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Contents
Get the most from this book
5
How to use this book
6
AS LEVEL
Part 1 Basic economic ideas and resource
allocation
1
Introducing economics
Part 2 The price system and the microeconomy
2
3
4
Demand and supply curves
Elasticity
Market equilibrium and the price system
Part 3 Government microeconomic intervention
5
The government in the microeconomy
Part 4 The macroeconomy
6
7
8
9
10
National income
Aggregate demand and aggregate supply analysis
Economic growth
Unemployment
Price stability
7
7
24
24
40
54
73
73
88
88
97
114
125
134
Part 5 Government macroeconomic intervention 146
11
Macroeconomic policy
Part 6 International economic issues
12
13
International trade and protectionism
The balance of payments and exchange rates
146
164
164
182
3
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Contents
A LEVEL
Part 7 The price system and the microeconomy
14
15
16
17
18
19
20
Marginal utility and consumer choice
Efficiency and market failure
Private costs and benefits, externalities and social costs
and benefits
Types of cost, revenue and profit, short-run and long-run
production
Different market structures: perfect competition and
monopoly
Different market structures: monopolistic competition
and oligopoly
The growth and objectives of firms
197
197
208
218
234
256
276
292
Part 8 Government microeconomic intervention 310
21
22
23
Government policies to achieve efficient resource allocation
310
and correct market failure
Equity and redistribution of income and wealth
329
Labour market forces and government intervention
337
Part 9 The macroeconomy
24
25
26
27
The circular flow of income and the multiplier
Economic growth and sustainability
Employment and unemployment
Money and banking
362
362
376
392
407
Part 10 Government macroeconomic intervention 423
28
Macroeconomic policy
Part 11 International economic issues
29
30
31
32
The balance of payments and exchange rates
Economic and human development
Relationships between countries
Globalisation
423
446
446
462
489
503
Glossary 516
Index 527
4
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Get the most from this book
This textbook has been tailored explicitly to cover the Cambridge International AS & A Level Economics syllabus
(9708) for first examination from 2023. The text provides the foundation for studying this qualification, but you
will no doubt wish to keep up to date by referring to additional topical sources of information about economic
events. This can be done by reading serious newspapers, visiting key sites on the internet, and reading magazines
such as Economic Review.
The syllabus is built around key concepts – the essential ideas, theories, principles or mental tools that help
learners to develop a deep understanding of the subject and make links between different topics. An icon
indicates where each key concept is covered.
Scarcity and choice
The fundamental problem in economics is that resources
are scarce and wants are unlimited, so there is always
a choice required between competing uses for the
resources, and an opportunity cost in making this choice.
markets and governments are able to respond to these
changes in different ways depending on the time frame.
Some economic decisions have a time frame element –
trading off a cost in the present for a benefit in the future,
for example.
The margin and decision making
In economic theory, decision making by consumers, firms
and governments is based on choices at the margin – for
example, firms will produce up to the point where the
revenue generated by an extra unit of output is equal to the
cost of producing it. However, economic decision making
can be based on facts, theory, effectiveness, priorities/
objectives and values/ethical judgements.
Efficiency and inefficiency
Individual markets and the economy as a whole can be
both efficient and inefficient in different ways when using
scarce resources.
The role of government and the issues of equality
and equity
There is a trade-off between, on one side, freedom for
firms and individuals in unregulated markets and, on
the other side, greater social equality and equity through
government regulation of individuals and markets.
Equilibrium and disequilibrium
Individual markets and the economy as a whole are
always moving into and out of equilibrium, constantly
altering the allocation of resources.
Progress and development
Economics studies how societies can progress in
measurable money terms and develop in a wider, more
normative sense regarding living standards, inclusivity
and sustainability.
Time
Economic conditions change in different time periods,
such as the short run and the long run. Individuals, firms,
Special features
A LEVEL Economics
★ the distinction between equity and equality
★ the difference between equity and efficiency
★ absolute poverty and relative poverty
★ policies that can be adopted towards equity and inequality
★ the poverty trap
In all countries, there is inequality in the distribution of income and wealth. In this
chapter, we explore ways in which a government can attempt to influence the way
in which resources are allocated among different groups in society, particularly in
response to the presence of poverty.
22.1 Equity and inequality
Regulation, equality and equity
KEY TERMS
inequality: where
different groups within
society receive differing
amounts of income and/
or wealth
equity: where people
in the same situation
receive equal treatment
Some degree of inequality in the distribution of income within a society is inevitable.
Individuals have different innate talents and abilities, and choose to undertake
different types and levels of education and training. This means that they acquire
different sets of skills, which open up different income-earning opportunities.
Inequality also arises because of the pattern of ownership of assets. In other words,
complete equality of income in a society (whereby everyone receives the same amount
of income and wealth) can never be achieved.
Provide another
example of how some
groups receive unequal
treatment compared
with others in your
country.
Bulleted summaries of each topic
can be used as a revision tool.
there are problems in terms of logistical and political problems.
» Transfers from rich to poor households in the form of monetary benefits or
benefits in kind are one of the most important ways of tackling inequality.
» Such benefits can be universal (provided to all) or means tested.
» Proposals have been discussed whereby a guaranteed safety net would be
provided in the form of a universal basic income (UBI) that would be paid to
everyone.
» Pilot schemes have been launched in a number of countries around the world.
» Problems can arise if benefit levels are set so high that individuals have little
incentive to work — this is known as ‘the poverty trap’.
taxation needs to be handled carefully to ensure that the net effect on the
income distribution is as desired.
LEARNING LINK
END-OF-CHAPTER QUESTIONS
End of chapter questions to help
you prepare for examination.
1 Read the following extract and then answer the questions that follow.
Universal basic income: old hat or new fashion?
A separate issue is whether there can be equity in the way that people are treated.
One aspect of this is whether individuals face equal opportunities, and whether
identical people receive identical treatment in economic terms. Many people would
acknowledge that people in identical circumstances and with identical skills, abilities
and experience should receive identical income. There are situations in which such
equal treatment is not achieved. One example is that male and female workers receive
unequal treatment in many societies.
5
The idea of a universal basic income (UBI) is nothing new — the notion has been
around since the sixteenth century. More recently, libertarian economist Milton
Friedman surprisingly endorsed its use through a negative income tax system.
Friedman realised that even if an economy achieves Pareto optimality, a tradeoff might be required between efficiency and equity in policy design.
Other proponents of UBI argue it is the best way to end absolute and relative
poverty: just give everyone money! Some also say it will help society cope with
the coming automation-induced job losses.
SUMMARY: EQUITY AND EQUALITY
In 2017, the Finnish government decided to see what would happen if, in a trial,
10 it chose 2,000 unemployed citizens at random and gave them Ð560 ($635) every
» Inequality in the distribution of income and wealth occurs in all societies.
» This results from differences in talents, abilities and experience, and from
month for 2 years. Participants were assured they would keep receiving the UBI
if they got a job. The trial ended in 2018 and the results are still being debated.
differences in the ownership of assets.
» Equity is where people in the same situation receive equal treatment.
» Equity is also present in societies to some degree.
12
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22
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KEY TERMS
headcount ratio:
a measure of the
percentage of a
country’s population
living below a poverty
line
22 Equity and rEdistribution of incomE and wEalth
International
Poverty Line: an
agreed measure that
defines the absolute
poverty line based on
international prices,
set at PPP$1.90 from
October 2015
persistent poverty:
where a household is
currently in relative
income poverty and
has also been in this
state in at least 2 of the
preceding 3 years
STUDY TIP
This distinction
between absolute
and relative poverty
is an important one.
Absolute poverty
is almost entirely
confined to the less
developed countries,
but relative poverty
can exist in any society,
even in the more
developed nations.
A common way of measuring the poverty rate in a country is to estimate the
percentage of the population living below a poverty line, known as a headcount ratio.
The poverty line in this context is an estimate of the income needed to ensure basic
human survival. People living below this level are perceived to be in absolute poverty.
To enable international comparisons of poverty levels, the World Bank has defined an
International Poverty Line. This is based on 2011 prices, and from October 2015 it was
set at $1.90. The line has to be reset every few years in line with changing prices over
time. The World Bank estimated that around 736 million people worldwide were living
beneath this level in 2015 (down from 1.9 billion in 1990). Some individual countries
also set their own national poverty line to reflect local conditions.
Progress has been made to reduce the number of people living in absolute poverty
on this definition, except in sub-Saharan Africa, where the number continues to rise.
However, there was concern that poverty remained a problem, with people living on
incomes that were not significantly higher than the International Poverty Line.
In October 2018 the World Bank launched additional poverty lines to reflect typical
national poverty lines in lower- and upper-middle-income countries. It was estimated
that in 2015, over a quarter of the world’s population was surviving on less than $2.20
per day, and almost a half on less than $5.50 per day.
Figure 22.1 shows estimates of the poverty headcount ratio for a range of countries
around the world. For most developed economies, the headcount ratio at this level
is zero or close to it. Italy is unusual in appearing on this graph, as relatively few
developed countries have poverty on this measure.
China
Sri Lanka
Italy
Pakistan
Brazil
Indonesia
Bangladesh
Nepal
South Africa
India
Zimbabwe
Tanzania
Zambia
Uzbekistan
Madagascar
Explain why it is
necessary to recalibrate
the poverty line on a
regular basis.
Test yourself 22.3
Calculate the median
adjusted household
disposable income
level for the UK in 2017,
based on the fact that
the UK relative poverty
threshold is 60% of the
median.
10
20
7/9/20 8:04 PM
Case studies to show economic
concepts applied to real-world
situations.
CASE STUDY 3.1

Acommonproblem
Fishing and fisheries have been contentious in many countries. Who should have
the rights to catch fish in international waters? Or should the seas be open to
all? And how about a stretch of inland water such as Lake Victoria, the largest
freshwater lake in Africa, which shares borders with Uganda, Kenya and Tanzania.
30
40
50
60
Follow-upquestions
1 How would you expect a market to evolve if the good has these
characteristics of being non-excludable but rivalrous?
2 Give another example of where this problem could arise.
EXTENSION MATERIAL
Profitmaximisation
The profit-maximising condition can be written as:
wage = marginal revenue × marginal physical product of labour
which is the same as:
marginal revenue = wage ÷ MPP L
Extension points to stretch your
understanding.
Remember that capital input is fixed for the firm in the short run, so the wage
divided by the MPPL is the firm’s cost per unit of output at the margin. This
shows that the profit-maximising condition is the same as that derived for a
profit-maximising firm in Chapter 17: in other words, profit is maximised where
marginal revenue equals marginal cost. This is just another way of looking at the
firm’s decision.
QUANTITATIVE SKILLS 17.2
Table 17.2 provides an arithmetic example to illustrate the relationship between these different aspects of
costs. The firm represented here faces fixed costs of £225 per week. The table shows the costs of production
for up to 6,000 units of the firm’s product per week. Column 3 shows total variable costs of production: you
can see that these rise quite steeply as the volume of production increases. Adding fixed and variable costs
gives the total costs at each output level. This is shown in column 4, which is the sum of columns 2 and 3.
70
80
% of population
Source: based on data from World Development Indicators
▼ Table 17.2Theshort-runrelationshipbetweenoutputandcosts(in£s)
▲ Figure 22.1 Poverty headcount ratio at $1.90 (% of population)
(1)
Output
(000 units
per week)
In Europe (including the UK), estimates of poverty are based on a regular survey
of households conducted in EU member states and some other selected countries.
In 2017, the UK’s threshold for poverty was set at £12,597. This is based on
adjustments for household size and composition. Households with income below
this are described as being in relative income poverty (or being ‘at risk of poverty’);
households that experience this in the current year and at least 2 of the 3 preceding
years are said to be in persistent poverty.
1
2
Figure 22.2 presents some data for a range of European countries in 2017. The
proportion of people below the relative poverty line varies substantially across these
countries, from 11.5% in Finland to 23.6% in Romania.
(2)
Fixed costs
(STFC)
225
225
(3)
Total
variable
costs
(STVC)
85
150
3
225
210
4
225
300
(4)
Total costs
(2) +(3)
(STC)
310
375
(5)
Average
total cost
(4)/(1)
(SATC)
310
187.5
(6)
Marginal
cost
∆(4)/∆(1)
(SMC)
65
60
435
145
525
131.25
175
5
225
475
700
140
395
6
225
870
1,095
182.5
90
(7)
(8)
Average
Average
variable
fixed cost
cost (3)/(1) (2)/(1)
(SAVC)
(SAFC)
85
225
75
112.5
70
75
75
56.25
95
145
Worked examples of quantitative
skills that you will need to
develop.
45
37.5
14
8
310445_22_Cambridge_006-014.indd 8
Page_012.indd 12
Therelationshipbetweenoutputandcosts
0
Test yourself 22.2
Test yourself: short questions
designed to allow you to check your
understanding of key concepts.
treated: for example, through encouraging equal opportunities.
» One approach to tackling inequality is to implement a negative income tax, but
» The balance between (progressive) direct taxation and (regressive) indirect
6
Study tips: short pieces of advice
to help you present your ideas
effectively and avoid potential
pitfalls.
SUMMARY: POLICIES TOWARDS EQUITY AND
INEQUALITY
» Policy towards equity needs to promote fairness in the way that people are
Chapter 5 introduced some key concepts related to inequality in the distribution
of income in a society, and ways in which the degree of inequality can be
measured. It also explained the distinction between income and wealth.
Test yourself 22.1
Key terms: clear, concise
definitions of essential key terms
where they first appear.
Imagine that you are the Minister for Poverty Alleviation in a country in which the
(absolute) poverty line is set at $500. Of the people living below the poverty line,
you know that there are two distinct groups, each made up of 50 individuals. The
people in group 1 have an income of $450, whereas those in group 2 have only
$250. Suppose that your budget for poverty alleviation is $2,500.
a Your prime concern is with the most needy: how would you use your budget?
b Suppose instead that your prime minister instructs you to reduce the
percentage of people living below the poverty line: do you adopt the same
strategy for using the funds?
c How helpful is the poverty line as a strategic target of policy action?
22 EQUITY AND REDISTRIBUTION OF INCOME AND WEALTH
What this chapter covers
Exercises to provide active
engagement with economic
analysis.
EXERCISE 22.1

Equity and redistribution of
income and wealth
22 EQUITY AND REDISTRIBUTION OF INCOME AND WEALTH
Learning links show the
connections between themes
and cross-reference further
treatment of topics.
22
22 Equity and rEdistribution of incomE and wEalth
A statement of the key topics
covered in each chapter.
7/9/20 1:33 PM
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5
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How to use this book
How to use this book
Welcome to economics – or, if you have previously studied this subject, welcome back.
This book is designed to help you learn, revise, test yourself and practise your knowledge and skills application for
the Cambridge International AS & A Level Economics 9708 syllabus for examination from 2023. Any subject or field
of expertise requires a solid theoretical background, and economics is no exception. It is the application of skills
in an unfamiliar context that defines where the static content of a textbook transits into the dynamic world of real
economics.
This textbook offers a clear progression through the topics to support students transitioning from previous study in
economics as well as those studying economics for the first time:
» We start with easing the way into the basic economic ideas – the building blocks of the course, for example the
basic economic problem.
» We then introduce the principles of micro- and macroeconomics, while studying the behaviour of economic
agents and the consequences of government policies.
» The concepts of international trade present the big picture of economic relations between countries in today’s
sometimes turbulent world.
During this journey, the skills acquired and honed will help you to learn, make links and discuss key relationships,
dependencies, causes and effects of the above.
This is underpinned by the seven key concepts introduced on page 5. They are the anchor points of your course and
the tools an economist uses to study the behaviour of individuals, firms and governments, markets and national
economies. Acknowledging the importance and role of these key concepts is a step towards putting together the
different sections of this textbook into a coherent understanding of the principles of economics. The key concepts
resurface in different topics across the textbook and are signposted to flag the relationships to look out for. The icons
act as quick reminders to revisit the concepts and encourage you to take a more holistic approach to the subject.
