at price Pe.
· Firm inefficiency In product markets, higher than
What is a price floor?
A legally set minimum price is called a price floor.
In this case the price that can be legally charged by
sellers of the good must not be lower than the price
floor, or minimum price. In Figure 2.20(a), a price
floor, Pf, has been set above the equilibrium price,
Pe. At this price, there arises a surplus, because the
quantity demanded, Qd, is smaller than quantity
supplied, Qs. If the market were free, the forces of
demand and supply would exert a downward pressure
on price until it reached Pe. However, now this cannot
happen, because the price hits the legally set price
floor.
In order to have an impact, the price floor must be
above the equilibrium price. Figure 2.20(b) shows a
situation where the price floor has no effect on the
market, because it is lower than the equilibrium price:
Pf lies below Pe. The market achieves equilibrium price
and quantity (Pe and Qe), and the price floor has no
practical impact.
Consequences of price floors
· Surpluses The effect of a price floor set above the
equilibrium price of a good is to create a surplus of
the good or resource. There will be excess quantity
supplied, and sellers of the product will be unable
to sell all of it at the legal minimum price. In Figure
2.20(a), the difference between Qs and Qd represents
the excess quantity supplied, or surplus. In general,
the imposition of price floors leads to surpluses.
(a) Price floor that
is constraining.
· Smaller quantity demanded and purchased A price
P
S
surplus
equilibrium product prices can lead to inefficient
production; firms that have high costs of production
due to inefficiencies do not face incentives to cut
costs by using more efficient production methods,
because the high price offers them protection
against lower cost competitors. This leads to
inefficiency.
· Overallocation of resources to the production of the good
In product markets, a higher than equilibrium price
results in too many resources being allocated to the
production of the product, resulting in a larger than
optimum (or ‘best’) quantity produced of the good.
Whereas the optimum quantity that should be
produced would be Qe, actually Qs is produced.
· Illegal sales at prices below the floor Since firms
cannot sell their entire product, they may illegally
try to sell part of their surplus product at prices
below the legal minimum. In the labour market, if
there is a minimum wage set by the government,
this can be a major problem as some workers may
illegally offer their labour at wages (the price of
labour) below the legal minimum (see the example
below on minimum wages).
Examples of price floors
Minimum wages
Many countries around the world have minimum
wage laws that determine the minimum price of
labour (the wage rate) that an employer (a firm) must
pay. The objective is to guarantee an adequate income
(b) Price floor that is
not constraining.
P
S
Pf
Pe
Pe
Pf
D
D
0
Figure 2.20 Price floors.
Qd
Qs
Q
0
Qe
Q
Chapter 2: Markets 55
to low income workers (who tend to be mostly
unskilled). Figure 2.21(a) shows the market for labour,
which is one of the resource markets, with standard
demand and supply curves. The ‘price’ of labour is
the wage. The demand for labour curve shows the
quantity of labour that firms are willing and able to
hire at each wage, and the supply of labour curve
shows the quantity of labour that workers supply
at each wage. Supply and demand determine the
equilibrium wage, We, where the quantity of labour
demanded is equal to the quantity of labour supplied.
The minimum wage, Wm, lies above the equilibrium
wage, We. Therefore the quantity of labour supplied at
the minimum wage rate, Qs, is larger than the quantity
of labour demanded, Qd. There results a surplus of
labour in the market equal to the difference between
Qs and Qd. This surplus of labour is unemployment,
as it corresponds to people who would like to work
but have not been employed. The impacts of the
minimum wage are:
· a surplus of labour equal to Qs − Qd
· an increase in the wage of those who are employed,
from We to Wm
· an increase in costs of production for firms
· a decrease in the quantity of labour employed, from
Qe to Qd
· an increase in unemployment, due partly to the
decrease in quantity of labour employed (the
difference between Qe and Qd) and partly to an
increase in the quantity of labour supplied due to
the higher wage rate (the difference between Qs
and Qe)
price of labour (wage)
wages below the legal minimum; this often involves
illegal immigrants who may be willing to supply
their labour at very low wages.
P
supply
of
labour
Wm
We
Farmers’ incomes in many countries, resulting from
the sale of their products in free markets, are often
considered to be too low (some of the reasons for
this will be considered in Chapter 3). One way that
governments support farmers’ incomes is by setting
price floors for certain key agricultural products.
Price floors for agricultural products are called price
supports. Price support schemes generally are
methods used to raise the price of a product above its
equilibrium market price. Figure 2.21(b) shows the
market for an agricultural product with a price floor,
Pf, set above the equilibrium price, Pe. The impacts of
the price floor are the following:
· There results a surplus equal to Qs − Qd, since at Pf
the quantity consumers demand is given by Qd,
while the quantity farmers supply is Qs; this surplus
quantity must be disposed of in some way, and is
usually bought by the government at price Pf.
by total quantity sold times the price at which it is
sold. In the free market, farmers’ revenues would
have been Qe × Pe, which is equal to the rectangle
0QeAPe. Following the imposition of the price floor,
farmers’ revenues increase to an amount equal to
the rectangle 0QsBPf.
· Consumers are worse off; whereas in the free market
situation they would be buying Qe at the price Pe,
they now buy a smaller quantity (Qd) and pay a
higher price (Pf).
(b) An agricultural
product market
with price floor.
P
Pf
S
C
surplus
B
A
Pe
demand
for
labour
0
Figure 2.21 Examples of price controls.
56
labour surplus =
unemployment
Price floors to support farmers’ incomes
· Farmers’ revenues increase; revenue is determined
· possible illegal employment of some workers at
(a) Labour market
with minimum
wage.
The consequences of minimum wage legislation are
quite controversial, as it is uncertain whether it results
in an increase in unemployment in practice. Some
economists argue that labour productivity (defined
as the amount of output produced per worker) may
increase due to the minimum wage, with the result
that employment of unskilled labour could even
increase following the imposition of minimum wages.
Part 2: Microeconomics
Qd Qe Qs
quantity of labour
Q
D
0
Qd
Qe
Qs
Q
· There results encouragement of inefficient
producers; the higher than equilibrium minimum
price offers protection to high cost, inefficient
farmers against lower cost, more efficient ones.
· There are significant costs to the government,
which are paid for out of taxes (and therefore by
taxpayers). The cost to the government of buying
the surplus is equal to the quantity of the surplus
times the price at which it sold, Pf; this is given by
the area of the rectangle QdQsBC. In addition, there
are further costs of storing the surplus.
· There results an overallocation of resources to the
production of the product, and therefore allocative
inefficiency. Too many resources are allocated to
the production of the good. Whereas an optimal
(or ‘best’) allocation would mean that Qe would
be produced (determined by the free market
equilibrium) now the greater quantity Qs is being
produced.
· There follows, further, a global misallocation of
agricultural resources. The European Union, the
United States and many other countries rely on
price supports for agricultural products to support
their farmers, giving rise to an overallocation of
resources to these products, excess production and
surpluses. The surpluses are sometimes sold in
world markets, with the result that they work to
lower world prices. Countries that do not have price
supports are then forced to sell their agricultural
exports at artificially low world prices. The low
prices that prevail in these countries signal to
local farmers that they should cut back on their
production, resulting in an underallocation of
resources to the production of such products. Low
world prices also mean lower export revenues. This
pattern often involves less developed countries that
feel frustrated in their development efforts, and is a
highly contentious issue (it will be discussed further
in Chapters 12 and 15).
(a) Price fixing resulting in a shortage.
Commodity agreements and buffer stock
schemes
A commodity is a standardized product, and usually
refers to a good that is produced in the primary sector.
The primary sector is that part of the economy that
makes direct use of natural resources; it therefore
includes agriculture, forestry, fishing and extractive
P
S
a
b
D1
0
Let’s consider tickets for a sports event, shown in
Figure 2.22. Note that the supply curve is vertical,
indicating that there is a fixed supply of tickets,
determined by the fixed number of seats available for
each event (the vertical supply curve was considered
earlier in the section on ‘Supply’, page 42). The ticket
price is given by Pf, and is fixed by the organizing
body. Panel (a) illustrates an event for which there is
large demand, given by D1. If the price could respond
to market forces, it would rise to Pe. However it is
fixed at Pf, where there arises a shortage of tickets
equal to the horizontal difference between points a
and b. Panel (b) illustrates an event for which there
is low demand, given by D2. Here, the equilibrium
price would have been Pe, however price is fixed at the
higher level Pf, giving rise to a surplus of tickets equal
to the horizontal difference between points c and d.
(b) Price fixing resulting in a surplus.
Pe
Pf
The price controls considered above involve setting
a legal maximum or legal minimum price. In these
cases, the price is allowed to change, as long as it
does not rise above the price ceiling or fall below the
price floor. However, there are other situations where
the price is fixed so that it cannot change at all. This
is seen most frequently in the case of ticket prices
for theatres, movies and sports events of all kinds,
where prices are usually fixed ahead of time by the
organizing body (which may be private or public), and
cannot increase or decrease according to the forces of
supply and demand.
P of tickets
P of tickets
P
Setting fixed prices
Q
Figure 2.22 Price fixing and surpluses and shortages.
Pf
S
c
d
Pe
D2
0
Q
Chapter 2: Markets 57
industries (fuels, metals and so on). The primary
sector tends to be more important in less developed
countries, and declines in relative importance as a
country becomes more developed. Many developing
country economies depend heavily on production
and exports of commodities. This dependence can
pose serious problems for these economies, because
commodity prices tend to fluctuate a lot (increase and
decrease) over short periods of time, and they also
tend to fall over long periods of time.
Commodity agreements are agreements attempting
to increase or stabilize world prices of commodities on
which developing countries depend for their export
earnings, so as to protect members against price
fluctuations and falling prices. They generally involve
international agreements between representatives of
producers as well as government authorities. Buffer
stock schemes are a special type of commodity
agreement intended to limit price fluctuations.
These have existed at different times for a number of
commodities, including cocoa, coffee, rubber, sugar,
tin and wheat. Another type of commodity agreement
involves setting export quotas, which attempt to limit
the quantity of exports and therefore increase price.
Commodities for which these have been tried are
sugar and coffee.
Buffer stock schemes try to provide price stability
for products whose price can fluctuate widely over
short periods of time. Agricultural product prices are
especially subject to wide fluctuations, partly because
production depends on factors beyond the farmer’s
control, such as floods, drought, pests and so on,
causing shifts in the supply curve, and giving rise to
higher or lower prices. Price fluctuations can also be
caused by changes in demand, so as the demand curve
shifts, this also gives rise to higher or lower prices.
(The reasons for price fluctuations of agricultural
products will be considered more fully in Chapter 3.)
(a) Buffer stock scheme to stabilize price when price
fluctuates due to unstable supply.
S2
P
P2
Pt
Qt
The way the scheme works is as follows: When supply
is large, say at S1, and prices are low (P1), at the target
price Pt there results a surplus (or excess quantity) of
the product equal to Q1 − Qt. The authorities buy up
this surplus and put it in storage; in so doing, they
succeed in keeping the price at Pt, and prevent it from
falling due to the surplus. When supply is low, say at
S2 and prices are high (P2), at the price Pt there results a
shortage (or insufficient quantity) of the product equal
to Qt − Q2. The authorities now sell this quantity of the
product from the stocks they have kept in storage, and
thus keep the price from rising due to the shortage.
The result is that the price stabilizes at Pt.
We can also carry out the analysis in terms of price
fluctuations due to unstable demand, as shown in
Figure 2.23(b). When demand is low, say at D1, there
results a low price of P1, whereas a high demand of D2
gives rise to price P2. Say now the authorities set the
target price at Pt (between P1 and P2). When demand
is low, say at D1, at the target price Pt there results a
surplus equal to Qt − Q1, which the authorities buy up
(b) Buffer stock scheme to stabilize price when price
fluctuates due to unstable demand.
P
S1
shortage
Q2
Figure 2.23(a) shows how a buffer stock scheme is
intended to work when price fluctuations are due to
unstable supply. Say that weather conditions have
been good in one particular season, the supply curve
is S1, and given the demand curve D, the market price
is P1. But if in the next season the weather conditions
are adverse, this will cause a decrease in output, and
therefore a leftward shift of the supply curve to S2, and
an increase in price to P2. If a government (or group
of governments) decides to implement a buffer stock
scheme to stabilize prices, it will determine a price
at which it would like the product to sell. We can
call this the target price, Pt, and it will be somewhere
between P1 and P2. At price Pt, quantity qt should be
supplied. The purpose of the scheme is to try to ensure
that this quantity qt will be supplied all the time, so as
to maintain the price at Pt.
Q1
P1
surplus
S
P2
Pt
P1
Q1
Qt
shortage
q2
qt
Figure 2.23 Buffer stock schemes.
58
Part 2: Microeconomics
q1
D2
surplus
D
0
Q2
D1
Q
0
q1
qt
q2
Q
and put into storage. When demand is high, say at
D2, at the target price Pt there results a shortage equal
to Q2 − Qt. The authorities then sell some of the stocks
they have in storage, and so prevent the price from
increasing.
In practice, the authorities would not need to keep
track of changing demand and supply. They would
buy some of the product during times when price is
falling in order to prevent the price decrease, and sell
during times of rising prices in order to prevent the
price increase.
However, in practice buffer stock schemes have not
worked very well. Problems include the following:
· high costs of storage
· underfunding of the schemes
· the need to be able to predict future prices that arise
from supply or demand shifts; this is very difficult
due to the unpredictability of the shifts
· the need to balance surpluses with shortages over
several years which may not match each other
· running out of stocks during times of rising prices
· the inability to address the problem of declining
prices over the long run (to be discussed in
Chapters 14 and 16); when market prices fall over
long periods, there result a series of surpluses that
accumulate at the ‘target’ price season after season;
purchasing these surpluses leads to major financial
difficulties.
For example, a buffer stock scheme for tin ran into
serious difficulties when a dramatic fall in the demand
for tin occurred; this led to a very large accumulation
of stocks that bankrupted the tin scheme in 1985.
Test your understanding 2.10
1 Why do price controls result in market
disequilibrium?
2 The ceiling of a room is its upper surface and
the floor is its lower surface. Yet in demand and
supply analysis we have the reverse: a ceiling lies
below equilibrium price and a floor lies above
equilibrium price (if they are to be effective).
Using appropriate diagrams, explain why this is
so.
3 Explain, using diagrams, how price ceilings and
price floors give rise to surpluses and shortages.
4 Explain, using diagrams, how fixing price at a
particular level can give rise to surpluses when
demand is low and shortages when demand is
high.
5 In what way are underground markets a kind of
price rationing?
6 Using appropriate diagrams, explain how price
controls (price ceilings and floors) can work
to prevent the achievement of allocative and
productive efficiency.
7 (a) Using an appropriate diagram, show how a
price ceiling impacts upon price and quantity in
the market. (b) Discuss the likely consequences
of price ceilings. (c) Evaluate the desirability of
these consequences from a social point of view.
8 (a) Using an appropriate diagram, show how a
price floor impacts upon price and quantity in
the market. (b) Discuss the likely consequences
of price floors. (c) Evaluate the desirability of
these consequences from a social point of view.
Commodity agreements were popular from about the
1960s to the 1980s. Most have since collapsed because
of the various difficulties listed above. None succeeded
in stabilizing or increasing commodity prices over
long periods of time, and they are therefore no longer
seriously considered as a method to assist developing
countries in their development efforts.
Chapter 2: Markets 59
Questions for
review
2.1
[10 marks] Identify, and compare and contrast,
the main characteristics of the four market
structures: perfect competition, monopoly,
monopolistic competition, and oligopoly.
2.2
[10 marks] Growing populations and rising
incomes in developing countries have affected
the price of meat. (a) Assuming meat is a normal
good, use a demand and supply diagram to
explain the impacts on the price of meat.
(b) Producers of meat responded to the change in
price by increasing the quantity of meat supplied;
use your diagram from part (a) to show the
increase in quantity of meat supplied.
2.3
[10 marks] ‘Quantity demanded increases as price
falls. Yet a fall in demand, ceteris paribus, leads to
a fall in price.’ Do these two statements contradict
each other? Explain.
2.4
[10 marks] Figure 2.15(a) presents two market
equilibrium positions. A comparison of the two
shows that a lower price is associated with a
greater quantity sold. Does this violate the law of
supply? Explain.
2.5
[10 marks] In the standard demand and supply
analysis, an increase in demand, ceteris paribus,
leads to a larger equilibrium quantity supplied,
and yet supply does not change. How is this
possible?
2.6
[10 marks] Using supply and demand diagrams,
show how prices function as signals and incentives
in a market economy.
2.7
[15 marks] (Based on Chapters 1 and 2.)
Wassily Leontief, a Russian-born economist who
emigrated to the United States in 1925 because
of his opposition to Soviet communism, and
who in 1973 won the Nobel Prize in Economics,
was a keen supporter of strong government
intervention in the economy and state economic
planning (central planning). Using a mathematical
technique known as input–output analysis, he
proved that a centrally planned economy can
achieve the identical allocation of resources as a
free market economy. Yet, in practice, one of the
greatest shortcomings of economies that made
heavy use of central planning (such as communist
systems) has been the failure to achieve efficient
resource allocation. (a) Explain resource allocation
and relate it to the ‘what to produce’ and ‘how to
produce’ economic questions. (b) What are the
60
Part 2: Microeconomics
most likely causes of inefficient resource
allocation in centrally planned economies?
(c) What characteristics of market systems do you
think are mainly responsible for the advantages
that markets have over command mechanisms
and central planning? (Hint: consider the problem
of information required by decision-makers to
plan economic activities, as opposed to the role
of prices as signals and incentives; how does the
invisible hand in market economies solve this
problem?)
2.8
[5 marks for part (a); 15 marks for part (b)]
Greece has legislation that determines a national
minimum wage. At one time the government
proposed that the law be suspended (not enforced)
in areas that have high unemployment. Public
reaction to the proposal was mixed, with some
people in favour and others against. (a) Use
demand and supply diagrams to explain what the
proposal was trying to achieve. (b) Evaluate the
likely impacts of such a policy, considering who
may gain, who may lose, and why.
2.9
[10 marks for parts (a) and (b); 15 marks
for parts (c), (d) and (e)] In 1973 OPEC (the
Organization of the Petroleum Exporting
Countries) increased the price of crude oil, which
is the key input in petrol (gasoline) production.
This led to an increase in the price of petrol. Some
countries initially responded by imposing price
controls (a price ceiling, or legal maximum price)
on petrol. Following this sequence of events, there
emerged shortages in the petrol market. (a) Use a
demand and supply diagram to show the impact
of the increase in the price of crude oil on the
equilibrium price and quantity of petrol/gasoline.
(Hint: what effect does an increase in the price of
an input (crude oil) have on the supply of petrol?)
(b) Use a supply and demand diagram to show
the effects of the price ceiling in the petrol market.
(c) Was the petrol shortage due to the actions
of OPEC or due to the price controls? Explain.
(d) What could have been done to prevent the
shortage? (e) Evaluate the policy of petrol price
controls.
2.10
[15 marks] The United States and the European
Union use price supports (price floors, or legal
minimum prices) for sugar to support sugar
producers. Use a demand and supply diagram to
illustrate, explain and evaluate the impacts in the
market for sugar.
HL
2.11
[10 marks] In athletic and artistic events where
ticket prices are fixed ahead of time by the
organizing body, and are not allowed to fluctuate
in response to demand and supply, we often see
the practice where some people buy tickets at the
official price and later resell them to interested
viewers at a higher price. Use a demand and
supply diagram to explain why this practice
occurs.
2.12
[15 marks] (a) What are commodity agreements
and buffer stock schemes? (b) What do they
attempt to achieve? (c) Why are buffer stock
schemes no longer used by developing countries
as part of their development strategies? (d) Using
demand and supply diagrams, show how buffer
stock schemes attempt to achieve their objective
in the event that (i) prices fluctuate due to
unstable demand, and (ii) prices fluctuate due to
unstable supply.
Higher level
2.13
[10 marks] What are Giffen goods? Under what
circumstance might they exist? What do they tell
us about the law of demand?
2.14
[10 marks] (a) Provide two possible explanations
(other than Giffen goods) for a demand curve that
slopes upwards. (b) Why are these a violation of
the law of demand? (c) Do you think that each
of these is likely to be a violation of individual
demand or market demand?
Chapter 2: Markets 61
Chapter 3
Microeconomics
Elasticities
Elasticity is a measure of the responsiveness or sensitivity of a variable to changes in price or any of the
variable’s determinants. In this chapter we will examine four kinds of elasticities, selected because of
their numerous applications to important economic problems.
OBJECTIVES
After studying this chapter you should be able to:
·
·
·
·
·
·
define and calculate the price elasticity of demand, the cross-elasticity of demand, the income elasticity of
demand, and the price elasticity of supply
understand the technical characteristics of each of these elasticities
identify the determinants of each elasticity concept and be able to predict their impacts on demand or supply
apply each elasticity concept to a variety of real-world situations
define and explain flat rate and ad valorem taxes (higher level topic)
analyse the incidence of taxes and subsidies on consumers and producers, taking elasticities into consideration
(higher level topic).
3.1 Price elasticity of demand (PED)
According to the law of demand, there is an inverse
relationship between price and quantity demanded:
the higher the price, the lower the quantity
demanded, and vice versa, all other things equal. We
now want to know by how much quantity responds
to change in price.
Price elasticity of demand is a measure of the
responsiveness of the quantity of a good demanded
to changes in its price. In general, if there is a large
responsiveness of quantity demanded, demand
is referred to as being elastic; if there is a small
responsiveness, demand is inelastic.
62
Part 2: Microeconomics
Determinants of the price elasticity of
demand
Let’s consider the factors that determine whether the
demand for a good is elastic or inelastic:
· Availability of substitutes The more substitutes
a good or service has, the more elastic will be
its demand. If a good or service has many close
substitutes, then an increase in its price will make
consumers switch to other products that satisfy the
same need, therefore there will be a relatively large
drop in quantity demanded, i.e. large responsiveness
to the price increase. For example, there are
many brands of toothpaste, all of which are close
substitutes for each other. If there is an increase in
the price of one brand of toothpaste, with the prices
of all the others remaining the same, consumers are
likely to switch to these others. This means there
will be a relatively large drop in quantity demanded
of the now more expensive toothpaste following
the increase in its price, so its demand is elastic. If
a good or service has few or no substitutes, then
an increase in price will bring forth a small drop in
quantity demanded. For example, an increase in the
price of petrol (gasoline) is likely to give rise to a
small drop in quantity demanded, because there are
no close substitutes; therefore the demand for petrol
is inelastic.
· Broad or narrow definition of a good or service A good
can be defined broadly (for example, fruit) or
narrowly (a specific kind of fruit, such as oranges,
apples, pears, etc.). The broader the definition of
a good, the fewer substitutes it will have and the
less elastic the demand will be. The narrower the
definition, the more there are substitutes, and the
more elastic the demand. The demand for apples is
more elastic than the demand for fruit, because of
the availability of oranges, pears or other fruits that
are close substitutes for apples. An increase in the
price of apples, for example, will lead consumers
to switch to a substitute good. Similarly, a Honda
has a higher price elasticity of demand than all cars
considered together.
· Necessities versus luxuries Necessities are goods
or services that we consider to be essential or
necessary in our lives; we cannot do without them.
Luxuries, on the other hand, are not necessary
or indispensable. The demand for goods that are
necessities is less elastic than the demand for
luxuries. For example, the demand for medications
tends to be very inelastic because people’s health or
life depend on them; therefore quantity demanded
is not very responsive to changes in price. The
demand for food is also inelastic, because people
cannot live without it. On the other hand, the
demand for diamond rings is elastic as most people
view them as luxuries.
· Length of time The longer the time period in which
a consumer makes a purchasing decision, the more
elastic the demand. As time goes by, consumers
have the opportunity to consider whether they
really want the good, and to get information on the
availability of alternatives to the good in question.
For example, if there is an increase in the price of
heating oil, consumers can do little to switch to
other forms of heating in a short period of time,
and therefore demand for heating oil tends to be
inelastic over short periods of time. But as time
goes by, they can switch to other heating systems,
such as gas, or they can install better insulation, or
they can buy more blankets, and demand tends to
become more elastic.
· Proportion of income spent on a good or service The
a good or service, the more elastic the demand. An
item such as a pen takes up a very small proportion
of one’s income, whereas summer holidays take up a
much larger proportion. If there is an increase in the
price of pens and in the price of summer holidays,
the response in quantity demanded is likely to be
greater in the case of summer holidays than in the
case of pens.
· Addiction The greater the degree of addiction to a
substance (drugs, cigarettes and so on) the more
inelastic the demand. A price increase will not bring
forth a significant reduction in quantity demanded
if one is severely addicted.
Test your understanding 3.1
1 Identify and explain the determinants of the
price elasticity of demand.
2 State in which case demand is likely to be more
elastic in each of the following pairs of goods,
and why:
(a)
(b)
(c)
(d)
(e)
(f)
chocolate or Cadbury’s chocolate
orange juice or water
cigarettes or candy bars
a notepad or a computer
heating oil in one week or in one year
bread or caviar.
Definition and formula for the price elasticity
of demand
We now turn to an examination of the technical
properties of the price elasticity of demand (PED).
The formula for the PED
Let’s say we are considering the price elasticity of
demand (PED) for good X. The formula used to
measure its PED is the following:
price elasticity
= PED =
of demand
percentage change in
quantity of good X demanded
percentage change in
price of good X
If we abbreviate ‘change in’ by the Greek letter Δ, this
formula can be rewritten as:
PED =
%Δ Qx
%Δ Px
larger the proportion of one’s income needed to buy
Chapter 3: Elasticities 63
To calculate the percentage change in quantity
(%Δ Q), we divide the change in quantity by the initial
quantity and multiply by 100. Similarly, to calculate
the percentage change in price (%Δ P), we divide the
change in price by the initial price and multiply by
100. The above formula can therefore be rewritten as
shown below:
Δ Qx
PED =
Qx
Δ Px
Px
Δ Qx
× 100
=
× 100
Qx
Δ Px
Px
The sign of the PED
Since price and quantity demanded are inversely
related, the PED will always be a negative number.
This is because for any percentage increase in price
(a positive denominator), there will be a percentage
decrease in quantity demand (a negative numerator),
giving rise to a negative PED. Similarly, for a
percentage price decrease there will be a percentage
price increase, again resulting in a negative PED.
However, the common practice is to drop the minus
sign and consider the PED as a positive number. (In
mathematics dropping the minus sign of a number
is called taking its absolute value.) This is done in
order to avoid confusion when making comparisons
between different values of PED. Using positive
numbers, we can say, for example, that a PED of 3 is
larger than a PED of 2. (Had we been using the minus
sign, − 2 would be larger than − 3.)
The use of percentages
Elasticity is measured in terms of percentages for two
reasons:
· We need a measure of responsiveness that is
independent of units. First, we want to be able to
compare the responsiveness of quantity demanded
of different goods; it makes little sense to compare
units of oranges with units of computers or
cars. Second, we want to be able to compare
responsiveness across countries that have different
currency units; an elasticity measured in terms of
euros will not be comparable with an elasticity
1
The more advanced student may note that the value of this elasticity of
demand depends on the choice of the initial price–quantity combination.
In the calculation above, this was taken to be 255, 6000. If we had taken
300, 5000 as the initial price–quantity combination, we would get a PED
value of 0.94. (The student can calculate this as an exercise.) This difficulty
can be overcome by use of the ‘midpoint formula’:
Δ Qx
PED =
average Qx
Δ Px
.
average Px
64
Part 2: Microeconomics
measured in yen or pounds. By computing changes
in quantity and changes in price as percentages, we
express them in common terms, thereby making
comparisons of responsiveness for different goods
and across countries possible.
· It is meaningless to think of changes in prices or
quantities in absolute terms (for example, a $15
increase in price or a 20 unit decrease in quantity)
because this tells us nothing about the relative size
of this change. For example, a $15 price increase
means something very different for a good whose
original price is $100 than for a good whose original
price is $5000. In the first case there is a 15%
increase, and in the second there is a 0.3% increase.
Using percentages to measure price and quantity
changes allows us to put responsiveness into
perspective.
The same arguments apply to all other elasticities that
we will consider.
Calculating the PED
We can now use the formula given above to calculate
the PED. Let’s suppose that consumers buy 6000 CD
players when the price is $255 per CD player, and they
buy 5000 CD players when the price is $300.
PED =
6000 − 5000
5000
255 − 300
300
=
1000
5000
− 45
300
=
0.20
− 0.15
= −1.33 or 1.33
since we drop the minus sign. Therefore in this
example the price elasticity of demand (PED) for CD
1
players is 1.33.
Test your understanding 3.2
1 It is observed that when the price of pizzas is
$16 per pizza, 100 pizzas are sold; when the
price falls to $12 per pizza, 120 pizzas are sold.
Calculate the price elasticity of demand.
2 A 10% increase in the price of a particular good
gives rise to an 8% decrease in quantity bought.
What is the price elasticity of demand?
<tyu>Test your understanding 3.2
In the example above,
1000
PED =
5500
45
= 1.12, where 5500 =
5000 + 6000
2
and 277.5 =
255 + 300
2
,
277.5
i.e. we use the average of the two Qx values and the average of the two Px
values instead of the initial Qx and initial Px.
Interpreting the price elasticity of demand
to price changes, and demand is said to be price
elastic or elastic. In Figure 3.1(b) demand is elastic:
the percentage change in quantity demanded (10%)
is larger than the percentage change in price (5%),
therefore the PED is greater than one.
The range of values for the PED
The value of the PED involves a comparison of
two numbers: the percentage change in quantity
demanded (the numerator in the formula for the PED)
and the percentage change in price (the denominator).
This comparison yields several possible values and
range of values for the PED. Each of these values
and range of values are summarized in Table 3.1 and
shown graphically in Figure 3.1.
In addition, there are three special cases:
· Demand is unit elastic when PED = 1 The percentage
change in quantity demanded is equal to the
percentage change in price, so that the PED is
exactly equal to one; demand is then said to be unit
elastic. Figure 3.1(c) shows a unit elastic demand
curve, where the percentage change in quantity
demanded is equal to the percentage change in
price, and therefore PED is equal to one. In the
example shown, a 5% increase in price results in a
5% decrease in quantity demanded
· Demand is price inelastic when PED < 1 (but greater than
zero) The percentage change in quantity demanded
is smaller than the percentage change in price, so
that the value of the PED is less than one; quantity
demanded is relatively unresponsive to changes in
price, and demand is said to be price inelastic or
inelastic. Figure 3.1(a) illustrates inelastic demand:
the percentage change in quantity demanded
(in this example a 5% decrease) is smaller than
the percentage change in price (a 10% increase),
therefore the PED is less than one.
· Demand is perfectly inelastic when PED = 0 The
percentage change in quantity demanded is zero;
there is no change in quantity demanded no matter
what happens to price; the PED is then equal to
zero and demand is said to be perfectly inelastic.
For example, a heroin addict’s quantity of heroin
demanded is unresponsive to changes in the price
of heroin. Figure 3.1(d) presents a perfectly inelastic
demand curve, where the PED is equal to zero. The
perfectly inelastic demand curve is vertical (parallel
· Demand is price elastic when PED > 1 (but less than
infinity) The percentage change in quantity
demanded is larger than the percentage change in
price, so that the value of the PED is greater than
one; quantity demanded is relatively responsive
Frequently encountered cases.
(a) Price inelastic demand: 0 < PED < 1.
(b) Price elastic demand: 1 < PED < ∞.
P
P
5%
P2
P2
P1
10%
P1
D
D
0
Q2 Q1
5%
Special cases
(d) Perfectly inelastic demand: PED = 0.
(c) Unit elastic demand: PED = 1.
P
5%
0
Q
P
0
Q
10%
(e) Perfectly elastic demand: PED = ∞.
P
D
P1
P2
P1
Q2 Q1
D
D
Q2
Q1
Q
0
Q1
Q
0
Q
5%
Figure 3.1 Demand curves and PEDs.
Economics for the IB Diploma
Figure 3.1
Mac/eps/Illustrator Col s/s
Text: Agenda
emcdesign
Studio: Peters & Zabransky
Chapter 3: Elasticities 65
Table 3.1
Characteristics of price elasticity of demand.
Value of PED
Classification
Interpretation
0 < PED < 1
(greater than zero and less than one)
inelastic demand
quantity demanded is relatively
unresponsive to price
1 < PED < ∞
(greater than 1 and less than infinity)
elastic demand
quantity demanded is relatively responsive
to price
PED = 1
unit elastic demand
percentage change in quantity demanded
equals percentage change in price
PED = 0
perfectly inelastic demand
quantity demanded is completely
unresponsive to price
PED = ∞
perfectly elastic demand
quantity demanded is infinitely responsive
to price
Frequently encountered cases
Special cases
to the vertical axis). Price changes do not give rise to
any change in quantity demanded, which remains
constant at Q1.
· Demand is perfectly elastic when PED = infinity
When a change in price results in an infinitely
large response in quantity demanded, demand is
perfectly elastic. As we can see in Figure 3.1(e)
the perfectly elastic demand curve is parallel to
the horizontal axis. At price P1, consumers will
buy any quantity that is available. If there is a fall
in price, buyers will buy all that they can get (an
infinitely large response); if there is an increase
in price, quantity demanded will drop to zero.
This apparently strange kind of demand will be
considered in Chapter 5 (at higher level).
The numerical value of the PED can therefore vary
from zero to infinity. In general, the larger the value
of the PED, the greater the responsiveness of quantity
demanded. The PED for most goods and services is
greater than zero and less than infinite, and other
than exactly unity (or one). The cases of unit elastic,
perfectly inelastic and perfectly elastic demand are
rarely encountered in practice; however, they have
applications in economic analysis and for this reason
are included in our discussion of PEDs.
Variable PED and the straight-line
demand curve
In our classification of demand curves above, only
three demand curves have constant (unchanging)
PEDs throughout their entire range. These are the
special and unusual cases of the vertical demand curve
with a PED of zero for all prices, the horizontal
66
Part 2: Microeconomics
demand curve with a PED of infinity for all quantities,
and the unit elastic demand curve with a PED equal
to one. Most demand curves that are observed in
the real world have variable PEDs over the range of
the demand curve. To illustrate this, let’s consider a
demand curve that consists of a straight line (which is
the kind of demand curve that we are using), shown in
Figure 3.2.
Figure 3.2 illustrates the following principle. When
price is low and quantity is high, demand is inelastic;
as we move up the demand curve towards higher
prices and lower quantities, demand becomes
progressively more elastic. We can see this by
calculating the PED at three different points.
· PED between points a and b Price increases from $10
per unit of A to $15. Quantity demanded falls from
80 units of A to 70 units. Δ Q = 10 , and
Q
80
Δ P = 5 . Using the formula for PED, we divide the
P
10
percentage change in quantity demanded Δ Q by
Q
the percentage change in price Δ P and find that
P
the PED is 1 (= 0.25). Demand is inelastic.
4
· PED between points c and d Suppose that price
increases from $25 to $30. Quantity demanded falls
from 50 to 40 units. Δ Q = 10 and Δ P = 5 .
Q
50
P
25
The percentage change in quantity demanded
divided by the percentage change in price is equal
to 10 divided by 5 , and that is equal to one or
50
25
unit elasticity.
PED and the relative steepness of the
demand curve (supplementary material)
P ($)
50
45
40
35
30
25
20
15
10
5
0
f
PED = 4
e
d
elastic portion of
demand curve
PED = 1
c
inelastic portion
of demand curve
b PED = 0.25
a
10 20 30 40 50 60 70 80 90 100
units of good A
Figure 3.2 Variability of PED along a straight-line demand curve.
· PED between points e and f Suppose finally that price
increases from $40 per unit of A to $45. Quantity
demanded falls from 20 units of A to 10 units.
Δ Q = 10 , and Δ P = 5 . Dividing the
Q
20
P
40
percentage change in quantity demanded by the
percentage change in price we find that the PED is 4.
Demand is elastic.
On any straight-line demand curve, there is an
elastic portion of the curve at high prices and low
quantities, and an inelastic portion at low price and
high quantities. At the midpoint of the demand
curve, there is unit elastic demand. There is no
special economic meaning in this pattern; it results
simply from the arithmetic involved in calculating
elasticities.2
Therefore the terms elastic and inelastic should not
be used to refer to an entire demand curve (with
the exception of the three special cases where PED
is constant throughout the entire demand curve).
Instead, they should be used to refer to a portion of
the demand curve that corresponds to a particular
price or price range.
Figure 3.1, which showed the particular demand
curve that corresponds to each category of elasticities,
suggests that the value of the PED is closely related
to the steepness (or flatness) of the demand curve.3 It
would appear that the flatter the demand curve, the
more elastic the demand and the higher the PED; the
steeper the demand curve, the less elastic the demand
and the lower the PED. However, we cannot conclude
whether demand is more or less elastic in different
demand curves simply by comparing the steepness of
the corresponding demand curve. The reasons for this
are the following:
· Demand curves drawn on different scales are not
comparable. Figure 3.3 shows two identical demand
curves with different scales on the horizontal axis.
It would be incorrect to conclude that the steeper
demand curve has a less elastic demand.
· Even if two or more demand curves are drawn on
the same diagram, in which case there is no problem
of scale, it is still not always possible to say which
curve is the more or less elastic. The reason for this
is that the PED is not constant along most demand
curves; as we have seen, it varies from being highly
elastic to highly inelastic.
P
5
4
3
2
1
D
0
5 10 15 20 25 30
Q
P
5
4
3
2
1
0
D
5
10
15
20
25 Q
Figure 3.3 Two identical demand curves.
2
The varying PED along a straight-line demand curve may be contrasted
with the slope, which is always constant along a straight line. The slope
is defined as the vertical change between two points on the curve
divided by the horizontal change between the same two points; in the
ΔP
case of the demand curve it is given by
. A comparison of the slope
ΔQ
with PED shows that the two are different and should not be confused.
The constant slope of the straight-line demand curve tells us that an
increase in price produces the same unit decrease in quantity demanded
anywhere along the demand curve. This is different from the concept
of elasticity, which provides a measure of the responsiveness of quantity
demanded to changes in price in percentage terms. The slope measures
absolute changes; the elasticity measures relative changes. The slope is
not appropriate as a measure of the responsiveness of quantity demanded
for the reasons discussed earlier in the section ‘Definition and formula for
price elasticity of demand’.
3
In mathematical terms the steepness (or flatness) of a curve is referred to
as the slope of the curve. See the previous footnote for a discussion of the
difference between the slope and the elasticity.
Chapter 3: Elasticities 67
So when is it correct to compare PEDs of demand
curves by referring to their steepness?
PEDs can be compared by reference to the steepness of
the demand curves only in the event that the demand
curves in question intersect at some point, that is,
when the demand curves share a price and quantity
combination, such as demand curves D1 and D2 in
Figure 3.4(a). In this figure, for any given price, D1 is
flatter and more elastic than D2.
For example, if price falls from P1 to P2, the resulting
percentage change in quantity will be larger for D1
(increase from Q1 to Q3) than for D2 (increase from Q1
to Q2). In general, when demand curves intersect, then
for any given price, the flatter the demand curve, the
more elastic is the demand; the steeper the demand
curve, the less elastic is the demand.4 Note that this
generalization holds only for comparisons between
two demand curves at a particular price. It does not
hold for different prices because of the variability of
the PED along the demand curve.
If demand curves do not intersect, comparing PEDs on
the basis of steepness or flatness, even for a particular
price, can be misleading. For example, consider the
two parallel demand curves shown in Figure 3.4(b),
which obviously do not share a price–quantity
combination. It is tempting to conclude that their
(a) Intersecting demand curves and PEDs.
P
PED of D1 > PED of D2
at each possible price
PEDs are the same at each price since they are parallel
to each other. However, this would be incorrect,
because in fact, for each price, D2 is less elastic (has
a lower PED) than D1. To see why, consider price P1,
which corresponds to the midpoint of D1, and hence
represents the point at which PED = 1 for D1. At this
price level, PED < 1 for D2, as it lies in the inelastic
portion of this demand curve. Therefore at P1, the
PED corresponding to D2 is lower than the PED
corresponding to D1.
Test your understanding 3.3
1 Specify the value for each of the PEDs below
and show diagrammatically the shape of the
demand curve that corresponds to each one:
(a) perfectly elastic demand; (b) unit elastic
demand; (c) perfectly inelastic demand.
2 How would you show price elastic and price
inelastic demand in the same diagram? Explain.
3 Provide examples of goods the demand for
which is likely to be (a) elastic, and (b) inelastic.
4 Which price elasticity of demand values or range
of values do we see most frequently in the real
world?
5 Why must we always compare the PEDs of
different demand curves at the same price?
(...continued)
(b) Parallel demand curves and PEDs.
P
PED = 1
P1
PED < 1
P1
P2
D1
D2
Q1 Q2 Q3 Q
0
PED = 1
0
D1
D2
Q
Figure 3.4 Demand curves and PEDs.
4
To see why this is so, the more advanced student can consider the ratio
of PEDs of D1 and D2 in Figure 3.4:
%Δ Q1
PED1
=
PED2
%Δ P
%Δ Q2
%Δ P
where %Δ Q1 is the percentage change in quantity for D1, %Δ Q2 is the
68
Part 2: Microeconomics
percentage change in quantity for D2, and %Δ P is the percentage change
in price when price changes from P1 to P2. The %Δ P cancels out from the
numerator and denominator, and we are left with
PED1
%Δ Q1 ,
=
PED2
%Δ Q2
in other words, the ratio of PEDs is equal to the ratio of percentage
changes in quantity. This is exactly what we see in Figure 3.4: the flatter
demand curve D1, with the larger PED, has the larger percentage change
in quantity.
Test your understanding 3.3
(...continued)
6 What can we conclude about the relative PEDs
of two demand curves that (a) are parallel to
each other; (b) that intersect; (c) that do not
intersect?
7 Suppose that the demand for good X increases
(shifts to the right) as a result of a successful
advertising campaign. Using an appropriate
diagram, explain what will happen to the price
elasticity of demand at each particular price.
Applications of the price elasticity of demand
The price elasticity of demand is a very important
concept in economics, with numerous applications.
Some of these will be considered presently; others will
be studied in later chapters.
PED and total revenue
Total revenue (TR) is the amount of money received
by firms when they sell a good (or service), and is
equal to the price (P) of the good times the quantity
(Q) of the good sold. Therefore TR = P × Q.
We are interested in examining what will happen to
the firm’s total revenue (TR) when there is a change
in the price of the good it produces and sells. We
know that P and Q are inversely related to each other,
so that an increase in P will give rise to a decrease
in Q demanded and vice versa. What can we say
about the resulting change in total revenue? Will it
increase or decrease? The change will depend on the
price elasticity of demand of the good. We have the
following three possibilities.
Demand is elastic (PED > 1)
When demand is elastic, an increase in price causes a
fall in total revenue, while a decrease in price causes
a rise in total revenue. To see why, consider that if
demand is elastic, a 10% price increase will result in a
larger than 10% decrease in quantity demanded (since
PED > 1). The impact on total revenue of the decrease
in quantity is bigger than the impact of the increase
in price; therefore total revenue falls. If there is a price
decrease, a 10% price fall results in a larger than 10%
increase in quantity demanded, and total revenue
increases.
These results are shown graphically in Figure 3.5(a)
(page 70). Recall how the PED varies along the demand
curve. Since we are considering elastic demand, we
are examining a price change that occurs in the upper
left portion of the demand curve. Total revenue is
represented by the area of the rectangles obtained by
multiplying price times quantity (since TR = P × Q). At
the initial price and quantity, P1 and Q1, total revenue
is given by the sum of the rectangles A and B. When
price increases to P2 and quantity drops to Q2, total
revenue is given by the sum of the rectangles A and
C. What happened to total revenue due to the price
increase? The rectangle B was lost and the rectangle C
was gained. Since the loss (B) is larger than the gain
(C), total revenue fell.
We can use the same diagram to explore a price
decrease when PED > 1, simply by assuming that the
initial price and quantity are P2 and Q2; price then
falls to P1 while quantity increases to Q1. In this case,
the gain is given by rectangle B, which is greater than
the loss shown by rectangle C, thus total revenue
increases.
When demand is elastic, an increase in price causes a
fall in total revenue, while a decrease in price causes a
rise in total revenue.
Demand is inelastic (PED < 1)
When demand is inelastic, an increase in price causes
an increase in total revenue, while a decrease in
price causes a fall in total revenue. Since PED < 1, the
percentage change in quantity demanded is smaller
than the percentage change in price. In this case, a
10% price increase will produce a smaller than 10%
decrease in quantity demanded, and total revenue
will rise. This happens because the impact on total
revenue of the increase is larger than the impact of the
decrease. If price falls, a percentage price decrease will
give rise to a smaller percentage increase in quantity
demanded and total revenue will fall.
Graphically these results can be seen in Figure 3.5(b).
We are now examining the bottom right portion of
the demand curve where demand is inelastic (PED < 1).
In the case of a price increase, total revenue gained
(rectangle C) is larger than total revenue lost (rectangle
B); therefore total revenue increases. If price falls
from P2 to P1, the gain in total revenue (rectangle B)
is smaller than the loss (rectangle C); therefore total
revenue falls.
Chapter 3: Elasticities 69
(a) PED > 1 (elastic demand).
(b) PED < 1 (inelastic demand).
(c) PED = 1 (unit elastic demand).
P
P
P
PED > 1
P2
P1 C
PED > 1
PED = 1
PED < 1
A B
0
Q2 Q1
Q
D
PED = 1
P2
P1
0
PED < 1
C
A
Q2 Q1
P2
B
Q
D
P1
C
A
0
Q2
D
B
Q1
Q
Figure 3.5 PED and total revenue.
When demand is inelastic, an increase in price causes
an increase in total revenue, while a decrease in price
causes a fall in total revenue.
Demand is unit elastic (PED = 1)
When demand is unit elastic, the percentage change
in quantity is exactly equal to the percentage change
in price, and total revenue remains constant. In
Figure 3.5(c), as price and quantity change, the gain
in total revenue is exactly matched by the loss, and
total revenue remains unchanged.
When demand is unit elastic, a change in price does
not cause any change in total revenue.
These results are summarized as follows:
Elastic PED (PED > 1): price and total revenue change
in opposite directions.
Inelastic PED (PED < 1): price and total revenue
change in the same direction.
Unit elastic PED (PED = 1): as price changes, total
revenue remains unchanged.
PED and firm pricing decisions
The above discussion on the relationship between
price elasticity of demand and total revenue shows
that businesses must take the PED into consideration
when considering changes in the price of their
product. If a business wants to increase its total
revenue, it must decrease its price if demand is elastic,
or it must increase its price if demand is inelastic.
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Part 2: Microeconomics
If demand is unit elastic, the firm will be unable to
change its total revenue by changing its price.
Remember that the PED falls as price falls along a
straight-line demand curve. In the upper left portion
of the curve, demand is highly elastic. At high prices,
where demand is elastic, a firm can increase its total
revenue by lowering price. Total revenue will continue
to increase as price falls until price reaches the point
on the demand curve where PED is unit elastic. If price
falls further, total revenue will begin to fall because
price is now in the inelastic range of the demand
curve. This means that total revenue is at a maximum
when price is at the point where demand is unit
elastic.
It is important not to confuse a firm’s total revenue
with profit. Profit is total revenue minus total costs.
A firm interested in maximizing profits may not want
to maximize total revenue. As total revenue rises, it
is possible that total costs may rise faster, in which
case the firm’s profit will be lower. It is impossible to
say what will happen to profit as total revenue rises
without looking at what happens to costs. Costs will
be examined in Chapter 4 (a higher level topic).
PED and price discrimination (higher
level topic)
Price discrimination takes place when firms charge
distinct groups of buyers different prices for the
same good or service. This can occur because each
group of buyers has a different PED for the good or
service. Therefore firms can increase their revenues by
charging a higher price to those buyers whose demand
for the good is inelastic and a lower price to those
buyers with elastic demand. Price discrimination will
be discussed in Chapter 5 (at higher level).
HL
PED and excise taxes
Governments often levy taxes on specific goods. Such
taxes are called excise taxes, also known as indirect
taxes. Governments must consider the price elasticity
of demand for the goods to be taxed if they are
interested in increasing tax revenues (i.e. the revenues
of the government resulting from taxation). The lower
the elasticity of demand for the good being taxed, the
larger the tax revenues for the government.
This can be seen in Figure 3.6, showing the case of
inelastic demand in panel (a) and elastic demand in
panel (b). Note that we are assuming that the two
demand curves are drawn on the same scale, and that
if they were drawn in the same diagram they would
intersect. (In fact, they would intersect at the point
of the initial equilibrium, which is the same price–
quantity combination in both diagrams.) Recall from
Chapter 2, page 43, that the imposition of a tax on a
good has the impact of shifting the supply curve to
the left (or upward). The curve will shift from S1 to S2
so that the vertical distance between S1 and S2 is equal
to the amount of the tax per unit of output. The new,
after-tax equilibrium occurs at price Pt and quantity Qt,
determined by the point of intersection between the
demand curve, D, and the new supply curve, S2. The
shaded area represents the government’s tax revenue,
and is obtained by multiplying the amount of the
tax per unit times the number of units, or quantity
Qt. A comparison of the two figures indicates that
tax revenue is larger in the case of inelastic demand.
Excise taxes are therefore as a rule levied on goods
such as cigarettes and petrol (gasoline), all of which
have a low PED.
(a) Inelastic demand.
P
PED and short-term price instability of
agricultural products
Food (produced in the agricultural sector) has a highly
price inelastic demand, because it is a necessity and
it has no substitutes. The same applies to a variety of
other primary products (such as oil and minerals),
known as commodities. In the case of food, in
developed countries its PED is estimated to be between
0.20 and 0.25. Low price elasticity of demand, in
combination with fluctuations in agricultural output
over short periods of time, creates serious problems
for agriculture because of major fluctuations in
agricultural product prices, which in turn impact on
farmers’ incomes. Let’s see why.
Agricultural production depends on many factors
beyond the farmer’s control, such as drought, pests,
floods, frost and other such natural disasters, as well
as exceptionally good weather conditions, which
occur over short periods of time. These appear in our
standard demand and supply analysis as wide supply
changes (supply curve shifts). In Figure 3.7 (page 72),
let’s say that S1 represents supply under normal weather
and other environmental conditions; the supply curve
shifts to the left to S2 in the event of adverse conditions,
and to the right to S3 in the event of favourable
conditions. Such supply shifts are considered together
with inelastic demand in panel (a), which characterizes
demand for food. Panel (b) shows supply shifts
together with elastic demand, which characterizes
other goods (manufactured or industrial products) and
services. A comparison of the two diagrams reveals
that the supply curve shifts give rise to major price
fluctuations in the case of inelastic demand, and much
milder price fluctuations in the case of elastic demand.
Large price fluctuations occurring over short periods
of time are referred to as price volatility. (Volatility
means instability or high variability.) We can see,
(b) Elastic demand.
final
equilibrium
P
S2
tax
per
unit
Pt
S1
initial
equilibrium
P1
final
equilibrium
Pt
P1
Qt
Q
tax
per
unit
S1
initial
equilibrium
D
D
0
S2
0
Qt
Q
Figure 3.6 PED, excise (indirect) taxes and tax revenues.
Economics for the IB Diploma
Figure 3.6
Mac/eps/Illustrator Col s/s
Text: Agenda
Chapter 3: Elasticities 71
(a) Supply shifts with inelastic demand.
(b) Supply shifts with elastic demand.
S2
S2
S1
P
P2
S1
P
S3
S3
P2
P1
P1
P3
P3
D
D
0
Q2 Q1 Q3
0
Q
Q2
Q1
Q3
Q
Figure 3.7 The effect of changes in supply on agricultural product prices and farmer revenues.
for the
Diploma
therefore, Economics
why prices
inIBthe
agricultural sector tend to
Figure 3.7
be highly Mac/eps/Illustrator
volatile, whereas
they tend to be much less
Col s/s
Text: Agenda
so in the manufacturing
and services sectors, where
emcdesign
demand tends
to be more elastic.
Studio: Peters & Zabransky
Two important results follow from this analysis:
· As agricultural product prices fluctuate widely, so do
farmers’ incomes, which depend on the revenues
(price times quantity) that farmers receive from
selling their output.
· A poor crop (giving rise to S2) results in a higher
price, P2, compared to the normal price P1, and a
lower quantity of output, Q2. Because of inelastic
demand for farm products, the percentage increase
in price is larger than the percentage decrease in
quantity, and so total revenue increases for farmers.
A good crop (leading to S3) results in a lower price,
P3, and higher output, Q3; here the percentage
decrease in price is larger than the percentage
increase in quantity, and so farmers’ revenue falls.
The rectangle given by P3 times Q3, representing
farmers’ revenue when the crop is good, is smaller
than the rectangle given by P2 times Q2, or farmers’
revenue when the crop is poor. By comparison, in
the case of elastic demand, revenue increases when
the crop is good and decreases when the crop is
poor.
This means that for consumers, a good harvest results
in lower food prices, while for farmers a good harvest
ironically translates into lower revenues. Fluctuating
prices and hence fluctuating farmers’ incomes over
short periods of time have been a key rationale for
price support schemes (see Chapter 2, page 56, as well
as Chapters 12 and 16).
72
Part 2: Microeconomics
Test your understanding 3.4
1 Explain and show diagrammatically how total
revenue will change if:
(a) price increases and demand is elastic
(b) price decreases and demand is inelastic
(c) price increases and demand is perfectly
inelastic
(d) price increases and demand is inelastic
(e) price decreases and demand has unit
elasticity
(f) price decreases and demand is elastic.
2 How can knowledge of the price elasticity of
demand for a product help the firm that is
producing it?
3 Suppose flooding destroys a substantial
portion of this season’s crop. Using appropriate
diagrams, explain what is likely to happen to
farmers’ revenues, assuming the demand for the
product is highly inelastic.
4 The government would like to levy indirect
taxes (excise taxes) on certain goods in order to
raise tax revenue. Using appropriate diagrams,
explain how price elasticity of demand can help
it decide which products it should tax.
5 Use the concept of PED and appropriate
diagrams to explain why agricultural product
prices tend to fluctuate more (are more volatile)
compared to manufactured product prices over
the short term.
3.2 Cross-elasticity of demand (CED)
Interpreting the cross-elasticity of demand
Definition and formula for the cross-elasticity
of demand
· the sign of the CED: unlike the PED, whose minus
In Chapter 2, page 36, we learned that the prices of
substitutes and complements of a good are among
the factors that influence demand for the good and
determine the position of its demand curve. We
saw that changes in the prices of substitutes and
complements cause demand curve shifts. What we
would now like to ask is by how much a demand
curve will shift, or what is the responsiveness of
demand, given a change in the price of a substitute or
complement?
The cross-elasticity of demand (also known
as cross-price elasticity of demand) is a measure
of the responsiveness of the demand for one good
(say X) to a change in the price of another good
(say Y). It provides us with information on the
direction of change of demand (whether it increases
or decreases), and on the magnitude of the demand
shift (by how much demand shifts).
The formula for the cross-elasticity of demand is
the same as the formula for the PED, only now we
consider the relationship between the percentage
change in demand of one good (X) and the percentage
change in the price of another good (Y):
percentage change in
demand for good X
cross elasticity
= CED =
of demand
CED =
percentage change in
price of good Y
%Δ Qx
%Δ Py
which can be rewritten as:
Δ Qx
CED =
Qx
Δ Py
Py
Δ Qx
× 100
=
× 100
Qx
Δ Py
Py
The cross-elasticity of demand provides two kinds of
important information:
sign is ignored, the cross-elasticity of demand is
either positive or negative, and the sign is crucially
important to its interpretation
· the magnitude of the CED: how small or large is its
numerical value.
Positive CED: substitutes
The cross-elasticity of demand is positive (CED > 0)
when the change in the demand for the one good is
in the same direction as the change in the price of
the other good, in other words, when the price of Y
increases the demand for X also increases; and when
the price of Y falls, the demand for X also falls. This
occurs when the two goods, X and Y, are substitutes
for each other (substitutes were defined in Chapter 2,
page 36).
For example, Coca-Cola® and Pepsi-Cola® are
substitutes for each other. Let’s consider what happens
to the demand for Pepsi®, shown in Figure 3.8(a)
(page 74), as the price of Coca-Cola® changes. If the
price of Coca-Cola® increases, the quantity of CocaCola® demanded falls, and the demand for Pepsi®
increases as consumers switch from Coca-Cola® to
Pepsi®, that is, there will be a rightward shift in the
demand curve for Pepsi®. On the other hand, if the
price of Coca-Cola® falls, the quantity of Coca-Cola®
demanded increases, and the demand for Pepsi® falls
as consumers now switch from Pepsi® to Coca-Cola®;
there results a leftward shift in Pepsi®’s demand curve.
(Note that in the case of Coca-Cola®, whose own price
is changing, we refer to increases or decreases in the
‘quantity demanded’, whereas with Pepsi® we refer to
increases or decreases in ‘demand’ because of demand
curve shifts.)
In fact, the cross-elasticity of demand for Coca-Cola®
and Pepsi-Cola® has been estimated to be about + 0.7.5
This means that a 1% increase in the price of one will
give rise to a 0.7% increase in demand for the other.
Alternatively, a 10% increase in the price of one will
give rise to a 7% increase in the demand for the other.
This is considered to be an example of fairly high
substitutability.
5
F. Gasmi et. al. ‘Econometric Analysis of Collusive Behavior in a Soft-Drink
Market’, Journal of Economics and Management Strategy (Summer 1992),
Chapter 3: Elasticities 73
(a) Substitutes and positive CED: demand for Pepsi Cola®
P
S
D2
D3 D1
D increases
as price of
Coca-Cola®
increases
D falls as price
of Coca-Cola® decreases
0
The larger the numerical value of the negative
cross-elasticity of demand, the greater is the
complementarity between two goods, and the larger
will be the demand curve shift. Two goods with a CED
of − 0.8 are stronger complements than two goods
with a CED of − 0.5.
Q
(b) Complements and negative CED: demand for tennis balls
P
S
D2
D3
0
balls will also fall; there will therefore be a leftward
shift in the demand curve for tennis balls. If there
is a fall in the price of tennis rackets, the quantity
of tennis rackets demanded will increase, and the
demand for tennis balls will also increase; the demand
curve for tennis balls will shift to the right.
D1
D increases
as price of
tennis rackets
decreases
D decreases as
price of tennis rackets increases
Q
Figure 3.8 Cross-price elasticities.
Economics for the IB Diploma
Figure 3.8
The
larger the value of the cross-elasticity of demand,
Mac/eps/Illustrator Col s/s
the
greater
Text:
Agenda is the substitutability between two goods,
emcdesign
and
the larger will be the demand curve shift. For
Studio: Peters & Zabransky
example, two substitute goods with a CED of + 0.7 are
stronger substitutes for each other than two goods
with a CED of + 0.3.
Negative CED: complements
Zero CED: unrelated products
If the cross-elasticity of demand is zero (CED = 0)
or close to zero, this means that two products are
unrelated or independent of each other. For example,
potatoes and telephones are unrelated to each other:
a change in the price of one is unlikely to have an
impact on demand for the other.
Test your understanding 3.5
1 What can you conclude about the relationship
of goods A and B in the following situations?
(a) the quantity of good A increases by 10%
in response to a price decrease in good B
of 15%
(b) the quantity of good B decreases by 10%
in response to a price decrease in good A
of 15%
(c) the quantity of good B remains
unchanged in response to a price decrease
in good A of 15%.
2 Can you provide examples of pairs of goods that
might correspond to goods A and B in parts (a),
(b) and (c) of question 1?
3 If the CED between Coca-Cola® and Pepsi®
The cross-elasticity of demand is negative (CED < 0)
when the demand for one good and the price of
another good change in opposite directions; this
occurs when the two goods are complements.
(Complements were defined in Chapter 2, page 36.)
Figure 3.8(b) shows the demand for tennis balls. If the
price of tennis rackets increases, the quantity of tennis
rackets demanded will fall, and since tennis rackets are
used together with tennis balls, the demand for tennis
74
Part 2: Microeconomics
is 0.7, how will the quantity of Coca-Cola®
demanded change if the price of Pepsi® increases
by 5%? (Your answer should be in percentage
terms, and should indicate whether the quantity
of Coca-Cola® will increase or decrease.)
4 For the answer to question 3, show
diagrammatically (a) the ‘change in quantity
demanded’, and (b) the ‘change in demand’
for Pepsi® and Coca-Cola®, respectively, that
will result from the 5% increase in the price of
Pepsi®.
Applications of the cross-elasticity of demand
There are a number of situations where businesses as
well as government would be interested in knowing
the cross-elasticities of demand for various products.
It is not only of interest to know whether two or
more goods are substitutes or complements (positive
or negative sign), but also, knowing the degree of
substitutability or complementarity (the magnitude of
the numerical value) can be very useful.
Substitute goods
Substitutes produced by a single business
When a business produces a line of products that
are similar to each other, such as Coca-Cola® and
Sprite®, which are both produced by Coca-Cola®, it
must consider the cross-elasticity of demand for these
products when making decisions about prices. Since
the two goods are substitutes, a fall in the price of
Coca-Cola® would be followed by a fall in the demand
for Sprite®. Should Coca-Cola® cut the price of CocaCola®? To make a decision it must have information
about:
· the PED for Coca-Cola®, so that it can determine
whether a price cut will lower or raise total revenue
from Coca-Cola®
· the CED for Coca-Cola® and Sprite®; it is not enough
to know that the CED > 1 (i.e. that the two goods
are substitutes for each other). In addition, it is
important to know the degree of substitutability
between them. If the value of the CED is positive
but low (low substitutability), a percentage decrease
in the price of Coca-Cola® will produce only a small
percentage drop in demand for Sprite®, so that the
sales of Sprite® would not be seriously affected. But
if the value of the CED is positive and high, a fall
in the price of Coca-Cola® will produce a large drop
in demand for Sprite®. Increased sales of CocaCola® would come at the expense of Sprite® sales
– something that the company would probably want
to avoid.
Substitutes produced by rival businesses
A business is also interested in knowing the CED of
substitutes in the event that they are produced by
rival businesses. For example, Coca-Cola® would be
interested in knowing the CED between Coca-Cola®
and Pepsi-Cola®. A large CED would mean that if
Coca-Cola® dropped its price, Pepsi® would suffer a
serious drop in sales, whereas a low CED would mean
that Pepsi® would not be seriously affected. Coca-Cola®
would also want to know this CED in order to be able
to predict the effect on Coca-Cola® sales of any change
in the price of Pepsi®.
Substitutes and mergers between firms
A merger takes place when two firms unite to form a
single firm. Businesses that produce close substitutes,
i.e. goods with a high CED, might be interested in
merging because that way they would eliminate the
competition between them. Governments generally
try to prevent firm mergers that are likely to result in
a major reduction of competition. One of the roles
of government in the economy is to try to promote
competition between firms. (The reasons for this will
be explored in Chapters 5 and 6.) Therefore knowledge
of the CED of goods produced by rival firms interested
in merging can be used to determine whether the
merger should be permitted to take place.
Complementary goods
Knowledge of the CED for complementary products is
also useful for business pricing decisions. Products that
have a low (negative) CED are weakly complementary
and will not be of much interest. However a high
(negative) CED means that lowering the price of one
good can result in a significant increase in demand
and sales for the other.
This prompts collaboration between businesses
that produce complementary goods. For example,
sports clothing and sports equipment are highly
complementary, as are charter flights and holiday
hotels. A fall in the price of charter flights is
likely to produce a significant increase in holiday
hotel occupancy. We find airlines frequently
collaborating with hotels to take advantage of the
complementarities.
Test your understanding 3.6
1 How can knowledge of cross-elasticities of
demand help firms decide on how to price
their products in the case of (a) substitutes;
(b) complements?
2 In what way can the cross-elasticity of demand
help governments decide whether or not to
allow a merger between two firms to take place?
Chapter 3: Elasticities 75
3.3 Income elasticity of demand (YED)
Definition and formula for income elasticity
of demand
Another factor influencing demand for a good and the
position of the demand curve is consumer income.
Recall from Chapter 2, page 35, that the impact of
income on demand depends on whether the good in
question is normal or inferior. If the good is normal,
income and demand change in the same direction: an
increase in income gives rise to an increase in demand
(a rightward shift of the demand curve) while a fall
income causes demand to fall (a leftward demand
shift). On the other hand, if the good is inferior,
income and demand change in opposite directions:
an increase in income produces a decrease in demand,
and a decrease in income produces an increase in
demand.
The income elasticity of demand is a measure of
the responsiveness of demand to changes in income.
It provides information on the direction of change
of demand, given a change in income, and on the
magnitude of the change (by how much the demand
curve will shift).
The formula for the income elasticity of demand is
the same as the formula for the PED, only now we
consider the relationship between the percentage
change in demand for a good, X, to a percentage
change in income, which we abbreviate as Y:
income
elasticity of = YED =
demand
YED =
percentage change in
demand for good X
percentage change
in income
%Δ Qx
%Δ Y
which can be rewritten as:
Δ Qx
YED =
Qx
ΔY
Y
76
Part 2: Microeconomics
Δ Qx
× 100
=
× 100
Qx
Δ Yy
Y
Interpreting the income elasticity of demand
The income elasticity of demand provides two kinds of
important information:
· its sign (whether it is positive or negative)
· its numerical value: whether it is greater or smaller
than one.
The sign of the income elasticity of
demand (normal or inferior goods)
The sign of the income elasticity of demand provides
us with the following information.
· YED > 0 The income elasticity of demand is positive
(YED > 0) when demand and income change in the
same direction (i.e. both increase or both decrease).
A positive YED indicates that the good in question
is normal. Most goods are normal goods (normal
goods were defined in Chapter 2, page 35).
· YED < 0 A negative income elasticity of demand
(YED < 0) indicates that the good is inferior:
demand for the good and income move in
opposite directions (as one increases the other
decreases). Examples include bus rides, used
clothes and used cars; in these cases, as income
increases, the demand for these goods fall as
consumers switch to consumption of normal
goods (new cars, new clothes and so on).
(Inferior goods were defined in Chapter 2,
page 36).
The value of the income elasticity of
demand
Test your understanding 3.7
We are especially interested in examining normal
goods (since most goods are normal). We are therefore
looking at goods with a YED that is greater than zero
(positive).
· YED > 1 If a good has an YED that is greater than
one, it is said to be income elastic. This means
that a percentage change in income will give rise
to a larger percentage change in demand (in the
formula for the YED, the numerator is larger than
the denominator).
· YED < 1 If on the other hand a good has an
YED that is less than one, it is said to be
income inelastic: the percentage change in
income produces a smaller percentage change
in demand (the numerator is smaller than the
denominator).
Figure 3.9 shows an initial demand curve, D1, and
shifts of the curve that occur in response to increases
in income, depending on the sign and value of the
YED. If the YED is negative, indicating an inferior
good, an increase in income causes a leftward shift
of the demand curve to D2. If the YED is positive,
indicating a normal good, the demand curve shifts to
the right to D3 or D4. The greater the (positive) YED,
the larger the rightward shift of the demand curve.
P
YED < 0 0 < YED < 1 YED > 1
inferior
good
0
D2
income
inelastic
demand,
normal
good
D1
income
elastic
demand,
normal
good
D3
D4
Q
Figure 3.9 Demand curve shifts in response to increases in income for
Economics for the IB Diploma
different
values of the YED.
Figure 3.9
Mac/eps/Illustrator Col s/s
Text: Agenda
emcdesign
Studio: Peters & Zabransky
1 Your income increases from £1000 a month to
£1200 a month. As a result, you increase your
purchases of pizzas from 8 to 12 per month,
and you decrease your purchases of cheese
sandwiches from 15 to 10 per month. (a)
Calculate your income elasticity of demand for
pizzas and for cheese sandwiches. (b) What kind
of goods are pizzas and cheese sandwiches for
you? (c) Show diagrammatically the impacts of
your increase in income on your demand for
pizzas and cheese sandwiches.
2 A 15% increase in income leads to a 10%
increase in demand for good A and 20% increase
in demand for good B. Explain which of the two
goods is income elastic and which is income
inelastic.
Determinants of the income elasticity of
demand
Assuming that the YED > 0 (so we are talking about
normal goods), the following factors determine
whether the YED will be high or low.
· Necessities or luxuries This is the most important
determinant. Necessities, such as food, clothing
and housing, tend to have an income elasticity of
demand that is positive but less than one; they are
in other words income inelastic. In the case of food,
for example, as income increases, people will buy
more food but the proportion of income spent on
food increases at a lower rate (more slowly) than
income. In developed countries, the YED for food
is about 0.15 to 0.2. This means that a 1% increase
in income will produce a 0.15% to 0.2% increase
in spending on food. Alternatively a 10% increase
in income will result in a 1.5% to 2% increase in
spending on food. By contrast, luxuries, such as
travel to other countries, private education and
eating in restaurants have an income elasticity
greater than one; they are income elastic. This
means that as income increases, the proportion of
income spent on such goods increases at a higher
rate than income.
· Income level of consumers What is a necessity and
what is a luxury depends on income levels. For
people with extremely low incomes, even food
and certainly clothing can be luxuries. As income
increases, certain items that used to be luxuries
become necessities. For example, items like CocaCola® and coffee for many poor people in less
Chapter 3: Elasticities 77
developed countries are luxuries, whereas for
consumers in developed countries they have become
necessities. The income elasticity of demand for
particular items therefore varies widely depending
on income levels. The income elasticity of demand
for food is about 0.15 in some more developed
countries, but is about 0.8 in very poor countries.
This means that for an increase in income of 10%,
spending on food increases by only 1.5% in rich
countries and by 8% in poor countries.
Test your understanding 3.8
1 What do you think is most likely to have
happened to the income elasticity of demand for
laptops since they were first introduced? Explain.
2 How can you account for the fact that income
elasticity of demand for food has been estimated
to be about 0.15 to 0.2 in more developed
countries and about 0.8 in less developed
countries?
Applications of the income elasticity of
demand
YED and the rate of expansion of
industries
Over time, as countries grow and develop
economically, society’s income increases. Increasing
income means a growing demand for goods and
services, and a growing output to meet this demand.
Let’s say that total income in an economy grows at
an average of about 3% per year. Some industries
produce goods and services the demand for which
grows at a rate of more than 3% (elastic demand), with
a YED greater than one. Examples include restaurants,
movies and foreign travel. Other industries produce
goods and services the demand for which grows at a
rate of less than 3% (inelastic demand); these have
a YED less than one, and include items like food,
clothing and furniture. The first group (with the elastic
demand) represents goods and services or industries
that grow and expand faster than total income in the
economy, whereas the second group represents goods
or services or industries that grow more slowly than
total income.
Information on the YED of different products can be
interesting for firms as it reveals the products that are
likely to have the most rapidly expanding markets.
The higher the YED for a particular good or service,
78
Part 2: Microeconomics
the greater the expansion of its market is likely to
be in the future; the lower the YED, the smaller the
expansion.
YED and sectoral change in an economy
A sector is defined to be a part of an economy. All
economic activity in every economy can be classified
under the following three sectors:
· the primary sector, dominated by agriculture,
and also including fishing, forestry and all extractive
activities (such as mining)
· the secondary sector, including manufacturing
· the tertiary sector, including commerce, finance,
transportation and all other services (education,
health care, and so on), also referred to as the
services sector.
The contribution of each of these sectors to total
economic activity can be measured in several ways,
such as in terms of the value of output they produce
(GDP), or the number of people they employ.
Regardless of how it is measured, the relative size
of this contribution tends to change over time as
a country grows and becomes economically more
developed. Less developed countries tend to have
very large primary sectors due to the predominance
of agriculture in the economy as well as extractive
activities (oil, minerals, natural gas and so on) and
small manufacturing and services (secondary and
tertiary) sectors. This means that the bulk of output
they produce is agricultural and other primary product
output, and a very large proportion of the working
population is employed in the primary sector. The
developed countries of today were in a similar position
many decades ago. Their historical experience shows
that as they grew and developed, their agricultural
sector became less and less important, and was partly
replaced by manufacturing and services. As they grew
and developed further, and the relative importance of
agriculture and the primary sector generally continued
to shrink, manufacturing became increasingly replaced
by services. Thus, while less developed countries
tend to be dominated by the primary sector, more
developed countries tend to be dominated by services.
Figure 3.10 illustrates this process for a hypothetical
growing economy. Each sector’s relative importance
is measured in terms of its percentage contribution to
GDP (recall from Chapter 1, page 9, that GDP refers to
a common measurement of the value of output of an
economy). Note that the changing percentages shown
in Figure 3.10 refer to changing shares or percentage
(a)
(b)
5%
agriculture
(primary sector)
(c)
10%
services
15%
manufacturing
75%
agriculture
(primary sector)
30%
services
40%
agriculture
(primary sector)
65%
services
30%
manufacturing
30%
manufacturing
Figure 3.10 Changing relative shares (in terms of percentage of GDP) of the primary, secondary and tertiary sectors for a hypothetical economy as it grows.
contributions of each sector to total output. If total
output is increasing over time, a falling share over
time for a particular sector (such as the primary sector)
does not mean that primary sector output is falling;
it could mean that this sector’s output is growing,
but growing more slowly than total output, so that
its percentage share is falling. An increasing share for
a sector means that output for that sector is growing
more rapidly than total output.
the agricultural and manufacturing sectors; this is
shown in the progression from panel (a) to (b) to (c)
in Figure 3.10. Many services have very high YEDs, so
that the percentage increase in the demand for these
is significantly larger than the percentage increase in
income. In the developed world today, among the
industries experiencing the fastest growth are services,
including education, health care, travel and financial
services.
Changes in the relative importance of the three sectors
as economic growth and development occur can be
explained in terms of income elasticity of demand.
Agriculture, the main part of the primary sector,
produces food, which as we know has a YED that is
positive but less than one (it is income inelastic). This
means that as society’s income grows over time, the
demand for agricultural output grows more slowly
than the growth in income. Other primary products
tend to have a low income elasticity of demand as
well.6 By contrast, manufactured products (cars,
televisions, computers and so on) have a YED that
tends to be greater than one (income elastic), so
that as society’s income grows, the demand for these
products grows faster than income. The result is that
over time, the share of agricultural output as a share of
total output in the economy shrinks, while the share
of manufactured output grows. In Figure 3.10, this is
shown in the change in output shares from panel (a)
to panel (b).
YED and long-term impacts on
agricultural and other primary product
prices
At the same time that the share of manufacturing
output is increasing at the expense of agriculture, the
services sector tends to expand at the expense of both
In developed countries, major technological advances
in agriculture have occurred over several decades that
have shifted the supply curve of agricultural products
A low YED for food (agricultural products), compared
to a high YED for manufactured products and services,
has important implications for the level of prices of
agricultural products relative to prices of manufactured
products and services over long periods of time.
We have seen that a low YED for food compared to
manufacturing and services means that as income
rises, a relatively smaller proportion of income is
spent on food and a relatively larger proportion on
manufactured products and services. This indicates
that as incomes rise, demand for manufactured
products and services rises more rapidly than the
demand for food. The result is that the prices of these
goods and services rise more rapidly than the prices of
agricultural products.
The case of more developed countries
6
For example, cotton and rubber have synthetic substitutes, so as income
increases, a relatively larger proportion of it is spent on the synthetic
materials, while a relatively lower fraction goes towards cotton and rubber.
Chapter 3: Elasticities 79
to the right. Against this background of increasing
supply, low income elasticity of demand for food is
responsible for the failure of demand for agricultural
products to grow sufficiently over long periods of time
in order to keep up with the increases in supply. This
is shown in Figure 3.11. Supply has shifted from S1 to
S2 due to substantial technological advances. Demand
shifts from D1 to D2 due to economic growth and
increasing incomes, but because of the low YED the
size of the demand shift is relatively small. With the
increase in demand being smaller than the increase in
supply, there is a downward pressure on prices.
Less developed countries (LDCs) tend to have very
large agricultural sectors, and in many cases their
economies depend heavily on exports of agricultural
products. Over the past several decades, there have
been large increases in the supply of a number of
agricultural products exported by LDCs (cocoa, coffee,
sugar, cotton and others). Given low YEDs for these
products, there has been by slow growth in global
demand. Figure 3.11 illustrates the results of large
growth in supply with relatively slower growth in
demand. Downward pressures on agricultural product
prices mean that LDCs that rely heavily on exports
of such products have been suffering declines in
export revenues over many years, with major negative
consequences for their growth and development
efforts. (We will return to these topics in Chapters 14
and 16.)
S1
P2
D2
D1
Q
Figure 3.11 Long-term decline in agricultural product prices.
80
Economics for the IB Diploma
Figure 3.11
Mac/eps/Illustrator Col s/s
Text: Agenda
emcdesign
Part
2: Microeconomics
Studio: Peters & Zabransky
observed rapid growth in certain service
industries, including health care, education, and
financial services compared to other industries
such as food (in the primary sector) and
furniture (n the secondary sector)?
2 Using the concept of YED and an appropriate
diagram, explain why agriculture is often referred
to as a ‘declining industry’.
diagram to explain why agricultural product
prices tend to fall relative to prices of
manufactured products over the long term.
3.4 Price elasticity of supply (PES)
Definition and formula for the price elasticity
of supply
Until now we have been studying demand elasticities,
all of which involve consumer responses. We now
turn to examine the price elasticity of supply, which
concerns firm responses to changes in price. We know
that according to the law of supply, there is a positive
(direct) relationship between price and quantity
supplied: when price increases, quantity supplied
increases, and vice versa. But by how much does
quantity supplied change?
Price elasticity of supply is a measure of the
responsiveness of the quantity of a good supplied
to changes in its price. In general, if there is a large
responsiveness of quantity supplied, supply is referred
to as being elastic; if there is a small responsiveness,
supply is inelastic.
