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UPDATED TO 2022 SYLLABUS
CAIE A2 LEVEL
ECONOMICS
(9708)
SUMMARIZED NOTES ON THE THEORY SYLLABUS
CAIE A2 LEVEL ECONOMICS (9708)
1. Basic Economic Ideas and
Resource Allocation
1.1. Efficient Resource Allocation
Productive efficiency: when a firm is producing at the
lowest possible cost.
Pareto optimality: where it is impossible to make
someone better off without making someone else worse
off. The PPC shows that one good has to be given up to
produce more of the other. All the points on the graph
are pareto efficient including point Y. A point outside the
curve indicates an increase in resources. Pareto
inefficiency is caused when the resources are not used to
the complete potential. Point X on the graph is pareto
inefficient.
productive efficiency in perfect competition:
Allocative efficiency: where price is equal to marginal
cost; firms are producing those goods and services most
wanted by consumers.
Dynamic efficiency is a form of productive efficiency that
benefits a firm over time. Resources are reallocated in
such a way that output increases relative to the increase
in resources
1.2. Social Costs & Benefits
Social cost/benefit: is total cost/benefit to whole society
due to an economic activity. (Social cost = Private
cost/benefit + External cost/benefit)
Private cost/benefit: is internal cost/benefit of an
economic activity.
External cost/benefit: is 3rd party cost/benefit of an
economic activity.
1.3. Market Failure
Market failure occurs when there is an oversupply or
undersupply of goods. Market failure occurs when:
There are externalities present in the market
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There is provision of merit and demerit goods
There is provision of public and quasi-public goods
Information failure exists
There is adverse selection or moral hazard
There is abuse of monopoly power in the market
1.4. Externalitites
Externality: where the actions of producers or consumers
give rise to side effects on third parties who are not involved
in the action; sometimes referred to as spillover effects
Negative/Positive externality: where the side effects have a
negative/positive impact and impose costs/provide benefits
to third parties.
Negative production externalities: These are spillover
effects that occur as a result of production activity.
Negative consumption externalities: These are created by
consumers as a consequence of their use of products
that result in harm to others who are not involved in the
consumption.
Positive production externalities: These are benefits to
third parties and are created by producers of goods and
services.
Positive consumption externalities: Here, the benefits are
the spillover effects of consumption of a good or service
on others
1.5. Cost-Benefit Analysis
Cost-benefit analysis (CBA): a method for assessing the
desirability of a project taking into account the costs and
benefits involved
Shadow price: one that is applied where there is no
recognised market price available
Step
Advantages
Disadvantages
Identification
All cost/benefit
considered
Identification is
tough
Monetary
evaluation
Most will have market
prices
Shadow prices
Forecast
Future consequences
Uncertainty in
estimation
Interpretation
All info. useful
Bureaucracy
Decision
making
Investment projects
Public expenditure
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CBA adds up the total costs of a program or activity and
compares it against its total benefits. The technique assumes
that a monetary value can be placed on all the costs and
benefits of a program, including tangible and intangible
returns to other people and organizations in addition to
those immediately impacted. As such, a major advantage of
cost-benefit analysis lies in forcing people to explicitly and
systematically consider the various factors which should
influence strategic choice.
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Budget line - the combinations of 2 products obtainable
with income and price
Marginal rate of substitution: is the quantity of one
product an individual is prepared to give up in order to
obtain an additional unit of another leaving the individual
at same utility. It is diminishing.
Indifference curve: this shows the different combinations
of two goods that give a consumer equal satisfaction.
Refer to Equi-marginal principle as well
Indifference curve
Higher curves present at higher consumption.
All curves are downward sloping
Indifference curves cannot cross
Indifference curves are convex to the origin
\n
2. The Price System & The
Micro economy
2.1. Utility
Utility: is the satisfaction gained from consumption of a
product.
Total utility: is the satisfaction gained from the
consumption of all units of a product over a particular
period of time.
Marginal utility: is the satisfaction gained from one more
unit of a product consumed over a particular period of
time.
Note: Consumers purchase products when P ≤ MU
Law of diminishing marginal utility: states that as the
quantity consumed of a product by an individual
increases, marginal utility decreases.
Diminishing marginal utility assumes that consumers
are always rational. However, in some cases like buy 1
get 1 free or when payment can be deferred using
credit card, the consumers may not be rational.
Equi-marginal principle: Consumers maximize their utility
where their marginal valuation for each product
consumed is the same.
MU ∗ A
MU ∗ B
MU ∗ C
=
=
=⋯
P∗A
P∗B
P∗C
​
​
​
2.2. Indifference Curves & Budget Lines
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Substitution/Income effect: is the change in quantity
demanded of a product due to change in relative
price/real income.
The budget line will shift when there is:
A change in the prices of one or both products with
nominal income (budget) remaining the same.