Going beyond the textbook
As you progress through the course, you will find that there is far more to economics than what fits between the covers
of any textbook. Our Cambridge International AS & A Level Economics Workbook from the same series is available to enhance
your academic experience by providing guidance for developing and applying your skills and knowledge, for example by
using diagrams and practising your quantitative skills, as well as engaging with a variety of multiple-choice, data response
and essay-style questions that follow the order of this textbook.
The series of publications also offers support for teachers – our Cambridge International AS & A Level Economics
Teacher Resource Pack is aimed at both new and experienced teachers to help them deliver a structured and engaging
economics course that encourages students to pursue the subject further and beyond the school classrooms.
This textbook provides the foundation for studying this qualification, but you will no doubt wish to keep up to date
by referring to additional topical sources of information about economic events.
The team of authors wish you a successful and enjoyable journey as you discover the world of economics.
Test yourself, exercises and case studies
Answers to the test yourself questions and commentaries on the exercises and case study questions can be found at:
hoddereducation.com/cambridgeextras
End of chapter questions
The practice questions in this book are designed to help you apply your knowledge and skills learnt throughout this
course. They do not follow the exact formulation in the exam – for example, the number of parts in data response
questions in this book may not always necessarily reflect the number that would appear in an exam.
Guidance for answers to the end of chapter questions is available in our Cambridge International AS & A Level
Economics Teacher Resource Pack.
6
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AS LEVEL PART 1 Basic economic ideas and resource allocation
1
Introducing economics
1 Introducing economics
What this chapter covers
★
★
★
★
★
★
★
the fundamental economic problem
scarcity, choice and opportunity cost
decision making at the margin
basic questions of resource allocation
economics as a social science
positive and normative statements
the importance of the time period
★
★
★
★
★
★
factors of production
the division of labour and specialisation
the role of the entrepreneur
resource allocation in different economic systems
production possibility curves
classification of goods and services: free goods,
private goods, public goods, merit and demerit
goods
Welcome to economics. Many of you opening this book will be meeting economics for
the first time, and you will want to know what is in store for you as you set out to
study the subject. This opening chapter sets the scene by introducing you to some
key ideas and identifying the scope of economic analysis. As you learn more of the
subject, you will find that economics is a way of thinking that will broaden your
perspective on the world around you.
1.1 Scarcity, choice and opportunity cost
KEY TERM
scarcity: a situation that
arises because people
have unlimited wants
in the face of limited
resources
Test yourself 1.1
Thinking of yourself,
give an example of a
‘want’ and a ‘need’.
The fundamental economic problem faced by any society in the world is that of
scarcity. For countries in sub-Saharan Africa or parts of South Asia, it seems obvious
that there is scarcity. However, it is also true of relatively prosperous economies such
as those of Switzerland, the USA and the UK.
It is true in the sense that all societies have finite resources, but people have
unlimited wants. A big claim? Not really. There is no country in the world in which all
wants can be met, and this is clearly true at the global level.
There is a difference between wants and needs. Everyone needs to breathe and to eat,
so air and food are necessary for human life. However, people would like to consume
goods that are not strictly essential to maintain life, such as ice cream or designer
clothes. These are known as wants.
Talking about scarcity in this sense is not the same as talking about poverty. Poverty
might be seen as an extreme form of scarcity, in which individuals lack the basic
necessities of life – whereas even relatively prosperous people face scarcity because
resources are limited.
Scarcity and choice
The key issue that arises from the existence of scarcity is that it forces people, firms
(businesses) and governments to make choices. Each individual must choose which
goods and services to consume. In other words, everyone needs to prioritise the
consumption of whatever commodities they need or would like to have, as they cannot
satisfy all their wants. Firms need to make choices about what to produce, and what
techniques of production to use. At the national level, governments have to make
choices between alternative uses of resources.
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It is this need to choose that underlies the subject matter of economics. Economic
analysis is about analysing those choices made by individual people, firms or
governments.
1
The margin and decision making
KEY TERMS
AS LEVEL PART 1 BASIC ECONOMIC IDEAS AND RESOURCE ALLOCATION
marginal principle:
the idea that
economic agents may
take decisions by
considering the effect of
small changes from the
existing situation
microeconomics: the
study of economic
decisions taken by
individual economic
agents, including
households and firms
macroeconomics:
the study of the
interrelationships
between economic
variables at an
aggregate (economywide) level
LEARNING
LINK
The marginal
approach is explored
more fully in
Chapter 14.
Test yourself 1.2
Give examples of ways
in which government
spends its funds.
The notion of ‘the margin’ is important in much of economic analysis. Decisionmakers – whether they be firms or consumers – are seen to take decisions with
reference to small changes in behaviour. For example, a firm may decide whether
to increase its output by an extra unit by checking whether the additional revenue
that it would receive from selling the extra unit will compensate for the additional
cost of producing it. A consumer may decide whether the extra benefit of consuming
an additional can of cola is worth the price to be paid for it. This is known as the
marginal principle.
You will meet this approach to decision making in a variety of situations as you study
economics. At the heart of much of economic analysis is the notion that economic
agents have clear objectives, and that they take decisions that allow them to do
the best that they can to achieve those objectives. For example, it is often assumed
that consumers set out to gain as much satisfaction from consuming goods and
services as they can. Their decisions can be analysed by looking at small changes from
their current position, seeing whether a small (marginal) change can improve their
satisfaction.
Choices are made at different levels
When we come to explain how choices are made, it is helpful to be aware that choices
are taken by different sets of economic agents, and at different levels. Individuals
(people or households) take decisions about what goods and services to consume,
and about how much labour to supply. Firms (businesses) face choices about what
to produce and how to produce it. Governments need to take decisions about their
spending and taxation policies.
Microeconomics and macroeconomics
Economic thinking is applied in different ways, depending on whether the focus is
on the decisions taken by individual agents in the economy or on the interaction
between economic variables at the level of the whole economy.
Microeconomics deals with individual decisions taken by households or firms, or in
particular markets.
Macroeconomics examines the interactions between economic variables at the level
of the whole economy. For example, it might examine the effect of a change in income
taxes on the level of unemployment, or of the interest rate on total demand and the
rate of inflation.
In some ways the division between the two types of analysis is artificial. The same
sort of economic reasoning is applied in both types, but the focus is different.
EXERCISE 1.1
Think about the following, and see whether you think each represents a
macroeconomic or microeconomic phenomenon.
a The overall level of prices in an economy
b The price of ice cream
c The overall rate of unemployment in an economy
d The unemployment rate among catering workers in Karachi
e The average wage paid to construction workers in Kuala Lumpur
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Opportunity cost
KEY TERM
opportunity cost: in
decision making, the
value of the next-best
alternative forgone
One of the most important concepts in all of economic analysis is the notion of
opportunity cost. When an individual chooses to consume one good, he or she does
so at the cost of the item that would have been next in their list of priorities. For
example, suppose you have enough money in your pocket either for a can of cola or for
a snack from a street vendor. If you choose the cola, the opportunity cost of the cola
is the snack that you could have had instead. In other words, the opportunity cost is
the value of the next-best alternative forgone.
1
1 Introducing economics
EXERCISE 1.2
Abdul has just started his AS courses, and has chosen to take economics,
mathematics and geography, plus either French or English. What is Abdul’s
opportunity cost of choosing French?
This important notion can be applied in many different contexts because whenever
you make a decision, you reject an alternative in favour of your chosen option. You
have chosen to read this book, when instead you could be out with your friends.
▲ Sweet potatoes
Test yourself 1.3
Suppose your school or
college wants to build a
new sports hall. Identify
possible elements of
the opportunity cost of
such a project.
As you move further into studying economics, you will encounter the notion of
opportunity cost again and again. For example, firms take decisions about the sort
of economic activity in which to engage. A farmer with limited land available has to
decide whether to plant onions or sweet potatoes; if they decide to grow onions, they
have to forgo the opportunity to grow sweet potatoes. From the government’s point of
view, if it decides to devote more resources to the provision of healthcare, it will have
fewer resources available for, say, defence.
STUDY TIP
Opportunity cost is a key concept in economics, and will be important in a variety of
contexts. In particular, it captures the way in which economists take decisions, which
may be quite different from how non-economists approach choice. Make sure you
understand it and watch for situations in which it is relevant.
Basic questions of resource allocation
The choices that are made by people, firms and governments influence the way in
which a society allocates its resources, and this is at the heart of the subject matter of
economics. The US economist Paul Samuelson (who won the Nobel Prize for Economic
Sciences in 1970) identified three key questions that economics sets out to investigate:
1 What? What goods and services should be produced in a society from its scarce
resources? In other words, how should resources be allocated among producing
cars, potatoes, banking services and so on?
2 How? How should the productive resources of the economy be used to produce
these various goods and services?
3 For whom? Having produced a range of goods and services, how should these be
allocated among the population for consumption?
EXERCISE 1.3
With which of Samuelson’s three questions (what,
how, for whom) would you associate the following?
a A firm chooses to switch from producing DVDs in
order to increase its output of Blu-ray discs.
b The government reduces the highest rate of
income tax.
c Faced with increased labour costs, a firm
introduces labour-saving machinery.
d There is an increase in social security benefits.
e The owner of a curry house decides to close down
and take a job in a local factory.
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AS LEVEL PART 1 BASIC ECONOMIC IDEAS AND RESOURCE ALLOCATION
1
SUMMARY: SCARCITY, CHOICE AND OPPORTUNITY COST
» The fundamental problem faced by any society is
scarcity, because resources are finite but wants
are unlimited. As a result, choices need to be
made.
» Choices need to be made at all levels (individuals,
households, firms, government).
» Microeconomics deals with individual decisions
made by consumers and producers, whereas
macroeconomics analyses the interactions
between economic variables in the economy as a
whole – but both use similar ways of thinking.
» Each choice has an opportunity cost – the value of
the next-best alternative.
» Economics deals with the questions of what
should be produced, how it should be produced,
and for whom.
1.2 Economic methodology
Economics as a social science
KEY TERM
model: a simplified
representation of reality
used to provide insight
into economic decisions
and events
Economics sets out to tackle some complex issues concerning what is a very complex
real world. This complexity is such that it is essential to simplify reality in some way;
otherwise the task would be overwhelming. Economists therefore work with models.
These are simplified versions of reality that are more straightforward to analyse,
allowing economists to focus on some key aspects of the world.
In evaluating a model, it is always important to examine the assumptions that are
made, and to ask what happens if these assumptions do not hold.
Consumer behaviour
is explored more
fully in Chapter 14;
the objectives of
firms are discussed
in Chapter 20.
The use of models is one way in which economists try to approach their discipline in
a ‘scientific’ manner. Much of economics is about human behaviour. This complicates
matters because humans do not all act in the same way as each other – and may
not even act the same on different days. This makes individual behaviour difficult
to predict or explain. However, when we are dealing with large numbers of people,
we can be reasonably sure about how they will behave on average. A key assumption
made in mainstream economics is that economic agents act rationally. Consumers
take decisions that will bring them as much satisfaction as possible, and firms take
decisions that allow them to make as much profit as possible. The approach taken by
economists justifies the claim that economics is a ‘social science’.
KEY TERMS
Positive and normative statements
positive statement: a
statement about what
is, i.e. about facts
Economics tries to be objective in analysis. However, some of its subject matter
requires careful attention in order to avoid being subjective. In this connection,
it is important to be clear about the difference between positive and normative
statements.
LEARNING
LINK
normative statement:
a statement involving a
value judgement that is
about what ought to be
value judgement: a
statement based on
your opinion or beliefs,
rather than on facts
STUDY TIP
There are some words
that betray normative
statements, such as
‘should’ or ‘ought to’ –
you should watch for
these.
In short, a positive statement is about facts. In contrast, a normative statement is
about what ought to be. Another way of looking at this is that a statement becomes
normative when it involves an opinion or value judgement.
Suppose the government is considering raising the tax on cigarettes. It may
legitimately consult economists to discover what effect a higher tobacco tax will
have on the consumption of cigarettes and on government revenues. This would be a
positive investigation, in that the economists are being asked to use economic analysis
to forecast what will happen when the tax is increased.
A very different situation will arise if the government asks whether it should raise
the tax on cigarettes. This moves the economists beyond positive analysis because it
involves a value judgement – so it is now a normative analysis.
Most of this book is about positive economics. However, you should be aware that
positive analysis is often called upon to inform normative judgements. If the aim of
a policy is to stop people from smoking (which reflects a normative judgement about
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Test yourself 1.4
Is the following a
normative or a positive
statement? ‘The
government ought to
raise unemployment
benefits.’
ceteris paribus: a Latin
phrase meaning ‘other
things being equal’; it is
used in economics when
we focus on changes
in one variable while
holding other influences
constant
Critics of economics often joke that economists always disagree with one another:
for example, it has been said that if you put five economists in a room together,
they will come up with at least six conflicting opinions. However, although
economists may arrive at different value judgements, and thus have differences
when it comes to normative issues, there is much greater agreement when it comes
to positive analysis.
Ceteris paribus
Often models work by allowing them to focus on one thing at a time. A model almost
always begins with assumptions that help economists to simplify their questions.
These assumptions can then be gradually relaxed so that the effect of each one of
them can be observed. In this way, economists can move towards a more complicated
version of reality. A common example is where we want to focus on one particular
aspect of an economic issue or variable, and assume that other things remain
constant. This is captured by the Latin phrase ‘ceteris paribus’.
1
1 Introducing economics
KEY TERM
what ought to happen), then economic analysis may be used to highlight the strengths
and weaknesses of alternative policy measures in a purely positive fashion.
The importance of the time period
LEARNING
LINK
We return to this
issue at the end of
section 1.3.
Notice that the timescale over which decisions are made is important. Firms and
consumers may not be able to adjust their behaviour very much in the short run, as
they may be committed to decisions already made. In the long run, they may be able
to be more flexible – for example, firms can hire more labour and install new capital.
Consumers may need time to adjust to changing market conditions, or to change their
buying habits.
SUMMARY: ECONOMIC METHODOLOGY
» Economists work with models that help to simplify reality.
» Positive statements are about what is, whereas normative statements are
about what ought to be.
» The ceteris paribus assumption helps economists to focus on key issues,
holding other things constant.
» The time period over which decisions are taken has an important influence on
the outcomes.
1.3 Factors of production
People in a society play two quite different roles. On the one hand, they are the
consumers, the ultimate beneficiaries of the process of production. On the other, they
are a key part of the production process in that they are essential in producing goods
and services.
KEY TERM
factors of production:
resources used in the
production process;
inputs into production,
including labour,
capital, land and
enterprise
More generally, it is clear that both human resources and physical resources are required
as part of the production process. These productive resources are known as the
factors of production.
The most obvious human resource is labour. Labour is a key input into production. Of
course, there are many different types of labour, encompassing different skill levels
and working in different ways. Enterprise (or ‘entrepreneurship’) is another human
resource that is seen as increasingly important in the economy. An entrepreneur is
someone who organises production and identifies potentially profitable projects to be
undertaken. Management is also sometimes classified as a human resource, although it
might be seen as a particular form of labour.
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Natural resources are also inputs into the production process. In particular, all
economic activities require some use of land, and most use some raw materials.
An important distinction here is between renewable resources such as forests, and
non-renewable resources such as oil or coal.
1
AS LEVEL PART 1 BASIC ECONOMIC IDEAS AND RESOURCE ALLOCATION
There are also produced resources – inputs that are the product of a previous
manufacturing process. If you like, these can be regarded as a stock of past production
used to aid current production. For example, machines are used in the production
process; they are resources manufactured for the purpose of producing other goods.
These inputs are referred to as fixed capital, which includes things like factory buildings
and transport equipment as well as plant and machinery. Firms also need working
capital, made up of goods that are used up during the production process.
▲ Fixed capital includes machinery
The way in which these inputs are combined in order to produce output is another
important part of the allocation of resources. Firms need to take decisions about the
mix of inputs used in order to produce their output. Such decisions are required in
whatever form of economic activity a firm is engaged.