S2
P1
0
1 What is one likely explanation behind the
3 Use the concept of YED and an appropriate
The case of less developed countries
P
Test your understanding 3.9
The formula for the price elasticity of supply (PES) is
the same as the formula for the PED, only now we
consider the relationship between the percentage
change in quantity supplied of a good, X, and the
percentage change in its price:
In addition, there are three special cases:
price elasticity
= PES =
of supply
PES =
percentage change in
quantity of good X supplied
percentage change in
price of good X
%Δ Qx
%Δ Px
which can be rewritten as:
Δ Qx
PES =
Qx
Δ Px
Px
Δ Qx
× 100
=
× 100
Qx
Δ Px
Px
Interpreting the price elasticity of supply
The range of values for the PES
The price elasticity of supply ranges in value from zero
to infinity. Note that because of the direct relationship
between price and quantity supplied, the PES is
positive.
The value of the PES involves a comparison of
the percentage change in quantity supplied (the
numerator in the formula for the PES) with the
percentage change in price (the denominator). This
comparison yields the following possible values
and range of values of the PES, each of which is
summarized in Table 3.2 and shown graphically in
Figure 3.12 (both on page 82):
· Supply is price inelastic when PES < 1 The percentage
change in quantity supplied is smaller than the
percentage change in price, so that the value of the
PES is less than one; quantity supplied is relatively
unresponsive to changes in price, and supply is said
to be price inelastic or inelastic. Figure 3.12(a)
shows an inelastic supply curve (PES < 1): in the
example considered here, a 10% increase in price
gives rise to a 5% increase in quantity supplied.
· Supply is price elastic when PES > 1 The percentage
change in quantity supplied is larger than the
percentage change in price, so that the value of
the PES is greater than one; quantity supplied is
relatively responsive to price changes, and supply
is said to be price elastic or elastic. Figure 3.12(b)
shows an elastic supply curve (PES > 1) where the
percentage increase in price (10%) is smaller than
the percentage increase in quantity (20%).
· Supply is unit elastic when PES = 1 The percentage
change in quantity supplied is equal to the
percentage change in price, so that the PES is exactly
equal to one; supply is then said to be unit elastic.
In Figure 3.12(c), all three supply curves shown are
unit elastic curves, i.e. for all three, PES = 1. Any
supply curve that passes through the origin has a
PES equal to unity. The reason for this is that along
any straight line that passes through the origin,
between any two points on the line the percentage
change in the vertical axis (in this case price) is
equal to the percentage change in the horizontal
axis (in this case quantity). Therefore, for lines
that pass through the origin, it is important not to
confuse the steepness of the curve with the elasticity
of the curve.
· Supply is perfectly inelastic when PES = 0 The
percentage change in quantity supplied is zero;
there is no change in quantity supplied no matter
what happens to price; the PES is then equal to
zero and supply is said to be perfectly inelastic. In
Figure 3.12(d), the PES is equal to zero; no matter
what happens to price, quantity supplied does not
respond. The supply curve is vertical at the point
of fixed quantity supplied, Q1. The student will
note that this is exactly the same as the supply
curve shown in Figure 2.11 in Chapter 2, page 42).
Examples of a vertical supply curve include the
supply of fish at the moment when fishing boats
return from sea; the season’s entire harvest of fresh
produce brought to market; the supply of Picasso
paintings; and the number of seats in a stadium or
theatre.
· Supply is perfectly elastic when PES = ∞ The
percentage change in quantity supplied is infinite;
what this means in effect is that a very small a
change in price will result in a very large response
in quantity supplied; supply in this case is called
perfectly elastic, and is shown in Figure 3.12(e) as
a line parallel to the horizontal axis. What such a
supply curve means in practice is that at the price
where the supply curve is situated, firms can supply
any quantity of the good. (We will encounter such a
supply curve in Chapter 12.)
Chapter 3: Elasticities 81
Table 3.2 Characteristics of price elasticity of supply.
Value of PED
Classification
Interpretation
inelastic supply
quantity supplied is relatively
unresponsive to price
elastic supply
quantity supplied is relatively responsive
to price
PED = 1
unit elastic supply
percentage change in quantity supplied
equals percentage change in price
PED = 0
perfectly inelastic supply
quantity supplied is completely
unresponsive to price
perfectly elastic supply
quantity supplied is infinitely responsive
to price
Frequently encountered cases
0 < PED < 1
(greater than zero and less than one)
∞
1 < PED <
(greater than 1 and less than infinity)
Special cases
PED =
∞
(a) Price inelastic supply PES < 1.
P
Frequently encountered cases (b) Price elastic supply PES > 1.
P
S
S
P2
10%
10%
P1
0
Q1 Q2
P
Q1
Special cases
P
Q2
Q
20%
(d) Perfectly inelastic supply PES = 0.
S1
P1
0
Q
5%
(c) Unit elastic supply PES = 1.
P2
(e) Perfectly elastic supply PES = ∞.
P
S
S2
S3
0
P1
Q
0
Q1
Q
0
S
Q
Figure 3.12 Supply curves and the PES.
Economics for the IB Diploma
Figure 3.12most commonly
Price elasticities of supply
Mac/eps/Illustrator Col s/s
encountered in the Text:
realAgenda
world are those representing
elastic or inelastic supply,
emcdesignwith perfectly elastic,
Studio:
Peters
& Zabransky
perfectly inelastic and
unit
elastic
supply being
special cases. Note that only when two supply curves
intersect (that is, when they share a price and quantity
combination) is it possible to make comparisons of
price elasticities of supply by reference to the steepness
82
Part 2: Microeconomics
of the curves. (You may remember that we have the
same condition for making comparisons of PEDs in
the case of demand curves.) In the case of intersecting
supply curves, the flatter the supply curve, the more
elastic it is at any given price. For example, in
Figure 3.13, at any one particular price level, S3 is
more elastic than S2, which is more elastic than S1.
· The immediate time period This is a time period so
P
10%
short that the firm is unable to increase (or decrease)
any of its inputs in order to change the quantity
it produces. In this case supply is highly inelastic,
and may even be perfectly inelastic (PES = 0). In
Figure 3.13, this is represented by S1.
S2
S1
S3
P2
· The short run The short run is defined as a period
P1
0
Q1 Q2
3%
Q3
Q
15%
Figure 3.13 The length of time and PES.
It should also be noted that the PES varies along any
straight-line supply curve (as in the case of PED and
demand curves) so that when comparing the PES of
two different supply curves, this should be done only
at a specific price or price range.
Test your understanding 3.10
1 Specify the value or range of values for each of
the PESs below, and show diagrammatically the
shape of the supply curve that corresponds to
each one: (a) perfectly elastic supply; (b) unit
elastic supply; (c) perfectly inelastic supply.
2 How would you show price elastic and price
inelastic supply in the same diagram? Explain.
3 Which price elasticity of supply values or range
of values do we see most frequently in the real
world?
Determinants of the price elasticity of supply
Length of time
The main factor determining the price elasticity of
supply is the ease and speed with which firms can shift
resources and production between different products,
and this in turn depends on the amount of time firms
have to adjust resource use and therefore the quantity
supplied in response to a change in price. We can
distinguish between three time periods:
of time during which a firm can vary (increase or
decrease) some but not all of its inputs. At least
one of its inputs is fixed in quantity. For example,
in the event of a price increase it can hire more
labour, but there is not enough time to expand its
factories or build new ones. This means that the
firm can increase the quantity it produces by using
more of some inputs (such as labour) but these will
have to work together with the other inputs that
are fixed in quantity. The result is that quantity
supplied will increase only a little in response to
the price increase; supply is inelastic (PES < 1) and is
represented by a curve such as S2 in Figure 3.13.
· The long run The long run is defined to be a period
of time long enough so that a firm can vary all
of its inputs: factories, machinery and so on can
be adjusted to respond fully to the price change.
The response of quantity supplied to the price
change will be much greater, and quantity supplied
increases substantially in response to a price
increase; supply is elastic (PES > 1) as shown by S3 in
Figure 3.13.
Thus in the examples of Figure 3.13, we see that a 10%
price increase (from P1 to P2) produces a zero change in
quantity supplied in the case of S1 where PES = 0 (the
immediate time period); or a 3% increase in quantity
supplied in the case of S2 when PES < 1 (the short run),
and a 15% increase in quantity supplied for S3 when
PES > 1 (the long run). As the time available to firms
to adjust their inputs increases, the responsiveness of
quantity supplied to a price change increases.
Spare capacity of firms
Sometimes firms may have capacity to produce that is
not being used (for example, factories or equipment
may be idle for some hours each day). If this occurs, it
is relatively easy for a firm to respond with increased
output to a price rise. But if the firm’s capacity is fully
used, it will be more difficult to respond to a price rise.
The greater the spare (unused) capacity, the higher
is the PES (the more elastic the supply); the less the
spare capacity, the smaller the PES (the less elastic the
supply).
Chapter 3: Elasticities 83
Test your understanding 3.11
1 Suppose that in response to an increase in
the price of good X from $10 to $15 per unit,
the quantity of good X produced (a) does not
respond at all during the first week; (b) increases
from 10,000 units to 12,000 units over five
months; and (c) increases from 10,000 to 18,000
units over two years. Calculate the PES for each
of these three time periods.
2 (a) How can you account for the difference
in the size of the three elasticities of Question
1? (b) Draw a supply curve that is likely to
correspond to each of the three elasticities in a
single diagram.
Applications of the price elasticity of supply
PES and short-term price instability of
agricultural products
In general, agricultural products (as well as other
primary products) tend to have a lower price elasticity
of supply than industrial (manufactured) products,
particularly over short periods of time. The main
reason for this is the time needed for quantity supplied
to respond to price changes. It takes relatively long
periods of time for resources to be shifted in and out
of agriculture, and agriculture is also constrained by
growing seasons for particular products that farmers
cannot control. In the case of other primary products
(such as oil, natural gas and minerals), time is needed
to make the necessary investments and to begin
production.
Earlier, in our discussion of price elasticity of demand
(PED), we saw that fluctuating supply over short
periods of time in combination with price inelastic
demand for food is a major factor contributing to
short-term price and income instability for farmers.
Now we will see that fluctuating demand over short
periods of time in combination with price inelastic
supply of agricultural and other primary products also
contributes to price and income instability in the farm
sector.
Why does demand for agricultural products fluctuate?
Within any particular country, the demand for food
tends to be relatively stable (i.e. the determinants
of demand do not change significantly). However,
if a country exports (i.e. sells to other countries) a
relatively large portion of its agricultural output, then
84
Part 2: Microeconomics
a part of its total demand for agricultural products
will be made up of foreign demand. Foreign demand
for agricultural products can be unstable for several
reasons. Crop failures in other countries can raise
foreign demand for a country’s products, while good
harvests will lower it. Increased protection of farmers
in other countries through government policies such
as price supports (discussed in Chapter 2, page 56) or
quotas and tariffs (to be discussed in Chapter 12) will
lower foreign demand whereas reduced protection will
increase it. Changes in consumer tastes can also affect
demand.
Figure 3.14 shows a fluctuating demand curve (it is
steep, indicating low price elasticity of demand); in
panel (a) it interacts with inelastic supply, which is
typical in the case of agriculture, and in panel (b) with
elastic supply, which is more typical of manufactured
products. Clearly, price fluctuations are substantially
larger in the case of inelastic supply. Large price
fluctuations mean large revenue fluctuations, or
unstable income for farmers.
(a) Demand shifts with inelastic supply.
S
P
P2
P1
P3
0
D3
D1
D2
Q
(b) Demand shifts with elastic supply.
P
S
P2
P1
P3
D2
D3
0
D1
Q
Figure 3.14 The effect of changes in demand on agricultural product
prices and farmer revenues.
Short-run and long-run price elasticities
of supply
It was noted above that agricultural products tend
to have lower price elasticities of supply than
manufactured products over short periods of time
because they need more time to respond to price
changes. This suggests that over longer periods of
time the PES of agricultural products is larger.
Table 3.3 shows that this is in fact the case. The
longer the time producers (firms) have to make the
necessary adjustments, the greater the responsiveness
of quantity supplied to price changes (see Figure 3.13).
Because the length of time available to producers is
such an important determinant of the price elasticity
of supply, it is important to make a distinction
between short-run and long-run price elasticities of
supply.
Table 3.3 Short-run and long-run PES for selected commodities.
Commodity
Short-run PES
Long-run PES
Cabbage
0.36
1.20
Carrots
0.14
1.00
Cucumbers
0.29
2.20
Onions
0.34
1.00
Green peas
0.31
4.40
Tomatoes
0.16
0.90
Cauliflower
0.14
1.10
Celery
0.14
0.95
Test your understanding 3.12
1 Use the concept of PES to explain why
agricultural product prices are volatile over the
short term.
2 Why is it important to make a distinction
between short-run and long-run price elasticities
of supply?
3 Why do agricultural products generally tend to
have a lower PES than manufactured products
over short periods of time?
Table 3.4 provides a summary of key characteristics of
all the elasticities considered in this chapter.
Table 3.4 Elasticity concepts summarized.
Elasticity
Formula
Values
Description
PED = 0
perfectly
inelastic
PED < 1
price inelastic
PED = 1
unit elastic
PED > 1
price elastic
PED = ∞
perfectly
elastic
Cross%Δ Qx
elasticity of
CED =
demand
%Δ Py
CED > 0
substitutes
CED < 0
complements
CED = 0
unrelated
Income
elasticity of
demand
YED > 0
normal good
YED < 0
inferior good
YED > 1
income elastic
YED < 1
income
inelastic
PES = 0
perfectly
inelastic
PES < 1
price inelastic
PES = 1
unit elastic
PES > 1
price elastic
PES = ∞
perfectly
elastic
Price
elasticity of
demand
PED =
YED =
%Δ Qx
%Δ Px
%Δ Qx
%Δ Y
Price
elasticity of
supply
PES =
%Δ Qx
%Δ Px
3.5 Elasticities of demand and supply
and incidence of taxes and subsidies
(higher level topic)
This topic involves an additional application of the
concepts of price elasticity of demand and price
elasticity of supply.
Indirect taxes: flat rate and ad valorem
Indirect taxes are taxes levied on spending to buy
goods and services. They are called indirect because,
whereas they involve payment of some of the tax
by the consumer, they are paid to the government
authorities by the suppliers (firms), that is, indirectly.
Examples of indirect taxes are excise taxes (or excise
duties), which are taxes on specific goods and services
(such as taxes on cigarettes), general sales taxes and
Chapter 3: Elasticities 85
HL
HL
value added tax (VAT). Indirect taxes can be contrasted
with direct taxes, involving payment of the tax
directly by consumers or firms to the government
(such as personal income taxes). (Both direct and
indirect taxes will be considered in
Chapter 11.)
Indirect taxes can be
· flat rate taxes, involving an absolute amount per
unit of the good or service sold, such as for example,
€5 per packet of cigarettes.
· ad valorem taxes, involving a fixed percentage
of the price of the good or service; in this case the
amount of tax increases as the price of the good or
service increases.
When a tax is imposed on a good or service, this tax
must be paid to the government by the firm. From the
point of view of the firm, this means that for every
level of output that the firm is willing and able to
produce and supply, it must now receive a price that
is higher than the original price by the amount of the
tax. This in effect involves a shift of the supply curve
upward by the amount of the tax. (Note that this is
equivalent to a leftward shift of the supply curve; a
leftward shift means that for each price, the firm is
now willing to supply less output.) Figure 3.15 shows
how the supply curve shifts in the case of a flat rate
tax and an ad valorem tax. In the case of a flat rate tax,
the shift of the supply curve is parallel, because the tax
is an absolute amount for each unit of output sold and
so is the same for all prices. Therefore in panel (a) S2 is
parallel to S1. In the case of the ad valorem tax, the new
supply curve S2 is steeper than S1; since it involves a
percentage of the price, the absolute amount of the tax
(shown in the diagram) increases as price increases.
(a) Flat rate tax.
P
The incidence of indirect taxes and subsidies
on consumers and producers
The incidence of indirect taxes
It was noted above that when a tax is imposed on a
good or service, the tax is paid to the tax authorities
by the producers (firms). However, this tells us
nothing about who ultimately pays the tax. Suppose,
for example, that producers are able to pass on to
consumers a part of the tax in the form of higher
prices. Although the producers are responsible for
payment of the tax to the government, the burden of
the tax is no longer fully on the producers, as part of
the tax has been passed to consumers. The idea of who
ultimately pays the tax is referred to as tax incidence.
Tax incidence refers to the burden of a tax, or those
who are the ultimate payers of the tax.
Let’s consider the case of the incidence of a flat rate
tax for simplicity (the analysis would be exactly the
same in the case of an ad valorem tax). Figure 3.16(a)
shows a supply curve shift from S1 to S2 due to the
imposition of a tax. The demand curve remains
constant at D since demand is not affected by the tax.
The initial equilibrium is at point a, so the price paid
by consumers is P1 and quantity purchased is Q1. After
the tax is imposed, the equilibrium moves to point b,
given by the intersection of the demand curve with
the new supply curve, S2, so that the price paid by
consumers increases to P2, and the quantity purchased
falls to Q2. Remember that the vertical difference
between the two supply curves (P2 − P3) represents the
amount of tax per unit of output. This means that
whereas producers receive from consumers price P2 per
unit, they must also pay the government the amount
of P2 − P3 per unit (or the tax per unit). Therefore the
final price received by the producer after payment of
the tax is P3.
(b) Ad valorem tax.
S2
P
S2
tax per S
1
unit
tax
S1
tax
0
Figure 3.15 Supply curve shifts due to indirect taxes.
86
Part 2: Microeconomics
Q
0
Q
HL
HL
What can we now say about the incidence of the tax?
The full amount of the tax is given in the figure by
(P2 − P3) × Q2, or the amount of tax per unit multiplied
by the number of units sold; this is the entire shaded
area, and is equal to the government’s tax revenue.
The incidence of the tax is partly on consumers and
partly on producers:
Tax burden of consumers
= (P2 − P1) × Q2
Tax burden of producers
= (P1 − P3) × Q2
Tax revenue for the government = (P2 − P3) × Q2
(a) Incidence of flat rate tax.
S2
P
P2
tax per
unit
b
consumers
P1
P3
S1
a
producers
Q2
Q1
Q
(b) Incidence of flat rate subsidy.
P
P3
P1
S1
producers
consumers
subsidy
per unit
c
S2
P2
d
Subsidy share of consumers
= (P1 − P2) × Q2
Subsidy share of producers
= (P3 − P1) × Q2
Q1
Q2
Note that the imposition of an indirect tax or a
subsidy has the effect of changing the allocation of
resources. In Figure 3.16(a), the indirect tax results in
an underallocation of resources to the production of
the good, since the final equilibrium point, b, gives
rise to a lower level of output: Q2 < Q1. By contrast, the
imposition of a subsidy results in an overallocation of
resources to the production of the good, since in the
final equilibrium, d, quantity is greater: Q2 > Q1.
Elasticity of demand and supply and the
incidence of indirect taxes
D
0
A flat rate subsidy is one that involves a fixed
payment per unit of output, and results therefore
in a downward, parallel shift of the supply curve,
from S1 to S2 as shown in Figure 3.16(b). The vertical
difference between the two supply curves represents
the amount of subsidy per unit of output. The initial
equilibrium is at point c, determining price P1 and
quantity Q1; following the granting of the subsidy, the
final equilibrium occurs at point d, with lower price
P2 and larger quantity Q2. In the final equilibrium,
consumers pay price P2, but producers receive price
P3. The difference between the two, P3 − P2, represents
the amount of the subsidy per unit. The full amount
of the subsidy is therefore given by (P3 − P2) × Q2. The
subsidy is shared between consumers and producers:
Total cost of subsidy to government = (P3 − P2) × Q2
D
0
government to firms, in order to study the incidence
of subsidies, or how the payment by the government
is shared between consumers and firms.
Q
Figure 3.16 Incidence of flat rate tax and subsidy, shared between
consumers and producers.
The incidence of subsidies
A subsidy is a payment made by the government to
producers or consumers and has the opposite effect of
a tax. Possible objectives of subsidies may be to change
the distribution of output or income (in favour of
producers or consumers; see Chapter 11); or to correct
positive externalities (see Chapter 6); or to increase
exports (see Chapter 12). For now, we will confine
ourselves to subsidies involving payments from the
We have seen that the burden (or incidence) of
indirect taxes is shared between consumers and firms.
The distribution of the burden, however (i.e. who
has a larger burden and who has a smaller burden),
depends on the price elasticities of demand and supply
for the good or service that is being taxed. As we will
see, these elasticities determine:
· the relative tax burdens of consumers and producers
· the size of the government’s tax revenues.
The case of demand elasticities
Figure 3.17 (page 88), showing the burden of a flat rate
tax being shared between consumers and producers,
is similar to Figure 3.16(a), only in Figure 3.17(a)
demand is elastic, whereas in panel (b) it is inelastic.
Chapter 3: Elasticities 87
HL
HL
of the tax, and tax revenues for the government are
substantial.
(a) Elastic demand.
P
S2
tax per
unit
P2
P1
P3
The case of supply elasticities
Figure 3.18 is also similar to Figure 3.16(a), only now
panel (a) shows elastic supply and panel (b) inelastic
supply.
S1
consumers
producers
D
0
Q2
Q1
Q
(b) Inelastic demand.
P
S2
tax per
unit
S1
P2
consumers
P1
producers
P3
0
D
Q2 Q1
Q
Figure 3.17 The incidence of an indirect tax with elastic and inelastic
demand.
Once again, the full amount of tax is given by
(P2 − P3) × Q2, or the amount of tax per unit multiplied
by the number of units sold; this is the entire shaded
area, and is equal to the government’s tax revenue.
The incidence of the tax is partly on consumers and
partly on producers:
Tax burden of consumers
= (P2 − P1) × Q2
Tax burden of producers
= (P1 − P3) × Q2
Tax revenue for the government = (P2 − P3) × Q2
When supply is elastic, most of the tax burden
falls on consumers, whereas with inelastic supply,
most of the tax burden falls on producers. Further,
tax revenue for the government is larger the more
inelastic the supply.
For example, the supply of oil is inelastic in the short
run, but becomes more and more elastic over longer
periods of time (the long run). Therefore taxes on oil
have a larger incidence on producers than consumers
in the short run, and tax revenues are larger in the
short run. As time goes by, since supply becomes more
elastic in the long run, the incidence of the tax begins
to shift more towards the consumer and tax revenues
begin to fall.
P
P2
P1
P3
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Part 2: Microeconomics
S2
S1
producers
Q2
D
Q
Q1
(b) Inelastic supply.
S2
S1
tax per
unit
P2
P1
consumers
producers
P3
0
This is why we generally see excise taxes being
imposed on goods whose demand is inelastic, such as
cigarettes and petrol; consumers pay the larger part
tax per
unit
consumers
0
P
In the case of elastic demand, shown in panel (a),
most of the tax burden falls on producers, while with
inelastic demand, shown in panel (b), most of the
burden falls on consumers. Moreover, tax revenue
for the government is greater in the case of inelastic
demand, because as price rises due to the tax, quantity
demanded falls proportionately less, and so tax
revenue is high.
(a) Elastic supply.
Q2
Q1
D
Q
Figure 3.18 The incidence of an indirect tax with elastic and inelastic
supply.
HL
HL
In general, tax revenues for the government will be
greater the more inelastic the demand and the more
inelastic the supply. Further, the tax burden will fall
proportionately more on the group whose activities are
less responsive to price changes: on consumers whose
purchases are not very responsive to price increases
(inelastic demand), and on producers whose sales are
not very responsive to price increases (inelastic supply).
The low responsiveness (low price elasticities) means
that as price increases due to the imposition of the tax,
consumers or producers do not change their buying
and selling activities substantially, and so as a result
must bear a relatively larger portion of the tax burden.
HL
Test your understanding 3.13
1 Indirect taxes are usually paid to the government
by firms. Yet firms do not bear the full burden
(incidence) of such taxes. Why?
2 (a) Define flat rate and ad valorem taxes;
(b) provide examples of each; and (c) show
how the supply curve shifts when each of these
is imposed on a product.
3 What determines whether the incidence of an
indirect tax or the incidence of a subsidy falls
mainly on consumers or mainly on producers?
4 Using appropriate diagrams, show how the
incidence of an ad valorem tax will be shared
between consumers and producers in the case of
(a) elastic demand; and (b) inelastic demand.
What conclusions can you draw about relative
tax burdens and price elasticities of demand?
5 Using appropriate diagrams, show how the
incidence of an ad valorem tax will be shared
between consumers and producers in the case of
(a) elastic supply; and (b) inelastic supply. What
conclusions can you draw about relative tax
burdens and price elasticities of supply?
Questions for
review
3.1
[15 marks] (a) Define the concept of elasticity.
(b) Define the four elasticity concepts you have
studied. (c) Show the formula you would use to
calculate each of these elasticities. (d) Which
elasticities involve movements along the demand
or supply curves, and which involve shifts of the
curve(s)?
3.2
[15 marks] Explain the factors that determine the
value of each of the four elasticities.
3.3
[10 marks] It is commonly believed that a
producer of a good will increase total revenue by
increasing the price of the good produced. Do you
agree? Explain, using a diagram in your answer.
3.4
[10 marks] Use demand and supply analysis
and a diagram, and the fact that the demand for
agricultural products tends to be price inelastic,
to show how a good crop can impact on farmers’
revenues.
3.5
[15 marks] The price of meat increases by 10%,
the quantity demanded of meat falls by 12% and
the demand for fish increases by 9%. (a) What is
the price elasticity of demand for meat? (b) What
is the cross-elasticity of demand between meat
and fish? (c) What can you conclude about the
demand for meat (is it price elastic or inelastic)?
(d) What can you conclude about the relationship
between meat and fish? (e) Using appropriate
diagrams, illustrate the impact of the increase
in the price of meat on the quantity of meat
demanded and the demand for fish.
3.6
[10 marks] The price of pizzas falls by 15%, the
quantity demanded of pizzas increases by 17%
and the demand for colas increases by 20%.
(a) What is the price elasticity of demand for
pizzas? (b) What is the cross-elasticity of demand
for pizzas and colas? (c) What can you conclude
about the demand for pizzas? (d) What can you
conclude about the relationship between pizzas
and colas?
Chapter 3: Elasticities 89
Questions for
3.7
3.8
review
[15 marks] Your annual income increased
from $16,000 to $20,000 (a 25% increase). Your
spending on purchases of bread fell by 5%, while
your spending on purchases of food in general and
eating out in restaurants increased by 15% and
30% respectively. (a) Which elasticity of demand
concept is relevant for analysing the changes in
your consumption patterns? (b) Calculate this
demand elasticity for each of these items.
(c) What can you conclude about the changes
in your demand for these three items? (d) Show
diagrammatically the impact on your demand for
these three items that resulted from your increase
in income.
[10 marks] You are conducting an international
comparative study on income elasticities and find
that the income elasticities of demand for many
products are higher in more developed countries
than the corresponding figures in less developed
countries. How can you explain these differences?
3.9
[20 marks] (a) Explain which elasticity concepts
may be important to firms and why. (b) Explain
which elasticity concepts may be important to
governments and why.
3.10
[10 marks] Which elasticity of demand concept
is useful in explaining the fall in agriculture’s
share in GDP and the increase in the shares of
manufactured products and services as a country
grows and develops? Explain.
3.11
[10 marks] (a) What is the main determinant
of the price elasticity of supply? (b) How does
this help explain the different price elasticities of
supply we generally find between agricultural and
manufactured products?
3.12
[5 marks] What do you think is the price elasticity
of supply of Picasso’s paintings? Explain.
3.13
[20 marks] Prices of agricultural products (as well
as other primary products) tend to be volatile (to
fluctuate) over the short term and tend to decline
over the long term. Use the concepts of price
elasticity of demand, price elasticity of supply and
income elasticity of demand to explain short-term
volatility and long-term price declines.
90
Part 2: Microeconomics
Higher level
3.14
[10 marks] (a) How is the incidence (burden) of
indirect taxes affected by the price elasticity of
demand and the price elasticity of supply of the
particular goods being taxed? (b) Under what
conditions does the greater part of tax incidence
fall on producers and under what conditions
on consumers? Use diagrams to illustrate your
answers.
3.15
[10 marks] How are government tax revenues
from indirect taxes affected by the price elasticity
of demand and the price elasticity of supply of the
particular goods being taxed?
3.16
[15 marks] The government is considering
imposing an indirect tax on cigarettes or on
yachts. (a) Which of the two goods should it tax
if it is interested in increasing its tax revenues?
(b) Using diagrams, explain how the incidence
(burden) on consumers and producers of a flat
rate tax on cigarettes and on yachts is likely to be
different.
HL
Chapter 4
Microeconomics
The theory of the firm I
Costs, revenues and profit (higher level topic)
This chapter and the next are concerned with the behaviour of firms. Much of firm behaviour depends
on the type of market structure within which the firm operates. Market structures were introduced in
Chapter 2, page 28, and will be studied in greater detail in Chapter 5. The present chapter introduces
the student to the fundamental concepts that are necessary to analysing firm behaviour: costs, revenues
and profit.
OBJECTIVES
After studying this chapter you should be able to:
·
·
·
·
HL
·
·
·
·
·
·
·
distinguish between accounting and implicit costs
distinguish between the short run and the long run
identify a variety of cost concepts and cost curves
understand the short-run technical relationship between inputs and output illustrated by the law of diminishing
marginal returns
explain how the law of diminishing marginal returns is related to costs of production in the short run
explain how short-run costs are related to long-run costs
explain the factors that account for the shape of the long-run average total cost curve
understand revenue concepts
distinguish between accounting, economic and normal profit
evaluate the profit maximization goal of firms assumed by standard economic theory
identify and explain alternative theories of firm behaviour.
HL
4.1 Costs
Introduction to costs of production
Firms use resources, or factors of production, or inputs
(these terms are used interchangeably) to produce
goods and services. When firms use resources to
produce, they incur costs of production, which
include money payments plus anything else given up
by a firm for the use of resources. Let’s examine costs
of production more closely.
Accounting, implicit and economic costs
In Chapter 1, page 4, the concept of opportunity cost
was introduced and defined as the value of the best
alternative that must be sacrificed in order to obtain
something.
Chapter 4: Theory of the firm I
91
HL
In economics, because of the condition of scarcity, all
costs are opportunity costs. Therefore the costs of all
resources used by a firm to produce goods and services
can be considered as opportunity costs. What this
means in effect is that all the resources used by the
firm have alternative uses that must be sacrificed in
order that they can be used by the firm. This sacrifice
is the opportunity cost.
From the point of view of the firm, we can distinguish
between two kinds of opportunity costs, depending
on who owns the resources the firm uses. Resources
are either owned by the firm itself, or are owned by
outsiders to the firm from whom the firm acquires
them. This very obvious distinction has important
implications for understanding costs from an
economist’s perspective.
Accounting costs
When the firm needs resources that it does not own,
it must purchase them from outsiders and make a
monetary payment (a payment of money) to the
resource suppliers in exchange for acquiring the
resources. For example, a firm hires labour and pays
a wage; it purchases materials and pays the price to
the seller; it uses electricity and pays the electricity
supplier, and so on.
The payments made by a firm to outsiders in order
to acquire resources for use in production are called
accounting costs (also sometimes known as
‘explicit costs’).
Accounting costs are so termed because they include
the costs usually recorded by accountants in the firm’s
books. The opportunity cost of using resources that
are not owned by the firm is equal to the amount paid
to acquire them; the monetary payments could have
been made to buy something else instead, which is
now being sacrificed.
Implicit costs
The firm may own some of the resources that it uses
for its production, such as, for example, an office
building that is owned and used by the same business.
In this case, the firm does not make a monetary
92
Part 2: Microeconomics
payment to acquire the resource. There is nonetheless
a cost involved in the use of the self-owned resource,
which is the sacrifice of income that would have been
earned if the resource had been employed in its best
alternative use.
The sacrificed income that arises from the use of selfowned resources by a firm is an opportunity cost that
is called an implicit cost.
For example, in the case of the office building owned
and used by the firm, the opportunity cost is the rental
income that could have been earned had the building
been rented out. The hours of work that a firm owner
puts into his or her own business have an opportunity
cost equal to what the firm owner could have earned if
he or she had worked elsewhere. The entrepreneurial
abilities that the firm owner puts into the business
(risk-taking, innovative capabilities, organizational
and managerial abilities) entail a further opportunity
cost equal to what these abilities could have earned
elsewhere.
Economic costs
When we add a firm’s accounting costs to its implicit
costs, we obtain the firm’s ‘economic costs’.
Economic costs are the sum of accounting and
implicit costs, or the total opportunity costs incurred
by a firm for its use of resources, whether purchased or
self-owned. When economists refer to ‘costs’ they are
actually referring to ‘economic costs’. Economic costs
are larger than accounting costs by the amount of the
implicit costs.
Consider the following example. Let’s say you were
holding a job paying you a salary of £60,000 a year,
which you decided to quit because you wanted to
open your own business. You estimate that your
entrepreneurial talent that you are putting into your
business is worth £45,000 a year. You set up your office
in a spare room of your house that you used to rent
out for £4000 a year. Further, you borrowed £30,000,
for which you are paying interest of £2000 a year. You
then used the borrowed sum of £30,000 to purchase
supplies and materials. You have also hired an
assistant whom you pay £18,000 a year. Your implicit,
accounting and economic costs are as follows:
HL
HL
Implicit costs
£ 60,000 (your foregone salary)
+ £ 45,000 (your foregone income from your
entrepreneurial talent)
+ £ 4,000 (your foregone rental income from
your spare room)
£109,000
Accounting costs
£ 2,000 (interest on your loan)
+ £ 30,000 (purchase of supplies and
materials)
+ £ 18,000 (assistant’s salary)
£ 50,000
Economic costs ( = total opportunity costs)
£ 109,000 (implicit costs)
+ £ 50,000 (accounting costs)
£ 159,000
An accountant would only add up the accounting
costs of £50,000, and would ignore the implicit costs
of £109,000.
Fixed, variable and total costs
The distinction between fixed and variable inputs
discussed above in connection with the short and
long run leads us to a distinction between fixed and
variable costs:
· Fixed costs arise from the use of fixed inputs Fixed
costs are defined to be costs that do not change as
output changes. Examples of fixed costs include
rental payments, property taxes, insurance
premiums and interest on loans. These are payments
that do not increase if the firm produces more
output, and do not decrease if it produces less. Even
if a firm ceases to produce (i.e. there is zero output),
these payments will still have to be made in the
short run.
· Variable costs arise from the use of variable inputs
These are costs that vary (or change) as output
increases or decreases, therefore they are ‘variable’.
An example of a variable input is labour. To produce
more output, the firm hires more labour, and
therefore has increased wage costs. In general, the
more variable inputs a firm uses, the greater will be
the variable costs of production.
· Total costs are the sum of fixed and variable costs
The short run and the long run
In Chapter 3, page 83, we distinguished between
the short run and the long run as two different time
periods during which firms adjust their inputs to
change the amount of output produced. We now
return to the difference between the short and long
run once again because it is very closely related to a
key distinction relating to costs of production.
· The short run is a time period during which at
least one input is fixed and cannot be changed by
the firm. For example, if a firm wants to increase
output, it can initially hire more labour and increase
materials, tools and equipment, but it cannot
quickly change the size of its buildings, factories and
heavy machinery. As long as these latter inputs are
fixed, the firm is operating in the short run.
· The long run is a time period long enough so that
all inputs can be changed. Using the example above,
in this time period the firm can build new buildings
and factories and buy more heavy machinery; in
other words it can change all of its inputs. In the
long run the firm has no fixed inputs; all inputs are
variable.
Note that the long run and the short run do not
correspond to any particular length of time. Some
industries may require months to change their fixed
inputs while other may require years.
Note that fixed costs arise only in the short run
when the firm has fixed inputs. In the long run
all inputs are variable and so all costs are variable.
Therefore in the long run, with fixed costs equal
to zero, a firm’s total costs are equal to its variable
costs.
Average costs
Average costs are costs per unit of output. They
tell us how much each unit of output produced by the
firm costs on average. Average cost is simply total cost
divided by the number of units of output. From our
discussion above, we have three total costs, each of
which corresponds to an average cost:
total costs
average
total fixed costsaverage
(TFC)
(AFC)
total variable costsaverage
(TVC)
(AVC)
total costsaverage
(TC)
(ATC)
costs
fixed costs
variable costs
total costs
To calculate average costs, we simply divide each of
the totals by the units of output (Q) that the firm
produces:
AFC =
TFC
Q
AVC =
TVC
Q
ATC =
TC
Q
Chapter 4: Theory of the firm I 93
HL
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It was noted above that total cost is the sum of fixed
costs plus variable costs:
TC = TFC + TVC
Similarly, average total costs are the sum of average
fixed costs plus average variable costs:
ATC = AFC + AVC
Test your understanding 4.1
(...continued)
6 (a) Define the three kinds of average costs, and
explain how they are derived from the three
kinds of total cost. (b) How are the three kinds
of average costs related to each other?
7 Define marginal cost; how is it related to total
cost and total variable cost?
Marginal cost
Marginal cost (MC) is the extra or additional cost of
producing one more unit of output. It tells us by how
much total costs increase if there is an increase in
output by one unit. It is calculated by considering the
change in total cost (TC) resulting from a change in
output. In addition, it can be calculated by considering
the change in total variable cost (TVC) that results
from a change in output. The reason why the two
are equivalent is that fixed costs are constant (do not
change) as output increases or decreases. Marginal cost
is given by
MC =
Δ FC
ΔQ
=
Δ TVC
ΔQ
where the Greek letter Δ stands for ‘change in’. As we
will see later in this chapter, the concept of marginal
cost plays a very important role in a firm’s decision on
what quantity of output to produce.
Test your understanding 4.1
1 Provide some examples of (a) accounting costs;
and (b) implicit costs.
2 Why do both implicit costs and accounting costs
Costs of production in the short run
We are now in a position to examine costs of
production more closely. We will begin with a
discussion of costs in the short run; we are therefore
dealing with both fixed and variable inputs, and
therefore with both fixed and variable costs.
A firm’s costs of production depend on the level of
output it produces, but for any particular level of
output, costs depend on
· input prices, which are determined in product
markets through supply and demand
· the quantities of inputs required for production,
which in turn depend on a technical relationship
between the inputs and the output that these
produce.
The technical relationship between inputs and output
is of crucial importance in understanding short-run
costs. This is because it provides us with information
on the quantities of inputs required to produce a
particular level of output.
represent opportunity costs to the firm?
3 Why are economic costs greater than accounting
costs?
4 Define (a) fixed costs, (b) variable costs, and
(c) total costs, and explain how they are related
to the distinction between the short run and the
long run.
5 Which of the following are fixed and which are
variable costs:
(a) insurance premiums on the value of the
property owned by a business
(b) interest payments on a loan taken out by a
business
(c) wage payments to the workers that are hired
by a business
(d) payments for the purchase of seeds and
fertilizer by a farmer.
(...continued)
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Part 2: Microeconomics
Total product, marginal product and
average product
To study the relationship between inputs and output,
we need to develop three more concepts. Since we
are studying the short run, we know that the firm has
both fixed and variable inputs. For simplicity, let’s
consider a hypothetical firm that uses only two inputs,
land and labour, where land is the fixed input and
labour is the variable input; we can think of this firm
as a very simple farm. The only way that the farm can
increase the quantity of its output in the short run is
by increasing the quantity of the labour it hires. The
three new concepts are the following:
· Total product (TP) is the total quantity of output
produced by a firm.
· Marginal product (MP) is the extra or additional
output that results from one additional unit of
the variable input, labour; it tells us by how much
output increases as labour increases by one unit.
HL
HL
Table 4.1
Total, marginal and average products.
(1)
Units of variable input
(labour)
HL
(2)
Total product
(units of output) = TP
(4)
Average product
(units of output) = AP
(3)
Marginal product
(units of output) = MP
Δ TP
MP = Δ units of labour
0
1
2
3
4
5
6
7
8
9
10
11
0
2
5
9
14
18
21
23
24
24
23
21
Marginal product is given by
MP =
Δ TP
Δ units of labour
· Average product (AP) is the total quantity of
output per unit of variable input, or labour; this tells
us how much output each unit of labour (i.e. each
worker) produces on average. Average product is
given by
AP =
Δ TP
units of labour
Table 4.1 shows a hypothetical example of the total
product that results as the number of units of labour
working on the fixed piece of land (the farm) increase.
Once we are given the information in columns (1)
and (2), it is a simple matter to calculate marginal and
average products. Marginal product is calculated by
taking the change in TP (due to the increase in labour)
and dividing it by the change in the units of labour.
For example, the marginal product of the third unit of
labour is
(9 – 5)
(3 – 2)
=
4
1
=4
the marginal product of the sixth unit of labour is
(21 – 18)
(6 – 5)
=
3
1
=3
−
2
3
4
5
4
3
2
1
0
−1
−2
TP
AP = units of labour
−
2
2.5
3
3.5
3.6
3.5
3.3
3
2.7
2.3
1.9
The total, marginal and average products appearing in
Table 4.1 are shown graphically in Figure 4.1(a) and
(b) (page 96). Panel (a) plots the total product data
of column (2) of the table, while panel (b) plots the
marginal and average product data of columns (3) and
(4). The vertical axis in both figures measures units of
output, and the horizontal axis measures units of the
variable input (labour). Note that the scale of variable
input units on the horizontal axis is identical in both
panels, so that the MP and AP curves in panel (b)
correspond to the TP curve in panel (a). Both panels (a)
and (b) are divided into three parts:
· Increasing marginal product When labour units are
between 0 and 4, the marginal product of labour is
increasing, as we see in panel (b). This means that
the addition to total product made by each successive
unit of labour gets bigger and bigger as shown in
panel (a) (we can say that total product increases
at an increasing rate). When 4 units of labour are
employed, marginal product (equal to five units of
output) is maximum.
· Decreasing marginal product When labour units are
between 4 and 9, the marginal product of labour
is decreasing, as we can see in panel (b). Here, the
addition to total product made by successive units of
labour becomes smaller and smaller, shown in panel
(a) (it increases at a decreasing rate).
Average product is calculated by taking the total
product and dividing it by the units of labour that
gave rise to this amount of product. For example,
the average product of the third unit of labour is
9
3
= 3; of the sixth unit of labour it is
21
6
= 3.5
Chapter 4: Theory of the firm I
95
HL
(c) Total product curve.
25
20
units of output
(a) Total product curve
based on data of
Table 4.1.
units of output
HL
TP
15
10
TP
5
0
1 2 3 4 5 6 7 8 9 10 11
units of variable input (labour)
increasing decreasing negative
marginal
marginal
6 marginal
product
product
5 product
4
3
2
AP
1
0
-1 1 2 3 4 5 6 7 8 9 10 11
-2
units of variable input
MP
-3
(labour)
(d) Marginal and
average product
curves.
units of variable input (labour)
units of output
(b) Marginal and average
product curves
based on data of
Table 4.1.
units of output
0
AP
0
MP
units of variable input (labour)
Figure 4.1 Total, marginal and average products.
Economics for the IB Diploma
· Negative marginal product At 8 Figure
and4.1 9 unitsColof
Mac/eps/Illustrator
s/s labour,
Text: Agenda
a maximum,
as we can see in
emcdesign
Studio:
Peters & Zabransky
ninth unit of
labour
adds zero
total product is at
panel (a), and the
units of output, i.e. the marginal product of the
ninth unit of labour is zero, shown in panel (b).
Beyond 9 units of labour, total product begins
to fall; this corresponds to the negative marginal
product of the tenth and eleventh units of labour
that can be seen in panel (b).1
The relationship between the marginal
and average product curves
example involving test scores. Assume that you have
an average of 80 in your tests so far in a particular
subject, and you would like to increase your average.
If your next text score (the ‘marginal’ score) is greater
than your average of 80, your average will increase. If,
on the other hand, your next test score is lower than
your average of 80, then your average will fall. This
relationship between your average and marginal test
scores is exactly the same as the relationship between
average and marginal products.
Generalized product curves
Average product also rises initially and then declines
(panel (b) of Figure 4.1). Note the relationship between
the average and marginal product curves: when the
marginal product curve lies above the average product
curve (MP > AP), average product is increasing; and
when the marginal product curve lies below the
average product curve (MP < AP), average product is
decreasing. This means that the marginal product
curve must always intersect the average product
curve when this is at its maximum. The reason for
this lies in the mathematical relationship between
the average and marginal values of any variable. To
understand this relationship, we can consider a simple
Panels (c) and (d) of Figure 4.1 show the total,
marginal and average product curves that result in
the general case when a variable input is added to
a fixed input. These curves illustrate the technical
relationship between inputs and output that we need
to understand in order to study cost of production in
the short run. We turn to this relationship next.
The mathematically inclined student will note that the marginal product,
measuring the change in total product that arises from an additional unit
of labour, is the slope of the total product curve. Therefore with increasing
marginal product, MP increases (panel (b)) because the slope of the TP
curve is increasing (panel (a)). With decreasing marginal product, MP falls
because the slope of the TP curve decreases. When 9 units of labour are
employed, the slope of the TP curve is 0 (i.e. the marginal product of the
ninth worker is zero) and beyond that the MP, or the slope of the TP curve,
becomes negative.
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Law of diminishing marginal returns
In the short run, the technical relationship between
inputs and output is provided by the law of
diminishing marginal returns:
HL
According to the law of diminishing marginal
returns (also known as the law of diminishing
marginal product), as more and more units of a
variable input (such as labour) are added to one
or more fixed inputs (such as land), the marginal
product of the variable input at first increases, but
there comes a point when the marginal product of the
variable input begins to decrease. This relationship
presupposes that that the fixed input(s) remain fixed,
and that the technology of production is also fixed.
The law of diminishing marginal returns is reflected in
the data of Table 4.1 and the curves of Figure 4.1. Let’s
examine it more carefully.
When there are zero workers on the land, there is
no farm output at all; it is equal to zero. When one
worker is hired, there will be some output, and so
total product is equal to two units. Marginal product,
given by the change in total product that arises when
one unit of labour is added, is also equal to two units.
But one worker alone on the farm must do all the
ploughing, planting, harvesting, etc., with the result
that output is quite low. Say now that a second worker
is hired. The two workers share the work, and total
product increases to five units, indicating that the
output that the two together produce is more than
double the output of the first working alone. The
additional (or marginal) product due to the second
worker (three units) is greater than that of the first
(two units). This process is repeated with the addition
of the third and fourth workers, and marginal product
increases with the addition of each one.
With four workers, marginal product is the greatest
it can be; when the fifth worker is added, marginal
product begins to fall, and falls continuously
thereafter. This is the point at which diminishing
returns set in. Why does this happen? On the farm,
it happens because of overcrowding: each additional
worker has less and less land to work with, and
so produces less and less output. Eventually, the
conditions on the farm become so crowded that the
ninth worker adds zero extra output; with the addition
of the tenth worker the marginal or extra product is
negative and total product begins to decrease.
More generally, marginal product will begin to fall
at some point not just on a farm with a fixed piece
of land, but whenever more and more units of a
variable input are added to a fixed input (provided
the technology of production is unchanging). For
example, in the case of a factory where more and more
workers are hired, each worker will have fewer and
fewer machines and equipment to work with, and so
will add less and less output.
(Imagine what would happen if diminishing returns
did not exist. Using our farm example, it would be
possible for food production to increase indefinitely
just by continuously adding variable inputs to a fixed
piece of land – a clear impossibility!)
Test your understanding 4.2
1 Define (a) total product, (b) marginal product,
and (c) average product and show how they are
related to each other.
2 Copy the following table, filling in the missing
figures on your copy:
Units of
variable
input
(labour)
Total
product
0
1
2
3
4
5
6
7
10
22
35
46
54
59
61
60
Marginal
product
Average
product
3 Using the information in question 2,
(a) Plot the total product, marginal product and
average product curves.
(b) Define the law demonstrated by the pattern
shown by the marginal product and average
product figures and curves.
(c) Why does this law only hold in the short
run?
(d) With how many units of the variable input
do we see the beginning of diminishing
marginal returns (diminishing marginal
product)?
(e) With how many units of the variable
input do we see the beginning of negative
marginal returns?
(f) Explain the relationship between the average
product and marginal product curves.
Short-run costs of production: deriving
the short-run cost curves
The law of diminishing marginal returns is very
important to understanding costs of production in the
short run. We will now examine a typical firm’s total,
average and marginal costs.
Chapter 4: Theory of the firm I
97
HL
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· column (9) shows marginal cost, obtained by
Let’s continue with our example of the simple farm
and the data in Table 4.1, and assume that the farm
incurs fixed costs of €200 per week (for rent for the
land), and that the cost of labour is €100 per worker
(or per unit of labour) per week. We now have all the
information we need to calculate the firm’s shortrun production costs, and to see how these change
as output increases. All of the farm’s short-run costs
appear in Table 4.2, where
dividing the change in total cost (from column 5) by
the change in the number of units of output (from
column 1); for example, when total cost increases
from €200 to €300, so that Δ TC = 100, TP increases
from 0 to 2 units of output, so that ΔQ = 2.
Dividing 100 by 2, we obtain MC = 50. Marginal cost
can also be calculated as the change in total variable
cost divided by the change in total product, because
Δ TVC = Δ TC. (You can confirm this by comparing the
figures in column 4 with those in column 5).
· columns (1) and (2) contain the same data on total
product and corresponding labour input that appear
in Table 4.1
· column (3) shows the farm’s total fixed cost (TFC)
All the cost information of Table 4.2 is shown
graphically in Figure 4.2 (a) and (b). (Panels (c) and (d)
show cost curves in the general case for a firm in the
short run.) Both panels (a) and (b) measure costs on
the vertical axis, and units of output on the horizontal
axis. Panel (a) illustrates the three total cost curves
(total fixed cost, total variable cost and total cost),
and panel (b) the three average cost curves and the
marginal cost curve.
consisting of rental payments of €200
· column (4) shows the farm’s total variable cost,
which is simply the number of workers (from
column 2) times the cost of €100 per worker
· column (5) calculates total cost, which is the sum of
total fixed cost (column 3) plus total variable cost
(column 4)
· column (6) shows average fixed cost, obtained by
dividing total fixed cost (column 3) by the number
of units of output (column 1)
In panel (a):
· The TFC curve is parallel to the horizontal axis, as
· column (7) calculates average variable cost, obtained
it represents a fixed amount of costs that do not
change as output changes.
by dividing total variable cost (column 4) by the
number of units of output (column 1)
· The TVC curve shows that TVC increases as output
· column (8) shows average total cost, obtained by
increases; however, it does not increase at a constant
rate; this is due to the law of diminishing marginal
returns, which we will reconsider shortly.
dividing total cost (column 5) by the number of
units of output (column 1): alternatively, average
total cost is the sum of AFC plus AVC
· The TC curve is the vertical sum of TFC and TVC,
and so the vertical difference between TC and TVC
is equal to TFC.
Table 4.2 Total, average and marginal costs.
(1)
Total
product
= TP or Q
(units)
98
(2)
Labour
(units of
labour)
(3)
Total fixed
cost
= TFC
(¤)
(4)
Total
variable
cost
= TVC
(¤)
(5)
Total cost
= TC
TC =
TFC + TVC
(¤)
(6)
Average
fixed cost
= AFC
TFC
AFC =
Q
(¤)
(7)
Average
variable
cost
= AVC
TVC
AVC =
Q
(¤)
0
0
200
0
200
-
-
2
5
9
14
18
21
23
24
1
2
3
4
5
6
7
8
200
200
200
200
200
200
200
200
100
200
300
400
500
600
700
800
300
400
500
600
700
800
900
1000
100
40
22.2
14.3
11.1
9.5
8.7
8.3
50
40
33.3
28.6
27.8
28.6
30.4
33.3
Part 2: Microeconomics
(8)
Average
total cost
= ATC
TC
ATC =
Q
or ATC =
AFC + AVC
(¤)
(9)
Marginal
cost
= MC
Δ TC
MC =
ΔQ
MC =
Δ TVC
ΔQ
(¤)
-
150
80
55.5
42.9
38.9
38.1
39.1
41.6
50
33.3
25
20
25
33.3
50
00
HL
HL
HL
TC
1000
TVC
800
600
TC
TVC
400
200
TFC
0
2 4 6 8 10 12 14 16 18 20 22 24
output, Q
160
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
TFC
MC
output, Q
(d) Average cost and
marginal cost
curves.
MC
ATC
costs
costs
0
(b) Average cost
and marginal
cost curves
based on the
data of Table 4.2.
(c) Total cost, total
variable cost, and
total fixed cost
curves.
costs
1200
costs
(a) Total cost, total
variable cost,
and total fixed
cost curves
based on the
data of Table 4.2.
AVC
ATC
AVC
AFC
AFC
2 4 6 8 10 12 14 16 18 20 22 24
output, Q
0
output, Q
Figure 4.2 Total, average and marginal cost curves
In panel (b):
· The AFC curve indicates that AFC falls continuously
as output increases, because it represents the
amount of fixed costs (TFC) divided by an ever
growing quantity of output.
· The three remaining curves, AVC, ATC and MC,
though they are different from each other, all follow
the same general pattern: at first they fall, they
reach a minimum, and then they begin to rise.2
· Note that the ATC curve is the vertical sum of AFC
and AVC, and so the vertical difference between the
ATC and the AVC curves at any level of output is
equal to AFC.
· The MC curve intersects both the AVC and ATC curves
at their minimum points. The reason behind these
relationships is the same as in the case of marginal
and average products, discussed earlier (recall the
example of test scores, which applies equally well
here). When marginal cost is below average variable
cost (MC < AVC), then average variable cost is
falling; when marginal cost is greater than average
variable cost (MC > AVC), then average variable
cost is rising. The same applies to the relationship
between marginal cost and average total cost: when
MC < ATC, then ATC is falling, and when MC > ATC,
then ATC is rising.
The law of diminishing marginal returns
and the shape of the cost curves
The law of diminishing marginal returns is very
important in determining the shape of the cost curves.
The reason for the U-shape of the AVC curve (as well as
the ATC curve) can be found in the law of diminishing
marginal returns. Remember that the marginal
product of labour at first increases. This means that
each additional unit of output can be produced with
fewer and fewer units of labour; therefore the labour
cost of each unit of output (or what is average variable
cost) falls initially. But when additional units of labour
eventually run into diminishing returns, the marginal
product of labour begins to fall. Each additional unit
The mathematically more advanced student may note that marginal cost
(MC) represents the slope of the total cost (TC) curve.
2
Chapter 4: Theory of the firm I
99
Note from Table 4.1 that when five units of labour
are hired, average product is at its maximum; this
is exactly the point of production at which average
variable cost is at its minimum (as shown in Table
4.2). This happens because when workers on average
produce the most they can produce, the labour cost
of producing each unit of output is the lowest it
can be.
The explanation for the shape of the marginal cost
curve can also be found in the law of diminishing
marginal returns. When marginal product is
increasing, the extra output produced by each
additional unit of labour rises. When this happens,
the additional cost of one more unit of output, or
marginal cost, falls. Decreasing marginal product, on
the other hand, means that the additional output of
each unit of labour is falling, and so the additional
cost of each extra unit of output (marginal cost) must
be increasing. Note that maximum marginal product
(shown in Table 4.1) occurs when four units of labour
are hired; this is also when marginal cost is at its
minimum (see Table 4.2). In other words, when the
additional output produced by an extra worker is
the most it can be, then the extra labour cost of
producing an additional unit of output is the least
it can be.
These relationships are illustrated in Figure 4.3,
indicating that the product curves are mirror images
of the cost curves. The MC curve mirrors the MP curve,
and the AVC curve mirrors the AP curve. (You must
note the labelling of the axes of the product and cost
curves, which are different from each other.)
The U-shape of the AVC and ATC, as well as the MC
curves is due to the law of diminishing marginal
returns.
Shifts in the cost curves
The cost curves shown above will shift in response to
two factors: changes in resource prices, or changes in
Another way to see this numerically, is to consider the average product
figures in Table 4.1. We know that each unit of labour costs €100, i.e. €100
= cost per unit of labour. If we divide 100 by average product,
cost per unit of labour
= variable cost per unit of output,
we have
output per unit of labour
3
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Part 2: Microeconomics
HL
units of output (AP, MP)
of output now requires more and more units of labour,
and so the labour cost of each unit of output, or
average variable cost, begins to increase.3
AP
0
MP
units of variable input (labour)
MC
costs (AVC, MC)
HL
AVC
0
output, Q
Figure 4.3 Product curves and cost curves.
technology. If resource prices increase, there will result
an increase in costs of production. Which particular
curves will be affected will depend on whether the
price increases involve fixed or variable costs. If there
is an increase in a fixed cost of production, this will
affect total fixed cost and total cost, as well as average
fixed cost and average total cost, all of which will shift
upward. Variable costs and marginal cost will remain
unaffected. This is shown in Figure 4.4(a), where we
see AFC and ATC shifting upward to the dotted lines,
while AVC and MC remain unchanged. If, on the
other hand, there is an increase in variable costs (say,
because of an increase in wages), total variable cost
and total cost, as well as average variable cost, average
total cost and marginal cost, will all increase. This can
be seen in Figure 4.4(b), where AVC, ATC and MC have
shifted upward to the dotted lines. In the event that
resource prices fall, giving rise to decreases in costs
of production, the corresponding curves will shift
downward.
which is average variable cost. When the units of labour are few, AVC is
high; as the labour units increase AVC falls, and after reaching a minimum,
AVC begins to rise, thus resulting in the U-shaped curve.
HL
(a) Increase in FC.
HL
(b) Increase in VC.
ATC1
ATC
AVC
MC1
ATC1
MC
ATC
cost
cost
MC
AVC1
AVC
AFC1
AFC
0
output
AFC
0
output
Figure 4.4 Shifts in the cost curves.
Changes in technology also impact upon costs of
production because they increase the amount of
output that can be produced by a given level of inputs.
An improved technology would therefore shift the
product curves of Figure 4.1 (total product, average
product and marginal product) upwards, and this
would correspond to a downward shift in the cost
curves.
Test your understanding 4.3
1 For question 2 of Test your understanding
4.2, suppose that the price of labour is $2000
a month and fixed costs are $1500 a month.
Calculate TFC, TVC, TC, AFC, AVC, ATC and MC.
2 Why does the average fixed cost curve decline
continuously throughout its range?
3 What accounts for the U-shape of (a) the average
variable cost curve; (b) the average total cost
curve?
4 Given a diagram such as Figure 4.2(a), explain
what is represented by (a) the vertical distance
between the TC and TFC curves; (b) the vertical
distance between the TC and TVC curves.
5 In Figure 4.2(b), explain what is represented by
(a) the vertical distance between ATC and AFC;
(b) the vertical distance between ATC and AVC.
6 How does the law of diminishing marginal product
affect the shape of the marginal cost curve?
7 Why does marginal cost intersect both average
variable cost and average total cost at their
minimum points?
8 Show diagrammatically how (a) a fall in
insurance premiums, and (b) a fall in wage rates
would impact upon the AFC, AVC, ATC and MC
curves of a firm.
Costs of production in the long run
In the long run, there are no fixed inputs, and there
are therefore no fixed costs. All the inputs can be
changed, including those that require time, such as
building new factories and buildings and acquiring
more capital equipment and machines.
In the long run all inputs are variable, and there are
only variable costs. Total costs include only total
variable costs, and average total costs are average
variable costs.
Average costs in the long run
When a firm changes or varies its inputs that are fixed
in the short run, in effect it changes its size or scale.
We can consider the firm’s fixed inputs collectively as
the firm’s plant (including land, buildings, factories
and heavy machinery). If we think of the farm
example we considered earlier, suppose the farmer
changes the size of the land making up the farm (what
used to be the fixed input); the result is to change
plant size. Therefore, whereas in the short run the
plant size is fixed, in the long run it is variable.
Although the firm has the option of changing its plant
size over the long run, at any given point in time it
operates in the short run. This follows simply from
the fact that the firm cannot be changing plant size all
the time the way it can easily change variable inputs
like labour. A firm can hire or fire workers on a daily
basis if the need arises, but it cannot change the size
of the land comprising a farm, or the size and number
of buildings and factories, over short periods of time.
Once the decision to change plant size materializes,
and all the inputs have been changed accordingly, the
Chapter 4: Theory of the firm I
101
HL
larger plant becomes fixed again, and the firm is once
more in the short run. So what do we mean when we
talk about the long run?
It is convenient to think of the long run as the firm’s
planning horizon. If a firm wants to expand its
production, it must at some point think in terms of
expanding the size or scale of its plant, in other words,
to change and increase its fixed inputs. If it does not
increase its fixed inputs, its production process will
run into diminishing marginal returns of its variable
inputs (diminishing marginal product). Therefore, to
expand output it must increase its size or scale. To do
this, it will consider what level of output it wants to
produce, and will then choose the scale accordingly.
Therefore, as the firm plans its future activities, in the
long run, it can select any size or scale for its plant,
depending on the quantity of output it is aiming for.
The particular size it will choose will be the one that
allows the firm to minimize costs for that particular
level of output, i.e. to produce that level of output at
the lowest possible cost. Let’s take a closer look at what
this means.
Long-run average total cost curve
Let’s consider our farmer who produces with two
inputs, land and labour. The farmer wants to expand
production and considers the long-run options. To
simplify our analysis, let’s assume that there are only
four possible farm (or plant) sizes. Each farm size, with
its own particular level of the fixed input of land, is
represented by a different short-run average total cost
curve (SRATC), shown in Figure 4.5(a).
Let’s assume that the farmer is initially producing
output Q1 on SRATC1, but would like to increase
production. Which SRATC should the farmer select?
The answer depends on how much output the farmer
wants to produce, and which SRATC will minimize
cost for that particular level of output. If the farmer
wants to increase output to Q2, for example, this can
be done without changing farm size, by remaining
on SRATC1 in the short run. Yet a larger farm size,
corresponding to SRATC2, can produce output Q2 at a
lower average cost. As the farmer increases output
Note that while a decision to produce a particular level of output in
the long run involves selection of the firm scale that minimizes costs for
that level of output, the firm will not necessarily be operating at the
lowest possible cost on the SRATC curve of its choice. In Figure 4.5(b), say
a firm wants to produce output Q1; it will then choose to be on SRATC1
at point a, which is the point where SRATC1 just touches the long-run
curve, corresponding to output level Q1. But the point of minimum
average cost on SRATC1 is point b, representing output Q2, not point a.
Therefore minimum average cost in the short run is not necessarily the
4
102
Part 2: Microeconomics
in the short run it will be possible to produce at the
lowest possible cost on SRATC1 only up to point a,
where the farmer should consider increasing farm size
(going into the long run) and moving onto SRATC2.
If the decision is made to increase the farm size and
move onto SRATC2, output can continue to increase at
the lowest possible cost until point b is reached, where
the farmer once again should consider increasing farm
size (going into the long run again) and switching
to SRATC3. We can see then that points like a, b and
c represent output levels at which the farmer should
increase the farm size, so as to continue to minimize
average costs as output increases. It follows then
that the farmer’s planning horizon is made up of the
boldface portions of the short-run average cost curves
in Figure 4.5(a), which connect all possible points of
intersection between successive SRATC curves.
In practice, it is likely that there will not be only
four possible firm sizes as in our example, but rather
many more, as shown in Figure 4.5(b). In this case
the long-run average total curve is the curve that just
touches (i.e. is tangent to) each of the short-run cost
curves. It represents the lowest possible average cost,
or cost per unit of output, for every level of output,
when all resources are variable. When the firm plans
its activities over the long run, it can choose where
on the long-run curve it wishes to be; it will then end
up on the SRATC curve at the point where this just
touches the long-run curve (i.e. the point of tangency
between the two). The long-run average total cost
curve is also called a firm’s planning curve, as well as
an envelope curve (because it envelopes the short-run
curves).4
The long-run average total cost curve is defined
as a curve that shows the lowest possible average cost
that can be attained by a firm for any level of output
when all of the firm’s inputs are variable. It is also
known as a planning curve, or envelope curve.
This leads us to an important question to which we
turn next: why does the long-run average total cost
curve have downward-sloping and upward-sloping
segments?
same as minimum average cost in the long run. When the long-run curve is
downward sloping, there will always be a larger firm size that can achieve
lower average costs than the short-run minimum (i.e. SRATC2 achieves
lower average costs than point b on SRATC1); and when the long-run curve
is upward sloping, there will always be a smaller firm size that can achieve
lower average costs than then short-run minimum. There is only one SRATC
curve whose minimum coincides with the long-run minimum, and that is
SRATCm, shown in boldface in Figure 4.5(b).
HL
(a) Short- and long-run average total cost curves.
SRATC4
SRATC1
b
SRATC2
SRATC3
c
b
LRATC
SRATC1
SRATC2
SRATCm
costs
a
HL
(b) Long-run average total cost curve as an envelope curve.
a
costs
HL
LRATC
0
Q1
Q2
output, Q
Q3
0
Q1 Q2
output, Q
Figure 4.5 The long-run average total cost curve.
Economies and diseconomies of scale
The long-run average total cost curve (LRATC) has a
U-shape (see Figure 4.5(b)).
The reasons for the U-shape of the long-run average
total cost (LRATC) curve have nothing whatever to
do with diminishing marginal returns, which are a
feature only of short-run production and short-run
average costs, including costs associated with fixed
inputs. Instead, the shape of the long-run average
total cost curve can be found in economies and
diseconomies of scale.
Economies of scale
Economies of scale are decreases in the average
costs of production that occur as a firm increases its
output by increasing its plant size, i.e. by increasing all
its inputs. Economies of scale explain the downwardsloping portion of the long-run average total cost
curve: as output increases, and a firm increases plant
size by increasing all inputs, the average cost, or cost
per unit of output, falls. There are several reasons why
this can occur:
· Specialization of labour As plant size increases, more
workers must be employed, allowing for greater
labour specialization. Increased labour specialization
means that each worker specializes in performing
tasks that make use of skills, interests and talents,
thereby increasing efficiency and allowing output to
be produced at a lower average cost.
· Specialization of management Larger plant sizes
allow for more managers to be employed, each of
whom can be specialized in a particular area (such
as production, sales, finance, etc.) again resulting in
greater efficiency and lower average cost.
· Efficiency of capital equipment Large machines are
sometimes more efficient than smaller ones; for
example, a large power generator is more efficient
than a small one (it can produce more output per
unit of inputs). However, a small firm with a small
volume of output cannot make effective use of large
machines, and so is forced to use the smaller, less
efficient ones.
· Indivisibilities of capital equipment Some machines
are only available in large sizes that require large
volumes of output in order to be used effectively.
They cannot be divided up into smaller pieces of
equipment.
· Indivisibilities of efficient processes Some production
processes, such as mass production assembly
lines, require large volumes of output in order to
be used efficiently. Even if all inputs are used in
proportionately smaller quantities, it may not be
possible to achieve the same degree of efficiency.
· Spreading of certain costs over larger volumes of output
Costs of certain activities such as design, research
and development, and advertising result in lower
average costs if they can be spread over large
volumes of output.
Diseconomies of scale
Diseconomies of scale are increases in the average
costs of production that occur as a firm increases its
output by increasing its plant size, i.e. increasing all its
inputs. Diseconomies of scale are responsible for the
upward-sloping part of the long-run average total cost
curve: as a firm increases plant size, costs per unit of
output increase. Reasons for diseconomies of scale can
include:
· Management inefficiencies As a firm grows larger
and larger, there may come a point where its
management runs into difficulties of coordination,
Chapter 4: Theory of the firm I
103
organization, cooperation and monitoring. The
result is that average costs begin to increase as the
firm expands.
· Poor worker motivation If workers begin to lose their
motivation, to feel bored and to care little about
their work, they become less efficient, with the
result that costs per unit of output start to increase.
Constant returns to scale
Constant returns to scale may appear in some longrun average total cost curves as in Figure 4.6(a), where
there is a horizontal segment of the curve between the
downward-sloping and the upward-sloping portions.
Constant returns to scale involve constant long-run
average costs over a certain range of output. In this
range, as output increases (with all inputs increasing),
average costs do not change, i.e. the firm does not
encounter economies or diseconomies of scale.
average total cost
(a) Varying firm sizes.
0
economies
of scale
diseconomies
of scale
constant returns
to scale
Qmes
LRATC
average total cost
(b) Few large firms.
0
LRATC
Q1
output, Q
Qmes
(c) Natural monopoly.
0
LRATC
output, Q
Qmes
Figure 4.6 Minimum efficient scale and the structure of industry.
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Part 2: Microeconomics
Firms are generally eager to take advantage of
economies of scale, and try to take care so as to avoid
diseconomies of scale. Empirical studies agree that
firms can achieve substantial economies of scale by
increasing their size, but there is some debate over
whether firms experience diseconomies. Some studies
suggest that after exhausting economies of scale,
many firms exhibit constant returns to scale, and
do not run into diseconomies of scale even as size
becomes very large.
Minimum efficient scale and the structure
of industries (supplementary material)
There is a point on the long-run average total cost
curve that represents the lowest level of output
at which the lowest long-run total average costs
are achieved, called the minimum efficient scale
(MES). In Figure 4.6 this is represented by Qmes. The
minimum efficient scale is the level of output at which
economies of scale are exhausted; beyond that level
of output average costs will either be constant or they
will begin to increase. When there are constant returns
to scale, the minimum efficient scale can be achieved
by firms of varying sizes, producing any output
ranging from Qmes to Q4 in Figure 4.6(a).
The importance of the concept of minimum efficient
scale lies in the information it can reveal about the
structure of industries, such as whether it is likely that
an industry will consist of many firms, some of which
are smaller and some larger, as opposed to a small
number of large firms, or at the extreme a single very
large firm providing for the entire market. Each of
these possibilities is illustrated in Figure 4.6. (Market
structures were discussed in Section 2.1.)
Q1
Q2 Q3 Q4
output, Q
average total cost
HL
The long-run average total cost curve in Figure 4.6(a)
indicates that the firm reaches the minimum efficient
scale at a low level of output, shown as Qmes, and
then begins to experience constant returns to scale,
that is, long-run average costs remain constant for an
extended range of output. If this level of output, Qmes,
is a small fraction of the total market, then there are
likely to be many firms of varying sizes in the industry;
examples include clothing and shoe manufacturing,
other light manufacturing such as furniture and wood
products, food processing, retailing and banking.
These tend to be industries that fall under the market
structure of monopolistic competition.
Panel (b) shows the LRATC curve of a firm that
experiences economies of scale over a very large range
of output. It is only at the very large level of output
of Qmes that the minimum efficient scale is achieved,
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at which point the firm runs into either diseconomies
of scale or constant returns to scale (the dotted lines
beginning at Qmes indicate that either of these two
possibilities may arise). Qmes in this figure represents
a large fraction of the total market. This means that
there can only be a small number of large firms
in this industry. If smaller firms tried to enter this
industry, they would have difficulty competing with
the larger firms because of their higher average costs.
(Compare the average total costs of a firm producing
output Q1 with the average costs of a firm producing
at Qmes.) Examples of such industries include car and
refrigerator manufacturers, heavy industries such as
aluminum and steel, and pharmaceutical industries.
These tend to be industries that fall under the market
structure of oligopoly.
In panel (c), the minimum efficient scale occurs at a
level of output, Qmes, so large that if the firm expands
to that point where it exhausts all economies of scale,
it will be supplying the entire market. Such a firm is
called a natural monopoly (studied in Chapter 5).
(It may be noted that the U-shaped long-run average
total cost curve does not cover firms under perfect
competition. This is because firms under perfect
competition do not experience economies and
diseconomies of scale, as we will see in Chapter 5.)
Test your understanding 4.4
1 (a) Define the long-run average total cost curve.
(b) Why is the long-run average total cost curve
also referred to as a ‘planning curve’?
2 Explain what factors can cause (a) economies of
scale; (b) diseconomies of scale.
3 (a) What is the relationship between economies
and diseconomies of scale and the shape of the
LRATC? (b) What do constant returns to scale
signify?
4 If, as many economists suggest, a firm is unlikely
to run into diseconomies of scale after achieving
all possible economies of scale, what would its
long-run average total cost curve look like?
5 Explain (a) the concept of minimum efficient
scale, and (b) its relationship to market
structures.
4.2 Revenues and profits
HL
Revenues
As we learned when examining the circular flow model
in Chapter 1, page 6, revenues are the payments firms
receive when they sell the goods and services they
produce over a given time period. We will now make
a distinction between three fundamental revenue
concepts: total, marginal and average revenue.
The firm’s total revenue (TR) is obtained by
multiplying the price at which a good is sold (P) by the
number of units of the good sold (Q):
TR = P × Q
The firm’s marginal revenue (MR) is the additional
revenue arising from the sale of an additional unit of
output, and is given by
MR =
Δ TR
ΔQ
The firm’s average revenue (AR) is revenue per unit
of output sold:
AR =
TR
Q
The analysis of revenues is not the same for all firms,
regardless of market structure, because it depends on
whether or not the firm has any control over the price
at which it sells its product. As you may remember
from our discussion in Chapter 2, Section 2.1, page 29,
firms under perfect competition have no control over
price. By contrast, firms under the three other market
structures do have varying degrees of control, which
depend on their degree of market power. In analysing
revenues, we must therefore make a distinction
between situations where:
· The firm has no control over price, and price is constant
as output varies In this case, the price at which the
good is sold does not change; no matter how much
quantity the firm sells, the price is always the same;
this occurs only under perfect competition, where
the firm has no control over the price at which it
sells its product.
· The firm has at least some degree of control over price,
and price varies with output In this case, as output
changes, the price at which the good is sold also
changes; this occurs under all market models other
than perfect competition, where the firm has some
degree of control over the price at which it sells its
product.
Chapter 4: Theory of the firm I
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We will examine revenues and the curves that
correspond to each revenue concept in detail in
Chapter 5 in the context of market structures.
Profits
Economic profit versus accounting profit
In a general sense, profit equals total revenue minus
total costs. The precise meaning of the term ‘profit’ in
this expression depends on the meaning ascribed to
‘costs’. In Section 4.1, we made a distinction between
accounting costs (the monetary payments made by a
firm to acquire resources owned by others), implicit
costs (the opportunity costs of using resources owned
by the firm), and economic costs or total opportunity
costs (the sum of accounting plus implicit costs). Based
on these cost distinctions, we can make the following
profit distinctions:
accounting profit = total revenue minus
accounting costs
Figure 4.7(b) shows the case where the firm is making
zero economic profit. It is assumed here that the
firm’s total revenue is £159,000. But this is exactly
equal to economic costs; therefore economic profit is
zero. When economic profit is zero, accounting profit
(£109,000) is equal to implicit costs.
(a) Positive economic profit.
economic profit
(supernormal,
abnormal profit)
(£21,000)
economic costs =
opportunity costs
The profit definition that is relevant for our purposes
is economic profit, which is equal to total revenue
minus economic costs. In Economics, when we use the
term ‘profit’ on its own, we generally mean ‘economic
profit’.
In Figure 4.7 we can see the difference between
economists’ and accountants’ perspectives. Each box
represents a firm’s total revenue, which is split up
between profits and costs. Let’s use our numerical
example of costs presented in Section 4.1, in order to
calculate economic and accounting profit. In Figure
4.7(a), let’s assume that the firm is making total
revenue of £180,000. Implicit costs = £109,000, and
accounting costs = £50,000, and when these are added
up we obtain economic costs, which amount
to £159,000. Economic profit is therefore £21,000
(= £180,000 − £159,000). Accounting profit, on the
other hand, is £130,000 (= £180,000 − £50,000). Note
that economic profit is smaller than accounting profit,
since accounting profit ignores implicit costs.
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Part 2: Microeconomics
implicit costs
(£109,000)
total
revenue
(£180,000)
accounting costs
(£50,000)
accounting profit
(£130,000)
accounting costs
(£50,000)
(b) Zero economic profit.
Accountants'
perspective
Economists'
perspective
economic profit = total revenue minus
economic costs
= total revenue minus the sum
of accounting costs plus
implicit costs
Accountants'
perspective
Economists'
perspective
economic costs =
opportunity costs
implicit costs
(£109,000)
accounting costs
(£50,000)
total
revenue
(£159,000)
accounting profit
(£109,000)
accounting costs
(£50,000)
Figure 4.7 Economists’ and accountants’ perspectives on costs and
profits.
Normal profit
We can now make one more distinction. When
economic profit is equal to zero, and total revenue is
equal to total economic costs, as in Figure 4.7(b), the
firm is said to be making normal profit.
Normal profit can be defined as the minimum
amount of revenue that the firm must receive so that
it will be induced to keep the business running (as
opposed to shutting down). It can also be defined as
that part of revenue that covers total economic costs
(opportunity costs), which include all accounting
plus implicit costs.
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These apparently different definitions are in fact
consistent: the minimum amount of revenue the firm
must receive to make it worthwhile to stay in business
and keep all its resources employed in the firm is equal
to the revenue that covers all the firm’s costs, implicit
costs plus accounting costs. Normal profit is included
among the economic costs of the firm, since it
involves payments for the use of all resources, whether
owned by outsiders (accounting costs) or self-owned
resources (implicit costs). Note that any accounting
profit in excess of normal profit is economic profit.
For this reason, economic profit is also known as
supernormal profit (because it involves profit
that is over and above normal profit), or abnormal
profit. Table 4.3 summarizes the cost, product,
revenue and profit concepts we have studied.
Table 4.3 Summary of cost, product, revenue and profit concepts.
Cost concepts
Definition
Equation
Accounting cost
The monetary payment made by a firm to an outsider to acquire
an input.
Implicit cost
The income sacrificed by a firm that uses a resource it owns.
Economic cost
The sum of accounting and implicit costs, also equal to the firm’s
total opportunity costs.
Total fixed cost (TFC)
Costs that do not change as output changes; arise from the use of
fixed inputs.
Total variable cost (TVC)
Costs that vary (change) as output changes; arise from the use of
variable inputs.
Total cost (TC)
The sum of fixed and variable costs.
TC = TFC + TVC
Average fixed cost (AFC)
Fixed cost per unit of output.
AFC =
Average variable cost (AVC)
Variable cost per unit of output.
AVC =
Average total cost (ATC)
Total cost per unit of output.
Marginal cost (MC)
The change in cost arising from one additional unit of output.