A change in the level of nominal income with the
relative prices of the two products remaining the
same.
The substitution effect is shown on the indifference curve
(IC) I1. The point moves on the curve from E1 To E2 or
vice versa. This causes the budget line to change from B1
to the dotted budget line. The income effect causes point
to move from E2 to E3 causing a shift in IC from I1 to I2.
The table below shows hoe price change affects different
types of goods.
Price effect = Substitution effect + Income effect.
Giffen/Veblen good: are goods whose price and demand
are directly related as they are necessary/luxurious.
CAIE A2 LEVEL ECONOMICS (9708)
PRICE
EFFECTS
Price change
Good
type
Price effect (on
demand)
Demand
change
Fall
Normal
Both effects ↑
Rise
Fall
Inferior
Sub. effect ↑ > In.
effect ↓
Rise
Fall
G/V
Sub. effect ↑ > In.
effect ↓
Fall
Rise
Normal
Both effects ↓
Fall
Rise
Inferior
Sub. effect ↓ > In.
effect ↑
Fall
Rise
G/V
Sub. effect ↓ > In.
effect ↑
Rise
Average fixed cost= total fixed cost / output
Average variable cost= total variable cost / output
Average total cost= total cost / output
Marginal cost= change in cost/change in quantity
2.3. Costs
Production function- this shows the maximum possible
output from the given set of factor inputs.
Marginal product - the in the change output arising from
the use of one or more units of a FOP
The minimum efficient scale (MES) is the balance point at
which a company can produce goods at a competitive
price.The MES is the point on a company's long-run
average cost curve where economies of scale have been
exhausted, and constant returns have begun.
Diminishing returns - where the output from an
additional unit of input leads to a fall in the marginal
product.
Fixed costs - those costs that are independent of output
in the short run so that is a straight line and doesn’t
change with output.
Variable costs - those that vary directly with output; all
costs are variable in the long run so the graph is curved
and changes with output
Total cost= total fixed cost + total variable cost. It starts at
the fixed cost line and follow the variable cost line since it
the combination of both
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Isoquant: is a curve that shows a particular level of output
over a combination of inputs. It is similar to the
indifference curve. Output refers to the total physical
product. The points x, y and z on the graph below shows
the same output.
Costs in the short run
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Supernormal profit- is any profit in excess of normal
profit. It only exists in the short term and only for
monopolies TR>TC
Revenue
Total revenue (TR) = price x quantity
Average revenue (AR)= total revenue / output
Revenue:
Total revenue (TR) = price x quantity
Average revenue (AR)= total revenue / output
Costs in the long run
When TR is maximum, MR is 0
2.5. Economies and diseconomies of
scale
LRAC envelope curve
Increasing returns to scale- where output increases at a
proportionately faster rate than the increase in factor
outputs.
Decreasing returns to scale- Where factor input increase
at a proportionally faster rate than the increase in output
Economies of scale - the benefits gained from falling longrun average costs as the scale of output increases
External economies of scale: cost saving accruals to all
firms in an industry as the scale increases
Diseconomies of Scale - where long-run average cost
increase as the scale of output increases
Economies of scale
Internal
External
Technical
Transport
Financial
Concentration
Managerial
Knowledge
Marketing
Ancillary industries
Purchasing
Specialised labour
Risk-bearing
Reputation
Increased dimensions
In the LRAC envelope curve when the curve is sloping
down there are increasing economies of scale. The lowest
point on the curve has constant economies and as the
curve starts rising there are decreasing economies of
scale present.
Least cost combination:
(MPP factor A) / (P factor A) = (MPP factor B) / (P factor B)
2.4. Profit
There are 3 types of profit:
Normal profit- a cost of production that is just sufficient
for the firm to keep running in the same industry
Subnormal profit- any profit less than the normal profit. If
the problem persists then the firm will leave the industry
and go into one that will make a profit. This is where p<ac
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Economies of scope
Diseconomies of scale
Internal
External
Lack of communication
Competition for inputs
Demotivation
Congestion
Alienation
Pollution
Slack management (Xinefficiency)
Non-flexibility
Labour disputes & turnover
2.6. Types of market structure and their
objectives
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Market Structure - the way in which market is organised
in terms of the number of firms and barriers to the entry
of new firms
MNC- A multinational corporation (MNC) is one that has
business operations in two or more countries.
Industry- group of productive enterprises or
organisations that produce or supply goods, services, or
sources of income.
Barriers to entry- any restriction that prevents new firms
from entering an industry.
Perfect competition an ideal market structure that has
many buyers and sellers, identical or homogeneous
products and no barriers to entry
Monopoly - a pure monopoly is Just 1 firm in an industry
with very high barriers of entry.
Monopolistic competition a market structure where there
are many firms, differentiated product and few barriers
to entry
Oligopoly- a market structure with few firms and high
barriers to entry.