EXERCISE 1.4
Classify each of the following as human, natural
(renewable or non-renewable) or produced
resources:
a Timber
b Services of a window cleaner
c Natural gas
Test yourself 1.5
Give an example of each
of the four factors of
production.
d Solar energy
e A tractor
f A computer programmer who sets up a company
to market his software
g A computer
Rewards to the factors of production
The factors of production need to be rewarded in return for the services that they
provide.
Labour
When households supply their labour, they do so in return for wages and salaries. The
wage is the reward for the labour services that households supply, for which they must
give up their leisure time.
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Capital
Interest is regarded as the return on the use of capital services. It is the return
that the firm gains from using the capital goods in the production process. In
doing this, the firm forgoes the interest that it could have gained from investing in
a financial asset.
1
Enterprise
Land
In the case of land, it is the rental that constitutes the reward for the use of land in
production.
Division of labour and specialisation
KEY TERM
division of labour
and specialisation: a
process whereby the
production procedure
is broken down into a
sequence of stages, and
workers are assigned to
specialise in particular
stages according to
their skills
STUDY TIP
Notice that a key
difference between
physical and human
capital is that a firm
owns its physical
capital, but cannot own
its workers.
STUDY TIP
Be careful to avoid
confusing ‘production’
(the output of a good)
with ‘productivity’ (the
efficiency with which a
good is produced).
How many workers does it take to make a pin? The eighteenth-century British
economist Adam Smith figured that ten was about the right number. He argued that
when a worker was producing pins on his own, carrying out all the various stages
involved in the production process, the maximum number of pins that could be
produced in one day was 20 – given the technology of his day, of course. This would
imply that ten workers could produce about 200 pins if they worked in the same way as
the lone worker. However, if the pin production process were broken into ten separate
stages, with one worker specialising in each stage, the maximum production for a
day’s work would be a staggering 48,000. This is known as division of labour.
1 Introducing economics
Profit is seen as the reward for enterprise. By recognising income-earning
opportunities for the firm and by taking on the risk, the entrepreneur is able to make
profit for the business.
The division of labour is effective because individual workers become skilled at
performing specialised tasks. By focusing on a particular stage, they can become
highly adept, and thus more efficient, at carrying out that task. In any case, people
are not all the same, so some are better at certain activities. Furthermore, this
specialisation is more efficient because workers do not spend time moving from one
activity to another. Specialisation may also enable firms to operate on a larger scale
of production. You will see later that this may be advantageous.
This can be seen in practice in many businesses today, where there is considerable
specialisation of functions. Workers are hired for particular tasks and activities. You
do not see your star striker putting on the goalkeeper’s jersey at half time because
they fancy a change. Earlier in the chapter, it was argued that ‘labour’ is considered a
factor of production. This idea will now be developed further by arguing that there are
different types of labour, having different skills and functions. The stock of skills and
expertise that contribute to a worker’s productivity is known as human capital. The
amount of output produced per worker is known as labour productivity.
Although we refer to the division of labour, we can extend these arguments to
consider specialisation among firms, or even among nations. For example, consider
car manufacturing. The process of mass producing cars does not all take place within
a single firm. One firm may specialise in producing tyres; another may produce
windscreens; another may focus on assembling the final product. Here again,
specialisation enables efficiency gains to be made.
At national level, specialisation again takes place, simply because some countries
are better equipped to produce some products than others. For example, it would not
make sense for the UK to go into commercial production of pineapples or mangoes.
There are other countries with climatic conditions that are much more suitable for
producing these products. Most Formula 1 racing teams have their headquarters in the
UK, and there are benefits from this specialisation.
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The advantages and disadvantages of specialisation
AS LEVEL PART 1 BASIC ECONOMIC IDEAS AND RESOURCE ALLOCATION
1
Everyone is different. Individuals have different natural talents and abilities that
make them good at different things. Indeed, there are some lucky people who seem to
be good at everything. From society’s point of view, specialisation allows the better
use of limited resources, so that overall the economy can produce more.
However, although there may be many advantages that flow from specialisation,
it is also important to realise that there may be a downside if individuals, firms or
countries overspecialise. If workers spend all of their time on repetitive tasks, they
are likely to get bored, and begin to lose concentration and job satisfaction. In other
words, the tedium of their tasks may lead them to become careless and inefficient.
If a firm focuses on production of a very narrow range of products and then finds
that demand is falling for those products, then it will face difficulties. It may thus be
advisable to maintain some diversity in the output range, in the hope that demand
will not fall for all products simultaneously. Complete specialisation may not always be
the best way for a firm to become successful in the long run.
Test yourself 1.6
Name a possible
disadvantage of
overspecialisation in
production.
Nations may also find problems if they overspecialise. For example, it could be argued
that all nations should retain some agricultural activity for strategic reasons. If a
nation were to be completely dependent on imported foodstuffs, and then became
engaged in a war, this could leave the country in a very vulnerable position. Indeed,
this was one of the motivations for the establishment of what would become the
European Union.
The role of the entrepreneur
Test yourself 1.7
Give one reason why a
household might not
be able to change its
spending behaviour in
the short run.
Enterprise provides dynamism and innovation in an economy, especially within the
sector dominated by small and medium-sized firms. The role of the entrepreneur
in contemporary economies is viewed as being especially important. An effective
entrepreneur is able to identify potential income-earning opportunities for businesses
and is willing to assess and bear the risk involved in embarking on new projects or
start-ups. The entrepreneur is also responsible for organising the other factors of
production in the most efficient and effective way.
Defining time periods
KEY TERMS
short run: the period
over which a firm is free
to vary its input of one
factor of production
(labour), but faces fixed
inputs of the other
factors of production
long run: the period over
which the firm is able to
vary the inputs of all its
factors of production
very long run: the
period over which the
firm is able to vary the
inputs of all its factors
of production and in
which technological
change may occur and
the government policy
environment may alter
The way in which ‘time’ is treated in economics is important. In economic thinking,
time is not seen in terms of a specific period, like a month, year or decade. Instead,
time is important because decisions cannot be taken and implemented immediately.
It takes time for a firm, consumer or government to change behaviour, and for those
changes to take effect.
Think about this from the viewpoint of a firm wanting to expand its production. In
the short run, the firm may not be able to bring in new machinery, or rent more
buildings, but it may be able to hire more workers, or persuade its current workforce to
work longer hours. In other words, in the short run, labour may be flexible, but capital
and other factors of production are likely to be fixed. In the long run, the firm may
also be able to bring more capital into the production process. In the very long run,
the firm may be able to adopt new technologies and adjust to changes in government
policy and the external environment.
LEARNING LINK
The significance of time in affecting firms’ decisions is explored more carefully
in Chapter 17.
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SUMMARY: FACTORS OF PRODUCTION
» The amount of output produced in a period
important in contemporary economies by
identifying income-earning opportunities and
being willing to bear risk.
» Some factors of production are more readily
varied in the short run, underlining the importance
of the timescale of decision making.
1.4 Resource allocation in different economic systems
With so many different individuals and organisations (consumers, firms,
governments) all taking decisions, a major question is how it all comes together.
How are all these separate decisions coordinated so that the overall allocation
of resources in a society is coherent? In other words, how can it be ensured that
firms produce the commodities that consumers wish to consume? And how can the
distribution of these products be organised? These are some of the basic questions
that economics sets out to answer.
LEARNING
LINK
The way in which
prices guide the
allocation of
resources is
explained in Chapter 4;
Chapter 21 discusses
ways in which the
government seeks
to ensure that the
price mechanism
works effectively,
and explains the
importance of
property rights.
KEY TERMS
market economy:
market forces are
allowed to guide the
allocation of resources
within a society
centrally planned
economy: decisions on
resource allocation are
guided by the state
1
1 Introducing economics
depends on the inputs of factors of production:
labour, capital, enterprise and land.
» The factors of production are rewarded by wages
and salaries, interest, profits and rents.
» Adam Smith introduced the notion of division of
labour, which suggests that workers can become
more productive by specialising in stages of the
production process.
» Entrepreneurs are seen as being especially
Market economies
A market economy is one in which market forces are allowed to guide the allocation
of resources within a society. Prices play the key role in this sort of system, providing
signals and incentives to producers and consumers. Consumers express changes in
their preferences by their decisions to buy (or not to buy) at the going price. This is
then a signal to firms, which are able to respond to changes in consumer demand,
given the incentive of profitability, which is related to price.
The government’s role in a free-market economy is limited, but nonetheless
important. The government needs to provide a stable and secure environment in
which markets can work effectively. Households, firms and entrepreneurs need to
have secure ownership rights if they are to face the right incentives to consume,
produce and innovate.
Within such a system, consumers try to maximise the satisfaction they gain from
consuming a range of products, and firms seek to maximise their profits by responding
to consumer demand through the medium of price signals.
Centrally planned economies
In contrast, a centrally planned economy is one in which the government undertakes
the coordination role, planning and directing the allocation of resources. Given
the complexity of modern economies, reliance on central planning poses enormous
decision-making dilemmas. In order to achieve a satisfactory allocation of resources
across the economy, the government needs to make decisions on thousands of
individual matters.
Micromanagement on this sort of scale is costly to implement administratively. The
collapse of the Soviet bloc in the 1990s largely discredited this approach, although
a small number of countries (such as North Korea and Cuba) continue to stick with
central planning. China has moved away from pure central planning by allowing prices
to be used as signals.
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AS LEVEL PART 1 BASIC ECONOMIC IDEAS AND RESOURCE ALLOCATION
1
EXTENSION MATERIAL
An example of decision making under
central planning
An example of the sorts of issues that can arise
under central planning comes from the experience
in Russia after the 1917 revolution. Factories were
given production targets to fit in with the overall
plan for the development of the economy. These
targets then had to be met by the factory managers,
who faced strong incentives to meet those targets.
Factories producing nails were given two sorts
of targets. Some factories were given a target to
produce a certain number of nails, whereas others
were given targets in weight terms. The former
responded by producing large numbers of very small
nails; the latter produced a very small number of
very big nails. Neither was what the planners had in
mind!
Mixed economies
Almost every country in the world now operates a mixed economy system; even a
country such as the USA, where market forces are relatively free, is a mixed economy.
In such a system, prices provide signals to firms and consumers, but the government
intervenes by providing market infrastructure and by influencing the allocation
of resources through imposing taxes and undertaking expenditure and through
regulation. As this course progresses, you will see a variety of ways in which such
intervention takes place, and will come to understand the reasoning that underpins
such intervention – especially in situations where the free market fails to produce the
best possible allocation of resources.
KEY TERMS
mixed economy:
resources are allocated
partly through price
signals and partly on
the basis of direction by
government
transition economies:
countries that moved
from central planning to
being a mixed economy
The extent to which the state intervenes in resource allocation varies across
countries. North Korea is an example of a country that operates in a way that most
resembles a centrally planned economy. The USA is often quoted as an example of an
economy in which the government does intervene in some areas but allows markets
to have a strong influence on how resources are allocated. There is a spectrum of
state involvement, with Cuba tending towards central planning and many European
countries such as the UK and Germany have greater reliance on markets. Countries
such as Russia and China come somewhere in between.
It has been argued that any such state intervention should be market-friendly: in
other words, when governments intervene in the economy, they should do so in a
way that helps markets to work, rather than trying to have the government replace
market forces.
Transition economies
Test yourself 1.8
Name an example of a
mixed economy.
LEARNING
LINK
The role of the
entrepreneur was
explained in the
previous section.
The transition from a centrally planned economy to a mixed economy can be painful.
This was seen in the break-up of the Soviet bloc in the 1990s, when countries in
eastern Europe went through a difficult time both economically and politically, facing
impacts on employment, output and inflation. During the transition period, both
firms and consumers need to become accustomed to the idea that they have increased
freedom to make decisions, and that prices need to adjust and take a more active role
in providing signals and incentives. People and firms need to get used to the idea that
they need to take risk, rather than depending on the state to take decisions for them.
Governments need to move away from trying to micro-manage economic decision
making and allow market forces to take over the coordination role.
The role of entrepreneurs in these transition economies was especially important.
They were the ones who needed to recognise opportunities and be willing to take on
risk. In the process, many of them were able to reap rewards in terms of profit.
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SUMMARY: RESOURCE ALLOCATION IN DIFFERENT ECONOMIC SYSTEMS
» Resource allocation concerns the way in which
a society deploys its productive assets among
alternative uses.
» Alternative choices about resource allocation have
implications for the wellbeing of society.
» Society faces a coordination problem in seeking to
find a good pattern of resource allocation.
» The coordination problem is tackled in different
ways in market, centrally planned and mixed
economies.
production possibility
curve (PPC): a curve
showing the maximum
combinations of goods
or services that can be
produced in a set period
of time given available
resources and the state
of technology
The nature and meaning of a production possibility curve
Economists rely heavily on diagrams to help in their analysis and to interpret their
models. In exploring the notion of opportunity cost, a helpful diagram is the
production possibility curve (PPC ). This shows the maximum combinations of goods
that can be produced with a given set of resources and technology.
First consider a simple example. In Exercise 1.2, Abdul was studying for his AS.
Suppose now that he has got behind with his homework. He has limited time available,
and has five economics questions to answer and five maths exercises to do. An
economics question takes the same time to answer as a maths exercise.
1 Introducing economics
1.5 Production possibility curves
KEY TERM
1
Maths exercises
What are the options? Suppose he knows that in the time available he can tackle
either all of the maths and none of the economics, or all of the economics and none
of the maths. Alternatively, he can try to keep both teachers happy by doing some of
each. Figure 1.1 shows his options.
6
A
5
4
D
C
3
2
E
1
0
B
0
1
2
3
4
5
6
Economics problems
▲ Figure 1.1 The production possibility curve
He can devote all of his efforts to maths, and leave the economics for another day.
He will then be at point A in the figure. Alternatively, he can do all the economics
exercises and no maths, and be at point B. The line joining these two extreme points
shows the intermediate possibilities. For example, at C he does two economics
exercises and three maths problems.
The line shows the maximum combinations that Abdul can tackle – which is why it
is sometimes called a ‘frontier’. There is no way he can manage to be beyond the
frontier (for example, at point D), as he does not have the time (i.e. resources) to
do so. However, he could end up inside the frontier, at a point such as E. This could
happen if he gives up, and squanders his time by watching television; that would be
an inefficient use of his resources – at least in terms of tackling his homework.
Opportunity cost and the PPC
As Abdul moves down the line from left to right in Figure 1.1, he is spending more
time on economics and less on maths. The opportunity cost of tackling an additional
economics question is an additional maths exercise forgone. The PPC in this case
is a straight line because the opportunity cost of tackling an additional economics
question is constant.
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Figure 1.2 shows how the PPC provides information about opportunity cost. Suppose
we have a farmer with 10 hectares of land who is choosing between growing sweet
potatoes and onions. The PPC shows the combinations of the two crops that could be
produced. For example, if the farmer produces 300 tonnes of onions on part of the
land, then 180 tonnes of sweet potatoes could be produced from the remaining land.
In order to increase production of potatoes by 70 tonnes from 180 to 250, 50 tonnes
of onions must be given up. Thus, the opportunity cost of 70 extra tonnes of sweet
potatoes is seen to be 50 tonnes of onions.
Onions (tonnes)
450
400
350
300
250
200
150
100
50
0
PPC
0
100
180
200
250
300
400
500
Sweet potatoes (tonnes)
▲ Figure 1.2 Opportunity cost and the production possibility curve
KEY TERMS
investment:
expenditure undertaken
by firms to add to
the capital stock; an
increase in the capital
stock
consumption:
household spending on
goods and services in
the economy
We can also imagine a production possibility curve for a whole economy, as long
as we are prepared to simplify reality. Assume that an economy produces just two
types of good: capital goods and consumer goods. Capital goods are goods that
are to be used to increase the future capacity of the economy. For example, you
might think of machinery, trucks or factory buildings that will be used to produce
other goods in the future. Expenditure on such goods is known as investment.