ATC = AFC + AVC
Δ TC Δ TVC
MC =
=
ΔQ
ΔQ
Long-run average total cost
(LRATC) curve
A curve showing the lowest possible average cost that can be
attained for any level of output when all of the firm’s inputs are
variable.
TFC
Q
TVC
Q
Product concepts
Total product (TP or Q)
The total amount of product (output) produced by a firm.
Marginal product (MP)
The additional product produced by one additional unit of
variable input.
MP =
ΔTP
Δ units of variable input
Average product (AP)
Product per unit of variable input.
AP =
TP
Δ units of variable input
Revenue concepts
Total revenue
The total earnings of a firm from the sale of its output.
Marginal revenue
The additional revenue of a firm arising from the sale of an
additional unit of output.
Average revenue
Revenue per unit of output.
MR =
AR =
Δ TR
ΔQ
TR
Q
Profit concepts
Accounting profit
Total revenue minus accounting (explicit) costs.
Economic profit
(= abnormal, supernormal,
pure profit)
Total revenue minus economic costs (or total opportunity costs,
or the sum of accounting plus implicit costs).
Normal profit
The minimum amount of revenue required by a firm so that it will
be induced to keep running, which is equal to that part of revenue
that covers total opportunity costs (all explicit plus implicit costs).
Chapter 4: Theory of the firm I
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Test your understanding 4.5
1 Define (a) total revenue, (b) marginal revenue,
and (c) average revenue.
2 (a) Distinguish between economic profit and
accounting profit. (b) Which of the two is larger
and why? (c) Using the concept of opportunity
cost, explain which of the two concepts is used
by economists and why.
3 Define each of the following concepts and
explain the relationship between them: normal
profit, accounting profit and economic profit.
4.3 Goals of firms
Profit maximization
Standard economic theory of the firm assumes
that firm behaviour is guided by the firm’s goal to
maximize profit. Profit maximization involves
determining the level of output that the firm should
produce in order to make profit as large as possible.
Yet firms do not always make a profit; in some cases
their total revenue is not sufficient to cover all their
costs, in which case they make a loss. If a firm is
making a loss, it may eventually go out of business,
but until it decides to shut down, it will be interested
in producing the quantity of output that will make its
loss as small as possible. Therefore the theory of the
firm is also concerned with how much output a lossmaking firm should produce in order to minimize its
loss.
There are two approaches to analysing profit
maximization (or loss minimization): one involves
the use of the total revenue and cost concepts, and
the other involves the use of marginal revenues and
costs. Both these approaches yield identical results
for the profit-maximizing (or loss-minimizing) level
of output, though the second approach is more
relevant to analysing market structures (as we will
see in Chapter 5).
Profit maximization based on the total
revenue and cost approach
This approach is based on the simple principle that
profit = total revenue (TR) − total cost (TC)
where TC includes the firm’s economic or opportunity
costs (accounting plus implicit costs). We can see that:
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· If TR > TC, profit is positive; since ‘profit’ in
Economics means ‘economic profit’, the firm is here
making an economic profit.
· If TR = TC, the firm is making zero economic profit
(though it is earning normal profit).
· If TR < TC, the firm is making a loss (negative
economic profit).
The firm’s profit-maximization (loss-minimization)
rule in this approach is to choose to produce the
level of output where the value of TR − TC (= profit)
is as large as possible. When TR > TC and the firm is
able to make a profit, profit is maximized when the
firm produces a level of output where the difference
between TR and TC (TR − TC) is the largest. When
TC > TR and the firm is unable to make a profit and
therefore incurs a loss, the loss is minimized when the
difference between TC and TR is the smallest.
The amount of profit made by the firm is equal to the
numerical difference between TR and TC. If the firm is
making a loss, the amount of loss will be equal to the
numerical difference between TC and TR.
Profit maximization based on the
marginal revenue and cost approach
Profit maximization using this approach is based on a
comparison of marginal revenue with marginal cost to
determine the profit-maximizing level of output.
The firm’s profit-maximization rule in this approach
is to choose to produce the level of output where
marginal cost is equal to marginal revenue, i.e. where
MC = MR. The same rule, MC = MR, is used by the
firm that is interested in minimizing its loss.
We can best understand why the use of this rule
maximizes profit by use of diagrams that show the
relationship between MC and MR.
In Figure 4.8, both panels (a) and (b) show the
standard MC curve that we studied earlier in
Section 4.1. There are two kinds of marginal revenue
curves, depending on whether or not the firm has
any control over the price at which it sells its output.
You need not concern yourself at this point about
the shape of the MR curve, as it has no bearing on
the present argument (we will study these MR curves
in more detail in Chapter 5). Both panels (a) and
(b) illustrate the identical principle about profit
maximization.
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(a) Price constant.
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(b) Price varies with output.
MC
0
MC, MR
MC
MC, MR
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MR
Q1
Q
max
Q2
Q
0
Q1
Q
Q
max 2
MR
Q
Figure 4.8 Profit maximization based on MR = MC.
According to the profit-maximizing rule, MC = MR, so
the level of output that should be chosen by the firm
is determined by the point of intersection between the
MC and MR curves. Therefore in Figure 4.8 (a) and (b),
Qπmax is the level of output where profit is maximized.
Let’s see why this is so. Consider a firm producing
output Q1 in both panels (a) and (b), where MR > MC.
If this firm were to increase its output by one unit,
the additional revenue it would receive (MR) would
be greater than the additional cost it will incur (MC).
It is therefore in the firm’s interests to increase its
level of output. As long as it is producing any Q where
MR > MC, the firm should keep on increasing output,
and should stop where MR = MC, at output Qπmax.
What happens if it continues to increase its output
level beyond Qπmax, say to Q2, where MR < MC? At Q2,
the additional revenue it would receive for one extra
unit of output is less than the additional cost it would
incur, and so it should cut back on its Q. As long as
MR < MC, the firm should keep decreasing output.
There is only one point where the firm can do nothing
to improve its position, and that it is at Qπmax, where
MR = MC. At Qπmax, its profit will be the greatest it
can be.
· The model is based on the assumption that firms
Evaluating profit maximization as the
firm’s main goal
· The expectation that profits can be earned is a major
Standard economic theory assumes that profit
maximization is the overriding goal of firms. Yet the
assumption of profit maximization has been criticized
on a number of grounds:
· Profits ensure that a business can survive over the
· The use of marginal concepts (MR and MC) in
the theory is very unrealistic; firms cannot easily
identify marginal revenues and marginal costs, and
don’t even try to do so; therefore this theory does
not accurately describe methods actually used by
firms to determine price and output.
have perfect information at their disposal, whereas
in fact the information on which they base their
decisions is highly fragmentary and uncertain; firms
do not know what demand curves they face for their
products and they do not know how competitor
firms will behave in response to their actions.
· Short-run profit maximization may be unrealistic;
firms may not try to maximize profits in the short
run, as they might prefer lower profits in the short
run in exchange for larger profits over the long run.
· The factors determining demand and supply for
products and resources are continuously changing,
with demand and supplies continuously shifting,
so that any profit-maximizing decisions regarding
prices and output made today under current
conditions may be irrelevant by the time the output
is produced and ready for sale in the market.
· There is empirical evidence suggesting that some
firm behaviour may be prompted by objectives other
than profit maximization.
Yet the following arguments suggest that making profit
remains an important goal of firms:
consideration for going into business.
long term.
· Profits can be used to finance future investments as
well as a variety of activities, including research and
product development.
· Profits make it easier for a firm to obtain external
financing (such as borrowing from a bank).
· Profits are important to shareholders in the form of
higher dividends.
Chapter 4: Theory of the firm I
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· Profits are often used as a measure of management
· As a firm grows it can diversify into different
effectiveness.
markets and reduce its dependence on a single
market.
· Many empirical studies show that making profit is
· A larger firm has greater market power and increased
an important objective of firms.
ability to influence prices.
Additional firm goals
· A larger firm reduces its risks because it may be less
Over the years, economists have developed many
theories about firm behaviour. The following is a brief
survey of some of the more important of these.
· The objective of growth maximization reconciles
affected in an economic downturn and is less likely
to be taken over by another firm.
the interests of both owners and managers, because
both groups have much to gain from a growing firm
(whereas other maximization objectives pit firm
owners against firm managers: for example, profit
maximization is favoured by owners while sales
revenue maximization is favoured by managers).
Revenue maximization
In an alternative theory of firm behaviour,5 it has
been argued that the separation of firm management
from firm ownership, which increasingly dominates
business organization, has meant that firms’ objectives
have changed. Whereas profit maximization may
be the dominant motive of the traditional ownermanaged firm, firm managers who are hired by
the owners to perform management tasks may be
more interested in increasing sales and maximizing
the revenues that arise from larger quantities
sold. This goal of firms is referred to as revenue
maximization. The following arguments have been
used to explain why increasing sales and maximizing
revenues may be more useful to a firm than profit
maximization:
Managerial utility maximization
In this view, when firm management is separated
from firm ownership, managers develop their own
objectives that revolve around the maximization of
their own utility (satisfaction).7 Managerial utility
can be derived from increased salaries, larger fringe
benefits (such as free cars and expense accounts),
employment of more staff that gives rise to a feeling
of importance, and investments in the managers’
favoured projects. The result of all these activities may
be to cut into profits and make these lower than they
would otherwise be.
· Sales can be identified and measured more easily
over the short run than profits, and increased sales
targets can be used to motivate employees.
Satisficing firm behaviour
· Rewards for managers and employees are often
All of the above objectives assume that the firm tries
to maximize some variable, whether it is profit, sales
revenue, growth or managerial utility. H. Simon, a
Nobel Prize winning economist, has argued that the
large modern enterprise cannot be looked upon as
a single entity with a single maximizing objective;
instead it is composed of many separate groups within
the firm, each with its own objectives which may
overlap or may conflict. This multiplicity of objectives
does not allow the firm to pursue any kind of
maximizing behaviour. Firms therefore try to establish
processes through which they can make compromises
and reconcile conflicts to arrive at agreements, the
result of which is the pursuit of many objectives that
are placed in a hierarchy. This behaviour was termed
satisficing by Simon, referring to the idea that firms
try to achieve satisfactory rather than optimal or ‘best’
results.
linked to increased sales rather than increased
profits.
· It is often assumed that revenue from more sales will
increase more rapidly than costs; if this is the case,
profit (= TR − TC) will also increase.
· Increased sales give rise to a feeling of success,
whereas declining sales create a feeling of failure.
Growth maximization
In other approaches it is assumed that firms may be
interested in maximizing their growth rather than
their profits.6 Growth is seen as attractive for the
following reasons:
· A growing firm can achieve economies of scale and
lower its average costs.
· As a firm grows it can diversify into the production
of different products and reduce its dependence on a
single product.
5
The revenue-maximization goal of firms was described by W. J. Baumol in
1959.
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6
7
This is based on the work of R. Marris and others.
This is based on the work of O. E. Williamson in 1963.
HL
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Ethical and environmental concerns
The self-interested behaviour of firms often leads to
consequences that are detrimental to society. (Many
of these consequences will be examined in Chapter
6 under the topic of market failure.) It may often be
the case that the welfare of the firm is not consistent
with the welfare of society. A prime example
involves the self-interested firm that pollutes the
environment. In addition, firms can engage at times
in actions that most consumers would consider to be
ethically unacceptable, such as the practice in many
developing countries of employing children who are
extremely poorly paid and forced to work long hours,
or employing labour that is forced to work under
unhealthy or dangerous conditions. These situations
may arise in countries where there is widespread
poverty, and government legislation protecting the
rights of children and workers is either non-existent or
poorly enforced.
However, many firms are increasingly recognizing
that the pursuit of self-interest need not necessarily
conflict with ethical and environmentally responsible
behaviour. A negative image of the firm held by
workers and customers (buyers of the product) can
cut deeply into the firm’s revenues and profits by
lowering worker productivity and the firm’s sales.
Further, socially irresponsible firm behaviour may
lead to government regulation of the firm intended
to minimize the negative consequences of the firm’s
actions for society, whereas socially responsible
behaviour could instead result in avoidance of
government regulation. Therefore, firms face strong
incentives to engage in socially beneficial activities.
These can take many forms, including:
· avoidance of polluting activities
· engaging in environmentally sound practices
· support for human rights, such as avoiding
exploitation of child labour and labour in general in
less developed countries, or avoiding investments in
countries with politically oppressive regimes
· art and athletics sponsorships
· donations to charities.
Many of these practices have been the result
of increased consumer awareness of social and
environmental issues, growing consumer concern
over ethical and environmental aspects of business
practices, and even consumer activism that results
in boycotts of offending firms. One indication of the
influence and concern of consumers is the rapidly
growing interest in investments in companies
(through stock markets) that meet certain social,
ethical and ecological criteria.
It used to be held that ethical and environmentally
responsible behaviour on the part of firms will cut into
their profits. This presumption took into consideration
only the cost aspect of profits: for example, firms using
cheap child labour will face lower costs, and hence will
make higher profits than firms avoiding such practices.
Yet profits depend not only on costs, but also on
revenues. If consumers avoid buying the products of
offending firms, revenues will decline and profits will
go down as well, in spite of the lower costs. The same
arguments also apply to firms that may be pursuing
some strategy other than profit maximization, such as
revenue maximization.
A number of studies have attempted to measure the
impacts of socially responsible behaviour on the
profits of firms. Does ethical and environmentally
responsible behaviour lower or increase firms’ profits?
The results of these studies have been inconclusive.
The behaviour of firms themselves, however, suggests
that they do not want to risk consumer displeasure.
Test your understanding 4.6
1 (a) What are the two approaches to profit
maximization by firms? (b) What is the profitmaximizing rule of firms in each of the two
approaches?
2 What do firms determine by use of the profitmaximizing rules?
3 (a) Say a firm is producing a level of output Q
where MC > MR. What should it do to increase its
profit (or reduce its loss)? (b) If it is producing Q
where MC < MR, what should it do?
4 (a) Why are many economists critical of the
assumption made by the standard theory of the
firm that firm behaviour is prompted by the
objective to maximize profits? (b) What are
some arguments suggesting that profits are an
important consideration in firm behaviour?
5 Discuss some alternative possible goals of firms
that may influence their behaviour.
Chapter 4: Theory of the firm I
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Questions for
HL
review
4.1
[10 marks] Define and explain the law of
diminishing marginal returns, and provide an
example illustrating this law.
4.2
[10 marks] (a) Draw the marginal product
and average product curves of a firm, paying
special attention to their points of intersection.
(b) Explain the relationship between the two
curves. (c) What important economic principle
is responsible for their shapes? (d) How is the
distinction between the short run and the long
run related to this law?
4.3
[10 marks] (a) Draw the marginal cost (MC)
and average cost curves (AVC and ATC), paying
special attention to their points of intersection.
(b) Explain the relationship between MC and
AVC; MC and ATC. (c) What important economic
principle accounts for their shapes?
4.4
[10 marks] Show diagrammatically the impacts
on TFC, TVC, TC, AFC, AVC, ATC and MC of
(a) an increase in a fixed cost of production;
(b) a decrease in a variable cost of production.
4.5
[10 marks] Distinguish between a variety of
factors that can contribute to (a) economies of
scale, and (b) diseconomies of scale and illustrate
using a diagram.
4.6
[10 marks] Explain why a firm cannot be
maximizing profit if MC < MR or if MC > MR.
4.7
[10 marks for part (a); 15 marks for part (b)]
(a) Explain two ways that can be used by
economists to study profit maximization by a firm.
(b) Evaluate the assumption made by the standard
theory of the firm, that firm behaviour is guided
by the objective to maximize profits, referring to
possible alternative goals that firms may have.
4.8
[10 marks] Environmentally responsible
behaviour could involve the installation by
firms of anti-pollution equipment, giving rise
to an increase in their costs of production. And
yet studies suggest that this need not result in a
decrease in a firm’s profits. Use total revenue and
total cost concepts to explain how this is possible.
4.9
[10 marks] Using your knowledge about the
profit-maximizing behaviour of firms, explain why
a firm would be interested in producing a level of
Q after diminishing marginal returns (diminishing
marginal product) have set in, indicating that
marginal cost is increasing.
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Part 2: Microeconomics
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4.10
[10 marks for part (a); 10 marks for part (b)]
David Ricardo, a famous English economist of the
19th century, believed that agricultural output
would eventually stop growing, because as more
and more labour and capital inputs were added
to land that was fixed in quantity, the additional
output of labour and capital would become
smaller and smaller until it would no longer
be possible for total output to increase further.
(a) What is the law that describes the process
that Ricardo was referring to? (b) Do you think
Ricardo’s fears were justified? Explain why or why
not.
4.11
[15 marks] Compare and contrast, and explain
the causes of the U-shape of the short-run and
long-run average cost curves.
4.12
[10 marks] Why would a firm be interested in
keeping its business running even though it may
be earning zero economic (supernormal) profit?
4.13
[10 marks for parts (a) and (b); 10 marks for
part (c)] Consider the following statements, and
in each case explain why you agree or disagree.
(a) The ‘short run’ refers to a short period of time;
the ‘long run’ refers to a long period of time.
(b) When a firm is earning zero normal profit,
this means that it is just covering all its costs.
(c) Both the short-run average total cost curve
and the long-run average total cost curve have a
similar U-shape because of the law of diminishing
marginal returns.
Chapter 5
Microeconomics
The theory of the firm II
Market structures (higher level topic)
This chapter continues our study of firm behaviour. We will use the general principles that were outlined
in Chapter 4 to study how firms behave in the context of the structure of the market in which they
operate. A market structure (introduced in Chapter 2, page 29) describes the characteristics of market
organization that influence the behaviour of firms within an industry. It defines the firm’s environment,
and determines a number of outcomes such as how much quantity a firm will produce, what price it
will charge, how much profit it can make, how efficiently it can produce, and to what extent its actions
benefit consumers and society at large. Before reading this chapter, the student should review Section 2.1,
containing an overview of market structures.
OBJECTIVES
After studying this chapter you should be able to:
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·
·
·
·
·
·
·
·
·
·
·
identify the main characteristics of each of the four market structures: perfect competition, monopoly,
monopolistic competition, and oligopoly
examine how firms in each of the market structures determine the profit-maximizing level of output
understand the different demand curves faced by firms in each of the market structures
explain the significance of entry and exit in competitive market structures
appreciate the significance of barriers to entry and the consequences of market power
distinguish between the short-run and long-run equilibrium positions of the firm and industry in the different
market structures
analyse and explain the adjustment to long-run equilibrium in competitive market structures
explain the efficiency characteristics of each of the market structures
evaluate the desirability of each of the market structures from various perspectives, by identifying and
comparing their advantages and disadvantages
explain the theory of contestable markets and its implications for government policy
explain why firms often practise price discrimination, and identify the necessary conditions for this practice to
take place
evaluate price discrimination by considering its advantages and disadvantages from various perspectives.
Chapter 5: Theory of the firm II 113
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5.1 Perfect competition
Assumptions of the model
The model of perfect competition is based on the
following assumptions:
· There is a very large number of firms The large
number ensures that each firm’s output is very small
in relation to the size of the market. In addition, it
ensures that the firms cannot collude (agree to act
together so as to secure market power). The firms act
independently of each other and the actions of each
have an imperceptible impact on the others and on
market price.
· Each firm is a price-taker A price-taker is one who
accepts the price that is determined in the market by
the forces of demand and supply, and has no power
to influence it. Because the number of firms in the
perfectly competitive market is very large, and the
output of each is a small fraction of the total offered
in the market for sale, the firm cannot affect the
market price by varying its output, and must accept
the price as given. It is then free to sell whatever
quantity of output will maximize its profit at that
price.
· All firms produce identical products There is no
product differentiation; all products are identical
to each other. It is not possible to distinguish the
product of one producer from that of another.
· There is free entry and exit Another way of saying this
is that there are no barriers to entry and exit. Any
firm that wishes to enter the market can do so freely
as there is nothing to prevent it from doing so;
similarly if it wishes to leave the market it can do so
freely.
· There is complete information All firms and all
consumers have complete information regarding
products, prices, resources and methods of
production. This assumption ensures that no firm
has access to information not available to all others
that would allow it to produce at a lower cost
compared to its competitors. Also, it ensures that
all consumers are aware of the market-determined
price, and would therefore not be willing to pay any
higher price for the product.
These assumptions define a perfectly competitive
market. Although they are rarely if ever fully met
in the real world, there are certain industries that
are described more accurately by this model than
by any other, such as for example some agricultural
commodities (wheat, corn, livestock), other
commodities (silver and gold), and the foreign
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Part 2: Microeconomics
exchange market. In spite of its limited applicability
to real-world industries, this model is studied
because it offers major insights into the workings of
the competitive market. In addition, it serves as an
important standard or benchmark used by economists
to assess the degree of efficiency that is achieved in the
other market structures.
Demand and revenue curves under perfect
competition
The demand curve facing the firm
Consider the market or industry (these terms are used
interchangeably) for a product produced under perfect
competition. Figure 5.1(a) shows market demand
and supply for this product, which determine the
equilibrium price, Pe. Market demand is represented
by a standard downward-sloping demand curve, and
market supply by a standard upward-sloping supply
curve. Panel (b) shows the demand curve for the
product as it appears to the individual firm. It is a
perfectly elastic demand curve, shown by a horizontal
line at the price level Pe that has been determined in
the market. As we know from Chapter 3, page 66, a
perfectly elastic demand curve has a price elasticity of
demand (PED) equal to infinity throughout its range.
What does this mean for the firm?
The individual firm, being very small, can do nothing
to influence this price; it must accept it and sell
whatever output will maximize profit at the price Pe.
This explains why the firm is a price-taker. If the firm
raised its price above Pe, it would not be able to sell
any output, because buyers would buy the product
elsewhere at the lower price Pe. On the other hand,
since the firm can sell all it wants at price Pe, it would
have nothing to gain and something to lose (in terms
of revenue) if it dropped its price below Pe. Therefore
the firm will sell all its output at Pe.
The assumption that the perfectly competitive firm
is a price-taker has a very important implication:
the demand curve facing the firm is perfectly elastic
(horizontal) at the price for the good that has been
determined in the market for that good.
The firm’s revenue curves
The demand curve faced by the perfectly competitive
firm influences its revenue. This follows simply from
the principle that total revenue is equal to the price of
the good times the quantity sold (TR = P × Q). Let’s
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P
(a) Individual firm.
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(b) Market/industry.
P
S
Pe
Pe
D
D
0
Q
0
Q
Figure 5.1 Market (industry) demand and supply versus demand faced by the individual perfectly competitive firm.
assume that a perfectly competitive firm produces
and sells a good at €10 per unit. Based on this price,
we can calculate the firm’s total revenue, marginal
revenue and average revenue, and see how these
change as its output increases. The data are shown in
Table 5.1. Column (3) shows total revenue, calculated
by multiplying the units of output in column (1) by
the price shown in column (2). Column (4) calculates
marginal revenue, by taking the change in total
revenue and dividing it by the change in output.
Column (5) shows average revenue, obtained by
dividing total revenue by quantity, for each level of
output. The data in the table reveal an interesting
pattern:
No matter how much output the perfectly competitive
firm sells, P = MR = AR (price is equal to marginal
revenue which is equal to average revenue). This
follows simply from the fact that price is constant
regardless of the level of output sold.
This is an important result that holds only for firms
operating under perfect competition, because these are
the only firms that have no control over price and are
TR
80
70
60
50
40
30
20
10
0
forced to sell all their output at the single price that is
determined in the market.
The data of Table 5.1 are plotted in Figure 5.2. In
Figure 5.2(a) we can see that total revenue increases at
a constant rate, i.e. it is a straight line. Figure 5.2(b),
plotting marginal and average revenues, shows that
since price is constant at €10, P = MR = AR, and they
all coincide with the horizontal demand curve.
Table 5.1
Total, marginal and average revenue when price is constant.
(1)
Units of
output
(Q)
(2)
Product
price
(P)
(¤)
0
1
2
3
4
5
6
7
10
10
10
10
10
10
10
10
(3)
(4)
Total
Marginal
revenue
revenue
TR = P × Q
Δ TR
MR =
(¤)
ΔQ
(¤)
0
10
20
30
40
50
60
70
(5)
Average
revenue
TR
MR =
Q
(¤)
0
10
10
10
10
10
10
10
10
10
10
10
10
10
10
10
P, MR, AR (b) Marginal and average revenue.
(a) Total revenue.
TR
1 2 3 4 5 6 7 8 Q
Figure 5.2 Revenue curves under perfect competition.
80
70
60
50
40
30
20
10
0
D = P = MR = AR
1 2 3 4 5 6 7 8 Q
Chapter 5: Theory of the firm II
115
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Test your understanding 5.1
1 What are the assumptions defining the perfectly
competitive market model?
2 (a) Explain why the perfectly competitive firm
is a price-taker. (b) What would happen if this
firm tried to raise its price above the market
price? (c) What would happen if it lowered its
price below the market price?
3 How is the demand curve facing the perfectly
competitive firm related to the industry/market
demand curve?
As we know from Chapter 4, page 108, there are two
approaches to analysing profit maximization (or loss
minimization): the total revenue and cost approach,
and the marginal revenue and cost approach, both of
which yield identical results. We will now examine
each of these approaches in turn.
Short-run profit maximization based on
the total revenue and cost approach
As we know, profit is equal to total revenue minus
total cost (TR − TC). The firm is faced with the
following possibilities:
4 (a) Explain the relationship between the firm’s
average revenue (AR) and marginal revenue (MR)
in perfect competition. (b) How are they related
to product price? (c) How are they related to the
demand curve facing the firm?
· If TR > TC, the firm makes economic profit.
· If TR = TC, the firm is makes zero economic profit,
though it is earning normal profit.
· If TR < TC, the firm makes a loss (negative
economic profit).
Profit maximization in the short run
We now turn to profit maximization by the perfectly
competitive firm in the short run. Recall that the short
run is the period during which the firm has at least
one fixed input, or a fixed plant. This means that the
number of firms in the industry we are considering is
also fixed; since firms cannot vary their plant in the
short run, they cannot enter the industry or leave the
industry, as this would involve varying their fixed
resources.
What decisions are open to the firm in the short run?
Since the firm is a price-taker, having no power to
influence the price at which it sells its output, it can
only make decisions over (i) how much quantity of
output it should produce in order to maximize its
profit (or minimize its loss), and (ii) in the event that
it is making a loss, whether it should go on producing
or should shut down.
TC,
TR
(a) Profit-making firm.
TC,
TR
TC
b
Figure 5.3 (a) and (b) shows the standard total cost
curve that we considered in Chapter 4, page 99 (which
applies to all firms regardless of market structure; see
Section 4.1), together with the total revenue curve
derived in Figure 5.2(a) above. In panel (a), we note
that there is a range of output, Q, where TR lies above
TC, indicating that the firm is making economic
profit. The firm must now determine which is the
profit-maximizing level of Q. This occurs where the
difference between TR and TC is largest, and is given
by Qπmax. The amount of economic profit made by
the firm at this level of output is given by the vertical
difference between TR and TC. Note that at the points
where the TC and TR curves intersect, given by a and
b, TR = TC and economic profit is zero. These are
called break-even points, where the firm is earning
only normal profit.
(b) Loss-making firm.
TR
TC
TR
profit
a
0
loss
Q
max
Q
0
Figure 5.3 Profit maximization under perfect competition: total revenue and total cost approach.
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Part 2: Microeconomics
Ql min
Q
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Panel (b) illustrates the case where the firm is making a
loss. There is no level of output at which TR is greater
than TC, and there are no points of intersection
between TR and TC, indicating that there is no level
of output the firm can produce that will allow it to
break even. The firm’s objective here is to minimize
its loss, and this is done at output level Qlmin, where
the difference between TC and TR is the smallest.
The amount of loss made by the firm is equal to the
vertical difference between TC and TR.
Short-run profit maximization based on
the marginal revenue and cost approach
Profit maximization using this approach involves two
steps:
(i) Comparison of marginal revenue with marginal cost to
determine profit-maximizing (or loss-minimizing) level
of output As we know from Chapter 4 (Section 4.3,
page 108) a firm interested in maximizing profit
(or minimizing loss) produces that level of output
where marginal revenue is equal to marginal cost,
or where MR = MC. This can be seen in Figure 4.8(a)
in Chapter 4, page 109, where Qπmax was shown to
be the profit-maximizing level of output.
(ii) Comparison of average revenue and average cost to
determine the amount of profit (or loss) To determine
the size of the profit or loss, the firm must consider
average revenue and average cost. We know that
profit = TR − TC. If we divide this throughout by
output, Q, we obtain an expression for profit per
unit of output, in other words, in terms of averages:
profit
Q
=
TR
Q
−
TC
Q
or alternatively
profit
Q
= AR − ATC
(since AR =
TR
Q
and ATC =
TC
Q
).
Moreover, since P = AR (as shown in Table 5.1
and Figure 5.2(b)), it follows that
profit
Q
= P − ATC
This is the key to calculating the size of the firm’s
profit or loss.
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At the profit-maximizing level of output Q (given by
the MC = MR rule):
· If P > ATC, the firm makes an economic profit.
· If P = ATC, the firm breaks even, making zero
economic profit, though it is earning normal profit.
· If P < ATC, the firm is makes a loss (negative
economic profit).
Using this two-step approach, we will now examine
the behaviour of the perfectly competitive firm in the
short run. To do this, we will make use of the diagrams
appearing in Figure 5.4 (page 118). Each of these
diagrams contains identical cost curves (AVC, ATC and
MC; note that MC always intersects AVC and ATC at
their minimum points). The only thing that differs
between the diagrams is the position of the perfectly
elastic demand curve, which shows different possible
prices that the firm, being a price-taker, must accept.
Figure 5.4(a): profit maximization and
economic profit in the short run
As shown in the diagram, market price is P1, and thus
P1 = MR1 = AR1 represent the demand curve facing
the firm. Using the profit-maximizing rule MR = MC,
the intersection of the MR and MC curves determines
the firm’s profit-maximizing level of output, Q1
(simply draw a line from the point of intersection to
the horizontal axis). To determine the profit level of
the firm, we compare P1 with ATC along this same
vertical line at the level of output Q1. Since P > ATC,
we conclude the firm is making profit per unit equal
to P1 − ATC, which is represented by the vertical
distance between points a and b. To find total profit,
we multiply profit per unit times the total number of
units produced; this is given by
profit =
profit
Q
×Q
and is represented by the shaded area in the diagram.
Note that all profit measures in our discussion refer
to economic profit, also known as abnormal or
supernormal profit.
In general, when P > ATC at the level of output where
MC = MR, the firm is making an economic profit.
Chapter 5: Theory of the firm II 117
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price, revenue, costs
(a) Economic profit.
MC
P1
a
total profit
b
ATC AVC
P1 = MR1 = AR1 = D1
profit
Q
Q1
0
Q
price, revenue, costs
(b) Zero economic profit (normal profit).
MC
ATC
P2
AVC
P2 = MR2 = AR2 = D2
Q2
0
Q
price, revenue, costs
(c) Economic loss; the firm continues to produce.
MC
P3
ATC
c
total loss
d
loss
Q
Q3
0
AVC
P3 = MR3 = AR3 = D3
= break-even price
Q
price, revenue, costs
(d) Loss in the short run and the shut-down price.
MC
ATC
AVC
e
P4
0
total loss
P4 = MR4 = AR4 = D4
f
loss
= AFC = shut down price
Q
Q4
Q
price, revenue, costs
(e) The loss-making firm that will not produce.
MC
ATC
g
P5
h
0
Q5
AVC
P5 = MR5 = AR5 = D5
Q
Figure 5.4 Short-run equilibrium positions of the perfectly competitive firm.
Figure 5.4(b): zero economic profit (normal
profit) in the short run
The market-determined price has fallen to P2,
corresponding to demand curve D2. Applying once
again the MR = MC rule, we find the profit-maximizing
level of output to be Q2. Note that at the point of
118
intersection of MR and MC, price P2 is exactly equal to
minimum ATC. What does this tell us about the firm’s
profit position? Profit per unit is given by P2 − ATC,
which in this case is equal to zero. Therefore the firm
is making zero economic profit. However, it is earning
normal profit, meaning that its revenues are just
sufficient to cover all of implicit plus accounting costs,
or all economic costs of production. The price that
is equal to minimum ATC is called the break-even
price. This is the price at which the firm breaks even,
where its total revenues are equal to its total costs
(implicit plus accounting costs), making economic
profit equal to zero.
Part 2: Microeconomics
In general, when P = minimum ATC at the level of
output where MC = MR, the firm is breaking even: it
is making zero economic profit, but is earning normal
profit.
Figure 5.4(c): loss minimization in the
short run
In some cases, the market price that the firm must
accept is too low to provide enough revenue to enable
it to cover all its costs. This occurs when the price falls
to a level such as P3, corresponding to demand curve
D3, which is below minimum ATC. Using the MC =
MR rule, we see that the profit-maximizing or lossminimizing level of output is Q3, for which P < ATC,
indicating that the firm is making a loss. Therefore
output Q3 represents the firm’s loss-minimizing
output. The vertical difference between ATC and P3, or
the difference between points c and d, represents the
firm’s loss per unit of output, or
loss
Q
. If we multiply
this vertical distance by Q3, we get the total loss
incurred by this firm, given by the shaded area.
What should this firm do? Should it go on producing
at a loss or should it stop producing and shut down?
To answer this question, we must remember that the
firm is in the short run. This means that if it stops
producing, it will have zero revenue and zero variable
costs (it will have fired all its workers, and will not be
purchasing any other variable inputs), but since it will
still have some fixed inputs it will have some fixed
costs (such as interest payments on loans, insurance
payments, rental payments, etc.). The fixed costs are
costs that must be paid even though the firm is not
producing anything. Therefore, with zero revenues and
zero variable costs, the firm that does not produce in
the short run will incur a loss equal to its fixed costs.
Remember that the firm’s objective is to make its
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loss as small as possible. What if by producing some
output the firm can receive enough revenue to cover a
portion of its fixed costs, plus whatever variable costs
it is incurring? In this event, it will be worthwhile
for the firm to continue to produce even though it
is making a loss, because its loss will be smaller than
the loss it would make if it stopped producing. This
answers the loss-making firm’s question: it is better to
produce rather than shut down, as long as the loss
it makes by producing is less than its total fixed
cost. In terms of our per unit analysis here, the firm
should produce as long as the loss per unit incurred by
producing is less than its average fixed cost (AFC, or
cost per unit).
This situation is illustrated in panel (c). The vertical
difference between ATC and AVC is equal to AFC (since
AFC + AVC = ATC). Therefore the loss per unit, which
is given by ATC − P3 at output level Q3 (or the vertical
difference between points c and d), is smaller than
AFC. Therefore this firm should not shut down in
the short run; it should produce its loss-minimizing
output, because the loss it makes by producing is
smaller than its fixed cost.
In general, when ATC > P > AVC at the level of output
where MC = MR, the firm is making a loss but should
continue to produce because its loss is smaller than its
fixed cost. Graphically, this occurs when the demand
curve lies below minimum ATC and above minimum
AVC.
Figure 5.4(d): loss in the short run and the
shut-down price
There is a price level below which the firm will stop
producing, termed the shut-down price, given by
P = minimum AVC, and shown as P4 in panel (d),
corresponding to demand curve D4. At exactly this
price, the firm will be indifferent between producing
Q4, given by the intersection between MR and MC,
and not producing at all. Whether the firm produces
output Q4 or whether it does not produce at all, the
loss per unit of output will be exactly equal to AFC,
given by ATC − AVC (or the vertical difference between
points e and f).
Figure 5.4(e): the loss-making firm that will
not produce
If the market price that the perfectly competitive firm
must accept is so low that it falls below minimum
AVC, then it will no longer be worthwhile for the firm
to go on producing. As panel (e) shows, if the firm
were to produce, it would produce Q5 units of output,
given by the point of intersection between the MR
and MC curves. However, at this level of output, the
loss per unit is equal to the difference between points
g and h, which is greater than AFC. Therefore in this
case the firm is better off not producing at all.
In general, when P < minimum AVC at the level of
output where MC = MR, the firm should shut down
because the loss it will incur by shutting down is
smaller than if it produces any level of output.
The firm’s short-run decisions on how much output
to produce, and whether or not it should produce if
it is making a loss, are summarized in Figure 5.5. The
cost curves, and the five prices and demand curves
depicted here are exactly the same as those appearing
in the five panels of Figure 5.4. We can summarize
these results as follows:
In perfect competition:
· When P > ATC, the firm realizes an economic profit.
· When P = minimum ATC, the firm realizes zero
economic profit, and therefore earns normal profit;
this is the break-even point, achieved at the breakeven price.
· When ATC > P > AVC, the firm produces at a loss, but
its loss is less than fixed costs (loss per unit < AFC)
and therefore it continues to produce.
· When P = minimum AVC, the firm is indifferent
between producing and shutting down; in both
cases its loss = fixed costs (loss per unit = AFC); this
is the shut-down point, reached at the shut-down
price.
· When P < AVC, the firm shuts down (stops
producing) because if it continues to produce, it
will make a loss greater than its fixed costs (by
not producing it will have a loss equal to its fixed
costs).
In general, when P = minimum AVC at the level
of output where MC = MR, the firm is indifferent
between producing its loss-minimizing level of output
or shutting down.
Chapter 5: Theory of the firm II 119
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ATC
price,
revenue,
costs
P = minimum ATC = break-even price
firm makes normal profit,
or zero economic profit
P = minimum AVC = shut-down price
firm is indifferent between producing
at a loss or not producing
P > ATC
firm makes economic
(supernormal) profit
MC
1
P1
2
P2
ATC > P > AVC
firm makes loss but
continues to produce
P < AVC
firm makes loss
and shuts down
3
P3
P4
P5
0
AVC
4
5
Q5 Q4 Q3 Q2 Q1
output, Q
Figure 5.5 Summary of the perfectly competitive firm’s short-run decisions, and the firm’s short-run supply curve.
The firm’s short-run supply curve
As we know, any profit-maximizing firm produces the
level of output determined by the rule MC = MR. But
under the assumptions of perfect competition, where
price is constant for all levels of output, it is also the
case that MR = P, so that the profit-maximizing rule
can be rewritten as MC = P. This means that the MC
curve shows the level of output Q that the perfectly
competitive firm is willing and able to supply in the
market in a series of possible prices. Note that this is
none other than the definition of the firm’s supply
curve, which we studied in Chapter 2, page 40.
However, as we now know, the firm will not supply
the market if the price falls below minimum AVC.
We can therefore redefine the perfectly competitive
firm’s short-run supply curve to be the portion of
its marginal cost curve that lies above the point of
minimum AVC.
In Figure 5.5, the firm’s short-run supply curve is
represented by the boldface segment of the MC curve.
As we know from Chapter 2, page 41, the industry
(market) supply curve is obtained by adding up,
or summing horizontally, all the individual firm
supplies; therefore the industry supply is the sum of all
individual firm MC curves above minimum AVC.
Short-run equilibrium under perfect
competition
Each of the positions shown in the five panels of
Figure 5.4 represents a short-run equilibrium position
for an individual firm operating within a perfectly
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Part 2: Microeconomics
competitive market structure (industry). Each firm
equilibrium corresponds to an equilibrium in the
market as well, where the point of equality between
quantity demanded and quantity supplied determines
the market price that each firm accepts (as shown in
Figure 5.1). These short-run equilibrium positions
for the individual firm and for the market hold and
will continue to hold, ceteris paribus. In other words,
as long as everything that could cause a disturbance
to the system is held constant and unchanging, and
as long as the firm remains in the short run, these
equilibrium positions will continue indefinitely. In
the short run, the firms cannot change any of their
fixed resources, and as long as nothing else changes
(such as market demand, resource prices, the
technology of production, etc.), the individual firms
in the industry will go on producing the output levels
shown in Figure 5.4, earning economic profit, or
normal profit, or making a loss by producing, or not
producing at all.
Test your understanding 5.2
1 (a) Using the total revenue and cost approach
to profit maximization, how do we know if a
firm is making economic profit, normal profit, or
loss? (b) How will the firm maximize its profit or
minimize loss using this approach?
2 (a) Using an appropriate diagram, illustrate the
case where a firm is earning normal profit using
the total revenue and cost approach to profit
maximization. (b) Suppose now there is a fall in
the market price; how would this would affect
your diagram of part (a)? (c) What will happen
to the firm’s normal profit after the price fall of
part (b)?
(...continued)
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Test your understanding 5.2
(...continued)
3 We know from Chapter 4 (page 108) that the
profit-maximizing (loss-minimizing) rule using
the marginal revenue and cost approach is
MC = MR. Yet in perfect competition, the firm
will maximize profit (minimize loss) where
MC = P. How is this possible?
4 Using appropriate diagrams and the
marginal revenue and cost approach to profit
maximization, show when a firm (a) earns
economic profit (you must show profit per
unit and total profit); (b) earns normal profit;
(c) incurs a loss (you must show loss per unit
and total loss).
5 Suppose a firm in the short run is making a
loss. (a) Use appropriate diagrams to show
how it makes a decision between continuing
to produce in the short run or shutting down
(stopping production). (b) What is the largest
possible loss it will be prepared to accept before
shutting down? (c) Using an appropriate
diagram, show the lowest possible price it will
be prepared to accept before shutting down.
6 (a) Show diagrammatically the perfectly
competitive firm’s short-run supply curve.
(b) What does your diagram indicate about
the relationship between the firm’s supply
curve and AVC?
Perfect competition in the long run
In the short run the number of firms in an industry
cannot change, because each firm has at least one
fixed resource, which it cannot vary. In the long
run all of the firm’s resources are variable, therefore
the number of firms in the industry is no longer
unchanging. New firms can enter the industry,
existing firms can change their plant size (increase
or decrease their fixed resources), or firms can
liquidate (sell) their fixed resources and leave the
industry altogether. There is therefore free entry
and exit of firms in an industry, which is one of
the characteristics of this market structure noted at
the beginning of Section 5.1. Free entry and exit is
the key to understanding the long run under perfect
competition, and depends crucially on the assumption
that there are no fixed resources.
The difference between shutting down in the short
run and shutting down in the long run is that in the
short run, whereas a loss-making firm can choose to
produce zero output, it still has a fixed plant for which
it incurs fixed costs. In the long run the loss-making
firm can shut down its plant completely and stop
incurring any costs at all. For example, say you are
running a dry cleaning business, and you are renting
the premises. Suppose that in the short run the price
of your services has fallen so low that it is less than
your minimum AVC. You therefore ‘shut down’ in the
sense that you stop providing dry cleaning services.
However, you still have to go on paying the rent (your
fixed costs) until your rental contract expires. It is only
when your rental contract expires that you can go into
the long run and ‘shut down’ completely, thus not
having any more fixed costs.
Role of economic (abnormal) profits
and losses in adjustment to long-run
equilibrium
In the long-run equilibrium of the perfectly
competitive market structure, all firms earn zero
economic profits (they earn normal profit). The reason
behind this important principle is that if firms earn
economic profit or make losses in the short run, the
profits and losses give rise to a process of entry and
exit of firms that makes the short-run profits or loss
tend to zero.
The long-run equilibrium position of the firm and
the industry under perfect competition is shown in
Figure 5.6. As a result of entry or exit, the market
settles at the price Pe, which is just equal to the firm’s
short-run and long-run minimum ATC, where each
firm is earning normal profit. Each firm in the industry
produces output Qf, and the industry as a whole
produces output Qi (equal to the sum of all the firms’
outputs).
In perfectly competitive long-run equilibrium, firms’
economic profits and losses are eliminated, and
revenues are just enough to cover all economic costs
so that every firm earns normal profit.
We will see how firms and the industry arrive at this
long-run equilibrium position by considering two
examples below.
Changes in demand and adjustment to
long-run equilibrium
Let’s assume that a perfectly competitive industry is in
long-run equilibrium; each firm is producing the level
of output that allows it to earn normal profit.
Chapter 5: Theory of the firm II
121
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(a) The firm.
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(b) The industry (market).
price, costs, revenue
P
MC
SRATC
D = MR
Pe
S
LRATC
Pe
D
0
Qf
Q
Qi
0
Q
Figure 5.6 The firm and industry long-run equilibrium position under perfect competition.
This is shown in Figure 5.7(b), with D1 and S1
determining price P1 (initial position 1 for the
industry). P1 is the price accepted by each firm in the
industry, and is equal to minimum ATC for each firm,
as shown in Figure 5.7(a).
Suppose now that there is a change in consumer tastes
in favour of the product produced in this industry;
the industry demand curve shifts to the right, from D1
to D2 in panel (b) (position 2 for the industry). With
market demand at D2, the market price increases to
P2, which becomes the new price that firms in the
industry now accept. In panel (a) we see that, at the
higher price P2, by the MC = MR rule, firms now equate
MC with P2 (which is their new MR). Firms therefore
begin to earn a short-run economic profit, since
P2 > ATC, and profit per unit of output = a − b.
In the long run, the increased profit realized by firms
in the industry leads to the entry of new firms into the
industry, that are attracted by the prospect of making
economic profits. Output in the industry increases,
and, as a result, the industry supply curve S1 in panel
(b) begins to shift to the right, and it continues to shift
costs, revenue, P
(a) The firm.
until it reaches S2, where the market price has fallen
back to the level of P1 (position 3 for the industry). At
price P1, all firms are earning normal profit once again.
What has happened in this adjustment process?
The increased consumer demand initially resulted
in a higher market price for the good, as well as in
economic profits for firms, which acted as a signal
and incentive for new firms to enter the industry. As
supply increased, the price fell back to its original
level, but output for the industry as a whole increased
from Q1 to Q2, as shown in panel (b). Therefore the
market responded to the consumers’ desire for an
increased supply.
In the event that market demand were to fall, the
market demand curve would shift to the left, price
would fall, and firms would begin to incur losses.
The long-run response will be for firms to leave the
industry. The industry supply curve will shift to
the left up to the point that price climbs back to its
original position (where it is equal to firms’ minimum
ATC), and the industry’s output will be reduced.
P
S1
MC
a
P2
P1
0
b
Qf
ATC
profit
unit
Q
P2
P1
0
Figure 5.7 An increase in demand and the long-run response of firms and the industry.
122
(b) The industry (market).
Part 2: Microeconomics
S2
2
1
Ql
3
D2
D1
Q2
Q
Changes in technology or resource prices,
and adjustment to long-run equilibrium
Test your understanding 5.3
If there is an improvement in the technology of
production, or if resource prices change, these
will be reflected in the firm’s cost curves. Both an
improvement in technology and a fall in resource
prices mean lower costs for the firm, and appear
as a downward shift in the firm’s cost curves. This
means that firms that were previously earning only
normal profit (at the long-run equilibrium) will now
be earning economic profit. This will result in new
entrants into the industry, and the industry supply
curve will shift to the right. As it does so, the market
price begins to fall, and the supply curve will keep
shifting and the price falling until the new market
price is equal to the new, lower minimum ATC curve,
intersected at its minimum point by the new lower
MC curve. The end result will be that output of the
industry will increase, the final market price will be
lower, and all firms will be earning normal profit once
again. If resource prices were to increase, there would
result an upward shift in the firm’s cost curves, and
the final equilibrium for the industry would involve
a lower quantity of output produced and a higher
equilibrium price.
losses in the short run. Using appropriate
diagrams, show what will happen to (a) the
number of firms in the industry; (b) industry
supply; (c) the market price; (d) the losses of the
firms; and (e) the quantity of output.
4 (a) Use diagrams to show an individual firm’s
and the market’s equilibrium position in the
long run. (b) What is the relationship between
price, ATC and MC for the individual firm
when it is in long-run equilibrium? (c) Does
the firm earn any profit when it is in long-run
equilibrium (recall that the term ‘profit’ in
Economics refers to ‘economic profit’)?
5 Consider a perfectly competitive market that
is in long-run equilibrium. Using appropriate
diagrams, explain the process of adjustment to
a new long-run equilibrium, and show what
happens to equilibrium price and quantity
in the event that there is (a) a change in
consumer tastes against the product (i.e. market
demand falls); and (b) an improvement in the
technology of production.
1 How would you use the assumption of free entry
Allocative and productive (technical)
efficiency
and exit in a perfectly competitive industry to
distinguish between the short run and the long
run?
The concept of economic efficiency was explained in
Chapter 2, page 49, where we saw that competitive
markets achieve economic (allocative and productive)
efficiency. Figure 5.8 shows the long-run equilibrium
position of a firm and industry in perfect competition.
(Note that 5.8(b) is the same as Figure 2.18 of
Chapter 2, page 50). The equilibrium price accepted
by the firm when it is in long-run equilibrium is Pe,
determined in the market by the intersection of the
supply and demand curves, where the market supply
curve illustrates marginal cost (MC) and the market
2 Consider an industry where firms are earning
economic profits in the short run. Show
diagrammatically what will happen to (a) the
number of firms in the industry; (b) industry
supply; (c) the market price; (d) the economic
profits of the firms; and (e) the industry’s
quantity of output.
(...continued)
(a) The firm.
(b) The market/industry.
P
MC
S = MC
ATC
Pe
0
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(...continued)
3 Consider an industry where firms are making
Test your understanding 5.3
costs, revenue, P
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P = MR = Pe
Q
Figure 5.8 Productive and allocative efficiency in perfect competition.
Pe
0
consumer
surplus
producer
surplus
D = MB
Q
Chapter 5: Theory of the firm II
123
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demand curve marginal benefit (MB). We know from
Chapter 2, page 51, that when the competitive market
is in equilibrium, price is determined where MB =
MC, and the sum of consumer plus producer surplus
is maximized. We will now examine the concepts of
productive and allocative efficiency at the level of the
firm.
Allocative efficiency
Allocative efficiency occurs when firms produce
the particular combination of goods and services
that consumers mostly prefer. The condition is the
following:
Allocative efficiency is achieved when MB = MC;
since MB = P, this condition can be restated as
P = MC.
Productive efficiency
Productive efficiency occurs when firms produce at
the lowest possible cost. The condition for productive
efficiency is the following:
Productive efficiency is achieved when
P = minimum ATC.
When the price of a good is equal to the lowest
possible cost per unit (minimum ATC), this means that
resources are being used economically, and that they
are not being wasted. Production of the good uses up
the least amount of resources possible.
Efficiency and perfect competition in the
long run
Figure 5.8(a) indicates the following:
Let’s examine this idea more carefully. The price, P,
paid by consumers to acquire a good reflects consumer
preferences and the benefits that consumers feel they
derive from consumption of a good; more precisely,
P reflects the marginal or additional benefit that
consumers derive from consumption of one more unit
of the good. This marginal benefit is represented by
the amount of money consumers are willing to pay in
order to buy one more unit of the good. Marginal cost,
MC, is a measure of the value, or opportunity cost, of
the resources used to produce one extra unit of the
good. When price is equal to marginal cost, there is
equality between what consumers are prepared to pay
to get one more unit and what it costs to produce it.
We can better understand why allocative efficiency is
achieved when P = MC by considering what happens
when the two are not equal to each other. In the
event that P > MC, an additional unit of the good
is worth more to consumers than what it costs to
produce it. There is an underallocation of resources to
the production of the good; in other words, too few
resources are used to produce the good, too little of the
good is produced, and consumers would be better off if
more resources were devoted to the good’s production.
If P < MC, an additional unit of the good costs more
to produce than what the unit is worth to consumers;
there is an overallocation of resources to the good. Too
much of it is being produced, and consumers would be
better off if output were reduced. In both these cases,
allocative inefficiency results. Therefore, resources are
allocated efficiently among their competing uses only
when the price of a good is equal to the marginal cost
of producing it.
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Part 2: Microeconomics
Both allocative and productive efficiency are achieved
by the perfectly competitive firm when it is at its longrun equilibrium position. At the point of production,
determined by MR = MC, price is equal to marginal
cost, and therefore society’s scarce resources are being
allocated efficiently. Also, at the point of production,
P = minimum ATC, and therefore the lowest possible
costs are being achieved; hence there is no waste of
resources. The achievement of economic (allocative
and productive) efficiency by the firm when it is in
long-run equilibrium is summarized by:
P = MC = minimum ATC.
Panel (b) shows how the economic efficiency at the
level of the firm corresponds to economic efficiency
at the level of the industry. We can examine industrywide efficiency by considering the size of consumer
and producer surplus, introduced in Chapter 2,
page 50. As you may remember, the sum of consumer
and producer surplus is maximum when price is
determined by MB = MC, indicating that economic
efficiency is being achieved.
When P = MC and P = minimum ATC for the firm, the
sum of consumer and producer surplus is maximum
for the industry. Another way to see that efficiency at
the level of the industry is being achieved is to note
that marginal benefit is equal to marginal cost
(MB = MC).
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The achievement of economic (allocative and
productive) efficiency in long-run equilibrium in
perfect competition is a very important result, because
perfect competition is the only market structure
where allocative and productive efficiency are
realized. This is a key reason why economists use
perfect competition as a standard or benchmark for
assessing the efficiency of the other three market
structures.
Efficiency and perfect competition in the
short run
Figures 5.4 (a) and (c) illustrated the firm’s short-run
equilibrium position when it is making economic
profits and losses, respectively. What can we say
about the achievement of efficiency in the short run?
When the firm is earning an economic profit, as in
panel (a), at the profit-maximizing level of output,
determined by MR = MC, we can see that the firm
achieves allocative efficiency, since P = MC. The same
is true for the loss-making firm, at its loss-minimizing
level of output, as shown in panel (c). Therefore the
perfectly competitive firm always achieves allocative
efficiency (both in the short run and in the long run).
What can we say about productive efficiency? In the
short run, neither the profit-making nor the lossmaking firm achieves productive efficiency, though
for different reasons. In the case of the profit-making
firm, P > minimum ATC, whereas in the case of the
loss-making firm, P < minimum ATC.
Evaluating perfect competition
It was noted in the beginning of this chapter
(page 114), that perfect competition, though not a
very realistic market structure, offers a number of
insights into the workings of the competitive market
mechanism. Let’s consider what these are.
of productive efficiency), and (b) the absence of
economic profits, which would have led to a higher
price. You can check this by comparing panels (a)
and (b) in Figure 5.4, indicating that the price that
allows the firm to earn economic profit is higher
than the price that prevails in long-run competitive
equilibrium, where the firm earns only normal
profit.
· Competition leads to the closing down of inefficient
producers Inefficient firms are those that produce
at higher than necessary costs. Inefficiency (in the
sense of productive inefficiency) could be due to
factors like less productive labour, or the use of
outdated technologies, or poor entrepreneurship.
The revenues of inefficient firms are insufficient to
cover all the costs, and so these firms make losses
and are therefore forced to shut down in the long
run and leave the industry. When this occurs, we
say that inefficient firms cannot compete with more
efficient, lower cost firms.
· The market responds to consumer tastes We have seen
that changes in consumer tastes will be reflected in
changes in market demand and therefore market
price. By creating short-run economic profits or
losses, price changes result in long-run adjustments
that make the quantity of output produced by the
industry respond to consumer tastes.
· The market responds to changes in technology or
resource prices We have also seen that if there is an
improvement in the technology of production, or if
there is a change in resource prices, the cost curves
will shift upward or downward, leading to economic
profits or losses, once again setting into motion a
long-run adjustment process that will lead finally to
a long-run equilibrium that has accommodated all
the changes.
Limitations of the model
Insights provided by the model
· Allocative efficiency As we have seen, perfect
competition leads to the best or ‘optimal’ allocation
of resources based on the mix of goods and services
that consumers mostly want, achieved through the
equality of P with MC in long-run equilibrium.
· Productive efficiency Perfect competition also leads to
production at the lowest possible cost, thereby using
resources in the best possible way, achieved through
the equality of P with minimum ATC in long-run
equilibrium.
· Low prices for the consumer The consumer benefits
from low prices, which are due to (a) production
at the lowest possible cost (from the achievement
· Unrealistic assumptions The model rests on a number
of very strict and unrealistic assumptions that are
rarely met in the real world.
· Limited possibilities to take advantage of economies
of scale Economies of scale (studied in Chapter 4,
page 103) lead to lower average costs as a firm
grows larger and larger. In perfect competition the
requirement that the firms are many and small
prevents them from growing to a size large enough
to take advantage of economies of scale.
· Lack of product variety All firms within an industry
produce identical or undifferentiated products. This
is a disadvantage for consumers, who tend to prefer
product variety.
Chapter 5: Theory of the firm II 125
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· Waste of resources in the process of long-run adjustment
It is possible that the continuous opening and
closing of firms as the industry adjusts to changes in
demand, resource prices and technology in the long
run may lead to a waste of resources.
· Limited ability to engage in research and development
The lack of economic profits in the long run may
be a major constraint on engaging in research and
development, as firms have limited resources to
devote to this activity.
· Market failure Even if it were possible to meet all of
the assumptions of the perfectly competitive market
model, there are many situations that arise in the
real world leading to a less than ‘best’ (this is known
as suboptimal) allocation of resources, because
of market failures. Market failures arise when the
actions of consumers or producers have unintended
side-effects that impact on third parties, or parties
outside the market. Market failures will be the
subject of Chapter 6.
Test your understanding 5.4
1 Why do you think we study the perfectly
competitive market model extensively, when
there are only very few industries in the
real world that tend to meet the unrealistic
assumptions of this model?
2 What do we mean by (a) productive efficiency,
and (b) allocative efficiency? (c) Using
appropriate diagrams, show how the perfectly
competitive firm achieves both productive and
allocative efficiency in long-run equilibrium.
(d) Show diagrammatically which of these
two conditions is not likely to be achieved
in the short run. (e) How would you show
the achievement of economic (allocative
and productive) efficiency for the perfectly
competitive industry?
3 How do you think the achievement of
productive and allocative efficiency are related
to the definition of Economics that we discussed
in Chapter 1 (Section 1.1, page 3)?
4 Evaluate the perfectly competitive market model
by referring to the insights it offers and its
limitations.
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Part 2: Microeconomics
5.2 Monopoly
Assumptions of the model
The model of monopoly rests on the following
assumptions:
· There is a single seller The term monopoly is derived
from the Greek work meaning ‘single seller’. When
there is a single firm producing a good or service
for the entire market, it is called a pure monopoly.
The firm is therefore the entire industry. (In the real
world, a monopolistic industry may consist of one
firm that dominates the market with a very large
market share. For example, DeBeers Company of
South Africa controls over 80% of diamond sales,
and is considered to be a monopoly.)
· There are no close substitutes If substitute goods
existed, then consumers could easily switch to
buying a substitute good, in which case there would
no longer be a monopoly for the good in question.
Therefore the monopolist produces a good or service
that has no close substitutes.
· The monopolist is a price-maker In contrast to
perfectly competitive firms, which are pricetakers (accepting the price that is determined in
the market), the monopolist exercises substantial
power to influence the price at which it sells its
good, and is therefore called a price-maker. Since
the monopolist is the entire industry, it faces a
downward-sloping demand curve (the industry or
market demand curve). Therefore, by choosing a
level of output to produce, it also determines the
price at which this output will be sold. (This will be
further explained below.)
· There are significant barriers to entry The monopolist
owes its dominance in the market and the absence
of competitor firms to the inability of other firms
to enter the industry. Anything that prevents other
firms from entering the industry is called a barrier
to entry (also defined in Chapter 2, page 29).
Monopoly lies at the opposite extreme of market
structures to perfect competition. As a single seller, the
monopolist faces no competition from other firms and
it has substantial market power (the ability to control
price; see Figure 2.1). Yet a pure monopoly is quite rare
in the real world. Like perfect competition, it is studied
because of the insights it offers into the ability of firms
to exercise market power, also known as monopoly
power. Monopoly power arises whenever a firm faces
a demand curve that is downward-sloping. As we will
see throughout the rest of this chapter, firms in all
market structures except perfect competition face a
downward-sloping demand curve, and therefore have
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Barriers to entry
There are several kinds of barriers to entry.
Economies of scale
Economies of scale result in the downward-sloping
portion of a firm’s long-run average total cost curve,
and permit lower average costs to be achieved as
the firm increases its scale or size (see Chapter 4,
page 103). A barrier to entry exists when economies
of scale are extensive and the LRATC curve declines
over a very large range of output. In Figure 5.9(a) it
can be seen that the average total costs incurred by a
large firm on SRATC1 are substantially lower than the
average costs faced by a smaller firm on SRATC2. The
large firm will be able to remain in business, because
it can charge a lower price than the smaller firm and
force the smaller firm into a situation where it will not
be able to cover its costs. Therefore, if a new firm tries
to enter the industry on a small scale it will be unable
to compete with the larger one due to its higher
average costs.
Figure 5.9(b), at the point where market demand, D,
intersects the LRATC curve, LRATC is still declining,
meaning that economies of scale have not yet been
fully exhausted and the minimum efficient scale
occurs at a higher level of output. (The minimum
efficient scale, you may remember from Chapter 4,
page 104, is the lowest level of output at which lowest
average total costs are achieved.) As output increases,
average costs (or costs per unit of output) fall, and
keep on falling even beyond the point where the
entire market demand for the product is satisfied. A
market like this cannot support more than one firm.
Natural monopoly acts as a strong barrier to entry
of new firms into the industry because potential
entrants realize that it would be extremely difficult
to attain the low costs of the already existing firm.
Examples of natural monopolies include water, gas
and electricity distribution, cable television, fire
protection and postal services. The falling average
costs over a very large range of output often occur
because of very large capital costs (such as laying pipes
for water distribution, or laying cables for electricity
distribution, or putting a satellite into orbit).
(b) Natural monopoly.
(a) Economies of scale.
SRATC2
SRATC1
LRATC
0
Q
costs
varying degrees of monopoly power, or the ability to
influence the price at which they sell their output.
We therefore study monopoly not only to better
understand those markets where firms come close to
meeting the conditions of pure monopoly, but also to
familiarize ourselves with some of the issues relating
to the market structures lying between the extremes of
perfect competition and pure monopoly.
costs
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0
LRATC
D
minimum
efficient
scale
Q
On the other hand, a new firm attempting to enter
the market on a very large scale so as to be able to
take advantage of the economies of scale would
encounter huge start-up costs, and would be unlikely
to take the risk involved. As we will see later in this
chapter, economies of scale form a significant barrier
to entry in the case not only of monopolies but also of
oligopolies.
Figure 5.9 Economies of scale and natural monopoly as a barrier
to entry.
Natural monopoly
· patents, which allow a firm that has developed a
A natural monopoly is illustrated in Figure 5.9(b).
If the market demand for a product is within the range
of falling LRATC, this means that a single large firm
can produce for the entire market at a lower average
total cost than two or more smaller firms. When this
occurs, the firm is called a natural monopoly.
Note that there are two factors at work making for
a natural monopoly: costs and market demand. In
Legal barriers
Legal barriers include:
new product or invention to be its sole producer for
a specified period of time; for that period, the firm
producing the patented product has a monopoly on
that particular product; examples include patents on
new pharmaceutical products; Polaroid and instant
cameras, Intel and microprocessor chips used by
IBM computers
· licences, granted by governments, for particular
professions or particular industries; licences may be
required, for example, to operate radio or television
stations, or to enter a particular profession (such as
medicine, dentistry, architecture, law and others);
Chapter 5: Theory of the firm II
127
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such licences do not usually result in a monopoly
but they do have the impact of limiting competition
· copyrights, which guarantee that an author (or an
author’s appointed person) has the sole rights to
print, publish and sell copyrighted works
The demand and revenue curves under
monopoly
The demand curve facing the monopolist
· public franchises, which are granted by the
government to a firm which is to produce or supply
a particular good or service
· tariffs, quotas and other trade restrictions, which limit
the quantities of a good that can be imported into a
country, thus reducing competition.
Note that not all of these legal barriers lead to
monopoly. What they all have in common, instead,
is that they limit competition, and in so doing
contribute to the creation of some degree of monopoly
power.
Control of essential resources
Monopolies can arise from ownership or control
of an essential resource. A classic example of an
international monopoly is DeBeers, the South African
diamond firm, that mines roughly 50% of the world’s
diamonds and purchases about 80% of diamonds sold
on open markets. Whereas it is not the sole diamond
supplier, its large market share allows it to have a
significant control over the price of diamonds. On a
national level, an example is Alcoa (the Aluminum
Company of America), which, following the expiration
of patents in 1909, was able to maintain its monopoly
position on the production of aluminium within the
United States until the Second World War, because of
its control of almost all the bauxite resources within
the country. On a local level, professional sports
leagues create a local monopoly by signing long-term
contracts with the best players and securing exclusive
use of sports stadiums. A local monopoly is a single
producer/supplier within a particular geographical
area. Local monopolies appear more commonly
than national or international ones. For example,
a local grocery store in a residential area located
some distance from any other stores may be a local
monopoly.
Aggressive tactics
If a monopolist is confronted with the possibility of
a new entrant into the industry, it can create entry
barriers by cutting its price, advertising aggressively,
threatening a takeover of the potential entrant, or any
other behaviour that can dissuade a new firm from
entering the market.
128
Part 2: Microeconomics
Since the pure monopolist is the entire industry,
the demand curve it faces is the industry or market
demand curve, which is downward sloping. This is the
most important difference between the monopolist
and the perfectly competitive firm, which faces
perfectly elastic demand at the price level determined
in the market.
The two demand curves shown in Figure 5.10 indicate
that the perfectly competitive firm is a price-taker with
zero market power, while the monopolist is a pricemaker with a significant degree of market power.
All firms under market structures other than perfect
competition are to varying degrees price-makers,
as they all face downward-sloping demand curves.
Of these, the monopolist has the greatest degree of
market power, or the ability to influence price, because
it is the sole firm in the industry.
However, whereas the monopolist has a significant
degree of control over price, its control is limited
by the position of the market demand curve. Given
a market demand curve such as that shown in
Figure 5.10(b), when it chooses how much output
to produce, say Q1, it simultaneously determines the
price at which the good can be sold, which in this
case is P1. It could not possibly sell output Q1 at a price
such as P2; note that the price–quantity combination
P2 and Q1 is at point a, which lies off the demand
curve. If it wants to sell its output at price P2, it can do
so, but it will only be able to sell quantity Q2 at that
price. In other words, the monopolist cannot make
independent decisions on both price and quantity;
when it decides on one, P or Q, this simultaneously
determines the other, because of the constraining
effect of the demand curve. To say the same thing
differently, the monopolist cannot choose any
price–quantity combination that is not on the market
demand curve.
HL
· Average revenue (shown in column 5 of Table 5.2) is
HL
(a) Facing the perfectly
competitive firm.
(b) Facing the monopolist.
P
P
P2
P=D
0
equal to price (shown in column 2 of the table):
TR
since TR = P × Q, and AR is , it follows that P must
Q
be equal to AR.
· The AR and P curves represent the demand curve
a
facing the firm.
P1
· MR is less than P, represented by the demand
D
Q
0
Q2
Q1
Q
Figure 5.10 Demand curves.
The monopolist’s revenue curves
Under perfect competition where the firm is a pricetaker, the market-determined price is constant for all
levels of output, giving rise to the perfectly elastic
(horizontal) demand curve. But when a firm faces a
downward-sloping demand curve, it is no longer true
that price is constant for all levels of output that can
be produced by the firm. When the demand curve is
downward sloping, if the firm wants to sell a greater
quantity of output, it must lower its price. Since total
revenue is equal to price times quantity sold
(TR = P × Q), the variability of price as output changes
means that the firm facing a downward-sloping
demand curve has revenues and revenue curves
that are very different from those of the perfectly
competitive firm. Table 5.2 provides some hypothetical
data for the monopolist’s total, marginal and average
revenues, and the diagrams in Figure 5.11 plot these
data.
Observing Table 5.2 and Figure 5.11, we may note the
following:
· As output (Q) increases, product price (P) falls
(because of the downward-sloping demand curve).
Total revenue (TR), obtained by Q × P, at first
increases, reaches a maximum at six and seven
units of output, and then begins to fall.
· Marginal revenue, showing the change in total
revenue resulting from a change in output, falls
continuously; MR is equal to zero when total
revenue is at its maximum (at seven units of
output), and becomes negative when total revenue
falls. Since total revenue begins to fall beyond seven
units of output, marginal revenue, showing the
change in total revenue, must be negative.1
1
Marginal revenue represents the slope of the total revenue curve (just as
marginal cost is the slope of the total cost curve).
2
To understand this, consider the following numerical example. Say output
increases from 3 to 4 units. Marginal revenue will be the result of a gain
curve; in other words the MR curve lies below the
demand curve (except the first unit of output). The
reason is that, unlike in perfect competition, where
MR = P, here the firm must lower its price in order
to sell more output. The lower price is charged not
only for the last unit of output but all the previous
units of output sold. Marginal revenue, or the extra
revenue from selling an additional unit of output, is
therefore equal to the amount of the price of the last
unit sold minus what is lost by selling all the other
units of output at the now lower price.2
Table 5.2 Total, marginal and average revenue when price varies with
output.
(1)
Units of
output
(Q)
(2)
(3)
(4)
Product
Total
Marginal
price
revenue
revenue
(P)
(TR = Q × P)
Δ TR
MR =
(¤)
(¤)
ΔQ
(¤)
0
1
2
3
4
5
6
7
8
9
10
12
11
10
9
8
7
6
5
4
3
12
22
30
36
40
42
42
40
36
30
12
10
8
6
4
2
0
-2
-4
-6
(5)
Average
revenue
TR
AR =
Q
(¤)
12
11
10
9
8
7
6
5
4
3
The monopolist’s output and price
elasticity of demand
In Table 5.2 and Figure 5.11, in the range of output
where total revenue is increasing and marginal
revenue is positive, the demand curve facing the firm
(represented by P = AR) is price elastic (PED > 1); in
the range of output where total revenue is falling and
marginal revenue is therefore negative, the demand
curve is price inelastic (PED < 1). To see why this is
so, recall from Chapter 3, page 69, the relationship
between PED and total revenue. When demand is
and a loss. The gain is €9, obtained from selling the fourth unit of output
at the price of €9. The loss is equal to €1 for each of the initial 3 units of
output that previously were selling for €10 and must now sell for €9, equal
to €3. Marginal revenue is equal to the gain minus the loss, or 9 − 3 = 6.
Chapter 5: Theory of the firm II
129
HL
HL
The above observations have some important
implications for the level of output produced by the
monopolist.
total revenue ( )
(a) Total revenue.
40
35
30
25
20
15
10
5
0
The monopolist will not produce any output in the
inelastic portion of its demand curve.
TR
1 2 3 4 5 6 7 8 9 10 11
Q
(b) Marginal and
average revenue.
price, revenue ( )
15
PED > 1
(elastic
demand)
PED = 1
(unit elastic demand)
Test your understanding 5.5
PED < 1
(inelastic
demand)
10
1 What are the assumptions defining the market
model of monopoly?
5
P = AR = D
0
1 2 3 4 5 6 7 8 9 10 11
Q
-5
MR
Figure 5.11 Revenue curves under monopoly.
elastic, price and total revenue change in opposite
directions (so that a percentage decrease in price
gives rise to a larger percentage increase in quantity
demanded and total revenue rises); when demand is
inelastic, price and total revenue change in the same
direction (a percentage decrease in price gives rise to
a smaller percentage increase in quantity demanded,
and total revenue falls). These relationships can be
seen in Figure 5.11. Price decreases shown in panel (b)
from €12 to €6 (along the demand curve) correspond
to positive marginal revenue, as well as increasing
total revenue in panel (a); therefore in this price range
demand is elastic. Price decreases beyond €6 (along
the demand curve) correspond to negative marginal
revenue, shown in panel (b), and falling total revenue,
shown in panel (a). Another way to see the same thing
is to remember (from Chapter 3, page 66) that the
PED varies along a straight-line demand curve, with
the upper left segment being elastic, the midpoint
being unit elastic, and the lower right segment being
inelastic. In Figure 5.11(b), the point where PED = 1
occurs at the level of output where total revenue is
maximum, and MR = 0.
130
Part 2: Microeconomics
In Figure 5.11(b), the monopolist will not produce
any output greater than seven units, which is where
TR is maximum and MR = 0. If it did, its total revenue
would fall, while its total cost would increase (since
greater output always involves more cost). Since
profit = TR − TC, a lower TR and a higher TC mean
lower profit.
2 Explain how (a) economies of scale and
(b) natural monopoly can result in a
monopolistic market structure by posing
barriers to entry. Use diagrams and examples
to illustrate your answers.
3 Why is the size of a market important in
determining whether a monopoly is ‘natural’ or
not?
4 How can legal factors provide barriers to entry
into an industry? Provide some examples.
5 (a) Compare and contrast the demand curve
facing the perfectly competitive firm and
that facing the monopolist. (b) What is the
relationship between market power and the
differences between the two demand curves?
(c) Why is one firm a ‘price-taker’ and the other
a ‘price-maker’?
6 Explain why P = MR in perfect competition, and
both of these coincide with the demand curve
facing the firm, whereas in monopoly, MR < P
for all units of output (except the first), and
therefore the MR curve lies below the demand
curve.
7 (a) Explain the relationship between the
monopolist’s average revenue (AR) and marginal
revenue (MR). (b) How are they related to
product price? (c) How are they related to the
demand curve facing the firm?
(...continued)
HL
HL
Test your understanding 5.5
(...continued)
8 Show diagrammatically the relationship
between total revenue (TR), marginal revenue
(MR), and demand (D) for a monopolistic firm.
TC
b
TR
9 Why will the monopolist avoid producing in
a
the inelastic portion of its demand curve? Use
diagrams to support your answer.
10 What is the maximum level of output that a
monopolist might consider producing? What
would the monopolist be maximizing at this
level of output? Use diagrams to support your
answer.
HL
(a) Profit maximization.
TC,
TR
0
Q
Q
max
(b) Loss minimization.
TC
TC,
TR
Profit maximization by the monopolist
The identical principles govern the profit-maximizing
behaviour of the monopolist as that of the perfectly
competitive firm; what differs between the two in
the analysis of profit maximization are the shapes
of their respective demand and revenue curves.
The monopolist therefore follows the same profitmaximizing rules: maximize the difference between
TR and TC in the total revenue and cost approach; or
find the point of equality between MC and MR in the
marginal revenue and cost approach.
Profit maximization based on the total
revenue and cost approach
The diagrams in Figure 5.12 show the standard total
cost curve derived in Chapter 4, page 99 (which
applies equally to firms under all market structures).
In addition, they show the total revenue curve shown
in Figure 5.11(a) above. Panel (a) illustrates the case of
a profit-making firm, whereas the firm in panel (b) is
making a loss.
Profit is maximized when the difference between TR
and TC is largest; this occurs at output level Qπmax,
where the difference between TR and TC is maximum.
The amount of profit made by the firm is given by the
vertical difference between TR and TC at Qπmax.
TR
0
Q
Figure 5.12 Profit maximization and loss minimization under monopoly:
total revenue and cost approach.
In Figure 5.12(b), there is no level of output for which
TR > TC; instead, TC > TR for all output levels; therefore
the firm can only make a loss. Output level Qlmin shows
the level of output where the firm’s loss is minimized,
and the amount of loss is represented by the smallest
difference between TC and TR.
Profit maximization based on the
marginal revenue and cost approach
The monopolist interested in maximizing profit
(or minimizing loss) will follow the same two-step
approach used by the perfectly competitive firm.
The monopolist, like the perfectly competitive firm,
will determine the profit-maximizing level output
by use of the MC = MR rule. Then, for that level of
output, it will determine whether it is making a profit
or loss by use of the principle that
profit
Note that at the points where the TC curve intersects
the TR curve, points a and b, TR = TC, and economic
profit is equal to zero (at these points, the firm would
be earning normal profit).
Ql min
Q
= P − ATC
If P > ATC, the monopolist is making a profit; if
P = ATC it is earning normal profit (zero economic
profit); if P < ATC it is making a loss.
Chapter 5: Theory of the firm II
131
Let’s consider these steps in more detail by examining
Figure 5.13. Both panels (a) and (b) of the figure
show the standard ATC and MC curves (derived
in Chapter 4, page 99). On these cost curves, the
monopolist’s demand and marginal revenue curves are
superimposed. Consider first panel (a).
the demand curve at output level Qlmin. Loss per unit
of output (loss/Q) is given by ATC − P (the distance
c–d), and total loss is given by the shaded area, found
by multiplying loss per unit of output by the total
number of units produced.
· We first find the point of intersection between MR
Just as in perfect competition, the loss-making
monopolist will continue to produce in the short run
as long as its losses are smaller than its fixed costs (i.e.
as long as P > minimum AVC). In the long run (when
all resources are variable), the loss-making monopolist
is likely to shut down or move its resources to
another more profitable industry. However, the
distinction between the short run and the long run
is not as important in the case of monopoly as it is
in perfect competition. Under perfect competition,
the distinction between the short and long runs is of
crucial importance because as firms enter and exit an
industry, economic profits and losses disappear, and
firms are left with normal profits in their long-run
equilibrium.
and MC, or where MR = MC, which determines the
profit-maximizing level of output, Qπmax.
· For that level of output, Qπmax, we draw a vertical
line upward to the AR (or demand) curve (point a)
and from there extend a horizontal line leftward to
the vertical axis; this will determine the price, Pe, at
which the monopolist will sell output Qπmax.
· For the output level Qπmax, we then find profit per
unit (profit/Q), given by P − ATC; this is simply the
vertical difference between the average revenue (or
demand curve) and the ATC curve, represented by
the vertical distance between points a and b.
· To find total profit, we multiply profit per unit times
the total number of units produced; this is given by
profit =
profit
Q
×Q
and is represented by the shaded area.
The monopolist need not always make profits. Yet
how is it that a monopolist, being a price-maker, can
incur losses? This can happen simply because the price
that the monopolist can charge is always constrained
by the industry demand curve, as explained earlier. If
the costs faced by the monopolist are high relative to
demand, and price cannot cover ATC, losses will be
inevitable. This is shown in Figure 5.13(b), where the
monopolist is minimizing loss. At the level of output
Qlmin, determined by the point of intersection between
MR and MC (where MR = MC), the monopolist’s loss
will be minimized. The price that will be charged
is given by Pe, found by extending a line upward to
(a) Profit maximization.
Under monopoly, high barriers to entry prevent
potential competitor firms from entering a profitmaking industry, and the monopolist can therefore
continue making economic profits indefinitely in the
long run.