Imperfect competition - any market structure except for
perfect competition.
Types of objectives:
Different objectives of firm
Profit maximisation- gain a lot of profits
Sales revenue maximisation- maximise turnover
Sales maximisation - maximize volume of sales
Satisficing - reasonable level of profit
Loss minimizing
Ethical objectives
The graph above is called the perfect competition model. In
the industry in the short run a new firm enters
2.8. Monopolistic competition
Characteristics:
large no of buyers and sellers
Few barriers to entry and exit
Consumers have a wide choice of differentiated products
Firms have some influence on the market price
2.9. Barriers to entry and pricing
strategy
Barriers to entry:
2.7. Perfect Competition
Perfect competition occurs when all companies sell identical
products, market share does not influence price, companies
are able to enter or exit without barrier, buyers have perfect
or full information, and companies cannot determine prices.
Characteristics:
large no. of buyers and sellers have perfect knowledge
No individual firm has an influence on the market price
products are homogenous on identical
Freedom of entry or exit
All consumers have complete info about the product,
prices, means of production
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Impossible to enter because industry is state ownednatural monopoly
High fixed or setup costs
If a firm is shutting down some costs cannot be
recovered- barriers to exit
Ads and brand name with a high degree of customer
loyalty is difficult to overcome
Economies of scale- lower for large firms
Production process patented by legal company
Some firms may already have monopoly access to raw
materials
Pace of innovation is quick
Firms can hide existence of abnormal profit by limit
pricing
Market conditions
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Pricing strategy:
Limit pricing- where firms will deliberately lower the prices
and abandon a policy maximization to stop new firms from
entering a market.
Predatory pricing: is adopted by monopoly/oligopoly to force
competitions out of market thereby exploit monopoly power
by setting prices well below average cost.
Price leadership- a situation in a market whereby a particular
firm has the power to change prices, the result of which is
that competitors follow this lead.
Diagram A shows the existence of consumer surplus. This
shows that the consumers are willing to pay more than what
is charged by the firm. However, in diagram B, there is no
existence of consumer surplus, this means that the firm
leaves no room for the consumers to be able to pay extra
rather they charge the highest price the consumers are
willing to pay. The two diagrams show how the same firm
charges different prices in 2 different industries to increase
profit. The firm may do this because of different elasticities in
2 markets or the income of the majority of people in different
markets.
2.10. Oligopoly
Characteristics:
Market is dominated by a few firms
Decisions are independent
High barriers to entry
Products may be differentiated
Uncertainty and risks associated with price competition
may lead to price rigidity
Cartel- a formal agreement between oligopoly firms to limit
competition by limiting output or fixing prices. They decide
prices in the industry & long term survival of a cartel depends
upon the high barriers to entry
Threats to a cartel
possibility of a price war - 1 firm breaks rank to gain
higher market share
if some members have higher costs - less profits
no dominant firm that has the power to control others
legal obstacles do not act in the best interest of
consumers.
Non-price competition
physical characteristics
location
service level
advertising
Price discrimination- Price discrimination is when identical or
largely similar goods or services are sold at different prices
by the same provider in different markets.
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Collusion- a non-competitive, secret and sometimes illegal
agreement between rivals which attempts to discreet the
market’s equilibrium.
Kinked demand curve- a means of analysing the behaviour of
firm in oligopoly where there is no collusion.
CAIE A2 LEVEL ECONOMICS (9708)
Positives of monopoly
The logic of the kinked demand curve is based on
A few firms dominate the industry
Firms wish to maximise profits
Impact of price rise
If a firm increases the price, then it becomes more
expensive than rivals and therefore, consumers will
switch to its rivals.
Therefore for a price rise, there is likely to be a significant
fall in demand. Demand is, therefore, price elastic.
In this case, of increasing price firms will lose revenue
because the percentage fall in demand is greater than the
percentage rise in price.
Impact of price cut
If a firm cut its price, it is likely to lead to a different effect.
In the short term, if a firm cuts price it would cause a big
increase in demand and therefore would lead to a rise in
revenue. The firm would gain market share.
However, other firms will not want to see this fall in
market share and so they will respond by also cutting
price to follow the first firm. The net effect is that if all
firms cut price – the individual firm will only see a small
increase in demand.
Because there is a ‘price war’ demand for a firm is price
inelastic – there is a smaller percentage rise in demand.
If demand is inelastic and price falls, then revenue will
fall.
2.11. Monopoly
Characteristics of a monopoly
A single seller
No close substitutes
High barriers to entry
Monopolist is the price maker
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a monopolist cannot at always make abnormal profit
competitive market has uncertainty of profits monopolist can invest this and provide better quality and
job security
investment may take the forms of process innovation.
profit would be used to finance product innovation.