In contrast, consumer goods are for present use. They are goods that people
consume, such as apples, televisions and private cars. This sort of expenditure is
known as consumption.
Figure 1.3 illustrates society’s options in a particular period. Given the resources
available, society can produce any combination of capital and consumer goods along
the PPC. Thus, point A represents one possible combination of outputs, in which the
economy produces C1 consumer goods and K1 capital goods.
Capital goods per period
AS LEVEL PART 1 BASIC ECONOMIC IDEAS AND RESOURCE ALLOCATION
1
B
A
K1
C
PPC
0
C1
Consumer goods per period
▲ Figure 1.3 Capital and consumer goods
As with the simpler examples, if society were to move to the right along the PPC,
it would produce more consumer goods – but at the expense of capital goods. So,
the opportunity cost of producing consumer goods is measured in terms of forgone
opportunities to produce capital goods.
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The shape of the PPC: constant and increasing
opportunity costs
LEARNING
LINK
The significance of a position within a PPC
It is now possible to interpret points B and C. Point B is unreachable given present
resources and technology, so the economy cannot produce that combination of goods.
This applies to any point outside the PPC. On the other hand, at point C society is
not using its resources efficiently. In this position there is unemployment of some
resources in the economy. By making better use of the resources available, the
economy can move towards the frontier, reducing unemployment in the process.
1
1 Introducing economics
In some
circumstances, a
country may be able
to consume beyond
its PPC by engaging in
international trade.
This is explained in
Chapter 12. Chapter
15 discusses what is
meant by ‘efficiency’
in economic analysis.
Notice that the PPC has been drawn as a curve instead of a straight line. This is
because not all factors of production are equally suited to the production of both
sorts of good. When the economy is well balanced, as at A, the factors can be
allocated to the uses for which they are best equipped. However, as the economy
moves towards complete specialisation in one of the types of good, factors are no
longer being best used, and the opportunity cost changes. For example, if nearly all
of the workers are engaged in producing consumer goods, it becomes more difficult
to produce still more of these, whereas those workers producing machinery find they
have too few resources with which to work. In other words, the more consumer goods
are being produced, the higher is their opportunity cost.
The causes and consequences of shifts in a PPC
Capital goods per period
Figure 1.3 focused on a single period. However, if the economy is producing capital
goods, then in the following period its capacity to produce should increase, as it will
have more resources available for production. How can this be shown on the diagram?
An expansion in the available inputs suggests that in the next period the economy
should be able to produce more of both goods. This is shown in Figure 1.4.
PPC1
PPC0
Consumer goods per period
KEY TERM
▲ Figure 1.4 Economic growth
potential economic
growth: an expansion in
the productive capacity
of the economy
Suppose that in one year the production possibility curve was at PPC0. However, in
the following year the increased availability of resources enables greater production,
and the frontier moves to PPC1. This is a process of potential economic growth, an
expansion of the economy’s productive capacity through the increased availability of
inputs. Notice that the decision to produce more capital goods today means that fewer
consumer goods will be produced today. People must choose between consuming more
now or having more to consume in the future.
LEARNING
LINK
The meaning and
importance of
economic growth is
explored in Chapters 8
and 25.
The PPC need not always shift in parallel to the original curve. If there is an
improvement in technology that favours the production of only one of the goods,
then the slope of the PPC would change as it shifts. For example, in Figure 1.5, an
improvement in the technology used to produce consumer goods allows more consumer
goods to be produced, and the production possibility curve shifts from PPC0 to PPC1.
The opportunity cost of producing consumer goods in terms of capital goods has
changed, and this is reflected in the change in the slope of the PPC.
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Suppose that a firm
devises a new and
more cost-effective
production method.
How would this affect
the PPC?
0
PPC0
PPC1
Consumer goods per period
▲ Figure 1.5 A change in production technology
Similarly, if there is a reduction in the resources available – for example, if a key
natural resource is exhausted or becomes unavailable – then the PPC will shift inwards.
EXERCISE 1.5
Bijal has been cast away on a desert island, and has to
survive by spending her time either fishing or climbing
trees to get coconuts. The PPC in Figure 1.6 shows the
maximum combinations of fish and coconuts that she
can gather during a day. Which of the points A to E
represents each of the following?
a A situation where Bijal spends all her time fishing
b An unreachable position
c A day when Bijal goes for a balanced diet – a
mixture of coconuts and fish
d A day when Bijal does not fancy fish, and spends
all day collecting coconuts
e A day when Bijal spends some of the time trying
to attract the attention of a passing ship
Coconuts per day
AS LEVEL PART 1 BASIC ECONOMIC IDEAS AND RESOURCE ALLOCATION
Test yourself 1.9
Capital goods per period
1
A
E
B
D
PPC
C
0
Fish per day
▲ Figure 1.6 Fish and coconuts
SUMMARY: PRODUCTION POSSIBILITY CURVES
» The production possibility curve shows the
maximum combinations of goods or services
that can be produced in a period by a given set
of resources.
» At any point on the PPC, society is making full use
of all resources.
» At any point inside the PPC, there is unemployment
of some resources.
KEY TERMS
private (or economic)
goods: goods that are
scarce
free goods: goods
such as the earth’s
atmosphere that are not
normally regarded as
being scarce
» Points beyond the PPC are unattainable.
» In a simple society producing two goods (consumer
goods and capital goods), the choice is between
consumption today and investment for the future.
» As society increases its stock of capital goods, the
productive capacity of the economy increases, and
the production possibility curve moves outwards:
this may be termed ‘potential economic growth’.
1.6 Classification of goods and services
Free goods and private goods
Goods which are scarce are known as private goods (sometimes known as economic
goods). Most goods fall into this category. However, there are also some goods that
may be regarded as free goods. An example might be the earth’s atmosphere, which
would not normally be regarded as being scarce.
The three features that characterise a private good are:
» other people can be excluded from consuming it
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» once consumed by one person, it cannot be consumed by another
» a person need not choose to consume it.
1
You buy a can of cola, you drink it, and it’s gone. You may choose to share it with a
friend, but you do not have to: by drinking it you can prevent anyone else from doing so.
Furthermore, once it is gone, it’s gone: nobody else can subsequently consume that cola.
KEY TERMS
Public goods
public good: a good
that is non-exclusive,
non-rivalrous and nonrejectable – consumers
cannot be excluded from
consuming the good,
consumption by one
person does not affect
the amount of the good
available for others to
consume, and once it
is provided to all, no
individual can reject it
Examples of public goods that are often cited include street lighting, a lighthouse and
a nuclear deterrent. For example, once street lighting has been provided in a particular
street, anyone who walks along that street at night benefits from the lighting – no one
can be excluded from consuming it. So street lighting is non-exclusive. In addition, the
fact that one person has walked along the street does not mean that there is less street
lighting left for later walkers. So street lighting is also non-rivalrous. Furthermore, one
person walking along the street cannot avoid being lit.
free-rider problem:
when an individual
cannot be excluded from
consuming a good, and
thus has no incentive to
pay for its provision
merit good: a good that
brings unanticipated
benefits to consumers,
such that society
believes it will be
underconsumed in a
free market
STUDY TIP
Do not confuse the
idea of ‘public goods’
with publicly provided
goods. For example,
in common usage, we
may refer to ‘public
education’ and ‘public
healthcare’. However,
these are not public
goods: they are merit
goods because the
government believes
that they will be
undervalued (and
underconsumed) by
individuals.
1 Introducing economics
The first feature can be described as excludability, whereas the second feature might
be described by saying that consumption of a private good is rivalrous: the act of
consumption uses up the good. The third feature means that the good is rejectable: if
an individual does not wish to consume the good, they do not have to do so.
Not all goods and services have the characteristics of a private good. There are goods
that, once provided, are available to all. In other words, people cannot be excluded from
consuming such goods. There are other goods that do not diminish through consumption,
so they are non-rivalrous in consumption. Goods that have the characteristics of nonexcludability, non-rivalry and non-rejectability are known as public goods.
Once the good has been provided, there is no incentive for anyone to pay for it – so the
market will fail, as no firm will have an incentive to supply the good in the first place.
This is often referred to as the free-rider problem, as individual consumers can freeride and avoid having to pay for the good if it is provided.
Roads are sometimes seen as examples of public goods, but it could be argued that rivalry
is involved when roads become congested. In many cases roads are non-excludable,
except where it is feasible to impose tolls. However, the rivalry aspect suggests that
roads cannot be considered to be pure public goods, as they do not have all the
characteristics of public goods. Instead they may be described as semi-public goods.
Merit goods
There are some goods that the government believes will be undervalued by consumers,
so that too little will be consumed in a free market. In other words, individuals do not
fully perceive the benefits that they will gain from consuming such goods. These are
known as merit goods.
One situation in which the merit good phenomenon arises is where the government
is in a better position than individuals to take a long-term view of what is good for
society. In particular, governments may need to take decisions on behalf of future
generations as well as the present. Resources need to be used wisely in the present
in order to protect the interests of tomorrow’s citizens. Notice that this may require
decision-makers to make normative judgements about the appropriate weighting to be
given to the present as opposed to the future.
Underpinning the idea of a merit good is that the government has better
information about the good than consumers, so needs to take decisions on their
behalf. For example, if parents do not have full information about the benefits of
education for their children, they may make poor decisions about their schooling.
The authorities may then see that they should intervene and take decisions on
behalf of the population, for example by imposing a minimum school-leaving age.
Otherwise, education may be under-consumed.
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AS LEVEL PART 1 BASIC ECONOMIC IDEAS AND RESOURCE ALLOCATION
1
Demerit goods
KEY TERM
demerit good: a good
that brings less benefit
to consumers than they
expect, such that too
much will be consumed
by individuals in a free
market
LEARNING
LINKS
Public, merit and
demerit goods (and
how to deal with
them) are discussed
further in Chapter 5.
The idea of
information failure is
explored more fully
in Chapters 5 and 21.
Test yourself 1.10
Give an example each
of public goods, merit
goods and demerit
goods.
There is also a category of goods that governments think will be overconsumed in
a free market. These are known as demerit goods – or sometimes as ‘merit bads’.
Obvious examples are hard drugs and tobacco. Here the argument is that individual
consumers overvalue the benefits from consuming such a good. Again, the root cause
of demerit goods is an information failure.
SUMMARY: CLASSIFICATION OF GOODS AND SERVICES
» Most goods are economic goods because they are scarce, but there are also
some free goods.
» Public goods are non-exclusive, non-rivalrous and non-rejectable.
» A merit good is one that brings unanticipated benefits to consumers, such that
society believes it will be underconsumed in a free market.
» A demerit good is one that brings less benefit to consumers than they expect,
such that too much will be consumed by individuals in a free market.
END OF CHAPTER QUESTIONS
Multiple choice
1 The basic economic problem causes individuals, firms and governments to:
A use up resources more intensively
B make choices
C act irrationally
D increase their wants
2 What distinguishes human capital from physical capital?
A Human capital yields a more variable reward than physical capital.
B Human capital brings more economic value to the firm.
C The use of human capital in the production process does not involve a transfer
of title on the resource.
D Human capital plays a more important role in mixed than in planned economies.
Data response
1 Read the following extract and then answer the questions that follow.
Resource allocation and the factors of production
In a mixed economy such as that of the USA, it is the interaction of demand from
consumers and supply from firms that predominantly allocates resources through
the price mechanism.
A centrally planned economy is one in which the state controls the allocation
of resources and the distribution of goods and services. Countries such as
North Korea employ this approach to their resource allocation.
Those who support a planned economic system argue its superiority derives
from the idea that ‘planning makes life fairer for everybody’. Moreover, they
argue the pure market mechanism will face difficulties with the production
and consumption of merit, demerit and public goods.
Within any firm in any economic system, specialisation is evident when
each worker performs specific tasks within an overall production process.
Specialisation is likely to require additional training of the workforce.
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%5
1
4
3
2
1
0
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: CEIC Data
▲ Figure 1.7 US labour productivity growth, 2010–19
a Labour productivity is a measure of output per worker. With reference
to Figure 1.7, compare the trend in labour productivity growth in the
USA between the periods 2011–13 and 2017–19.
b Explain, with the use of an example from the extract, what is meant by
a ‘value judgement’.
c Consider the extent to which a firm is likely to experience advantages
when introducing the division of labour and specialisation.
d Define a ‘free good’ and explain how the nature of merit and demerit
goods will affect the extent of their consumption in a free market.
e North Korea and the USA adopt different economic systems to solve their
basic economic problem. Identify two advantages of each system and
justify which of the two systems you would recommend.
1 Introducing economics
–1
Essay style
2 aAn economy categorises its output into public goods and all other goods
andservices. With the help of a production possibility diagram, explain how
potential economic growth can be illustrated for this economy and consider
how an improvement in technology that favours one of the categories will affect
the production possibility diagram.
bDiscuss whether a pure public good is more likely to be provided in a market
economy or a centrally planned economy.
CASE STUDY
Plantains and tobacco
Jacob is a subsistence farmer who lives in Nangare, a
village in the west of Uganda. He lives in a mud hut and
owns two sheep, two chickens and one mattress for
his household of ten people. He farms a small piece of
land, on which he grows plantains (a staple food crop in
Uganda, related to the banana) and some tobacco. One
of the key decisions that Jacob faces is how to allocate
his land between plantains and tobacco. If he chooses
to plant more tobacco in his field, he faces a cost, as
growing more tobacco means growing fewer plantains.
A number of factors are likely to influence this
decision. For example, the prices of plantains and
tobacco may be important, and it may be that the
costs involved in growing the two crops are different.
Or it may be that some parts of the land are more
suitable for growing one of the crops. There may also
be other crops that could be grown on the land. All of
these factors could affect Jacob’s decisions.
Follow-up questions
a With reference to Jacob’s choice between growing
plantains and tobacco, explain the concept of
opportunity cost.
b Draw a production possibility curve to illustrate
Jacob’s choice of producing plantains and
tobacco.
c Identify a point on the diagram that you drew for
part (b) to illustrate a situation in which:
i Jacob uses his land to produce only plantains.
ii Jacob uses his land to produce a combination
of plantains and tobacco.
iii Jacob does not use all of the land available,
but produces a combination of the two crops.
Go online at hoddereducation.com/cambridgeextras
for another case study for Chapter 1.
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AS LEVEL PART 2 The price system and the microeconomy
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
2
Demand and supply curves
What this chapter covers
★ demand for a good or service (individual and
market)
★ supply of a good or service
★ the determinants of demand and the demand
curve
★ the law of demand
★ the determinants of supply and the supply curve
★ movements along and shifts of the demand or
supply curve
The demand and supply model is perhaps the most famous of all pieces of economic
analysis; it is also one of the most useful. It has many applications that help explain
the way markets work in the real world. It is thus central to understanding economics.
This chapter introduces the key features of the model, looking in turn at the behaviour
of buyers (which tells us about demand) and sellers (which tells us about supply).
2.1 Demand
KEY TERM
effective demand:
the quantity of a
good or service that
consumers are willing
and able to buy given
its price, the price
of other goods, and
consumers’ incomes
and preferences
Our starting point for looking at the demand and supply model is to be clear about what
is meant by ‘demand’. As the word itself suggests, demand is partly about ‘wants’ – how
much of a good or service consumers want to consume. However, the previous chapter
argued that there is always scarcity, so consumers cannot simply demand everything that
they might want. This suggests that when we come to talk about demand, it is important
to be aware that demand for a good or service is constrained because of scarcity. So,
effective demand is the quantity of a good or service that consumers are willing
and able to buy given its price, the price of other goods, and consumers’ incomes and
preferences. We will explore each of these elements in turn.
Individual demand
Consider an individual consumer. Think of yourself, and a product that you consume
regularly. What factors influence your demand for that product? Put another way, what
factors influence how much of the product you choose to buy?
Test yourself 2.1
Which of the four
categories would
apply if you demand
a good because you
have been influenced
by advertising that
persuades you that
everyone must have it?