Revenue maximization by the monopolist
In Chapter 4, we saw that whereas the standard theory
of the firm assumes that firm behaviour is governed by
the goal of profit maximization, alternative theories
of firm behaviour argue that firms may pursue other
goals instead. One of these is the goal of revenue
maximization. If a firm attempts to maximize revenue
(rather than profit), how much output will it produce?
(b) Loss minimization.
Pe
profit
0
MC
a
ATC
b
Q
MR
max
D = AR
Q
price, costs, revenue
MC
price, costs, revenue
HL
c
d
Pe loss
0
MR
Ql min
Figure 5.13 Profit maximization and loss minimization under monopoly: marginal revenue and cost approach.
132
Part 2: Microeconomics
ATC
D = AR
Q
HL
The answer to this question can be seen in Figure 5.11
above. In panel (a), we can see that total revenue (TR)
is maximum when seven units of output are produced.
This corresponds to the point where marginal revenue
(MR) is equal to zero in panel (b). Therefore the
revenue-maximizing monopolist produces that level of
output where MR = 0.
A comparison of the profit-maximizing firm with the
revenue-maximizing firm will reveal that the revenue
maximizer will produce a larger quantity of output
and sell it at a lower price than the profit maximizer. If
you examine Figure 5.13(a), showing the equilibrium
position of a profit-maximizing monopolist, you will
notice that the profit-maximizing level of output,
which occurs where MC = MR, lies to the left of
the level of output where MR = 0. Also, in view of
the downward-sloping demand curve facing the
monopolist, the higher level of output produced
where MR = 0 must be sold at a lower price than
Pe, which is the price of the profit-maximizing
monopolist.
Test your understanding 5.6
1 (a) What are the profit-maximizing rules used
by the monopolist in the total revenue and cost
approach, and in the marginal revenue and cost
approach? (b) Do they differ from those used by
the perfectly competitive firm?
2 How does the profit-making monopolist
determine (a) the price at which output will be
sold; (b) whether the firm is earning economic
profit, normal profit, or incurring a loss? (c) Is
there any difference in methods used by the
perfectly competitive firm and the monopolist to
determine profits or losses?
(...continued)
(a) Industry in perfect competition.
Test your understanding 5.6
monopolist (a) earns economic profit (show
profit per unit and total profit); (b) earns normal
profit; (c) incurs losses (show loss per unit and
total loss).
4 Why can a monopolist continue to earn
economic profits in the long run?
Evaluating monopoly and comparing with
perfect competition
Criticisms of monopoly
Higher price, lower output by the
monopolist compared to the industry in
perfect competition
A comparison of monopoly with perfect competition
at the level of the industry reveals that price is higher
and quantity of output produced lower in monopoly
than in a perfectly competitive industry. Figure 5.14
shows the long-run equilibrium positions of a perfectly
competitive industry, composed of many small firms,
and of a monopoly, which is the entire industry.
Panel (a) shows the standard market demand (= MB
or marginal benefit) and supply (= MC or marginal
cost) curves for the perfectly competitive industry,
determining the equilibrium price and quantity, Ppc
and Qpc. The equilibrium position of this industry is
given by point a, or the point of point of intersection
of the industry demand and supply curves.
(b) Monopoly.
MC
a
P = MRpc
D = MB
0
Qpc
Q
price, costs, revenue
Ppc
HL
(...continued)
3 Show diagrammatically the case where a
S = MC
price, costs, revenue
HL
Pm
b
a
Ppc
D = MB
0
Qm
Qpc
Q
MRm
Figure 5.14 Lower output and higher price under monopoly.
Chapter 5: Theory of the firm II
133
HL
Now let’s suppose that the numerous small firms in
the perfectly competitive industry of panel (a) are
bought up by one firm, so that what was a perfectly
competitive industry becomes a monopoly, shown
in panel (b). The MC curve of panel (a), or what was
the competitive industry’s supply curve (equal to the
sum of all the individual firm supplies, or MC curves),
is now the monopolist’s marginal cost curve. The
demand curve remains unchanged, but this demand
curve takes on a different significance. Under perfect
competition, each firm was faced by a perfectly elastic
demand curve at the price level Ppc, and the firm’s
marginal revenue was equal to price (MRpc = Ppc).
But the monopolist is faced with the entire industry
demand curve, D, and therefore its marginal revenue
(MRm) curve now lies below D. When the monopolist
applies the MR = MC rule to determine the profitmaximizing level of output, the result is Qm output;
and given the demand curve that determines price for
each level of output, the equilibrium price is Pm.
Since Qm < Qpc, the industry under monopoly produces
a smaller quantity of output than the industry
under perfect competition. And since Pm > Ppc, the
monopolist sells output at a higher price than the
perfectly competitive industry. Higher prices and
lower output go against consumers’ interests.
Impacts on consumer and producer
surplus, and deadweight loss
The lower output and higher price of the monopolist
have important implications for consumer and
producer surplus. As you may remember from our
earlier discussion, the perfectly competitive industry
is economically efficient because the sum of consumer
and producer surplus is maximum. In monopoly,
this condition no longer holds, and the industry is
therefore inefficient. This can be seen in Figure 5.15,
which is the same as Figure 5.14, only consumer
and producer surplus are now shown for both the
perfectly competitive industry and the monopoly.
In panel (a), triangle A represents consumer surplus,
while triangle B is producer surplus. Panel (b) shows
the inefficiencies that result in monopoly. Note the
following:
· Triangle C, representing consumer surplus in
monopoly, is smaller than triangle A in perfect
competition. There are two reasons for this. One is
that the higher price of the monopolist (Pm rather
than Ppc) has cut into consumer surplus and reduced
it. The other is that the lower quantity produced by
the monopolist (Qm rather than Qpc) has cut another
portion of consumer surplus, shown as triangle E.
· The area D, representing producer surplus in
monopoly shows that producer surplus has
increased by taking away a portion of consumer
surplus (due to the monopolist’s higher price), and
it has also decreased by losing the triangle F (due to
the monopolist’s lower quantity).
· The sum of triangles E + F represents deadweight
loss, defined as the loss of total (consumer and
producer) surplus due to a higher price and lower
quantity.
The presence of deadweight loss in monopoly
indicates that there is economic inefficiency: the sum
of consumer plus producer surplus is less in monopoly
compared to perfect competition by the amount of
the deadweight loss. Moreover, the monopolist gains
at the expense of consumers as a portion of consumer
surplus is converted into producer surplus.
(a) Perfect competition.
P
Ppc
(b) Monopoly.
S = MC
A
consumer
surplus
P
Pm
producer
surplus
B
Qpc
Q
MC
C
D
E
F
deadweight loss
producer
surplus
D = MB
0
consumer
surplus
0
Qm
D = MB
Qpc
MRm
Figure 5.15 Consumer and producer surplus and deadweight loss in monopoly, and comparison with perfect competition.
134
Part 2: Microeconomics
Q
HL
MC
ATC
Pe
0
Qpe
HL
(b) Monopoly.
price, costs, revenue
(a) Perfectly competitive firm.
price, costs
HL
MC
Pe
D
0
Q
at long-run equilibrium
Pe = min ATC (productive efficiency)
Pe = MC (allocative efficiency)
ATC
Qm
Q
MR
at long-run equilibrium
Pe > min ATC (productive inefficiency)
Pe > MC (allocative inefficiency)
Figure 5.16 Allocative and productive efficiency in perfect competition and monopoly
Allocative and productive inefficiency
In the above discussion we compared the equilibrium
positions of perfect competition and monopoly at the
level of the industry. We will now see how economic
inefficiency can be explained at the level of the
individual firm. Figure 5.16, showing the long-run
equilibrium position of the firm in perfect competition
and monopoly, indicates that, unlike the perfectly
competitive firm, the monopolist does not achieve
allocative or productive efficiency.
The condition for allocative efficiency is given by
P = MC at the profit-maximizing level of output (as
explained on page 124). At the profit-maximizing
level of output Qm, the monopolist’s price, Pe, is higher
than marginal cost, and therefore there is allocative
inefficiency and a misallocation of resources. The fact
that P > MC means that some consumers place a greater
value on the production of the good than it costs the
monopolist to produce it.
In monopoly there is an underallocation of resources
to the good; too few resources are being used to
produce it, too little is produced and there is therefore
allocative inefficiency, since P > MC at the profitmaximizing level of output.
The condition for productive efficiency is given by
P = minimum ATC at the profit-maximizing level
of output (as explained on page 124). Figure 5.16
indicates that the monopolist does not achieve
productive efficiency. At the profit-maximizing level
of output, Qm, the monopolist’s price, Pe, is higher
than minimum ATC, therefore there is productive
inefficiency. The output produced by the monopolist,
Qm, is not at the point of minimum ATC.
The monopolist produces at higher than minimum
average total cost, and there is therefore productive
inefficiency, shown by P > minimum ATC at the profitmaximizing level of output.
Lack of competition may give rise to higher
costs
Whereas in perfect competition firms are under
constant pressure to produce with the lowest possible
costs in order to survive, under monopoly the absence
of competitor firms may result in higher costs for
many possible reasons such as a poorly
motivated workforce, lack of innovation and use of
new technologies, poor management, or avoidance
of risk. The possibility of making and maintaining
economic profits over the long run due to the presence
of barriers that prevent the entry of competitors
can make the monopolist less concerned about
keeping costs as low as possible. This is known as Xinefficiency, defined as producing at a higher than
necessary ATC. Note that this is a separate issue from
the lack of productive efficiency noted above. Lack
of productive efficiency means that while the firm
does not produce at the point of minimum ATC, it
does produce at some point on the ATC curve. Xinefficiency indicates that the firms’ costs are higher
than ATC, as shown in Figure 5.17 (page 136).
Chapter 5: Theory of the firm II
135
HL
HL
minimum ATC (prod. efficiency)
ATC
costs
costs > ATC (X-inefficiency)
ATC > minimum ATC (prod. inefficiency)
0
Q
Figure 5.17 X-inefficiency in monopoly.
Possibly not technologically innovative
The presence of economic profits over the long
run enables monopolists to engage in research and
development (R&D) in the quest for new products
and new technologies, yet it is possible that the lack
of competition deprives them of incentives to pursue
such activities aggressively. Under perfect competition,
by contrast, firms are under constant pressure to
innovate technologically so that they can outperform
their competitors, yet the normal profits they earn
over the long run do not allow them to finance major
R&D activities.
Negative impacts on the distribution of
income
The persistence of economic profits over the long
run is another key criticism of monopolies. This
problem clearly does not arise in perfect competition.
Since monopolies charge higher prices than perfectly
competitive firms, this involves a distribution of
income away from consumers (who must pay the
higher prices) and toward the owners of the monopoly
(in the form of economic profits).
Benefits of monopoly
When a monopoly can achieve substantial economies
of scale, it is even possible that its lower costs will
permit price and output levels that approach those of
a perfectly competitive industry.
This is shown in Figure 5.18, where Qm and Pm are
the output and price of the standard monopolist,
and Qpc and Ppc are the output and price of the
perfectly competitive industry. Let’s say now that
the monopolist succeeds in achieving significant
economies of scale, so that its costs fall, and its MC
curve shifts downward to MCes. The intersection of
MCes with the monopolist’s MR curve determines
the profit-maximizing level of output, Qpc, which is
identical to that of the perfectly competitive industry.
Moreover, the monopolist will sell output Qpc at price
Ppc, which is the price of the perfectly competitive
industry. Note that if the MCes curve was even lower,
then the monopolist would produce a larger quantity
of output and sell it at a lower price than the perfectly
competitive industry.
Consumers can therefore gain from economies of scale
because lower costs of production translate into lower
prices, as well as the increased quantity of output.
Society as a whole also gains because lower costs of
production mean increased efficiency in the use of
resources.
By contrast, a perfectly competitive firm, due to its
very small size, cannot capture economies of scale.
P
Economies of scale
Pm
In the beginning of this section we saw that
economies of scale are a major barrier to entry in the
case of monopoly, particularly in the case of a natural
monopoly. Economies of scale lead to falling average
costs over a large range of output and firm scale,
and when there is a natural monopoly average costs
may continue to fall even at the level of output that
satisfies market demand.
Ppc
Extensive economies of scale are a major argument in
favour of large firms that can achieve lower costs as
they grow in size.
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MC
MCes
D
0
Qm Qpc
Q
MRm
Figure 5.18 Economies of scale leading to lower price and greater
quantity produced by the monopolist.
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Product development and technological
innovation
Perfect competition and monopoly as
guides to understanding the real world
It was noted earlier that the protection offered to
monopolies by high barriers to entry, shielding them
from competition, could make them less likely to
innovate than small firms that are continuously
subject to the pressures of competition. Yet there are
also arguments suggesting that monopolies have good
reasons to be more innovative than small competitive
firms. First, their economic profits provide them with
the ability to finance large research and development
(R&D) projects. Second, protection from competition
due to high barriers to entry arguably favours
innovation and product development, by offering
firms the opportunity to enjoy the profits arising
from their innovative activities (new inventions, new
products, new technologies, etc.); this, after all, is the
rationale of awarding firms patent protection for a
period of time. Third, it is possible that firms may use
product development and technological innovation as
a means of creating barriers to entry for new potential
rivals; if a firm can develop a new product that
potential rivals are unable to produce, the rivals may
be less likely to try to enter the industry and compete
with the innovating firm.
While both these models are unrealistic
representations of the real world, they serve as
powerful analytical tools for understanding and
evaluating real-world situations, as well as for helping
governments prescribe policy measures to deal with
issues in the industrial sector.
Possibility of greater efficiency and lower
prices due to technological innovations
In the event that monopolies successfully engage in
R&D that leads to technological innovations, they
may adopt production processes and new technologies
that can make them more efficient (i.e. able to produce
at a lower cost), and some of these lower costs could
be passed to consumers in the form of lower prices.
Small, competitive firms have limited abilities to
innovate and develop new technologies.
Monopoly and government regulation
Whereas monopoly may offer some potential
benefits to society, there is general agreement
among economists that its disadvantages outweigh
its advantages. The absence of competition, higher
prices, lower quantity of output produced, productive
and allocative inefficiencies, higher than necessary
costs and negative impacts on income distribution
are held to be detrimental to society. Therefore most
countries around the world do not encourage private
monopolies. In the event that there are natural
monopolies, these are usually owned or regulated by
the government, so that they will not be permitted
to engage in behaviour that goes against society’s
interests.
HL
The model of perfect competition is the basis of an
idealized free market economy, where price is the
rationing system that supplies answers to the what,
how and for whom questions. The market and the
price mechanism are the means by which allocative
and productive efficiency can be achieved, thereby
avoiding waste of resources, and allowing people to
achieve mutually advantageous outcomes.
The model of monopoly, on the other hand, reveals
the consequences of restrictions of competitive
forces at the extreme. Whereas pure monopolies are
rare in the real world, the monopoly model sheds
light on the behaviour of firms under conditions of
limited competition. We will therefore return to the
topics discussed above in our discussion of the two
structures that lie in between perfect competition and
monopoly: monopolistic competition and oligopoly.
Test your understanding 5.7
1 Using an appropriate diagram, show whether
or not the monopolist achieves (a) productive
efficiency, and (b) allocative efficiency.
2 Use the concepts of consumer and producer
surplus and deadweight loss to show economic
inefficiency of monopoly.
3 Why do you think monopoly as a market
structure, and monopolistic power generally,
come under heavy criticism and are held to be
against the society’s best interests?
4 What are some potential benefits of monopolies?
5.3 Monopolistic competition
Assumptions of the model
The model of monopolistic competition is based on
the following assumptions:
· There is a large number of firms This assumption is
similar to that of perfect competition, where the
large firm number ensures that each firm has a
Chapter 5: Theory of the firm II
137
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small share of the market, and that each firm acts
independently of the others. Moreover, the large
number of firms ensures that collusion (agreement
to act together so as to secure market power) is
not possible. However, though large, the number
of firms may not be quite as large as in perfect
competition.
· There is relatively free entry and exit This assumption
is also similar to perfect competition in that there
are no significant barriers to entry of new firms into
the industry.
· There is product differentiation Unlike
in perfect competition, where firms within an
industry produce and sell an identical product, in
monopolistic competition each firm produces and
sells a product that is different from any other.
Product differentiation can be achieved in a number
of ways:
❍
❍
❍
❍
❍
physical differences: products may differ in size,
shape, materials, texture, taste, packaging, etc.
(think, for example, of the variety of clothes,
shoes, books, processed foods, furniture)
quality differences: over and above their physical
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, for example,
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, purchase terms, and others
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, drycleaners, petrol (gas) stations, restaurants.
Product differentiation and the demand curve
Elements of competition and monopoly
As the term ‘monopolistic competition’ suggests,
this market structure combines elements of both
competition and monopoly. It resembles perfect
competition in that there are many firms in the
industry and that there is freedom of entry and exit.
It is like monopoly, on the other hand, because of
product differentiation. The reason is that 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 5.19. Let’s examine this idea more
closely.
In perfect competition, we know that if a firm raises
its price, it will lose all its sales to its competitors
(Figure 5.19(a)). In monopoly, if a firm raises its
price, it will lose some but not all sales, as it is the
sole producer of the good, and consumers have
no alternative product to which they can turn
(Figure 5.19(b)). In monopolistic competition
(Figure 5.19(c)), if a firm raises its price, it will lose
more sales than the monopolist, because consumers
now do have substitute products that they can
purchase instead; but it will not lose as many sales
as the perfectly competitive firm because of product
differentiation
(a) Perfect competition.
(b) Monopoly.
(c) Monopolistic competition.
P
P
P
D
D
D
0
Q
0
Figure 5.19 Demand curves facing the firm under three market structures.
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Q
0
Q
HL
HL
– in other words, the substitutes that are available
are not perfect substitutes, as they are under perfect
competition.
This has important implications for the firm under
monopolistic competition. It means that to the extent
that 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.
Monopolistically competitive firms engage heavily in
product development (research that leads to new and/
or better products) leading to product differentiation.
The greater the degree of product differentiation, the
less elastic will be the demand curve facing the firm
(because the less close will be the substitutes), the
greater the degree of monopoly power of the firm, and
hence the greater the potential for making economic
profits.
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, the greater the monopoly power
(the ability to control price), and the larger the firm’s
potential to increase short-run economic profits.
Monopolistically competitive firms compete with
each other on the basis of both price and nonprice competition. The more successful they are in
increasing their sales and market share through nonprice competition methods, the less they need to rely
on price competition. 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 (in other
words price reductions) in order to increase their sales
and market share.
Test your understanding 5.8
1 What are the assumptions defining the market
model of monopolistic competition?
Yet product differentiation by itself is not enough for
the creation of monopoly power; it is also important
for consumers to be convinced that the product is
worth purchasing. Monopolistically competitive
firms pursue this objective through advertising and
branding (creating brand names for their products).
The objective of advertising and branding is to
influence consumer tastes in favour of the product.
They attempt to achieve this by making the demand
curve for a good shift to the right, and by making it
rotate so it becomes steeper. These two changes mean
that demand increases and it becomes less elastic.
The roles of price and non-price
competition
Price competition among firms occurs when a firm
lowers its price in order to attract customers away
from rival firms, and thereby increase its sales at the
expense of other firms. Non-price competition, by
contrast, occurs when firms use methods other than
price reductions in order to attract customers away
from rivals. The most common forms of non-price
competition are product differentiation, advertising
and branding. Firms that can attract customers by use
of these methods increase their monopoly power and
their ability to control the price of their product. They
can charge a higher price without risking loss of buyers
to rival firms. In general, the more differentiated
2 Think of some examples of monopolistically
competitive firms in your neighbourhood.
3 (a) In what ways is a monopolistically
competitive firm like a firm in perfect
competition; in what ways is it like a monopoly?
(b) Explain how and why the demand curve of
the monopolistically competitive firm differs
from the demand curves of the firm in perfect
competition and in monopoly.
4 (a) What do firms in monopolistic competition
try to achieve through product differentiation,
advertising and branding? (b) How do these
activities relate to the demand curve facing the
firm?
5 What is (a) price competition, and (b) nonprice competition? (c) How do monopolistically
competitive firms compete with each other?
6 Why do you think we never see price competition
and non-price competition in (a) perfectly
competitive firms, and (b) monopolies?
Profit maximization
Economic profit or loss in the short run
The short-run equilibrium position of the individual
firm under monopolistic competition is identical to
Chapter 5: Theory of the firm II
139
HL
(b) Normal profit.
economic
profit
MC
Pe
ATC
D
0
Qe
Q
MC
ATC
Pe
D
0
Qe
MR
HL
(c) Losses.
Q
price, costs, revenue
price, costs, revenue
(a) Economic profit.
price, costs, revenue
HL
losses
MC
ATC
Pe
D
0
Qe
MR
MR
Q
Figure 5.20 Short-run equilibrium of the firm under monopolistic competition.
that of the monopolist, the only difference being
in the price elasticity of demand of the demand
curve facing the firm, as the demand curve is more
elastic and flatter in monopolistic competition than
in monopoly. In the short run, the firm can make
economic profits, or normal profit, or losses. Each of
these possibilities is shown in Figure 5.20. The firm
applies the MR = MC rule to find the profit-maximizing
or loss-minimizing level of output (Qe), and then for
that level of output compares price (given by the
demand curve) with ATC to determine profit per unit
or loss per unit.
In panel (a) the firm is realizing economic profits,
since P > ATC at Qe; in panel (b) the firm’s economic
profit is exactly zero since P = ATC at Qe, and therefore
the firm is earning normal profit; and in panel (c), the
firm is incurring losses because P < ATC at Qe. Each of
these positions is a possible short-run equilibrium for
the firm.
Normal profit in the long run
The assumption of free entry and exit of firms in the
industry is of crucial importance in determining the
long-run equilibrium position of the firm (just as
under perfect competition).
The profitable industry
Panel (a) of Figure 5.20 shows the short-run
equilibrium position of a firm that is making
economic profit. In the long run, when firms can
adjust their plant sizes by changing their fixed inputs,
the economic profit will draw new entrants into
the industry. As new firms enter, they will attract
customers away from the existing firms. The impact
on the existing firms will be to shift the demand curve
they face to the left, in other words the demand facing
the firms will decrease as the new firms capture a share
of their market. Firms will continue to enter, and the
demand curve facing them will keep shifting leftward,
until it reaches the point where it is tangent to (it just
touches) the ATC curve. Here, the firms in the industry
will be earning only normal profits, and entry of new
firms into the industry will stop.
Figure 5.21 shows the long-run equilibrium position
of the firm under monopolistic competition. At the
level of output where MR = MC, P = ATC, therefore
economic profit is zero and each firm is earning
normal profit. Note that this figure is the same as
panel (b) of Figure 5.20, where it happens that a firm is
earning normal profit in the short run.
The unprofitable industry
In monopolistic competition, over the long run,
industries in which firms earn economic profits will
attract new entrants, while loss-making firms in
unprofitable (loss-making) industries will shut down
their plants and leave the industry. The process of
entry and exit of firms in the long run ensures that
economic profit or loss is zero and all firms earn
normal profit.
Let’s examine the process of adjustment.
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In panel (c) of Figure 5.20 we see the short-run
equilibrium of a loss-making firm. The presence of
losses will make some firms shut down completely
and leave the industry. As they do so, their customers
will switch their purchases to the remaining firms,
which will experience an increase in demand for their
product. This will show up as a rightward shift of
the demand curve facing them, and this process will
continue until losses disappear and firms are earning
normal profit. As before, this will occur when the
demand curve is tangent to (just touches) the ATC
curve, so that at the level of output where MR = MC,
HL
HL
price, costs, revenue
MC
ATC
Pe
D
0
Qe
Qc
MR
Q
Figure 5.21 Long-run equilibrium of the firm under monopolistic
competition.
P = ATC, and economic profit is zero. Once again the
long-run equilibrium will be as shown in Figure 5.21,
where the firm is earning zero economic profit.
Criticisms of the model
· A difficulty with the above analysis is that it suggests
that firms make decisions only on quantity of
output and price, whereas in fact, as we have seen,
a major dimension of their decisions involves
non-price competition (product development and
advertising). This means that profit-maximization
decisions are more complex than this simple model
suggests, since they involve additional decisions
on research and development (R&D) for product
differentiation, as well as advertising, all of which
lead to some monopoly power.
· In the real world, entry into the industry may not
be as free as the model suggests, and this is another
factor leading to some monopoly power.
· Another difficulty presented by this model is that in
view of product differentiation, it is not possible to
derive an industry demand curve, as each product
is different from the others. Therefore we can only
examine monopolistic competition at the level of
the firm.
Efficiency in monopolistic competition
Allocative and productive inefficiency
As we know, allocative efficiency is given by the
condition P = MC, and productive efficiency by the
condition P = minimum ATC.
Figure 5.21, illustrating the long-run equilibrium
position of the firm under monopolistic competition,
reveals that neither allocative nor productive
efficiency is 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. Also, price is greater than
minimum average total cost, and therefore average
cost is higher than what is optimal from society’s
point of view.
Excess capacity
A firm’s capacity output is that output at which
ATC is minimum; this is the output level at which
the firm’s plant capacity is fully used. In Figure 5.21,
capacity output is Qc. Yet the firm does not produce
output Qc; the profit-maximizing rule MR = MC makes
it produce output Qe in order to maximize profit,
which is smaller than Qc. The difference between
capacity output and profit-maximizing output is called
excess capacity. Excess capacity is the amount of
output that is lost when firms underuse their plant
and produce a level of output that does not minimize
average total cost. If all firms produced at the point of
minimum ATC, the same quantity of total (industry)
output could have been produced by fewer firms,
and the costs to society would have been lower.
Excess capacity results from the firm’s downwardsloping demand curve. (Only if the demand curve
were horizontal could it be tangent to the ATC curve
at its minimum point, as in perfect competition.)
Excess capacity is therefore the result of product
differentiation, which gives rise to the downwardsloping demand curve. (Note that excess capacity is
closely related to productive inefficiency: they are
both the result of P > minimum ATC.)
There are numerous examples of excess capacity:
restaurants with empty tables, gas (petrol) stations
with no one at the pump, retail outlets of all kinds
with few customers, hotels with empty rooms.
Yet product differentiation gives rise to greater product
variety for consumers. It is often argued that excess
capacity (or productive inefficiency) is the ‘price’
consumers must pay for product variety. The greater
the product variety, the larger will be the excess
capacity, and the greater the productive inefficiency
Chapter 5: Theory of the firm II
141
HL
(and the closer will the firm be to monopoly). By
contrast, the less the product variety, the lower
the excess capacity and the greater the productive
efficiency (the closer will be the firm to perfect
competition).
Comparison of monopolistic competition with
other market structures
The discussion above has covered many of the relevant
issues that arise in a comparison of monopolistic
competition with perfect competition and monopoly.
What follows is simply a summary of the key
differences between the market models.
Monopolistic competition and perfect
competition
· Normal profit According to the models, firms in both
perfect and monopolistic competition achieve zero
economic profit (normal profit) in the long run.
However, the similarity ends here because of the
different price elasticities of demand of the demand
curve facing each firm.
· Productive and allocative efficiency Whereas the
perfectly competitive firm achieves both productive
and allocative efficiency in long-run equilibrium,
the monopolistically competitive firm achieves
neither. Fewer than optimal resources are allocated
to the production of the good, and average cost is
not minimum at the point of production.
· Excess capacity Since the firm under perfect
competition produces the level of output where ATC
is minimum, it is making full use of its plant and
has no excess capacity. The firm under monopolistic
competition produces a lower level of output than
that where ATC is minimum, and therefore has
excess capacity.
· Product variety Whereas all firms under 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.
Monopolistic competition and monopoly
· Normal and economic profits Whereas the firm under
monopolistic competition earns normal profit in the
long run, the monopoly can earn economic profits
due to high barriers to entry that prevent new
entrants from entering the industry.
· Allocative and productive efficiency Both these market
structures face downward-sloping demand curves,
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and therefore both have MR curves that lie below
the demand curve. This means that at the profitmaximizing level of output (found by MR = MC),
P > MC for both (i.e. no allocative efficiency). Also,
P > minimum ATC for both (i.e. no productive
efficiency).
· Competition and costs Competition between firms
under 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.
· Competition and prices Free entry and exit under
monopolistic competition drives economic profits
down to zero in the long run, and allows prices to
be lower for the consumer than is possible under
monopoly, where barriers to entry allow the firm to
maintain profits over the long run.
· Economies of scale Some economies of scale may
be achieved by the firm under monopolistic
competition, but the potential for this is much
greater under monopoly, which can be to the
benefit of the consumer (see the discussion under
monopoly).
· Research and development The evidence is ambiguous
on the incentives faced by monopolies to engage
in R&D; however, the economic profits that they
can earn over the long run puts them in a better
position with respect to financing R&D.
Test your understanding 5.9
1 Show diagrammatically the case where a
firm in monopolistic competition (a) earns
economic profit (show profit per unit and
total profit); (b) earns normal profit; (c) incurs
losses (show loss per unit and total loss).
2 What is the role of free entry and exit of firms
in monopolistic competition in the adjustment
from short-run to long-run equilibrium?
3 (a) Show diagrammatically the firm’s longrun equilibrium position in monopolistic
competition. (b) Comment on whether the
firm achieves economic profit or normal profit
in long-run equilibrium.
4 To what extent does the firm in monopolistic
competition achieve efficiency? (Refer to the
different efficiency concepts discussed in this
section.)
(...continued)
HL
HL
Test your understanding 5.9
(...continued)
5 Explain what is meant by the idea that excess
capacity is the ‘price’ of product variety.
6 Evaluate the desirability of monopolistic
competition from a social perspective.
5.4 Oligopoly
Assumptions of oligopoly
Oligopoly is more complex than the other market
models because there is not just one type of oligopoly;
as we will see there are several models of oligopolistic
behaviour. However, the following characteristics are
shared by all of these:
· A small number of large firms The term ‘oligopoly’
derives from the Greek word meaning ‘few sellers’.
Oligopolistic industries tend to be dominated by
a small number of large firms, though in any one
industry the firms are likely to vary in size.
· High barriers to entry All the barriers to entry
discussed under monopoly are also relevant to
oligopoly. They include economies of scale, which
make it prohibitive for new firms starting on a
small scale to compete due to very high costs
(for example, the aircraft and car industries); or
legal barriers such as patents (the pharmaceutical
industry); or control of natural resources (such
as oil, copper, silver); or aggressive tactics such as
advertising or threats of takeovers of potential new
firms. An additional barrier to entry in oligopoly
includes high start-up costs (the costs of starting
a new firm) associated with developing a new or
differentiated product. Many established oligopolies
spend enormous sums on product differentiation
and advertising, making it very difficult for new
firms to match such expenditures.
In addition, oligopolistic firms share some further
characteristics that make them uniquely different from
any other market structure:
· Mutual interdependence Firms in perfect and
monopolistic competition, due to their large
numbers in the industry, behave independently
of each other, so that when they make decisions
such as how much output to produce, they do
not take the possible actions of other firms into
consideration. By contrast, the small number of
firms in oligopolistic industries makes the firms
mutually interdependent; in other words, decisions
taken by one firm affect other firms in the industry,
so that they depend on each other. If any one
firm changes its behaviour, this can have a major
impact on the demand curve facing the other firms.
Therefore firms are keenly aware of the actions of
their rivals. Mutual interdependence explains why
oligopolistic firms behave differently from firms
under other market structures.
· Strategic behaviour Strategic behaviour is based on
plans of action that take into account rivals’ possible
courses of action. It is similar to playing a card
game, or chess, where each player’s actions are based
on the expected actions and reactions of its rival(s).
Strategic behaviour of oligopolistic firms is the result
of their mutual interdependence. For example, a
firm plans a course of action X if its rivals follow
a specific policy, and it plans course of action Y if
its rivals follow a different policy. Under oligopoly,
firms planning their strategies make great efforts
to guess the actions and reactions of their rivals in
order to formulate their own strategy.
· Conflicting incentives Firms under oligopoly face
incentives that conflict, or clash with each other:
❍
· Differentiated or homogeneous (undifferentiated)
products Firms under oligopoly may produce
differentiated products or undifferentiated products.
Examples of oligopolies producing differentiated
products include pharmaceuticals, cars, aircraft,
breakfast cereals, cigarettes, refrigerators and
freezers, cameras, tyres, bicycles, motorcycles, soaps,
detergents. Examples of oligopolies producing
undifferentiated products are fewer; examples
include oil, steel, aluminium, copper, cement.
❍
Incentive to collude The term collusion refers
to an agreement between the firms to limit
competition between them. Firms in oligopoly are
especially concerned to limit price competition
between them as much as possible. By colluding,
firms reduce uncertainties resulting from not
knowing how rivals will behave, and maximize
profits for the industry as a whole. Collusion
can involve an agreement to divide the market
between the firms in some specific way (such as
according to market shares), or to limit quantity
to be produced by the industry as a whole and
therefore fix the price; the result involves limiting
competition and increasing industry profits.
Incentive to compete At the same time, each
oligopolistic firm also faces an incentive to
compete with its rivals, in the hope that in this
Chapter 5: Theory of the firm II
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Clearly, firms in an industry cannot both collude
and compete; they must do one or the other.
There is significant diversity in the behaviour of
oligopolistic firms, and for this reason there is no one
theory, or model, of oligopoly. Instead, there are a
number of models, each of which attempts to explain
some aspects of oligopolistic behaviour, but none of
which is wholly satisfactory as a general theory of
oligopoly. The models can be classified under two
main categories: collusive and non-collusive oligopoly.
We will discuss each of these in turn.
Test your understanding 5.10
1 Identify the main characteristics of the
oligopolistic market structure.
Suppose the firms of an industry decide to form a
cartel by fixing price. Figure 5.22 illustrates how
the cartel maximizes profit. Note that this figure is
identical to Figure 5.13(a), which illustrates profit
maximization for a monopolist.
price, costs, revenue
way it will capture at least a portion of its rivals’
market shares and profits, thereby increasing its
profits at the expense of the other firms.
HL
MC
a
Pe
b
profit
0
ATC
Q
MR
D = AR
max
Q
Figure 5.22 Profit maximization by a price-fixing cartel.
2 Why do firms under oligopoly face conflicting
objectives?
3 Are oligopolistic firms independent or
interdependent? What kind of behaviour does
this characteristic make them engage in (that
tends to resemble a card game)?
Collusive oligopoly
It was noted above that firms under oligopoly face
an incentive to collude, the main objective being to
coordinate prices, limit competition between them,
and reduce uncertainties. Collusive oligopoly refers
to the type of oligopoly where firms agree to restrict
output and fix the price, in order to limit competition,
increase monopoly power and increase profits.
Collusion may be formal, usually taking the form of a
cartel, or it may be informal, such as price leadership.
Formal collusion: cartels
A cartel is a formal agreement between firms in
an industry to undertake concerted actions to limit
competition. The agreement may involve limiting
and fixing the quantity to be produced by each
(setting production quotas); fixing the price at which
output can be sold; setting restrictions on non-price
competition (such as advertising); dividing the market
according to geographical or other factors; or agreeing
to set up barriers to entry. Whatever the case, the
objective is to increase the monopoly power of the
firms within the industry.
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In effect, when the firms in an industry collude (agree
to limit competition between them), they collectively
behave like a monopoly.
In Figure 5.22 the demand curve and marginal revenue
curve shown are for the industry as a whole. The MC
curve is the sum of all the MC curves of all the firms in
the cartel. The cartel equates MR with MC to find the
cartel’s profit-maximizing level of output, Qπmax, and
then determines price Pe (given by the demand curve).
It is then a question of dividing up industry output
Qπmax between all the firms, or deciding how much
of the total quantity will be produced by each firm.
One way this can be done is to agree on what share
of the market each firm will have based on historical
market shares. Another way is that firms may agree
to compete with each other for market shares using
non-price competition (product differentiation and
advertising).
The best-known example of a cartel is OPEC (the
Organization of Petroleum Exporting Countries),
composed of a group of 13 oil-producing countries.
OPEC periodically tries to raise the world price of
oil by cutting back on its total output. Each member
country is assigned an output level (quota) that it is
permitted to produce. The restricted quantity of oil
results in a higher price.
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Firms participating in a cartel have much to gain
in terms of monopoly power and increased profits;
however, there are a number of problems involved
with setting up and maintaining a cartel, to which we
turn next.
Obstacles to forming and maintaining
cartels
The following factors make it difficult for a cartel to be
established and maintained:
· Cost differences between firms Ideally, each firm
would like to have a share of output that will allow
it to equate its MC with MR, as this will maximize
profit for each individual firm as well as for the
cartel as a whole; however, this is extremely difficult
in practice, since each firm faces different cost
curves (it is most unlikely that all the firms will have
identical costs). Since the price that is agreed upon
by the cartel is common to all the firms, firms with
higher average costs will have lower profits, while
the lower cost firms will enjoy higher profits. In
general, cost differences between firms are a major
constraint to the successful formation of a cartel
because of the difficulties this entails in agreeing on
a common price and on how to allocate the output
among the firms.
· Firms face different demand curves Firms are likely to
face different demand curves partly because they
have different market shares and partly because of
product differentiation. The more differentiated the
product, the greater the differences between demand
curves facing the firms are likely to be. Differences
in the demand curves mean difficulties in reaching
agreement on a common price.
· Number of firms The larger the number of firms,
the more difficult it is to arrive at an agreement
regarding price and the allocation of output, as the
greater number of contending views make consensus
and compromise more difficult to achieve.
· The possibility of cheating Every firm in a cartel
faces an incentive to cheat on the agreement, by
offering to secretly lower the price for some buyers,
or else offer other concessions. A firm that cheats
can increase its market share and its profit at the
expense of other firms. But if many firms cheat, or
if cheating is discovered by other firms in the cartel,
then the cartel is in danger of collapsing.
· The possibility of a price war A possible outcome of
one or more firms cheating on the cartel agreement
is a price war where one firm’s price cut is matched
by a retaliatory price cut by other firm. Say one firm
decides to cheat on the cartel by secretly lowering
its price. If another firm discovers the cheating
firm, it may react by lowering its price as well; there
may follow a succession of price cuts as firms try to
capture market shares from their rivals. The result
of a price war is to make all the firms of an industry
collectively worse off due to the low resulting prices
and lower profits. It is even possible for a price war
to result in prices that are lower than average costs,
thus giving rise to losses for the firms. Price wars
eventually wind down and firms return to higher
price policies.
· Recessions During recessions (periods of low or
falling incomes and low levels of economic activity)
sales fall and profits are reduced; at such times firms
have an increased incentive to lower their prices and
cheat on the agreement in order to increase their
sales at the expense of other firms, thus endangering
the survival of the cartel. Economic stability (the
absence of recession or inflation) makes it easier
for firms to plan for the future and this facilitates
agreements between the firms.
· Potential entry into the industry If a cartel is
successful, it will make large economic profits, and
this will encourage new entry into the industry. If
there are new entrants, increased industry supply
will drive price down and will cut into the cartel’s
profits. The cartel’s long-run survival therefore
depends on high barriers to entry that block
potential new entrants.
· The industry lacks a dominant firm The presence of
a dominant firm facilitates reaching agreement, as
this firm can assume a leadership position in the
negotiations leading to the agreement. For example,
in the case of OPEC, the dominant member of
the cartel is Saudi Arabia, which is also the largest
producer of oil among all the members. The lack of
a dominant firm makes agreement among the cartel
members more difficult to reach.
· Legal barriers Cartels are illegal in many countries,
including the European Union, the United Kingdom
and the United States. The reason is that they
restrict competition and are therefore held to be
against consumers’ and society’s best interests.
Informal collusion: price leadership and
other approaches
The difficulties involved in establishing and
maintaining cartels as well as their illegality sometimes
make firms turn towards informal types of collusion,
where the objective once again is to avoid competitive
price-cutting, coordinate prices, limit competition
and reduce uncertainties. One type of informal
collusion is price leadership, where a dominant firm
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in the industry (which may be the largest, or it may
be the one with lowest costs) sets a price and also
initiates any price changes. The remaining firms in
the industry in effect become price-takers, accepting
the price that has been established by the leader. The
agreement binds the firms as far as price goes, but
they are then free to engage in non-price competition.
A characteristic of price leadership arrangements is
that price changes tend to be infrequent, and are
undertaken by the leader only when major demand or
cost changes occur. Examples of industries that have
at different times followed the price leadership model
include US Steel, Kellogg’s (breakfast cereals), and R. J.
Reynolds (cigarettes).
Obstacles to sustained price leadership are similar to
the obstacles faced by cartels:
· Cost differences between firms, particularly in cases
where there is significant product differentiation,
make it difficult for firms to follow a leader.
· Whereas some firms may follow the leader, others
may not, in which case the leader risks losing sales
and market share in the event it initiates a price
increase that is not followed.
· Firms still face the incentive to cheat by lowering
their price (below that of the leader) in order
to capture market share and increase profits; a
breakdown in price leadership can result in a price
war among firms where successive rounds of price
cuts leave the firms in the industry worse off due to
lower profits.
· High industry profits can attract new firms
that will cut into market shares and profits of
established firms and endanger the price leadership
arrangement.
· Price leadership, depending on where and how it is
practised, may or may not be legal.
Another type of informal collusion may involve
informal agreements where the firms agree to use a
rule for coordinating prices. One such rule is limit
pricing, where the firms informally agree to a set a
price that is lower than the profit-maximizing price,
so as to achieve lower than the highest possible profits
and therefore discourage new firms from entering the
industry (recall that new firms are attracted to highly
profitable industries). With limit pricing, firms may in
effect end up sacrificing some profit in order to avoid
attracting new firms into the industry.
Whenever some agreement is reached on a method
of price coordination, market shares can then be
determined on the basis of non-price competition.
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Test your understanding 5.11
1 What do firms in oligopoly try to achieve
through collusion?
2 (a) What is a cartel and how is it related to
collusive oligopoly? (b) Show how a cartel
resembles a monopoly.
3 What are the obstacles to forming and
maintaining cartels?
4 Identify other approaches that may be used by
firms in oligopoly to achieve collusion.
Non-collusive oligopoly: the kinked demand
curve
It is generally observed in the real world that prices
of oligopolistic industries tend to be inflexible or
‘sticky’; once a particular price is reached, it tends
to be relatively stable over extended periods of time.
Moreover, in situations when prices do change,
they tend to change in unison for all the firms in an
industry. Price inflexibility can be easily explained
in the case of collusive oligopoly, since in this case
firms collude to coordinate prices. However, price
inflexibility is also observed in the real world in
situations of non-collusive oligopoly, where
oligopolistic firms do not agree, whether formally or
informally, to fix prices or collaborate in some way.
The kinked demand curve is a model that has
been developed to explain price inflexibility of
oligopolistic firms that do not collude, and is
illustrated in Figure 5.23. In this model, firms do
not make formal or informal agreements with each
other on how to fix or coordinate prices; instead,
their pricing behaviour is strongly influenced by
their expectations of how rival firms will react if
they undertake a price change. These expectations
are reflected in the kinked (i.e. not straight) demand
curve facing each firm, as shown in the figure. Note
that corresponding to the kinked demand curve
is a broken marginal revenue curve; the break in
MR occurs exactly at the point of the kink in the
demand curve, and is a reflection of the abrupt drop
in marginal revenue at the point where the demand
curve suddenly bends.
Imagine that there are three firms, A, B, and C, each
producing output Q1 and selling it at price P1; this
price–quantity combination corresponds to point Z on
the demand curve, or the point of the kink. We now
want to see why the firms perceive the demand curve
that faces them to have this peculiar shape.
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This simple model illustrates three important points:
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P
· Firms that do not collude are forced to take into account
P1
the actions of their rivals in making pricing decisions,
otherwise they risk lowering their revenues and
profits, which in turn could lead to price instability.
The kinked demand curve model illustrates the
interdependence of oligopolistic firms.
Z
· Even though the firms do not collude, there is still price
stability; firms are reluctant to change their price
because of the likely actions of their rivals, which
could result in lower profits for the firm initiating
price changes.
D
0
Q1
Q
MR
Figure 5.23 The kinked demand curve.
Let’s say that firm A contemplates a price change, but
before changing (increasing or decreasing) its price, it
tries to predict how firms B and C will react, and what
will be the consequences of their reaction. Firm A’s
line of reasoning is the following:
· If I raise my price, what will A and B do? They are
unlikely to increase their price as well, because
if they continue to sell at price P1, many of my
customers will leave me and start buying from
B and C. It follows that B’s and C’s market share
will increase, while my market share will fall. It is
therefore not in my interests to increase my price.
My demand curve is relatively elastic above Z,
because for any price increase I will face a relatively
large decrease in sales and revenues, and my profits
may fall (though not all my customers will leave me
because of my differentiated product).
· If I decrease my price, what will A and B do? They
are now likely to decrease their price as well, because
if they do not, I will capture a large portion of their
sales, and I would be better off at their expense. If
they decrease their price, then I will capture only a
very small part of their market shares. My demand
curve is relatively inelastic below Z, because for
any price decrease I will have only a very small
increase in sales and revenues, and my profits may
fall. It is therefore not in my interests to drop my
price.
· I should therefore not change my price, and should
continue selling at P1.
This line of reasoning is the same for all three firms, A,
B and C.
· Firms do not compete with each other on the basis
of price; they do not try to increase their sales by
attracting customers through lower prices. A lower
price not only invites price cuts by rivals, with
resulting lower profits for all the firms involved, but
also, if some firms overreact with price cutting, there
is a risk of setting off a price war.
In the kinked demand curve model, shown in
Figure 5.23, each firm perceives the demand curve
it faces to be elastic for prices above Z and inelastic
for prices below Z. If one firm raises its price above
Z, the others will not follow; if it lowers its price
below Z, the others will match the price decrease. In
either case, the firm will be worse off. Therefore no
firm takes the initiative to change its price, and they
all remain ‘stuck’ at point Z for extended periods of
time.
However, the model is subject to limitations:
· It cannot explain how the firms arrived at point Z,
or the point of the kink in the demand curve.
· It is inappropriate as an explanation of oligopolistic
pricing behaviour during periods of inflation, when
prices are observed to increase, and during recession,
when prices often drop, to the point that at times
they can initiate price wars.
Test your understanding 5.12
1 How does non-collusive oligopoly differ from
collusive oligopoly?
2 a) Show the kinked demand curve model
diagrammatically. (b) How can you account
for the shape of the kinked demand curve (use
the elasticity concept in your answer). (c) What
does this model try to explain? (d) What are the
limitations of the model?
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The role of non-price competition in oligopoly
Unlike firms in monopolistic competition that
compete on the basis of both price and non-price
competition, oligopolistic firms go to great lengths to
avoid price competition; in other words, they avoid
trying to increase market shares by cutting prices.
Firms in oligopoly are better off coordinating their
pricing behaviour where they can (through formal or
informal collusion), and when they do not collude
they still avoid competitive price-cutting as this is
likely to result in lowering their profits. However,
oligopolistic firms usually do engage in intense nonprice competition. Non-price competition, as we
learned in Section 5.3, involves efforts by firms to
increase their market share by methods other than
price, which typically include product development,
advertising and branding. This applies to firms under
both collusive and non-collusive oligopoly.
Non-price competition is very important in oligopoly
for the following reasons:
· Oligopolistic firms very often have considerable
financial resources (due to large profits) that they
can devote to both R&D (research and development)
and advertising. Whereas monopolistically
competitive firms also engage in non-price
competition, the resources at their disposal for these
purposes are generally not as significant.
· The development of new products provides firms
with a competitive edge; they increase their
monopoly power, demand for the firm’s product
becomes less elastic, and successful products give
rise to opportunities for substantially increased sales
and profits.
· Product differentiation can increase a firm’s profit
position without creating risks for immediate
retaliation by rivals. It takes time and resources for
rival firms to develop new competitive products. It
would be very difficult to engage in a ‘new product
war’ as opposed to a price war, in which price cuts
can be very quickly matched or exceeded by rival
firms.
Evaluating oligopoly
Criticisms of oligopoly
We have seen that oligopolistic firms avoid price
competition and often engage in practices that aim
at fixing or coordinating prices, the objective being
to gain monopoly power. To the extent that they
succeed in avoiding price competition, they achieve
a considerable degree of monopoly power, and are
therefore subject to the same criticisms as monopoly:
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· Neither productive nor allocative efficiency is
achieved.
· Higher prices are charged and lower quantities
of output are produced than under competitive
conditions.
· There may be higher production costs due to lack of
competitive pressures.
· Firms may possibly be less technologically
innovative.
· They contribute to a more unequal distribution of
income.
For more details on each of these points, see the earlier
section on monopoly (page 127).
In addition, it may be argued that oligopoly may be
an even less socially desirable market structure than
monopoly because:
· Whereas there is anti-monopoly legislation in
many countries that protects against the abuse of
monopoly power, the difficulties of detecting and
proving collusion among oligopolistic firms means
that such firms may actually behave like monopolies
by colluding and yet may get away with it.
Benefits of oligopoly
The benefits of oligopoly are also similar to the
benefits of monopoly:
· Economies of scale can be achieved due to the
large size of oligopolistic firms, leading to lower
production costs to the benefit of society and the
consumer (through lower prices).
· Product development and technological innovations
can be pursued due to the large economic
(supernormal) profits from which research funds
can be drawn. This benefit of oligopoly is more
important than in the case of monopoly, since nonprice competition forces firms to be innovative in
order to increase their market share and profits.
· Technological innovations that improve efficiency
and lower costs of production may be passed to
consumers in the form of lower prices.
For more details on these points see the earlier section
on monopoly.
Over and above the benefits of oligopoly that are
similar to monopoly, oligopoly also offers the
following advantage:
· Product development leads to increased product
variety, thus providing consumers with greater
choice (monopoly does not offer product
differentiation and variety).
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Advantages and disadvantages of
advertising (supplementary material)
Oligopolies engage heavily in advertising as part
of non-price competition. The only other market
structure where advertising figures prominently is
monopolistic competition, where firms also engage in
non-price competition. Therefore many of the issues
discussed here apply also to monopolistic competition.
Firms under perfect competition obviously do not
advertise as they produce a homogeneous product,
whereas under monopoly there is no need for
advertising as the monopolist is the sole producer of a
good.
Economists disagree on the efficiency aspects of
advertising. On the positive side, the following
arguments suggest that advertising can increase overall
efficiency:
· Advertising provides consumers with information
about alternative products; it makes it easier for
consumers to search for the product that is best
suited to their needs, and therefore reduces time and
effort that could be wasted searching for alternative
products.
· Advertising may create needs that consumers would
not otherwise have; this ultimately results in a waste
of resources as consumers end up buying goods and
services that they would not have desired had they
not been influenced by advertising.
Some of the points noted under advantages and
disadvantages of advertising contradict each other.
It is possible that different circumstances give rise to
different (positive or negative) results, though it is
also possible that economists sometimes interpret the
same observations differently, thus coming up with
conflicting conclusions.
Test your understanding 5.13
1 (a) Why is non-price competition important
to firms in oligopoly? (b) Why do oligopolistic
firms avoid price competition?
2 Evaluate oligopoly, referring to advantages and
disadvantages from a social perspective.
3 (optional) What are the likely advantages and
disadvantages of advertising?
· Advertising by rival firms increases competition
between them, and therefore contributes to
decreasing their monopoly power.
· Advertising facilitates the introduction of new
products by providing the relevant information to
consumers; in this way, competition (non-price)
increases between firms.
· By facilitating the introduction of new products,
advertising can help lower barriers to entry of new
firms into the industry.
· By facilitating the introduction of new products,
advertising can also provide firms with an added
incentive to engage in research and development for
the development of new products.
On the negative side, the following arguments suggest
that advertising contributes to lowering efficiency:
· Huge sums spent on advertising by large
oligopolistic firms can create barriers to the entry of
new firms that cannot match such expenditures.
· Advertising increases costs of production and
ultimately means higher prices for consumers.
· Successful advertising increases a firm’s monopoly
power.
· Consumers may become confused and misled as to
the qualities of the product, and may end up paying
higher prices for inferior products.
5.5 The theory of contestable markets
In our study of market structures, we have seen
that the degree of competition between firms varies
enormously, ranging from perfect competition where
there is a large number of firms, to no competition
when there is a single firm in the market. In between
the two extremes lie monopolistic competition,
where there is a relatively large number of firms, and
oligopoly, where there is only a small number of firms.
The degree of competition in an industry appears
to be inversely related to the number of firms in the
industry: the fewer the firms, the less the competition,
and the greater will be the potential for monopoly
power and economic profits.
The theory of contestable markets is an approach to
the study of market structures developed recently
which suggests that the degree of competition
achieved in a market may not depend on the actual
number of firms in the industry after all, but rather
on the ease with which potential firms can enter
and leave an industry. This is a theory with possible
applications to markets where there are a few large
sellers (oligopoly), or there is a single large seller
(monopoly).
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It is argued in this approach that what matters more
in achieving competitive conditions for firms is
not so much whether they face actual competition
from existing rivals, but whether they face potential
competition from potential new entrants. If the
barriers to entry are low, then there is a constant threat
that new firms may enter the industry. And if the costs
of exiting the industry are also low (that is, a new firm
can easily leave the industry by selling its assets or
transferring them for use in another industry), then
a potential new entrant will be less concerned about
the possibility of losses from the purchase of costly
fixed inputs. The implication then is that even if the
industry is a monopoly or an oligopoly, the threat of
new firms will make the established firms behave as if
they were in a competitive industry.
If this is the case, competition will be limited and the
conclusions of the traditional theory of the firm, as
discussed in this chapter, still hold. The contestable
markets theory is in the process of being empirically
tested, and no conclusions have as yet emerged
regarding its validity.
The credibility of this theory depends crucially on
the extent of barriers to entry and costs of exit from
the industry. For a market to be contestable, there
must be low entry barriers and low exit costs. If these
conditions hold, the following conclusions can be
drawn:
5.6 Price discrimination
· If a market is contestable, the firm(s) will behave in
The single-price firm versus the price
discriminating firm
a competitive way.
· Costs of production will be lower and the extent of
inefficiencies will be reduced.
· Lower costs of production mean lower prices for the
consumer.
· Government policy should be directed towards
lowering barriers of entry and costs of exit in
industries so to make them more contestable and
therefore make the firm(s) behave competitively.
A contestable market is a market that new firms
can enter and exit at a low cost. In a contestable
market, the threat of possible new entrants causes
existing firms in the industry to behave competitively
(resulting in greater efficiency and lower prices)
even though the industry may be a monopoly or an
oligopoly.
The theory of contestable markets has been criticized
because it presumes that barriers to entry and costs
of exit are low in oligopolistic and monopolistic
industries, whereas in fact in many industries they
may be quite high. High barriers to entry mean a
limited threat of new entrants; high costs of exit mean
a potential entrant will be less likely to risk entering.
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Test your understanding 5.14
1 Explain the theory of contestable markets.
2 What conditions must hold for this theory to be
valid?
3 If the theory is valid, how would it change the
conclusions of the traditional theory of the firm?
Definition and conditions for price
discrimination
So far in our study of firm behaviour we have assumed
that firms under all market structures charge a single
price for all units of output they sell. This applies
not only to firms under perfect competition (where
price is constant for all units of output), but also to
firms under monopoly, oligopoly and monopolistic
competition. In monopoly, for example, we have
seen that while price varies according to the quantity
of output that can be sold, once the firm makes a
choice on what quantity of output it will sell, all the
units of output are sold at the same price. In Figure
5.10(b) above, if the firm chooses to produce Q1 units
of output, all of that output will be sold at the single
price P1. If it had chosen to produce Q2 units of output,
all of that output would be sold at the single price P2.
Firms that sell all of their output at the same price do
not practise price discrimination.
Yet firms often find that they can increase their profits
by selling their product at different prices. Price
discrimination is the practice of charging a different
price for the same product when the price difference
is not justified by differences in costs of production.
(If price differences are due to differences in a firm’s
costs of production, then they do not qualify as ‘price
discrimination’.)
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Price discrimination allows firms to increase their
profit because it offers them opportunities to reduce
consumer surplus and convert it into profits, or reduce
deadweight loss and convert that into profits, or a
combination of both.
We will see how this is done in the discussion that
follows.
Conditions for price discrimination
In order for a firm to be able to practice price
discrimination, the following conditions must be
satisfied:
The price discriminating firm must have
some market power
In all types of price discrimination, the price
discriminating firm must have some degree of market
power, or some ability to control price; in other words,
it must face a downward-sloping demand curve. Price
discrimination can in fact occur in all the market
structures except perfect competition.
Natural monopolies (such as electricity, gas and
water companies), having a significant degree of
market power, practise price discrimination whenever
they can. For example, electricity companies often
charge lower prices at night than during the day for
consumption of electricity. Water companies often
charge different prices according to the quantity of
water consumed. Oligopolistic firms also often practise
price discrimination; for example, airlines as a rule
charge higher fares during peak travel seasons such
as during summer months. Similarly, firms under
monopolistic competition also price discriminate:
movie theatres may charge different prices to children
or older people, or different prices according to
viewing time; restaurants often offer discounts (lower
prices) for particular groups of customers or on
particular days.
On the other hand, the firm under perfect competition
can sell any amount of its output at the single price
that has been determined in the market; if it tries to
increase its price to some customers, it will lose those
customers to different sellers; and it would have no
reason to lower its price for some customers since it
can sell its entire output at the higher market price.
Therefore the perfectly competitive firm has no
possibility of charging different prices for the same
good.
Separation of consumers as individuals or
into groups
Consumers must be separated from each other on the
basis of some characteristic, such as time, geography,
age, gender, technology, income or other factors.
Firms differentiate their prices on the basis of these
characteristics. For example, movie theatres and hotels
often charge lower prices to older people and children
(consumer separation by age); telephone companies
sometimes offer lower rates for evening or weekend
calls (consumer separation by time); publishers often
charge different prices for the same books in different
countries (consumer separation by geography); car
salespeople sometimes try to sell cars at different
prices by guessing customers’ income levels (consumer
separation by income).
No possibility of resale
The price discriminating firm must ensure that it is
not possible (or at least it is very difficult and costly)
for any consumer to buy at the low price and resell
at the higher price. If resale were possible or easy,
consumers would avoid purchasing from the firm at
the higher price, and would try to buy the product
from other consumers who had bought at the lower
price. In some cases, resale is impossible due to the
nature of the product, especially where services are
involved, such as in the case of medical services, legal
services and education.
Different willingness to pay or different
price elasticities of demand
Consumers must have a different willingness to pay for
the product or different price elasticities of demand.
The idea of willingness to pay is very closely related
to demand, which we studied in Chapter 2, page 32.
As you may remember, the demand curve shows what
price the consumer is willing to pay in order to get
different quantities of a good (ceteris paribus). There
are two points to bear in mind about willingness to
pay that are important for our purposes. One is that
different people have a different willingness to pay
for the same good, because they have different tastes
and preferences, and different incomes. This is an
important reason why different people have different
demands for a good. The second point is that as the
available quantity of a good increases, an individual
consumer’s willingness to pay for the good falls (as
a result of the principle of falling marginal benefit;
see Section 2.2 for a review of these concepts). This is
entirely consistent with what we know about the law
of demand, according to which any one consumer is
willing to buy more of a good as its price falls; hence
the downward slope of the demand curve.
Chapter 5: Theory of the firm II 151
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Types of price discrimination
There are three types of price discrimination, to which
we now turn.
First degree: discrimination among
individual consumers
First degree price discrimination is based on the
principle that each consumer has a different
willingness to pay for a good, because of different
preferences or income. The firm sells each unit of
the product to a different consumer, and charges the
maximum price for each unit of the good sold that the
consumer is willing to pay. This type of discrimination
is also known as perfect price discrimination, or
‘discrimination among individual consumers’, because
each consumer pays a different price.
Perfect price discrimination is extremely difficult, if at
all possible, to achieve in practice, for the following
reasons:
· It presupposes that the firm has detailed knowledge
of each consumer’s demand, and therefore knows
the maximum price that each consumer is willing to
pay for the product; yet it is virtually impossible for
any firm to acquire such information.
· It presupposes that the firm can prevent resale;
this means that each consumer would have to be
kept separate from every other, which is virtually
impossible to achieve.
Yet there are a number of situations where sellers try
to approximate perfect price discrimination by trying
to obtain the highest possible price that a consumer is
willing to pay. For example, haggling and bargaining
over price in a flea market can result in getting some
consumers to pay a price in line with their willingness
to pay, which can vary according to their desire for
the product or their income. Certain service providers
like doctors and lawyers try to size up their clients
according to characteristics like income, on the basis
of which they can then try to charge the highest
price the consumer is willing to pay. Car dealers and
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Part 2: Microeconomics
real estate agents similarly try to estimate willingness
to pay of potential car and house buyers so as to
ask for the highest possible price. Note that most of
these examples involve the provision of services, and
therefore preclude the possibility of resale because of
the nature of the transaction (it is not possible to resell
a medical or legal service).
Why would a firm gain if it could practise first
degree or perfect price discrimination? We can see the
answer to this question in Figure 5.24, which shows
the profit-maximizing position of two firms with
market power (they face downward-sloping demand
curves). Panel (a) shows the familiar profit-maximizing
position of the firm that charges a single price for all
units of output. The firm maximizes profit at the level
of output Q1, where MR = MC, and the demand curve
determines the profit-maximizing price P1 at which
all units of output are sold. The shaded area under P1
represents the firm’s profit (given by (P1 − ATC) Δ Q1).
The figure also shows the area of consumer surplus,
under the demand curve above price P1.
(a) Single-price firm.
price, costs, revenue
The consumer’s willingness to pay is related to
price elasticity of demand, which we studied in
Chapter 3, page 62. Consumers who have a high
willingness to pay for a good also have a lower
price elasticity of demand (PED) for the good. In
other words, for a particular price and quantity
combination, the demand curve of the consumer
with a higher willingness to pay is steeper (i.e. less
elastic) than the demand curve of a consumer with
a lower willingness to pay.
P1
cons.
surplus
MC
ATC
econ.
profit
deadweight
loss
0
D
Q1
Q
MR
(b) Perfectly (first degree) price discriminating firm.
price, costs, revenue
HL
economic
profit
MC
ATC
D = MR
0
Q2
Q
Figure 5.24 Comparison of the non-price discriminating (single price)
firm with the perfectly (first degree) price discriminating firm.
HL
HL
Panel (b) shows the profit-maximizing position of
a firm that perfectly price discriminates; note that
here, the demand curve is the same as the marginal
revenue curve. The reason is that when the firm
practises perfect price discrimination, its marginal
revenue for each unit of output is equal to the price
at which this unit of output is sold. When the firm
lowers its price to sell the next unit of output, this
price is its marginal (or additional) revenue for that
unit of output. The firm in panel (b) maximizes profit
by equating MR with MC, giving rise to output Q2. But
now, we don’t have a single price but a whole range of
prices, given by the demand curve, corresponding to
each level of output from 0 to Q2.
Based on Figure 5.24, it can be concluded that the firm
that practises first degree price discrimination has:
· Increased profits Profit increases from the area in
panel (a) to the entire area under the demand curve
up to ATC in panel (b). The increased profit is the
firm’s rationale for pursuing price discrimination.
· No consumer surplus under perfect price discrimination
All of the consumer surplus is taken away from
consumers, and is converted into profit, as can be
seen in panel (b). Consumer surplus is reduced to
zero.
· Increased output under perfect price discrimination Both
firms produce the level of output where MR = MC.
But since in the case of the price discriminating
firm the MR curve is the same as the demand curve,
the point of intersection of MR with MC occurs at
a higher level of output than that of the non-price
discriminating firm: Q2 > Q1. Therefore perfect price
discrimination leads to a higher level of output.
· No deadweight loss under perfect price discrimination
Part of the deadweight loss of the single-price firm
with market power is converted into profit, as can
be seen in panel (b). The remaining part of the
deadweight loss (the part that is under the ATC)
is in any case producer surplus, and therefore the
firm has captured the total surplus (consumer plus
producer surplus).
· Allocative efficiency under perfect price discrimination
Allocative efficiency is given by the condition P =
MC. Since under perfect price discrimination the
demand curve, which determines price, is also the
marginal revenue curve, when we equate MC with
MR to get the profit-maximizing level of output, we
are also equating MC with P. The firm that practises
perfect price discrimination achieves the socially
desirable condition of allocative efficiency, meaning
that the quantity of output has increased to the
socially desirable level.
Second degree: discrimination among
quantities
Second degree price discrimination is based on the
principle that an individual consumer’s willingness
to pay decreases as larger quantities of a good are
purchased; this means simply that the consumer is
willing to buy a larger quantity of the product only
if the price of the product for successive units falls.
This type of price discrimination usually involves
charging a higher price for the first units of the
product purchased, a lower price for additional
units purchased, and so on, as the buyer purchases
more units of the product. This is why this type of
discrimination is also known as ‘discrimination among
quantities’. There are many real-world examples of
second degree price discrimination:
· food items at the retail level offering discounts when
a large quantity is purchased, so that as the quantity
purchased increases, the price per unit falls
· industrial buyers receiving large discounts for bulk
buying
· airline programmes for frequent flyers
· discounts for frequent users of mass transport
systems
· season tickets for concerts
· utility companies, such as natural monopolies
(electricity, gas, water) commonly charging
consumers one price for a specific quantity of the
product, a lower price for an additional quantity,
and so on.
Figure 5.25 (page 154) illustrates what could happen
if a single-price firm decides to practise second degree
price discrimination. As a single-price firm, it equates
MC with MR (not shown in the figure) to determine
output Q1 and price P1. Profit is given by area A. Let’s
say that Q1 is equal to 100 units of output. Now the
firm decides to take advantage of consumers’ varying
willingness to pay, by varying the prices at which it
sells different quantities. It decides to sell the first 50
units of output at the higher price P2, with the result
that it receives additional profit by the amount of area
B. Then it also sells an additional 30 units of output at
the lower price P3, which gives it further extra profit of
the amount in area C.
The results of second degree price discrimination are
usually the following:
· total revenue and profit increase
· the firm’s output increases
· there will be an improvement in allocative
efficiency, although the result will not be full
Chapter 5: Theory of the firm II 153
HL
HL
allocative efficiency, where P = MC, as in perfect
price discrimination
· the firm will convert some (though not all) of
consumer surplus and deadweight loss into profit.
P
P2
P1
P3
0
B
A
50
C
Q1 130
100
D
Q
Figure 5.25 Second degree price discrimination.
Third degree: discrimination among
consumer groups
Third degree price discrimination is based on the
principle that different consumer groups have
different price elasticities of demand for the product.
This is the most common type of price discrimination,
occurring when consumers are separated into
different groups (or markets) each of which is
charged a different price; hence it is also known as
‘discrimination among consumer groups’. The firm
charges higher prices to consumers with a lower price
elasticity of demand, and lower prices to those with
a higher elasticity of demand. There are numerous
examples of this type of price discrimination:
· cinemas, museums, hotels, transport companies and
others often charge lower prices for children and
older people than to the rest of consumers
· airlines charge higher prices for business travellers
than for leisure travellers
· airlines charge higher prices the closer the booking
date is to the date of travel
· restaurants and theatres may offer special discounts
(i.e. lower prices) on week nights
· hotels may offer discounts (i.e. lower prices) for
winter or mid-week stays
· telephone companies often charge lower rates in the
evenings and at weekends
· hairdressers may charge higher prices for women
· dry-cleaners may charge higher prices for women’s
clothes
· bars may offer lower prices for a short period
immediately after working hours (5 or 6 p.m.).
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The key condition that makes this kind of price
discrimination profitable for a firm is that each
consumer group must have a different price elasticity
of demand. For example, business travellers’ demand
for airline tickets is relatively inelastic (low PED), and
therefore airline tickets are often more expensive if
there is no stay-over on a Saturday night; this pricing
policy is based on the assumption that business
travellers are usually unwilling to stay overnight on
a Saturday. Children and elderly people have a more
elastic demand (higher PED) for movies, transport
services and other products and are therefore charged
lower prices. The demand for telephone services by
businesses is less elastic during the day on weekdays,
and therefore higher prices are charged during those
hours. The demand for hotels in winter and on
weekdays, as well as the demand for restaurant meals
on weekdays, are more elastic than during holidays
and on weekends, and therefore lower prices are
charged during these times. Similarly, the demand
for drinks in bars is more elastic in the early hours of
the evening and therefore here, too, lower prices are
charged.
The firm’s profit-maximizing strategy in third degree
price discrimination is illustrated in Figure 5.26. Let’s
assume that there are only two consumer groups (or
two markets) for product X, which are distinguished
from each other on the basis of differing price
elasticities of demand (PEDs). Panel (a) shows the
consumer group of market 1 to have a relatively
inelastic demand (low PED), while panel (b) shows the
consumer group of market 2 to have a relatively elastic
demand (high PED). The two marginal revenue curves
are added horizontally to give rise to the total market
marginal revenue curve in panel (c), which also shows
the firm’s marginal cost curve.
To maximize profit, the firm equates MR with MC,
and the point of intersection between the two
determines the profit-maximizing level of output Q3.
The firm must now divide the output Q3 between
the two markets. It will do this by equating its MC of
the total market with the marginal revenue of each
individual market, i.e. MC = MR = MR1 = MR2. This
will yield output level Q1 in market 1, which is sold
at price P1 (determined by the demand curve D1), and
output level Q2 in market 2, which is sold at price
P2 (determined by the demand curve D2). (Note that
Q1 + Q2 = Q3.) Figure 5.26 shows that the firm will
charge:
· a higher price (P1) for the consumer group with the
relatively inelastic demand
· a lower price (P2) for the consumer group with the
relatively elastic demand.
HL
HL
(a) Market 1.
(b) Market 2.
P
P
P1
P
MC
P2
MR = MR1 + MR2
D2
D1
0
HL
(c) Market 1 and market 2.
Q1
MR1
Q
0
Q2
MR2
Q
0
Q3
Q
Figure 5.26 Third degree price discrimination.
· Consumer surplus increases for some groups (those
When the firm raises price for consumers with the
low PED, total revenue increases because the price
rise is proportionately larger than the decrease in
quantity demanded. When the firm lowers price for
consumers with the high PED, total revenue again
increases because the increase in quantity demanded
is proportionately larger than the decrease in price.
Higher total revenues mean higher economic
profits.
The results of third degree price discrimination are
very complex, and it is difficult to generalize. The
following points may be noted:
· As in all cases of price discrimination, total revenue
that gain from the price fall) and it decreases
for other groups (those that lose from the price
increase).
· What happens to overall consumer surplus
depends on what happens to output. If output falls,
consumer surplus falls; if output increases, consumer
surplus may either increase or decrease, depending
on the particular situation.
Summary of advantages and disadvantages of
price discrimination
The desirability of price discrimination from a social
point of view is controversial, because it presents a
trade-off between efficiency and equity.
and economic profits increase.
· Total output may increase or decrease; if it increases,
it does not reach the socially optimum level
(allocative efficiency will not be achieved).
· If output increases, then under certain conditions it
will also increase allocative efficiency; if output falls,
then allocative efficiency will worsen.
· Prices under third degree price discrimination will
be lower for some groups and higher for other
groups, compared to the single price charged by
the single-price firm. Therefore some consumer
groups can benefit if a product that was previously
not affordable now comes within their reach, for
example students, pensioners, leisure travellers
who plan far ahead of time, mid-week restaurant
goers, and many others). On the other hand, those
groups who have to pay higher prices will clearly
lose, and for some of them, the product will become
unaffordable.
At the most general level, if output increases as a
result of price discrimination, there is usually also
an improvement in allocative efficiency, which is
desirable from a social point of view. However, the
increase in allocative efficiency is often achieved as
a result of the conversion of consumer surplus into
profit, which is undesirable from a social point of view
because of negative impacts on equity and income
distribution.
To complicate matters further, the impacts of price
discrimination on the consumer, the producer and
overall society are ambiguous, partly because they
depend on the type of price discrimination being
practised, and partly because for each type of price
discrimination, the outcomes are not always certain,
as they depend on the circumstances of each market.
The following contains a summary of possible impacts
of price discrimination.
Chapter 5: Theory of the firm II
155
HL
From the firm’s perspective
· Higher revenues and profits The price discriminating
firm benefits as a result of higher revenues and
higher profits. This is, after all, the rationale of price
discrimination from the point of view of the firm.
If profits did not increase, the firm would not
engage in price discrimination.
· Possibility of increased monopoly power A firm that
uses aggressive tactics to increase its monopoly
power can use price discrimination to charge high
prices in one market and low prices in another
market with the intention of driving out rival firms
that may be unable to compete with the low price.
If it succeeds, it increases its monopoly power.
· No deadweight loss under perfect price discrimination
As noted earlier, part of the deadweight loss of the
firm that does not price discriminate is converted
into profit (see Figure 5.24). The remaining part
of the deadweight loss (the part that is under the
ATC) is in any case producer surplus, and therefore
the firm captures the total surplus (consumer plus
producer surplus).
From the consumer’s perspective
· Output Total output increases under first and second
degree price discrimination; under third degree
price discrimination total output may increase or
decrease. When total output increases, consumers
benefit either because some can consume more of
the product (second degree price discrimination),
or because some consumers who would not have
purchased the product can now do so because
it is offered at a lower price (third degree price
discrimination). However, it is also possible that
total output may decrease under third degree price
discrimination, in which case consumers will be
worse off.
· Prices Those consumers who pay the lower price
benefit, but those who pay the higher price lose.
Second degree price discrimination could be
considered an unfair practice for consumers who
live alone and therefore do not buy large quantities
of items that are discounted when bought in larger
quantities, as well as for low income consumers who
cannot take advantage of the discounts that come
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Part 2: Microeconomics
with large volumes of consumption. Third degree
price discrimination is arguably an unfair practice
for those consumers with a low PED who must pay
more than those with a higher PED, i.e. there arises
a problem of equity.
· Consumer surplus and income distribution Consumer
surplus usually decreases (though this is unclear in
the case of third degree price discrimination). When
it decreases, it is because it is converted into profits,
thereby transferring income from consumers to
producers, which is undesirable from consumers’
perspective.
· Higher prices due to increased monopoly power If a firm
succeeds in driving rival firms from a market, it can
use its increased monopoly power to increase prices,
which is to the detriment of consumers.
From a social perspective
· Allocative efficiency If there is an improvement
in allocative efficiency, society as a whole gains,
because resources come closer to being allocated
in accordance with the condition P = MC (or
more generally, where marginal benefit is equal to
marginal cost). However full allocative efficiency is
only achieved under perfect price discrimination,
which is highly unrealistic. In the real world, where
actual price discriminating practices depart from
perfect price discrimination, second degree price
discrimination is likely to lead to an improvement
in allocative efficiency, whereas in third degree price
discrimination allocative efficiency may improve or
it may worsen.
· Economies of scale and lower prices If total output
increases significantly, there may result lower
average costs due to economies of scale, which could
benefit the firm as well as consumers if the lower
costs translate into lower consumer prices.
· Technological innovation Greater economic profits
for the firm may be reinvested in research and
development (R&D) activities, with the result that
the consumer and society as a whole may benefit
from increased product development and from
technological innovations leading to lower costs
and lower consumer prices.
HL
HL
Test your understanding 5.15
1 (a) Explain the meaning of price discrimination.
(b) What conditions must hold for price
discrimination to take place? (c) Why do firms
practise price discrimination?
2 Why is it impossible for a perfectly competitive
firm to practise price discrimination?
3 (a) Which type of price discrimination is very
difficult (if at all possible) to achieve in practice?
Why? (b) Which is the most common type of
price discrimination?
(...continued)
Questions for
(...continued)
HL
4 There are three types of price discrimination.
Identify what these are, and explain which
discriminates among (a) individual consumers;
(b) quantities of the good purchased; and
(c) consumer groups. (d) Can you provide
examples of each type of price discrimination?
5 (a) What can happen to consumer surplus
and deadweight loss when firms practise price
discrimination? (b) What are the impacts on the
profits of the price discriminating firm?
review
5.1
[10 marks] (a) Using appropriate diagrams,
explain the difference between a firm that is a
‘price-taker’ and one that is a ‘price-maker’.
(b) Under what market structure(s) can we expect
to find each of these?
5.2
[10 marks] Explain the relationship between price,
average revenue and marginal revenue for firms
that are (a) ‘price-takers’; and (b) ‘price-makers’.
5.3
Test your understanding 5.15
[10 marks] Explain and use diagrams to show why
in long-run equilibrium a perfectly competitive
firm makes normal profit (zero economic or
supernormal profit), whereas in the short run it
can make an economic (or supernormal) profit or
loss. (Hint: you must refer to the importance of
economic profits and losses in moving from shortrun to long-run equilibrium.)
5.4
[10 marks] Using diagrams, show under what
conditions a perfectly competitive firm will
(a) continue to produce in the short run even
though it is making a loss; (b) shut down.
5.5
[10 marks] Using diagrams, explain the difference
between the break-even price and the shut-down
price of a perfectly competitive firm.
5.6
[10 marks] Using diagrams, compare and contrast
how firms in perfect competition and monopoly
determine the profit-maximizing (loss-minimizing)
level of output, using marginal revenue and cost
concepts.
5.7
[10 marks] (a) Using a diagram, show how
a monopolist maximizes profit. (b) Is there a
difference between the short-run and long-run
equilibrium of the monopolist?
5.8
[10 marks] (a) Using diagrams, show the profitmaximizing position of a firm that is earning
abnormal (economic) profit under monopolistic
competition in the short run. (b) Can this firm
earn abnormal profit also in the long run?
(c) Show the long-run equilibrium position of
this firm.
5.9
[20 marks] (a) Distinguish between collusive and
non-collusive oligopoly. (b) Provide examples of
models that explain the behaviour of firms in each
of these two types of oligopoly.
5.10
[10 marks for parts (a), (b) and (c); 8 marks
for part (d)] (a) What is a cartel? (b) If a group
of firms formed a cartel that tried to coordinate
prices, what market structure would they be
similar to? Using a diagram, show their profitmaximizing level of output and price.
(c) What factors make it difficult for a cartel
to be maintained over a long period of time?