If benefits of economies of scale would be passed on to
consumers then they would have gained from it
X inefficiency - where the typical costs In a competitive
market above those experienced in a more competitive
market. This happens when the firm lacks the incentives to
lower the costs.
Natural monopoly- A natural monopoly is a type of monopoly
that exists typically due to the high start-up costs or powerful
economies of scale of conducting a business in a specific
industry which can result in significant barriers to entry for
potential competitors. This can also be made by government
for example utilities because private firms may exploit the
customers.
Note: Only the monopoly can make abnormal profit in the
short run. A monopoly is the only firm in the market which
means there is one buyer and several sellers who sell to the
monopoly firm. Due to this the monopoly can ask the firms
to reduce the prices therefore increasing profits since the
average cost has reduced. The monopoly firm can also
charge quite high prices to the consumers since the
consumers have no choice but to buy from the monopoly
firm. This increases revenue and therefore profits as well.
2.12. Comparing monopoly with perfect
competition
price in monopoly is higher than it is in perfect
competition
monopoly output is lower
the monopolist is making short term abnormal profits
the firm in perfect competition is productively efficient,
producing the optimum output. It is also allocatively
efficient, producing where price = MC
The monopoly firm captures consumer surplus and turn
it into abnormal profit
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The monopoly firm is productively inefficient, producing
less than the optimum output in the search for extra
profit. The price change is well above marginal cost and
so is not allocatively efficient.
If a perfectly competitive industry was turned into a
monopoly, there would be a welfare loss of area x in
addition to greater allocative inefficiency.
Perfect competition comparison with a profit maximizing
monopoly
Relationship between AR, MR and TR
2.13. Contestable market
Any market structure where there is a threat that potential
entrants are free and able to enter this market
Features of contestable market
free entry
Number and size of firms are irrelevant
only normal profit can be earned in the long run
threat of potential entrants into the market is overriding
all firms are subject to the same regulations and gov.
control.
mechanisms must be in place to prevent the use of unfair
pricing designed by established firms to stop new firms
from entering.
cross subsidisation is eliminated
2.14. Relationship between different
costs and revenues
Profit maximising
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AC and MC relationship
AC can fall, when MC is rising when MC is less than AC. AC
cannot rise, when MC is falling.
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Conglomerate integration- producing in an unrelated
industry
Horizontal integration: where a firm merges or acquires
another in the same line of business.
2.15. Why do small firms exists?
Why so many small firms exist in a world where the power
lies with the monopolies
economic activities where size of market is small to
support large firms
business may involve specialist skills possessed by few
people
where the product is a service- offer customers personal
attention
small firms may be the big firms of tomorrow
There are particular obstacles to the growth of small
firms.
the entrepreneur may not always have expansion as the
objective of firm
recession and rising unemployment can trigger an
increase in start-ups
small businesses may receive financial help.
small businesses are more efficient and competitive
2.16. Why and how firms grow
motives behind firms growth
have reduction in ATC over time through benefits of EOS
achieve higher profits, → boost sales → profits
diversity product range economies of scale
capture resources of another business.
Economies of scope - reduction in ATC made possible by a
firm increasing the different goods it produces
Internal growth - firm decides to retain profits and invest it in
the business for it to grow
External growth- firm expands by joining others through
takeover or mergers
Diversification- where the firm grows through the
production or sale of a wide range of different products
Vertical integration- where a firm grows by producing
backward or forwards in its supply chain.
Vertical forward integration is for producing forward
in the supply chain
Vertical backward integration is for producing
backward in the supply chain
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2.17. Game theory
Prisoner’s dilemma- The prisoner's dilemma is a standard
example of a game analyzed in game theory that shows why
two completely rational individuals might not cooperate,
even if it appears that it is in their best interests to do so.
The prisoner’s dilemma presents a situation where two
parties, separated and unable to communicate, must each
choose between co-operating with the other or not. The
highest reward for each party occurs when both parties
choose to co-operate.
Principal agent problem- a principal hires an agent to own
the business but there is a case of info. failure since the
principal is unable to ensure that the appointed agent is
taking the necessary decisions to run the firm in the best
interests of shareholders. For ex. agent is following objective
of satisficing whereas the principal believes he or she is
implementing policy of profit maximization.
3. Government
Microeconomic Intervention
3.1. Externalities
Deadweight loss: the welfare loss when due to market
failure desirable consumption and production does not
take place. A deadweight loss is a cost to society created
by market inefficiency, which occurs when supply and
demand are out of equilibrium. Mainly used in
economics, deadweight loss can be applied to any
deficiency caused by an inefficient allocation of
resources.
Equality means each individual or group of people is
given the same resources or opportunities.