When thinking about the factors that influence your demand for your chosen product,
common sense will probably mean that you focus on a range of different points. You
may think about why you enjoy consuming the product. You may focus on how much it
will cost to buy the product, and whether you can afford it. You may decide that you
have consumed a product so much that you are ready for a change; or perhaps you will
decide to try something advertised on television, or being bought by a friend.
Whatever the influences you come up with, they can probably be organised into four
categories that ultimately determine your demand for a good:
» The price of the good is an important influence on your demand for it, and will
affect the quantity of it that you choose to buy.
» Your income will determine how much of the good you can afford to purchase.
» The price of other goods may be significant.
» Almost any other factor that you may have thought of can be listed as part of your
preferences.
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Notice that however much you like a particular product, your effective demand is
constrained by the prices of goods and the income that you have to devote to it.
This reflects the notion of scarcity that was introduced in Chapter 1, and also applies
across the whole market for a good.
2
This common-sense reasoning provides the basis for the economic analysis of demand.
You will find that a lot of economic analysis begins in this way, by finding a way to
construct a model that is rooted in how we expect people or firms to behave.
A similar line of argument may apply if we think in terms of the demand for a
particular product – say, smartphones. The market for smartphones can be seen as
bringing together all the potential buyers (and sellers) of the product, and market
demand can be analysed in terms of the factors that influence all potential buyers
of that good or service. In other words, market demand can be seen as the total
quantity of a good or service that all potential buyers would choose to buy at
any given price. The same four categories of factors that influence an individual’s
decision to buy will also influence the total market demand for a product. In
addition, the number of potential buyers in the market will influence the size of
total demand at any price.
2 Demand and supply curves
Market demand
SUMMARY: DEMAND
» The effective demand for a good or service is the
quantity that consumers are willing and able to
buy given its price, the price of other goods, and
consumers’ incomes and preferences.
KEY TERM
firm: an organisation
(business) that brings
together factors of
production in order to
produce output
LEARNING
LINKS
The notion of factors
of production was
introduced in
Chapter 1.
The assumption that
firms aim to maximise
profits may not always
be true in reality, but
it provides the basis
for exploring decisions
taken by firms. In
Chapter 20 we discuss
alternative objectives
that firms may have.
» The individual demand for a good or service is the
quantity that an individual consumer is willing and
able to buy.
» Market demand is the total demand for a good or
service as provided by all sellers.
2.2 Supply
In discussing demand, the focus of attention is on consumers, and on their willingness
to pay for goods and services. In thinking about supply, attention switches to firms,
as it is firms that take decisions about how much output to supply to the market. It is
important at the outset to be clear about what is meant by a ‘firm’. A firm exists to
organise production: it brings together various factors of production, and organises
the production process in order to produce output.
The organisation of a firm can take various forms. A firm could be a sole proprietor:
probably a small business such as a newsagent where the owner of the firm also runs
the firm. A firm could be a partnership – for example, a dental practice in which
profits (and debts) are shared between the partners in the business. Larger firms may
be organised as private or public joint-stock companies, owned by shareholders. The
difference between private and public joint-stock companies is that the shares of a
public joint-stock company are traded on the stock exchange, whereas this is not the
case with the private company.
In order to analyse how firms decide how much of a product to supply, it is necessary
to make an assumption about what it is that firms are trying to achieve. Assume
that they aim to maximise their profits, where ‘profits’ are defined as the difference
between a firm’s total revenue and its total costs.
As in the case of demand, individual supply considers the quantity of a good or service
that is supplied by an individual firm, whereas market supply is concerned with the
total supply of a good or service across all firms in the market.
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SUMMARY: SUPPLY
2
» The individual supply of a good or service is the quantity that an individual firm
(business) is prepared and able to sell at any given price.
» The market supply of a good or service is the quantity supplied by all firms
2.3 Determinants of demand
There are several factors that determine the demand for a good or service, whether at
the individual or the market level.
Demand and the price of a good
Perhaps the most obvious influence on the demand for a good is its price. Assume for
the moment that all other influences that affect demand are held constant, so that
the focus is only on the extent to which the price of a good influences the demand
for it. This is a common assumption in economics, as mentioned in Chapter 1, when
it was expressed by the Latin phrase ceteris paribus, meaning ‘other things being
equal’. Given the complexity of the real world, it is often helpful to focus on one
thing at a time.
LEARNING LINK
The term ‘ceteris paribus’ was explained in section 1.2 of Chapter 1.
KEY TERMS
law of demand: a law
that states that there is
an inverse relationship
between quantity
demanded and the price
of a good or service,
ceteris paribus
demand curve: a graph
showing how much of a
good will be demanded
by consumers at any
given price
So how is the demand for smartphones influenced by their price? Other things being
equal (ceteris paribus), you would expect the demand for smartphones to be higher when
the price is low and lower when the price is high. In other words, you would expect an
inverse relationship between the price and the quantity demanded. This is such a strong
phenomenon that it is referred to as the law of demand. It is one of a small number of
‘laws’ in economics – in other words, it is always expected to hold true.
If you were to compile a list that showed how many smartphones would be bought
at any possible price and plot these on a diagram, this would be called the demand
curve. Figure 2.1 shows what this might look like. As it is an inverse relationship, the
demand curve slopes downwards from left to right. Notice that this need not be a
straight line: its shape depends on how consumers react at different prices.
Price of smartphones ($)
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
operating in the market.
60
50
40
30
20
Demand
10
0
0
20
40
60
80
100
120
Quantity of smartphones (thousands per period)
▲ Figure 2.1 A demand curve for smartphones
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QUANTITATIVE SKILLS 2.1
Reading a graph
You may also wonder why this is called a demand
‘curve’ when it is a straight line. In fact, it need not be
a straight line, but a straight line is convenient. Think
of it as a straight curve.
EXERCISE 2.1
Table 2.1 shows how the demand for trinkets varies
with their price.
a Draw the demand curve.
b How many trinkets would be sold at a price
of $65?
c At what price would 50 trinkets be demanded?
2
2 Demand and supply curves
An important skill is to be able to read off numerical
values from a graph such as Figure 2.1. If you wanted
to see what the quantity demanded would be at a
particular price, you would select the price on the
vertical axis, and then read off the value on the
horizontal axis at that price. For example, in this
figure, if price were to be set at $40, the quantity
demanded would be 20,000 per period. However, if
the price were only $20, the demand would be higher,
at 60,000.
If you are studying maths as one of your A Level
subjects, you may wonder why we draw the demand
curve with price on the vertical axis and quantity on
the horizontal axis, when we are saying that quantity
depends on price and not the other way round. The
simple answer is that Alfred Marshall drew it this
way when he became the first person to draw a
demand curve in his economics textbook in 1890, and
it became the norm.
▼ Table 2.1 The demand for trinkets
Price ($)
Quantity
100
0
90
3
80
7
70
15
60
25
50
40
40
60
30
85
20
120
EXTENSION MATERIAL
Income and substitution effects
An analysis of why the demand curve should be
downward sloping would reveal that there are
two important forces at work. At a higher price, a
consumer buying a smartphone has less income left
Test yourself 2.2
Which of the following
would trigger the law of
demand? A change in:
a preferences
b the price of other
goods
c the price of the good
d income
over. This is referred to as the income effect of a price
increase. In addition, if the price of smartphones
goes up, consumers may find other goods more
attractive and choose to buy something else instead
of smartphones. This is referred to as the substitution
effect of a price increase.
As the price of a good changes, a movement along the demand curve can be observed
as consumers adjust their buying pattern in response to the price change.
Notice that the demand curve has been drawn under the ceteris paribus assumption.
In other words, it was assumed that all other influences on demand were held
constant in order to focus on the relationship between demand and price. There are
two important implications of this procedure.
First, the price drawn on the vertical axis of a diagram such as Figure 2.1 is the
relative price – it is the price of smartphones under the assumption that all other
prices are constant.
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AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
2
STUDY TIP
Remember that a
movement along the
demand curve is a
response to a change
in the price of the good,
whereas a change in
any of the other factors
that affect demand
causes a shift of the
curve.
Second, if any of the other influences on demand change, you would expect to see a
shift of the whole demand curve. It is very important to distinguish between factors
that induce a movement along a curve, and factors that induce a shift of a curve. This
applies not only in the case of the demand curve – there are many other instances
where this is important. We return to this issue at the end of the chapter.
EXTENSION MATERIAL
Snob effects
For some goods a ‘snob effect’ may lead to the demand curve sloping upwards.
The argument is that some people may value certain goods more highly simply
because their price is high, especially if they know that other people will observe
them consuming these goods; an example might be Rolex watches. In other
words, people gain value from having other people notice that they are rich
enough to afford to consume a particular good. This idea that people like to
show off by consuming expensive articles was first pointed out by Thorstein
Veblen at the end of the nineteenth century. He referred to this as a conspicuous
consumption effect.
However, although there may be some individual consumers who react to price
in this way, there is no evidence to suggest that there are whole markets that
display an upward-sloping demand curve for this reason. In other words, most
consumers would react normally to the price of such goods.
Demand and consumer incomes
KEY TERM
normal good: a good
where the quantity
demanded increases in
response to an increase
in consumer incomes
The second influence on demand is consumer incomes. For a normal good, an
increase in consumer incomes will, ceteris paribus, lead to an increase in the quantity
demanded at any given price. Foreign holidays are an example of a normal good
because, as people’s incomes rise, they will tend to demand more foreign holidays at
any given price.
▲ Foreign holidays are an example of a normal good
Figure 2.2 illustrates this. D0 here represents the initial demand curve for foreign
holidays. An increase in consumers’ incomes causes demand to be higher at any given
price, and the demand curve shifts to the right – to D1.
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Price
2
0
D1
Quantity of foreign holidays per period
▲ Figure 2.2 A shift in the demand curve following an increase in
consumer incomes (a normal good)
KEY TERM
This time an increase in consumers’ incomes in Figure 2.3 causes the demand curve to
shift to the left, from its initial position at D0, to D1 where less is demanded at any
given price.
Price
inferior good: a good
where the quantity
demanded decreases in
response to an increase
in consumer incomes
However, demand does not always respond in this way. For example, think about bus
journeys. As incomes rise in a society, more people can afford to have a car, or to use
taxis. This means that, as incomes rise, the demand for bus journeys may tend to fall.
Such goods are known as inferior goods.
2 Demand and supply curves
D0
D1
0
D0
Quantity of bus journeys per period
▲ Figure 2.3 A shift in the demand curve following an increase in
consumer incomes (an inferior good)
EXERCISE 2.2
Test yourself 2.3
What is meant by a
‘normal’ good?
Identify each of the following products as being either a normal good or an
inferior good:
a Digital camera
d Bicycle
b Magazine
e New car
c Potatoes
f Second-hand car
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Giffen goods
Remember that a consumer’s response to a change
in the price of a good is made up of a substitution
effect and a real income effect (see the extension
point on page 27). The substitution effect always
acts in the opposite direction to the price change:
in other words, an increase in the price of a good
always induces a switch away from the good towards
other goods. However, it can now be seen that the
real income effect may operate in either direction,
depending on whether it is a normal good or an
inferior good that is being considered.
Suppose there is a good that is very inferior. A
fall in the price of a good induces a substitution
effect towards the good, but the real income effect
works in the opposite direction. The fall in price is
equivalent to a rise in real income, so consumers
will consume less of the good. If this effect is really
strong, it could overwhelm the substitution effect,
and the fall in price could induce a fall in the quantity
demanded: in other words, for such a good the
demand curve could be upward sloping.
Such goods are known as Giffen goods, after Sir
Robert Giffen, who pointed out that this could happen.
However, in spite of stories about the reaction of
demand to a rise in the price of potatoes during the
great Irish potato famine, no examples of Giffen
goods have been identified. The notion remains only a
theoretical possibility.
Demand and the price of other goods
substitutes: two
goods are said to
be substitutes if
consumers regard them
as alternatives, so that
the demand for one
good is likely to rise if
the price of the other
good rises
complements: two
goods are said to be
complements if people
tend to consume them
jointly, so that an
increase in the price of
one good causes the
demand for the other
good to fall
The demand for a good may respond to changes in the price of other related goods, of
which there are two main types. On the one hand, two goods may be substitutes for
each other. For example, consider two different (but similar) breakfast cereals. If there
is an increase in the price of corn flakes, consumers may switch their consumption to
muesli, as the two are likely to be substitutes for each other. Not all consumers will
switch, of course – some may be deeply committed to corn flakes – but some of them
are certainly likely to change to another cereal.
On the other hand, there may also be goods that are complements – for example,
products that are consumed jointly, such as breakfast cereals and milk, or cars and
petrol. Here a fall in the price of one good may lead to an extension in its demand
accompanied by an increase in demand for its complement.
Whether goods are substitutes or complements determines how the demand for one
good responds to a change in the price of another. Figure 2.4 shows the demand
curves (per period) for two goods that are substitutes – tea and coffee.
a) The market for tea
b) The market for coffee
Price of coffee
KEY TERMS
Price of tea
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
2
EXTENSION MATERIAL
P1
P0
Dc0
Dtea
0
Q1 Q0
Quantity of tea
0
Dc1
Quantity of coffee
▲ Figure 2.4 A shift in the demand curve following an increase in
the price of a substitute good
If there is an increase in the price of tea from P0 to P1 in panel (a), more consumers
will switch to coffee and the demand curve in panel (b) will shift to the right – say,
from Dc0 to Dc1.
For complements the situation is the reverse: in Figure 2.5 an increase in the price
of tea from P0 to P1 in panel (a) causes the demand curve for milk to shift leftwards,
from Dm0 to Dm1.
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b) The market for milk
2
Price of milk
Price of tea
a) The market for tea
P1
P0
Dm1 Dm0
Dtea
Q1
Q0
Quantity of tea
0
Quantity of milk
▲ Figure 2.5 A shift in the demand curve following an increase in
the price of a complementary good
Demand, consumer preferences and other influences
The discussion has shown how the demand for a good is influenced by the price of
the good, the price of other goods, and by consumer incomes. It was stated earlier
that almost everything else that determines demand for a good can be represented as
‘consumer preferences’. In particular, this refers to whether you like or dislike a good.
There may be many things that influence whether you like or dislike a product. In part
it simply depends on your own personal inclinations – some people like dark chocolate,
others prefer milk chocolate. However, firms may try to influence your preferences
through advertising, and sometimes they succeed. Or you might be one of those
people who get so irritated by television advertising that you compile a blacklist of
products that you will never buy! Even this is an influence on your demand.
2 Demand and supply curves
0
In some cases your preferences may be swayed by other people’s demand – again, this
may be positive or negative. Fashions may influence demand, but some people like to
go against (or lead) the trend.
You may also see a movement of the demand curve if there is a sudden surge in the
popularity of a good – or, indeed, a sudden collapse in demand.
Test yourself 2.4
Are people likely to
respond more or less
strongly to a change in
price as time passes?
The above discussion has covered most of the factors that influence the demand for a
good. However, in some cases it is necessary to take a time element into account. Not
all of the goods bought are consumed instantly. In some cases, consumption is spread
over long periods of time. Indeed, there may be instances where goods are not bought
for consumption at all, but are seen by the buyer as an investment, perhaps for resale
at a later date. In these circumstances, expectations about future price changes may
be relevant. For example, people may buy antiques or works of art in the expectation
that prices will rise in the future. There may also be goods whose prices are expected
to fall in the future. This has been common with many hi-tech products; initially a
newly launched product may sell at a high price, but as production levels rise, costs
may fall, and prices also. People may therefore delay purchase in the expectation of
future price reductions.
EXERCISE 2.3
Draw some demand curves for the following
situations, and think about how you would expect the
demand curve to change (if at all).
a The demand for chocolate following a campaign
highlighting the dangers of obesity
b The demand for oranges following an increase in
the price of apples
c The demand for oranges following a decrease in
the price of oranges
d The demand for Blu-ray discs following a
decrease in the price of Blu-ray players
e The demand for private transport following an
increase in consumer incomes
f The demand for public transport following an
increase in consumer incomes
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2
SUMMARY: DETERMINANTS OF DEMAND
» An important influence on the demand for a good
» The demand curve is downward sloping, as the
relationship between demand and price is an
inverse one.