(d) Why do many countries have laws that make
cartels illegal?
5.11
[10 marks for parts (a) and (b); 5 marks for
part (c)] (a) What model is appropriate for the
study of non-collusive oligopoly? (b) Use this
model to show why prices in oligopolistic markets
tend to be stable over extended periods of time.
(c) How does this model help us understand the
importance of non-price competition in oligopoly
(or why firms in oligopoly try to avoid price
competition)?
Chapter 5: Theory of the firm II
157
HL
5.12
[10 marks] (a) Explain why many firms in
monopolistic competition try to behave like
monopolists. How do they try to achieve this
objective? (b) Explain why many oligopolistic
firms try to behave like monopolists. How do they
try to achieve this objective?
5.13
[10 marks] What are some explanations of price
stability that we generally observe in oligopolistic
markets?
5.14
[15 marks] (a) In what market structures do we
find price competition and non-price competition?
(b) What role do price competition and nonprice competition play in these market structures?
(c) What are the impacts on the demand curve
facing firms that successfully engage in non-price
competition? (d) What is the significance of this
kind of demand curve from the point of view of
the firm?
5.15
5.16
[15 marks] (a) Why do we study perfect
competition and monopoly even though they are
not encountered very frequently in the real world?
(b) Evaluate the perspective that governments
should try to increase the degree of competition in
industries.
[10 marks] (a) Discuss allocative and productive
efficiency and use diagrams to show in which
market model(s) they occur. (b) Why are they
important concepts?
5.17
[20 marks] Evaluate each of the four market
structures, discussing its advantages and
disadvantages from the point of view of
consumers and society: (a) perfect competition;
(b) monopoly; (c) monopolistic competition;
(d) oligopoly.
5.18
[10 marks for parts (a), (b) and (c); 5 marks for
part (d)] (a) What is the theory of contestable
markets? (b) Which market structures is it relevant
to? (c) How do its conclusions differ from those of
the standard theory of the firm? (d) What are its
implications for government policy?
5.19
[15 marks] (a) Explain the meaning of ‘barriers to
entry’ and provide examples of different kinds of
barriers. (b) What role do barriers to entry play in
determining types of market structure?
5.20 [10 marks] Many countries have legislation
making unregulated, privately owned monopoly
illegal. What are the reasons behind this
government policy?
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Part 2: Microeconomics
5.21
[15 marks] (a) Using an appropriate diagram,
explain what a ‘natural monopoly’ is. (b) Using
your diagram of part (a), explain why governments
often do not break up natural monopolies in order
to increase competition.
5.22 [15 marks] Evaluate the desirability of monopoly
from consumers’ and society’s point of view, and
compare with perfect competition.
5.23 [15 marks] Evaluate the desirability of
monopolistic competition from consumers’ and
society’s point of view, and compare with perfect
competition.
5.24 [15 marks] Evaluate the desirability of
monopolistic competition from consumers’
and society’s point of view, and compare with
monopoly.
5.25 [15 marks] Evaluate the desirability of an
oligopolistic market structure from the point of
view of consumers’ and society’s interests, and
compare with perfect competition.
5.26 [15 marks] Evaluate the desirability of an
oligopolistic market structure from the point of
view of consumers’ and society’s interests, and
compare with monopolistic competition.
5.27 [15 marks] Some firms may pursue the goal
of revenue maximization rather than profit
maximization. (a) Using the monopoly market
model, illustrate how a firm can determine
the level of output at which its revenue will be
maximum. (b) Show how the revenue-maximizing
level of output differs from the profit-maximizing
level of output. (c) Can a perfectly competitive
firm maximize revenue? Why or why not?
5.28 [10 marks for parts (a) and (b); 15 marks for
part (c)] (a) What conditions must be satisfied
for a firm to be able to successfully practise price
discrimination? (b) Provide examples of price
discrimination. (c) Discuss some of the positive
and negative effects of price discrimination from
the point of view of firms, consumers and society.
5.29 [15 marks] It is often the case that airline fares
are lower for travellers who purchase their tickets
ahead of time than for flyers who purchase their
tickets the last moment. (a) Explain how this
can occur. (b) What characteristic of consumer
demand allows airline companies to do this?
(c) Evaluate the impacts for consumers, producers
and society.
HL
Chapter 6
Microeconomics
Market failure
In this chapter we will see why the market economy fails to achieve many of its promises, and how
government intervention can help markets overcome their failures.
OBJECTIVES
After studying this chapter you should be able to:
·
·
·
·
·
·
·
·
·
·
explain the meaning of market failure in terms of the inefficient allocation of resources
relate externalities to market failure
examine negative externalities and identify appropriate government policies intended to correct them
understand the relationship between environmental externalities and sustainable development
examine positive externalities and identify appropriate government policies intended to correct them
explain and distinguish between merit goods, demerit goods and public goods, and identify appropriate policies
to address the market failures they pose
evaluate the range of policies that governments can use to correct market failures
understand why monopoly power constitutes market failure, and identify appropriate policies intended to
address it
have an awareness of the existence of additional market failures, and the possible failure of government policy
evaluate the free market economy.
6.1 Market failure and allocative
inefficiency
Our discussion so far has shown that a free,
competitive market economy will give rise to a
number of highly desirable outcomes (see Chapter 1,
page 21 and Chapter 2, page 47). However, the
achievement of these outcomes depends on a number
of very strict and unrealistic conditions that are
practically never met in the real world. Therefore, in
reality, the market mechanism, working freely and on
its own, fails to achieve these highly desirable results.
Yet this failure does not lessen the significance of the
market as a mechanism that can advance the wellbeing of societies; instead, it suggests that if markets
are to achieve their potential to improve social wellbeing, they must be supported by government policies
that correct for their failings.
Market failures constitute a major justification for
government intervention in the market economy,
giving rise to the mixed market economy (studied in
Chapter 1, page 23).
The study of market failure focuses on one particular
failing: the free market’s inability to achieve allocative
efficiency in a variety of circumstances. In Chapter 2,
page 50, we learned that in a free market, when the
price of a good adjusts to make quantity demanded
equal to quantity supplied, the equilibrium quantity
reflects the ‘best’ or optimal allocation of resources to
the production of that good. This condition is known
as allocative efficiency, defined as the production
of the particular combination of goods and services
that consumers mostly prefer, and is achieved when
marginal benefit equals marginal cost, at which point
Chapter 6: Market failure 159
the what to produce question is answered in the most
satisfactory way. Yet in the real world, the market
often fails to achieve efficient outcomes:
Market failure refers to the failure of the market
to allocate resources efficiently, or to provide the
quantity and combination of goods and services
mostly wanted by society (the optimum). Market
failure results in allocative inefficiency, where too
much or too little of goods or services are produced
and consumed from the point of view of what is
socially most desirable.
Allocative efficiency can be attained only under the
strict conditions of perfect competition, which, as we
know from Chapter 2 (and Chapter 5 for higher level
students), can in fact only be somewhat approximated
by a very limited number of markets in the real
world. Therefore it is not surprising that real–world
markets rarely, if ever, allocate resources efficiently. To
complicate matters further, while perfect competition
is necessary for the achievement of allocative
efficiency, it is not enough. In addition, there are
numerous other sources of allocative inefficiency
that are unrelated to the degree of competition. We
will study some of the more important kinds of these
failures under the following topics:
6.2 Externalities
Diverging private and social benefits and costs
When a consumer buys and consumes a good, she
or he derives some benefits. When a firm produces
and sells a good, it incurs costs. But sometimes, the
benefits and the costs spill over onto other consumers
or producers who have nothing to do with consuming
or producing the good. When this happens, there is an
externality.
An externality occurs when the actions of
consumers or producers give rise to positive or
negative side-effects on other people who are not part
of these actions, and whose interests are not taken
into consideration.
The other people feeling the effects of an externality
are often referred to as ‘third parties’, outsiders to the
transaction. If the side-effects on third parties involve
benefits, there arises a positive externality, also
known as a spillover benefit; if they involve costs, in
the form of adverse or negative side-effects, there arises
a negative externality, also known as a spillover
cost:
· externalities, arising when the actions of consumers
or producers have side-effects in the form of costs or
benefits for others who are external to the market
· merit and demerit goods, which are goods that are
underprovided or overprovided by the market
· public goods, which are usually not provided at all by
the market
· abuse of monopoly power, arising in situations where
the absence of competitive conditions permits firms
to take actions that are against the public interest
· some additional failures of markets and government
failure (supplementary material).
Allocative efficiency is a very useful concept as a
standard or benchmark, used by economists to
identify real-world situations that involve serious
departures from the ideal of a perfect allocation of
resources. Once these are identified, it is possible to
design government policies aimed at eliminating
or reducing the extent of the inefficiencies, thereby
bringing the economy closer to the achievement
of the ideal. For each of the above causes of market
failure, we will also discuss a variety of policies that
governments can pursue to correct the failures.
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positive externalities = spillover benefits
= positive side-effects on third
parties
negative externalities = spillover costs
= negative side-effects on third
parties
Externalities can result either from consumption
activities (consumption externalities) or from
production activities (production externalities).
To fully understand externalities, let’s return for a
moment to the demand and supply curves that we
studied in Chapter 2. The standard demand curve of
the market model reflects the value that consumers
attach to the good demanded, or, what is the same
thing, the benefits that consumers derive from
purchasing and consuming the good, measured by the
prices they are willing to pay for it. As we know,
P
S = MPC
Pe
very important implications: it means that if there
are externalities, the equilibrium price and quantity
determined by the intersection of the standard
demand curve (MPB), and the standard supply curve
(MPC) will no longer be a social optimum, and there
will now be allocative inefficiency. To address this
problem, we must find the social benefits and the
social costs:
D = MPB
0
Qopt
allocative efficiency
is achieved
Q
Figure 6.1 Demand, supply and allocative efficiency when there are no
externalities.
the demand curve can be thought of as a ‘marginal
benefit curve’ (see Figure 2.2(b)). Since the benefits
derived from consuming the good go to private
individuals (the consumers buying the good), we can
think of the demand curve as representing marginal
private benefits, shown as MPB in Figure 6.1.
The standard supply curve, on the other hand, reflects
firms’ costs of production, specifically marginal
costs. We can therefore think of the supply curve as
representing marginal private costs, appearing as MPC
in Figure 6.1.
The market demand and supply curves that we are
familiar with therefore reflect the marginal private
benefits and marginal private costs accruing to buyers
and sellers. Now, if there are no externalities, so that
the actions of buyers and sellers do not produce any
side-effects on third parties, the marginal private
benefit (or demand) curve and marginal private cost
(or supply) curve determine an equilibrium price
and quantity that reflect a social optimum, or ‘best’
outcome in which there is allocative efficiency. In
Figure 6.1, allocative efficiency is achieved at output
Qopt. This is none other than the market equilibrium
achieved by the intersection of the demand and
supply curves we are familiar with, where MPB = MPC,
illustrating the achievement of allocative efficiency
(see also Figure 2.18).
If, however, there is an externality, there will arise
additional benefits or costs affecting third parties,
or outsiders to the transaction, in which case the
full benefits and costs to society will differ from the
private ones. Specifically, there will arise marginal
social benefits that will be different from the
marginal private benefits; or marginal social costs
that will be different from the private costs. This has
Social benefits = private benefits + externality
Social costs = private costs + externality
Social benefits and social costs in relation to private
benefits and costs appear in Figures 6.2 and 6.4–6.6. In
a diagram, social benefits appear as a marginal social
benefit curve, MSB, representing the full benefits to
society from the consumption of a good, and social
costs as a marginal social cost curve, MSC, representing
the full costs to society of producing the good. The
intersection of MSB and MSC represents a social
optimum in which allocative efficiency is achieved.
There are four types of externalities:
· negative externalities (spillover costs) in
production
· negative externalities (spillover costs) in
consumption
· positive externalities (spillover benefits) in
production
· positive externalities (spillover benefits) in
consumption.
Test your understanding 6.1
1 (a) What is an externality? (b) Use the
concept of allocative efficiency to explain how
externalities relate to market failure.
2 Explain the difference (a) between private
benefit and social benefit; and (b) between
private cost and social cost.
Negative production externalities (spillover
costs)
Illustrating negative production
externalities
Negative production externalities are spillover costs
created by producers. The problem of environmental
Chapter 6: Market failure 161
(a) Negative production externality.
(b) Correcting the negative production externality
by imposing a tax on the firm.
MSC
P
P
spillover
cost
S = MPC
P1
0
P2
MSC
tax =
spillover
cost
S = MPC
P1
Qopt Qm
D = MPB
Q
D = MPB
0
Qopt Qm
Q
Figure 6.2 Negative production externalities.
pollution, created as a side-effect of production
activities, is very commonly analysed as a negative
externality in production.
Consider the case of a cement factory that emits
smoke into the air and disposes of its waste by
dumping it into the ocean. There is a production
externality, because over and above the firm’s private
costs of production, there are additional costs that spill
over onto society (spillover costs) due to the polluted
air and ocean, with negative consequences for the
local inhabitants, swimmers, sea life, the fishing
industry, and the marine ecosystem. This is shown in
Figure 6.2(a), where the supply curve given by MPC
reflects the firm’s private costs of production, and the
marginal social cost curve given by MSC represents
the full cost to society of producing cement. The
vertical difference between MSC and MPC represents
the spillover costs, or the costs arising from the
externality. Therefore, for each level of output, Q,
social costs given by MSC, or the full cost to society of
producing cement, are greater than the firms’s private
costs by the amount of the spillover costs to third
parties from the pollution.
In Figure 6.2(a), the free market gives rise to
quantity Qm of cement produced, determined by
the intersection of MPB and MPC. But the socially
optimum (or ‘best’) quantity is Qopt, determined by
the intersection of MPB and MSC. At Qopt, the value
of cement to consumers (MPB) is exactly equal to the
social cost of producing it. This gives rise to a very
important result:
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Part 2: Microeconomics
When there is a negative production externality, the
free market overallocates resources to the production
of the good; in other words, too many resources are
allocated to produce the good, and too much of it
is produced relative to the social optimum. This is
shown by Qm > Qopt in Figure 6.2(a).
Correcting negative production
externalities
If this problem could be corrected, then Qopt quantity
of cement would be produced, and allocative
efficiency would be achieved. There are several
options that governments may pursue.
Legislation and regulations
Legislation and regulations can be used to prevent
or reduce the effects of production externalities. In
the case of the polluting firm, legislation can be used
to completely forbid the dumping of certain toxic
substances into the environment (into the rivers,
oceans, etc.). More commonly, however, legislation
may not totally ban the production of pollutants, but
rather could attempt to achieve one of the following:
· limit the emission of pollutants by setting a
maximum level of pollutants that are permitted
· limit the quantity of output produced by the
polluting firm
· require polluting firms to install technologies
reducing the emissions.
In all these cases, the impact would be to lower the
quantity of the good produced, and to bring it closer
to the optimal quantity Qopt in Figure 6.2(a) by shifting
the MPC supply curve upward towards the MSC curve.
Pollutant and output restrictions achieve this directly
by forcing the firm to produce less. Requirements
to install technologies reducing emissions achieve
this by imposing higher costs of production due to
the purchase of the non-polluting technologies. The
government’s objective is to make the MPC curve
shift upwards until it coincides with the MSC curve,
in which case Qopt will be produced, price will increase
from P1 to P2, and the problem of overallocation
of resources to the production of the good will be
corrected.
Imposing a tax on the firm causing the
negative production externality
A different kind of policy involves the imposition
of taxes on the polluting firm. The government
could impose a tax on the firm per unit of the good
produced, or a tax per unit of pollutants emitted. Both
of these would result in an upward shift of the supply
(MPC) curve. The optimal (or best) tax policy will be
to impose a tax that is exactly equal to the spillover
cost, in which the MPC curve will shift upward until
it overlaps with MSC. This is shown in Figure 6.2(b),
where the new, after-tax equilibrium quantity is
Qopt, given by the intersection of MSC (= MPC + tax)
and the demand curve, MPB. The tax has resulted
in production of a lower quantity, which is also the
optimum quantity, and a higher price (P2). At this
equilibrium, the overallocation of resources will be
corrected.
Tradable permits
Tradable permits are permits to pollute that are
issued to firms by a government or an international
body, and that can be traded (bought and sold) in a
market. This is a relatively new policy option, which
works in the following way. Consider a number of
firms whose production results in environmental
pollution. Each firm is granted by the government a
particular number of permits (or rights) to produce
a particular level of pollutants over a given period of
time. The permits to pollute can be bought and sold
among interested firms, with the price of permits
being determined by supply and demand. If a firm
can produce its product by emitting a lower level of
pollutants than the level set by its permits, it can sell
its extra permits in the market. If a firm needs to emit
more pollutants than the level set by its permits, it can
buy more permits in the market.
Figure 6.3 shows a market for tradable pollution
permits. The supply of permits is perfectly inelastic
(i.e. the supply curve is vertical), as it is fixed at a
particular level by the government (or an international
authority if several countries are participating). This
fixed supply of permits is distributed to firms. The
position of the demand-for-permits curve determines
the equilibrium price. As an economy grows and the
firms increase their output levels, the demand for
permits is likely to increase, as shown by the rightward
shift of the demand curve from D1 to D2. With supply
fixed, the price of permits increases from P1 to P2.
P
S of tradable permits
P2
P1
D2
D1
0
Q1
Q
Figure 6.3 Market for tradable pollution permits.
Correction of negative production externalities
involves pursuing policies that shift the MPC (supply)
curve upward towards the MSC curve in Figure 6.2(b).
If the MPC curve shifts so that it overlaps with the
MSC curve, then the optimal quantity of the good will
be produced, the overallocation of resources will be
corrected, and allocative efficiency will be achieved.
The effect will be to lower the quantity of the good
produced so that it equals Qopt, and to raise the price
of the good from P1 to P2.
Evaluating alternative policies
Economists usually prefer solutions to negative
production externalities based on taxes and tradable
permits, rather than government legislation and
regulations. Both taxes and tradable permits dealing
with negative production externalities have the effect
of internalizing the externality, meaning that the
spillover costs that were previously external are now
internal: they are now paid for by producers who
are parties to the transaction. When the externality
is internalized, firms pay for the spillover costs
themselves, whether by having to pay taxes, or by
having to buy tradable permits.
Chapter 6: Market failure 163
Both taxes and tradable permits are market-based
methods of dealing with externalities. Unlike
legislation and regulations (which are based on the
command mechanism), taxes and tradable permits
make firms internalize the externality, thereby
providing firms with incentives to cut back on the
pollution they produce.
In the case of taxes, if firms are taxed on the basis
of pollutants emitted, they face an incentive to use
production methods that pollute less. Firms do not
all face the same costs of reducing pollution; for
some firms, the costs of reducing pollution will be
much lower than for others, and they will be the ones
most likely to cut their pollution emissions to avoid
paying the tax. The firms that face the highest costs
of reducing pollution will be the ones least likely to
cut their pollutants, and so will pay the tax. The result
is that taxation can lead to lower pollution levels at
a lower overall cost. Similarly, in the case of tradable
permits, the system creates incentives for firms to cut
back on their pollution if they can do so at relatively
low cost. If it is a relatively low cost procedure for a
firm to cut back on its pollutant emissions, it will be in
its interests to do so and sell excess permits. Firms that
can only reduce pollution at high cost will be forced to
buy additional permits.
There are, however, some difficulties involved with
both taxes and tradable permits. In the case of taxes,
there are serious practical difficulties in determining
the amount of pollutants emitted and in designing a
tax that will be equal in value to the amount of the
pollution. Tradable permits require the government to
determine not only the amount of pollutants emitted,
but also to set a maximum level for each type of
pollutant for which permits will be distributed to the
polluting firms; this latter task would involve having
technical information on how much of each pollutant
is acceptable from an environmental point of view,
which is often not available. Therefore, in practice,
assuming that a government is interested in correcting
negative production externalities involving pollution,
it is most unlikely that it could achieve the desired
shift in the MPC curve shown in Figure 6.2(b), leading
to production of the optimal quantity Qopt.
Legislation and regulations, apart from being based
on the command method (rather than the market),
suffer from similar limitations, and can at best be only
partially effective, given the difficulties of devising
measures that can shift the supply (MPC) curve so that
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Part 2: Microeconomics
it exactly overlaps with the MSC curve. Therefore, such
measures can only attempt to partially correct the
problem.
Test your understanding 6.2
1 (a) Using diagrams, show how private and social
costs differ when there is a negative production
externality. (b) How does the equilibrium
quantity determined by the market differ from
the quantity that is optimal from the point of
view of society’s preferences? (c) What does
this tell you about the allocation of resources
achieved by the market when there is a negative
production externality?
2 Provide some examples of negative production
externalities.
3 For each of the examples you provided in
question 2, state and explain the most effective
method(s) of correcting the externality.
4 Using diagrams, show how the negative
externality can be corrected by use of (a) taxes,
and (b) legislation and regulations that limit the
quantity of pollutants.
5 Explain how tradable pollution permits can
contribute to correcting negative production
externalities.
6 (a) What does it mean to ‘internalize an
externality’? How can this be achieved?
(b) Why do economists prefer market-based
methods that internalize negative production
externalities to command methods (such as
legislation and regulations)? (c) What are some
difficulties that governments face in designing
market-based methods?
Negative consumption externalities
(spillover costs)
Illustrating negative consumption
externalities
Negative consumption externalities are spillover costs
created by consumers. For example, when consumers
smoke in public places, there are spillover costs in the
form of costs to non-smokers due to passive smoking.
When there is a consumption externality, the marginal
private benefit (demand) curve does not reflect social
benefits. In Figure 6.4(a), the buyers of cigarettes have
a demand curve, MPB, but in the course of smoking
(b) Advertising and
persuasion.
(a) Negative consumption
externality.
(c) Correcting the negative consumption
externality by imposing a tax on the
firm producing the good.
MPC + tax
P
S = MPC
P1
D = MPB
spillover
cost
P
S = MPC
spillover
cost
Qopt
Qm
P1
P2
Q
0
P2
S = MPC
P1
D = MPB
D1 = MPB1
MSB = D2 = MPB2
after demand decreases
MSB
0
tax =
spillover
cost
P
Qopt Qm
Q
MSB
0
Qopt
Qm
Q
Figure 6.4 Negative consumption externalities.
create costs for non-smokers. Because of these costs,
the marginal social benefit curve, MSB, lies below
the MPB curve. The vertical difference between MPB
and MSB represents the spillover costs. The market
determines an equilibrium quantity, Qm, given by
the intersection of the MPB and MPC curves, but
since there are spillover costs of consumption, the
social optimum is given by Qopt, determined by
the intersection of the MSB and MPC curves. Since
Qm > Qopt, the market overallocates resources to the
production of the good, and too much of the good is
produced and consumed.
Other examples of negative consumption externalities
include:
· heating homes and driving cars by use of fossil fuels
that pollute the atmosphere
· partying with loud music until the early hours of
the morning, and disturbing the neighbours.
Correcting negative consumption
externalities
If this problem were corrected, Qopt quantity of
the good would be produced, reflecting allocative
efficiency. Options that can be pursued by the
government include the following:
· Advertising and persuasion Advertising and
campaigns by the government can be used to
try to persuade consumers to buy fewer goods
with negative externalities, such as anti-smoking
campaigns. In this case the objective is to try to
decrease demand for such goods and services, so
that the private marginal benefit (demand) curve,
MPB, shifts leftward towards MSB. Figure 6.4(b)
illustrates the case where D1 = MPB1 (before the
advertising campaign) shifts to D2 = MPB2 after
the campaign, where it coincides with MSB. Qopt is
produced and consumed, and the price falls from P1
to P2.
· Legislation and regulations Legislation can be used
When there is a negative consumption externality, the
free market overallocates resources to the production
of the good, and too much of it is produced relative to
what is socially optimum. This is shown by Qm > Qopt
in Figure 6.4(a).
In general, negative externalities (spillover costs),
whether these arise from production or consumption
activities, lead to an overallocation of resources to the
good in question, and therefore to overprovision of
the good.
to prevent or limit consumer activities that impose
costs on third parties. For example, there may be
legal restrictions on such activities as smoking in
public places, playing loud music in the middle of
the night and discarding rubbish (trash) in public
places. This also has the effect of shifting the
marginal private benefit (demand) curve towards
the marginal social benefit curve, so that Qopt will be
produced and consumed, and the price of the good
will fall.
· Imposing a tax on the firm producing the good that
causes the negative consumption externality As we
have seen in Figure 6.4(a), the marginal social
benefit curve (MSB) lies below the marginal benefit
(demand) curve (MPB) by an amount that is equal
Chapter 6: Market failure 165
to the spillover cost. If a tax is imposed on the
firm producing the good that has the negative
consumption externality, there will result a decrease
in supply and an upward shift of the supply curve
from MPC to MPC + tax, as shown in Figure 6.4(c).
If the tax is exactly equal to the spillover cost, then
the quantity produced and consumed will drop to
Qopt, which is determined by the intersection of the
MPB curve with the MPC + tax curve. Qopt represents
the socially optimum quantity, and price will
increase from P1 to P2. The tax can therefore permit
allocative efficiency to be achieved.
Moreover, there are also problems with calculating
the precise magnitude of the tax required, as well
as the type of legislation or regulations that would
be effective. Therefore, in the cases of all policies
(advertising, legislation, regulations and taxes), it is
only possible to move the economy in a direction
towards correction of the externality, rather than
achieving a precise allocation of resources where Qopt
is produced and consumed.
Test your understanding 6.3
1 (a) Show diagrammatically how private and
Correction of negative consumption externalities
involves decreasing demand and shifting the demand
(MPB) curve leftward toward the MSB curve, as in
Figure 6.4(b), or decreasing supply and shifting the
supply (MPC) curve upward (through the imposition
of a tax) so that its intersection with MPB determines
Qopt in Figure 6.4(c). When production occurs at Qopt,
the overallocation of resources will be corrected and
allocative efficiency is achieved. The effect will be to
lower the quantity of the good produced, and lower
or raise the price of the good paid by the consumer
depending on whether the correction was brought
about by a decrease in demand (price will fall) or a
decrease in supply (price will increase).
Evaluating alternative policies
As in the case of negative production externalities,
economists prefer market-based solutions to the
problem of negative consumption externalities as
well; therefore taxes are the preferred measure. A
possible difficulty that arises in this respect is that
some of the goods whose consumption leads to
negative consumption externalities have an inelastic
demand. As higher-level students may remember
from Chapter 3, page 71, the imposition of a tax on a
good with an inelastic demand results in an increase
in government revenues, because the percentage
decrease in quantity demanded is smaller than the
percentage increase in price (due to the tax). Therefore
it is possible that imposing taxes on such goods as
petrol/gasoline and cigarettes (both of which have an
inelastic demand) works to increase government tax
revenues more than it works to decrease the demand
for these goods.
An additional difficulty involves the technical
problem of information needed on the amount of
pollution created, by which products and produced by
which firms, which is exceedingly difficult to collect.
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Part 2: Microeconomics
social benefits diverge when there is a negative
consumption externality. (b) When there is a
negative consumption externality, how does
the equilibrium quantity determined by the
market diverge from the quantity that is optimal
from the point of view of society’s preferences?
(c) What does this tell you about the allocation
of resources achieved by the market when there
is a negative consumption externality?
2 Provide some examples of negative
consumption externalities.
3 For each of the examples you provided in
question 2, state and explain the most effective
method(s) of correcting the externality.
4 Show diagrammatically how a negative
consumption externality can be corrected by use
of (a) legislation and regulations that limit the
spillover costs, (b) advertising and persuasion,
and (c) taxes.
5 How does a negative consumption externality
differ from a negative production externality?
6 (a) What kinds of measures do economists
prefer to correct negative consumption
externalities? (b) Why might these not be very
effective?
Environmental concerns and sustainable
development
Environmental concerns and negative
externalities
Environmental pollution involves negative
externalities of monumental proportions, and results
from both production and consumption activities.
Factories that pollute the air, water, and soil, or that
cause any other kind of environmental damage,
are producers who do not bear the costs of the
pollution they create, thus imposing spillover costs
that are borne by society at large. The social costs
of production are greater than the private costs of
production by the amount of the spillover cost (i.e.
the cost to society due to the pollution). Emissions
by cars and homes using fossil fuels pollute the
atmosphere and are by-products of consumption
activities involving the use of cars and home heating
by consumers. These also impose spillover costs on
society, and the social benefits from consumption
are lower than private benefits by the amount of the
spillover costs. These are just some examples of the
many ways that producers and consumers can damage
the environment.
When societies produce and consume without regard
for the natural environment, they are likely to engage
in activities that result in environmental pollution and
degradation. Environmental pollution and degradation
arise to a very large extent from the use and overuse
of natural resources that have no ownership, in other
words, they do not belong to anyone. Examples of
natural resources without ownership are the air, the
oceans, rivers and lakes, wildlife, the fish in the sea,
forests, biodiversity, and even the global climate and
the ozone layer. Although we often don’t think of
these goods as being natural resources, they are a very
important part of what economists traditionally have
called the factor of production ‘land’, which includes
all ‘gifts of nature’.
When factories, homes or cars use fossil fuels that emit
pollutants into the atmosphere or into oceans, rivers
and lakes, they ‘use up’ a portion of these natural
resources, although they do not pay for them. Some
of these activities result in ozone depletion, with
harmful effects on life from the sun’s radiation; they
‘use up’ part of the ozone layer, yet they don’t pay
for its use. Some of these activities also give rise to
global warming, with possibly devastating effects on
agriculture, health and ecosystems; this involves ‘using
up’ the benefits provided by a stable global climate,
which are also not paid for. When fish are fished out
of the sea, the fishing industry uses up a portion of the
global stock of fish and possibly disrupts the marine
ecosystem, both of which it does not pay for. 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 and the ozone
layer, yet once again resources are used up but are not
paid for.
Why are all these natural resources not paid for even
though they are being used up? The reason is that
they are not owned by anyone. Since they have no
owner, they are not exchanged in any market; they
do not have a price, and they are therefore available
for anyone to use without payment. Since there is no
price to ration their use, they are subject to overuse.
Natural resources that have no ownership and are
therefore subject to overuse are called open access
resources, or common property resources.
Thinking about pollution and environmental
degradation in terms of use and overuse of open
access resources is another way of viewing negative
environmental externalities. The use of open access
resources involves negative externalities due to
depletion of essential resources not paid for by the
user, thereby imposing spillover costs on society. To
see this more clearly, consider Figure 6.2(a) above,
illustrating a negative production externality. The
marginal private cost (supply) curve, MPC, can
represent the private costs of a fishing firm that fishes
in the open seas. The fishing activities of this firm
may impose spillover costs in the form of depletion
of the stock of fish, and environmental damage due
to disruption of the marine ecosystem. The presence
of spillover costs means that the marginal social cost
curve, MSC, lies above the private marginal cost (or
supply) curve, MPC, since social costs of fishing are
greater than the private costs. The vertical difference
between the two curves represents costs to society,
consisting of depletion of the fish stock and disruption
of the marine ecosystem (the open access resources)
that the fishing firm has used up but has not paid for.
Overuse of common access resources can also be seen
to result from negative consumption externalities,
shown in Figure 6.4(a) above. Take the demand for
heating oil, represented by the demand curve MPB.
The use of clean air (and the creation of pollution)
is represented by the spillover cost that causes the
marginal social benefit curve (MSB) to lie below MPB.
The spillover cost represents the clean air (the open
access resource) that consumers have used up in
heating their homes but have not paid for.
The meaning of sustainable development
Environmental pollution and degradation are closely
related to the concept of sustainable development
(introduced briefly in Chapter 1, page 10). Sustainable
development has been defined as ‘development that
meets the needs of the present without compromising
Chapter 6: Market failure 167
the ability of future generations to meet their own
needs’. 1
This concept has been developed in an effort to link
economic and environmental goals. Economic goals
involve efforts to increase the quantities of output
produced and consumed (economic growth) in order
to satisfy ever more needs and wants of human beings;
environmental goals involve the preservation of the
environment.
The economic goal of continuously increasing
quantities of output produced and consumed is very
often pursued without regard for possible impacts
on the environment; in other words, the goal of
preservation of the environment is often ignored. Yet
as long as this occurs, there may arise serious ecological
dangers for future generations of people. The concept
of sustainable development highlights the point that
there are trade-offs between the well-being of present
generations of people and the well-being of future
generations. If we in the present use up resources
at a rate that leaves fewer or lower quality resources
behind, we are satisfying our needs and wants now at
the expense of the well-being of people in the future,
who with fewer or lower quality resources at their
disposal will be less able to satisfy their own needs and
wants. If we enjoy the benefits today of production
and consumption by changing the global climate and
by using up clean air, seas and rivers, forests and the
ozone layer, we are penalizing future generations, who
will suffer the consequences of our excesses.
Negative production and consumption externalities,
if they occur on a large scale, lead to unsustainable
development. We will return to the relationships
between economic growth and sustainable
development in Chapter 19.
Addressing the overuse of open access
resources
Many of the measures considered earlier for the
purpose of dealing with negative production and
consumption externalities apply equally to the overuse
of open access resources:
· Taxes If the overuse of clear air, rivers and seas by
firms is considered as spillover costs of firms whose
private costs of production are lower than the social
costs, taxes on the polluting firms can be used to
address the problem of resource misallocation. The
analysis is the same as that shown in Figure 6.2(b).
1
Brundtland Commission (World Commission on Environment and
Development), Our Common Future (Oxford University Press, 1987).
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· Legislation and regulations Legislation can impose
restrictions on the use of open access resources. For
example, there can be restrictions on permissible
fishing practices, or limits by setting quotas on
quantities that can legally be fished. Hunting laws
restrict what can be hunted and at what times of the
year, and often impose total bans on the hunting
of particular species. Alternatively, the government
may grant or sell licences for the use of specific
resources, as with fishing or hunting licences.
· Advertising and persuasion Governments can make
efforts to convince consumers to cut back on use
of pollution-creating substances, and to increase
consumption of energy-efficient consumer goods,
such as cars, heating systems, light bulbs, etc. They
can also try to use persuasion to convince producers
to cut back on their emissions of hazardous and
polluting wastes.
· Tradable permits Tradable permits can be used to
deal with the problem of open access resources if
potential users of particular resources are assigned
tradable quotas specifying the amount of the
resource they are permitted to use.
In addition, there is another policy measure that
attempts to strike at the problem of open access
resources by going to the source of the problem, which
is their lack of ownership:
· Extension of property rights When clean air is
polluted, no one can claim damages because no one
owns it. In effect, the lack of property rights over
open access resources means that producers and
consumers use them as if they were free goods
(i.e. goods with a zero opportunity cost). However,
open access resources are subject to the condition of
scarcity, and have an opportunity cost greater than
zero; therefore they are not free goods.
The lack of ownership of open access resources lies
at the heart of the problem of their overuse, i.e. their
overallocation to the production of goods and services.
When there are no property rights over resources,
producers and consumers use them as if they were free
goods. The market fails to allocate resources efficiently
because there is no market. Extension of property
rights would involve establishing property rights over
resources that no one owns, allowing the holder of
the property rights to charge a price for the use of the
resource. Price would ration the use of the resource,
and less of it would be used up.
This approach could include, for example, the right
to clean air, or the right to a smoke-free environment.
The impact of an extension of property rights would
be that anyone who violates them would be liable to
pay, and therefore negative externalities, or spillover
costs, would be transformed into private costs. If there
is ownership of clean air, then anyone who uses it up
by polluting it would have to pay for it, and the cost
of the pollution would become a private cost borne
by the polluter. By having to pay for the use of the
resource, its use will be reduced and overallocation of
the resource will be corrected. This is another way of
internalizing the externality.
However, whereas extension of property rights is
a sound approach in theory, in practice there are
significant problems in trying to establish property
rights over common access resources. It would be very
difficult and costly to try to establish property rights
over oceans, rivers and the atmosphere. Therefore,
governments interested in preservation of open
access resources often resort to other more practical
solutions, such as legislation and regulations (fishing
quotas, hunting and logging restrictions) or tradable
permits in the case of the right to use up clean air.
Many negative externalities that relate to the
environment have impacts that extend beyond
national boundaries. When this occurs, international
collaboration is called for.
International cooperation/agreements
Policies are made mainly by national governments.
However, when externalities have international
repercussions, cooperation among governments is
crucially important as a method of controlling adverse
consequences on certain open access resources, such
as the global climate and the ozone layer. For example,
the ozone layer has suffered ozone depletion, giving
rise to reduced protection against the sun’s ultraviolet
radiation. This has been the result of human activities
involving the production of nitrogen oxides and
chlorofluorocarbons (CFCs). The ozone layer is an
open access resource over which there are no property
rights. No one can claim damages for its destruction.
The responsibility for its destruction lies with
polluting activities within virtually every country, and
the consequences of its destruction are felt globally.
An important example of international collaboration
intended to deal with a negative environmental
externality with enormous global repercussions is
the Kyoto Protocol of 1997. Its objective was to make
signatory countries commit themselves to reduce
emissions of carbon dioxide and other greenhouse
gases over a period of time so as to slow down the
problem of global warming and climatic change. It
also contained provisions for the development of
a market of tradable emissions permits, according
to which each participating country was to be
assigned certain pollution permits which it would
be able to trade (buy and sell) with other countries.
However, the Kyoto Protocol came under a great deal
of criticism and has not been implemented in full.
Many environmental specialists argued that even
if it were implemented, the agreed reductions in
emissions were too small to have a significant impact
on the problem of global warming. In February 2007,
in the ‘Washington Declaration’, a number of the
larger more developed and less developed countries
began discussions on an agreement that is intended
to replace the Kyoto Protocol, to be developed by
2009. Like the Kyoto Protocol, the new agreement
is intended to be based on limits to emissions and a
tradable emissions permit system.
Test your understanding 6.4
1 (a) Define open access resources. (b) Explain the
consequences of the lack of price as a rationing
mechanism. (c) Since open access resources have
no price, are they free goods?
2 How do property rights (or lack of these) relate
to the overuse of open access resources?
3 Under what circumstances is international
collaboration essential for the preservation of the
environment?
4 How does overuse of common access resources
relate to sustainable development?
Positive production externalities (spillover
benefits)
Illustrating positive production
externalities
Positive production externalities are spillover benefits
created by producers. If, for example, a firm engages
in research and development, and succeeds in
developing a new technology that spreads throughout
the economy, there are spillover benefits, because not
only the firm, but also society as a whole benefits from
widespread adoption of the new technology. Because
of the spillover benefits, the social costs of research
and development are lower than the private costs. In
Figure 6.5(a) (page 170), MSC lies below MPC. The
Chapter 6: Market failure 169
· A pharmaceutical company develops a new
(a) Positive production externality.
S = MPC
P
spillover
benefit
MSC
medication that benefits not only its users but also
those around them from the improved quality of
life, increased life expectancy, and so on.
Correcting positive production
externalities
Subsidies
0
D = MPB
Q
Qm Qopt
(b) Correcting the positive production externality
by use of a subsidy.
P
S = MPC
subsidy =
spillover benefit
MSC
P1
P2
0
Qm Qopt
D = MPB
Q
Figure 6.5 Positive production externality.
market determines equilibrium Qm, determined by
the intersection of the MPB and MPC curves, while
the social optimum is given by Qopt, determined by
the intersection of the MPB with MSC curves. Since
Qm < Qopt, the market underallocates resources to
research and development activities that lead to new
technologies, and not enough of them are undertaken.
When there is a positive production externality, the
free market underallocates resources to the production
of the good, in other words, too few resources are
allocated to produce the good, and too little of it is
produced relative to what is socially optimum. This
is shown by Qm < Qopt in Figure 6.5(a).
Further examples of positive production externalities
include the following:
· Firms train workers who after a period switch jobs
and work elsewhere; spillover benefits are created as
the new employers and society as a whole benefit
from the trained workers.
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Part 2: Microeconomics
A positive production externality gives rise to a
marginal social cost curve (MSC) that lies below the
marginal private cost (supply) curve, the difference
between the two being the spillover benefit. If the
government provides a subsidy to the firm per unit
of the good produced that is equal to the spillover
benefit, then the private marginal cost (supply) curve
will shift downward so that it will coincide with the
social marginal cost curve, as shown in Figure 6.5(b).
The result will be to increase quantity produced to
Qopt and to lower the price from P1 to P2. The problem
of underallocation of resources and underprovision
of the good is corrected, and allocative efficiency is
achieved.
Correction of positive production externalities
involves shifting the MPC (supply) curve downward
(through the imposition of a subsidy) towards the
MSC curve in Figure 6.5(b). If the MPC curve shifts
so that it overlaps with the MSC curve, then the
optimal quantity of the good will be produced, the
underallocation of resources will be corrected, and
allocative efficiency will be achieved. The effect will
be to increase the quantity of the good produced so
that it equals Qopt, and to lower the price of the good
from P1 to P2.
Positive consumption externalities (spillover
benefits)
Illustrating positive consumption
externalities
When there is a positive consumption externality,
spillover benefits are created by consumers. For
example, the consumption of education benefits the
person who receives the education, but in addition
gives rise to spillover benefits, involving benefits to
society from a more productive workforce, lower
unemployment, higher rate of growth, more economic
development, lower crime rate, etc. Similarly, the
consumption of health care services benefits not only
the person receiving the services, but also society and
the economy, because a healthier population is more
productive, and may enjoy a higher rate of economic
growth. In such cases, the marginal social benefit
curve, MSB, in Figure 6.6(a), lies above the marginal
private benefit curve and the difference between
the two consists of the spillover benefits to society.
Since Qopt > Qm, the market underallocates resources to
education, and too little of it is produced.
When there is a positive consumption externality, the
free market underallocates resources to the production
of the good, and too little of it is produced relative to
what is socially optimum. This is shown by Qm < Qopt
in Figure 6.6(a).
In general, positive externalities (spillover benefits),
whether these arise from production or consumption
activities, lead to an underallocation of resources to
the good in question, and therefore to underprovision
of the good.
Correcting positive consumption
externalities
· Advertising and persuasion Governments can
use advertising to try to persuade consumers to
buy more goods with positive externalities. For
example, they can try to encourage the use of
sports facilities for improved health. The objective
here is to increase demand for such services, so
that once again the marginal private benefit curve,
D1 = MPB1, will shift to the right in the direction
of the marginal social benefit curve (MSB) in
Figure 6.6(b). If the MPB curve shifts enough, it
will shift to D2 = MPB2 to coincide with MSB, and
Qopt will be produced and consumed.
· Subisidies When there is a positive consumption
externality, the marginal social benefit curve lies
above the marginal private benefit (demand)
curve. A subsidy to the producer of the good with
the positive externality will result in increasing
supply and shifting the supply curve downward.
If the subsidy is equal to the spillover benefit, the
new supply curve will be MPC + subsidy, shown
in Figure 6.6(c). The socially optimum quantity
Qopt will now be produced, determined by the
intersection of the MPB and MPC + subsidy curves,
and the price will fall from P1 to P2. The problems
of underallocation of resources and underprovision
of the good have been addressed, and allocative
efficiency is achieved.
· Legislation Legislation can be used to promote
greater consumption of goods with positive
externalities. For example, many countries have
legislation that makes education compulsory up to
a certain age. In this case, demand for education
increases, and the marginal private benefit curve
shifts to the right. Ideally, it will shift until it reaches
the MSB curve, as shown in Figure 6.6(b), with the
shift from D1 = MPB1 to D2 = MPB2, where Qopt will be
produced and consumed.
Correction of positive consumption externalities
involves increasing demand and shifting the demand
(MPB) curve rightward towards the MSB curve, as
in Figure 6.6(b), or increasing supply and shifting
the supply (MPC) curve downward (through the
imposition of a subsidy) so that its intersection with
MPB determines Qopt in Figure 6.6(c).
(a) Positive consumption
externality.
(b) Correcting the positive externality by
legislation or persuasion.
(c) Correcting the positive consumption
externality by use of a subsidy.
P
P
P
S = MPC
S = MPC
S = MPC
subsidy =
spillover
benefit
P2
P1
MSB
MSB = D2 = MPB2
P1
spillover
benefit
spillover
benefit
0
Qm Qopt
D = MPB
Q
0
D1 = MPB1
Qm Qopt
Q
MPC +
subsidy
P1
MSB
P2
0
Qm
D = MPB
Qopt
Q
Figure 6.6 Positive consumption externality.
Chapter 6: Market failure 171
When production occurs at Qopt, the underallocation
of resources will be corrected and allocative efficiency
is achieved. The effect will be to increase the quantity
of the good produced, and raise or lower the price of
the good paid by the consumer depending on whether
the correction was brought about by an increase in
demand (price will increase) or an increase in supply
(price will fall).
Evaluating measures to correct spillover
benefits
Subsidies are widely used as a method to deal with
positive consumption externalities, and also to a lesser
extent positive production externalities. However, a
difficulty involved in achieving the results indicated
in Figure 6.5(b) and Figure 6.6(c) in practice is that
it is very difficult to measure the size of the spillover
benefits, and to calculate the precise size of the
subsidy that the activities in question should receive.
Therefore, in the real world it is very unlikely that
governments are able to shift the MPC curves by the
amount necessary to correct the positive externalities.
The most that can be hoped is that the policies in
question will be a step in the right direction.
Legislation and advertising are subject to similar
limitations concerning calculating the size of the
spillover benefits, and can only help shift the MPB
curve in the right direction, rather than achieve a
demand increase that will bring the economy to the
Qopt level of output.
Test your understanding 6.5
1 Show diagrammatically how a positive
consumption externality differs from a positive
production externality, and explain the
difference.
2 What is the impact on resource allocation
of (a) positive production externalities, and
(b) positive consumption externalities.
3 Provide examples of (a) positive production
externalities, and (b) positive consumption
externalities.
4 What policy options are available to
governments wishing to correct (a) a positive
production externality, and (b) a positive
consumption externality?
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6.3 Merit goods, demerit goods and
public goods
Merit and demerit goods
Merit goods are goods that are held to be desirable
for consumers, but which are underprovided by the
market.
Note that the term ‘good’ in the expression ‘merit
good’ applies to both goods and services. Reasons for
underprovision include:
· The good may have positive externalities In this case
too little is provided by the market. Examples of
merit goods include education (for the reasons
noted above in the discussion of externalities);
immunization programmes (which benefit not only
those who have received them but also the broader
population by wiping out a disease).
· Low levels of income and poverty Some consumers
may want certain goods or services but cannot
afford to buy them. Recall that demand shows
the quantities of a good or service that consumers
are willing and able to buy at different prices. If
they have low incomes, they may be willing but
not able to buy the good or service, in which case
their desire does not show up in the market, and
market demand (the sum of all individual demands)
is too low. Examples include health care services,
medicines, education and recreational facilities,
which people on low incomes often cannot afford to
buy in the market.
· Consumer ignorance Consumers may be better off if
they consume certain goods and services but they
may be ignorant of the benefits, and so do not
demand them. For example, preventive health care
(such as immunization, annual health check-ups)
can prevent serious diseases, but lack of knowledge
about the benefits may lead consumers to demand
too little of these services.
Note that more than one factor may be at work
simultaneously; for example, the underprovision of
health care services can result from all three reasons
listed above.
Subsidies in the case of merit goods
Demerit goods are goods that are considered to be
undesirable for consumers and are overprovided by
the market.
Reasons for overprovision include:
· The good may have negative externalities Too much of
it will be provided by the market. One example is
cigarettes.
· Consumer ignorance or indifference Consumers may
not be aware of the harmful effects upon others of
their actions, or they may not care.
There are several ways governments can address the
problem of merit and demerit goods:
Direct public provision of merit goods
Merit goods are provided by the market, but in
quantities lower than the social optimum. The
government can use tax revenues to provide the merit
goods directly, thereby supplementing the market’s
provision. In addition, if the government directly
provides the merit good, it is also likely to ‘subsidize’
it, meaning that it makes it available to its users at
a very low or zero price. Examples include health
care, education, and sports facilities, which are often
provided by the government in parallel with the
private sector.
For example, national health systems in many
countries use tax revenues to provide health care
services to their populations free or nearly free of
charge. Other countries with social insurance systems
similarly use social insurance contributions (which
are also a type of tax) to provide health services to
their populations free or nearly free of charge. In the
United States the government provides free health care
to certain consumer groups (elderly people and low
income people). Many governments of less developed
countries that don’t have sufficient tax revenues to
provide a broad range of health care services try to
provide basic health services to people on low incomes
free of charge. In the case of education, elementary
education is provided by the government free of
charge to consumers in most countries, and many
governments also provide education up to university
level at no or low cost to consumers. In most countries
where there is government provision of health care
and education services, there is also private sector
provision of these services (though to varying degrees).
Merit goods are often goods with positive externalities,
so by increasing the supply through subsidies provided
to private producers, the quantity supplied will
increase to the optimal quantity, thus correcting the
underprovision (see Figure 6.6(c)). For example, in
the United States, private universities often receive
subsidies by the government.
Taxes in the case of demerit goods
Since demerit goods are often goods that have
negative externalities, the logic of using taxes to
correct this problem is that taxes lower the quantity
of the demerit good produced to the optimal quantity,
so that they correct the problem of overallocation of
resources and overprovision of the good (see
Figure 6.4(c)).
Advertising and persuasion for both merit
and demerit goods
Governments can use advertising to provide
information to consumers and try to persuade them
to buy more merit goods. For example, they can try
to encourage consumers to have annual health checks
for improved health. The objective here is to increase
demand for such services, so that the private benefits
demand curve (MPB) will shift to the right in the
direction of the social benefits demand curve (MSB)
in Figure 6.6(b). Similarly, advertising can be used to
try to persuade consumers to buy fewer goods with
negative externalities and demerit goods, such as antismoking campaigns. In this case, the objective is to
try to decrease demand for such goods and services, so
that the private benefits demand curve, MPB, will shift
leftward towards MSB in Figure 6.4(b).
Legislation and regulations for both merit
and demerit goods
Legislation can be used to promote greater
consumption of merit goods. For example, many
countries have legislation that makes education
compulsory up to a certain age. Legislation can also
be used to prevent or limit consumer activities that
impose costs on third parties and consumption of
demerit goods. For example, such activities as smoking
in public places, and playing loud music in the middle
of the night are often prohibited.
Chapter 6: Market failure 173
Public goods
Public goods versus private goods
To understand what public goods are, it is useful to
consider the definition of private goods. A private
good has two characteristics:
produced by a private firm, people could not be
prevented from using it even though they would
not pay for it. Yet no profit-maximizing firm would
be willing to undertake the production of a good it
cannot sell to users at some price. As a result, the
market fails to produce goods that are non-excludable.
· It is rivalrous, meaning that its consumption by one
person reduces its availability for someone else;
for example, your computer, your textbook, your
pencils, your clothes are rivalrous, because when
you buy them, another person cannot buy the same
ones; most goods are rivalrous.
· It is excludable, meaning that 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.
Since most goods are rivalrous and excludable, it
follows that most goods are private goods.
A public good has the following two characteristics:
· It is non-rivalrous; its consumption by one person
does not reduce consumption by someone else.
· It is non-excludable; it is not possible to exclude
someone from using the good.
Goods that are non-rivalrous and non-excludable
are also known as pure public goods. 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.
Public goods and the free rider problem
How do public goods relate to market failure? In the
case of excludable goods, it is possible to prevent
people from buying and using the good simply by
charging a price for it; those who don’t pay the price
do not buy it and do not get to use it. Therefore
private firms have an incentive to provide excludable
goods because they can charge a price to sell them,
and therefore can cover their costs. Non-excludable
goods differ: if a non-excludable good were to be
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Part 2: Microeconomics
Public goods illustrate the free rider problem,
which arises in situations where people can enjoy
the use of a good without having to pay for it, in
other words they take a ‘free ride’. The free rider
problem arises from non-excludability. (Note that
open access resources, discussed earlier, are also
subject to the free rider problem, because they are
also non-excludable.)
Public goods are like merit goods in the sense that
they are goods that are desirable for society but are
underprovided by the market. However, they also
differ from merit goods. Merit goods are usually
provided by the market (private firms), but in smaller
than optimal quantities. Public goods, on the other
hand, are usually not provided at all by the market.
Also, merit goods are often private goods in that they
are rivalrous and excludable, while public goods are
neither.
Note also that public goods, though provided to
consumers free of charge, are not ‘free goods’.
Free goods (recall from Chapter 1, page 4) are not
subject to the condition of scarcity, thus having an
opportunity cost of zero. Public goods, on the other
hand, are produced by the government with scarce
resources that have alternative uses; they therefore
have an opportunity cost greater than zero. It should
also be noted that not all goods provided by the
government are public goods. The government
provides (or sometimes subsidizes) many other goods,
such as merit goods, as well as goods produced by
natural monopolies.
Public goods that are not ‘pure’
There are some goods that do not fit neatly into the
category of private goods or public goods (they can
be considered to be ‘impure’ public goods). There are
goods that are:
· non-rivalrous (like public goods), and
· excludable (like private goods).
Examples include public museums that charge an
entrance fee, public recreational facilities that charge
fees for use of the facilities, and toll roads. All these
goods and services are excludable because consumers
must pay to use them. Since the price system can be
made to work here as a rationing mechanism, they
could be provided by private firms. However, they all
have very large positive externalities, thus justifying
direct government provision.
Correcting the market’s failure to provide
public goods
The market fails to allocate resources to public goods,
since they are usually not provided by private firms.
Therefore the government must step in to ensure that
public goods will be produced, and will be produced
at socially desirable levels. Thus public goods are
directly provided by the government, are financed out
of taxation revenues, and are made available to the
public free of charge.
Test your understanding 6.6
1 Provide examples of (a) merit goods, (b) demerit
goods, and (c) public goods.
position of the single seller can be preserved. This
market structure is characterized by the absence of
competition.
Monopoly power (explained in Chapter 2, page 31)
refers to the ability of a firm or a group of firms to
control the price of the product that prevails in the
market. This type of power can be exercised not only
by monopolies, but also by oligopolies that behave
like monopolies (through collusion or cooperation).
An oligopoly, it will be recalled, is a market structure
characterized by a few large sellers and high barriers to
entry. Monopoly power can also be exercised by firms
in monopolistic competition, which also have some
degree of control over prices (though less than in the
cases of monopoly and oligopoly).
The exercise of monopoly power is considered to be
socially undesirable for the following reasons:
· It results in allocative inefficiency: the value
attached to the good by consumers is greater than
the cost of producing the good, and therefore there
is an underallocation of resources to the good – too
few resources are devoted to the good.
2 Use the concept of resource allocation to explain
· It results in productive inefficiency: production does
how (a) merit goods, (b) demerit goods, and
(c) public goods are related to market failure.
· It results in lower output of the industry as a whole
3 Explain why (a) public goods, and (b) open
access resources are subject to the free rider
problem.
4 Explain the differences between merit goods and
public goods.
5 What are appropriate government policies to
correct market failures associated with (a) merit
goods, (b) demerit goods, and (c) public goods?
6 (a) Define the characteristics of ‘rivalry’ and
‘excludability’, and use them to classify and
define private goods, public goods and impure
public goods. (b) How do you think these
characteristics apply to free goods?
6.4 Monopoly power
Monopoly was discussed briefly in Chapter 2
(Section 2.1, page 29) and extensively in Chapter 5,
page 126 (at higher level). It refers to a type of market
structure where (a) there is a single firm dominating
the market for a product, (b) the product has no
close substitutes, and (c) there are high barriers to
entry (it is very difficult for other firms to enter the
industry). Barriers to entry ensure that the monopoly
not take place at the lowest possible cost.
than the output that would have resulted if the
industry were organized as a competitive one.
· It results in a higher price for the product than the
price that would have prevailed if the industry were
organized as competitive one.
· Monopoly power entails an absence of competition,
and this may lead to higher costs of production, as
the firm is not under any competitive pressure to
increase efficiencies in production.
· The persistence of profits over the long run
earned by the owners of the firm(s) exercising
monopoly power may contribute to a more unequal
distribution of income (note that this does not
apply to firms in monopolistic competition in the
long run).
Governments can pursue the following kinds of
policies to prevent the exercise of excessive monopoly
power:
Legislation and regulation
Legislation in the form of anti-monopoly laws can
be used to prevent the development of substantial
monopoly power or the exercise of monopoly power.
For example, legislation is often used to prevent
collusion among oligopolistic firms and to
Chapter 6: Market failure 175
Table 6.1
Market failures and their impacts on resource allocation.
Type of market failure
The market’s impact on resource allocation
negative production externality
overallocates resources
negative consumption externality
overallocates resources
positive production externality
underallocates resources
positive consumption externality
underallocates resources
merit goods
underallocates resources
demerit goods
overallocates resources
public goods
underallocates resources (or allocates no resources)
monopoly power
underallocates resources
encourage competition between them; to prevent
mergers between firms that would result in too
much monopoly power; to break up monopolies or
near-monopolies that have been found to engage
in monopolistic practices into smaller units that
will behave more competitively; and in general to
encourage competitive behaviour in the economy.
Test your understanding 6.7
(...continued)
2 What kinds of policies can governments pursue
to avoid undesirable consequences of excessive
monopoly power?
Government regulation of natural monopolies (for
example, gas, electricity, water, etc.) can result in
the enforcement of policies that are more favourable
to consumers: prices can be set at lower levels and
quantities at higher levels than the unregulated
monopolist is likely to set. Ideally, regulation would
force the natural monopoly to produce the level of
output that achieves allocative efficiency.
Table 6.1 lists the various kinds of market failures
considered in Sections 6.2–6.4, and shows what
impact the free, unregulated market will have on the
allocation of resources to the production of the good
or service. The objective of government policy in each
case should be to correct the misallocation problem
so as to achieve an outcome that comes as close as
possible to the social optimum.
Public (government) ownership
Important note
Government ownership of a monopoly is another
method governments use to prevent abuse of
monopoly power. Government ownership is
sometimes pursued as an alternative to government
regulation of natural monopolies, such as water,
electricity and telephone companies, and the postal
service. The objectives of government ownership are
similar to the objectives of government regulation of
natural monopolies: to ensure that prices are lower and
output greater than would result from an unregulated
monopoly. Ideally, the level of output should be such
that allocative efficiency will be achieved.
Now that you have completed the required part of
Chapter 6 and Microeconomics, you are reminded
to go back to Chapter 1 and reread Section 1.3,
starting on page 16. You will find that it will now
make much more sense to you.
Test your understanding 6.7
1 (a) Why is abuse of monopoly power socially
undesirable? (b) What impacts does this kind
of market failure have on the allocation of
resources?
(...continued)
176
Part 2: Microeconomics
6.5 Additional failures
(supplementary material)
Markets can fail in a number of additional ways as
well. Moreover, even the government, intending to
pursue policies that will correct market failures, may
itself fail to improve the operation of markets, and
may in fact worsen it.
Imperfect information and information
asymmetries
The competitive market mechanism presupposes that
all firms and all consumers have complete information
regarding products, prices, resources and methods of
production. This kind of information is important for
markets to work well, as firms, consumers and resource
owners must be in possession of sufficient and equal
information in order to make informed decisions
about their buying and selling activities.
However, the real world abounds with examples
where firms and consumers are in situations where
information is missing, or where they do not have
equal access to information.
It is often the case that sellers have information about
the quality of a good or service that they do not make
available to consumers. For example, sellers of used
cars have information regarding the car’s quality
that they are unlikely to reveal to potential buyers
in the event that 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 to human health. Individuals claiming
to be doctors, some of whom have had little or no
training in medicine, could practice medicine and
even surgery, giving rise to huge costs in terms of
human health and safety.
Examples along these lines are endless, and illustrate
the problem of asymmetric information between
sellers and buyers, in cases where sellers have access
to information that is not readily available to buyers.
In addition, sellers of goods and services could also
withhold information related to their role as buyers of
resources, specifically labour resources; for example,
they could hide information from potential employees
regarding unsafe working conditions, also with serious
negative consequences for the safety of the workers
they employ.
And yet, in the real world, as consumers and as
workers, we are not as a rule concerned about the
possibility of buying foods and medications that will
harm us, or about the possibility of being treated by a
doctor with no training in medicine, or about being
deceived by a firm about the level of safety in working
conditions. The reason is that the government
intervenes in markets by passing laws and regulations
that ensure that there are certain quality standards
that must be maintained by producers and sellers
of food and medications (and goods and services
generally), as well as minimum safety standards in
the workplace. In the case of doctors, most countries
around the world have laws that require 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 lawyers to plumbers to electricians.
However, even though governments intervene in
the interests of the consumer and the worker, it is
not always possible to eliminate the information
asymmetries that exist between sellers and buyers. To
illustrate this point, we may consider the following
important examples from the areas of health care
and law, where doctors and lawyers have specialized,
technical (medical and legal) information about their
clients that the clients themselves do not possess
(because they do not have the necessary technical
expertise). 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, whether medical or
legal, than are necessary. This practice leads to what is
known as supplier-induced demand, meaning that it
is demand induced (i.e. created) by the supplier, which
would not have arisen if the supplier and the client
had equal access to information.
Problems with asymmetric information also involve
situations where the buyer has information that
she or he does not make available to the seller. Such
problems often arise in the area of insurance. For
example, people in poor health may try to buy health
insurance without revealing their true state of health
to the insurance company.
In all cases where asymmetric information is involved,
the allocation of resources is affected. The impact may
be to overallocate or underallocate resources to the
production of goods and services, depending on the
nature of the information asymmetry.
For example, in cases of supplier-induced demand,
there results an overallocation of resources to the
services provided by the suppliers who induce the
extra, unnecessary demand for the service. In cases
where the buyer of insurance withholds information
from the seller, there results an underallocation of
resources to insurance services, as the insurance
company reduces provision of insurance in an effort
to protect itself against the possibility of providing
insurance coverage to very high risks. In the area
of health care, the problem of underallocation of
resources by the market to health insurance (private
insurance companies) has given rise to government
Chapter 6: Market failure 177
intervention in health care in many countries around
the world. Government intervention may take the
form of direct provision of health care services at
low or zero prices to an entire population, financed
by tax revenues, so as to ensure that the entire
population has health insurance coverage (as in all
countries with a National Health Service); alternatively
government intervention can take the form of social
health insurance, which may cover a country’s entire
population (as in many European countries), or which
selectively covers only certain vulnerable groups of the
population (as in the United States).
Coordination failures
One of the objectives of virtually every country
in the world is to achieve economic growth. This
objective is particularly important in less developed
countries, many of which show stagnating economies
that register very low and sometimes even negative
growth rates. Coordination failures provide a possible
explanation for the failure of firms to be set up and to
contribute to growth in developing countries.
Consider the following example. Let’s say that firms
would be able to increase their output, thereby
contributing to economic growth, if they began
producing in a market requiring skilled labour. But
they will not enter this market if the skilled labour
is not available; at the same time, workers will not
acquire the skills if the firms that could hire them
don’t exist. As a result, the firms do not enter this
market, and the workers don’t acquire the skills. Both
the firms and the workers get stuck in a position where
they are worse off than they would have been if they
could coordinate their activities and simultaneously
enter the new market and acquire the necessary skills.
Consider another example, where farmers could
increase their production of agricultural goods for sale
in the market, thereby giving rise to growth of output
and increases in their incomes. To do this they need
intermediaries, or ‘middlemen’, who will effectively
represent them in distant markets. As long as the
middlemen are not available, the farmers will not
begin producing for the market; and as long as the
agricultural output for the market is not produced, the
middlemen will not become available.2 Once again,
the farmers get stuck in a position where they are
producing less output than they could, and potential
2
See Michael P. Todaro and Stephen C. Smith, Economic Development
(Pearson Education, 2006), where these ideas are explored more fully.
178
Part 2: Microeconomics
middlemen that could have benefited themselves and
the economy do not emerge. Once again, everyone is
worse off, and the possibilities for expanding output
remain unrealized.
A coordination failure involves a situation where the
inability of economic decision-makers to coordinate
their behaviours results in an outcome where
everyone is worse off than they would have been had
coordination been possible. Coordination failures
arise when two or more activities that must begin
simultaneously fail to do so.
The important point is that coordination failures occur
even as decision-makers make economic decisions
that are in their best self-interest. Coordination
failures lead to underdevelopment traps, where
the inability to coordinate activities that must begin
simultaneously traps people into a situation from
which they cannot escape without outside help.
Development economists are looking increasingly at
coordination failures as a likely cause of the inability
of some developing countries to begin growth
and development. Coordination failures require
government intervention or foreign aid to help people
escape underdevelopment traps by allowing the
simultaneous occurrence of the necessary activities.
Weak or missing market institutions
In order to be able to function effectively, markets
need a particular social, institutional and legal
environment that is often missing in the real
world, particularly in less developed countries and
in transition economies. This environment must
include the existence and enforcement of property
rights, enforcement of legal contracts, effective
legal recourse, a stable currency, a well-developed
banking and insurance system, an effective road and
utility infrastructure system, and readily available
information on prices, quantities and quality of
goods, services and resources to consumers, firms and
resource owners. In the absence of these conditions,
markets are highly imperfect in their functions and
fail to function effectively. We will come back to these
institutions in Chapters 15 and 16, where we will
study their importance to growth and development in
less developed countries.
Macroeconomic objectives
Every real-world economy has certain macroeconomic
objectives that must be addressed. These include
price stability (the general price level should rise
only gradually); full employment (everyone who is
willing and able to work should be able to find a job);
economic growth (the economy’s output should be
steadily increasing); and a reasonable balance of trade
(exports and imports of goods and services should
be reasonably balanced). The market mechanism
cannot accomplish these tasks on its own, and
requires government intervention through the use of
appropriate policies in pursuit of these objectives. The
first three of these objectives and appropriate policies
will be discussed in Part 3; the fourth in Part 4.
The problem of government failure (policy
failure)
We have learned in this chapter that government
intervention in markets is essential in order to ensure
that markets work effectively and that failures are
corrected. Yet government intervention does not
always improve the operation of markets. Sometimes,
not only are market failures not corrected, but instead
they may be magnified, or may even be created where
they did not previously exist.
We have already seen examples of government
intervention in markets that has the effect of
worsening the allocation of resources, in our study
of price controls in Chapter 2 (Section 2.4, page 53).
Economists generally do not look upon price controls
very favourably, because these invariably intensify
problems of resource misallocation. Yet they are often
used nonetheless, because governments are driven by
various objectives, not all of which involve improving
the functioning of the economy. (For example, price
support systems in agriculture are used to support
farmers’ incomes, even though it is well known that
these increase allocative inefficiency, that they result
in higher prices and lower quantities of output, etc., as
discussed in Chapter 2, page 56.)
Government failure, also known as policy failure,
occurs when government intervention in markets
results in less efficient outcomes than those that would
have prevailed in the absence of the intervention. It
occurs because:
· Governments are a reflection of politics, and
respond to political pressures created by the
influence of powerful interest groups and the
sometimes narrow interests of their supporters. This
is certainly the case in the use of price supports
to support farmers’ incomes in many developed
countries, giving rise to a global misallocation of
resources, at the same time as they hurt consumers
and taxpayers as well as farmers in less developed
countries. (This example of government failure is
so important it will be studied in more detail in
Chapter 16.)
· Governments do not always have all necessary
information at their disposal to formulate
appropriate policies.
· Government policies have a certain inertia that is
sometimes difficult to change. Once particular laws,
rules and regulations have been established, they
cannot be changed easily because of rigidities and
the unwieldiness of the political process.
One of the more striking examples of government
failure involves the use of ‘perverse subsidies’. As
we know, subsidies have the effect of increasing
output produced by shifting the market supply
curve downward (or to the right; see Figure 6.5(b)
and 6.6(c)). In more developed and less developed
countries alike, subsidies are often used for fossil fuels,
with the effect of encouraging fossil fuel production
and consumption, contributing significantly to
environmental pollution, and reducing incentives for
the development of alternative non-polluting energy
sources. Reasons for fossil fuel subsidies include the
promotion of the industrial sector by keeping costs
down, promotion of international competitiveness
of industrial products, support of domestic fuel
production to ensure adequate domestic supply and to
reduce reliance on foreign sources (for those countries
that are fossil fuel producers), and to keep fuel prices
low for consumers. The impacts of subsides on fossil
fuels are entirely inconsistent with the pursuit of
sustainable development.
Test your understanding 6.7
1 How do information problems give rise to
market failure?
2 (a) What are coordination failures? (b) Why are
they important to less developed countries?
3 What are some of the institutions that are
necessary for a market to function effectively?
4 Problems relating to government behaviour
have traditionally been studied by sociologists
and political scientists. Why do you think these
subjects are now also studied by economists?
Chapter 6: Market failure 179
Questions for
6.1
6.2
6.3
6.4
6.5
6.6
180
review
[10 marks] (a) Explain the meaning of ‘market
failure’, using the concept of allocative efficiency.
(b) Referring to the difference between (i) private
and social benefits; and (ii) private and social
costs, explain why this distinction is important
in connection with the achievement of allocative
efficiency.
[20 marks] Using diagrams, show the impacts
on resource allocation, and provide an example,
in each of the following cases: (a) a negative
externality in production; (b) a negative
externality in consumption; (c) a positive
externality in production; (d) a positive
externality in consumption.
[15 marks for part (a); 15 marks for part (b)]
(a) Using diagrams, show how the concept of
(i) negative production externalities and
(ii) negative consumption externalities can
be used to analyse the problem of pollution.
(b) Evaluate possible policy responses in the
case of each of these.
[20 marks] Using diagrams and the concepts of
positive and negative externalities, show how each
of the following leads to market failure: (a) a cure
is discovered for HIV/AIDS; (b) a firm discovers
a new robot technology that is widely adopted
by other firms; (c) in some poor countries, very
poor farmers are forced to clear forests to create
more arable land for farming; (d) in many poor
countries, very poor farmers use wood and other
biomass fuels for heating and cooking purposes in
their homes, often with very poor ventilation.
[10 marks for part (a); 10 marks for part (b)]
A policy tool that governments can use to correct
market failures involving spillover benefits is
subsidies. Using diagrams, explain how subsidies
can help correct (a) a positive consumption
externality resulting from the consumption of
education; (b) a positive production externality
resulting from a firm’s activities in research and
development (R&D).
[15 marks] (a) How can the concept of market
failure be used to explain environmental
problems? (b) Define ‘sustainable development’
and explain its relationship to environmental
problems. (c) What are some policies governments
can use to try to correct these kinds of market
failures.
Part 2: Microeconomics
6.7
[15 marks] (a) Using the concept of ‘merit good’,
explain the reasons why education and health
care services are underprovided by the private
sector. (b) What are the policy options open to
governments to correct this problem?
6.8
[15 marks] (a) Define merit goods and public
goods; discuss their similarities and differences;
and show how each one is a type of market failure.
(b) What kinds of policies can governments
pursue to deal with the market failure that each of
these gives rise to?
6.9
[15 marks] (a) Providing examples and using
diagrams, explain the difference between merit
and demerit goods. (b) What are some appropriate
government policies governments can use to
correct these types of market failure?
6.10
[10 marks] Both public goods and free goods are
non-rivalrous and non-excludable. Yet they differ
from each other in very important ways. Define
public goods and free goods, and explain how
they differ from each other.
6.11
[10 marks] (a) Define monopoly power.
(b) Why is it considered to be socially
undesirable? (c) What can the government do to
limit excessive monopoly power?
6.12
[10 marks] (a) What are tradable permits?
(b) Using a diagram, explain how a market for
tradable permits is intended to work. (c) What
kinds of problems can they be used to address?
6.13
[15 marks] (Based on Chapters 3 and 6) Explain
the following statement: ‘An indirect tax imposed
by the government on heating oil for the purpose
of addressing the problem of pollution (a negative
consumption externality) will be less effective the
more inelastic is the demand for oil.’
6.14
[15 marks] Using your knowledge of Economics
acquired by reading Chapters 1–2 and Chapter 6,
evaluate the free market economy, taking
into account its potential advantages and its
shortcomings.
Part 3
Macroeconomics
Macroeconomics studies the economy as a whole. In contrast to
microeconomics, where we examine specific product and resource
markets and the behaviour of individual decision-making units
such as consumers, firms and resource owners, we now focus on
the larger picture of the economy, composed of collections of
many consumers, firms, resource owners and markets. Instead of
individual product prices, we study the general price level of the
economy; instead of demand for individual products, we examine
total demand for goods and services; and instead of individual firm
and industry supply, we examine the total output produced in the
economy. Further, we study total employment, total investment,
total exports and imports and more such totals or wholes, which in
macroeconomics are called aggregates.
The study of macroeconomics is prompted by some very
important economic objectives that cannot be understood and
analysed at the level of microeconomics. The most important of
these objectives are the following:
·
·
·
·
·
how to achieve full employment
how to achieve a stable or gently rising price level
how to achieve economic growth
how to achieve an equitable distribution of income
how to achieve external balance (balance of trade and avoidance of
balance of payments problems).
The first four of these objectives are the subject of Part 3 of this book
on Macroeconomics. External balance is discussed in Part 4, which
deals with the international economy.
Chapter 7
Macroeconomics
Macroeconomic
concepts and
measurement
In this chapter we will discover how economists measure an economy’s total output and income, as well
as growth in output and income. We will also study measurement of economic development, which,
though related to output and income growth, extends far beyond it.
OBJECTIVES
After studying this chapter you should be able to:
·
·
·
·
·
·
·
·
·
·
·
·
·
·
182
use the circular flow of income model to explain three ways of measuring the economy’s aggregate output and
income
understand the significance of leakages and injections for the size of the circular flow of income
distinguish between gross and net investment, and GDP and NDP
explain the difference between GDP and GNP, and explain how they relate to measurement of output as
opposed to measurement of the standard of living
distinguish between nominal and real values of income and output measures, and explain their significance in
making comparisons of output and income measures over time
distinguish between total and per capita measures, and explain their significance in measuring total output,
standards of living and economic growth
explain the concept of economic growth and how this is measured
analyse the sources of economic growth
explain the concept of economic development and how this differs from economic growth
explain why some limited economic development is possible without growth, but that growth is essential to
development over extended periods of time
evaluate the GDP measure as the basis for making international comparisons of welfare
explain the significance of purchasing power parities in international comparisons of GDP
identify and explain the complexities of measuring economic development
use individual and composite indicators as indicators of economic development and show the limitations of GDP
as a measure of economic development.
Part 3: Macroeconomics
The simple circular flow of income
In Chapter 1, page 6, we developed the circular flow
model to help us understand how the different parts
of the economy are interrelated. We will now use
the same model to see how the output and income
of a nation are measured. If you refer to Figure 1.1
(page 6), you will remember that there are two flows
in this model: the flow of factors of production and
goods and services (called the ‘real flow’), and the
flow of payments from firms to consumers and from
consumers to firms (called the ‘money flow’). In the
money flow, households receive payments from firms
when they sell their factors of production, consisting
of rent (for land), wages (for labour), interest (for
capital) and profit (for entrepreneurship); these
represent the income of households. Households use
their income to pay firms for the goods and services
they buy. These payments are household expenditure
(or consumer expenditure).
This simple model demonstrates an important
principle: the income flow from firms to households
is equal to the expenditure flow from households to
firms. In other words, the incomes generated through
the sale of all the factors of production must be equal
to the expenditures by households on goods and
services. This constitutes the circular flow of income.
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. 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. Adding up all these values, we
arrive at the value of total output. This value is the
same as consumer expenditure, because spending by
consumers is equal to each item they buy multiplied
by its respective price. Therefore the factor income
flow equals the expenditure flow that equals the value
of output.
Adding leakages and injections
The real-world economy is more complicated than
this simple model suggests. We can arrive at a closer
approximation of the real world by adding injections
and leakages (also known as withdrawals) to the
money flow of Figure 1.1. To understand what these
are, consider a pipe with water flowing through it,
as in Figure 7.1. As the water flows through the pipe,
some of it 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.
lea
k
The circular flow model revisited
es
ag
water flow
ns
We will begin our study of macroeconomics with an
examination of the overall quantity of goods and
services, or total output produced in an economy, also
known as aggregate output. This concept is closely
related to the economy’s total income.
The circular flow of income illustrates an important
principle: in any given time period (say a year), the
value of output produced by an economy is equal to
the total income that is generated in producing that
output, which is equal to the expenditures made to
purchase that output.
tio
7.1 Measuring national income and
output
ec
inj
Figure 7.1 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:
leakages
saving
taxes
imports
injections
investment
government spending
exports
Saving and investment
The first pair involves saving and investment. Saving
is that portion of consumer income that is not spent
but is saved. Investment is spending by firms for
the production of capital goods. You may remember
from Chapter 1, page 5, that capital is one of the
four factors of production. Investment is therefore
the spending by firms to produce capital goods. This
is why capital goods are also known as investment
goods. How are saving and investment linked together
as leakages and injections?
Chapter 7: Macroeconomic concepts and measurement 183
Households usually save a portion 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.) in order 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 7.2, which, in addition to
the simple money flow of Figure 1.1, shows the three
leakage/injection pairs listed above. (For simplicity,
this figure omits the real flow.) The leakages appear in
the left-hand side of the figure, and the injections on
the right. We can see that saving leaks out of the flow
of consumer expenditures, and after passing through
financial markets is injected back into the expenditure
flow as investment.
and purchased by foreigners. Imports and exports are
linked together through ‘other countries’. Imports
appear as a leakage because they represent household
spending that leaks out as payments to the other
countries that have 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.
Taxes and government spending
Next we consider taxes and government spending,
which are connected to each other through the
government. Households pay taxes to the government;
this represents a leakage because it is income that is
not spent to buy goods and services. The government
uses the funds collected through taxes to finance
government expenditures (on education, health,
defence, etc.) and this spending is an injection back
into the expenditure flow. As we can see in Figure 7.2,
taxes flow out of the expenditure flow as leakages, and
government spending flows back in as injections.
Imports and exports
The third pair involves imports and exports. Imports
are goods and services that have been produced in
other countries and purchased by domestic buyers.