CAIE A2 LEVEL ECONOMICS (9708)
Efficiency: The term efficiency refers to the peak level of
performance that uses the least amount of inputs to
achieve the highest amount of output. Efficiency requires
reducing the number of unnecessary resources used to
produce a given output, including personal time and
energy.
Equity recognises that each person has different
circumstances and allocates the exact resources and
opportunities needed to reach an equal outcome. The
distribution is fair.
Horizontal and vertical equity: Horizontal equity refers to
the idea that people in the same circumstances should be
treated in the same way. Vertical equity refers to the idea
that people on higher incomes should take on a greater
share of the responsibility for paying for public services.
Nudge theory- proposes positive reinforcement and
indirect suggestions as ways to influence the behavior
and decision-making of groups or individuals. It is
basically encouraging consumers to make rational
decisions or ones in their self-interest. For example,
giving them information about the negative effects of
smoking to encourage them to quit.
Privatization: where there is a change in ownership from
the public to the private sector.
Imposition of indirect tax:
Externality occurs when the marginal social benefits (MSBs)
differ from the marginal private benefits (MPBs); equally, it is
when the MSCs are not equal to the MPCs
Such differences occur in four situations:
negative externalities in production
negative externalities in consumption
positive externalities in production
positive externalities in consumption
Intervention to correct externalities takes many forms
including:
use of indirect taxes
various types of regulation
property rights
provision of information
pollution permits
subsidies
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3.2. Inequality
Lorenz curve: a graphical representation of inequality.
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Gini coefficient: a numerical measure of inequality There are
three main types of policies that are available to reduce
inequality in the distribution of income and wealth. The more
the Lorenz curve shifts towards the equality line the better
Gini coefficient= (area A)/(area A+B)
These are:
1. providing benefits Means-tested benefits: benefits
that are paid only to those whose incomes fall below a
certain level. Poverty trap: where an individual or a
family are better off on means-tested benefits rather
than working. Universal benefits: benefits that are
available to all irrespective of income or wealth.
2. through the tax system Progressive tax: one where
the rate rises more than proportionately to the rise in
income. Regressive tax: one where the ratio of
taxation to income falls as income increases.
3. through other policies. A further way of reducing
inequalities in society is for the government to
provide certain important services free of charge to
the user. The two most significant examples of such
free provision in many economies are health care and
junior and secondary education
Negative income tax: a unified tax and benefits system where
people are taxed or receive benefits according to a single set
of rules. Derived demand: where the demand for a good or
service depends upon the use that can be made from it
3.3. Labour
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Shifts in the long run supply of labour
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Labour demand: Demand for labour is a concept that
describes the amount of demand for labour that an economy
or firm is willing to employ at a given point in time
MRPL: The marginal revenue product of labour (MRPL) is the
change in revenue that results from employing an additional
unit of labour, holding all other inputs constant
Two important features of the workings of labour markets.
These are:
increase the wages of their members
improve working conditions
maintain pay differentials between skilled and unskilled
workers
fight job losses
provide a safe working environment
secure additional working benefits
prevent unfair dismissals
1. the wage paid to labour equals the value of the
marginal product of labour
2. the willingness of labour to supply their services to
the labour market is dependent upon the wage rate
that is being offered
equilibrium in labour market
Increase in demand for labour causes rise in employment
and rise in wages Increase in supply for labour causes rise in
employment and fall in wages
1. Transfer earnings: This is the minimum payment
necessary to keep labour in its present use. For
example, the government will give the unemployed
people benefits so that when there is the need for
that labour, the labour is available.
2. Economic rent: Any payment to labour which is over
and above transfer earnings. This is usually the salary
given to the people.
Monopsony: where there is a single buyer in a market.
3.5. Government failure
Government failure: where government intervention to
correct market failure causes further inefficiencies. There are
three main reasons why government failure may occur.
These are as a result of:
3.4. Trade union and minimum wage
trade unions aim to:
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1. imperfect information There is a lack of information
about the true value of a negative externality. There is
CAIE A2 LEVEL ECONOMICS (9708)
a lack of information about the level of consumer
demand for a product.
2. undesirable incentives The imposition of taxes can
distort incentives. Politicians may be motivated by
political power rather than economic imperatives.
3. policy conflict.
However, it is possible that government intervention
might sometimes increase existing inequality. this is
simply understood by recognising that the imposition
of any tax will have a distributional effect.
Nudge theory: to use encouragement and suggestions to
change people’s behaviour for better.
3.6. Monopsony and labour market
failure
Monopsony
It is the type of market where there is only one buyer and
multiple sellers.
Monopsony power of employers: dingle buyer of a particular
type of labour. They pay relatively lower wages and employ
less people in a competitive labour market.
Trade unions can help the problems caused by monopsonist
but only till some extent. They can negotiate a minimum
wage but their employment can go down too.