» The market demand for a good depends on
the price of the good, the price of other goods,
consumers’ incomes and preferences and the
number of potential consumers.
2.4 Determinants of supply
KEY TERMS
competitive market:
a market in which
individual firms cannot
influence the price of
the good or service they
are selling, because of
competition from other
firms
supply curve: a graph
showing the quantity
supplied at any given
price
The demand curve shows a relationship between quantity demanded and the price
of a good or service. A similar relationship between the quantity supplied by firms
and the price of a good can be identified in relation to the behaviour of firms in a
competitive market – that is, a market in which individual firms cannot influence
the price of the good or service that they are selling, because of competition from
other firms.
In such a market it may well be supposed that firms will be prepared to supply more
goods at a high price than at a lower one (ceteris paribus), as this will increase their
profits.
The supply curve illustrates how much the firms in a market will supply at any given
price, as shown in Figure 2.6. As firms are expected to supply more goods at a high
price than at a lower price, the supply curve will be upward sloping, reflecting this
positive relationship between quantity and price.
Price
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
or service is its price.
» The demand curve shows the relationship
between demand for a product and its price,
ceteris paribus.
Supply
STUDY TIP
Always be careful to
distinguish between
‘price’ and ‘cost’. These
are sometimes used
interchangeably in
everyday language,
but in economics they
mean different things.
From a consumer’s
point of view ‘price’ is
what has to be paid
for a good or service;
‘cost’ is what the
firm must pay out in
producing a good or
service.
Test yourself 2.5
Explain why firms in a
competitive market will
be prepared to supply
more output at a higher
price, ceteris paribus.
0
Quantity per period
▲ Figure 2.6 A supply curve
QUANTITATIVE SKILLS 2.2
Lines on a diagram
Be clear about why the upward-sloping nature of the supply curve reflects the
fact that firms are willing to supply more output at a higher price, whereas the
downward-sloping nature of the demand curve reflects the way that consumers
are willing to purchase more of a good when the price is relatively low. This is
bound up with the way in which we interpret the supply (or demand) curve. In
Figure 2.6, think about how firms behave when the price is relatively low – that
is, when you pick a price low down on the vertical axis. The quantity that firms
are willing to supply is read off from the supply curve – and is relatively low.
However, if you read off the quantity from a higher price, the quantity is also
higher. You need to become accustomed to interpreting lines and curves on a
diagram in this way. The shape of the line (or curve) shows the extent to which
firms respond at different prices.
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EXERCISE 2.4
▼ Table 2.2 The supply of trinkets
Price ($)
Quantity
100
98
90
95
80
91
70
86
60
80
50
70
40
60
30
50
20
35
10
18
2
2 Demand and supply curves
Table 2.2 shows how the supply of trinkets
varies with their price.
a Draw the supply curve.
b How many trinkets will be supplied if
the price is $35?
c If 65 trinkets are supplied, what will be
the price?
Notice that the focus of the supply curve is on the relationship between quantity
supplied and the price of a good in a given period, ceteris paribus – that is, holding
other things constant. As with the demand curve, there are other factors affecting the
quantity supplied. These other influences on supply will determine the position of the
supply curve: if any of them changes, the supply curve can be expected to shift.
We can identify six important influences on the quantity that firms will be prepared to
supply to the market at any given price:
»
»
»
»
»
»
production costs
the technology of production
taxes and subsidies
the price of related goods
firms’ expectations about future prices
the number of firms in the market
Costs and technology
If firms are aiming to maximise profits, an important influence on their supply
decision will be the costs of production that they face. Chapter 1 explained that
in order to produce output, firms need to use inputs of the factors of production –
labour, capital, land and enterprise. If the cost of those inputs increases, firms will
in general be expected to supply less output at any given price. There is a decrease
in supply. The effect of this is shown in Figure 2.7, where an increase in production
costs induces firms to supply less output at each price. The curve shifts from its initial
position at S0 to a new position at S1. For example, suppose the original price was $10
per unit; before the increase in costs, firms would have been prepared to supply 100
units of the product to the market. An increase in costs of $6 per unit that shifted the
supply curve from S0 to S1 would mean that, at the same price, firms would now supply
only 50 units of the good. Notice that the vertical distance between S0 and S1 is the
amount of the change in cost per unit.
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Price ($)
2
S1
S0
10
0
50
100
Quantity per period
▲ Figure 2.7 The supply curve shifts to the left if production costs increase
QUANTITATIVE SKILLS 2.3
Interpreting distance on a graph
LEARNING
LINK
Chapter 1 introduced
the factors of
production and their
importance to firms;
the way in which a
firm’s costs influence
its decision making
is discussed in
Chapter 17.
In Figure 2.7, we show the supply curve as shifting to the left with an increase in
costs of $6 per unit. How do we know by how much the curve will shift? Notice
that with quantity at 50 units, cost has increased from $4 to $10 per unit, and it
is this vertical distance that determines how far the supply curve moves. We will
see a similar effect in Figure 2.9 in relation to taxes and subsidies.
In contrast, if a new technology of production is introduced, which means that firms can
produce more cost effectively, this could have the opposite effect, shifting the supply
curve to the right. This is shown in Figure 2.8, where improved technology reduces costs
faced by firms and induces them to supply more output at any given price, so the supply
curve shifts from its initial position at S0 to a new position at S1. Therefore, if firms in
the initial situation were supplying 50 units with the price at $10 per unit, then the
introduction of new technology that brings a fall in costs of $6 per unit would induce
firms to increase supply to 100 units (if the price remained at $10).
Price ($)
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
4
S0
S1
10
4
0
50
100
Quantity per period
▲ Figure 2.8 The supply curve shifts to the right if new
technology lowers production costs
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Taxes and subsidies
The impact and
incidence of taxes
and subsidies are
explored in Chapter 5,
see pages 75–77.
b) A subsidy
S
S
with
tax
Price
LEARNING
LINK
Price
a) A sales tax
Subsidy
Tax
0
S
Quantity
0
S
with
subsidy
2
2 Demand and supply curves
Suppose the government imposes a sales tax such as VAT on a good or service. The
price paid by consumers will be higher than the revenue received by firms, as the
tax has to be paid to the government. This means that firms will (ceteris paribus)
be prepared to supply less output at any given market price. Again, the supply curve
shifts to the left. This is shown in panel (a) of Figure 2.9, which assumes a fixed per
unit tax. The supply curve shifts, as firms supply less at any given market price. On
the other hand, if the government pays firms a subsidy to produce a particular good,
this will reduce their costs, and induce them to supply more output at any given price.
The supply curve will then shift to the right, as shown in panel (b).
Quantity
▲ Figure 2.9 The effects of taxes and subsidies on supply
Prices of other goods
It was shown earlier that from the consumers’ perspective, two goods may be
substitutes for each other, such that if the price of one good increases, consumers
may be induced to switch their consumption to substitute goods. Similarly, there
may be substitution on the supply side. A firm may face a situation in which there
are alternative uses to which its factors of production may be put: in other words,
it may be able to choose between producing a range of different products. A rise in
the price of a good raises its profitability, and therefore may encourage a firm to
switch production from other goods. This may happen even if there are high switching
costs, provided the increase in price is sufficiently large. For example, a change in
relative prices of sweet potatoes and onions might encourage a farmer to stop planting
sweet potatoes and grow onions instead.
In other circumstances, a firm may produce a range of goods jointly. Perhaps one good
is a by-product of the production process of another. An increase in the price of one
of the goods may mean that the firm will produce more of both goods. This notion of
joint supply is similar to the situation on the demand side where consumers regard two
goods as complements.
Expected prices
Because production takes time, firms often take decisions about how much to supply
on the basis of expected future prices. Indeed, if their product is one that can be
stored, there may be times when a firm will decide to allow stocks of a product to
build up in anticipation of a higher price in the future, perhaps by holding back some
of its production from current sales. In some economic activities, expectations about
future prices are crucial in taking supply decisions because of the length of time
needed to increase output. For example, a firm producing palm oil, rubber or mangoes
needs to be aware that newly planted trees will take several years to mature before
they are able to yield their product.
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AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
2
▲ Newly planted trees may take several years to mature
The number of firms in the market
As the market supply curve is the sum of the supply curves of individual firms, if more
firms join the market, the market supply curve will shift to the right. Similarly, if some
firms go out of business, the market supply curve will shift to the left.
SUMMARY: DETERMINANTS OF SUPPLY
» The selling price of a good or service is an important influence on the quantity
that firms are prepared to supply.
» The market supply curve shows the quantity that firms in a market are
prepared and able to supply at any given price.
» The market supply of a good or service depends on production costs, the
technology of production, taxes and subsidies, the price of related goods and
firms’ expectations about future prices.
STUDY TIP
In order to emphasise
the difference between
a shift of the demand
curve and a movement
along it, the convention
is to use an extension
(or contraction) of
demand (supply) for a
movement along the
demand (supply) curve,
and to use an increase
(or decrease) to denote
a shift of the curve.
2.5 Movements along and shifts of the demand
or supply curve
It is important to be able to distinguish between the shift of a curve (demand or
supply) and a movement along it.
First think about the demand curve. Remember that the demand curve has been
drawn under the ceteris paribus assumption. In other words, it was assumed that all
other influences on demand were held constant in order to focus on the relationship
between demand and price. There are two important implications of this procedure.
As the price of a good changes, a movement along the demand curve can be observed
as consumers adjust their buying pattern in response to the price change.
However, if any of the other influences on demand changes, you would expect to see
a shift of the whole demand curve. It is very important to distinguish between those
factors that induce a movement along a curve (known as an extension (or contraction)
of demand), and factors that induce a shift of a curve (an increase or decrease
in demand).
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The two panels of Figure 2.10 show this difference. In panel (a) of the figure, the
demand curve for Xbox games has shifted to the right because of a change in one of
the factors that influences demand. In panel (b), the price of Xbox games falls from P0
to P1, inducing an extension (movement along the demand curve) as demand expands
from Q0 to Q1.
b) A movement along the
demand curve
Price of Xboxes
P0
P1
Test yourself 2.6
D0
0
D1
Quantity of Xbox games
D
0
Q0 Q1
Quantity of Xbox games
▲ Figure 2.10 A shift in the demand curve and a movement along it
In the same way, a change in the price of a good or service induces a movement
along the supply curve (known as an extension (or contraction) of supply), whereas
an increase (or decrease) in the other determinants of supply leads to a shift in the
curve itself.
Test yourself 2.7
If a producer finds that
the market price of its
product has increased,
would this induce a
contraction of supply,
an extension of supply
or a shift in the supply
curve?
2 Demand and supply curves
Price of Xboxes
a) A shift in the demand
curve
Explain the difference
between an extension
of demand and an
increase in demand.
2
EXERCISE 2.5
Draw supply curves for each of the following situations to show whether there is
a shift of the supply curve or a movement along it.
a The supply of accountancy services following the introduction of more
efficient computer software
b The supply of a good following an increase in taxes on sales
c The supply of ice cream following a rise in its selling price during a hot
summer
d The supply of tennis balls after several firms in the market go bankrupt
EXERCISE 2.6
For each of the following, decide whether the demand curve or the supply curve
will move, and in which direction.
a Consumers are convinced by arguments about the benefits of organic
vegetables.
b A new process is developed that reduces the amount of inputs that firms
need in order to produce bicycles.
c There is a severe frost in Brazil that affects the coffee crop.
d The government increases the rate of value added tax.
e Real incomes rise.
f The price of tea falls: what happens in the market for coffee?
g The price of sugar falls: what happens in the market for coffee?
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AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
2
SUMMARY: MOVEMENT ALONG AND SHIFTS OF A CURVE
» There is an important distinction to be drawn
between a movement along a curve and a shift of
the curve.
» For a demand curve, a change in the price induces
a movement along the demand curve, but a change
in one of the determinants of demand (other than
its price) causes a shift of the curve.
» An increase in price leads to a movement up along
the demand curve, known as a contraction of
demand.
» A decrease in price leads to a movement down
along the demand curve, known as an extension of
demand.
» For a supply curve, a change in the price induces
a movement along the supply curve, but a change
in one of the determinants of supply (other than its
price) causes a shift of the curve.
» An increase in price leads to a movement up along
the supply curve, known as an extension of supply.
» A decrease in price leads to a movement down
along the supply curve, known as a contraction of
supply.
END OF CHAPTER QUESTIONS
Multiple choice
1 The cost of a major factor of production in the steel industry increases. A steel
producer manages to resist the rise in costs by retrenching workers. In response
to the higher costs, many firms exit the industry. What is the effect on the steel
producer of the reduction in competition?
A a movement up along the steel producer’s supply curve
B a shift in the steel producer’s supply curve to the right
C an increase in the steel producer’s profits
D an increase in the steel producer’s productivity
2 Which of the following changes will not increase market demand at every
given price?
A an effective advertising campaign promoting the benefits of the product
B an increase in the quality of the product
C a decrease in substitutes available
D a fall in the price of the product
Data response
1 Read the following extract and then answer the questions that follow.
Cambodia’s energy problems and solutions
Cambodia is experiencing increases in economic growth and an expanding
population. In Phnom Penh, the capital of Cambodia, this can cause significant
problems when the supply of electricity does not meet the demand. This
results in frequent load-shedding power cuts that occur across different parts
5 of the city at different times.
The impact of the power load shedding on the economy can be significant.
Despite many shirt manufacturing firms in Phnom Penh experiencing
increased effective demand, many are badly affected when their machines
stand idle during the power cuts. Some have even gone out of business. In
10 November 2019, the president of Cambodia warned there would be loadshedding power cuts until April 2020.
As part of a solution the authorities have considered increasing the price of
electricity. Shirt manufacturers point out that this will lead to an increase
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in their costs and the price of the shirts they produce. At the same time the
15 government has subsidised the installation of solar panels as an alternative
energy source. To help pay for the subsidy, the government is considering an
increase in sales tax.
2
In Cambodia’s agricultural sector, there is a far smaller impact from the
power cuts. However, in this sector, ongoing poor weather conditions are
20 significantly affecting supply.
a Identify two factors that could have caused the current increase in the
demand for shirts in Cambodia.
b Explain what is meant by ‘effective demand’ in the extract (line 8).
c Identify and explain the evidence in the extract that suggests there
could be a decrease in the quantity of shirts demanded and a decrease
in the supply of shirts in the future.
d Explain how the number of firms that manufacture shirts in Phnom Penh
going out of business would affect the market supply curve for shirts in
Cambodia.
e Explain, with the aid of a diagram and with reference to the extract, the
likely change in the supply of agricultural products.
f Assess, with the aid of a diagram, the likely effect of an increase in sales
tax on the supply of shirts in Cambodia.
2 Demand and supply curves
Source: adapted from ‘Cambodia Struggles to Keep the Lights On’,
Asia Times, 2 December 2019
Essay style
2 a I n 2020, the Dutch government announced plans to double its financial
assistance for firms producing renewable energy. The financial help included
a higher price paid for energy produced through renewable sources and a
production subsidy.
With the help of a diagram, explain the likely effects on the supply of renewable
energy as a result of the measures taken by the Dutch government in 2020
and consider whether the assumption of ceteris paribus is likely to hold in this
situation.
bDiscuss whether there will be an increase in the demand for a good following
an increase in income and an increase in the price of a related good.