Exports are goods and services produced domestically
It should be noted that leakages and injections do
not have to be equal to each other. In fact, in the real
world, they are unlikely to be equal. When they are
unequal, there are important consequences for the
circular flow of income. If a leakage is greater than an
injection, then the size of the circular flow of income
becomes smaller. For example, say that saving (a
leakage) is larger than investment (an injection). This
means that a portion of the household income that
leaks in the form of saving into financial markets does
not come back into the flow as investment. The result
is that the expenditure flow will become smaller. Fewer
goods and services will be purchased, firms will cut
back on their output of goods and services, they will
buy fewer factors of production, unemployment will
increase (since firms buy a smaller quantity of labour
services) and household income will be reduced.
If, on the other hand, a leakage is smaller than an
injection, then the size of the circular flow will
become larger. For example, if exports are larger than
imports, the size of the expenditure flow increases
since more expenditures are injected into the spending
flow than are leaking out. Households will demand
more goods and services, firms will begin to produce
more by purchasing more factors of production,
unemployment will fall (as firms now buy a larger
quantity of labour services), and household income
will increase. Summarizing we can say that:
factor incomes
(wages, rents, interest, profit)
households
(consumers)
firms
(businesses)
consumer expenditure
(spending on goods and services)
ni
mp
ort
s
Figure 7.2 Circular flow of income with leakages and injections.
184
Part 3: Macroeconomics
t
en
st m
inve
government
me
ern
v
o
g
nt
spe
n di
ng
on
exp
orts
di
en
sp
ng
o
tax
es
financial markets
di
ng
savi
ng
en
sp
other countries
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 these need not
be equal to each other. If leakages are larger than
injections, the income flow becomes smaller; if
injections are larger than leakages the income flow
becomes larger.
Test your understanding 7.1
1 Use the simple circular flow model to
(a) illustrate the circular flow of income, and
(b) show the equality between factor income
flow, the household expenditure flow and the
value of output.
2 (a) What are leakages and injections in the
circular flow of income? (b) Use the circular
flow of income model to illustrate how the
three pairs of leakages and injections are linked
together.
3 What happens to the size of the income flow
when (a) leakages are larger than injections,
and (b) injections are larger than leakages?
National income accounting
We have seen that the circular flow of income
illustrates an important principle: in any given
time period, the value of total (or aggregate) output
produced by an economy is equal to the total income
that is generated in producing that output, which
is equal to the expenditures made to purchase that
output. We will now use this principle to see how
national income or the value of output is measured.
Measurement of an economy’s national income or
output is referred to as national income accounting.
Knowing the value of national income or output is
very useful because it allows us to:
· assess an economy’s performance over time (are
income and output increasing over time; are they
decreasing?)
· make comparisons of income and output
performance with other economies
· establish a basis for devising policies that will meet
economic objectives.
Note that we have been referring throughout
to the ‘value’ of output. Why speak in terms
of values, and not in terms of quantities, as we
did in microeconomics? The answer is that in
macroeconomics we must find a way to add up the
quantities of output of hundreds of thousands of
different goods and services. Yet how can we add
up quantities of computers, apples, cars and theatre
tickets? What unit of measurement can we use? To
get around this difficulty, we measure output in
money terms, or in terms of the value of goods and
services. When we speak of the ‘value’ of a good, we
mean simply the quantity of the good multiplied
by its respective price. Sometimes the term ‘value’
may not be explicitly mentioned. For example, one
may speak of the ‘level of aggregate output’ or just
simply ‘aggregate output’. Whatever the case, in
macroeconomics output is always measured in value
terms.
There are three ways to measure the value of aggregate
output, all suggested by the circular flow of income
model, and all giving rise to the same result:
· the expenditure method, which adds up all
spending on final goods and services produced
within a country in a given time period
· the income method, which adds up all income
earned by the factors of production in the course of
producing all goods and services within a country
in a given time period
· the output method, which calculates the value of
all final goods and services produced in the country
within a given time period.
The expenditure method
The expenditure method measures the total amount
of spending on final goods and services within a
country in a particular time period (usually a year).
The term ‘final’ requires some explanation. Final
goods and services are those that are ready for final
use, and can be contrasted with intermediate goods
and services, which are those purchased as inputs for
the production of final goods. When we measure the
value of aggregate output, we include only purchases
of final goods and services.
For example, food items such as meat and vegetables
are intermediate goods for a restaurant that uses them
to prepare a meal, and the meal is the final good. If
in measuring expenditures we included spending on
the food items plus spending on the meal, this would
involve double counting and the value of aggregate
output would be exaggerated. On the other hand,
meat and vegetables purchased by a household for
Chapter 7: Macroeconomic concepts and measurement 185
consumption count as final goods, since they are not
used as inputs for the production of another good or
service.
Total spending can be broken down into four
components: consumption, investment,
government purchases, and net exports:
· Consumption spending, abbreviated as C, includes all
purchases by households on final goods and services
in the course of a year (except housing, which is
classified under investment). These expenditures
include spending on
❍
❍
❍
consumer durables (goods that have an expected
life of more than three years, such as cars,
refrigerators, washing machines, televisions, etc.)
spending on consumer non-durables (goods with
an expected life of less than three years, such as
food, clothing and medicines)
spending on services (entertainment, banking,
health care, education, etc.).
· Investment spending, abbreviated as I, includes the
following:
❍
❍
all spending by firms on capital goods (i.e.
buildings, machinery, equipment, etc.)
all spending on new construction (housing and
other buildings).1
· Government purchases, abbreviated as G, refers to all
spending on goods and services by governments at
all levels within a country (national, regional, local).
It includes purchases by the government of factors
of production, including labour services. It excludes
transfer payments, as these do not represent
government purchases.2
· Net exports (exports minus imports), abbreviated as
X − M, refers to the value of all exports (abbreviated
as X) minus the value of all imports (abbreviated
as M). Exports are goods and services produced
within the country and so must be included in
the measurement of aggregate output. Imports,
1
Investment spending includes one more item: changes in inventories.
Inventories refer to output produced by firms that remains unsold.
Businesses as a rule keep inventories to help them meet unexpected
increases in the demand for their product. Since inventories are output, it
means that they must be counted as part of the aggregate output that is
being measured. However, since they are output that has not been sold,
they cannot be counted under consumption expenditure (C); they are
therefore counted under investment.
2
Transfer payments are all payments transferred by the government
to particular social groups, such as unemployment benefits, disability
benefits and various other welfare payments. They are not included under
government spending because they do not represent payment for factors
of production, or payment for purchases of final goods and services.
Transfer payments will be considered in Chapter 11 under the topic of
income distribution.
186
Part 3: Macroeconomics
however, involve domestic spending on goods and
services that have been produced in other countries,
and so must be subtracted from expenditures
measuring domestic output.
If we add together the four components of spending,
we obtain a measure of aggregate output known as
gross domestic product (GDP):
C + I + G + (X − M) = GDP
Gross domestic product or GDP is defined as the
market value of all final goods and services produced
within a country during a given time period (usually
a year). It includes spending by the four components,
C + I + G + (X − M). It is the most commonly used
measure of the value of aggregate output.
The income method
The income method adds up all income earned by
the factors of production within a country in a given
time period: wages earned by labour, rent earned by
land, interest earned by capital, and profits earned by
entrepreneurship. When all factor incomes are added
up, the result is national income. Whereas national
income is often used as a measure of the level of
economic activity, it is not the same as GDP arrived at
by use of the expenditure approach. To arrive at GDP
using the income approach, it is necessary to make
some adjustments to national income.3
The output method
The output method measures the value of each good
and service produced in the economy over a particular
time period (usually a year) and then sums them
up to obtain the total value of output produced. It
measures the value of all final goods and services, in
order to avoid the double counting that would arise
from including the values of intermediate goods and
3
A detailed consideration of these adjustments is beyond the scope of
this book. For the interested student, they will be mentioned briefly here.
If we add depreciation and indirect taxes to national income, we obtain
a measure of aggregate output called gross national product (GNP). The
difference between GNP and GDP will be considered later in this chapter.
Depreciation refers to the wearing out of capital goods, and will also be
considered later. The reason we add depreciation and indirect taxes to
national income in order to obtain GNP (and GDP) is that the value of
output measured by the expenditure approach includes both these items.
By contrast, national income, measuring only the incomes of the factors of
production, does not include either of the two.
services. The method used to obtain the value of only
final goods and services is to count only the value
added in each step of the production process.4
The output approach calculates the value of output
by economic sector, such as, for example, agriculture,
manufacturing, transport, banking, etc. The value of
output of each sector is then added up to obtain the
total value of output for the entire economy. This
approach provides us with the opportunity to study
the performance of each individual sector, and to
make comparisons of performance across sectors.
The three approaches give rise to the same result, after
allowance is made for statistical discrepancies that
arise in the course of measuring the different variables
involved.
Test your understanding 7.2
and are discarded. The loss of value of capital that gets
worn out in the course of a year is called depreciation.
Capital goods that become worn out and are discarded
must be replaced. This means that in any given year,
of the total new production of capital goods, a portion
goes to replace capital goods that have been discarded
(depreciated), and the rest are new additions to the
stock of capital goods.
Recall that investment, one of the components of
GDP, refers in part to spending by businesses on
capital goods. Total investment that takes place
within a year is known as gross investment. Gross
investment can therefore be divided into two parts:
· the part that goes toward replacing worn out capital
goods, or depreciation
· the part that consists of new additions to the stock
of capital goods, known as net investment.
1 Why is it useful to know the value of aggregate
output?
To put it more simply:
2 Explain why (a) we measure aggregate output in
value terms; (b) we count only the value of final
goods and services when measuring the value of
output.
3 What are the four expenditure components of
GDP? Explain each of these.
4 (a) Explain three ways that GDP can be
measured. (b) Why do they give rise to the
same result?
Key distinctions relating to measures of the
value of output
gross investment = depreciation + net investment
(total investment) = (discarded + (additions of
capital goods)
new capital)
This means that
gross investment − depreciation = net investment.
It follows that:
· If gross investment is greater than depreciation,
there is positive net investment, and the stock of
capital goods has increased.
· If gross investment is less than depreciation, then
net investment is negative, and the stock of capital
goods has declined.
Distinction between gross and net
What does the term ‘gross’ in ‘gross domestic product’
refer to? It is related to spending to produce capital.
You may remember from Chapter 1, page 5, that
capital, which is a produced factor of production,
consists of buildings, equipment and machinery. All
of these have a finite life, in other words, they do not
last forever. Within any given year, some of the capital
goods in an economy become completely worn out
4
For example, say the production of a good goes through the following
steps. Firm A sells raw materials for $700 to Firm B. Firm B uses the raw
materials and produces an intermediate good that it sells to Firm C for
$1100. Firm C uses this intermediate good to produce a final good that it
sells for $1700. How much value has been added in this process? Firm A
added $700 of value. Firm B added $400 of value (= $1100 − $700), and Firm
C added $600 of value (= $1700 − $1100). When we add these up we obtain:
Returning now to our discussion of measures of the
value of output, it becomes clear that in the expression
for gross domestic product, GDP = C + I + G + (X − M),
I refers to gross (or total) investment. This is because
GDP measures an economy’s total output, and
therefore includes total spending on capital goods,
whether these involve replacements of depreciated
capital, or new additions to the capital stock.
$700 + $400 + $600 = $1700. Note that the sum of the values that were
added in each step of the production process is exactly equal to the value
of the final product. If we had added up the values of the two intermediate
products and the final product, we would have: $700 + $1100 + $1700 =
$3500, which greatly exaggerates the value of the product due to double
counting. By counting only values added in each step of the production
process, the problem of double counting is avoided.
Chapter 7: Macroeconomic concepts and measurement 187
An alternative way of measuring the value of aggregate
output is to use net investment instead. We then arrive
at a measure called net domestic product (NDP):
NDP = C + In + G + (X − M)
where In = net investment. It follows then that
NDP = GDP − depreciation
Test your understanding 7.3
1 (a) Explain the concepts of gross investment,
net investment and depreciation. (b) What is
the relationship between them?
2 How do the concepts in question 1 relate to the
stock of capital goods?
To eliminate the influence of changing prices on the
value of output, we must calculate real values. Real
value is a measure of value that takes into account
changes in prices over time. It is measured in terms of
prices that prevailed in one particular year in the past,
called a base year. Real GDP, in particular, is GDP that
is valued in the prices of the base year.
Meaningful comparisons over time in the value of
output, or expenditures, or income, or any variable
that is measured in money terms, require the use of
real values. For example, when we make comparisons
of GDP in a country over time, we must be sure to
use real GDP values, as these have eliminated the
influence of price changes, and give us an indication
of how actual output produced has changed.
3 How is it possible for net investment to be
negative? What does this mean for the stock of
capital goods?
4 What is the meaning of ‘gross’ in ‘gross
domestic product’?
5 What is the difference between GDP and NDP?
Distinction between nominal and real
Earlier it was noted that in macroeconomics we
measure output in value terms, and we defined
‘value’ to be the quantity of a good multiplied by
its price. Nominal value is money value, or value
measured in terms of prices that prevail at the time
of measurement. For example, if a pair of shoes costs
£100, this is its nominal value. If you buy this pair
of shoes, £100 is your nominal expenditure on these
shoes. If your monthly income is £2000, this is your
nominal income. Therefore when we calculate the
value of aggregate output, or expenditure, or income,
in money terms, we speak of nominal GDP, nominal
expenditure, nominal income, etc.
Yet prices change over time, and this poses a
measurement problem. Let’s say that nominal GDP
increases in the course of a year. This increase may be
due to changes in the quantities of output produced,
or changes in the prices of goods and services, or a
combination of both. We have no way of knowing
what part of the increase in nominal GDP is due to
changes in output and what part to changes in prices.
Yet we are interested in knowing how much the
quantity of goods and services has increased. We must
therefore find a measure of GDP that is not influenced
by changes in prices.
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Part 3: Macroeconomics
Nominal value is value measured in terms of current
prices (prices at the time of measurement), which
does not account for changes in the price level.
Real value is a measure of value that has eliminated
the influence of changes in the price level, and is
calculated by reference to constant prices. When a
variable is being compared over time, it is important
to use real values.
Test your understanding 7.4
1 Why do price changes over time pose a problem
when we want to make comparisons of GDP (or
any measure of output or income) over time?
2 Explain the difference between nominal and
real values.
3 Why is it important to use real values when
making comparisons over time?
4 You read in the newspaper that government
spending on education in your country
increased by 7% last year. What information do
you need to be able to make sense of this figure?
Calculating nominal and real GDP
We can better understand the use of base year prices
to calculate real GDP if we consider a numerical
example where we calculate nominal and real GDP.
Let’s consider a hypothetical economy producing
three items (a consumer good, a service and a capital
good): hamburgers, haircuts and tractors. Table 7.1(a)
shows the quantities of the three items produced and
their prices over a period of three years, and calculates
nominal GDP for each of the three years.
Table 7.1 Nominal and real GDP in a hypothetical economy.
(a) Calculating nominal GDP.
(1)
Goods and
services
(2)
2001
Q
(3)
2001
P
Hamburgers
37
£3
Haircuts
15
Tractors
10
(4)
2001
value
(Q × P)
(5)
2002
Q
(6)
2002
P
(7)
2002
value
(Q × P)
(8)
2003
Q
(9)
2003
P
(10)
2003
value
(Q × P)
£111
40
£4
£160
39
£5
£195
£18
£270
17
£20
£340
18
£21
£378
£50
£500
11
£60
£660
10
£65
£650
£881
Nominal GDP
£1160
£1223
(b) Calculating real GDP.
(1)
Goods and
services
(2)
2001
Q
(3)
2001
P
Hamburgers
37
£3
Haircuts
15
Tractors
10
Real GDP
(4)
2001
output in
2001 P
(Q × P)
(5)
2002
Q
(6)
2001
P
(7)
2002
output in
2001 P
(Q × P)
(8)
2003
Q
(9)
2001
P
(10)
2003
output in
2001 P
(Q × P)
£111
40
£3
£120
39
£3
£117
£18
£270
17
£18
£306
18
£18
£324
£50
£500
11
£50
£550
10
£50
£500
£881
In 2001, 37 hamburgers were produced and sold at
£3 each, making the total value of hamburgers in
that year £111; 15 haircuts were provided at £18
each making a total value of haircuts of £270; and 10
tractors were produced and sold at £50 each, with a
total value of tractors equal to £500. When we add up
the total values of the three goods and services, we
obtain nominal GDP, or the nominal value of goods
and services produced, which was £881 in 2001. The
nominal GDP figures appearing for 2002 and 2003 are
calculated in the same way.
Part (b) of Table 7.1 shows how we can use the
information given in part (a) to obtain real GDP
figures. Our objective is to calculate GDP figures for
each of the three years that, when compared with each
other, show us whether a larger or smaller quantity
of goods and services was produced in 2002 and
2003 compared to 2001. In order to do this we must
find the value of quantities produced in 2001, 2002
and 2003 using the same prices of any one year,
called a base year. Therefore real GDP is a measure of
output valued at constant (unchanging) prices. These
constant prices are simply the prices that prevailed
during the base year. We can choose any year we like
as the base year. In the example here the base year
selected is 2001. To calculate real GDP, we simply
£976
£941
multiply the quantities of output produced each year
by the prices of the base year.
If you compare part (a) of the table with part (b),
you will see that the figures in columns 2, 5 and 8
are exactly the same in both parts; this is because in
calculating both nominal and real GDP, we use the
quantities that were produced and sold in the current
year. Also, you will notice that in part (b) of the
table, the prices appearing in columns 3, 6 and 9 are
identical and are the prices that had prevailed in 2001;
this is because we use the prices of the base year, or
2001, to calculate real GDP.
For example, in 2002, the 40 hamburgers that were
produced and purchased are valued at the 2001 price
of hamburgers, which was £3; the 17 haircuts are
valued at the 2001 price of £18, and the 11 tractors are
valued at the 2001 price of £50. When we add up the
resulting values of the three goods and services shown
in column 7, we get a measure of real GDP of £976 in
2001 prices. Similarly, in 2003, the 39 hamburgers, 18
haircuts and 10 tractors were also valued at the prices
of 2001.
What can we conclude about the changes in real GDP
that occurred between 2001 and 2003? Whereas real
Chapter 7: Macroeconomic concepts and measurement 189
GDP increased from 2001 to 2002 (from £881 it went
up to £976), between 2002 and 2003 it decreased,
falling from £976 to £941. Note that real GDP fell
in 2002–03 even as nominal GDP increased over the
same period. The reason is that price increases caused
nominal GDP to rise, while falling quantities meant
that real GDP was falling.
(Note that in the base year, 2001, nominal GDP is
equal to real GDP; this must be the case since real
GDP is valued at base year prices. In the other two
years, 2002 and 2003, real GDP is lower than nominal
GDP; this is to be expected, because prices have been
increasing, and the real figures measure the value of
output after the influence of price increases has been
eliminated, while the nominal values also contain the
influence of the price increases.)
Nominal GDP measures the value of current output
valued at current prices, while real GDP measures the
value of current output valued at constant (base year)
prices. In order to make meaningful comparisons over
time, we must be sure we are using real values that
have eliminated the impacts of price changes.
It should be noted that when we refer to real GDP
figures, we must at the same time refer to the specific
base year whose prices were used for the computation.
In the example above, we must say ‘in 2003 real
GDP at 2001 prices was £941’. The figure of £941
is meaningless if we don’t know that 2001 prices
were used to calculate it. The reason is that if we had
used a different base year, we would have arrived
at a completely different figure for 2003 real GDP.
It follows, too, that it is meaningless to compare
real GDP figures that were calculated on the basis of
different base years.
Test your understanding 7.5
1 Explain the difference between nominal and
real GDP.
2 You read in one source of information that real
GDP in a hypothetical country in 2001 was
$243 billion; in another source of information
you read that real GDP in 2002 was $277
billion. (a) What information do you need to
be able to make sense of these figures? (b) What
information do you need to be sure that the two
figures can be compared with each other?
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Part 3: Macroeconomics
Distinction between total and per capita
Per capita means per person or per head. A per capita
measure takes the total value (of output, income,
expenditure, etc.) and divides this by the total
population of a country. Therefore per capita GDP of
a country is total GDP of that country divided by its
population.
The distinction between total and per capita measures
is very important for two reasons:
· Differing population sizes across countries Let’s say
there are two countries that have identical total
GDPs of £10 billion. Country A has a population of
1 million people and Country B has a population
of 2 million people. If we divide total GDP by
population we get GDP per capita of £10,000 for
country A and £5000 for Country B. Whereas both
countries have identical GDPs, Country B’s per capita
GDP is only half that of Country A, because of
differing population sizes.
· Population growth Changes in the size of GDP
per capita over time depend very much on the
relationship between growth in total GDP and
growth in population. In general, if total GDP
increases faster than the population, then GDP per
capita increases. But if the country’s population
increases faster than total GDP, then GDP per capita
falls. (We will soon do a numerical example to
illustrate this point, see page 192.)
Total measures of the value of output, such as GDP,
GNP, and income, provide a summary statement of
the overall size of an economy. Per capita figures are
useful as a summary measure of the standard of living
in a country, because they provide an indication
of how much of total output in the economy
corresponds to each person in the population on
average.
Note that if we are interested in making comparisons
in per capita GDP over time, we must examine real
GDP per capita, which is total real GDP divided by
the size of the population.
Test your understanding 7.6
1 Why is it sometimes important to make a
distinction between total measures and per
capita measures of income and output?
(...continued)
Test your understanding 7.6
(...continued)
2 What kind of information about an economy
does a total GDP figure provide, as opposed to a
per capita GDP figure?
3 If we want to compare GDP per capita in a
particular country over a period of years, why
must we use real per capita GDP figures (refer to
the previous section)?
Distinction between domestic and
national: GDP versus GNP
The distinction between ‘domestic’ and ‘national’
arises because in practically every country, income
generated within the country is not exactly the same
as income received by the residents of the same
country. The reason is that incomes (wages, rent,
interest and profits) are sometimes generated by
factors of production located within one country,
but whose owners are residents of another. Consider
the case where a United States multinational firm
operating in India remits (sends back) its profits to the
United States. The profit income is generated in India
(it is income resulting from a process of production
that is located in India), but is received by residents
in the United States. Should this income count as part
of the income and output of the United States or of
India? Consider also a Russian worker who lives and
works in Spain, and sends a large part of her income to
her family in Russia. Should her income count as part
of Spanish or Russian income and output?
The concepts ‘domestic’ and ‘national’ are used to
distinguish between different measures of aggregate
output and income that have been developed to deal
with this issue. The term ‘domestic’ in ‘gross domestic
product’ means that the output being measured has
been produced by factors of production located within
the boundaries of a country, regardless of whether
these factors of production are owned by residents of
the country or by foreigners. The income represented
by the GDP measure is similarly income generated
within the boundaries of the country, regardless of
factor ownership.
By contrast, the term ‘national’ is used in another
measure of aggregate output known as gross
national product (GNP). The term ‘national’ means
that the output being measured has been produced by
factors of production owned by residents of a single
country, regardless of the factors’ location within
or outside of the country. The income represented
by the GNP measure is therefore the income of the
residents of a country, regardless of where this income
was generated, i.e. regardless of where the factors
of production are located. (You may note that the
GNP measure is closer to national income, or the
sum of factor incomes as in the income approach to
measuring aggregate output, than to GDP, because
national income includes the income earned by factors
of production of the residents of a country, regardless
of the location of the factors. In fact, since 1998, the
expression ‘gross national product’, which had been
in use for many decades, has been replaced by ‘gross
national income’ (GNI). GNI is identical to GNP. In
this text we are using the GNP terminology in keeping
with the IB syllabus.)
To convert GDP to GNP, we:
· add to GDP the income of domestic residents that is
earned abroad, and
· subtract from GDP the income earned domestically
and paid abroad to foreigners.
Therefore
GNP = GDP + income from abroad
− income sent abroad
Returning to the example above, the profit income
remitted (sent back) to the United States counts as
Indian gross domestic product (GDP), because it was
generated within India, but it counts as part of United
States gross national product (GNP), because it is
income paid to United States residents.
GDP is the total market value of all final goods and
services produced within the boundaries of a
country during a given time period (usually a year),
regardless of ownership of the factors of production.
GNP is the total market value of all final goods and
services produced by the factors of production
supplied by the residents of a country during a
given time period (usually a year), regardless of where
the factors are located.
For some countries the difference in the relative sizes
of the two measures of output, GDP versus GNP, is not
very large. This happens when most of the production
occurring within the geographical boundaries of
a country is by factors of production owned by
residents of the country. When this is not the case,
the difference can be quite significant. The factors of
production that mainly account for differences in the
two measures are labour and capital. Countries that
Chapter 7: Macroeconomic concepts and measurement 191
have a large foreign presence, either as workers from
other countries (labour), or as foreign corporations
(capital), tend to have a larger GDP per capita than
GNP per capita, because the wages and profits of the
foreigners are included in their measure of GDP but
excluded from GNP. This is because a portion of wages
of foreign workers and profits of foreign corporation
owners are sent back to the home country, thus
counting as the GNP of workers’ and corporation
owners’ home country. By contrast, countries that
receive large transfers of money from workers or
corporation owners located in a foreign country are
likely to have a larger GNP per capita than GDP per
capita. For this reason, it is possible for some countries
to enjoy a higher standard of living even though they
may have relatively low levels of domestic production.
7.2 Concepts and measurement of
economic growth and economic
development
In developing countries, the presence of multinational
corporations that ‘repatriate their profits’, in other
words, send their profits back to the home country,
tends to make GDP larger than GNP. On the other
hand, if there are workers living abroad who are
sending some of their income back home (this is
referred to as ‘worker remittances’), this will tend
to make GNP larger than GDP. On balance, for
most developing countries that host multinational
corporations (have multinational corporation
operating within their boundaries), profit repatriation
tends to be far more important than worker
remittances, and therefore GDP is likely to be larger
than GNP.
Economic growth (introduced in Chapter 1, page 9)
refers to increases in the quantity of output (goods and
services) produced over a period of time (typically a
year), and is usually expressed as:
GNP per capita is a better indicator of the standards
of living of a country, because it represents incomes
actually received by the residents. On the other hand,
GDP per capita is a better indicator of the level of
output per person produced in a country.
Test your understanding 7.7
1 Define GDP and GNP, and explain how they
differ.
2 Think of some examples of countries where
(a) GNP is likely to be larger than GDP;
(b) GDP is likely to be larger than GNP.
3 Is GDP per capita or GNP per capita likely to be
a better indicator of (a) standards of living in a
country, and (b) the level of output produced
per person? Explain why in each case.
192
Part 3: Macroeconomics
Sections 7.2 and 7.3 serve as an introduction to the
topic of economic development of less developed
countries (LDCs), which forms the subject of Part 5.
Yet we will discover that many issues we touch upon
here apply to more developed countries (MDCs) as
well.
Economic growth
Defining and calculating economic
growth
· a percentage change in real GDP (or real GNP) over
a specified period of time; or
· a percentage change in real GDP per capita (or real
GNP per capita) over a specified period of time.
The formula for calculating percentage change of a
variable, A, is the following:
% change in A =
final value of A − initial value of A
× 100
initial value of A
For example, if real GDP in a hypothetical country was
$50 billion in 2004 (the initial value) and increased to
$51 billion in 2005 (the final value), its rate of growth
over this period would be given by
% change in real GDP =
51 − 50
× 100 = 2 %
50
Therefore real GDP increased by 2% in the period
2004–05. However, the percentage change representing
growth is not always a positive value; if real GDP has
fallen it will be negative. Say, for example, that real
GDP in a hypothetical country was $60 billion in
2006 and $57 in 2007. Using the same formula, we
can calculate its rate of growth to have been − 5%. The
negative rate of growth indicates that real GDP fell in
the period 2006–07.
Let’s now consider economic growth in per capita
terms. Say that real GDP has been growing in a
hypothetical country, so that is has a positive real GDP
growth rate. Does this mean that it also has positive
per capita GDP growth? The answer depends on how
fast the population has been growing. Remember that
real GDP per capita is simply real GDP divided by the
number of people in the population; it represents the
amount of GDP there is on average for each person.
If real GDP is growing faster than the population,
then the amount of real GDP that corresponds to
each person will get bigger and bigger, and there will
be positive growth in real GDP per capita. But if the
population is growing faster than real GDP, then the
amount of GDP per person on average will be less
and less, and the growth rate of real GDP per capita
will be negative. It is not uncommon to see countries
where total output is increasing but output per capita is
falling (as we will see in Table 7.2).
If we know the percentage change in real GDP and
the percentage change in the population, we can find
the percentage change in real GDP per capita in a very
simple way:
% change in real GDP per capita
= % change in real GDP − % change in population
For example, if real GDP has grown by 2% in the
course of a year, and the population has grown by
1.5%, then real GDP per capita growth is 0.5%. If,
however, the population grew by 3%, then the %
change in real GDP is − 1%, indicating that output per
person fell by 1%.
Note that throughout this discussion we are using real
as opposed to nominal GDP figures. The real figures
have eliminated the impact of price changes, thus
permitting meaningful comparisons of output over
time.
of resources and its productive inefficiency. This
means that if the country can make better use of its
resources by reducing unemployment and increasing
efficiency in production, it will move closer to the
PPC and increase the quantity of output it produces.
Therefore reductions in unemployment and increases
in productive efficiency are two factors that can cause
economic growth. In Figure 7.3(a), the movement
from point A to point B, which is closer to the PPC,
illustrates economic growth.
However, reduction of unemployment and
inefficiencies can only result in a limited amount of
economic growth. As the economy comes closer and
closer to its PPC, the possibility for further growth
becomes exhausted. In order for further growth to
occur, there must occur an increase in production
possibilities, illustrated by an outward shift of the
economy’s PPC. This is shown in Figure 7.3(b),
where the outward shifts of production possibilities
are accompanied by outward movements of the
economy’s points of production, from A to B, to C.
These movements are only possible because the
economy’s PPC is shifting outward.
What are the factors that cause outward shifts of the
PPC? As you may remember from Chapter 1, page 13,
these include:
· increases in the quantity of one or more factors of
production
· improvements in the quality of the factors of
production
· improvements in technology.
The sources of economic growth
We have seen how economic growth is defined and
calculated. The question we now turn to is: what are
the sources of economic growth, in other words, what
are the causes of growth? We can find the answer to
this question in the production possibilities model we
studied in Chapter 1 (page 11). You may remember
that the production possibilities curve (PPC) shows
the maximum attainable combinations of output that
can be produced by an economy with fixed resources
and technology, provided there is full or maximum
employment of resources and productive efficiency.
When an economy has fixed (unchanging)
quantities and quality of factors of production
and fixed technologies, it can achieve some
limited economic growth through reductions in
unemployment and improvements in productive
efficiency. However, sustained economic growth over
long periods of time depends crucially on increased
resource quantities, improved resource quality,
and technological improvements, i.e. increases in
production possibilities and outward shifts in the
economy’s PPC.
As we saw in Chapter 1, page 12, any economy is
most likely actually to be situated at some point
inside its PPC, as it is very difficult ever to achieve
full productive efficiency and maximum employment
of all resources. The further away an economy is
situated from its PPC, the greater is the unemployment
Chapter 7: Macroeconomic concepts and measurement 193
(a) Economic growth
caused by reductions in
unemployment and productive
inefficiency.
(b) Economic growth caused
by increases in production
possibilities.
Y
Y
C
B
B
A
A
0
0
X
X
Average annual
growth (%)
1990–2005*
Growth (%)
2005–06**
Middle East and
North Africa
2.3
3.6
Tunisia
3.3
4.1
Egypt
2.4
4.9
Jordan
1.6
4.0
Morocco
1.5
6.0
High income
countries
1.8
2.3
Greece
2.5
4.2
Figure 7.3 Using the production possibilities model to illustrate
economic growth.
United Kingdom
2.5
2.6
United States
2.1
2.4
The significance of economic growth
Japan
0.8
2.4
Economic growth rates achieved by countries around
the world are highly variable. While some countries
experience rapid growth, others grow much more
slowly. This can be seen in Table 7.2, showing average
annual growth rates of real GDP per capita for groups
of developing and developed countries, as well as for
some specific countries within each group. The groups,
and countries within the groups, are listed in order of
declining average growth rates over the period 1990–
2005.
Switzerland
0.6
2.6
Central and
Eastern Europe
and former Soviet
Union
1.4
5.7
Belarus
2.2
8.1
Kazakhstan
2.0
10.1
Romania
1.6
6.0
Table 7.2
Russian
Federation
− 0.1
7.3
Latin America and
Caribbean
1.2
4.2
Peru
2.2
6.5
Brazil
1.1
2.4
Real GDP per capita percentage growth.
Average annual
growth (%)
1990–2005*
Growth (%)
2005–06**
East Asia and
Pacific
5.8
8.6
China
8.8
10.1
Colombia
0.6
5.4
Vietnam
5.9
6.9
Venezuela
− 1.0
8.5
Thailand
2.7
4.2
0.5
4.7
Indonesia
2.1
4.3
Sub-Saharan
Africa
South Asia
3.4
6.9
Tanzania
1.7
3.3
India
4.2
7.7
Malawi
1.0
6.2
Sri Lanka
3.7
6.6
Nigeria
0.8
3.4
Nepal
2.0
− 0.1
− 0.6
2.1
Pakistan
1.3
4.1
194
Part 3: Macroeconomics
Central African
Republic
*Data from United Nations Development Programme, Human
Development Report 2007–08, available at http://hdr.undp.org/en/.
**Data from World Bank, World Development Report 2008 (World
Bank, 2007).
Although there are wide differences in growth rates of
countries within each group, on average the countries
of East Asia and the Pacific have been growing the
most rapidly, averaging growth of 5.8% per year in real
per capita GDP in the period 1990–2005. By contrast,
the countries in sub-Saharan Africa have shown
the lowest growth rates, with real per capita GDP on
average increasing by 0.5% per year over the same
period. We will discover many of the reasons behind
these highly variable growth rates in Part 5.
It is interesting to note that all the groups in
Table 7.2, and most of the countries in each group,
have experienced an increase in their rate of growth
in 2005–06 compared to the average of the previous
15 years.5
Widely differing growth rates have enormous
implications for a country’s economic performance
over extended periods of time. To see why this is so,
let’s consider what would happen to per capita GDPs
of three hypothetical economies that grow at different
rates over a period of 25 years. Imagine that each
economy starts out in 1990 with a GDP per capita of
$1000. The first one grows for 25 years at the high
annual rate of 5.8% (the rate of the East Asia and
Pacific group); the second country grows for 25 years
at the annual rate of 2.3% (the rate of the Middle East
and North Africa group). And the third country grows
for 25 years at the lower annual rate of 0.5% (the subSaharan African group). The results are presented in
Table 7.3. The country that grows at 5.8% per year for
25 years succeeds in more than quadrupling its GDP
per capita, while the country that grows at the lowest
rate of 0.5% per year for 25 years merely adds $133 to
its GDP per capita!
The longer the time period during which countries
experience relatively high growth rates, the greater is
the cumulative impact on their per capita GDPs, and
the greater the differences between per capita GDP
levels of high-growth and low-growth countries.
Very low (or even negative) growth rates in GDP
per capita in many sub-Saharan African and other
countries over long periods have had profound
impacts on the levels of living of their populations.
For many developing countries, particularly those with lower average
growth rates in the period 1990–2005, the surge in growth in the mid-2000s
has been due to rapid increases in the prices of their commodity exports. As
of autumn 2008, there are indications that the prices of commodities may
5
The enormous cumulative impact that rates of growth
have on levels of real GDP per capita explains why
governments around the world focus strongly on
factors and policies that will accelerate their rate of
growth. We will come back to these issues in Part 5.
Table 7.3
Growth of GDP per capita in hypothetical economies.
1990 GDP per
capita
Annual growth
rate
2015 GDP per
capita
$1 000
5.8%
$4094
$1 000
2.3%
$1 766
$1 000
0.5%
$1 133
Test your understanding 7.8
1 (a) Define economic growth; (b) how is
economic growth expressed?
2 How is it possible that a country can experience
positive real GDP growth and yet have falling
real GDP per capita (negative real GDP per capita
growth)?
3 When we calculate economic growth figures,
should we use nominal or real values of GDP (or
any other measure of output or income)? Why?
4 Say that an economy’s real GDP grew by 5% in
2007, and its population grew by 1.5% during
the same year. By how much did its real GDP per
capita grow?
5 Use the production possibilities model and a
diagram to show how the following can result in
economic growth (shift of the PPC or movement
of a point within the PPC:
(a) a fall in unemployment
(b) a discovery of new oil reserves
(c) an improvement in levels of health of the
population
(d) an increase in productive efficiency
(e) the widespread use of a new technology.
6 What must be occurring continuously if an
economy wants to maintain its growth over
long periods of time? Use the concepts of
production possibilities and actual output to
show why economic growth cannot continue
over long periods of time if there is no increase
in production possibilities.
start to come down again, and this may reduce their high rates of growth.
We will discuss these issues in Chapter 14, where we will study the impacts
of commodity price changes on growth and development.
Chapter 7: Macroeconomic concepts and measurement 195
Economic development
Increasing levels of output and incomes made possible
by economic growth mean that societies can better
satisfy the needs and wants of their populations and
secure improvements in their levels of living. However,
while economic growth can make improved levels
of living possible, it does not by itself guarantee that
this will occur. Persisting poverty and the failure of
many countries to secure long-lasting improvements
in the well-being of their populations, even if they
have achieved respectable rates of growth over
extended periods of time, have shown that economic
development is a highly complex and sometimes
elusive process.
Distinguishing between developing and
developed countries
The World Bank (an international financial institution
that lends to developing countries in order to assist
them in their development efforts, discussed in Part 5)
divides countries into four groups according to their
level of GNP per capita. These groups (based on 2006
GNP per capita) are
· low income, with GNP per capita of $905 or less
· lower middle income, with GNP per capita of
$906–$3595
· upper middle income, with GNP per capita of
$3596–$11,115
· high income, with GNP per capita of $11,116 or
high population growth rates, prevalence of disease
and poor health, low life expectancy, limited access
to basic services such as health care, education and
sanitation, and serious environmental problems.
It is important to note, however, that these
characteristics do not apply uniformly to all
developing countries. For example, whereas many
developing countries have relatively low literacy rates,
this does not apply to the countries of eastern Europe
and the former Soviet Union because of the priority
given to education under former communist regimes.
Tajikistan (a part of the former Soviet Union), with a
very low per capita GNP, has achieved a youth literacy
rate that is comparable to many highly developed
countries in the world; by contrast, Saudi Arabia with
a relatively high per capita GNP has a lower literacy
rate than other countries with a comparable per capita
GNP level.
In fact, classifying countries by level of GNP (or any
other output or income measure) does not accurately
represent their level of development. The World Bank
points out that ‘Classification by income does not
necessarily reflect development status.’ As we will see
later in this chapter (Section 7.3), a country’s level
of development varies widely depending upon what
characteristic is used; whereas one country may be
quite developed with respect to one characteristic, it
may be less so with respect to another.
High income, or developed economies, include the
countries of North America, western Europe, Australia,
Japan and New Zealand, as well as some eastern
European and some oil-producing countries in the
Middle East.
Further, it is important to note that classifying
countries as developing or developed with respect
to per capita GNP levels or any other characteristic
hides the lack of uniformity within countries. The
United States, for example, one of the economically
most advanced countries in the world, has pockets
of poverty, with lack of access to basic services such
as health care, low educational attainment, high
unemployment and low income levels. Similarly, most
less developed countries have pockets of great wealth
concentrated in the hands of a small proportion of
the population, with good access to health care, high
levels of education, lower birth rates and higher life
expectancy.
Developing countries (LDCs) include most of the
countries of Africa, Asia, Latin America and the Middle
East, and parts of eastern Europe and the former Soviet
Union. They tend to be characterized by widespread
poverty, use of less advanced production technologies,
low levels of industrialization and a correspondingly
high dependence on agriculture, highly unequal
distribution of income and wealth, relatively high
rates of illiteracy, high unemployment,
Different countries display the characteristics of
being ‘less developed’ or ‘more developed’ to varying
degrees. Moreover, there is a lack of uniformity within
countries with respect to the level of development;
there can be pockets of poverty in very wealthy
countries, as there can be pockets of wealth in very
poor countries.
more.
Table 7.4 lists all the countries in these country
groups. The first three groups (low, lower middle and
upper middle income) comprise the less developed
countries or LDCs (‘developing countries’), while
the high income economies are the more developed
countries or MDCs (‘developed countries’).
196
Part 3: Macroeconomics
Table 7.4 World Bank country groups by 2006 GNP per capita.
Low income economies
Afghanistan
Ghana
Mauritania
Bangladesh
Benin
Burkina Faso
Burundi
Cambodia
Central
African Rep.
Chad
Comoros
Guinea
Guinea-Bissau
Haiti
India
Kenya
Korea, Dem.
Rep.
Kyrgyz Rep.
Lao PDR
Mongolia
Mozambique
Myanmar
Nepal
Niger
Nigeria
Congo, Dem.
Rep.
Côte d’Ivoire
Liberia
Eritrea
Ethiopia
Gambia, The
Madagascar
Malawi
Mali
Pakistan
Papua New
Guinea
Rwanda
Solomon
Islands
Somalia
Sudan
Tajikistan
Tanzania
Timor-Leste
Togo
Uganda
Uzbekistan
Vietnam
São Tomé and Yemen, Rep.
Principe
Senegal
Zambia
Sierra Leone Zimbabwe
Lower middle income economies
Albania
Algeria
Angola
Belarus
Cuba
Djibouti
Dominican
Republic
Ecuador
Egypt, Arab
Rep.
El Salvador
Bhutan
Fiji
Bolivia
Bosnia and
Herzegovina
Cameroon
Cape Verde
China
Colombia
Georgia
Guatemala
Armenia
Azerbaijan
Congo, Rep.
Guyana
Honduras
Indonesia
Iran, Islamic
Rep.
Iraq
Jamaica
Jordan
Kiribati
Philippines
Samoa
Sri Lanka
Lesotho
Macedonia,
FYR
Maldives
Suriname
Swaziland
Marshall
Islands
Nicaragua
Micronesia,
Fed. Sts
Moldova
Morocco
Namibia
Paraguay
Syrian Arab
Republic
Thailand
Tonga
Tunisia
Turkmenistan
Ukraine
Vanuatu
West Bank and
Gaza
Upper middle income economies
American
Samoa
Estonia
Mayotte
Seychelles
Argentina
Belize
Botswana
Gabon
Grenada
Hungary
Brazil
Bulgaria
Latvia
Lebanon
Mexico
Montenegro
Northern
Mariana Islands
Oman
Palau
Chile
Libya
Panama
Costa Rica
Croatia
Lithuania
Kazakhstan
Poland
Romania
Dominica
Malaysia
Equatorial
Guinea
Mauritius
Russian
Federation
Serbia
Slovak Republic
South Africa
St Kitts and
Nevis
St Lucia
St Vincent and
Grenadines
Trinidad and
Tobago
Turkey
Uruguay
Venezuela, RB
High income economies
Andorra
Czech
Republic
Israel
Portugal
Antigua and
Barbuda
Aruba
Australia
Austria
Bahamas, The
Bahrain
Denmark
Italy
Puerto Rico
Japan
Korea, Rep.
Kuwait
Liechtenstein
Luxembourg
Qatar
San Marino
Saudi Arabia
Singapore
Slovenia
Macao, China
Malta
Monaco
Netherlands
Netherlands
Antilles
New Caledonia
Spain
Sweden
Switzerland
Taiwan, China
United Arab
Emirates
United
Kingdom
United States
Estonia
Faroe Islands
Finland
France
French
Polynesia
Barbados
Germany
Belgium
Greece
Bermuda
Greenland
Brunei
Guam
Canada
Hong Kong,
China
Cayman Islands Iceland
Channel
Islands
Cyprus
Ireland
New Zealand
Isle of Man
Norway
Virgin Islands
(US)
Peru
Defining economic development
The meaning of economic development has changed
dramatically over the years. In the past 50 to 60
years that economists have been concerned with
development, we can distinguish the following main
strands of thought:
· the 1950s and 1960s: focus on economic growth
· the 1970s: redistribution with growth
· the 1980s, 1990s and beyond: human development.
We will consider each of these in turn.
Chapter 7: Macroeconomic concepts and measurement 197
The 1950s and 1960s: focus on economic
growth
in 1973 showed that economic growth in the early
years benefited only the wealthiest groups, and in a
later phase benefited middle income groups, while the
position of the poorest 40% of the population grew
worse both relatively and absolutely. In other words,
the benefits of economic growth were not ‘trickling
down’ to the poorest members of society.
In the 1950s and 1960s, economists held that
economic growth and economic development were
virtually synonymous. A prominent development
economist, Charles P. Kindleberger, wrote in 1965:
Growth and development are often used synonymously
in economic discussion, and this is entirely appropriate
… In the early stages, any economy that grows is likely
to develop, and vice versa … In the less developed parts
of the world, i.e. countries that have low incomes or that
find difficulty in adapting to the economic opportunities
available to them, growth and development go hand in
6
hand.
Perceptions about what constitutes economic
development, and how this should be pursued, began
to change dramatically. Since economic growth, where
it did occur, did not work to eliminate widespread
poverty, what was needed was an approach that
would directly deal with the problems of developing
countries, and specifically the problem of persisting
poverty. In the new view, less developed countries
should combine the older focus on economic growth
with new ideas on redistribution of income and
wealth, and improved access of the poor to basic
goods and services.
It was believed that economic growth over long
periods of time would automatically provide economic
and social benefits for the wider population; larger
quantities of goods and services, including health
care and education, and employment opportunities
and social change would eventually be spread out
over most people in an economy, thereby achieving
economic development. This notion was termed
the trickle-down theory: benefits of growth would
eventually trickle down to everyone. Based on this
view, developing countries in this period pursued
policies that aimed at promoting their economic
growth. The work of a number of economists carried
out from the late 1940s to the 1960s was highly
influential in providing the theoretical grounds for
growth-oriented economic policies. (We will consider
some of these in Chapter 17.)
Economic development, as understood in the 1970s
(and beyond), can be defined as a process whereby
increases in real per capita incomes are accompanied
by improvements in levels of living of the population
and reductions in poverty and inequalities, which in
turn suggest decreases in the number of persons living
below a minimum level of real income, attainment of
a certain minimum level of consumption, increased
access to goods and services that satisfy basic needs
(including food, shelter, health care, education,
sanitation and others), increased employment
opportunities and reduction of unemployment,
and reductions of serious inequalities in wealth and
growth of different regions within a country.
The 1970s: redistribution with growth
By the late 1960s and early 1970s, it was becoming
increasingly apparent that many less developed
countries were not performing according to
expectations. First, it was noted that the GNP per capita
gap between rich countries and poor countries had
more than doubled on average in the period 1950–
75.7 Growth rates were highly uneven: while some less
developed countries were growing rapidly (particularly
the oil-rich countries in the Middle East), others were
experiencing very low or even negative growth rates
(especially in Africa).
The 1980s, 1990s and beyond: human
development
Many people in the development field today would
agree with the broad definitions of economic
development that appeared in the 1970s. Yet
thinking about development has progressed further
in more recent years, building on an even broader
interpretation of development that was provided by
Denis Goulet as early as 1971. Goulet defined three
core values of development: life sustenance, selfesteem, and freedom:8
Second, it became apparent that the number of
people living in extreme poverty (defined as living
on less than US$1 per day) was increasing rather than
decreasing. A major study of 43 countries published
· Life sustenance refers to access to basic services (merit
goods) such as education and health care services, as
Charles P. Kindleberger, Economic Development (McGraw-Hill, 1965).
David Morawetz, Twenty-Five Years of Economic Development: 1950–1975
(World Bank, 1977).
6
7
198
Part 3: Macroeconomics
D. Goulet, The Cruel Choice: A New Concept on the Theory Of
Development (Atheneum, 1971).
8
well as satisfaction of basic needs like food, clothing
and shelter.
· Self-esteem involves the feeling of self-respect;
development is desirable because it provides
individuals with dignity, honour and independence;
self-esteem is related to the absence of exploitation
and dominance associated with poverty and
dependence.
· Freedom involves freedom from want, ignorance
and squalor; it is freedom to make choices that are
not available to people who are subjected to the
conditions of poverty.
The economist Amartya Sen, who won the Nobel Prize
in Economics in 1998 for his work on poverty and
economic development, taking Goulet’s ideas further,
sees improvements in human welfare as arising from a
process of expanding freedoms:
Development can be seen . . . as a process of expanding
the real freedoms that people enjoy. Focusing on human
freedom contrasts with narrower views of development,
such as identifying development with the growth of gross
national product, or with the rise in personal incomes,
or with industrialization, or with technological advance,
or with social modernization. Growth of GNP or of
individual incomes can, of course, be very important
as a means to expanding the freedoms enjoyed by
the members of the society. But freedoms depend also
on other determinants, such as social and economic
arrangements (for example, facilities for education and
health care), as well as political and civil rights (for
example, the liberty to participate in public discussion
9
and scrutiny)…
Sen’s approach has been crystallized in the concept
of human development, introduced in the first
Human Development Report of the United Nations
Development Programme (UNDP) in 1990.10
Human development can be defined as a process of
expanding human freedoms: the freedom to satisfy
hunger; to be adequately fed; to be free of preventable
illnesses; to have adequate clothing and shelter; to
have access to clean water and sanitation; to be able to
read, write and receive an appropriate education; to be
knowledgeable; to be able to find work; to enjoy legal
protection; to participate in social and political life;
and, in general, to have the freedom to develop one’s
potential and lead a full and productive life.
Amartya Sen, Development as Freedom (Oxford University Press, 2001),
emphasis in the original.
10
The UNDP is an agency of the United Nations designed to foster
development in less developed countries. The UNDP’s Human Development
Reports are compiled annually and provide statistical and other
9
Based on the concept of human development, the
UNDP makes a key distinction between income poverty
and human poverty. Income poverty occurs when
income falls below a nationally or internationally
determined level that defines the poverty line (i.e.
anyone with less than this income is considered poor).
Human poverty, by contrast, involves deprivations
and the lack of opportunities and choices that allow
individuals ‘to lead a long, healthy, creative life and to
enjoy a decent standard of living, freedom, dignity, selfesteem and the respect of others’.11
To understand the distinction between income
poverty and human poverty, consider a villager whose
income increases, so that now he or she is able to
purchase more goods and services. If there are no
schools or health care services in the area, or if the
village is infested with malaria, the higher income will
be of limited use to the villager in securing a higher
standard of living. While income poverty is reduced
through the higher income, human poverty cannot be
lowered without explicit measures to provide a broad
range of social services to the entire population. On
the other hand, if people on low incomes have access
to education, health services, improved sanitation,
improved water supplies, etc., human poverty can be
reduced even while income poverty remains. Later in
this chapter we will see how economic and human
development, income poverty and human poverty are
measured.
Relating economic growth to economic
development
Economic growth can occur without economic
development. It was this experience for many
countries in the 1950s and 1960s that gave rise to a
rethinking and redefining of economic development.
Can economic development occur without economic
growth?
Some economic development may be possible in the
absence of rapid growth, if appropriate strategies are
undertaken to provide access to basic social services
for the poor. The production possibilities model
we studied in Chapter 1 shows how this can occur.
Consider Figure 1.5 on page 15 in Chapter 1, when an
economy produces some combination of industrial
goods (measured on the vertical axis) and merit goods
(measured on the horizontal axis). The merit goods
include education, health care services, sanitation,
information on numerous issues relating to human development in less
developed countries around the world.
11
UNDP, Human Development Report 1997, available at http://hdr.undp.
org/en/.
Chapter 7: Macroeconomic concepts and measurement 199
and clean water supplies, which are made available to
people on low incomes who would not otherwise have
access to them. (For simplicity it is assumed that actual
output is at some point on the production possibilities
curves). Suppose now that an economy is operating on
PPC1, is not experiencing much growth, and therefore
remains on PPC1. It can still achieve an improvement
in the well-being of its population, i.e. some economic
development, simply by cutting back on some of its
industrial goods production and increasing merit
goods production; this would entail a movement
along PPC1 downward and to the right.
However, over long periods of time, the possibilities
for improving the population’s well-being by moving
along the same PPC will be exhausted, and further
improvements will depend on outward shifts of the
PPC, as shown by the movement from PPC1 to PPC2
in Figure 1.5. Economic growth, made possible by
outward shifts of the PPC, is therefore necessary for
economic development to be sustained. Growing
output per capita translates into higher incomes and
an improved ability to provide the goods and services
needed by the population. We can therefore conclude
that:
Economic growth can occur without economic
development (or with limited economic
development). Some economic development can
occur without economic growth (or with limited
economic growth), but for limited periods of time and
to a limited extent. Sustained economic development
over extended periods of time requires economic
growth, in combination with policies that result in
improvements in quality of life through improved
access to basic social services (merit goods).
Test your understanding 7.9
1 Define economic development as it has come to
be understood since the 1970s.
2 (a) What is the ‘trickle-down theory’? (b) How
was it used during the 1950s and 1960s to
justify the pursuit of economic growth as the
road to economic development?
3 (a) Define human development. (b) Distinguish
between income poverty and human poverty.
(...continued)
Test your understanding 7.9
(...continued)
4 Use the production possibilities model to
(a) show how a country can experience growth
without economic development (see Chapter 1,
page 10); (b) show how it can achieve some
economic development without economic
growth; (c) explain why economic development
over long periods of time requires economic
growth.
Limitations of the GDP measure in
international welfare comparisons
Welfare is an expression for the state of well-being
of a population. When real per capita GDP of a
country increases over time, we might expect that the
population of this country achieves greater welfare.
Or, if GDP per capita in one country is greater than
that of another country, we might expect that the first
country enjoys a higher level of welfare. But would
these conclusions be valid?
The answer is that we cannot be sure. There are two
reasons why this is so. One is that GDP statistics
do not accurately measure the true value of output
produced in an economy. The other is that the
welfare of a population is closely related to the many
dimensions of economic and human development,
which GDP is unable to measure. As we will see in the
pages that follow, GDP per capita simply measures the
income or output of a country that corresponds to
each individual in the country on average; it cannot
account for levels of health, education, access to
clean water, and the numerous other dimensions of
economic and human development. It follows, then,
that GDP per capita can be quite misleading when used
as the basis for welfare comparisons across countries.
The factors limiting the usefulness of per capita GDP
for comparison purposes can be divided into those
that systematically result in understating society’s
welfare, those that systematically result in overstating
welfare, and those that result in either understating or
overstating welfare.
Why GDP figures understate welfare (or
why true welfare is greater than indicated
by GDP per capita)
· GDP does not include non-marketed output GDP,
as we know, measures the value of goods and
services that are traded in the marketplace and that
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generate incomes for the factors of production.
Yet some output of goods and services is not sold
in the market and does not generate any income;
this is called ‘non-marketed output’. The work of
women inside the home is one such example; one’s
own work on repairing and improving one’s own
home is another. If the housework and the home
repairs were carried out by hired workers, GDP
would be greater by the amount of their wages.
In less developed countries households are often
quite self-sufficient, with a substantial portion of
production, such as agricultural production, taking
place for a household’s own use and consumption,
and never reaching the marketplace. Non-marketed
output therefore is likely to be far greater in less
developed countries compared to more developed
ones. In general, exclusion of non-marketed output
from GDP leads to understating GDP and therefore
understating society’s welfare.
· GDP does not include output sold in underground
(informal) markets Here we have the case where
goods are traded in markets and do generate
incomes, but they go unrecorded and therefore are
not included in GDP. An ‘underground market’ (also
known as an ‘informal market’) exists whenever a
buying/selling transaction is unrecorded. It may
involve the provision of legal goods and services
(such as when a plumber does repairs in your home
and does not report the income received so as to
avoid paying taxes), or in transactions involving
illegal goods and services. The exclusion of
unrecorded output results in understating society’s
GDP.
· GDP does not take into account quality improvements
in goods and services The quality of many products
improves over time, yet this is not taken into
account in calculating the value of aggregate output.
Technological advances often permit improved
products to be sold at lower prices (for example,
mobile phones and computers). This process offers
significant benefits to consumers, which do not
show up in GDP figures. The exclusion of quality
improvements means that GDP understates society’s
welfare.
· GDP does not take into account increased leisure In
many countries around the world (particularly in
more developed ones) the average number of hours
worked per week has declined significantly, with
the number of hours of leisure correspondingly
increasing. This clearly contributes to society’s
welfare, yet is not accounted for in measures of
GDP. Once again, the neglect of growing leisure
understates society’s welfare.
· GDP does not take into account increased life expectancy
Increased life expectancy (the number of years one
can expect to live, on average) is another benefit
of technological improvements and higher income
levels that has contributed enormously to the
welfare of societies, but is not accounted for in GDP
figures.
Why GDP figures overstate welfare
(or why true welfare is smaller than
indicated by GDP per capita)
· GDP does not account for the value of negative
externalities, such as pollution, toxic wastes, and
other undesirable by-products of production In this
case, GDP overstates society’s welfare. Virtually all
countries contribute to environmental degradation
(though to varying degrees), as a result of which
welfare is reduced, though this is not reflected in
GDP figures.
· GDP does not take into account the depletion of
natural resources The depletion of natural resources
(rainforests, the ozone layer, wildlife) around
the world reduces welfare yet is also not taken
into consideration by standard national income
accounting. GDP figures once again overstate
welfare. We will come back to this topic in
Chapter 19.
Why GDP figures understate or overstate
welfare (or why true welfare may be
greater or smaller than indicated by GDP
per capita)
· GDP makes no distinctions regarding the composition
of output Whether a country produces military
goods (weapons, guns, tanks, etc.) or merit goods
(education, health care, other social services) or any
other type of goods, GDP includes the value of all
of without any distinctions regarding the degree
to which they contribute to the welfare of the
population. We know that economic development
and human development involve increasing
production of social services and merit goods that
contribute to higher levels of living. One country
may have a lower per capita GDP than another,
but higher levels of social service and merit goods
provision than the other. Which has the higher level
of welfare? The GDP measure will be inconclusive
and misleading if used as the basis for welfare
comparisons.
· GDP provides no information on the distribution
of income and output How equally or unequally
income and output are distributed over the entire
Chapter 7: Macroeconomic concepts and measurement 201
population is another key factor underlying
society’s welfare. Is the wealth of a nation highly
concentrated in relatively few hands or is it
relatively more equally distributed? Are the benefits
of a growing GDP concentrated among a small
group of beneficiaries or are they widely distributed?
Are inequalities increasing or decreasing? Economic
development and the reduction of poverty often
depend on the reduction of extreme inequalities.
The measure of GDP per capita cannot address any
of these questions, as it only provides an indication
of average output per person, and is therefore in this
respect, too, inconclusive and misleading as a basis
for international welfare comparisons.
· GDP does not account for quality of life factors A
society’s welfare depends upon a number of noneconomic factors, such as the crime rate, a sense of
security and peace arising from relations with other
countries, well-functioning institutions, stress levels
from working conditions, the degree of political
freedom, and many others. GDP cannot account
for any of these. As a result, welfare may be higher
or lower depending on the particular situation
prevailing with respect to each of these factors.
· GDP and differing domestic price levels Goods
and services can sell for vastly different prices in
different countries. This means that 100 yen (the
Japanese currency, after it has been converted into
local currencies) will be able to purchase more in a
low price country than in a high price country. If
international comparisons of GDP do not account
for differing price levels across countries, we will get
a highly misleading picture of welfare. This issue
will be discussed in some more detail in the section
that follows.
Purchasing power parities and welfare
comparisons across countries
If we were told that in 2005 India’s GDP per capita was
21,791 Indian rupees and China’s was 11,283 yuan, we
would be hard pressed to make a sensible comparison.
In order to be able to compare GDP (or GNP, or any
other monetary measure) between countries, we must
convert different national currencies into a single
currency. This conversion may be performed by use
of exchange rates, which are the rates at which one
currency can be converted into another. In terms of
US$, India’s GDP per capita in 2005 was $564 and
China’s was $1100.
However, expressing GDPs in terms of one common
currency does not solve the problem of making
international comparisons that measure the welfare
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Part 3: Macroeconomics
of populations, because of differing price levels across
countries. Let’s take two hypothetical countries that
have an identical GDP per capita of $1000. Imagine
that both countries produce only one identical good,
which sells for $100 in Country A and for $200 in
Country B. The $1000 per person in Country A can
buy 10 units of the good, but the same amount of
money can buy only 5 units of the good in Country
B. In other words, the $1000 of GDP per person in
country A, the low price country, has far greater
purchasing power. Purchasing power refers to the
quantity of goods and services that can be bought
with money. Although the two countries have
identical GDPs per capita in terms of $, the population
of country A can buy double the amount of the
good than the population of Country B. Clearly, the
population of country A on average has greater welfare
than the population of Country B.
Therefore, to be able to make comparisons of welfare
between two or more countries, we cannot simply
rely on exchange rates to convert one currency into
another. We need a method of currency conversions
that accounts for different price levels, and therefore
different purchasing powers across countries. Such a
method is provided by special exchange rates called
purchasing power parities (PPPs). Purchasing power
parity literally means ‘buying power equivalence’. It
is defined as the amount of a country’s currency that
is needed to buy the same quantity of local goods and
services that can by bought with US$1 in the United
States. A PPP exchange rate is an exchange rate
between currencies that makes their buying power
equal to the buying power of US$1, and therefore
equal to each other. (Use of the US$ as the basis for
the conversions is only a matter of convention, as
other currencies would also have been suitable for this
purpose.)
Table 7.5 shows GDP per capita for selected countries,
calculated both by use of exchange rates (in the first
column) and by use of purchasing power parities (in
the second column). The countries range from some of
the poorest to some of the wealthiest in the world, and
are listed in order of increasing GDP per capita based
on exchange rates. Note that in the second column of
figures, showing GDP per capita using PPPs, the same
country order no longer holds.
A look at Table 7.5 reveals an interesting pattern: for
the poorer countries starting at the top of the table,
the GDP figures based on PPPs are higher than those
based on exchange rates; for the wealthier countries
at the bottom of the table, GDP figures based on PPPs
are lower than those based on exchange rates. Why is
this so?
Table 7.5 Comparisons of GDP per capita using exchange rates and
purchasing power parities, 2003.
Country
GDP per capita
(exchange rates
US$)
GDP per capita
(purchasing
power parities,
US$ PPP)
Burundi
83
648
Ethiopia
97
711
Sierra Leone
149
548
India
564
2,892
Indonesia
970
3,361
China
1,100
5,003
Russian
Federation
3,018
9,230
Chile
4,591
10,274
Latvia
4,771
10,270
Mexico
6,121
9,168
Czech Republic
8,794
16,357
Korea, Republic
12,634
17,971
Greece
15,608
19,954
Australia
26,275
29,632
United Kingdom
30,253
27,147
Sweden
33,676
26,750
Japan
33,713
27,967
United States
37,648
37,648
Ireland
38,487
37,738
Switzerland
43,553
30,552
Source: Data from United Nations Development Programme, Human
Development Report 2005, available at http://hdr.undp.org/en/.
It is because prices of goods and services on average
tend to be lower in countries with low per capita GDPs,
and higher in countries with high per capita GDPs. To
understand what this means, consider two countries
that produce the identical quantity of output (goods
and services), but that have different prices for this
output. When the value of this output is calculated in
terms of US$ using exchange rates, it will appear to be
lower in the lower price country than in the higher
price country, even though the quantity of output
is the same. This is exactly what happens in the
real world. In the first column of figures, the output
of lower price countries at the top end of the table
appears to be lower than the equivalent output of
higher price countries at the bottom end. The second
column of figures, using PPPs to convert GDP per
capita, eliminates the impact on GDP of differing price
levels, and as a result, the differences in per capita GDP
between countries shrink enormously. Comparing
Switzerland with Burundi, we see that Swiss GDP per
capita based on exchange rates is 525 times greater
than Burundi’s; based on purchasing power parities,
Swiss GDP per capita is 47 times greater than Burundi’s.
The second comparison is a much better indicator of
the differences in welfare between the Burundian and
Swiss populations.
In the case of the United States, the two figures are
identical, since it is the purchasing power of the US$
within the United States that is used as the basis for
the PPP conversions.
Welfare comparisons across countries require measures
of per capita income or output based on conversions
of national currencies into US$ by use of purchasing
power parities (PPPs), so as to eliminate the influence
of price differences on GDP per capita.
Purchasing power parity exchange rates are computed
and published on a regular basis by a number of
international bodies, including the Organisation for
European Co-operation and Development (OECD),
European Union, World Bank and United Nations
agencies.
Test your understanding 7.10
1 Explain why GDP per capita may be
inappropriate as the basis for making
comparisons of a society’s welfare over time, or
for comparisons of welfare between countries.
2 Discuss some factors that cause GDP figures
to (a) understate a society’s true welfare;
(b) overstate a society’s true welfare; (c) to
understate or overstate a society’s true welfare.
3 (a) What are purchasing power parities?
(b) Why are they important for making valid
comparisons of GDP per capita across countries?
Chapter 7: Macroeconomic concepts and measurement 203
7.3 Measuring economic development
The complexities of measuring economic
development
Economic development, as we have seen, is a complex
and multifaceted process that is not accurately
reflected in accounting aggregates like GDP and
GNP per capita. Because of its many dimensions,
the level of economic development of any one
country cannot be reflected in any single measure.
Economists therefore consider specific individual
attributes or characteristics of an economy that tend
to distinguish countries according to their level of
economic or human development.
Individual attributes and characteristics of economies
are measured by use of indicators. An indicator is a
measurable variable that indicates the state or level
of something that is being measured. For example,
GDP per capita is an indicator of the level of output
or income per person. The number of years of life
expectancy is an indicator of the state of the health of
a population. The proportion of a population that can
read and write (the degree of literacy) is an indicator
of the level of education in the country. All these are
attributes of economic or human development.
The data comprising economic or human
development indicators (such as GDP, or life
expectancy, or literacy) are compiled by statistical
services in every country over a period of years and
are made available to international organizations
such as the World Bank and United Nations agencies.
Indicators are extremely useful for:
· monitoring how a country is changing (developing)
over a period of years with respect to the attribute
that the indicator measures
· making comparisons between countries with respect
to the attribute
· assessing how well a country is performing with
respect to particular goals or targets of development
(for example, an increase in the literacy rate
indicates an improvement in the educational level
of a population)
· devising appropriate policy measures to deal with
specific problems.
In addition to individual attributes and goals of
development, measured by individual indicators,
economists also use composite indicators. A
composite indicator is a summary measure of
several dimensions or goals of development. We will
consider both individual and composite indicators of
development in the sections that follow.
Individual and composite indictors, used in
combination with per capita GDP (or GNP) statistics,
are enormously useful as measures of different aspects
and levels of development, but they are also subject to
certain limitations:
· Each indicator measures only one aspect
of development; since development is a
multidimensional process, it is often necessary to
combine the use of many indicators to obtain an
overall picture of a country’s level of development.
· Indicators are based on statistical information, and
this poses a distinct set of problems:
❍
❍
❍
some countries have a limited capacity for
collection of statistical data
data are not fully available in many countries
definitions of variables and methods used by
statistical services vary from country to country,
despite efforts by international organizations
(such as the World Bank and United Nations
agencies) to achieve standardization.
These statistical problems mean that the indicators
cannot always be precise and should therefore be
interpreted carefully. Whether they are used to
examine how a country is changing over time with
respect to some characteristic, or to make comparisons
across countries, they should be used as rough guides
to provide general trends over time, or as indicative
of broad differences between countries, rather than as
very precise measures of changes or differences.
Test your understanding 7.11
1 Explain why it is easier to measure economic
growth than to measure economic development.
2 What are some of the difficulties involved in
measuring economic development?
3 How do economists measure economic
development?
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Part 3: Macroeconomics
Individual indicators
There are many hundreds of indicators that can be
used as measures of the different characteristics of an
economy and of the dimensions of development.
World Development Indicators (World
Bank)
The World Bank compiles a set of indicators known
as the ‘World Development Indicators’ (WDI). As of
2006, there were over 900 indicators, 695 of which
were available online in the Bank’s ‘WDI online list
of times series indicators’.12 The indicators provide
statistical information about the following areas:
· People 178 indicators provide information on
population and demography, labour, employment,
poverty, income, education and health.
· Environment 79 indicators provide information
on land use and agricultural production, energy
production, urbanization and emissions.
· Economy 264 indicators provide information on
diverse aspects of the economy, including national
accounts, trade, government finance, balance of
payments and external debt.
· States and markets 134 indicators provide
information on the investment and business
environment, tax and trade policies, defence
expenditures, arms trade, transport, power and
communications, and information and technology.
Millennium Development Goals and
indicators
In September 2000, the United Nations hosted
the largest meeting of world leaders ever to take
place in history, at which 147 heads of state
and government and 189 countries adopted the
Millennium Declaration: a global statement of
commitment to eliminating extreme poverty,
hunger, disease and environmental damage, through
development strategies based on the needs of the
poor, human rights and sustainable development.
What differentiates the Millennium Declaration from
statements of earlier years is that it establishes specific
goals and targets to be achieved within a period of
15 years, and specifies indicators to be used to monitor
country progress towards achieving the goals and
targets. The 8 goals, 18 targets and some of the 48
indicators of the Declaration are listed in Table 7.6.
As the table shows, there is one or more target
corresponding to each goal, while there are several
indicators that have been specified to monitor and
measure the progress made in each country with
respect to each target. For example, the second
target of goal 1, to halve in the 25 years to 2015
the proportion of people suffering from hunger,
is measured by two indicators: the proportion of
underweight children under five years of age, and the
proportion of the population whose dietary energy
consumption is below the minimum.13
· Global links 40 indicators on investment and trade,
financial flows, development assistance and aid,
migration, and travel and tourism.
12
Some (but not all) of these indicators can be accessed free of charge at
the World Bank’s website (http://devdata.worldbank.org/wdi2006/contents/
cover/htm).
13
The UNDP’s Human Development Reports, as well as indicators and other
information, can be accessed through the UNDP’s website (www.undp.org
or http://hdr.undp.org/en/statistics/).
Chapter 7: Macroeconomic concepts and measurement 205
Table 7.6 Millennium goals, targets and indicators.
Goals
Targets
Indicators
1 Eradicate extreme
poverty and
hunger.
1 Halve, between 1990 and 2015, the
proportion of people whose income
is less than $1 a day.
1 Proportion of population below $1 (1993 PPP) per day.
2 Poverty gap ratio (the poverty gap is the amount of income
required to raise everyone’s income to at least $1 a day).
3 Share of poorest quintile (i.e. the poorest fifth) in total income
2 Achieve
universal primary
education.
2 Halve, between 1990 and 2015, the
proportion of people who suffer
from hunger.
4 Prevalence of underweight children under five years of age.
3 Ensure that by 2015 children
everywhere will be able to
complete primary schooling.
6 Net enrolment ratio in primary education.
5 Proportion of population below minimum level of dietary
energy consumption.
7 Proportion of pupils starting grade 1 who reach grade 5.
8 Literacy rate, 15–24 years old.
3 Promote gender
equality and
empower women.
4 Eliminate gender disparity in
primary and secondary education,
preferably by 2005, and in all levels
of education no later than 2015.
9 Ratio of girls to boys in primary, secondary and tertiary
education.
10 Ratio of literate women to men, 15–14 years old.
11 Share of women in wage employment in the non-agricultural
sector.
12 Proportion of seats held by women in national parliament.
4 Reduce child
mortality.
5 Reduce by two-thirds, between
1990 and 2015, the under-five
mortality rate.
13 Mortality rate of children under five.
14 Infant mortality rate.
15 Proportion of one-year-old children immunized against
measles.
5 Improve maternal
health.
6 Reduce by three-quarters, between
1990 and 2015, the maternal
mortality ratio.
16 Maternal mortality ratio.
6 Combat HIV/AIDS,
malaria and other
diseases.
7 Have halted by 2015 and begun to
reverse the spread of HIV/AIDS.
18 HIV prevalence among pregnant women.
17 Proportion of births attended by skilled health personnel.
19 Condom use rate or the contraceptive prevalence rate.
20 Ratio of school attendance of orphans to school attendance
of non-orphans aged 10–14 years.
8 Have halted by 2015 and begun to
reverse the incidence of malaria
and other major diseases.
21 Prevalence and death rates associated with malaria.
22 Proportion of population in malaria-risk areas using effective
malaria prevention and treatment measures.
23 Prevalence and death rates associated with tuberculosis.
24 Proportion of tuberculosis cases detected and cured under
internationally recommended TB control strategy.
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Part 3: Macroeconomics
Goals
Targets
Indicators
7 Ensure
environmental
sustainability.
9 Integrate the principles of
sustainable development into
country policies and programmes
and reverse the loss of
environmental resources.
25 Proportion of land area covered by forest.
26 Ratio of area protected to maintain biological diversity to
surface area.
27 Energy use (kg oil equivalent) per $1000 GDP (PPP).
28 Carbon dioxide emissions per capita and consumption of
ozone-depleting CFCs.
29 Proportion of population using solid fuels.
8 Develop a global
partnership for
development.
10 Halve, by 2015, the proportion
of people without sustainable
access to safe drinking water and
sanitation.
30 Proportion of population with sustainable access to an
improved water source, urban and rural.
11 By 2020, to have achieved a
significant improvement in the
lives of at least 100 million slum
dwellers.
32 Proportion of households with access to secure tenure.
12 Develop further an open,
rule-based, predictable, nondiscriminatory trading and financial
system.
For targets 12–15: 12 indicators including measures of
development assistance, developed country imports from
developing countries, tariffs imposed by developed countries on
developing country agricultural exports, debt relief, debt service
and others.
13 Address the special needs of the
least developed countries.
31 Proportion of population with access to improved sanitation,
urban and rural.
14 Address the special needs of
landlocked developing countries
and small island developing states.
15 Deal comprehensively with the
debt problems of developing
countries through national and
international measures in order to
make debt sustainable in the long
term.
16 In cooperation with developing
countries, develop and implement
strategies for decent and
productive work for youth.
45 Unemployment rate of young people aged 15–24 years, male
and female and total.
17 In cooperation with
pharmaceutical companies, provide
access to affordable essential drugs
on a sustainable basis.
46 Proportion of population with access to affordable essential
drugs on a sustainable basis.
18 In cooperation with the private
sector, make available the benefits
of new technologies, especially
information and communications.
47 Telephone lines and cellular subscribers per 100 population.
48 Personal computers in use per 100 population and Internet
users per 100 population.
Source: Data from United Nations Development Programme, at www.undp.org.
Chapter 7: Macroeconomic concepts and measurement 207
Examples of individual indicators
We will now consider some examples of individual
indicators. The purpose of this discussion is to
illustrate some of the attributes that tend to
characterize less developed countries; to demonstrate
the use of indicators when making comparisons across
countries as well as over time (how is one country or
region performing relative to another; is a country
or region improving its performance over time?); to
show that GDP per capita can be a poor indicator of
the diverse dimensions of economic development;
to show that a country’s level of development can
vary enormously with respect to different indicators;
to show that development issues apply to developed
countries as well as developing ones; and finally, to
suggest that a great many countries, both more
developed and less developed, can make progress
with achieving development goals by making
better use of available resources (i.e. through a
reallocation of resources towards increased social
services provision and merit goods production).
Health indicators
Health indicators measure attributes of populations
related to health. Three commonly used health
indicators are life expectancy at birth, infant mortality
and maternal mortality. Data for all three are provided
in Table 7.7, which lists selected countries in order of
declining GDP per capita (in US$ PPP).
Life expectancy at birth refers to the number
of years one can expect to live, calculated as the
average number of years of life in a population. Life
expectancy is determined by many factors, and is
greater when there are:
· adequate public health services (such as populationwide immunization services and provision of health
information and education), and control and
prevention of communicable diseases (for example,
malaria, measles, tuberculosis, HIV/AIDS)
· adequate health care services with broad access by
the entire population
· a healthy environment, including access to safe
drinking water and sanitation, and low levels of
pollution
· an adequate and healthy diet and avoidance of
malnutrition
· a high level of education of the entire population
· healthy lifestyles, including low levels of smoking
· absence of serious income inequalities and poverty.
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Part 3: Macroeconomics
All these factors are among the numerous dimensions
of economic and human development. Therefore
life expectancy at birth is a widely used indicator of
development. In 2005, Japan had the highest life
expectancy in the world of nearly 82 years and
Zambia the lowest, at the shocking number of just
under 40 years (see Table 7.7).
Table 7.7 shows that lower levels of GDP per capita
(US$ PPP) tend to be associated with lower life
expectancies and vice versa. This is consistent with
what we would expect, since higher income countries
generally have more resources at their disposal to
provide the necessary services and appropriate living
conditions for their populations that will secure them
longer lives. However, there are very wide divergences
from this broad pattern, indicating clearly that
income per capita can explain only a small part of
the wide variations in life expectancy.
For example, Greece has a higher life expectancy
than the United States, though its GDP per capita
(in PPPs) is just over half that of the latter. More
surprisingly, Costa Rica surpasses the United States in
life expectancy, although its GDP per capita is roughly
a quarter that of the United States. There are other
striking examples of such divergences: Sri Lanka’s and
Armenia’s life expectancies are almost as high as Saudi
Arabia’s although their per capita GDP is less than
one-third of Saudi Arabia’s. Moldova’s life expectancy
is substantially higher than Russia’s, yet its GDP per
capita is less than one-fifth of Russia’s.
How is it possible that some countries have managed
to achieve high life expectancies relative to their level
of output and incomes, while others are faring less
well? The answer to these questions lies in the degree
to which countries have addressed the development
issues listed above, for example:
· The relatively low life expectancy in the United
States (compared to other highly developed
countries) may be due to inequalities in income and
education resulting in pockets of poverty, which
in turn are connected to poor housing and living
conditions, lifestyles that promote poor health
and poor nutrition, and low access to medical care
(due to lack of medical coverage). This results in
lower life expectancy among low income groups,
which lowers the average over the entire American
population.
· Saudi Arabia’s low life expectancy relative to
its income level is due to significant income
inequalities and inadequate attention to provision
of health care services to lower income groups.
Table 7.7
GDP per capita (US$ PPP) and health indicators in selected countries.