Labour market failure
skill gaps- less skills so employees are not quite
productive
geographical immobility- can’t migrate
economic inactivity- education or illness
inequality and discrimination
working poverty- people work but income is less
monopsony power of employers
How to solve labour problems
minimum wage for low paid jobs
legal protection of basic rights
higher trade union membership
enhanced scrutiny of mergers
4. The Macroeconomy
4.1. Economic growth
Economic growth- in the short-run is an increase in a
country's output and in the long run an increase in a
country’s productive potential
Actual economic growth on PPC and AD/AS diagram
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The actual growth on PPC is inside the curve. the points on
the curve show the use of all the resources but in reality not
all the resources are used especially labour so the diagrams
show how there is actual growth.
Potential growth shown on PPC and AD/AS diagram
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More efficient allocation
New export markets
Corporate tax reduction
Upturn in business cycle
Increase in labour force
Labour quality improvement
More research & development
Technological advances
Net investment in capital stock
Capital-intensive production \n
4.2. Trade cycles
Trade cycle- fluctuations in the economic activity over a
period of years
factors contributing to economic growth -increase in quantity
and quality of resources
costs of economic growth- opportunity cost, depletion of
resources, stress and anxiety
Benefits of economic growth- increased goods & services,
rise in employment, increases investment.
The potential growth how much the GDP or how much more
the resources the country could actually allocate.
Economic development- an increase in welfare and the
quality of life
Sustainable development - development that ensures
that the needs of the present generations can be met
without compromising the well being of future
generations.
Output gap- a gap between actual and potential output
Negative output gap- a situation where actual output is
below potential output
positive output gap- a situation where actual output is
above potential output.
4.3. GDP
ways of measuring GDP
output measure- measures the value of output produced
by industries.
income method - Using income of people
expenditure method - the amount people spend
Money GDP = total output measured in current prices
Real GDP - total output measured in constant prices.
Economic growth factors:
Increased mobility & flexibility
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Real GDP = (Money GDP x price index in base year) / price
index in current year.
Shadow economy- the output of goods and services not
included in official national figures
Purchasing power parity- a way of comparing
international living Standards by using an exchange rate
based on the amount of each currency needed to
purchase the same basket goods and services.
CAIE A2 LEVEL ECONOMICS (9708)
Avoid confusing national debt with budget deficit. The former
is built up over time while the latter occurs over the course of
1 year
Kuznets curve- a curve that shows the relationship
between economic growth and income inequality. The
Kuznets curve suggests that as an economy develops,
income becomes more unevenly distributed and then
after a certain income level is reached, income becomes
more evenly distributed. The thinking behind this initial
rise in income inequality is that as an economy develops
there will be a movement of labour from low-paid and
low-skilled agricultural jobs to higher paid and more
skilled manufacturing jobs.
4.4. Poverty cycles and development
traps
poverty cycle- the links between, for example, low income,
low savings, low investment and low productivity.
This also means that developing countries located in the
same region are usually affected by the same types of
problems. The problems of developing countries in subSaharan Africa, may, for example, be quite distinct from
those of developing countries in Asia. A number of
developing economies in Africa, Asia and Latin America
do, however, suffer from poverty cycles, which are also
sometimes referred to as development traps.The term
‘emerging economies’ describes those developing
economies that have high rates of economic growth and
are expected to give high rates of return on investment
while carrying a greater risk than investment in
developed economies.
Developing economies have low income or middle
income. Emerging economies tend to have middle or high
income and developed economies have high income. It
can, however, be misleading as some countries’
economies may be growing while others may be
contracting. It also does not capture all the influences on
development.
If either the proportion of debt service exceeds 80% of
GNI or the value of debt service to exports is 220% of
exports, then the country is considered to be severely
indebted. If either of the two rates exceeds 60% of the
critical level, then the country is said to be moderately
indebted. The presence of debt on such a scale diverts
resources to debt repayment and away from spending on
health and education, infrastructure and poverty relief.
Developing economies typically have a high dependence
on the primary sector. As an economy develops, the
contribution to GDP of the primary sector tends to
decline. The secondary sector becomes the major
contributor and as the economy develops further, the
tertiary sector usually makes the largest contribution to
output.
Developing economies tend to have high rates of
population growth. This is due largely to natural increases
in population size with the birth rate exceeding the death
rate.
Theories:
Development traps - restrictions on the growth of developing
economies that arise from low levels of savings and
investment
Developed economies- high income countries, Mature
markets, high standard of living, high levels of
productivity, economy with low GDP per head.
Developing economies - economy with high GDP per
head.
Emerging economies - economies with a rapid growth
rate and that provide good investment opportunities
Differences between different types of economies:
The differences that exist between them are related to
the geographical area in which the countries are located.
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Malthusian theory - the view that population grows in
progression whereas the quantity of food grows in
arithmetic geometric progression. However, there are
many technological changes made in.