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AS LEVEL PART 2 The price system and the microeconomy
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
3
Elasticity
What this chapter covers
★ price elasticity of demand (PED), income elasticity
(YED) and cross-price elasticity (XED)
★ formulae and calculation of elasticity measures
★ the PED and total revenue of a product
★ factors affecting the PED
KEY TERMS
elasticity: a measure
of the sensitivity of one
variable to changes in
another variable
price elasticity
of demand (PED):
a measure of the
sensitivity of quantity
demanded to a change
in the price of a good or
service. It is measured
as:
% change in quantity
demanded
% change in price
elastic: a term used
when the price
elasticity of demand
is numerically greater
than 1 but less than
infinity
★
★
★
★
elastic, inelastic and unitary elastic demand
factors affecting the YED and XED
the price elasticity of supply (PES)
the usefulness and significance of elasticity
measures
The previous chapter introduced the notions of demand and supply. We now turn our
attention to the way in which demand and supply respond to changes in the factors
that influence them, and examine how we can measure the degree to which demand
and supply are sensitive to each of the main factors.
Both the demand for and the supply of a good or service can be expected to depend
on its price as well as other factors. It is often important to know just how sensitive
demand and/or supply will be to a change in either price or one of the other
determinants – for example, in predicting how consumers, firms and the government
may be affected by a change in the market environment. The sensitivity of demand or
supply to a change in one of its determining factors can be measured by its elasticity.
3.1 The price elasticity of demand
The most common elasticity measure is the price elasticity of demand (PED). This
measures the sensitivity of the quantity demanded of a good or service to a change
in its price. The elasticity is defined as the percentage change in quantity demanded
divided by the percentage change in the price.
We define the percentage change in price as 100 × ΔP/P (where Δ means ‘change in’ and P
stands for ‘price’). Similarly, the percentage change in quantity demanded is 100 × ΔQ/Q.
When the demand is highly price sensitive, the percentage change in quantity
demanded following a price change will be large relative to the percentage change in
price. In this case, the PED will take on a value that is smaller than −1. For example,
suppose that a 2% change in the price of a good leads to a 5% reduction in quantity
demanded; the elasticity is then −5 divided by 2 = −2.5. When the price elasticity is
smaller than −1, demand is referred to as being price elastic.
QUANTITATIVE SKILLS 3.1
Describing elasticity
Because the PED is always negative, economists sometimes omit the minus
sign. Strictly speaking, demand is elastic where the PED is smaller than −1 and
inelastic if the value is between 0 and −1. Another way of expressing this is that
demand is elastic when the PED is negative with an absolute value larger than 1,
but this is quite clumsy. You may sometimes find people saying that demand is
elastic when the PED is larger than 1. What they mean is that the PED is smaller
than −1, that it is negative but with a numerical value greater than 1.
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KEY TERMS
inelastic: a term used
when the price elasticity
of demand is between
0 and −1
When demand is not very sensitive to price, the percentage change in quantity
demanded will be smaller than the original percentage change in price, and
the elasticity will then be between 0 and −1. For example, if a 2% change in
price leads to a 1% reduction in quantity demanded, then the value of the
elasticity will be −1 divided by 2 = −0.5. In this case, demand is referred to as
being price inelastic.
QUANTITATIVE SKILLS 3.2
3
3 Elasticity
unitary elastic: a term
used when the price
elasticity of demand is
equal to −1
There are two important things to notice about this. First, because the demand
curve is downward sloping, the elasticity will always be negative. This is because the
changes in price and quantity are always in the opposite direction. Second, you should
try to calculate the elasticity only for a relatively small change in price, as it becomes
unreliable for very large changes.
Calculating an elasticity
Price of pencils (cents)
Figure 3.1 shows a demand curve for pencils. When the price of a pencil is
40c, the quantity demanded will be 20. If the price falls to 35c, the quantity
demanded will rise to 30. The percentage change in quantity is 100 × 10/20 =
50 and the percentage change in price is 100 × −5/40 = −12.5. Thus, the
elasticity can be calculated as (50/−12.5) = −4. At this price, demand is highly
price elastic.
60
50
Elasticity is % change in Q /% change in P
i.e. 50/–12.5 = –4
40
35
30
Elasticity is
2.5/–10 = –0.25
20
109
0
0
Demand
20
30
40
82
60
80
100
120
Quantity of pencils per period
▲ Figure 3.1 A demand curve for pencils
At a lower price, the result is quite different. Suppose that the price is initially
10c, at which price the quantity demanded is 80. If the price falls to 9c, demand
increases to 82. The percentage change in quantity is now 100 × 2/80 = 2.5, and
the percentage change in price is 100 × −1/10 = −10, so the elasticity is calculated
as 2.5/−10 = −0.25, and demand is now price inelastic.
The phenomenon described in Quantitative skills 3.2 is true for any straight-line
demand curve: in other words, demand is price elastic at higher prices and inelastic at
lower prices. At the halfway point the elasticity is exactly −1, which is referred to as
unitary elasticity.
Test yourself 3.1
Why is the PED always
negative?
Why should the elasticity vary along a linear demand curve? The key is to be aware
that elasticity is defined in terms of the percentage changes in price and quantity.
When price is relatively high, a 1c change in price is a small percentage change, and
the percentage change in quantity is relatively large – because when price is relatively
high, the initial quantity is relatively low. The reverse is the case when price is
relatively low. Figure 3.2 shows how the elasticity of demand varies along a straightline demand curve.
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Test yourself 3.2
Suppose that a good has
a PED of −0.3. Would you
describe this as being
relatively elastic or
relatively inelastic?
Price
When the demand
curve is a straight
line, it always has
this property that
the elasticity gets
smaller as we move
down along it. Demand
curves need not always
be straight lines, of
course; they may be
curved. This depends
on how buyers respond
at different prices.
Within this range of the demand
curve, demand is
price elastic
At the mid-point of the
demand curve, we have
unit elasticity
Within this range of
the demand
curve, demand is
price inelastic
0
Quantity per period
▲ Figure 3.2 The price elasticity of demand varies along a straight line
The price elasticity of demand and total revenue
One reason why firms may have an interest in the price elasticity of demand is that if
they are considering changing their prices, they will be eager to know the extent to
which demand will be affected. For example, they may want to know how a change in
price will affect their total revenue. As it happens there is a consistent relationship
between the price elasticity of demand and total revenue.
Total revenue is given by price multiplied by quantity. In Figure 3.3, if price is at P0,
quantity demanded is at Q0 and total revenue is given by the area of the rectangle
0P0AQ0. If price falls to P1 the quantity demanded rises to Q1, and you can see that
total revenue has increased, as it is now given by the area 0P1BQ1. This is larger than
at price P1, because in moving from P0 to P1 the area P1P0AC is lost, but the area
Q0CBQ1 is gained, and the latter is the larger. As you move down the demand curve,
total revenue at first increases like this, but then decreases – try sketching this for
yourself to check that it is so.
Price
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
3
STUDY TIP
A
P0
P1
B
C
Demand
0
Q0
Q1
Quantity per period
▲ Figure 3.3 Demand and total revenue
STUDY TIP
Notice that from a firm’s point of view price times quantity is revenue (the amount
that firms receive from selling the good), but from the buyers’ point of view, this
is expenditure (i.e. spending by buyers). In this context, total revenue and total
expenditure are the same.
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QUANTITATIVE SKILLS 3.3
Elasticity and total revenue
Total revenue before and after the price change
can be calculated. Total revenue is equal to price
multiplied by quantity, so at the original price
revenue was 40 × 20 = 800. At the new lower price,
total revenue was 35 × 30 = 1,050. We can therefore
see that when the price elasticity of demand is
elastic, a fall in price leads to a rise in revenue.
When the price of a pencil fell from 10 to 9, and
quantity demanded rose from 80 to 82, demand was
A mathematical note: because the elasticity varies
along most demand curves, we would ideally like to
measure the elasticity at a particular point on the
curve. When calculating using percentage changes
we are measuring the elasticity along a segment
of the curve (an arc), so we may sometimes get
misleading results. We should therefore try to
calculate for as small a change as can be measured.
Those taking A Level Maths may realise that calculus
would enable us to measure elasticity at a point if we
knew the formula for the demand curve.
3
3 Elasticity
Quantitative skills 3.2 showed how to calculate the
price elasticity of demand at different points along a
demand curve for pencils. When the price of a pencil
fell from 40 to 35, the quantity demanded rose from
20 to 30, and elasticity was calculated to be −4.
inelastic (−0.25). At the original price, revenue was
10 × 80 = 800, and at the lower price it was 9 × 82 =
738. This time, total revenue has fallen with a fall in
price and inelastic demand.
Price
For the case of a straight-line demand curve, the relationship between elasticity and
total revenue is illustrated in Figure 3.4.
Elastic
Unit elastic
Inelastic
Demand
Quantity
Price
0
Total
revenue
0
Quantity
▲ Figure 3.4 Elasticity and total revenue
Remember that demand is price elastic when price is relatively high. This is the range
of the demand curve in which total revenue rises as price falls. This makes sense, as
in this range the quantity demanded is sensitive to a change in price and increases
by more (in percentage terms) than the price falls. This implies that, as you move
to the right in this segment, total revenue rises. The increase in quantity sold more
than compensates for the fall in price. However, when the mid-point is reached and
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3
This relationship is
relevant in
the discussion
of firms’ behaviour
in Chapter 20.
▼ Table 3.1 Total revenue, elasticity and a price change
Price elasticity of
demand
For a price increase, total
revenue…
For a price decrease, total
revenue…
Elastic
falls
rises
Unit elastic
does not change
does not change
Inelastic
rises
falls
If a firm is aware of the price elasticity demand for its product, it can anticipate
consumer response to its price change, which may be a powerful strategic tool.
Test yourself 3.3
What would happen to
a firm’s total revenue
if it were to increase
the price of its product
when demand is
elastic?
An important point must be made here. If the price elasticity of demand varies along
a straight-line demand curve, such a curve cannot be referred to as either elastic or
inelastic. To do so is to confuse the elasticity with the slope of the demand curve. It
is not only the steepness of the demand curve that determines the elasticity, but also
the point on the curve at which the elasticity is measured.
Two extreme cases of the price elasticity of demand should also be mentioned.
Demand may sometimes be totally insensitive to price, so that the same quantity will
be demanded whatever price is set for it. In such a situation, demand is said
to be perfectly inelastic. The demand curve in this case is vertical – as in Di in
Figure 3.5. In this situation, the numerical value of the price elasticity is zero, as
quantity demanded does not change in response to a change in the price of the good.
Price
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
LEARNING
LINK
demand becomes unit elastic, total revenue stops rising – it is at its maximum at this
point. The remaining part of the curve is inelastic: that is, the increase in quantity
demanded is no longer sufficient to compensate for the decrease in price, and total
revenue falls. Table 3.1 summarises the situation.
Di
De
Pe
0
Perfectly inelastic
demand
Perfectly elastic
demand
Qi
Quantity per period
▲ Figure 3.5 Perfectly elastic and inelastic demand
The other extreme is shown on the same figure, where De is a horizontal demand curve
and demand is perfectly elastic. The numerical value of the elasticity here is infinity.
Consumers demand an unlimited quantity of the good at price Pe. No firm has any
incentive to lower price below this level, but if price were to rise above Pe, demand
would fall to zero.
An example
A study carried out in Pakistan found that the price elasticity of demand for
household electricity was −0.63. This means that demand for electricity was inelastic.
If the price of electricity were to increase by 10%, there would be a fall of just 6.3%
in the quantity of electricity demanded.
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Factors that influence the price elasticity of demand
3
3 Elasticity
A number of important influences on the price elasticity of demand can now be
identified. The most important is the availability of substitutes for the good or
service under consideration. For example, think about the demand for cauliflowers.
Cauliflowers and broccoli are often seen as being very similar, so if the price of
cauliflowers is high one week, people might quite readily switch to broccoli. The
demand for cauliflowers can be said to be price sensitive (elastic), as consumers
can readily substitute an alternative product. On the other hand, if the prices of all
vegetables rise, demand will not change very much, as there are no substitutes for
vegetables in the diet. In other words, goods that have close substitutes available will
tend to exhibit elastic demand, whereas the demand for goods for which there are no
substitutes will tend to be more inelastic.
Associated with this is the question of whether an individual regards a good or service
as a necessity or as a luxury item. If a good is a necessity, then demand for it will tend
to be inelastic, whereas if a good is regarded as a luxury, consumers will tend to be more
price-sensitive. This is closely related to the question of substitutes, as by labelling a
good as a necessity, one is essentially saying that there are no substitutes for it.
A further influence on the price elasticity of demand is the relative share of the
good or service in overall expenditure. You may not notice small changes in the price
of an inexpensive item that is a small part of overall expenditure, such as salt. This
tends to mean that demand for that good is relatively inelastic. On the other hand,
an item that figures large in the household budget will be seen very differently, and
consumers will tend to be much more sensitive to price when a significant proportion
of their income is involved.
Finally, the time period under consideration may be important. Consumers may
respond more strongly to a price change in the long run than to one in the short run.
An increase in the price of petrol may have limited effects in the short run; however,
in the long run, consumers may buy smaller cars or switch to diesel. Thus, the
elasticity of demand tends to be more elastic in the long run than in the short run.
Habit or commitment to a certain pattern of consumption may dictate the short-run
pattern of consumption, but people do eventually adjust to price changes.
SUMMARY: THE PRICE ELASTICITY OF DEMAND
» The price elasticity of demand measures the sensitivity of the quantity of a
STUDY TIP
Be ready to identify the
four key influences on
the PED:
» the availability of
close substitutes
for the good
» whether the good
is perceived as a
necessity
» the proportion
of income or
expenditure
devoted to the good
» the time period over
which elasticity is
considered
»
»
»
»
»
»
good demanded to a change in its price.
As there is an inverse relationship between quantity demanded and price, the
price elasticity of demand is always negative.
Where consumers are sensitive to a change in price, the percentage change in
quantity demanded will exceed the percentage change in price. The elasticity of
demand then takes on a value that is smaller than −1, and demand is said to be
elastic.
Where consumers are not very sensitive to a change in price, the percentage
change in quantity demanded will be smaller than the percentage change in
price. Elasticity of demand then takes on a value that is between zero and −1,
and demand is said to be inelastic.
When demand is elastic, a fall (rise) in price leads to a rise (fall) in total revenue.
When demand is inelastic, a fall (rise) in price leads to a fall (rise) in total
revenue.
The size of the price elasticity of demand is influenced by the availability of
substitutes for a good, whether the good is seen as a luxury or a necessity, the
relative share of expenditure on the good in the consumer’s budget and the
time that consumers have to adjust.
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AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
3
EXERCISE 3.1
Examine Table 3.2, which shows the demand for
Pedro’s premium olive oil at different prices.
a Draw the demand curve.
b Calculate the price elasticity of demand when the
price increases from $8 to $10.
c Calculate the price elasticity of demand when the
price increases from $6 to $8.
d Calculate the price elasticity of demand when the
price increases from $4 to $6.
KEY TERM
income elasticity
of demand (YED):
a measure of the
sensitivity of quantity
demanded to a change
in consumer incomes
LEARNING
LINK
Normal and inferior
goods are discussed
in Chapter 2 as part
of the explanation of
demand.
Test yourself 3.4
What would be the
value of the YED if a 5%
increase in consumer
income leads to a
10% fall in quantity
demanded?
KEY TERM
necessity good: one
for which the income
elasticity of demand
is income-inelastic,
so demand varies
by relatively little as
income changes
▼ Table 3.2 Demand for Pedro’s olive oil
Price ($)
Quantity demanded
(bottles per week)
10
20
8
40
6
60
4
80
2
100
3.2 Income elasticity of demand
Elasticity is a measure of the sensitivity of a variable to changes in another variable.
In the same way as the price elasticity of demand is determined, an elasticity measure
can be calculated for any other influence on demand or supply. The income elasticity
of demand (YED) is therefore defined as:
YED =
% change in quantity demanded
% change in consumer income
The YED measures the extent to which the demand for a good or service will change
in response to a change in consumer incomes. The size and direction of the change in
demand will depend on how consumers perceive the good or service.
Factors affecting the YED
Unlike the price elasticity of demand, the income elasticity of demand may be
either positive or negative. Remember the distinction between normal and inferior
goods? For normal goods the quantity demanded will increase as consumer income
rises, whereas for inferior goods the quantity demanded will tend to fall as income
rises. So, for normal goods the YED will be positive, whereas for inferior goods it
will be negative.