Country
GDP per capita
(US$ PPP) 2005
Life expectancy
at birth (years)
2000–2005
Infant mortality
rate (per 1000
live births) 2005
Maternal mortality
ratio (per 100,000
live births) 2005*
United States
41,890
77.4
6
11
Norway
41,420
79.3
3
7
United Kingdom
33,238
78.5
5
8
Australia
31,794
80.4
5
4
Japan
31,267
81.9
3
6
Greece
23,381
78.3
4
3
15,711
71.6
21
18
Chile
12,027
77.9
8
16
Russia
10,845
64.8
14
28
Costa Rica
10,180
78.1
11
30
Turkey
8,407
70.8
26
44
Brazil
8,402
71.0
31
110
China
6,757
72.0
23
45
Venezuela
6,632
72.8
18
57
Armenia
4,945
71.4
26
39
Swaziland
4,824
43.9
110
390
Sri Lanka
4,595
70.8
12
58
Indonesia
3,843
68.6
28
420
India
3,452
62.9
56
450
Cambodia
2,727
56.8
98
590
Angola
2,335
41.0
154
1400
Moldova
2,100
67.9
14
22
Zimbabwe
2,038
40.0
81
880
Kyrgyzstan
1,927
65.3
58
150
Tajikistan
1,456
65.9
59
170
Uganda
1,454
47.8
79
550
Zambia
1,023
39.2
102
830
Sierra Leone
806
41.0
165
2100
Tanzania
744
49.7
76
950
Saudi Arabia
*Adjusted, based on reviews by the UN Children’s Fund (UNICEF), World Health Organization (WHO) and the UN Population Fund (UNFPA), to account for
problems of underreporting and misclassification.
Source: Data from United Nations Development Programme, Human Development Report, 2007–08, available at http://hdr.undp.org/en/.
Chapter 7: Macroeconomic concepts and measurement 209
· Costa Rica’s and Sri Lanka’s high life expectancies
are due to government policies that placed a high
priority to the provision of health care services for
low income groups.
· The very low life expectancies in sub-Saharan
African countries are due to a very large extent
to the disastrous impacts of HIV/AIDS, as well as
problems with sanitation, safe drinking water, lack
of education and information, poor public health
and health care services, and premature deaths due
to diseases that are both preventable and treatable
(such as malaria).
Infant mortality (also appearing in Table 7.7) refers
to the number of deaths of infants from the time
of birth until the age of one, per 1000 live births.
This is indicator 14 corresponding to goal 4 of the
Millennium Development Goals (see Table 7.6,
page 205). Maternal mortality refers to the
number of women who die per year as a result of
pregnancy-related causes (per 100,000 live births).
This is indicator 16 corresponding to goal 5 in the
Millennium Development Goals. Both infant and
maternal mortality are determined to some extent by
the same factors as life expectancy; however, more
than life expectancy, they reflect the quality of and
access to health care services. The reason is that very
many infant and maternal deaths occur because
the infant and mother do not have access to the
necessary health care during the mother’s pregnancy
and delivery, as well as during early childhood (and
additionally to lack of access to sanitation and clean
water and poor nutrition of the mother).
An examination of infant mortality and maternal
mortality figures reveals similar patterns as life
expectancy. While the United States has one of the
highest GDPs per capita in the world, and while its
infant and maternal mortality rates are very low by
world standards, still the probability of dying at birth,
infancy or during pregnancy or childbirth is higher
than in any other developed country. Sri Lanka, with
a lower GDP per capita than Swaziland, has about onetenth the number of infant deaths as the latter and
about one-seventh the number of maternal deaths.
Moldova has a lower GDP per capita than Angola, yet
it has less than one-tenth the number of infant deaths
compared to Angola; and for every one woman who
dies in Moldova due to pregnancy-related causes,
there are more than 63 women who die for similar
reasons in Angola. A close look at Table 7.7 will show
that there are many more examples of some countries
faring much better than others, in spite of having a
comparable or lower GDP per capita.
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Part 3: Macroeconomics
The discussion of health indicators illustrates the
following very important points:
· GDP per capita (or any other per capita income or
output measure) used on its own is a poor measure
of welfare of a population.
· Limited resources, due to low GDP per capita, are
not always the most important cause of poor
health outcomes. The data indicate that most (if
not all) countries, both developing and developed,
can do more with their available resources to
meet economic and human development goals by
making better use of these. We will discover in Part
5 that better use of resources involves pursuing
policies that reallocate these towards provision
of social services and merit goods, improving
the institutions through which these services are
delivered, as well as improving income distribution.
· Some development issues apply not only to
developing, but to developed countries as well,
because of the presence of pockets of poverty in
wealthy societies that make people on low incomes
subject to similar deprivations as poor people in
developing economies, as well as because of the
presence of institutions that do not make the most
effective use of available resources.
In Table 7.8 we see how infant mortality has developed
over time in various country groupings. Whereas
significant progress has been made in all regions and
groups, infant deaths have been falling less quickly
in sub-Saharan Africa, where they still remain at very
high levels compared to the rest of the world.
Table 7.8 Infant mortality rate (per 1000 live births), 1970 and 2005.
1970
2005
% change
East Asia and Pacific
84
25
− 70.2%
Eastern Europe and Central Asia
39
22
− 43.6%
Latin America and Caribbean
86
26
− 69.8%
Arab States
129
46
− 64.3%
South Asia
130
60
− 53.8%
Sub-Saharan Africa
144
102
− 29.2%
OECD (high income countries
only)
22
5
− 77.3%
OECD (all countries)
41
9
− 78.0%
Region
OECD is the Organization for Economic Co-operation and Development, a
group of mostly high income countries.
Source: Data from United Nations Development Programme, Human
Development Report, 2007–08, available at http://hdr.undp.org/en/.
Income poverty
You may remember from our earlier discussion that
income poverty occurs when income falls below a
nationally or internationally determined level that
defines the poverty line. Two commonly used poverty
lines are:
· living on less than $1.25 a day, which is defined as
extreme poverty
· living on less than $2 a day, which is defined as
moderate poverty.
Extreme poverty used to be defined for many years
as living on less than $1 a day. This was increased
to $1.25 a day in 2008, in order to take into
consideration more accurate measurements of the cost
of living in developing countries.
The first millennium development goal (to eradicate
extreme poverty and hunger) is thus concerned in
part with income poverty. The first of the two targets
corresponding to this goal is to halve in the period
to 2015 the proportion of people living in extreme
poverty, and the first indicator used to measure and
monitor progress towards the achievement of this
target is the percentage of a population living on less
than $1.00 a day.
In the summer of 2008, the World Bank published
one of the most comprehensive studies on poverty
in developing countries ever undertaken. The study
estimates that there are 1.4 billion people in the
Table 7.9
world living in extreme poverty (using the $1.25
a day poverty line), and that there are 2.6 billion
people living in moderate poverty (less than $2 a
day), representing nearly half the total population of
developing countries. Data on extreme and moderate
poverty in developing countries appear in Table 7.9,
both in terms of numbers of people (for extreme
poverty) and in terms of percentages, by geographical
regions, and for two years, 1990 and 2005.
Columns 4 and 5 in the table indicate that significant
progress was made in reducing the percentage of
people in extreme poverty, which fell from about
42% in 1990 to 25% in 2005. Columns 1 and 2 show
that there has also occurred a significant decrease in
terms of absolute numbers. However, progress has
been highly uneven across geographical regions.
The greatest declines in extreme poverty occurred in
the East Asia and Pacific region, as the percentage of
people living on less than $1.25 a day dropped from
60% in 1990 to 16% in 2001. South Asia also made
some progress, showing a drop from 52% to 40%
(however, note that the number of people in extreme
poverty, appearing in columns 1 and 2, has increased,
due to population growth).
Developments in the other regions look less
encouraging. The large increase in eastern Europe
and Central Asia (both in absolute numbers and
in percentage terms) was due to the collapse of the
former Soviet Union and communist regimes in
1990–91, causing huge disruptions to economic
Extreme and moderate poverty.
Region
East Asia and Pacific
(of which China)
Extreme poverty:
millions of people living on less than
$1.25 a day
Extreme poverty:
% of population living
on less than $1.25 a day
Moderate poverty:
% of population living
on less than $2.00 a day
(1)
1990
(2)
2005
(3)
% change
(4)
1990
(5)
2005
(6)
1990
(7)
2005
873.4
(683.2)
316.2
(207.7)
− 63.8
(− 69.6)
54.7
(60.2)
16.8
(15.9)
79.8
(84.6)
38.7
(36.3)
9.1
17.3
90.1
2.0
3.7
6.9
8.9
Latin America and Caribbean
42.9
46.1
− 7.5
9.8
8.4
19.7
16.6
Middle East and North Africa
9.7
11.0
13.4
4.3
3.6
19.7
16.9
South Asia
(of which India)
579.2
(435.5)
595.6
(455.8)
2.8
(4.7)
51.7
(51.3)
40.3
(41.6)
82.7
(82.6)
73.9
(75.6)
Sub-Saharan Africa
299.1
390.6
30.6
57.9
51.2
76.2
73.0
1,813.4
1,376.7
− 24.1
41.6
25.2
63.2
47.0
Eastern Europe and Central Asia
Total
Source: Data from Shaohua Chen and Martin Ravallion, ‘The Developing World Is Poorer than We Thought, But No Less Successful in the Fight against
Poverty’, World Bank, Development Research Group, Policy Research Working Paper 4703, August 2008.
Chapter 7: Macroeconomic concepts and measurement 211
activity and resulting in significant unemployment
and drops in incomes (though there are signs that
poverty in this group of countries has begun to go
down). The most worrisome region is sub-Saharan
Africa, where half of the total population lives in
extreme poverty (column 5), and nearly three-quarters
in moderate poverty (column 7). Whereas the share
of the total population in extreme poverty fell in the
period 1990 to 2005, the actual number of extremely
poor people increased because of population growth.
The country containing the largest number of
extremely poor people is India, with about 456
million people, or 42% of its total population, living
on less than $1.25 a day. (India belongs to the South
Asia group of countries.) Countries with the largest
percentages of extremely poor people are in subSaharan Africa, where in some cases more than 70% of
a country’s population live on less than $1.25 a day.
The 1.4 billion of extremely poor people in the world,
living on less than $1.25 a day, account for nearly
one-quarter of the world’s population. The 2.6 billion
people living on less than $2 a day (moderate poverty)
account for about 47% of the world’s population.
Income distribution
It is useful to distinguish between absolute
poverty and relative poverty. Measures of absolute
poverty define a minimum income level, so that
the percentage of a population (or the number of
individuals) whose income falls below the minimum
determines the amount of absolute poverty. Extreme
poverty and moderate poverty, discussed above, are
both examples of absolute poverty.
Measures of relative poverty, by contrast, compare
the income of one group in a society with the income
of another group. They are useful for determining how
equally or unequally society’s income is distributed
among its total population. One simple measure
of the degree of equality (or inequality) of income
distribution is the share of total income of a society
that goes to the poorest fifth (or ‘quintile’) of a
population.14 This measure corresponds to the first
of the Millennium Development Goals (to eradicate
extreme poverty and hunger) as indicator number 3.
14
It is also possible to consider the share of income of the top quintile,
as well as taking the ratio of the top quintile to the bottom quintile. The
analysis can also be carried out in terms of deciles (10% of the population)
212
Part 3: Macroeconomics
Some data for this indicator are provided in Table
7.10, column 2. Let’s consider what these figures
mean. If income were completely equally distributed,
everyone would receive exactly the same income, in
which case every quintile (every 20% segment of the
population) would receive exactly 20% of income. In
this hypothetical situation there would be no relative
poverty; since everyone would receive the same
income, no one would be poor relative to someone
else; everyone would be equally ‘poor’ or equally
‘rich’.
If income is unequally distributed, some quintiles
receive less than 20% and others more than 20%
of income. For example, in the case of Thailand,
the poorest 20% of the population receives 6.3% of
total income. In Colombia, the poorest 20% of the
population receives only 2.5% of total income. The
higher the percentage of income received by the
poorest 20% of the population, and the closer it is to
20%, the more equal is the distribution of income. The
smaller the percentage, and the closer it is to zero, the
more unequal the distribution of income. The more
unequal is the distribution of income, the greater is
the degree of relative poverty.
Table 7.10 (column 2) reveals some interesting
patterns. Latin America and sub-Saharan Africa tend to
have more unequal distributions of income compared
to the other regions. In economies with low per capita
incomes (such as in sub-Saharan African countries),
highly unequal income distributions mean very low
incomes for some groups as there is so little total
income to be distributed in the first place.
Also, it can be seen that there is no clear relationship
between GDP per capita levels (in PPPs) and the degree
of income inequalities. Among developing countries
as a whole, Latin American countries on average have
higher GDPs per capita than South Asian countries,
and yet their income inequalities tend to be far greater.
Moreover, South Asian countries, with very low per
capita GDPs, have income shares of the lowest quintile
that are comparable to those in countries in East
Asia and the Pacific, with higher GDPs per capita. We
will discover some reasons behind these patterns in
Chapter 16, where we will also see why highly unequal
income distributions can pose serious problems in
countries that are trying to grow and develop.
or quartiles (25% of the population). Other useful measures of income
distribution are the Lorenz curve and the Gini coefficient, both of which
will be examined in Chapter 11 (at higher level).
Table 7.10 Income distribution, literacy, water source and sanitation.
(1)
GDP per capita
(US$ PPP)
(2005)
East Asia and Pacific
6,604
(2)
Share of income
or
consumption
(%) of poorest
20%
(latest available
year)
(3)
Adult literacy
rate
(% ages 15 and
above)
(1995–2005)
(4)
% of
population
with
access to
improved water
source
(2004)
(5)
% of
population
with access to
improved
sanitation
(2004)
–
90.7
79
50
Cambodia
2,727
6.8
73.6
41
17
Philippines
5,137
5.4
92.6
85
72
China
6,757
4.3
90.9
77
44
Thailand
8,677
6.3
92.6
99
99
South Asia
3,416
–
59.5
85
37
Nepal
1,550
6.0
48.6
90
35
Pakistan
2,370
9.3
49.9
91
59
India
3,452
8.1
61.0
86
33
E. Europe and Central Asia
9,527
–
99.0
94
–
Tajikistan
1,356
7.9
99.5
59
51
Bosnia and Herzegovina
7,032
9.5
96.7
97
95
Kazakhstan
7,857
7.4
99.5
86
72
10,845
6.1
99.4
97
87
Latin America and Caribbean
8,417
–
90.3
91
77
Colombia
7,304
2.5
92.8
93
86
Brazil
8,402
2.8
88.6
90
75
Mexico
10,751
4.3
91.6
97
9
Middle East and North Africa
6,716
–
70.3
86
71
Russia
Yemen
930
7.4
54.1
67
43
Egypt
4,337
8.6
71.4
98
70
Algeria
7,066
7.0
69.9
85
92
Sub-Saharan Africa
1,998
–
60.3
55
37
Malawi
667
7.0
64.1
73
61
Sierra Leone
806
1.1
34.8
57
39
Zambia
1,023
3.6
68.0
58
55
Swaziland
4 824
4.3
79.6
62
48
Source: Data from United Nations Development Programme, Human Development Report, 2007–08, available at http://hdr.undp.org/en/.
Chapter 7: Macroeconomic concepts and measurement 213
Income distribution will also be discussed further
in Chapter 11. The interested student should refer
to Table 11.3 (page 318), which compares income
distribution by quintiles for a range of countries
grouped by income levels (including high income
countries).
Literacy, improved water source and
improved sanitation
Table 7.10 contains data for three more indicators:
· the adult literacy rate (column 3), or the percentage
of people aged 15 and above who can read and
write; this is related to indicator 8 of goal 2 of the
Millennium Development Goals (which refers to the
proportion of people ages 15–24 who can read and
write)
extremely important factors determining levels of
health. A significant proportion of poor levels of
health, and much of infant and child mortality (as
well as adult mortality) in developing countries is due
to limited access to clean water and sanitation services
by substantial proportions of populations. We will
come back to these issues in Part 5.
The data of Table 7.10 illustrate the points made
earlier: given their levels of GDP per capita, many
countries can do more with their available resources;
also, a country’s level of development can vary
enormously with respect to different indicators. For
example, Tajikistan has achieved a level of literacy that
is comparable to the most highly developed countries
in the world, yet it fares far less well with respect to
access to an improved water source and sanitation.
· the percentage of the population with access to an
improved source of water (column 4), indicator 30
of goal 7 of the Millennium Development Goals
· the percentage of the population with access to
improved sanitation (column 5), indicator 31 of goal
7 of the Millennium Development Goals.
The data on literacy reveal that there are very wide
variations among regions and among countries within
regions. Most developed countries (not shown in the
table) have literacy rates at or close to 99% of the
population. The developing country group with the
highest literacy rate is Eastern Europe and Central
Asia, and that is due to the very strong emphasis
placed on education by former communist regimes.
Countries of East Asia and Latin America are also
performing well. Literacy rates tend to be far lower
in the Middle East and North Africa group, and even
lower in some sub-Saharan African countries.
The interested student may also examine Table 16.1
(Chapter 16, page 435), which presents further
information on literacy rates and school enrolment in
developing countries. In Chapter 15 we will see why
literacy and education are very important sources of
economic growth and development.
The data in columns 4 and 5 indicate wide variations
among countries with respect to the proportion of
their populations that have access to improved water
and sanitation. Access to clean water and sanitation
are very important factors determining quality of
life and standards of well-being in societies, and are
214
Part 3: Macroeconomics
Demographic indicators
Demographic indicators show how populations
change in size, increasing or decreasing according to
numbers of births, deaths, and migration. Table 7.11
presents some demographic indicators for different
population groups around the world grouped by
income levels. Population growth rates have been
falling on average in all income categories, though
they remain much higher in the low income
countries, meaning that the populations in this group
of countries are growing more rapidly than elsewhere.
The reason for higher population growth rates lies
in higher birth rates, also shown in the table. The
crude birth rate (defined to be the number of births
occurring in one year, per 1000 population) in low
income countries was 29 in 2001, compared to 17 and
12 in middle and high income countries respectively.
High population growth rates result in a relatively
large proportion of children in the population,
while the proportion of elderly persons is relatively
small. This can be seen in the two ‘Population age
composition columns’ of the table. In low income
countries, the proportion of the population aged 0–14
is double that of the high income countries, while the
proportion aged 65 and above is less than one-third.
This means that all the people of working age (above
age 14 and less than 65) in low income countries
must work for and support proportionately double
the number of children as in high income countries.
In the high income countries the working population
must support a relatively larger elderly population.
Table 7.11 Demographic indicators by country income group.
Country
group
Total
population
(millions)
2001
Average
annual
population
growth rate,
1980–2001 (%)
Average annual
population
growth rate,
2001–2015 (est.)
(%)
Population
age
composition
0–14 (%)
Population
age
composition
65 + (%)
Crude
birth rate,
no. births
per 1000
Low
income
2505.9
2.1
1.5
36.4
4.4
29
Middle
income*
2667.2
1.4
0.8
27.1
6.9
17
High
income
957.0
0.7
0.3
18.4
14.3
12
*Includes both upper middle and lower middle income groups.
Source: Data from World Bank, World Development Indicators 2003 (World Bank, 2003).
The proportion of the non-working (dependent)
population that must be supported by people of
working age is called the dependency burden of
the population. It can be seen that, adding together
the two dependent age groups (children and the
elderly), the dependency burden is far greater for
the low income than for the high income countries
(40.8% of the population as opposed to 32.7%). A
higher dependency burden means that the income
of a family must be stretched out to cover the needs
of more family members. When the family income is
low to begin with, as in the case of most households
in many developing countries, the income per person
that results is often barely enough to cover basic needs.
While there is no birth rate or population growth rate
that is considered to be the ‘right’ one for any country,
it is believed today that high birth rates, and hence
high population growth rates, may hinder economic
development. We will consider the reasons for this in
Part 5.
Relative importance of primary, secondary
and tertiary sectors
You may remember from Chapter 3, page 78, that
whereas most less developed countries tend to have a
relatively large primary (mainly agricultural) sector, as
they grow and develop the relative share of agriculture
shrinks, becoming progressively replaced by industry,
and at a later stage by services (in Section 3.3 of
Chapter 3, page 78, we explained this phenomenon in
terms of elasticities). Table 7.12 (page 216) lists several
countries in order of declining GDP per capita (in US$
PPP), and shows the relative shares of GDP in each of
the three sectors. We can see that there is a general
trend for the share of agriculture to become smaller
as per capita GDP becomes larger, and for the share of
services to increase.
Composite indicators
In 1990, under the leadership of Mahbub ul Haq (a
highly influential Pakistani development economist),
and the strong intellectual influence of Amartya Sen
(who won the Nobel Prize for his work in economic
development), the United Nations Development
Programme (UNDP) introduced the concept of human
development, explained on page 198. Each year since
1990, the UNDP has produced a Human Development
Report which presents analyses of development issues
of current interest, as well as statistical information
on over 100 ‘human development indicators’ and four
composite indicators: the Human Development Index
(HDI), the Human Poverty Index (HPI), the GenderRelated Development Index (GDI) and the Gender
Empowerment Measure (GEM).
Composite indicators are usually expressed as an
‘index’. An index is a set of numbers showing the
relative position of a variable in a list. This will become
clearer in the consideration of composite indicators
below.
Chapter 7: Macroeconomic concepts and measurement 215
Table 7.12 GDP per capita (US$ PPP) and relative shares of primary, secondary and tertiary sectors in selected countries, 2003.
Country
GDP per capita
(US$ PPP)
Agriculture, value
added
(% of GDP)
Industry,
value added
(% of GDP)
Services,
value added
(% of GDP)
United Kingdom
27,147
1
26
73
Greece
19,954
7
23
70
Portugal
18,126
4
27
70
Korea, Rep.
17,971
4
41
55
Poland
11,379
3
33
64
Russian Federation
9,230
5
35
60
Brazil
7,790
10
40
50
Colombia
6,702
11
31
58
China
5,003
13
46
41
India
2,892
21
27
52
Vietnam
2,490
22
40
38
1,751
37
21
42
Togo
1,696
41
23
36
Uganda
1,457
32
21
47
Central African Rep.
1,089
56
22
23
Kyrgyzstan
Sources: Data from United Nations Development Programme, Human Development Report 2005, available at http://hdr.undp.org/en/;
data from World Bank, World Development Indicators 2005 (World Bank, 2005).
The Human Development Index
The Human Development Index (HDI) is the bestknown and most widely used index of the UNDP. It
is a summary measure of human development and
measures average achievement in three dimensions: (i)
a long and healthy life, measured by life expectancy
at birth (this indicator was discussed above); (ii)
knowledge, measured by adult literacy and the
combined primary, secondary and tertiary enrolment
ratio (or the ratio of the number of students enrolled
in a level of education to the total population of
school age for that level); and (iii) a decent standard
of living, measured by GDP per capita (in US$ PPP).
Each dimension is expressed as a value between 0
and 1, with 0 being the lowest possible value for the
dimension, and 1 being the highest. The composite
index is simply the average over the three dimensions.
Each country receives an HDI value from 0 to 1, and
the countries are ranked according to their HDI values.
216
Part 3: Macroeconomics
HDI ranks and HDIs (i.e. HDI values) for selected
countries, together with their corresponding GDP
per capita (in US$ PPP), appear in Table 7.13, where
countries are listed in order of declining HDIs. Of
the 177 countries for which the UNDP calculates
HDIs, Norway ranked second in 2005, meaning that
it had achieved the second highest level of human
development in the world, with an HDI of 0.968
(the first country was Iceland, not shown here). In
this table, countries have been selected to show
how it is possible to achieve similar levels of human
development with very different levels of GDP per
capita.
For example, Norway and Australia have very
similar HDIs, indicating that they have attained
approximately the same level of human development.
However, Australia has accomplished this high level
of human development with a lower GDP per capita.
The same can be said for New Zealand and the
United Kingdom, Greece and Germany, etc. The
most striking pair of countries is Tajikistan and South
Africa. Tajikistan’s GDP per capita is roughly one-tenth
of South Africa’s, and yet their HDIs are very close.
We can conclude that Tajikistan, with about onetenth the income per person of South Africa, has
succeeded in almost reaching South Africa’s level of
human development!
Table 7.13 Human Development Index and GDP per capita (US$ PPP)
for selected countries in order of decreasing HDI (increasing HDI rank).
Country
HDI
rank
Norway
Australia
Comparisons between HDIs and GDP per capita
confirm the important points made earlier (in
connection with health indicators):
· GDP per capita used in isolation from other
indicators can be a poor measure of the diverse
dimensions of development.
· Many countries, even with their given levels of
GDP per capita, are capable of making significant
improvements in the welfare of their populations
simply by making different choices regarding the
resources that are allocated to health, education
and other services or merit goods. In other words,
some economic and human development is
possible even in low income countries and in the
absence of significant growth.
Human
Development
Index (HDI)
2005
GDP per
capita
(US$ PPP)
2005
2
0.968
41,420
3
0.962
31,749
United Kingdom
16
0.946
33,238
New Zealand
19
0.943
24,996
Germany
22
0.935
29,461
Greece
24
0.926
23,381
Uruguay
46
0.852
9,962
Bahamas
49
0.845
18,380
Russian Federation
67
0.802
10,845
Albania
68
0.801
5,316
Turkey
84
0.775
8,407
Ecuador
89
0.772
4,341
Algeria
104
0.733
7,062
Other composite indicators
Vietnam
105
0.733
3,071
Moldova
111
0.708
2,100
Egypt
112
0.708
4,337
South Africa
121
0.674
11,110
Tajikistan
122
0.673
1,356
The United Nations Development Programme has
developed three more composite indicators. One
of these is the Human Poverty Index (HPI), based
on the concept of human poverty as distinct from
income poverty. There are actually two human poverty
indices: one is for less developed countries, and the
other is for more developed countries.
Swaziland
141
0.547
4,824
Madagascar
143
0.533
923
Angola
162
0.446
2,335
Malawi
164
0.437
667
Source: Data from United Nations Development Programme, Human
Development Report, 2007–08, available at http://hdr.undp.org/en/.
· Economic and human development issues apply
not only to developing countries, but to developed
countries as well.
The HDI is very useful as a tool for countries and
governments wishing to devise policies that focus
on human development. However, it should be
noted that the HDI, too, has its shortcomings as a
measure of development. This is because economic
and human development are much broader concepts
with more dimensions than are reflected in the HDI.
The HDI does not provide us with information about
income distribution, malnutrition, demographic
trends, unemployment, gender inequalities, political
participation, etc.
As you may remember, income poverty occurs when
income falls below a nationally or internationally
determined level that defines the poverty line (such
as $1.25 a day or $2 a day in developing countries).
Human poverty refers to deprivations and the lack
of opportunities and choices that allow individuals
to lead a long, healthy and creative life with a decent
standard of living, freedom, and dignity.
Chapter 7: Macroeconomic concepts and measurement 217
Human poverty is measured in the same three
dimensions as the Human Development Index,
but with the use of different indicators. The HPI in
developing countries uses the following indicators:
· deprivation in longevity, measured by the
probability at birth of not surviving to age 40
· deprivation in knowledge, measured by the
percentage of illiterate adults
· deprivations in the standard of living, measured by
❍
❍
❍
the percentage of people who do not have
sustainable access to safe water
the percentage of people who do not have access
to health services
the percentage of children under age five who are
underweight for their age.
Indicators used for the HPI of developed countries
include: (i) probability at birth of not surviving to age
60; (ii) percentage of adults lacking functional literacy
skills; (iii) percentage of people living below the
nationally determined poverty line; and (iv) the longterm underemployment rate.
Unlike the Human Development Index, which
focuses on positive achievements within a country,
the Human Poverty Index focuses attention on
deprivations (the lack of benefits or basic necessities).
In addition, by differentiating itself from income
poverty, it draws attention to the point that income
does not guarantee the absence of deprivations.
Table 7.14 presents the human poverty rank and
index for selected developing countries. (The Human
Poverty Index is calculated as a number from 1 to
100 and is expressed as a percentage.) The lower the
rank and index number of a country, the smaller is its
human poverty. The last column indicates whether
a country’s human poverty is greater or smaller than
income poverty. Income poverty (not shown in the
table) is defined as the percentage of the population
living on less than $1 a day. If a country’s human
poverty rank is larger than its income poverty rank,
this means that human poverty is greater than income
poverty, therefore the figure in the last column
has a positive sign (for example, Turkey and South
Africa). If, on the other hand, the human poverty
rank is smaller than the income poverty rank, then
income poverty is greater than human poverty, and
the figure in the last column is negative. Therefore,
in Costa Rica, Colombia, China and India there is
218
Part 3: Macroeconomics
greater income poverty than human poverty. When a
country has greater income poverty, this means that
the government is providing social services (education,
health care, safe water, etc.) that people have access to
and can benefit from even though their incomes may
be very low.
The Gender-Related Development Index (GDI)
is similar to the Human Development Index (HDI)
in that it measures the average achievement of the
population in the same three dimensions as the HDI,
using the same indicators, but adjusted to reflect
the inequalities between women and men in each
of the three dimensions. As we will see in Part 5
(Chapter 16), gender issues are worthy of special
attention because of the special roles of women in
economic and human development.
The Gender Empowerment Measure (GEM)
also measures gender inequalities but in different
dimensions: (i) political participation and
decision-making, measured by women’s and men’s
parliamentary seats; (ii) economic participation and
decision-making, measured by women’s and men’s
percentage shares of positions as legislators, managers,
and professional and technical positions; and (iii)
power over economic resources, measured by income
earned.
Table 7.14 Human and income poverty.
Country
Human
poverty
rank*
Human
Poverty
Index
(HPI)*
HPI rank
minus
income
poverty
rank*
Costa Rica
4
4.4
− 10
Colombia
10
8.1
− 13
Turkey
19
12.0
12
China
24
13.2
− 14
South Africa
52
31.7
20
India
48
31.4
− 12
Pakistan
71
41.9
24
Ethiopia
92
55.5
20
*A total of 95 countries are in this index, which does not include
developed countries.
Source: Data from United Nations Development Programme, Human
Development Report 2005, available at http://hdr.undp.org/en/.
Test your understanding 7.9
1 (a) Explain the concept of income poverty.
(b) What is the difference between extreme
poverty and moderate poverty? (c) How are
extreme poverty and moderate poverty related
to income poverty?
2 (a) Explain the difference between absolute
poverty and relative poverty. (b) How can we
measure absolute poverty? (c) How can we
measure relative poverty?
3 What is the difference between individual and
composite indicators? Can you provide some
examples of each?
4 What are the advantages of using the Human
Development Index over GDP per capita as a
measure of economic and human development?
5 What is the difference between the Human
Development Index and the Human Poverty
Index? What could be the advantage of using
the Human Poverty Index when studying
the problems of very low income groups in
developing countries?
6 Why do you think the United Nations
Development Programme constructs a Human
Poverty Index for more developed countries
in addition to a Human Poverty Index for less
developed countries?
7 Use examples of individual or composite
indicators (you may use the information in the
text) to illustrate the following points:
(a) GDP per capita is a poor indicator of levels
of welfare or levels of economic and human
development
(b) many countries around the world can
do more to promote the welfare of their
populations through a reallocation of
resources, even in the absence of economic
growth
(c) many economic development issues apply
to MDCs as well as LDCs
(d) countries may be more developed with
respect to some indicators and less
developed with respect to other indicators.
Chapter 7: Macroeconomic concepts and measurement 219
Questions for
review
7.1
[15 marks] (a) Explain the three methods that
can be used to measure aggregate output. (b) How
does the circular flow of income model help us
illustrate the equivalence of the three methods?
7.2
[15 marks] Explain whether you agree or disagree
with each of the following:
(a) You have just read in the news that GDP in
your country increased by 4% this year over last
year. You therefore conclude that the quantity of
output produced increased by 4%.
(b) In the early 1990s, following the collapse
of the Soviet Union, many eastern European
and former Soviet Union countries experienced
negative net investment for a period of time. This
means there was a drop in their stock of capital
goods.
(c) If a government wants a measure of its
population’s income per capita it should use GDP
per capita; if it wants a measure of the quantity of
output produced per capita it should use GNP per
capita.
(d) GDP per capita is a better indicator of a
country’s welfare than total GDP, because it
calculates the amount of output produced per
person in the population.
(e) The average American is 12.5 times richer
than the average Russian, since US GDP per capita
is 12.5 times greater than Russian GDP per capita,
based on the dollar–rouble exchange rate. (The
rouble is Russia’s national currency.)
7.3
[10 marks] You are interested in making welfare
comparisons (a) across a number of countries, and
(b) over time for a single country. What income
or output measures could you use in each case?
7.4
[5 marks] Explain what factors can account for
different values of GDP and GNP for a single
country.
7.5
[10 marks] Why does purchasing power differ
across countries? What problem does this
pose when we use GDP to make international
comparisons of welfare? How can this problem be
resolved?
7.6
[15 marks] Evaluate GDP per capita as a measure
of a society’s welfare and as the basis for making
international welfare comparisons.
7.7
[10 marks] Using the production possibilities
model and diagrams, explain the sources of
economic growth.
220
Part 3: Macroeconomics
7.8
[15 marks] Using the production possibilities
model and diagrams, evaluate the following
statements: (a) It is very difficult, if at all possible,
for economic development to occur without
economic growth. (b) If economic development
is to be maintained over a long period of time,
economic growth is essential.
7.9
[15 marks] An Economics textbook published in
1998 writes the following: ‘A country’s standard
of living depends on its ability to produce goods
and services. Policymakers who want to encourage
growth in standards of living must aim to increase
their nation’s productive ability by encouraging
rapid accumulation of the factors of production
and ensuring that these factors are employed
as effectively as possible’ (N. Gregory Mankiw,
Principles of Economics (Dryden Press, 1998), p.
537). (a) Use the production possibilities model to
illustrate the process that this textbook describes.
(b) Do you agree with the argument made here,
that a rapid accumulation of factors of production
together with their effective use will lead to
growth in a country’s standards of living? Explain
why or why not.
7.10
[10 marks] Compare and contrast the problems
involved in measuring economic growth and
measuring economic development.
7.11
[10 marks] Both individual indicators as well as
the Human Development Index can be used to
show that many countries can do more to increase
the well-being of their populations even with their
given level of GDP per capita. How is this possible?
7.12
[10 marks] Using examples of individual and
composite indicators, explain some of the
methods used by economists to measure economic
development.
Chapter 8
Macroeconomics
Aggregate demand and
aggregate supply
In this chapter we will develop the aggregate demand–aggregate supply model of the macroeconomy,
an important analytical tool for studying output fluctuations, changes in the price level and
unemployment, as well as economic growth. This chapter will lay the foundations for the analysis of
macroeconomic policies in Chapter 9 and the problems of unemployment and inflation in Chapter 10.
OBJECTIVES
After studying this chapter you should be able to:
·
·
·
·
·
·
·
·
·
·
·
·
·
·
·
distinguish between the phases of the business (trade) cycle
explain the difference between actual and potential GDP
define aggregate demand and identify the factors that cause it to change
distinguish between the short run and long run in macroeconomics
define short-run aggregate supply and identify the factors that cause it to change
explain short-run equilibrium in the AD-AS model
identify the three short-run equilibrium states of the economy, and relate them to inflationary and recessionary
(deflationary) gaps
identify factors that change short-run equilibrium, and their impacts on real GDP, the price level and the level of
employment
define long-run aggregate supply, the long-run aggregate supply (LRAS) curve and long-run equilibrium in the
neoclassical perspective
identify the factors that cause economic growth and shifts in the LRAS curve
understand that in the neoclassical perspective, recessionary and inflationary gaps cannot persist in the long run
explain the Keynesian aggregate supply curve in terms of wage and price rigidities
identify and explain recessionary (deflationary) and inflationary gaps in the Keynesian perspective
analyse less than full employment equilibrium (deflationary gaps) in the Keynesian perspective
understand the different policy implications of the neoclassical and Keynesian perspectives.
Chapter 8: Aggregate demand and aggregate supply 221
8.1 The business (trade) cycle:
economic fluctuations
time, shown on the horizontal axis. Note that 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.
Understanding the business (trade) cycle
In Chapter 7 we discussed the concept of economic
growth, and Table 7.2 (page 194) presented average
growth rates in real GDP per capita in selected
countries around the world for the period 1990–
2005, indicating that the output per person of most
economies usually grows over extended periods.
The growth rates in Table 7.2 consist of averages taken
over many years. These average growth rates can be
highly misleading if they are taken as an indication of
what happens on a year-to-year or month-to-month
basis. In fact, output growth virtually everywhere in
the world 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 decline, indicating negative growth or economic
contraction.
Fluctuations in the growth of real output, consisting
of alternating periods of expansion (increasing real
output) and contraction (decreasing real output), are
called business cycles, or alternatively trade
cycles or economic fluctuations.
Each cycle consists of a period of expansion, or growth
in real GDP, followed by a period of contraction, or
decline in real GDP (negative growth). Let’s consider
what these mean in some detail.
· Expansion An expansion occurs when there is
positive growth in real GDP, and is shown by those
parts of the curve in Figure 8.1 that are upward
sloping. During periods of growth in real GDP,
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
than before. An increase in the general price level is
known as inflation (this will be studied in Chapter
10).
· Peak A peak represents the cycle’s maximum level
of 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; in other
words, the economy is likely to be experiencing
inflation.
· Contraction 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 or more it is
termed a recession, which is characterized by
falling real GDP and growing unemployment of
resources. Increases in the price level may slow
The phases of the business (trade) cycle
A business cycle is shown in Figure 8.1, which plots
real GDP, measured on the vertical axis, against
real GDP actually achieved
peak
contraction
real GDP
expansion
potential GDP
peak
trough
trough
0
Figure 8.1 The business cycle (trade cycle).
222
Part 3: Macroeconomics
time (years)
down considerably, and it is even possible that
prices in some sectors may begin to fall. (However,
this is not always the case; some contractions are
accompanied by increasing price levels or inflation.)
· Trough 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 line going through the business cycle, called
‘potential output’, will be discussed below.)
The terms ‘business cycle’ and ‘trade cycle’ suggest 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
‘economic fluctuations’.
While each cycle typically lasts several years, it is
not possible to generalize, as there is wide variation
in duration (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 appearing in Figure 8.1 has an irregular
shape.
The relationship between real GDP and
unemployment
When real GDP fluctuates, it does so together
with a number of other macroeconomic variables.
One of the most important of these is the level of
employment or unemployment of labour, or how
many people in the workforce are working or are
unemployed (not working). There is a very close
relationship between changes in real GDP and the
level of unemployment in the economy. When real
GDP grows in the expansion phase, unemployment
falls; in the contraction phase, when real GDP
falls, unemployment increases. The reason for this
relationship is easy to see. In an expansion, real
GDP increases because firms increase the quantity of
output they produce; in order to do this, they must
hire more labour (and other resources), and therefore
unemployment falls. In a contraction, when real GDP
falls, firms cut back on their production, they lay off
workers, and the result is growing unemployment. We
can therefore say that:
As real GDP increases, unemployment falls, and
as real GDP falls, unemployment increases (ceteris
paribus).
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.
However, the term ‘full employment’ is misleading,
as it does not mean that all resources, including all
labour resources, are employed to the greatest extent
possible; it does not mean that unemployment is zero.
Whenever the economy produces its ‘full employment
level of output’, there is still some unemployment,
known as the natural rate of unemployment. We
can think of this as unemployment of labour that is
normal or ‘natural’ for the economy.
There are many reasons why unemployment never
falls to zero. At any point in 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 in order to be able to
get a new or better job, and some people who are
temporarily out of work. Therefore, even under the
best of circumstances for an economy, there will
always be some people who will be unemployed. (We
will return to these points in Chapter 10 when we
discuss unemployment more fully.) To summarize:
The full employment level of output or full
employment level of real GDP is that level of
real GDP at which unemployment is equal to the
natural rate of unemployment. The natural rate of
unemployment is the unemployment that exists
when there is ‘full employment’.
Actual and potential GDP
Let’s return now to the business cycle shown in
Figure 8.1. The cyclical line represents fluctuations in
real GDP that is actually achieved by an economy
over time. These fluctuations occur over relatively
short periods of time, typically lasting several years,
and are therefore referred to as ‘short-term economic
fluctuations’. The straight line going through the
cyclical line represents average growth over long
periods of time (many years), and is the economy’s full
employment level of output, discussed above, which is
also known as potential output or potential GDP.
Chapter 8: Aggregate demand and aggregate supply 223
Potential GDP represents the level of real GDP that can
be produced when there is full employment, meaning
that unemployment is equal to the natural rate of
unemployment. As you can see in the figure, real GDP
actually achieved fluctuates around potential GDP.
Figure 8.2 introduces a further concept related to the
business (trade) 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.
As Figure 8.2 illustrates, actual GDP fluctuates around
the full employment level of 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, which is equal to the natural rate of
unemployment. When the economy’s actual GDP is
greater than potential GDP, such as at point d, there
is an output gap, and unemployment has fallen 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.
Why we study the business (trade) cycle
Why are we interested in studying the business
cycle? Economic growth over long periods of time,
represented by an upward-sloping potential output
line, is a highly desirable objective (as we know from
Chapter 7, page 195). Growth in real output provides
opportunities to achieve higher incomes and higher
standards of living.
But deviations of actual output from potential
output over short periods of time are not desirable.
When actual output rises above potential output, the
economy often experiences a rapidly rising price level,
which is not good for the economy (we will see why in
Chapter 10). When actual output falls below potential
output, the economy experiences falling incomes and
growing unemployment, causing hardship for many
people and frustrating the objective of economic
growth.
In an ideal world, every economy would experience
economic growth over long periods of time, with
continuously 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 8.3 illustrates these
objectives in terms of the business cycle.
actual GDP > potential GDP;
there is an output gap:
unemployment < natural
rate of unemployment
expansion:
unemployment
falls
real GDP
d
contraction:
unemployment
increases
b
a
0
actual GDP
e
actual GDP < potential GDP; there is an
output gap: unemployment > natural
rate of unemployment
time (years)
Figure 8.2 Illustrating actual output, potential output and unemployment in the business (trade) cycle.
224
Part 3: Macroeconomics
c
potential GDP =
full employment GDP;
unemployment =
natural rate of
unemployment
Test your understanding 8.1
(a) Reducing the intensity of economic fluctuations:
achieving price stability and full employment.
real GDP
real GDP
1 Using a diagram, (a) identify the phases of the
business cycle; (b) explain how they relate to
unemployment and inflation; and (c) explain
the difference between actual and potential
output.
2 Why does unemployment never fall to zero,
even when there is ‘full employment’?
0
3 How does the ‘natural rate of unemployment’
time (years)
relate to the ‘full employment level of output’
and to ‘potential output’?
real GDP
(b) Economic growth.
potential
output
4 What would you conclude about an economy
whose business cycle showed (a) a horizontal
potential GDP line; (b) a downward-sloping
potential GDP line?
5 (a) What are three key macroeconomic
0
time (years)
objectives of economies? (b) Use a business
cycle diagram to illustrate what it means to
achieve these objectives.
Figure 8.3 Illustrating three macroeconomic objectives.
Using the business (trade) cycle, we can understand
macroeconomic objectives to involve:
· Reducing the intensity of expansions and
contractions: this is aimed at making output gaps
as small as possible, shown by the dotted line in
Figure 8.3(a). It involves flattening the cyclical
curve in order to make actual output come as close
as possible to potential output. It would eliminate
or lessen the problem of a rising price level in an
expansion, by achieving price stability, as well as
the problem of unemployment in a contraction.
· Increasing the steepness of the line representing
potential output (or full employment output),
shown by the dotted line in Figure 8.3(b): in effect,
this means achieving more rapid economic growth
over long periods of time.
In this chapter we will develop the analytical tools
that will help us understand what causes the business
(trade) cycle, and what government can do to achieve
the objectives of full employment, price stability and
economic growth (to be considered in Chapter 9).
8.2 The aggregate demand and
aggregate supply model in the short
run
Introducing the aggregate demand and
aggregate supply (AD-AS) model
The analytical tools we will develop in this chapter
are based on the aggregate demand and aggregate
supply (AD-AS) model of the macroeconomy. The
AD-AS model superficially resembles the microeconomic demand and supply model for a single
product or industry we developed in Chapter 2;
however, care must be taken not to confuse them
because they are in many respects very different from
each other.
The AD-AS model is one of the most controversial
areas in macroeconomics, interpreted differently
by economists according to differing theoretical
perspectives. Most of the disagreements centre on
aggregate supply and the shape of the aggregate
supply curve. In this section we will focus on a simple
interpretation of the model that most economists
would find useful as the basis for understanding
the macroeconomy. In Sections 8.3 and 8.4 we
will enter the area of controversy by studying two
Chapter 8: Aggregate demand and aggregate supply 225
Defining aggregate demand and the
aggregate demand curve
Aggregate demand is the total quantity of goods
and services that all buyers in an economy want to
buy at different possible price levels, ceteris paribus.
The total quantity of goods and services is represented
by real GDP (real GDP was explained in Chapter 7).
The aggregate demand curve shows the relationship
between the total quantity of goods and services
buyers want to buy, or real GDP demanded, and the
economy’s price level, ceteris paribus. Figure 8.4(a)
presents an aggregate demand curve. The horizontal
axis measures the quantity of goods and services, 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 7,
page 185. Aggregate demand includes:
·
·
·
·
the demand of consumers (C),
the demand of businesses (firms) (I),
the demand of government (G),
(a) The downward-sloping aggregate demand curve.
price level
Aggregate demand and the aggregate demand
curve
(You may have noticed something odd about the
definition of aggregate demand. In Chapter 7,
page 186 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 is
that when we define GDP to be equal to spending
by the four components, we are doing so for one
particular price level. When the price level changes,
the level of spending by the four components also
changes. The aggregate demand curve simply plots
the amount of real GDP the four components want to
buy at different possible price levels.)
AD
0
(b) Shifts in the aggregate demand curve.
the demand of foreigners for exports (X) minus the
demand for imports (M) (X − M or net exports).
AD3
0
Aggregate demand is the total amount of real output
(real GDP) that consumers, firms, the government
and foreigners demand (i.e. want to buy) at each
possible price level, over a particular time period,
ceteris paribus. The aggregate demand curve shows the
relationship between the total amount of real output
demanded in an economy by the four components,
and the economy’s price level over a particular time
period, ceteris paribus. The aggregate demand curve
is downward sloping; there is an inverse relationship
between the price level and aggregate output
demanded.
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Part 3: Macroeconomics
real GDP
price level
main theoretical perspectives, the neoclassical
and the Keynesian. The two perspectives arrive at
very different conclusions over what are the most
appropriate policies that governments must pursue to
achieve the three macroeconomic goals.
Figure 8.4 Aggregate demand.
real GDP
AD1
AD2
The downward slope of the aggregate
demand curve (supplementary material)
The reasons behind the downward slope of the
aggregate demand are very different from demand in
a single market that we studied in microeconomics.1
Aggregate demand slopes downward for the following
three reasons:
· The wealth effect Changes in the price level affect
the real value of people’s wealth. (Note that wealth
is not the same as income; wealth is the value of
assets that people own, including their houses, their
stocks and bonds, their jewellery, their works of art,
and so on.) If the price level increases, the real value
of wealth falls. People feel worse off and cut back on
their spending on goods and services. Therefore, as
the price level increases, less output is demanded,
and there results an upward movement along the
aggregate demand curve. If, on the other hand,
there is a fall in the price level, the real value of
wealth increases, people feel better off and increase
their spending, thus more output is demanded, i.e.
there is a downward movement along the aggregate
demand curve.
· The interest rate effect Changes in the price level
impact upon rates of interest, which in turn affect
aggregate demand. If there is an increase in the
price level, consumers and firms need more money
to carry out their purchases and transactions. This
leads to an increase in the demand for money,
which in turn results in an increase in rates of
interest.2 But as interest rates rise, there results
a decrease in consumer purchases financed by
borrowing, as well as in investment spending
by firms that must borrow to finance their
expenditures. Therefore, increases in the price level
lead to decreases in spending and a fall in quantity
of output demanded (a downward movement along
the AD curve). Similarly, a fall in the price level leads
to increases in spending and a rise in quantity of
output demanded (an upward movement along the
AD curve).
· The international trade effect If there is an increase in
the price level in the domestic economy while price
levels in other countries remain the same, exports
Students studying Economics at higher level may note that the
substitution effect and income effect explaining the downward slope of the
micro demand curve do not hold for aggregate demand. The substitution
effect tells as that when the price of a good changes, consumers substitute
relatively less expensive goods for more expensive goods. At the macro
level, there can be no substitution effect, because since aggregate
demand involves demand for all goods and services, it is not possible for
consumers to substitute more of lower price goods for higher price goods.
Also, according to the income effect in microeconomics, as the price of a
good changes, with the consumer’s nominal income held constant, there
results a change in real income, which therefore causes a movement along
1
will become more expensive to foreign buyers and
the quantity of exports demanded by foreigners will
fall. At the same time, domestic buyers will increase
their purchases from foreign countries (i.e. imports)
since the goods produced in other countries are now
relatively cheaper. Therefore, a rising price level
produces a fall in exports, X, and a rise in imports,
M, so that net exports, X − M, fall. Falling net exports
represent a fall in quantity of output demanded
(downward movement along the AD curve). A
decrease in the domestic price level relative to other
countries will give rise to a greater X and a lower
M (or an increase in net exports, X − M), and so
quantity of output demanded increases (an upward
movement along the AD curve).
Changes in aggregate demand (shifts in
the AD curve)
The aggregate demand curve can shift to the right
or to the left. It is important to distinguish between
movements on the aggregate demand curve, caused by
changes in the price level, discussed above, and shifts
of the aggregate demand curve, to which we turn next.
(This is analogous to microeconomic analysis where
we stressed the distinction between a movement along
the demand curve and a shift of the curve). Aggregate
demand curve shifts are shown in Figure 8.4(b).
A rightward shift from AD1 to AD2 means that
aggregate demand increases: for any particular price
level, a larger amount of real GDP is demanded; a
leftward shift from AD1 to AD3 means that aggregate
demand decreases: for any particular 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, or shifts in the
aggregate demand curve, can be caused by any
factor that produces a change in one of the four
components.
the downward-sloping demand curve. At the aggregate level, when the
general price level changes, nominal incomes also change. But if nominal
incomes change, there will not result an income effect.
2
Interest rates can be thought of as the ‘price’ of money services. Using
standard microeconomic analysis, we can see that as the demand for money
increases, while the supply is constant, the interest rate will rise. If, on the
other hand, the demand for money falls, while the supply of money is
constant, the interest rate will rise. We will examine interest rates briefly in
Chapter 10.
Chapter 8: Aggregate demand and aggregate supply 227
We will now examine what these factors are. But
before we do so, you must note the following
important point. Income (or national income) is
not included among the factors that can shift the
aggregate demand curve. The reason is that in the
aggregate demand model, changes in income cannot
initiate any aggregate demand curve shifts. This will
become clearer when we discuss the multiplier effect
in Chapter 9 (at higher level).
The factors that can shift the aggregate demand curve
are grouped below under each of the components of
aggregate demand.
Changes in consumer spending, as a result
of the following
· Changes in wealth Wealth refers to the value of
assets that households own, such as the value of
their homes, the value of stocks they own in the
stock market, the value of bonds, valuable paintings,
jewellery, and so on. Note that wealth is not the
same as income. An increase in consumer wealth
(for example, an increase in stock market values,
or an increase in the value of homes) makes people
feel wealthier; therefore they spend more and the
aggregate demand curve (AD) shifts to the right. A
decrease in wealth lowers aggregate demand; the AD
curve shifts to the left.
· Changes in expectations about future income, and
expectations about the future of the economy If
consumers expect their income to increase in the
future, or if they are optimistic about the future of
the economy, they are likely to spend more today,
and the AD curve shifts to the right. Expectations of
falling incomes in the future, as well as pessimistic
expectations about the future of the economy, cause
decreases in spending in the present, and the AD
curve shifts to the left.
· Changes in interest rates Some consumer spending
is financed by borrowing, and so it is sensitive to
interest rate changes. An increase in interest rates
makes borrowing more expensive, and so results 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 increase or decrease
as a result of a type of government policy called
‘monetary policy’ (we will examine this in
Chapter 9).
Note that this does not in any way contradict the point made above, that
changes in income cannot initiate a change in aggregate demand. This
is because changes in taxes and after-tax income do not affect national
3
228
Part 3: Macroeconomics
· Changes in personal income taxes If the government
decides to increase personal income taxes (taxes paid
by households), then consumer disposable income,
or the income that is 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’ (discussed in
Chapter 9).3
· Changes in the level of household indebtedness
‘Indebtedness’ refers to how much money people
owe from taking out loans in the past. If consumers
have a high level of debt from past loans (due to
past use of credit cards or taking out loans to finance
consumption), then they are under pressure to make
high monthly payments in order 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.
· Changes in the attitude towards spending Over time,
or in particular periods of time, households may
change their attitudes toward spending. After a
war or a major national calamity, households often
become cautious in their spending habits. This
means that, given their income level, they may
decide to spend less (and save more). In different
periods of time, households may become more
comfortable about spending more (and saving less).
Some economists argue that we are currently in an
age of ‘consumerism’, in which households want to
acquire more and more consumer goods; this would
mean that, for a given level of income, consumption
increases (while saving decreases) and aggregate
demand shifts to the right.
Note that this list does not include national income as
a factor that changes consumption and therefore shifts
the AD curve. As noted above, changes in income
cannot initiate a change in aggregate demand.
Changes in investment spending, as a
result of the following
· Changes in expectations about future sales If
businesses are optimistic about their sales and
economic activity in the future, they spend more on
income, as they simply involve a transfer of income from households to
the government. National income remains unchanged.
investments, and the AD curve shifts to the right.
Business pessimism, on the other hand, gives rise to
a leftward shift in the AD curve.
· Changes (improvements) in technology Improvements
in technology stimulate investment spending, thus
causing increases in aggregate demand.
· Changes in interest rates Increases in interest rates
raise the cost of borrowing, and force businesses to
reduce their investment expenditures if these are
financed by borrowing, and therefore the AD curve
shifts to the left. Decreases in interest rates mean
that businesses can now finance their investment
spending by borrowing at a lower cost, and therefore
the AD curve shifts to the right. As noted above,
interest rates change as a result of monetary policy
(see Chapter 9).
· Changes in business taxes If the government
increases taxes on profits of businesses as part of its
fiscal policy (see Chapter 9), firms’ after-tax profits
fall, and 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 shift.
· Legal/institutional changes Sometimes, the legal
and institutional environment in which businesses
operate can have an important impact on
investment spending. This is often the case in many
developing and transition economies where laws
and institutions do not favour small businesses
(we will study these issues in Part 5). For example,
small businesses often do not have access to credit;
in other words, they cannot borrow easily in order
to finance investments. Many developing and
transition economies do not have the necessary laws
that secure property rights (see Chapter 1, page 25).
In such situations, increasing access to credit (the
ability to borrow) and securing property rights
would result in an increase in investment spending,
thereby shifting the AD curve to the right.
Changes in government spending, as a
result of the following
· Changes in political priorities Governments have
many expenditures, such as 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 own expenditures in response to changes in its
priorities. Increased overall government spending
shifts aggregate demand to the right, and decreased
government spending shifts aggregate demand to
the left.
· Deliberate efforts to influence aggregate demand The
government can use its own spending as part of a
deliberate attempt to influence aggregate demand.
The impacts 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 9).
Changes in export spending minus import
spending, as a result of the following
· Changes in real national income abroad Let’s say we
are considering aggregate demand in country A,
which has trade links with country B. If country B’s
real national income increases, it will purchase more
goods and services from country A, which means
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 real national income falls,
it will buy less from country A, and country A’s
aggregate demand shifts to the left.
· Changes in exchange rates An exchange rate is the
price of one country’s currency in terms of another
country’s currency. Let’s again consider country A,
and assume that the price of its currency increases,
i.e. it appreciates, or becomes more expensive
relative to the currency of, say, country B. Country
B now finds country A’s output more expensive, and
it therefore decreases its purchases from country A;
therefore country A’s exports fall, and the AD curve
in country A 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 country A’s currency appreciation has two
effects: a fall in its exports, X, and an increase in its
imports, M, so that net exports, X − M, fall on both
counts, and aggregate demand shifts to the left. In
the opposite situation, where the price of country
A’s currency decreases (i.e. it depreciates), there
results an increase in X and a decrease in M, so that
X − M increases, and aggregate demand in country
A shifts to the right. (This discussion will become
much clearer after we consider exchange rates in
Chapter 13.)
Table 8.1 summarizes the factors that can cause
movements on or shifts of the aggregate demand
curve.
(If you have read the section on the downward slope
of the AD curve, marked as supplementary material,
you should take care not to confuse the wealth effect,
which results from a change in the price level (and
causes a movement along the demand curve), with
Chapter 8: Aggregate demand and aggregate supply 229
Table 8.1 Distinguishing between movements along and shifts of the
aggregate demand curve.
Movements along the aggregate demand curve are caused by:
Changes in the price level
Shifts in the aggregate demand curve are caused by:
Changes in consumer spending, arising from
· a change in wealth
· a change in expectations about future income and prices
· a change in interest rates (due to monetary policy)
· a change in personal income taxes (due to fiscal policy)
· a change in the level of household indebtedness
· a change in the attitude towards spending
Changes in investment spending, arising from
· a change in expectations about future sales
· a change (improvement) in technology
· a change in interest rates (due to monetary policy)
· a change in business taxes (due to fiscal policy)
· legal/institutional changes
Changes in government spending, arising from
· a change in political priorities
· deliberate efforts to influence aggregate demand (due to
fiscal policy)
Changes in foreigners’ spending, arising from
· a change in real national income abroad
· a change in exchange rates
changes in wealth which cause shifts in the aggregate
demand curve. The first case refers to a change in the
real value of wealth that has resulted from a change
in the price level. The second case refers to changes
in real wealth that have come about in the absence of
a change in the price level. The same must be said
about the difference between the interest rate effect
that results from a change in the price level (and
produces movements along the demand curve), and
changes in interest rates that occur in the absence of
a change in the price level.)
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Part 3: Macroeconomics
Test your understanding 8.2
1 (a) Define aggregate demand and explain its
components. (b) Show aggregate demand
diagrammatically, and define the relationship it
represents. (c) What causes a movement along
the aggregate demand curve? (d) What are the
four components of spending that cause shifts
of the aggregate demand curve?
2 Using appropriate 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 of aggregate expenditure involved:
(a) Consumers become optimistic about future
conditions in the economy (the level of
employment, the level of income, expected
economic growth, etc.).
(b) The government decides to increase taxes
on firms’ profits.
(c) Firms become fearful that a recession is
about to begin.
(d) The government decides to increase its
spending on heath care services.
(e) There is a decline in the real estate market
(average house prices fall).
(f) The central bank (a government
organization) decides to increase interest
rates.
(g) Real incomes in countries that purchase
a large share of country A’s exports fall;
examine the impact on aggregate demand
in country A.
(h) The government lowers personal income
taxes (taxes on income of households).
(i) New legislation makes property rights more
secure.
(j) There is an appreciation (an increase) in the
value of the euro relative to the US dollar;
examine the impact on aggregate demand
in eurozone countries (countries that have
adopted the euro).
(k) 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.
(l) A non-governmental organization (NGO)
introduces a progamme that provides credit
to small farmers, thereby making it easier
for small farmers to borrow in order to
finance the building of irrigation projects
and the purchase of new farm equipment.
Aggregate supply and the short-run aggregate
supply curve
In order to build our AD-AS model, we must now
make a distinction between the short run and the
long run as it relates to macroeconomics, as these
concepts differ from the corresponding distinction in
microeconomics.
time, perhaps a year or two or more
· minimum wage legislation fixes the lowest legally
permissible wage
· workers and labour (trade) unions resist wage cuts
· wage cuts have negative impacts on worker morale,
causing firms to avoid them
· ideas of fairness may dictate the level of wages.
The short run and long run in
macroeconomics
The short run and long run in macroeconomics are
defined as follows:
The short run in macroeconomics is the period
of time during which the nominal prices of resources,
particularly the price of labour (wages), do not change
in response to changes in the price level; we can think
of resource prices as being constant. (See page 188
for an explanation of nominal.) The long run in
macroeconomics is the period of time in which the
nominal prices of all resources, including the price
of labour (wages), change so as to reflect fully any
change in the price level. Simplifying the difference
between the two, we can say that in the short run
wages are constant, whereas in the long run wages
change in response to changes in the price level.
Wages, or the price of labour resources, are of
particular interest because they account for the largest
portion of firms’ costs of production, and therefore
strongly affect the quantity of output supplied by
firms. In addition, wages are singled out because they
do not change very much over relatively short periods
of time. Whereas the prices of most resources other
than labour usually change quickly in response to
changes in demand and supply, the price of labour
(wages) is often rigid (unchanging), for the following
reasons:
(a) The upward-sloping
SRAS curve.
· labour contracts fix wage rates for certain periods of
Defining aggregate supply and the shortrun aggregate supply curve
We begin by defining aggregate supply and the shortrun aggregate supply curve.
Aggregate supply is the total quantity of goods and
services produced in an economy at different price
levels, ceteris paribus. The short-run aggregate
supply (SRAS) curve shows the relationship
between the price level and the quantity of real GDP
produced by firms when resource prices (particularly
wages) do not change.
Figure 8.5(a) illustrates a short-run aggregate supply
curve, indicating that there is a positive (or direct)
relationship between the price level and real GDP
supplied: a higher price level is associated with a
greater quantity of real GDP, and a lower price level
with a lower quantity of real GDP. The explanation for
this relationship is based on firm profitability: when
there is an increase in the price level, this means that
output prices have increased; but with nominal
0
price level
(b) Shifts in the
SRAS curve.
price level
SRAS
Note that the distinction between the short run and
the long run in macroeconomics does not affect
aggregate demand. It is, however, crucial to our
understanding of aggregate supply, to which we turn
next.
0
real GDP
SRAS3 SRAS
1 SRAS
2
real GDP
Figure 8.5 The short-run aggregate supply (SRAS) curve in the neoclassical perspective.
Chapter 8: Aggregate demand and aggregate supply 231
resource prices and particularly the price of labour
constant since the economy is in the short run, it
follows that firms’ profits increase. As production
becomes more profitable, firms increase the quantity
of output they produce. There is therefore a positive
relationship between the price level and the quantity
of real GDP supplied.
Similarly, a falling price level means falling output
prices; with constant nominal wages, firm profitability
falls, and output decreases. Once again we have the
positive relationship between the price level and the
quantity of real GDP supplied.
Changes in short-run aggregate supply
(shifts in the SRAS curve)
A change in the price level, as we have seen, leads to
a movement on the SRAS curve. A number of factors
(other than the price level) can lead to shifts of the
SRAS curve, illustrated in Figure 8.5(b). This distinction
is analogous to what we learned in Chapter 2, page 42,
in connection with the supply curve for a specific
good.
A rightward shift from SRAS1 to SRAS2 means that
short-run aggregate supply increases: for any particular
price level, firms produce a larger quantity of real
GDP. A leftward shift from SRAS1 to SRAS3 means that
aggregate supply decreases: for any particular price
level, firms produce a smaller quantity of real GDP.
Important factors that can cause SRAS curve shifts
involve changes in firms’ costs of production and
sudden events called ‘supply shocks’:
· Changes in wages Wage changes can cause
significant shifts in the SRAS curve, since wages
constitute a major portion of firms’ costs of
production. Wages can change for a number of
reasons, such as, for example, changes in minimum
wage legislation (explained in Chapter 2, page 55),
or changes brought about by labour union
bargaining with employers. If nominal wages
increase, with the price level constant, firms’ costs
of production rise, resulting in a leftward shift
in the SRAS curve, such as from SRAS1 to SRAS3
in Figure 8.5(b). Such a shift means that for any
particular price level, a smaller quantity of real
output is produced and supplied. If wages decrease,
with the price level constant, firms’ costs drop,
232
Part 3: Macroeconomics
giving rise to a rightward shift in the SRAS curve,
such as from SRAS1 to SRAS2.
· Changes in non-labour resource prices Changes in the
price of non-labour resources, such as the price of
oil, equipment, capital goods, land inputs, or any
other resource, impact upon the SRAS curve in the
same way as changes in wages. An increase in the
price of a key resource shifts the SRAS curve to the
left; a decrease in the price shifts the SRAS curve to
the right.
· Changes in business taxes Business taxes are taxes
on firms’ profits, and are treated by firms like costs
of production. Therefore higher taxes on profits
are equivalent to increases in production costs and
so shift the SRAS curve to the left. Lower taxes on
profits are equivalent to lower production costs and
shift the SRAS curve to the right.
· Changes in subsidies offered to businesses Subsidies
have the opposite effect to taxes, as they involve
money transferred from the government to firms. If
they increase, the SRAS curve shifts to the right; if
they decrease, the SRAS curve shifts to the left.
· Supply shocks Supply shocks are events that have
a sudden and strong impact on short-run aggregate
supply. Some supply shocks directly affect aggregate
supply. If they are adverse supply shocks, they cause
a leftward shift of the SRAS curve. For example, a
war or violent conflict can result in the destruction
of physical capital and disruption of the economy,
leading to lower output produced and a leftward
shift in the SRAS curve. Unfavourable weather
conditions can cause a fall in agricultural output,
also shifting the SRAS curve to the left. Beneficial
supply shocks such as a major oil discovery or
unusually good weather conditions with a positive
effect on agricultural output lead to an increase in
aggregate supply and a rightward shift in the SRAS
curve. Supply shocks sometimes work by producing
sudden changes in firms’ costs of production. For
example, a sudden increase in the price of a major
input (such as oil) increases firms’ costs.
Over short periods of time, the SRAS curve tends to
shift to the left or to the right mainly as a result of
factors that influence firms’ costs of production (such
as changes in wages, changes in non-labour resource
prices and changes in business taxes or subsidies),
as well as supply shocks, which are sudden events
impacting on short-run aggregate supply.
Test your understanding 8.3
SRAS
2 (a) Distinguish between the short run and
the long run in macroeconomics. (b) What
are some of the factors that cause wages to be
inflexible (not change very easily and rapidly)?
price level
1 Define aggregate supply.
Pl1
Ple
Pl2
AD
3 (a) Show the short-run aggregate supply
(SRAS) curve in a diagram, and explain what
relationship it represents. (b) What factors
can cause a movement along the SRAS curve?
(c) What factors cause shifts in the SRAS curve?
4 Using diagrams, show the impact of each of the
following on the short-run aggregate supply
(SRAS) curve; explain what happens to SRAS
in each case. (a) The price of oil (an important
input in production) increases. (b) Below-zero
temperatures during a large part of the growing
season destroy agricultural output. (c) The
government lowers taxes on firms’ profits.
(d) The government eliminates subsidies on
agricultural products.
Macroeconomic equilibrium in the short run
Short-run equilibrium level of prices and
output
We are now in a position to put the aggregate
demand curve and the short-run aggregate supply
curve together. This will determine short-run
macroeconomic equilibrium.
The equilibrium level of real GDP occurs where
aggregate demand intersects aggregate supply. In
the short run, it is given by the point of intersection
of the aggregate demand curve and the short-run
aggregate supply curve, and determines the price level,
the level of real GDP and the level of employment
that prevail when the economy is in short-run
equilibrium.
This is shown in Figure 8.6, where Ple is the
equilibrium price level and Ye is the equilibrium level
of real GDP. As we know from our earlier discussion,
the level of real GDP is closely related to how much
unemployment there is in the economy. As real GDP
increases, firms hire more labour and unemployment
falls; as real GDP decreases, firms need fewer labour
0
Ye
real GDP
Figure 8.6 Short-run macroeconomic equilibrium.
resources, and unemployment rises. Therefore the
equilibrium level of real GDP also determines how
much unemployment there is in the economy.
At any price level and real GDP other than Ple and Ye,
the economy is in disequilibrium. At price level Pl1,
there is excess quantity of real GDP being supplied,
and this exerts a downward pressure on the price level,
which falls until it reaches Ple. At a price level lower
than Ple, such as Pl2, there is excess quantity of real
GDP demanded, exerting an upward pressure on the
price level, which will move upward until it settles at
Ple. At Ple, the quantity of real GDP demanded is equal
to the quantity of real GDP supplied, and the market is
in equilibrium.
Changes in short-run equilibrium
The short-run equilibrium position of an economy
changes whenever there is a change in aggregate
demand or short-run aggregate supply. Suppose there
occurs an increase in aggregate demand (a rightward
shift in the aggregate demand curve). This may be
due to any of the factors discussed earlier (such as an
increase in national income abroad, or an increase
in investment spending). The effect is shown in
Figure 8.7(a) (page 234), where aggregate demand
shifts from AD1 to AD2. An increase in aggregate
demand gives rise to a rise in the price level, from
Pl1 to Pl2, and a rise in real GDP, from Y1 to Y2. We
know, too, that these changes also result in a fall in
unemployment.
In the event of a decrease in aggregate demand (due,
for example, to pessimism among firms or a fall in net
exports), the AD curve shifts from AD1 to AD3, with
the result that the price level and real GDP fall from
Pl1 to Pl3 and from Y1 to Y3, along with increase in
unemployment.
Chapter 8: Aggregate demand and aggregate supply 233
(a) Changes in aggregate demand.
(b) Changes in short-run aggregate supply.
SRAS3
price level
price level
SRAS
Pl2
Pl1
Pl3
AD2
AD3
0
SRAS1
Pl3
SRAS2
Pl1
Pl2
AD
AD1
0
Y3 Y1 Y2
Y3 Y1 Y2
real GDP
real GDP
Figure 8.7 Changes in short-run macroeconomic equilibrium in the neoclassical perspective.
economy, shown in Figure 8.8, all of which are defined
in relation to the economy’s potential GDP. As you
may remember from our discussion in Section 8.1,
potential GDP is the economy’s full employment level
of real GDP, where unemployment is equal to the
natural rate of unemployment. Potential GDP appears
as Yp in the three panels of Figure 8.8, where a vertical
line drawn at Yp represents the level of real GDP at
which there is ‘full employment’. The three kinds of
short-run equilibrium are:
· Panel (a): recessionary (deflationary) gap In panel
(a), the intersection of the AD and SRAS curves
determines a level of equilibrium real GDP, Ye,
that lies to the left of potential GDP. When real
GDP is less than potential GDP, the economy is
experiencing a recessionary gap (also known as a
deflationary gap), and unemployment is greater
than the natural rate of employment. Why does
Recessionary (deflationary) gaps,
inflationary gaps and short-run full
employment equilibrium
We can identify three possible kinds of short-run
macroeconomic equilibrium positions for the
(a) The economy with a deflationary
(recessionary) gap.
(b) The economy with an
inflationary gap.
(c) The economy at the full
employment level of output.
price level
price level
SRAS
Ple
SRAS
Ple
AD
0
Ye Yp
0
Figure 8.8 Three short-run equilibrium states of the economy.
Part 3: Macroeconomics
SRAS
Ple
AD
real GDP
234
price level
Figure 8.7(b) shows shifts in the short-run aggregate
supply curve. A rightward shift in the SRAS curve
from SRAS1 to SRAS2 (for example, because of a
technological improvement, or if the government
decides to lower business taxes) will give rise to a lower
price level, Pl2, a higher level of real GDP, Y2, and lower
unemployment. On the other hand, a leftward shift in
the SRAS curve, from SRAS1 to SRAS3 (say, because of an
increase in business taxes or an increase in the price
of a key resource) will produce an increase in the price
level to Pl3, a fall in real output to Y3, and an increase
in unemployment.
Yp
Ye
real GDP
AD
0
Yp
real GDP
this happen? Remember that aggregate demand
consists of the demand for real GDP of consumers,
firms, the government and foreigners (the four
components). The recessionary gap has been created
because at the price level (Ple) determined by the
intersection of AD with SRAS, the quantity of real
GDP that the four components of aggregate demand
want to buy is less than the economy’s potential
GDP. In other words, with aggregate demand
represented by AD, there is not enough total
demand in the economy to make it worthwhile
for firms to produce potential GDP. With aggregate
demand at AD, firms therefore produce a smaller
quantity of real GDP than potential GDP. But this
also means that they require less labour for their
production, and so unemployment is greater than
the natural rate of unemployment.
· Panel (b): inflationary gap In panel (b), the
intersection of the AD and SRAS curves
determines a level of equilibrium real GDP,
Ye, that lies to the right of potential GDP.
When real GDP is larger than potential GDP, the
economy is experiencing an inflationary 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) determined by the intersection of AD
with SRAS is greater than the economy’s potential
output. There is too much total demand in the
economy, and firms respond by producing a greater
quantity of real GDP than potential GDP. To be
able to produce more output, firms’ labour needs
increase, and unemployment falls to become less
than the natural rate of unemployment.
· Panel (c): full employment level of real GDP In
panel (c), the intersection of the AD and SRAS
curve determines a level of equilibrium real
GDP that is exactly equal to potential GDP.
When the economy is producing its potential
GDP, unemployment is equal to the natural rate
of unemployment. The full employment level of
real GDP is the level of real GDP at which there
is no recessionary or inflationary gap. This occurs
because at the price level (Ple) determined by the
intersection of AD with SRAS, the quantity of real
GDP demanded by the four components is exactly
equal to the economy’s potential output.
Recessionary (deflationary) and inflationary gaps
represent short-run equilibrium positions of the
economy. A recessionary (deflationary) gap is
defined as 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; it arises when the AD curve
intersects the SRAS curve at a lower level of real GDP
than the full employment level. An inflationary
gap is defined as a situation where real GDP is greater
than potential GDP (and unemployment is smaller
than the natural rate of unemployment) due to
excessive aggregate demand; it arises when the AD
curve intersects the SRAS curve at a higher level of
real GDP than the full employment level. When the
economy is at its full employment equilibrium level
of GDP, the AD curve intersects the SRAS curve at the
level of potential (full employment) GDP, and there is
no deflationary or inflationary gap.
You can see from this discussion that the three shortrun equilibrium states of the economy correspond
to the phases of the business cycle that we studied
in Section 8.1: Ye of Figure 8.8(a) corresponds to a
point such as e in Figure 8.2, where the economy is
experiencing recession, unemployment is greater than
the natural rate and actual GDP is less than potential
GDP. Ye of Figure 8.8(b) corresponds to a point such
as d in Figure 8.2, where unemployment is lower
than the natural rate and actual GDP is greater than
potential GDP. Finally, Yp of Figure 8.8(c) corresponds
to points like a, b, and c where the economy is
producing actual GDP equal to potential GDP, or full
employment GDP, with unemployment at its natural
rate. Therefore, recessionary and inflationary gaps are
two types of output gaps.
Shifts in AD or SRAS: possible causes of the
business cycle
It is now a simple matter to consider the possible
causes of the business cycle studied in Section 8.1.
Assume that an economy is in full employment
equilibrium producing real GDP Yp in Figure 8.9(a)
(page 236), and then experiences a fall in aggregate
demand. Aggregate demand shifts leftward from AD1
to AD2, resulting in a recessionary gap, where real GDP,
Yrec is less than potential GDP, the price level is lower
Chapter 8: Aggregate demand and aggregate supply 235
(a) Changes in aggregate demand.
(b) Changes in aggregate supply.
SRAS2
SRAS1
Pl3
Pl1
Pl2
AD3
AD1
AD2
0
Pl2
SRAS3
Pl1
Pl3
AD
Yrec Yp Yinfl
recessionary
(deflationary) gap
price level
price level
SRAS
real GDP
inflationary
gap
0
recession with
inflation
('stagflation')
Y2 Yp Y3
real GDP
desirable outcome:
higher real
GDP with lower
price level
Figure 8.9 Possible causes of the business cycle.
at Pl2, and there is an increase in unemployment.
If, on the other hand, the economy that initially is
in long-run equilibrium experiences an increase in
aggregate demand, the rightward shift in the AD curve
from AD1 to AD3 will give rise to an inflationary gap,
where real GDP, Yinfl is greater than potential GDP, the
price level increases to Pl3 and unemployment falls.
Shifts in the short-run aggregate supply curve can also
contribute to economic fluctuations.4 In Figure 8.9(b),
starting from long-run equilibrium once again, a fall
in SRAS, shifting SRAS1 to SRAS2, will give rise to an
economic contraction, with real GDP falling to Y2 and
an increase in unemployment. Note, however, that
this contraction differs from the recessionary gap that
resulted from the fall in aggregate demand: the fall
in aggregate supply gives rise to an increase in the
price level, along with the decrease in real GDP. This
special set of circumstances is especially undesirable
for an economy, as it leads to the simultaneous
appearance of two problems: economic contraction
with unemployment, and a rising price level. This
combination of events has been termed ‘stagflation’
(combining ‘stagnation’ with ‘inflation’) and will be
further discussed in Chapter 9.
An increase in short-run aggregate supply shifting
SRAS1 to SRAS3 gives rise to an economic expansion
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
4
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Part 3: Macroeconomics
as real GDP increases to Y3 and unemployment falls.
Note that the expansion set into motion by the
increase in short-run aggregate supply is accompanied
by a falling price level (in contrast to the rising
price level that resulted from an increase in aggregate
demand). The rightward shift of the SRAS curve differs
fundamentally from the other three shifts considered
above, because it does not result in any undesirable
effects for the economy. Instead, the economy is now
experiencing two desirable developments: economic
expansion and increasing employment, with a falling
price level.
Most economists believe that changes in aggregate
demand are more important than changes in aggregate
supply as causes of the business cycle.
If the economy is initially in a position of full
employment equilibrium, a decrease in aggregate
demand causes recession while an increase in
aggregate demand causes inflation. A decrease in
aggregate supply causes both inflation and recession,
while an increase in aggregate supply brings about
two desirable outcomes: economic expansion
accompanied by a falling price level.
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.
1 Explain and use a diagram to show how shortrun equilibrium is determined in the AD-AS
model.
2 For each of the events listed below, use an
appropriate diagram to show the change in
short-run equilibrium, and the impacts on the
equilibrium price level, output (real GDP) and
unemployment. (a) Firms are pessimistic about
the future of the economy. (b) There is a fall in
the price of oil, a major input in production.