Prebish - Singer hypothesis: a theory that suggests that
tend to move against developing economies so that the
developing economies have to export more to gain the
terms a trade a given quantity of imports.
4.5. Unemployment
The size of a country’s labour force depends upon a wide
range of demographic, economic social and cultural factors,
such as:
the total size of the population of working age
CAIE A2 LEVEL ECONOMICS (9708)
the number of people who remain in full-time education
above the school leaving age
the retirement age
the proportion of women who join the labour force.
Labour productivity: output per worker hour.
Unemployment: the state of being willing and able to
work but without a job.
Full employment: the level of employment corresponding
to where all who wish to work have found jobs, excluding
frictional unemployment.
Natural rate of unemployment: the rate of
unemployment that exists when the aggregate demand
for labour equals the aggregate supply of labour at the
current wage rate and price level.
Frictional unemployment - unemployment that is
temporary and arises where people are in between jobs
Structural unemployment - unemployment caused as a
result of the changing structure of economic activity.
Cyclical unemployment - unemployment that results from
lack aggregate demand
Seasonal unemployment- unemployment that results
from change in seasons therefore changing demand for
the product.
reducing the rate of interest to increase consumer
expenditure and investment
increasing the money supply to, again, increase
consumer expenditure and investment
lowering the exchange rate, either through a formal
devaluation or through intervention in the foreign
exchange market in the case of a managed float, to
increase net exports.
4.6. Circular flow of income
Unemployment on AD/AS diagram
- Injections: additions to the circular flow of income.
Withdrawals: leakages from the circular flow of income.
An open economy is an economy that engages in
international trade. In contrast, a closed economy is one
that does not export or import goods and services.
Open economy: S + T + M = I + G + X
Closed economy: S +T = I + G
Difficulty in calculating unemployment:
Claimant count - a measure of unemployment based on
those claiming unemployment benefits Labour force
survey. a measure of unemployment based upon a
survey that identifies people who are actively seeking a
job.
Ways to correct unemployment:
Reflationary monetary and fiscal policy
The reflationary fiscal measures it may use are:
a reduction in indirect or direct taxation to increase
consumer expenditure
a cut in corporate taxes to stimulate investment
an increase in government spending.
The possible monetary measures include:
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Circular flow in a closed economy:
CAIE A2 LEVEL ECONOMICS (9708)
The consumption function, or Keynesian consumption
function, is an economic formula that represents the
functional relationship between total consumption and gross
national income.
Inflationary gap- the excess of aggregate expenditure ever
potential output (equivalent to a positive output gap).
Deflationary gap- a shortage of aggregate expenditure so
that potential output is not reached (equivalent to a negative
output gap).
In the diagram below, ab is the inflationary gap and vu is the
deflationary gap.
Circular flow in an open economy:
4.7. Multiplier
Multiplier = a numerical the estimate of a change in spending
in relation to final change in spending.
1/1-mpc or 1/mps
1/ mps+mrt- for closed or 3 sector economy
1/ mps+mrt+mpm- for open or 4 sector economy
Marginal propensity to save (mps)- the proportion of
extra income which is saved
Marginal rate of taxation (mrt)- the proportion of extra
income spent on imports
Marginal propensity to import (mpm)- proportion of extra
income spent on imports
Marginal propensity to consume (mpc)- proportion of
income that is spent
Average Propensity to Consume (APC) is the ratio
between total consumption and total income. Marginal
Propensity to Consume (MPC) is the ratio between
additional consumption and additional income.
4.8. Inflationary and deflationary gap
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Impact of a cut in government spending - a)
Impact of an increase in government spending- b)
CAIE A2 LEVEL ECONOMICS (9708)
that inflation is a monetary phenomenon. Keynesians,
however, argue that the equation cannot be turned into a
theory since V and Y can change with a change in the
money supply and so no predictions can be made about
what effect a change in M will have on P.
Types of market failure
Public good
Inequality
Monopoly
Merit good
Factor immobility
Externalities
demerit good
minimizing unemployment
increasing productivity
controlling inflation.
Quantitative easing: a central bank buying government
bonds from the private sector to increase the money supply.
Total currency flow: the current plus capital plus financial
balances of the balance of payments
4.10. Keynesian and Monetarists+
liquidity trap and virtuous cycle
Keynesians: economists who think that government
intervention is needed to achieve full employment.
Keynesian 45 degree diagram
4.9. Investment, money and market
failure
Induced investment investment made in response to
change in income
Autonomous investment: investment that is made
independent of income.
Accelerator theory: a model that suggests investment
depends on the rate of change in income.
Narrow money: money that can be spent directly.
Broad money: money used for spending and saving.
Fisher equation :MV = PY
M = money supply V = velocity P= price level y = output of
economy
The Fisher Effect states that the real interest rate equals
the nominal interest rate minus the expected inflation
rate.