(c) There is a significant rise in stock market
prices. (d) A war destroys a portion of an
economy’s physical capital.
3 (a) Using the AD-AS model and diagrams,
show the three short-run equilibrium states
of the economy and illustrate a recessionary
gap, an inflationary gap, and full employment
equilibrium. (b) Explain how each of the three
equilibrium states is related to the natural
rate of unemployment. (c) How are the three
equilibrium states related to the phases of the
business (trade) cycle?
4 Assuming the economy is initially in a position
of full employment equilibrium, explain how
each of the events in question 2 can contribute
to short-term economic fluctuations.
8.3 Macroeconomic controversies: the
neoclassical perspective
In this section we will study the theoretical perspective
of neoclassical economists. Neoclassical economics
builds on the work of the classical economists of
the 19th century. Some of the key principles of this
perspective include the importance of the price
mechanism in coordinating economic activities; the
concept of perfectly competitive market equilibrium;
and the conceptualization of 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 significant disagreement over their relevance to the
study of economics at the macro level.
The AD-AS model in the long run
Defining the long-run aggregate supply
curve and long-run macroeconomic
equilibrium
The neoclassical approach to the AD-AS model rests
crucially on the distinction we made earlier between
the macroeconomic short run and long run. This
approach examines what happens to the relationship
between real GDP and the price level when the
economy moves into the long run. In the long run, as
you may remember, all resource prices including wages
change so as to match changes in the price level. This
has some very important implications for the shape
of the long-run aggregate supply curve: the long-run
aggregate supply (LRAS) curve is vertical at potential
GDP, or the full employment level of real GDP. A
vertical LRAS curve indicates that in the long run a
change in the price level does not give rise to any
change in the quantity of real GDP produced.
Moreover, the economy is in long-run equilibrium
when the AD curve and the SRAS curve intersect
at a point that is on the LRAS curve, as shown in
Figure 8.10. Note that the economy’s long-run
equilibrium position is the same as the short-run
equilibrium position where the intersection of AD
with SRAS occurs at the economy’s potential GDP,
shown in Figure 8.8(c).
Since the LRAS curve is vertical at potential GDP,
it follows that deflationary (recessionary) and
inflationary gaps, appearing in Figures 8.8 (a) and (b),
can be represented diagrammatically in relation to the
economy’s LRAS curve. Simply label the vertical line
at Yp in Figures 8.8 (a) and (b) as LRAS, and you can
illustrate a deflationary gap and an inflationary gap
in relation to the LRAS curve.
LRAS
SRAS
price level
Test your understanding 8.4
AD
0
Yp
real GDP
Figure 8.10 Long-run equilibrium in the neoclassical perspective.
Economics for the IB Diploma
Figure 8.10
Mac/eps/Illustrator Col s/s
Chapter
8: Aggregate demand and aggregate supply
Text: Agenda
emcdesign
Studio: Peters & Zabransky
237
The long-run aggregate supply (LRAS) curve
shows the relationship between real GDP produced
and the price level when wages (and other resource
prices) change to reflect fully any changes in the price
level, ceteris paribus. The LRAS curve is vertical at
the full employment level of GDP, or potential GDP,
indicating that in the long run the economy produces
potential GDP, which is independent of the price
level.
Why the LRAS curve is vertical
There is a very simple explanation for the vertical
shape of the LRAS curve. Since nominal wages (and
other resource prices) are now changing to match fully
any output price changes, firms’ costs of production
remain constant even as the price level changes.
Therefore, as the price level increases or decreases,
with constant real costs, firms’ profits are also
constant, and firms no longer have any incentive to
increase or decrease their output levels.
For example, say the price level increases by 5%. 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. But in the long
run, wages (and other resource prices) also increase
by 5%. 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 will be fully matched by the same
percentage decrease in nominal wages (and other
resource prices), so that firms have no incentive to
decrease the quantity of output produced.
Why the LRAS curve is situated at
the level of potential GDP (or why
inflationary and deflationary gaps cannot
persist in the long run)
In our discussion above, we saw that recessionary
and inflationary gaps are two possible short-run
equilibrium positions of the economy where the
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
5
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Part 3: Macroeconomics
equilibrium level of real GDP differs from potential
GDP. But if the LRAS curve is vertical at the level
of potential GDP, it follows that recessionary and
inflationary gaps are only short-run phenomena
that cannot persist in the long run. As soon as the
economy moves into the long run, the recessionary
and inflationary gaps disappear, and the economy
moves automatically towards full employment
equilibrium.
To see how this occurs, consider Figure 8.11(a), where
an economy is initially in long-run equilibrium at
point a on SRAS1 and AD1, and real GDP is equal to
potential output, Yp. If there is a fall in aggregate
demand from AD1 to AD2, the economy will move
in the short run from point a to point b, where there
arises a recessionary gap; at b, real GDP has fallen to
Yrec and the price level has fallen from Pl1 to Pl2. But
the economy cannot remain in that position in the
long run. In the long run, the fall in the price level
will be matched by a fall in wages (and falls in other
resource prices), so that the SRAS curve will shift to
the right from SRAS1 to SRAS2, until the economy is
back on the LRAS curve, at point c. In other words,
the assumption of wage and price flexibility in the
long run has allowed the economy to automatically
come back to its long-run equilibrium position. The
recessionary gap was eliminated, and the only thing
that changed in response to the fall in aggregate
demand was the fall in the price level (from Pl1 to Pl3).5
The case where aggregate demand increases to
create an inflationary gap in the short run is shown
in Figure 8.11(b). Once again the economy begins
from a position of long-run equilibrium at point a. The
increase in aggregate demand is shown by the shift
from AD1 to AD2; in the short run the economy moves
to point b, where real GDP has increased to Yinfl, there
is an inflationary gap, and the price level has increased
from Pl1 to Pl2. But 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 SRAS1 to SRAS2, and
the economy arrives at point c, which is
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.
(a) Creating and eliminating a deflationary gap.
Pl1
Pl2
a
SRAS2
b
c
Pl3
LRAS
SRAS1
AD1
price level
price level
LRAS
(b) Creating and eliminating an inflationary gap.
Pl3
Pl2
Pl1
c
b
a
0
Yrec Yp
real GDP
AD2
AD1
AD2
0
SRAS2
SRAS1
Yp Yinfl
real GDP
Figure 8.11 LRAS and long-run equilibrium.
once again on the LRAS curve. In the long run, the
inflationary gap is eliminated and the only thing that
changed after the increase in aggregate demand was
the increase in the price level (to Pl3).6
unchanged. Similarly in Figure 8.11(b), as aggregate
demand increased from AD1 to AD2, the economy in
the long run moved from point a to c, indicating a
higher price level and unchanging real GDP.
In the neoclassical perspective, recessionary
(deflationary) and inflationary gaps are eliminated
in the long run by flexibility in resource prices. This
ensures that in the long run the LRAS curve will be
vertical at the level of potential GDP. The economy
has a built-in tendency towards full employment
equilibrium.
In the neoclassical perspective, changes in aggregate
demand can influence real GDP only in the short
run; in the long run, the only impact of a change in
aggregate demand is to change the economy’s price
level. Increases in aggregate demand in the long run
are therefore inflationary (i.e. cause inflation).
Test your understanding 8.5
Why in the long run aggregate demand
influences only the price level, leaving
real GDP unchanged
Our discussion above on the elimination of
deflationary and inflationary gaps illustrates another
important principle of the neoclassical interpretation
of the AD-AS model: changes in aggregate demand
can have an influence on real GDP only in the short
run; in the long run, they only result in increases in
the price level, having no impact on real GDP, as this
remains constant at the level of potential output and
the LRAS curve. In Figure 8.11(a), when aggregate
demand fell from AD1 to AD2, in the long run the
economy moved from point a to point c, indicating
a fall in the price level with real GDP remaining
When there is an inflationary gap, unemployment falls below the natural
rate, and there is a shortage 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
6
1 (a) Define and use a diagram to show the longrun aggregate supply (LRAS) curve. (b) What
can we say about the rate of unemployment in
the economy that occurs at the level of real GDP
determined by the position of the LRAS curve?
(c) What does the vertical shape of the LRAS
curve tell 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).
(...continued)
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 reverts to long-run equilibrium through the shift
in the SRAS curve.
Chapter 8: Aggregate demand and aggregate supply 239
Test your understanding 8.5
(...continued)
3 Draw two diagrams, illustrating recessionary and
inflationary gaps in relation to the LRAS curve.
4 Can inflationary or deflationary gaps persist
in the long run according to the neoclassical
perspective? Explain why or why not.
5 Why do neoclassical economists argue that in
the long run aggregate demand can only affect
the price level? Use a diagram to illustrate your
answer.
Changes in long-run aggregate supply (shifts
in the LRAS curve)
Economic growth in the AD-AS model
Real GDP in the long run is determined by the
position of the LRAS curve, which in turn is
determined by the economy’s potential output. Over a
period of time, potential output can change: the LRAS
curve shifts to the right or to the left in response to
factors that increase or decrease potential output.
Potential output is the total quantity of goods and
services, or real GDP, that an economy can produce,
given its factors of production (resources) and its
technology, assuming that there is ‘full employment’
(remember that there is still some unemployment,
which is the natural rate of unemployment). A
rightward shift of the LRAS curve indicates an increase
in potential output; a leftward shift indicates a
decrease. This is simply another way of representing
economic growth: as the LRAS shifts to the right,
there is an increase in real GDP, representing positive
economic growth; as it shifts to the left, there is a
decrease in real GDP, representing negative growth.
It is then a simple matter to see what factors can shift
the LRAS curve, as they are similar factors that cause
economic growth in the context of the production
possibilities model. As we know from Chapter 7
(see Figure 7.3, page 194), an economy can achieve
some growth by moving from one point inside its
PPC to another point closer to its PPC, if it makes
more efficient use of its resources and if it reduces
unemployment. Over longer periods of time, the
economy can continue to grow if there are increases
in the quantities of resources, improvements in their
quality and improvements in technology; all these are
represented by outward shifts in the PPC.
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Part 3: Macroeconomics
By the same token, the LRAS shifts to the right when
there are:
· Increases in efficiency When an economy increases
its efficiency in production, in effect it makes better
use of its scarce resources, and can therefore produce
a greater quantity of output (real GDP). Therefore
potential output increases, and the LRAS curve shifts
to the right. (Decreases in efficiency would shift the
LRAS curve to the left.)
· Reductions in the natural rate of unemployment The
natural rate of unemployment is the unemployment
that is ‘normal’ or ‘natural’ for an economy when
it is producing its ‘full employment’ level of
output. It includes unemployed people who are
in between jobs, who are retraining in order to
become more employable, and others. The natural
rate of unemployment is not fixed or unchangeable.
It differs from country to country and it can also
change over time within the same country. If
the natural rate of unemployment decreases, the
economy is making better use of its resources, and
can therefore produce a larger quantity of output
(real GDP). Therefore potential output increases, and
the LRAS curve shifts to the right. (An increase in
the natural rate of unemployment would result in a
leftward shift in the LRAS curve.)
But an economy’s ability to continue to increase
its potential output and shift its LRAS curve to the
right through increases in efficiency and reductions
in natural unemployment will at some point be
exhausted. The economy can continue to grow only
if there are increases in its production possibilities,
resulting from:
· Increases in the quantities of the factors of production If
one or more factor of production increases, the LRAS
curve shifts to the right. This is because an increase
in the quantity of a factor of production, such as an
increase in the quantity of physical capital, or the
quantity of labour, or the quantity of land (such as
when there is a discovery of new oil reserves) means
that the economy is now capable of producing
a larger quantity of real GDP. (If the quantity of
factors of production decreases, the LRAS curve
shifts to the left.)
· Improvements in the quality of factors of production
(resources) Improvements in resource quality will
shift the LRAS curve to the right. For example,
greater levels of education, skills or health constitute
an improvement in the quality of labour resources.
More highly skilled and educated workers or
healthier workers can produce more output than the
same number of unskilled or less healthy workers.
· Improvements in technology An improved technology
of production means that the factors of production
using it can produce more output, and the LRAS
curve shifts to the right. For example, workers who
work with improved machines and equipment that
have been produced as a result of technological
innovations will produce more output in the same
amount of time.
Rightward shifts in the LRAS curve illustrate an
increase in potential output and economic growth.
They result from similar factors that cause economic
growth in the production possibilities model. The
LRAS curve can shift to the right as a result of
increases in efficiencies and reductions in the natural
rate of unemployment. Over extended periods of
time, rightward shifts in the LRAS curve depend on
increases in the economy’s production possibilities,
which may arise from increases in quantities of factors
of production, improvements in quality of factors of
production and technological improvements.
The relationship between the SRAS and
LRAS curves
If an economy is experiencing economic growth,
its LRAS curve will be shifting rightward, indicating
increases in potential output. But its SRAS curve will
be shifting rightward as well because, at any given
moment in time, an economy is always producing on
an SRAS curve. This is shown in Figure 8.12. Therefore
any factor that shifts the LRAS curve must also shift
the SRAS curve.
LRAS1
LRAS2
SRAS2
SRAS3
price level
SRAS1
LRAS3
Are there any factors that can shift the SRAS curve
without shifting the LRAS curve? There are certain
events that have only a temporary impact on
aggregate supply, and these can shift the SRAS curve
for a short while, while leaving the LRAS curve
unchanged. Consider, for example, adverse weather
conditions during one season that cause a drop in
agricultural output. The SRAS curve will shift to the
left for that season, but will then revert back to the
original position when the weather changes back
to normal patterns, while the LRAS curve remains
unaffected. Changes in firms’ costs of production,
such as changes in wages, or changes in the prices of
other key inputs (such as oil), may similarly affect only
the SRAS curve. This applies to temporary changes that
do not have a lasting impact on real GDP produced.
Test your understanding 8.6
1 Illustrate diagrammatically the impacts on an
economy’s LRAS curve of the following:
(a) There is a widespread introduction of a
new technology that increases labour
productivity.
(b) The government provides training
programmes for workers to retrain and
improve their skills.
(c) A developing country receives large
amounts of foreign aid, which allows it to
purchase a large quantity of capital goods.
(d) An extensive nationwide public health
campaign undertaken by the government
improves levels of health of the population.
(e) The government introduces anti-monopoly
legislation, reducing the monopoly power
of firms and increasing the economy’s
productive efficiency.
2 (a) Using an appropriate diagram and the
concept of potential output, explain the
relationship between the LRAS curve and
economic growth.
(b) Can you think of some factors that can
affect the SRAS curve but not the LRAS
curve?
0
Y1
Y2
real GDP
Y3
Figure 8.12 Illustrating growth in potential output: shifts in the LRAS and
SRAS curves.
8.4 Macroeconomic controversies: the
Keynesian perspective
In this section we turn to the theoretical perspective
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,
Chapter 8: Aggregate demand and aggregate supply 241
(a) The implications of downwardly inflexible wages and prices.
Pl1
d
Pl2
Pl3
SRAS1
SRAS2
a
b
AD1
c
Keynesian AS
price level
price level
LRAS
(b) The Keynesian AS curve.
AD2
AD2
0
Yp
real GDP
a
d
0
AD1
Yp
real GDP
Figure 8.13 Keynesian analysis.
whose work in the first half of that century came
to form the basis of modern macroeconomics.
Keynes questioned the classical economists’ view of
the economic system as a harmonious system that
automatically tends towards full employment (on
which the neoclassical perspective is based), and
instead showed that it is possible for economies to
remain in a position of short-run equilibrium for long
periods of time.
Getting stuck in the short run
Wage and price downward inflexibility
The long-run aggregate supply curve in the
neoclassical perspective depends on the principle that
all resource prices and product prices are fully flexible
and respond to the forces of supply and demand.
But what if resource prices are not free to move in
the downward direction even over long periods of
time? Keynesian economists argue that there is an
asymmetry between wage movements in the upward
and downward directions. They note that 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 that we noted earlier (such as labour
contracts, which fix wage rates for certain periods of
time; minimum wage legislation; worker and union
resistance to wage cuts; and so on).
Moreover, Keynesian economists argue that not
only wages, but also product prices are inflexible in
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Part 3: Macroeconomics
the downward direction, even if an economy is in a
recessionary gap. In the event of a recessionary gap,
the neoclassical perspective predicts that the price
level will fall. Keynesian economists argue that this
is unlikely to happen. The line of reasoning is the
following: in a recession, if wages won’t go down,
firms will resist lowering their prices because that
would reduce their profits. Further, 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.
According to the Keynesian perspective, both wages
and prices are unlikely to fall even if the economy is
in a recessionary gap, and even if the recessionary gap
persists over long periods of time.
The inability of the economy to move into
the long run
If wages and prices do not fall easily even over long
periods of time, this in effect means that the economy
may get stuck in the short run, and cannot move into
the long run. Let’s see how this happens. Consider
Figure 8.13(a), which is similar to Figure 8.11(a). The
economy is initially at point a, producing potential
output Yp. There occurs then a decrease in aggregate
demand, so the AD curve shifts from AD1 to AD2. The
neoclassical 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 Pl1 to
Pl2; in the long run it will move to point c, where there
is an even lower price level, Pl3, and the economy is
once again producing potential output Yp. The fall in
the price level and in wages caused the recessionary
gap to disappear.
This argument suggests that the SRAS curve has the
shape shown in Figure 8.13(b). The horizontal part
of the curve is based on the Keynesian perspective
of downward inflexibility of wages and prices. Point
d in Figure 8.13(a) corresponds to point d in Figure
8.13(b). At this point, the economy is in a recessionary
gap, and may stay there indefinitely as it is unlikely
to move out of the recession unless the government
intervenes with specific policies.
In the Keynesian perspective, inflexible wages and
prices mean that the economy cannot move into
the long run. Inflexible wages and prices are shown
graphically by a horizontal segment of the Keynesian
aggregate supply (AS) curve.
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 period of time (perhaps years)
wages and prices would eventually begin to fall. But
in the Keynesian view, the period of waiting for this
to happen would be far too long. 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.
The shape of the Keynesian aggregate supply
curve
As we can see in Figure 8.14, the Keynesian aggregate
supply curve has three segments. In segment 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. This means
that if firms want to increase their output they can
easily do so by employing the unemployed labour and
other unemployed resources, without having to bid
up wages and other resource prices. In segment II, as
real GDP continues to increase, the AS curve begins
to rise, so that 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. Firms are forced to use less and less efficient
resources, which means that even though wages are
held constant (since the economy is in the short run),
the cost of production per unit of output increases.
The only way that firms will then be induced to
increase their output is if they can sell it at higher
prices. Therefore growing output gives rise 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. It
is possible for unemployment to fall further, which is
what happens when real GDP continues to increase
beyond Yp. Real GDP can continue to increase until it
reaches segment III.
In segment III, the AS curve becomes vertical at Ymax,
indicating that real GDP reaches a level beyond
which it cannot increase any more; at this point,
the price level rises very rapidly. Why can real GDP
no longer increase? The reason is that firms are now
using the maximum amount of labour and all other
resources that are available in the economy. Since it
is not possible for real GDP to increase any more, any
efforts on the part of firms to continue to increase
their output will only give rise to greater increases in
the price level, as shown by the vertical part of the AS
curve at Ymax.
Keynesian AS
segment III
price level
Now what if the price level and wages do not fall
following the decrease in aggregate demand? If the
price level cannot fall from Pl1, where it was initially,
the economy will move to point d on the new, lower,
aggregate demand curve, AD2. Even if the price level
succeeds in falling to Pl2, so the economy moves to
point b, the economy may get stuck there if wages do
not fall (remember that wages must fall in order 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 will be unable to eliminate
the recessionary gap. It will be stuck in the short run,
and will be unable to move into the long run.
segment II
segment I
0
Yp Ymax
real GDP
Figure 8.14 The Keynesian aggregate supply curve.
Chapter 8: Aggregate demand and aggregate supply 243
The three short-run equilibrium states of the
economy in the Keynesian perspective
Some key features of the Keynesian
perspective
Macroeconomic equilibrium in the Keynesian
perspective is determined by the point of intersection
of the aggregate demand curve and the Keynesian
aggregate supply curve. There are three shortrun equilibrium states of the economy, shown in
Figure 8.15.
Recessionary gaps can persist over long
periods of time
One of the most important principles arising from the
Keynesian interpretation of the AD-AS model is that
recessionary gaps can persist over long periods of time.
According to Keynes, this happens partly because of
the inability of wages and prices to fall so as to bring
the economy to its full employment level of output
(potential GDP). In addition, and very importantly,
the problem is caused by insufficient aggregate
demand. Whenever aggregate demand intersects the
horizontal segment of the Keynesian AS curve, the
economy is in a recessionary gap, because aggregate
demand is too low, and the four components of
aggregate demand are unable to buy enough output
to make it worthwhile for firms to produce real GDP
equal to full employment or potential GDP. Therefore
the level of equilibrium GDP is lower than potential
GDP.
Figure 8.15(a) shows the AD curve intersecting
the Keynesian AS curve in its horizontal segment,
determining Ye, which is less than Yp (potential GDP),
indicating that there is a recessionary (deflationary)
gap with unemployment greater than the natural rate.
In panel (b), the economy is producing at Ye, which is
greater than potential output 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. Panel (c) shows the case
where the economy has achieved full employment
equilibrium, or potential output, at Yp.
These three short-run equilibrium states of the
economy can be related to the business cycle we
studied in Section 8.1: Ye in Figure 8.15(a) corresponds
to a point such as e in Figure 8.2, where there is a
recessionary gap; Ye of Figure 8.15(b) corresponds
to a point such as d in Figure 8.2, where there is an
inflationary gap; and Yp of Figure 8.15(c) corresponds
to points like a, b and c in Figure 8.2, where the
economy’s actual output is equal to its potential
output, or full employment output.
(b) Inflationary gap.
Keynesian AS
price level
price level
Keynesian AS
(c) Full employment equilibrium.
Keynesian AS
price level
(a) Recessionary gap.
In Figure 8.15(a), the equilibrium level of real GDP
settles at Ye, determined by the intersection of the AD
and the AS curves. What differentiates the Keynesian
analysis is that, unlike in the neoclassical perspective
where the recessionary gap will disappear once the
economy moves into the long run, the economy here
cannot move into the long run, and will therefore
remain at an equilibrium like Ye indefinitely. This has
very important implications for economic policy. It
means that the government must intervene in the
economy with specific measures to help it come out
of the recessionary gap.
AD
AD
AD
0
Ye
real GDP
Yp
0
Yp Ye
real GDP
Figure 8.15 The three equilibrium states of the economy in the Keynesian perspective.
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Part 3: Macroeconomics
0
Yp
real GDP
(a) The neoclassical perspective
(b) The Keynesian perspective.
Keynesian AS
Pl1
Pl2
price level
price level
LRAS
AD3
Pl3
AD2
AD1
0
Yp
AD2
AD1
0
real GDP
Y1
Y2
AD3
real GDP
Y3
Figure 8.16 Impacts of increases in aggregate demand on real GDP and the price level.
In the Keynesian perspective, an economy can remain
for long periods of time in an equilibrium position
where there is less than full employment (i.e. a
recessionary or deflationary gap), which is caused by
insufficient aggregate demand.
Increases in aggregate demand need not
cause increases in the price level
Another important principle arising from the
Keynesian interpretation of the AD-AS model is
that increases in aggregate demand need not always
cause increases in the price level. In the neoclassical
perspective, increases in aggregate demand will always
give rise to increases in the price level. In the short
run, as AD shifts to the right causing a movement
along an upward-sloping SRAS curve, there will result
some increase in real GDP as well as an increase in
the price level (see Figure 8.7(a)). In the long run, you
may remember, increases in aggregate demand give
rise only to increases in the price level, while leaving
real GDP unaffected. This is shown in Figure 8.16(a).
In the Keynesian perspective, by contrast, when the
economy is in the horizontal range of the AS curve,
increases in aggregate demand lead to increases in real
GDP without affecting the price level. This is shown
in Figure 8.16(b). It is only when the Keynesian AS
curve begins to slope upward that further increases in
aggregate demand begin to result in changes in the
price level as well.
Illustrating economic growth in the
Keynesian perspective
While Keynesian analysis is a short-run analysis,
this certainly does not mean that the model cannot
explain economic growth over long periods of time.
Economic growth, involving increases in the full
employment level of real GDP, or potential GDP, can
be illustrated by rightward shifts in the Keynesian AS
curve and the AD curve, as shown in Figure 8.17. Any
factor causing shifts in the neoclassical LRAS curve
will also cause shifts in the Keynesian AS curve. As the
AS curve shifts to the right from AS1 to AS2, potential
output increases from Y1 to Y2. Figure 8.17 shows AD
shifting along with the AS curve, so the economy
in this case continues to be in a position of full
employment equilibrium as it grows (though it is not
necessary that the AD curve will always increase along
with the AS curve).
Keynesian AS1
Keynesian AS2
price level
It follows that Keynesian analysis is essentially a shortrun analysis. There is no such thing as a Keynesian
long-run aggregate supply curve. This does not mean
that Keynesian economists do not consider what
happens over long periods of time; it means only that
they do not accept the idea that the economy can
move into what neoclassical economists define as the
long run (where there is full resource and product
price flexibility). It follows then that in the Keynesian
perspective the economy does not automatically tend
towards full employment equilibrium.
AD2
AD1
0
Y1
Y2
real GDP
Figure 8.17 Economic growth in the Keynesian perspective.
Chapter 8: Aggregate demand and aggregate supply 245
Test your understanding 8.7
(a) Neoclassical AD-AS model.
LRAS
aggregate supply curve if wages and prices are
inflexible in the downward direction. Can the
economy move into the long run?
2 (a) Use a diagram to show the Keynesian AS
0
the Keynesian perspective?
8.5 Some final observations
Illustrating the neoclassical and Keynesian
perspectives
Figure 8.18 shows how some key concepts we have
considered in this chapter relate to each other in the
neoclassical and Keynesian theoretical perspectives.
Point a in both panels determines full employment
equilibrium output, or potential GDP. Note that the
LRAS curve in panel (a) is not the same as the vertical
segment of the Keynesian AS curve, as the latter
vertical segment represents the maximum possible
output that the economy can produce if it uses all its
resources.
246
Part 3: Macroeconomics
AD3
AD2 AD1
potential GDP =
full employment GDP
real GDP
Keynesian AS
economic
growth
c
b
deflationary
gap
4 Using diagrams illustrating the Keynesian
6 How would you illustrate economic growth in
b
price level
show the three short-run equilibrium states
of the economy, noting recessionary and
inflationary gaps and their relationship to the
full employment equilibrium position of the
economy (potential output).
position where there is less than full
employment for long periods of time in the
Keynesian perspective?
inflationary gap
a
(b) Keynesian AD-AS model.
3 Using the Keynesian perspective and diagrams,
5 Why can an economy remain in an equilibrium
SRAS
c
deflationary
gap
curve. (b) What does the flat segment of this
curve indicate about the relationship between
the price level and real GDP? (c) What does
the upward-sloping segment indicate about
this relationship? (d) What does the vertical
segment indicate about this relationship?
perspective, show and explain what happens to
the equilibrium level of real GDP and the price
level if aggregate demand shifts (a) within the
horizontal segment of the Keynesian AS curve;
(b) within the upward-sloping segment of the
Keynesian AS curve; (c) within the vertical
segment of the Keynesian AS curve.
economic
growth
price level
1 Explain what it means for the shape of the
0
a
AD2
inflationary gap
AD1
AD3
potential GDP =
full employment GDP
real GDP
Figure 8.18 Illustrating the neoclassical and Keynesian AD-AS models.
v
Point b in both panels represents a recessionary
(deflationary) gap, which occurs due to low aggregate
demand, given by AD2 in panels (a) and (b). Point c
in both panels represents an inflationary gap, which
arises due to strong aggregate demand, given by AD3.
Finally, economic growth is illustrated in both panels
by the rightward pointing arrows. In panel (a) it is
represented by a rightward shift of the LRAS curve;
in panel (b) by a rightward shift of the Keynesian AS
curve.
Policy implications of the neoclassical and
Keynesian perspectives
The business cycle and government policy
in the neoclassical perspective
In the neoclassical perspective, the economy is
conceived of as a stable system that tends towards
long-run equilibrium where there is full employment,
at the natural rate of unemployment. The system has
a built-in tendency to revert to long-run equilibrium
by itself. This argument has important implications
for the short-run fluctuations of the business cycle and
long-term economic growth.
Since short-term fluctuations (recessionary and
inflationary gaps) are seen to correct themselves
automatically, it follows that there is no need for the
government to do anything to correct them. What
the government must do is ensure that markets work
as competitively as possible, so that all resource and
product prices will be able to rise or fall as required
in order to allow the economy to settle at its point
of long-run equilibrium, which occurs at the level of
potential GDP.
In fact, continues the argument, if governments do
intervene with policies intended to correct short-run
fluctuations of real GDP, they may well achieve the
opposite of the intended results. Rather than reduce
the size of fluctuations, they may actually make them
bigger. Many neoclassical economists believe that
the deviations of real GDP from potential GDP that
we observe in real-world business cycles of many
countries are as large as they are because governments
in the real world do intervene with policies intended
to reduce the fluctuations of the business cycle.
When it comes to promoting economic growth,
aggregate demand cannot affect real GDP in the long
run. If aggregate demand increases, in the long run
it will only give rise to increasing price levels and
inflation. Governments should therefore concentrate
on policies that affect the supply side of the economy,
or policies that attempt to shift the LRAS curve to the
right, thereby aiming to achieve increases in real GDP
without causing inflation. Summarizing:
In the neoclassical perspective, if the government
pursues policies to influence aggregate demand,
in the short run these may intensify the business
cycle (i.e. make inflationary and deflationary gaps
larger); in the long run they will only result in
changes in the price level. What governments should
do, therefore, is (i) encourage competition so that
resource and output prices will respond to the forces
of supply and demand, which will allow the economy
to automatically correct short-run inflationary
and recessionary gaps; and (ii) adopt policies that
influence the supply side of the economy, which shift
the LRAS curve to the right, thereby achieving longrun economic growth.
The business cycle and government policy
in the Keynesian perspective
In the Keynesian perspective, the economy is viewed
as an unstable system because of recurrent shortterm fluctuations that do not have the ability to
automatically correct themselves. Such fluctuations
are seen as arising mainly due to changes in aggregate
demand, or shifts in the AD curve, caused by
spontaneous actions of firms and consumers. Keynes
himself considered fluctuations of the business
cycle to be caused mainly by changes in investment
spending, due to variations in firms’ expectations
about the future. Optimism about the future increases
investment spending, causing a rightward shift
in aggregate demand; pessimism about the future
decreases investment spending, leading to a leftward
shift. Keynes referred to alternating waves of optimism
and pessimism as ‘animal spirits’.
In the Keynesian view, when there is a recessionary
gap, there are many factors preventing the operation
of market forces, and so wages and product prices
do not fall even over extended periods of time. This
means the economy can remain in an equilibrium
position with less than full employment (in
recessionary gaps) for long periods. Therefore there
is an important role for government policy to play in
order to restore full employment and raise real GDP
to its potential GDP level. Government policy should
focus on the demand side of the economy, specifically
on policies that increase aggregate demand when there
is a recessionary gap, and decrease aggregate demand
when there is an inflationary gap; such policies are
essential if the economy is to achieve full employment
and price stability. Policies to influence aggregate
demand are particularly important when aggregate
demand is low. Summarizing:
In the Keynesian perspective, government policies
to influence aggregate demand are imperative in
order to deal with the short-term fluctuations of the
business cycle. Particularly when the economy is in a
less than full employment equilibrium (recessionary
or deflationary gap), government must intervene
with policies that will increase aggregate demand,
as otherwise the economy will remain stuck at low
levels of real GDP and high unemployment over long
periods of time. Efforts should be made to shift the
AD curve to the right, until it intersects the Keynesian
AS curve at full employment real GDP. It is only in the
upward-sloping and vertical portions of the Keynesian
AS curve that further increases in aggregate demand
become inflationary.
The mainstream economic perspective
Our discussion of the two different perspectives has
focused on the disagreement over whether
Chapter 8: Aggregate demand and aggregate supply 247
the economy can move into the long run, the
shape of aggregate supply curves, and their policy
implications. In fact, there are disagreements among
economists that extend beyond just these points.
We will come back to some additional aspects of the
debate in Chapters 9 and 10. Most economists today
are unlikely to be purely ‘neoclassical’ or purely
‘Keynesian’ in their view of the economy. While they
are likely to side more with one or the other of the
two perspectives, many would argue that elements of
both perspectives have some merit, and that policies
attempting to influence both aggregate demand and
aggregate supply are important in achieving the goals
of reducing short-term fluctuations while promoting
economic growth. These points will become clearer in
Questions for
8.1
8.2
8.3
the next chapter, where we will examine a variety of
demand-side and supply-side policies.
Test your understanding 8.8
Explain why (a) use of the LRAS curve to
account for economic growth leads to the policy
implication that governments should focus on
policies that try to influence the supply side of
the economy; (b) use of the Keynesian threesegment aggregate supply curve leads to the
policy implication that governments should
focus on the policies that try to influence the
demand side of the economy.
review
[10 marks] Use a business (trade) cycle diagram
to illustrate the following: (a) the phases of the
cycle; (b) potential GDP, or full employment GDP;
(c) recessionary (deflationary) and inflationary
gaps; (d) the level of output at which
unemployment is at the natural rate of
unemployment.
[10 marks] (a) Define aggregate demand, and
identify and explain each of its components;
(b) Identify some factors that cause changes in
each of the components, causing shifts in the AD
curve.
Keynesian) affect your answers to question 8.3 (a),
(f), (g), (i)?
8.5
[15 marks] Using diagrams and the concepts
of inflationary and recessionary (deflationary)
gaps, show if and how it is possible for the
equilibrium level of real GDP to differ from the
full employment level of real GDP: (a) in the
neoclassical short run; (b) in the long run; (c) in
the Keynesian version of the AD-AS model.
8.6
[10 marks] Using diagrams and the AD-AS model,
explain how each of the following will impact on
the SRAS or LRAS curve of an economy:
[3 marks for each part] Using diagrams and the
neoclassical AD-AS model, explain the impact each
of the following would have on Country A’s shortrun equilibrium price level, real GDP, and level of
unemployment:
(a) a long-lasting improvement in the
technology of production
(b) reduction of bureaucratic procedures that
increase productive efficiency
(c) major educational and retraining
programmes for workers
(a) consumer and business pessimism about the
future of the economy
(d) widespread drought, affecting agricultural
production
(b) a war that restricts supplies of key inputs
(c) a drop in interest rates
(e) a new discovery of oil reserves
(d) a significant rise in stock market values
(f) a war that destroys a significant portion of
the country’s productive capacity.
(e) an increase in wages due to trade union
activities (with the price level constant)
(f) an increase in personal income taxes
8.7
[10 marks] Use the concepts of AD, SRAS and
LRAS to distinguish between short-term economic
fluctuations (the business cycle) and economic
growth.
8.8
[15 marks] Assume that the economy is in
a recessionary (deflationary) gap and there
is unemployment of labour. In the absence
of government intervention, explain what
will happen: (a) in the view of a neoclassical
economist; (b) in the view of a Keynesian
economist.
(g) an increase in defence spending by the
government
(h) a fall in the price of oil (a major resource)
(i) an increase in real GDP in countries that are
major trading partners of Country A
(j) an increase in the value of Country A’s
currency (currency appreciation).
8.4
248
[10 marks] How does the shape of the aggregate
supply curve (whether it is neoclassical or
Part 3: Macroeconomics
Chapter 9
Macroeconomics
Demand-side and
supply-side policies
In this chapter we will use the aggregate demand and aggregate supply (AD-AS) model as the basis for
analysing and evaluating a variety of policy alternatives that can be used by governments to achieve the
macroeconomic objectives of price stability, full employment and economic growth.
OBJECTIVES
After studying this chapter you should be able to:
·
·
·
·
·
·
·
·
·
·
·
·
·
·
explain the objectives of demand-side policies
distinguish between fiscal and monetary policies
analyse the impacts of contractionary and expansionary fiscal and monetary policies on real GDP, the price level
and the level of unemployment
explain the impacts of demand-side policies on economic growth
evaluate (identify strengths and weaknesses of) fiscal and monetary policies
explain the objectives of supply-side policies
distinguish between market-oriented and interventionist supply-side policies
identify a variety of market-oriented supply-side policies
analyse the impacts of market-oriented supply-side policies on real GDP and economic growth, the price level
and unemployment
evaluate (identify strengths and weaknesses of) market-oriented supply-side policies
explain supply-side effects of demand-side policies, and demand-side effects of supply-side policies
define and calculate the multiplier, and explain its impacts on aggregate demand and real GDP (higher level topic)
explain the accelerator theory and multiplier–accelerator interactions (higher level topic)
define and explain the crowding-out effect and its impacts on aggregate demand and real GDP (higher level
topic).
9.1 Demand-side policies: shifts in the
aggregate demand curve
Objectives of demand-side policies
Demand-side policies focus on changing aggregate
demand, or shifting the aggregate demand curve in
the AD-AS model, in order to achieve the goals of price
stability, full employment and economic growth. They
are based on the idea that short-term fluctuations in
real GDP of the business cycle are due to actions of
firms and consumers that affect aggregate demand
and cause inflationary or recessionary (deflationary)
gaps (see Figures 8.8 and 8.15 in Chapter 8, pages 234
and 244). Demand-side policies try to counteract
the effects of these actions and bring aggregate
Chapter 9: Demand-side and supply-side policies 249
demand to the full employment level of real GDP, or
potential GDP. In addition, demand-side policies can
also impact on economic growth by contributing to
increases in potential GDP.
Active and purposeful government intervention in the
economy in order to pursue macroeconomic objectives
is termed discretionary policy, meaning that the
policy is at the discretion (or the choice and will) of
the government authorities. There are two types of
discretionary demand-side policies:
· fiscal policy
· monetary policy.
When discretionary fiscal and monetary policies
attempt to reduce the short-run fluctuations of the
business cycle, they can be called stabilization
policies, because they try to ‘stabilize’ the economy,
or eliminate short-run instabilities caused by sharp
increases and decreases of aggregate demand. If
stabilization policies worked as intended (which they
do only in part, as we will see), the business cycle
would be flattened out, and the economy’s actual
output would be very close to its potential output (see
Figure 8.3(a) in Chapter 8, page 225). In practice, the
most that stabilization can hope to achieve is to lessen
the severities of the business cycle.
Fiscal policy
Background to government finance
Governments have expenditures, involving spending
in many areas such as education, health care,
provision of public goods, etc., which they finance
through tax revenues. If tax revenues are equal to
government expenditures over a specified period
of time (usually a year), the government is said
to have a balanced budget. However, in practice,
the government’s budget is rarely if ever balanced,
as expenditures are usually larger or smaller than
revenues. Governments are therefore likely to have
a budget deficit, in which case expenditures are
larger than tax revenues, or a budget surplus, where
expenditures are smaller than tax revenues. In the
event that a government has a budget deficit, it
finances (pays for) the excess of expenditures over
revenues by borrowing. This is much as in the case of
personal finance: if you spend more than you earn,
it is likely that you finance your extra spending over
your income by borrowing.
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Over time, the government’s accumulation of
deficits minus surpluses is referred to as public
debt, or ‘government debt’. In any given year, if the
government runs a budget deficit, its debt will become
larger; if it runs a budget surplus its debt will become
smaller.
Fiscal policy refers to manipulations by the
government of its own expenditures and taxes in
order to influence the level of aggregate demand. You
may remember from Chapter 8, page 226, that the
components of aggregate demand are consumption
(C), investment (I), government spending (G), and net
exports (X − M). Fiscal policy can affect three of these
four components (see Table 8.1):
· the level of government spending, G, can be
changed as the government alters the level of its
own expenditures
· the level of consumption spending, C, can be
influenced if the government changes taxes levied
on consumers (personal income taxes), thereby
altering their level of disposable income, which is
the income of consumers after income taxes have
been paid
· the level of investment spending, I, can also be
influenced as the government changes taxes levied
on business profits.
Expansionary fiscal policy
Suppose the economy is experiencing a recessionary
gap caused by insufficient aggregate demand. This is
shown in Figures 9.1 (a) and (b), where the aggregate
demand curve AD1 intersects both the SRAS curve
and the Keynesian AS curve at a level of real GDP, Ye,
that is below the full employment (potential output)
level, Yp. Panel (a) is based on the neoclassical version
of the AD-AS model, while panel (b) is based on the
Keynesian version. (The impacts of fiscal policy can
be illustrated equally well by both.) The government’s
objective is to try to increase AD, shifting it from
AD1 to AD2, where the economy will achieve full
employment output, or potential GDP, Yp, thereby
eliminating the recessionary gap. Fiscal policy
undertaken to eliminate a recessionary gap is called
expansionary policy, because it works to expand
aggregate demand and the level of economic activity.
Expansionary fiscal policy may consist of:
·
·
·
·
increasing government spending
decreasing personal income taxes
decreasing business taxes, or
a combination of increasing spending and
decreasing taxes.
(a) Eliminating a deflationary gap (neoclassical AD-AS model).
(b) Eliminating a deflationary gap (Keynesian AD-AS model).
Keynesian AS
SRAS
Pl2
Pl1
price level
price level
LRAS
AD2
Pl2
Pl1
AD1
0
Ye Yp
AD2
AD1
0
real GDP
Ye
potential
output
Yp
real GDP
potential
output
Figure 9.1 Impacts of expansionary policy.
If the government increases its spending, there will
be a direct impact on aggregate demand, which will
increase. If the government decreases taxes, aggregate
demand is affected in a two-step process. In the case
of personal income taxes, a tax cut first leads to a rise
in disposable income, which is then likely to result in
an increase in consumption spending, thus causing
the aggregate demand curve to shift to the right. In
the case of cuts in business taxes, the lower taxes will
cause after-tax business profits to increase, which in
turn is likely to lead to higher investment spending
and therefore increased aggregate demand. In all three
cases, aggregate demand is intended to shift to the
right from AD1 to AD2 in Figures 9.1 (a) and (b), so that
the economy achieves full employment or potential
output Yp.
Finally, the government may decide to pursue a policy
of increasing government spending and lowering taxes
simultaneously. How can it increase its own spending
while keeping taxes constant or even decreasing them?
As explained above, it can do so by borrowing to
finance the excess of spending over tax revenues. If
initially it has a balanced budget, then by increasing
G while keeping taxes constant or lowering them, it
will create a budget deficit. If it already has a budget
deficit at the outset, then the deficit will become
larger. If, on the other hand, it has a budget surplus at
the outset, then the surplus will either become smaller,
or it will shrink until it eventually turns into a deficit.
Note that whether we consider the neoclassical
perspective or the Keynesian perspective, the impact
of the increase in aggregate demand will be to increase
real GDP. However, note that for a given increase in
aggregate demand, the size of the increase in real GDP
will not be the same in the two cases. The increase in
real GDP will be smaller in the neoclassical model
than in the Keynesian one, because of the upwardsloping SRAS curve in the neoclassical model. The
same is not true, however, for the price level. In the
neoclassical perspective, the increase in aggregate
demand will bring forth a rise in the price level,
because of the upward-sloping SRAS curve. In the
Keynesian perspective, the increase in aggregate
demand may result in no increase in the price level
at all if the AD shift occurs entirely within the
horizontal segment of the Keynesian AS curve. If the
AD shift is larger, so that it reaches into the upwardsloping part of the Keynesian AS curve, as shown in
Figure 9.1(b), there will be only a very small increase
in the price level.
Contractionary fiscal policy
Consider now the case where the economy is
experiencing an inflationary gap caused by excessive
aggregate demand, shown in Figures 9.2 (a) and (b)
(page 252): the aggregate demand curve AD1 intersects
the SRAS curve and the Keynesian AS curve at a level of
real GDP, Ye, that is greater than the full employment
or potential output level, Yp. The government’s
objective now is to attempt to lower AD, shifting it
from AD1 to AD2, so that AD2 intersects aggregate
supply at the full employment level of output, Yp,
thereby eliminating the inflationary gap. Fiscal policy
undertaken to eliminate an inflationary gap is called
contractionary policy, because it works to contract
aggregate demand and the level of economic activity.
Contractionary fiscal policy consists of:
·
·
·
·
decreasing government spending
increasing personal income taxes
increasing business taxes, or
a combination of decreasing spending and
increasing taxes.
Chapter 9: Demand-side and supply-side policies 251
(a) Eliminating an inflationary gap (neoclassical AD-AS model).
(b) Eliminating an inflationary gap (Keynesian AD-AS model).
Keynesian AS
SRAS
Pl1
Pl2
0
Ye
Pl1
Pl2
AD2
AD1
AD2
Yp
price level
price level
LRAS
real GDP
0
AD1
Yp Ye real GDP
potential output
potential output
Figure 9.2 Impacts of contractionary policy.
A decrease in government spending has a direct
influence on the aggregate demand curve, causing it
to shift to the left. An increase in personal income
taxes or business taxes is intented to affect aggregate
demand in a two-step process. As personal income
taxes increase, after-tax income falls, causing
consumption spending and aggregate demand to
fall. As taxes on profits increase, after-tax profits fall,
leading businesses to spend less on investment and
causing aggregate demand to fall. In all three cases, the
aggregate demand curve is meant to shift to the left.
The government can also pursue a combination of
decreases in government spending with increases in
personal income and business taxes. Depending on
the initial conditions that prevail in the government’s
budget, such a combination of policies would lead
to the creation of a budget surplus, or the shrinkage
of a budget deficit, or turning a budget deficit into a
surplus.
Fiscal policy involves manipulations by the
government of its own expenditures and taxes in
order to influence aggregate demand. The components
of aggregate demand that can be affected are
government spending (G), and investment (I) and
consumption (C) spending (the latter two through
changes in taxes). Expansionary fiscal policy can be
used when there is a recessionary gap, and aims to
increase aggregate demand, or shift the AD curve
to the right so that it intersects the AS curve at the
full employment level of real GDP (potential GDP).
Contractionary fiscal policy can be used when there
is an inflationary gap, and aims to decrease aggregate
demand, or shift the AD curve to the left so that it
intersects the AS curve at the full employment level
of real GDP (potential GDP).
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Test your understanding 9.1
1 Explain the difference between ‘government
budget deficit’ and ‘government debt’.
2 (a) What are the objectives of fiscal policy?
(b) Distinguish between expansionary and
contractionary fiscal policy. (c) What are the
components of aggregate demand that fiscal
policy can influence?
3 Using diagrams, show how the government can
use fiscal policy when there is (a) a recessionary
gap, (b) an inflationary gap.
4 Using diagrams, show and explain how the
following policies can impact on real GDP, the
price level and unemployment:
(a) the government lowers income taxes
(b) the government decreases its spending on
defence
(c) the government increases taxes on business
profits
(d) the government increases its spending on
the country’s road and highway system.
Monetary policy
Monetary policy is carried out by the central bank
of each country. The central bank is a government
financial institution whose purpose is to control
the supply of money, determine the rate of interest,
oversee the banking system, and carry out monetary
policy. Every country has a central bank. In the
countries of the European Union that have formed the
European Monetary Union (those countries that have
adopted the euro), the responsibility for monetary
policy has been transferred to a single organization,
the European Central Bank. Monetary policy impacts
indirectly on aggregate demand through the rate of
interest. To understand how monetary policy works,
we must first consider how the rate of interest is
determined.
Determination of the rate of interest
When we borrow money, we must make a payment
for the loan in addition to repaying the principal
(the amount of the loan); this payment for a loan is
interest. Interest is usually expressed as a percentage
of the principal to be paid per year; this percentage
is called the rate of interest. For example, let’s say
you borrow $1,000 for one year at the rate of interest
of 10% per year; at the end of the year you must pay
back the principal of $1,000, plus $100 of interest
(calculated as 10% of $1,000).
In the real world there are many different rates of
interest, depending on a number of factors, such as
the level of risk of a loan (the greater the risk, the
higher the interest rate); the length of the period of
time over which the loan must be paid, known as
‘maturity’ (the longer the time period, the lower the
interest rate); the size of the loan (the larger the loan,
the lower the interest rate); the degree of monopoly
power of the lender (the greater the monopoly power,
the higher the interest rate), and others. However,
when economists analyse the rate of interest in the
context of economic models (as we are doing here),
they simplify the analysis by adopting the common
practice of referring to ‘the rate of interest’ as if there
were only one.
We can understand how the rate of interest is
determined very simply as an application of the
familiar concepts of supply and demand in a special
market, the money market, shown in Figure 9.3(a).
The money market is a market where the demand
for money and the supply of money determine the
equilibrium rate of interest. The horizontal axis
measures the quantity of money in the economy, and
the vertical axis measures the rate of interest.
The rate of interest can be thought of as the ‘price’
of money services. The demand for money, Dm,
shows the relationship between the rate of interest
and the quantity of money demanded, and has the
familiar downward-sloping shape of a demand curve.
As the rate of interest falls, the quantity of money
demanded by the public at large (consumers, firms,
the government) increases.
(To understand better why the demand for money is
downward sloping, we must look into what ‘money’ is.
Money provides important services because it allows
consumers, firms and the government to carry out all
their buying and selling exchanges, or their spending.
In addition, money can be used as a form of saving
when it is used to buy bonds. (A bond is a certificate
issued by the government or a firm that promises to
pay interest at various intervals until a certain date
when the money is repaid to the bond holder.) Since
bonds pay interest, this means that the rate of interest
is very important in determining how much money
people want to hold as money, and how much of it
they want to hold in the form of bonds. When people
hold money, they sacrifice the interest they could have
received if they had bought bonds; in other words,
interest is the opportunity cost of holding money. The
higher the interest rate, the greater the opportunity
cost, in terms of sacrificed interest, and therefore
the lower the quantity of money demanded. As the
interest rates falls, the opportunity cost of holding
money decreases, and therefore the quantity of money
demanded rises. This is the explanation behind the
downward-sloping demand for money curve.)
The supply of money is fixed at a level that is decided
upon by the central bank. It appears in Figure 9.3(a) as
a vertical line, Sm, because it does not depend on the
rate of interest. The point of intersection between Dm,
showing the quantity of money demanded, and Sm,
showing the quantity of money supplied, determines
the equilibrium rate of interest, i, as illustrated in
Figure 9.3(a).
Monetary policy is carried out by the central bank,
through changes in the money supply, which
are undertaken in order to influence the rate of
interest. (There are several tools that the central bank
uses to alter the supply of money; a discussion of
these is beyond the scope of this course.) When the
money supply changes, this has the effect of shifting
the Sm curve. Figure 9.3(b) shows how changes in the
money supply affect the equilibrium rate of interest.
Say initially the money supply is at Sm1; with demand
for money Dm, the equilibrium rate of interest is i1. If
the central bank decides to increase the money supply,
the supply of money curve shifts to the right from Sm1
to Sm2, and the equilibrium rate of interest falls to i2. If
on the other hand the central bank decides to decrease
the money supply, the money supply curve shifts to
the left, from Sm1 to Sm3, and the equilibrium rate of
interest rises to i3.
Chapter 9: Demand-side and supply-side policies 253
(a) Equilibrium rate of interest.
(b) Changes in the supply of money cause changes in the
equilibrium rate of interest.
Sm3
rate of interest
rate of interest
Sm
i
Dm
0
Qe
quantity of money
Sm1
Sm2
i3
i1
i2
0
Dm
Q3
Q1 Q2
quantity of money
Figure 9.3 The money market and determination of the rate of interest.
In practice, when the central bank decides to conduct
monetary policy, it can target either the money supply
or the rate of interest; that is, it can make its decision
in terms of changing either the money supply or
the rate of interest. (Of course making a decision on
one automatically determines the other.) Central
banks in many countries used to target the money
supply. However, this presupposed having control
over the money supply in order to be able to target
by how much it should increase or decrease. Growing
difficulties in effectively controlling the supply of
money prompted central banks in many countries
to abandon money supply targeting and switch to
interest rate targeting. Interest rate targeting in effect
means that the central bank decides upon a target
interest rate, and then takes the necessary steps to
adjust the money supply so that the actual equilibrium
interest rate will become equal to the target interest
rate.
Changes in interest rates and aggregate
demand
The point of changing the money supply so as
to change interest rates is to ultimately influence
aggregate demand. If we refer to our discussion
of aggregate demand in Chapter 8, page 228, we
will remember that changes in interest rates affect
two of the four components of aggregate demand:
consumption, C, and investment, I (see Table 8.1).
Since some consumer spending is paid for out of
borrowing, a change in interest rates is intended to
affect the amount of consumer spending (C); similarly,
changes in interest rates affect the amount of
borrowing by businesses to finance their
investment expenditures (I).
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An increase in interest rates is intended to result in
lower consumer and business borrowing and spending
(lower C and I), and therefore a leftward shift in
aggregate demand. A decrease in interest rates is
intended to give rise to greater consumer and business
borrowing and spending (higher C and I), and
therefore a rightward shift in aggregate demand.
Expansionary (easy money) policy
Consider the case where the economy is experiencing
a recessionary gap due to insufficient aggregate
demand, as in Figures 9.1 (a) and (b). The central
bank decides to increase the money supply, causing a
rightward shift in the supply of money curve (from Sm1
to Sm2 as shown in Figure 9.3(b)). With the demand for
money constant, the interest rate falls from i1 to i2.
The drop in the rate of interest means a lower cost
of borrowing, and therefore consumers and firms are
likely to borrow more and spend more. The result
is that consumption spending (C) and investment
spending (I) increase. The effect will be to increase
aggregate demand and cause a rightward shift of the
aggregate demand curve. In fact, investment spending
is more sensitive than consumption spending to
interest rates changes, so that the increase in I is likely
to have a greater impact on aggregate demand than
the increase in C. The increase in aggregate demand
arising from the combined effect of the C and I
increases is shown in Figures 9.1 (a) and (b), where the
recessionary gap has been eliminated through the shift
of the AD curve from AD1 to AD2.
Note that, just as in the case of fiscal policy, whereas
the increase in AD will serve to increase real GDP, the
impact on the price level will be different, and will
be greater according to the neoclassical perspective
compared to the Keynesian perspective.
An increase in the money supply by the central bank
is referred to as an easy money policy; it is also an
expansionary policy, since the objective is to expand
aggregate demand and the level of economic activity.
Contractionary (tight money) policy
Let’s suppose now that the economy is experiencing
an inflationary gap caused by excessive aggregate
demand, as in Figures 9.2 (a) and (b). The central
bank reduces the money supply; this appears in
Figure 9.3(b) as a leftward shift of the Sm curve, from
Sm1 to Sm3. With the demand for money constant, there
results a higher rate of interest, i3. This means a higher
cost of borrowing, and therefore reduced borrowing
by consumers and firms (again, the impact will be
greater in the case of investment spending). The effect
of lower consumer spending (C) and lower investment
spending (I) is to lower aggregate demand, i.e. to shift
the aggregate demand curve to the right. This is shown
in both panels of Figure 9.2, where the inflationary
gap has been eliminated through the shift of aggregate
demand from AD1 to AD2.
A decrease in the money supply by the central
bank is referred to as a tight money policy, or
contractionary policy, as the objective is to contract
aggregate demand and therefore the economy.
Table 9.1 provides a summary of fiscal and monetary
policy measures, their effects on spending, and their
impacts on aggregate demand. The impacts of both
types of policies have been illustrated by use of the
same diagrams (Figures 9.1 and 9.2). Yet this simple
diagrammatical analysis hides important differences
between the two types of policies, related to the
very different channels that affect the spending of
the various aggregate demand components. Fiscal
policy works directly through changes in G, C and I
spending; monetary policy indirectly through changes
in interest rates that affect C and I spending. We will
discover some differences between the two types of
policies in the next section.
Table 9.1 Demand-side policies to correct recessionary
and inflationary gaps.
Expansionary policy (in recession)
Type of
policy
Measures
Effects
Fiscal
policy
increase government spending
increase AD
lower personal income taxes ➞
increase consumption spending
increase AD
lower business taxes ➞
increase investment spending
increase AD
Monetary
policy
increase supply of money ➞
lower interest rate ➞
(i) increase consumption
spending
increase AD
(ii) increase investment
spending
increase AD
Contractionary policy (in inflation)
Monetary policy is carried out by the central bank,
which aims at changing interest rates in order to
influence aggregate demand. The components of
aggregate demand that can be affected are investment
spending (I) and consumption spending (C). If the
economy is experiencing a recessionary gap, the
central bank may pursue an expansionary policy
through lower interest rates to encourage I and C
spending, the objective being to increase aggregate
demand, and shift the AD curve to the right so it
will intersect the AS curve at the full employment
level of real GDP (potential GDP). In the event of
an inflationary gap, the central bank can pursue a
contractionary policy though higher interest rates
aimed at discouraging I and C spending, causing the
AD curve to shift to the left so that it intersects the
AS curve at the full employment level of real GDP
(potential GDP).
Type of
policy
Measures
Effects
Fiscal
policy
decrease government spending
decrease AD
raise personal income taxes ➞
decrease consumption spending
decrease AD
raise business taxes ➞
decrease investment spending
decrease AD
Monetary
policy
decrease supply of money ➞
raise interest rate ➞
(i) decrease consumption
spending
decrease AD
(ii) decrease investment
spending
decrease AD
Chapter 9: Demand-side and supply-side policies 255
Test your understanding 9.2
1 (a) Explain the importance of the money supply
in determining the rate of interest. (b) What is
the government authority that is responsible for
changing the supply of money and carrying out
monetary policy?
2 (a) What are the objectives of monetary policy?
(b) Distinguish between expansionary and
contractionary monetary policy. (c) Why
do you think expansionary monetary policy
is also called an ‘easy money policy’; why is
contractionary monetary policy also known
as a ‘tight money policy’? (d) What are
the components of aggregate demand that
monetary policy can influence? (e) What is the
role of the rate of interest in monetary policy?
3 Using diagrams, show how the government
can use monetary policy when there is (a) a
recessionary gap, (b) an inflationary gap.
4 Using diagrams, show and explain the impact
on real GDP, the price level and unemployment
of the following policies undertaken by a
country’s central bank: (a) a fall in the rate of
interest; (b) an increase in the rate of interest.
Strengths and weaknesses of demand-side
policies for short-term stabilization
The discussion above has focused on illustrating the
expected impacts of demand-side policies intended
to counteract the fluctuations of the business cycle.
However, the complexities of the real world, which
are not reflected in the simple AD-AS model, present a
number of difficulties that often prevent these policies
from achieving the desired and expected impacts. We
now turn to consider the strengths and weaknesses of
fiscal and monetary policies.
output and incomes and high unemployment over
an extended period of time, showed that market
forces acting alone were inadequate to pull the
economy out of the deep recession and restore full
employment and output. In the now classic work
The General Theory of Employment, Interest and Money,
that made its appearance in 1936, John Maynard
Keynes (the originator of ‘Keynesian economics’)
argued that wages and prices were inflexible in
the downward direction even in the face of steep
recession, and that low aggregate demand could
keep the economy stuck in a recessionary gap
indefinitely if the government did not step in with
an active fiscal policy to pull it out. This situation,
as we saw in Chapter 8, Figure 8.15(a), page 244, can
occur when the AD curve intersects the Keynesian
aggregate supply (AS) curve at some point on its
horizontal segment, determining a level of real
GDP that is less than full employment GDP; it is
shown again in Figure 9.1(b) above. The strength
of fiscal policy is to pull an economy out of a
deep recession, or when the economy finds itself
in the horizontal segment of the AS curve. In the
autumn of 2008, fears of a major global recession
prompted governments around the world to pursue
expansionary fiscal policy in the form of increased
government spending, as well as tax cuts, in order to
stimulate low aggregate demand.
· Combating rapid and escalating inflation Inflationary
pressures (to be discussed in Chapter 10) arising
when there is an inflationary gap, can sometimes
get out of hand, resulting in rapid increases in the
price level over relatively short periods of time.
Contractionary fiscal policy may then be used
effectively to help bring the problem under control.
Weaknesses of fiscal policy
· Problems of timing Fiscal policy is subject to a
number of delays in timing called time lags:
❍
Strengths of fiscal policy
· Combating a deep recession Until the Great
Depression of the 1930s, classical economists
believed that short-term economic fluctuations were
self-correcting: in the event of a recession, wage and
price flexibility would work to correct the problem
and the economy would eventually revert to its full
employment equilibrium. (This is very similar to
the thinking of neoclassical economists, discussed
in Chapter 8, page 238, based on the ideas of the
classical economists.) However, the experience of
the Great Depression, which involved low levels of
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Part 3: Macroeconomics
❍
❍
there is a lag until the problem (recessionary or
inflationary gap) is recognized by the government
authorities and economists
there is a lag until the appropriate policy to
deal with the problem is decided upon by the
government
there is a lag until the policy takes effect in the
economy.
Some months may pass in the case of each of these,
and by the time the policy action has taken effect
the problem may have become less or more severe,
so that the policy action is no longer the appropriate
one.
· Problems of inadequate information The government
bases its policy decisions on statistical information
and forecasts about future developments that
are often inaccurate. Inaccuracies may lead to
inappropriate policies.
· Political constraints Government spending and
taxation are subject to numerous pressures that are
unrelated to fiscal policy considerations. Spending
for social services (merit goods such as health care
and education) and public goods is undertaken
for its own sake and cannot easily be cut if a
contractionary policy is required. On the other
hand, tax increases are politically unpopular and
may be avoided by the government even though
they might be necessary. Tax decreases could also be
inappropriately enacted because they are politically
popular. The upshot is that political factors may
sometimes lead to unsuitable fiscal policies.
· Crowding-out effect If the government pursues an
expansionary fiscal policy involving spending
increases in the absence of a corresponding increase
in revenues, it must borrow to make up the excess of
spending over its revenues. Government borrowing
in effect involves an increase in the demand for
money, and leads to an increase in the rate of
interest. A higher interest rate in turn can lead to
lower investment spending by private firms, or
a ‘crowding out’ of investment. This means that
the government’s expansionary fiscal policy is
weakened, since a greater G (government spending)
will be offset by a lower I (investment spending).
(Crowding out is a higher level topic (see page 275).)
• In a recession, tax cuts may not be very effective in
increasing aggregate demand Tax cuts are less effective
in a recession than increases in government
spending because part of the increase in after-tax
income is saved. If the proportion of income saved
rises due to pessimism about the future, the impacts
of tax cuts on aggregate demand will be even
weaker. Increases in government spending are more
powerful because they work in their entirety to
increase aggregate demand.
· Inability to ‘fine tune’ the economy Whereas fiscal
policy can lead the economy in a general direction
of larger or smaller aggregate demand, it cannot
‘fine tune’ the economy, i.e. it cannot be used to
reach a precise target with respect to the level of
output, employment and the price level. If fiscal
policy were successful, it would be possible to use it
to keep the economy’s real GDP at or very close to
its potential output level. However, experience has
shown that this cannot be done, as there are many
factors affecting aggregate demand simultaneously
that the government cannot control.
Strengths of monetary policy
The strengths of monetary policy lie chiefly in it
not being subject to some of the weaknesses of fiscal
policy:
· Relatively quick implementation Monetary policy can
be implemented more quickly than fiscal policy
because it does not have to go through the political
process, which is very cumbersome and time
consuming (though, as we will see below, monetary
policy is also subject to some time lags).
· No political constraints Monetary policy is not
subject to the same kinds of political pressures,
since it does not involve making changes in
the government budget, whether in terms of
government spending that would affect merit and
public goods provision, or government revenues
(taxes). Moreover, the central bank in many
countries, though a government organization, is
independent of the governing political party, and
therefore exercises greater freedom in pursuing
policies that may be politically unpopular (such
as higher interest rates that make borrowing more
costly).
· No crowding-out effect Monetary policy does not
lead to the crowding-out effect, which can result
from higher interest rates due to an expansionary
fiscal policy. The monetary policy counterpart to an
expansionary fiscal policy is an easy money policy,
which leads to lower (not higher) interest rates.
· Better suited to ‘fine tuning’ of the economy in
comparison with fiscal policy The above factors make
monetary policy better suited to ‘fine tuning’ the
economy, as compared to fiscal policy, in that it
may be more accurate with respect to achieving
output, price level and employment objectives.
However, it should be stressed that it is also subject
to limitations, and that there is in fact no policy
tool that economists can use to fully ‘fine tune’ an
economy.
Weaknesses of monetary policy
· Problems of timing Unlike fiscal policy, monetary
policy can be implemented and changed according
to perceived needs relatively quickly, because it does
not depend on the political process. However, like
fiscal policy, it remains subject to time lags (delays),
including a lag until the problem is recognized,
and a lag until the policy takes effect. Changes in
interest rates can take several months to have an
impact on aggregate demand, real output and the
price level. By then, economic conditions may have
changed such that the policy undertaken is no
Chapter 9: Demand-side and supply-side policies 257
longer appropriate. Moreover, if there is pessimism
in the economy, this time lag becomes even longer.
· Problems of inadequate information As in the case of
fiscal policy, the government bases its decisions on
statistical information and forecasts about future
developments that are often inaccurate. Such
inaccuracies may lead to inappropriate policies.
· Possible ineffectiveness in recession Whereas monetary
policy can work effectively when it restricts the
money supply (a tight money policy) to combat
inflation, it is less certain to be as effective in a
deep recession. An easy money (expansionary)
policy is intended to increase aggregate demand
by encouraging investment and consumption
spending through lower interest rates. This process
presupposes that banks will be willing to increase
their lending to firms and consumers, and that
firms and consumers will be willing to increase their
borrowing and their spending. However, in a severe
recession, banks may be unwilling to increase their
lending, because they may fear that the borrowers
might be unable to repay the loans. Moreover, if
firms and consumers are pessimistic about future
economic conditions, they may avoid taking out
new loans, and may even reduce their investment
and consumer spending, in which case aggregate
demand will not increase (it may even decrease),
and monetary policy will be unable to pull the
economy out of recession. This is not something
that happens often; however, it appears to have
occurred during the Great Depression of the 1930s
and some economists believe it occurred in Japan
in the late 1990s and early 2000s. In the autumn
of 2008, many economists expressed the fear that
it might be happening again. There was a concern
that even as interest rates fell (due to expansionary
monetary policy), lending by firms and consumers
might not increase as much as would be desirable
because banks were fearful that many borrowers
might be unable to repay their debts.
Inability of fiscal and monetary policies
to address supply-side causes of economic
contractions
In addition to respective weaknesses noted above,
both fiscal and monetary policies are unable to deal
with a particular combination of undesirable events.
We have seen that demand-side (fiscal and monetary)
policies undertaken for stabilization purposes attempt
to reverse the undesirable shifts in aggregate demand
that cause business cycle fluctuations. As we learned
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Part 3: Macroeconomics
in Chapter 8, page 234, if there is a recessionary
gap caused by a leftward shift in AD, there results
unemployment and a falling price level; these can
be potentially corrected by expansionary fiscal and
monetary policies that shift the AD curve rightward to
the full employment level of real GDP. An inflationary
gap, on the other hand, caused by a rightward
shift in the AD curve, gives rise to more than full
employment and a rising price level (inflation); this
can be potentially corrected by contractionary fiscal
and monetary policies that shift the AD curve leftward
to the full employment level of real GDP.
But what if the economy is experiencing a contraction,
with falling real GDP and a rising price level
simultaneously? This combination of events has been
termed stagflation (combining the words ‘stagnation’
and ‘inflation’), and first made its appearance in
the mid-1970s. We discussed it briefly in Chapter 8,
page 236, where it was illustrated in Figure 8.9(b)
by the leftward shift in the SRAS curve, from SRAS1
to SRAS2. Of the many explanations that have been
put forward to explain stagflation, the most popular
refers to increases in oil prices due to the actions of
OPEC (the Organization of the Petroleum Exporting
Countries), which cut back on its production of
oil, thereby giving rise to increases in the price of
oil, a major input in production. As we know from
Chapter 8, page 232, an increase in the price of a
major input gives rise to a leftward shift in the SRAS
curve, resulting in a lower level of real GDP and a
higher price level (inflation).
Fiscal and monetary policies are unable to resolve
both inflation and unemployment at the same time,
because inflation requires a contractionary policy,
while unemployment that arises in a recession requires
an expansionary policy. A contractionary policy
could address the problem of the rising price level,
but would make the recession worse; an expansionary
policy would help get the economy out of recession,
but would worsen the problem of inflation.
Demand-side policies (fiscal and monetary) are
suited to dealing with macroeconomic instability
that arises from shifts of the aggregate demand
curve. But these policies cannot address instability
arising from leftward aggregate supply curve shifts,
which give rise to both inflation and unemployment
simultaneously.
Fiscal or monetary policy?
Historically, Keynesian economists have tended to
believe that fiscal policy is more effective in achieving
stabilization, while neoclassical economists have
believed that monetary policy is more effective.
Most economists today would adopt a ‘middle of
the road’ perspective, according to which both fiscal
and monetary policies are able to influence aggregate
demand. While some disagreements remain, there
tends to be a convergence on the point that fiscal
and monetary policies should not be viewed as an
either–or choice, but are most effective when used
together in order to complement and reinforce each
other. Most economists believe that because of its
greater speed and flexibility, monetary policy is
better suited to dealing with short-term stabilization
efforts, particularly when there is an inflationary
gap. Fiscal policy, on the other hand, being more
cumbersome, inflexible and subject to political
constraints, should focus on creating a stable fiscal
environment, involving avoidance of very large and
persistent budget deficits or surpluses. In addition,
many economists believe that fiscal policy should be
used to complement monetary policy in the event
of strong economic downturns that may require an
extra helping hand to prevent a serious recession, or
to pull an economy out of a serious recession. In the
autumn of 2008, a number of governments turned
to expansionary fiscal policies to stimulate their
economies as they appeared to be going into recession,
particularly since there were fears that monetary
policy on its own might be unable to give rise to the
necessary increases in aggregate demand.
Test your understanding 9.3
1 Discuss the strengths and weaknesses of fiscal
policy.
2 Discuss the strengths and weaknesses of
monetary policy.
3 Why do decisions on whether or not to
use fiscal policy to stabilize the economy
sometimes depend on more than just economic
considerations?
4 Why do you think in recent decades monetary
policy tends to be preferred over fiscal policy
as a policy tool to correct the fluctuations of
economic activity (the business cycle)? (Refer
to the strengths and weakness of each type of
policy in your answer.)
(...continued)
Test your understanding 9.3
(...continued)
5 Explain why both fiscal and monetary policies
are not very well suited to dealing with
instabilities caused by decreases in aggregate
supply.
Discretionary policy or a monetary rule?
(supplementary material)
A quite different debate concerns the question
whether discretionary fiscal and monetary policies
should be pursued at all by government authorities
for macroeconomic stabilization. Some neoclassical
economists (namely ‘monetarists’) oppose the active
use of such policies, and argue that the weaknesses
of fiscal and monetary policies outlined above (time
lags, lack of sufficient information, crowding out,
etc.) combine to make discretionary policies part
of the cause of economic instability rather than its
cure. Such policies are destabilizing for the economy
and should therefore not be used at all. Demand-side
policies are seen to intensify the business cycle rather
than smooth it out.
In this view, the economy is capable of correcting
short-run instabilities on its own without government
intervention (this was explained in Chapter 8,
pages 238 and 246). Rather than use fiscal policy for
the sake of short-term stabilization, the government
should concentrate on making long-term decisions
about government spending and taxation that reflect
social priorities (such as how much to spend and
how to finance merit and public goods). In the case
of monetary policy, the central bank should avoid
changing the money supply in an effort to influence
interest rates, and should instead adopt a monetary
rule according to which the supply of money will
grow steadily each year at some pre-specified rate.
One possible monetary rule would be to have the
money supply grow at the same rate as the rate of
growth in potential GDP. (The reasoning behind such
a rule will become clear in Chapter 10 when we study
the monetarists’ quantity theory of money.) At the
same time, governments should pursue policies that
increase wage and price flexibility, which will improve
the economy’s self-correcting ability; and they should
also pursue policies that focus on the supply side of
the economy to promote long-term economic growth.
Chapter 9: Demand-side and supply-side policies 259
Economists who favour the use of demand-side
policies for short-term stabilization purposes base their
arguments on the Keynesian tradition of economic
thought, and argue that, left on its own, the economy
does not tend towards full employment equilibrium.
Cyclical fluctuations in real GDP are due to many
possible disturbances to economic activity related
to the behaviour of private sector decision-makers
(summarized in Table 8.1, page 230), which require
government intervention to counteract their impacts
on aggregate demand. Discretionary policies, though
imperfect, play an important role in preventing
large recessionary and inflationary gaps, therefore
smoothing out the business cycle. The adoption of
rules would make the economy more prone to cyclical
fluctuations.
Most economists hold the view that discretionary
demand-side policies are important for maintaining
full employment and price stability. This is the view
also held by most governments around the world
that use monetary and fiscal policies in pursuit of
these economic objectives. There is no country to
date that has tried implementing a monetary rule.
Some countries have tried a kind of monetary policy
based on the adoption of an inflation target, which
involves using monetary policy to try to maintain
the targeted rate of inflation (for example, Australia,
Canada, Finland, Norway, Sweden, Switzerland, the
United Kingdom and others). While this has come
the closest to the idea of a monetary rule, it is not the
same, because the target inflation involves a range of
inflation rates (for example 1%–3%), which means
that the central bank still has some leeway to conduct
discretionary monetary policy, as long as it remains
within the range of permissible (targeted) rates of
inflation.
Moreover, most mainstream economists believe
that demand-side and supply-side policies should be
used in combination in order to promote long-run
economic growth. We will come back to this point
later in this chapter.
Demand-side policies and long-term economic
growth
Demand-side policies focus mainly on short-term
stabilization; however, they can also contribute to
long-term growth of potential GDP. Demand-side
policies can do so indirectly, by providing a stable
macroeconomic environment, and directly, by leading
to aggregate expenditures that result in growth of
potential GDP.
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Part 3: Macroeconomics
Consumers and firms need a stable economic
environment in order to be able to plan and carry out
their economic activities. Firms, in particular, must
make plans in many areas, including what capital
goods to invest in, and whether, how and in what
areas to pursue research and development (R&D) and
technological innovations. Investment is the key to
the formation of new capital goods, and R&D is the
driving force of technological changes, both of which
are very important factors in increasing production
possibilities and increasing potential GDP (shifting the
LRAS curve to the right in the neoclassical context).
In order to be in a position to plan over long periods
of time, firms need economic stability, consisting of
avoidance of sharp economic upturns (inflation) and
downturns (recession and unemployment). Demandside policies aiming at economic stabilization are
therefore important in creating the macroeconomic
environment that encourages activities impacting on
long-term economic growth.
In addition, demand-side policies can impact directly
on the growth of potential GDP:
· They can directly encourage investment through
lower business taxes (fiscal policy) or lower interest
rates (monetary policy), thereby contributing to
new capital formation and R&D that promotes
technological innovations that increase potential
output and long-term economic growth.
· They can direct a portion of government spending
to the development of infrastructure (roads and
transport systems, telecommunications, harbours,
airports, etc.), which increases the quantity of
capital goods; on research and development, which
improves technology; on training and education
programmes that increase the quality of the labour
force and can also help lower the natural rate of
unemployment (we will see how in Chapter 10). All
these factors work to increase potential GDP, thus
supporting long-term economic growth.
In Figure 9.4, suppose an economy is initially in
long-run equilibrium on LRAS1. Suppose then that the
government pursues a variety of demand-side policies,
including increases in government expenditures on
infrastructure, R&D and training and education,
thereby increasing the quantity of capital goods, and
improving the level of technology and the quality of
labour force; or alternatively it lowers interest rates,
giving rise to increases in investment spending and a
greater quantity of capital goods. These demand-side
policies produce increases in aggregate demand, so
that AD shifts from AD1 to AD2. But these policies
also impact on aggregate supply, because of the
increase in the quantity of capital goods, the
improvements in the quality of labour, etc., so that
the LRAS and SRAS curves also shift to the right.
What has happened is that the demand-side policies
initiated a sequence of events that resulted not only in
an increase in aggregate demand, but also in increases
in growth in potential output. In the neoclassical
model, this shows up as a rightward shift of the LRAS
curve, as shown in Figure 9.4; in the Keynesian model,
it is a rightward shift of the Keynesian AS curve (see
Figure 8.17 in Chapter 8, page 245).
price level
LRAS1
LRAS2
SRAS1
SRAS2
Pl1
AD1
0
Y1
AD2
Y2
real GDP
Figure 9.4 Long-run economic growth: shifts in the AD, SRAS and LRAS
curves.
Demand-side policies have not only demand-side
but also supply-side effects, and can therefore affect
long-term economic growth by increasing potential
output. Their contribution to economic growth
includes creating a stable economic environment, as
well as encouraging private investment spending and
government spending, which in turn lead to increases
in potential output (through new capital formation,
increased R&D and technological improvements, and
improvements in the quality of the labour force), and
to reductions in the natural rate of unemployment.
Test your understanding 9.4
Explain how demand-side policies (a) have
supply-side effects; (b) can impact on long-term
economic growth. Use an appropriate diagram
in your answer.
9.2 Supply-side policies: shifts in the
aggregate supply curve
Objectives of supply-side policies
Supply-side policies focus on aggregate supply, and
specifically on factors aimed at directly shifting the
long-run aggregate supply (LRAS) curve to the right,
in order to achieve long-term economic growth. They
do not attempt to stabilize the economy (i.e. to reduce
the severity of the business cycle). There are two major
categories of supply-side policies: market oriented and
interventionist. Market-oriented policies tend to be
favoured by neoclassical economists, who emphasize
the importance of well-functioning competitive
markets in bringing about rightward shifts in the LRAS
curve. Interventionist supply-side policies attempt to
increase aggregate supply by relying on government
intervention rather than the market; these tend to
be favoured by economists influenced by Keynesian
economic thinking.
Market-oriented supply-side policies
In the early 1980s, a number of highly influential
neoclassical economists in the United Kingdom and
the United States began to emphasize the view that
growth in real GDP does not depend on aggregate
demand, but rather on the supply side of the
economy. This view was adopted by the government
headed by Margaret Thatche