For example, the money supply may initially be US$80
billion, the velocity of circulation 5, price level 100 and
output is 4 billion. If V and Y are unchanged, an increase
in the money supply by 50% to 120 would cause the price
level to also rise by 50% to 150. The monetarist view is
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Monetarists: economists who argue that control of the
money supply is essential to avoid inflation
Precautionary motive: a reason for holding money for
unexpected or unforeseen events.
Active balances: the amount of money held by
households or firms for possible future use.
Speculative motive: a reason for holding money with a
view to make future gains from buying financial assets.
Idle balances: the amount of money held temporarily as
the returns from holding financial assets are too low
CAIE A2 LEVEL ECONOMICS (9708)
Liquidity trap: a situation where interest rates cannot be
reduced anymore in order to stimulate an upturn in
economic activity
maintaining a maximum population size with optimal
standards of living for all people
5. Government Macro
Intervention
5.1. Interconnectedness of Macroeconomic Problems
Virtuous cycle: the links between, for example, an increase in
investment, increase in productivity, increase in income and
increase in saving.
4.11. Living standard comparison
Measurable Economic Welfare(MEW): a composite
measure of living standards that adjusts GDP for factors
that reduce living standards and factors that improve
living standards.
Human Development Index(HDI): a composite measure of
living standards that includes GNI per head, education
and life expectancy.
Multidimensional Poverty Index (MPI): a composite
measure of deprivation in terms of the proportion of
households that lack the requirements for a reasonable
standard of living.
NAIRU: i.e. non-accelerating inflation rate of
unemployment is unemployment rate at macroeconomic
equilibrium which prevents rate of inflation from rising.
Note: NAIRU is shown on expectations augmented Philips
curve/long-run Philips curve/very long-run aggregate
supply curve of new-classical economists.
optimum population: The optimum population is a
concept where the human population is able to balance
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The internal value of money is the value of money when
buying goods and services. This is the real value of money
and it is measured by the purchasing power of money.
Inflation reduces internal value of money.
Exports become dearer and imports cheaper.
Current account deficit occurs if ML-condition met.
Exchange rate falls due to reduced demand and
increased supply of currency.
Fall in unemployment increases AD, thus causes
inflation.
Timbergen’s rule: is that there must be at least one policy
measure for every macroeconomic objective**.**
Refer to AS section 5 for more.
Counter-cyclical fiscal measures are policy measures
which counteract the effects of the economic cycle. For
example, counter-cyclical fiscal policy actions when the
economy is slowing would include increasing government
spending or cutting taxes to help stimulate economic
recovery.
Macroeconomics problems arise when the economy does
not adequately achieve the goals of full employment,
stability, and economic growth this is why
macroeconomic failure occurs.
Macroeconomic conflicts
Economic growth vs Inflation: One macro-economic
conflict can come between economic growth and inflation
(which leads to a similar conflict between unemployment
and inflation). If there is rapid economic growth, it is
more likely that inflationary pressures will increase.
Economic growth vs Balance of payments: When
economic growth is led by consumer spending, it tends to
cause a deficit in the current account. This is because as
consumer spending rises, there will be a rise in import
spending.
Economic growth vs budget deficit: If government wants
to reduce budget deficit this will require higher taxes and
lower spending. However, this tightening of fiscal policy
will lead to a fall in AD and lead to lower economic
growth.
Similarly, if the government wants to boost the rate of
economic growth it could pursue expansionary fiscal
policy (tax cuts/spending rises). This should increase
aggregate demand and help economic growth – but there
will be a side effect, the budget deficit will rise.
CAIE A2 LEVEL ECONOMICS (9708)
5.2. Inflation
Government wants high employment with low inflation
Internal and external value of money: The internal value
of a country’s currency and its external value may be
closely connected. Th e internal value will fall as a result
of inflation. Each unit of the currency will buy less in the
domestic market.
Balance of payment and inflation: if a country’s inflation
rate rises above that of its main competitors, its price
competitiveness will fall. Export revenue will decline while
import expenditure rises and the current account balance
will deteriorate.
Unemployment and inflation:
Phillips curve: a curve that shows the relationship
between the unemployment rate and the inflation rate
over a period of time.
Expectations-augmented Phillips curve: a diagram that
shows that while there may be a trade-off between
unemployment and inflation in the short run, there is no
trade-off in the long run.
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5.3. Tax
Tinbergen’s rule: for every policy aim there must be at
least one policy measure.
Government macroeconomic failure: government
intervention reducing rather than increasing economic
performance.
Counter-cyclically: going against the fluctuations in
economic activity
Laffer curve: a curve showing tax revenue rising at first as
the tax rate is increasing and then falling beyond a
certain rate
CAIE A2 LEVEL
Economics (9708)
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