Suppose you discover that the YED for an economics magazine is 0.7. How do you
interpret this number? If consumer incomes were to increase by 10%, the demand for
the magazine would increase by 10 × 0.7 = 7%. This example of a normal good may be
helpful information for the magazine publishers, if they know that consumer incomes
are rising over time.
On the other hand, if the YED for coach travel is −0.3, this means that a 10% increase
in consumer incomes will lead to a 3% fall in the demand for coach travel – perhaps
because more people are travelling by car. In this instance, coach travel would be
regarded as an inferior good.
Goods for which there are no substitutes (such as food, water or essential medicines)
will be income-inelastic. People will buy such goods even if their income changes.
Such goods are necessities.
In some cases the YED may be very strongly positive. For example, suppose that the
YED for digital cameras is +2. This implies that the quantity demanded of such cameras
will increase by 20% for every 10% increase in incomes. Table 3.3 summarises the
ranges of the YED.
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▼ Table 3.3 Values of the YED
YED value
Description
Below −1
Elastic inferior good
Between −1 and 0
Inelastic inferior good
0
No relationship between income and quantity demanded
Between 0 and 1
Inelastic normal good
Above 1
Elastic normal good
Calculate the income elasticity of demand in each of
the following circumstances. In each case, assume
that consumer income rises by 5%. In each case,
classify the good using Table 3.3.
a
b
c
d
e
Quantity demanded changes from 150 to 165.
Quantity demanded changes from 80 to 78.
Quantity demanded changes from 100 to 102.
Quantity demanded changes from 400 to 320.
Quantity demanded stays at 600.
3 Elasticity
EXERCISE 3.2
3
SUMMARY: INCOME ELASTICITY OF DEMAND
» The income elasticity of demand (YED) measures
the sensitivity of demand to a change in consumer
incomes.
» For a normal good, the YED is positive, as an
increase (decrease) in income induces an increase
(decrease) in demand.
KEY TERM
cross elasticity
of demand (XED):
a measure of the
sensitivity of quantity
demanded of a good or
service to a change in
the price of some other
good or service
LEARNING
LINK
Substitutes and
complements are
explained in section
2.3 of Chapter 2.
» For an inferior good, the YED is negative, as an
increase (decrease) in income induces a decrease
(increase) in demand.
3.3 Cross elasticity of demand (XED)
Another useful measure is the cross elasticity of demand (XED). This is helpful in
revealing the interrelationships between goods. Again, this measure may be either
positive or negative, depending on the relationship between the goods. It is
defined as:
% change in quantity demanded of good X
XED =
% change in price of good Y
If the XED is seen to be positive, it means that an increase in the price of good Y leads
to an increase in the quantity demanded of good X. For example, an increase in the
price of apples may lead to an increase in the demand for pears. Here apples and pears
are regarded as substitutes for each other; if one becomes relatively more expensive,
consumers will switch to the other. A high value for the XED indicates that two goods
are very close substitutes. This information may be useful in helping a firm to identify
its close competitors.
On the other hand, if an increase in the price of one good leads to a fall in the
quantity demanded of another good, this suggests that they are likely to be
complements. The XED in this case will be negative. An example of such a relationship
is that between coffee and sugar, which tend to be consumed together.
Examples
Suppose you found that the XED for sugar with respect to a change in the price
of coffee was −0.087. This would imply that a 10% increase in the price of coffee
would lead to a 0.87% fall in the demand for sugar, suggesting that coffee and
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3
Test yourself 3.5
If the XED for a good
is negative, would this
suggest that the goods
are substitutes or
complements?
sugar are complements. If the XED for pineapples with respect to a change in the
price of mangoes was +0.532, this would suggest that a 10% increase in the price of
pineapples would lead to a 5.32% increase in the demand for mangoes, suggesting
that pineapples and mangoes are substitutes. If the XED were seen to be zero, this
would indicate that the goods concerned were unrelated – neither substitutes nor
complements.
Table 3.4 summarises the XED values.
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
▼ Table 3.4 Values of the XED
XED value
Description
Below −1
Elastic complement
Between −1 and 0
Inelastic complement
0
No relationship between the two goods
Between 0 and 1
Inelastic substitute
Above 1
Elastic substitute
EXERCISE 3.3
Calculate the cross elasticity of demand in each of
the following circumstances. In each case, assume
that the price of another good rises by 15%. In each
case, classify the good using Table 3.4.
a Quantity demanded changes from 200 to 260.
b
c
d
e
Quantity demanded changes from 400 to 310.
Quantity demanded changes from 500 to 560.
Quantity demanded changes from 50 to 47.
Quantity demanded stays at 300.
SUMMARY: CROSS ELASTICITY OF DEMAND
» The cross elasticity of demand (XED) measures the
sensitivity of the quantity demanded of one good or
service to a change in the price of some other good
or service.
» If the XED is positive, this indicates that the two
goods are substitutes.
» If the XED is negative, this indicates that the goods
are seen by consumers as complements.
» If the XED is zero, then the goods are unrelated.
3.4 Price elasticity of supply
KEY TERM
price elasticity
of supply (PES):
a measure of the
sensitivity of quantity
supplied of a good or
service to a change in
the price of that good or
service
As elasticity is a measure of sensitivity, its use need not be confined to influences on
demand, but can also be turned to evaluating the sensitivity of quantity supplied to a
change in its determinants – in particular, its price.
It was argued in Chapter 2 that the supply curve is likely to be upward sloping, so the
price elasticity of supply can be expected to be positive. In other words, an increase
in the market price will induce firms to supply more output to the market. The price
elasticity of supply (PES) is defined as:
PES =
Test yourself 3.6
Why is the PES a
positive number?
% change in the quantity supplied
% change in price
So, if the price elasticity of supply is 0.8, an increase in price of 10% will encourage firms
to supply 8% more. As with the price elasticity of demand, if the elasticity is greater than
1, supply is referred to as being elastic, whereas if the value is between 0 and 1, supply is
considered inelastic. Unitary elasticity occurs when the price elasticity of supply is exactly
1, so that a 10% increase in price induces a 10% increase in quantity supplied.
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Factors affecting the PES
Price
The value of the elasticity will depend on how willing and able firms are to increase
their supply. For example, if firms are operating close to the capacity of their existing
plant and machinery, they may be unable to respond to an increase in price, at least
in the short run. So here again, supply can be expected to be more elastic in the long
run than in the short run. Figure 3.6 illustrates this.
Ss
3
Sl
3 Elasticity
Test yourself 3.7
Will a firm’s supply
curve be more or less
elastic in the long run
as compared with the
short run?
0
Quantity per period
▲ Figure 3.6 Short- and long-run elasticity of supply
LEARNING
LINK
The distinction
between the short
run and the long run
will be more fully
discussed in Chapter
17, when we explore
how producers face
costs that may be
fixed in the short run.
KEY TERMS
perfectly elastic
supply: a situation in
which firms will supply
any quantity of a good
at the going price –
elasticity of supply is
infinite
perfectly inelastic
supply: a situation in
which firms can supply
only a fixed quantity,
so cannot increase or
decrease the amount
available – elasticity of
supply is zero
In the short run, firms may be able to respond to an increase in price only in
a limited way, and so supply may be relatively inelastic, as shown by Ss in the
figure. However, firms can become more flexible in the long run by installing new
machinery or building new factories, so supply can then become more elastic,
moving to Sl .
There are two limiting cases of supply elasticity. For some reason, supply may be
fixed such that no matter by how much price increases, firms will not be able to
supply any more. For example, it could be that a certain amount of fish is available
in a market, and however high the price goes, no more can be obtained. Equally,
if the fishermen know that the fish they do not sell today cannot be stored for
another day, they have an incentive to sell, however low the price goes. In these
cases, supply is perfectly inelastic and the supply curve would be vertical. At
the other extreme is perfectly elastic supply, where firms would be prepared to
supply any amount of the good at the going price so the supply curve would be
horizontal.
Using the PES
Knowing the value of the PES provides information about how readily firms are able
to respond to changes in market conditions. If the PES is strongly positive (supply is
highly elastic), then this indicates that firms are able to respond quickly and flexibly
to a change in market conditions, whereas when supply is inelastic, firms in the
market will not be able to react in the short run.
This could be important for the government’s decision making. If the government
wants to encourage the supply of a good, it will be important to know whether firms
will be able to increase supply speedily and easily. A high PES implies that firms will
not be able to react. There is no point in calling on firms to supply more if they do
not have the capacity to do so. Important in this is whether firms have access to
machinery, labour and raw materials needed to expand production.
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AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
3
EXERCISE 3.4
Calculate the price elasticity of supply in each of the
following circumstances.
In each case, assume that the price of the good rises
by 20%.
a Quantity supplied changes from 500 to 800.
b Quantity supplied changes from 200 to 220.
c Quantity supplied stays at 750.
SUMMARY: PRICE ELASTICITY OF SUPPLY
» The price elasticity of supply (PES) measures the
sensitivity of the quantity supplied to a change in
the price of a good or service.
» The size of the price elasticity of supply depends
on how flexible firms can be in varying their
output.
» The price elasticity of supply can be expected
to be greater in the long run than in the short
run, as firms have more flexibility to adjust their
production decisions in the long run.
3.5 T
he usefulness and significance of elasticities for
decision making
Knowledge of the PED, YED and XED can be useful to firms and to the government as
part of their decision making. These elasticities can help in assessing the likely impact
of proposed decisions.
The PED
For a firm, the PED will be informative about how buyers of the good are likely to
respond to a price change. This is important for a firm that is trying to set its price
to maximise profits. If a firm knows that demand is elastic, an increase in price would
lead to a fall in revenues, whereas if demand is inelastic, revenues would increase, as
buyers would respond less strongly to a price increase.
The significance of the PED turns partly on the difficulty of obtaining an estimate of
it. This is beyond the means of even a medium-sized firm. However, firms are likely
to have a sense of how consumers will react to a change in the price of their product,
which may be important in setting or changing price. An understanding of the factors
that influence the PED will help firms to come to a view about the likely elasticity of
demand that they face in respect of their product.
From the government perspective, imposing an indirect tax will raise the price and
lead to a fall in demand, so knowing the PED helps to forecast the tax revenues
expected. This is explored in Chapter 5. Introducing a subsidy would reduce the selling
price of a good, and knowing the PED allows the government to assess the impact of
such a move.
The YED
The YED will help a firm to forecast changing demand if real incomes are increasing,
or if the economy is heading into a recession. Knowing whether a good is normal or
inferior is significant in this situation. If a firm is trying to anticipate the future
state of demand for its product, then knowing that it is producing a normal good
(with a positive YED) will be good news if the economy is expanding, so that consumer
incomes are expected to rise.
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LEARNING
LINK
The XED helps in anticipating changes in demand if the prices of other products
are changing. A firm needs to know who its competitors are when devising its own
strategy, so it may be important to be aware of whether another firm’s products are
close substitutes, or whether they are complements. If the XED is strongly positive
with respect to a good produced by a rival firm, the firm will be aware that it needs to
take care when thinking about raising price, as demand would be affected and damage
its position in the market.
From the government perspective, imposing an indirect tax will raise the price and lead
to a fall in demand, so knowing the PED helps to forecast the tax revenues expected.
This is explored in Chapter 5. Introducing a subsidy would reduce the selling price of a
good, and knowing the PED allows the government to assess the impact of such a move.
3
3 Elasticity
The effects of
an indirect tax
are introduced
in Chapter 5 and
discussed in more
detail in Chapter 21.
The way in which
firms in a market
may react to each
other’s actions
is discussed in
Chapters 18 and 19.
The XED
It may not always be straightforward to obtain estimates of the various elasticities.
However, if economic agents know about the factors that influence the elasticities,
and if they understand their significance, they may be able to take better decisions.
EXERCISE 3.5
Imagine the following scenario. You are considering
a pricing strategy for a bus company. The economy
is heading into recession, and the company is
running at a loss. Your local rail service provider
has announced an increase in rail fares. How (if at
all) do you use the following information concerning
the elasticity of bus travel with respect to various
variables to inform your decision on price? Would you
raise or lower price?
» price elasticity of demand
−1.58
» income elasticity of demand
−2.43
» cross elasticity of demand with respect
to rail fares
+2.21
» your price elasticity of supply
+1.15
SUMMARY: THE USEFULNESS AND SIGNIFICANCE OF ELASTICITIES
» The elasticity measures can be useful to firms
by providing information about how demand is
likely to change in the face of changing market
conditions.
» The government can also use measures of
elasticity when seeking to devise policies.
» Finding reliable quantitative estimates of elasticity
measures is not straightforward.
END OF CHAPTER QUESTIONS
Multiple choice
1 Which of the options is valid along a normal, downward-sloping demand curve?
A The PED and hence total revenue (TR) are constant along the whole demand
curve.
B The PED falls when moving down along the demand curve, while TR first rises,
then falls.
C The PED and hence TR first rise and then fall when moving down along the
demand curve.
D The PED and hence TR first fall and then rise when moving down along the
demand curve.
2 Other things being equal, which of the following firms will experience an increase
in total revenue in times of recession?
A a firm with a PED of −0.8
B a firm with a PES of 1.8
C a firm with a XED of +0.8
D a firm with an YED of −1.8
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Data response
3
1 Study Tables 3.5 and 3.6 and then answer the questions that follow.
▼ Table 3.5 Estimated price and income elasticity data for selected food items
in Vietnam, 2020
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
Food item
Price elasticity of
demand
Price elasticity of
supply
Income elasticity of
demand
Rice
−0.89
0.52
0.96
Goat
−0.79
0.63
1.01
Poultry
−1.09
0.58
1.01
Fish
−0.94
0.64
1.03
Vegetables
−0.97
0.31
0.99
Fruit
−0.93
0.42
1.00
Source: adapted from Linh Hoang Vu, ‘Estimation and Analysis of Food Demand Patterns in
Vietnam’, 2020
▼ Table 3.6 Average salary/monthly consumer income in India, 2016–24
Year
Average salary/monthly consumer income
in India in Indian rupees (IRS)
2016
29,600
2017
30,700
2018
31,100
2019
31,600
2020
32,200
2024*
41,700
*estimated figure
Source: http://www.salaryexplorer.com
a With reference to Table 3.5:
i Use a formula to calculate the value of the price elasticity of supply
of rice and interpret the meaning of the value.
ii Explain how goat and poultry can have the same income elasticity
of demand but different price elasticity of demand.
b With reference to Table 3.6, if the demand for petrol in India increased
by 0.76% between 2019 and 2020, calculate the income elasticity of
demand for petrol in India in 2020.
c Explain, with reference to Table 3.5, why ‘time’ is likely to be an important
factor in determining the price elasticity of supply of vegetables.
d A Vietnamese poultry farmer is trying to increase her revenue as a result
of altering the price she charges. Assess the usefulness of the
information in Table 3.5.
Essay style
2 a T
he ‘Tiago’ is a small city car made by Tata Motors in India since 2016. It is
considered a functional vehicle and one of the least expensive in Tata’s range.
In 2020, Tata shifted its focus to the launch of the ‘Harrier’ – a five-seater petrol
sports utility vehicle (SUV) that sits at the luxury end of Tata’s fleet.
With the help of a formula, explain the meaning of income elasticity of demand
and consider the likely success of the 2020 launch of Tata’s Harrier SUV at a
time of rising incomes in India.
b Discuss whether income elasticity of demand or price elasticity of demand of
Tata’s Tiago car is likely to be greater.
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CASE STUDY
3
Fish
3 Elasticity
Imagine a remote island in the South
Seas.
Some of the islanders own canoes which
they use to go fishing, selling their catch
on the beach when they return each day.
Some islanders only go fishing
occasionally, as they find it more
worthwhile to spend their time on other
activities. The island has no electricity,
so there is no way of storing the fish that
are caught – if they are not consumed on
the day of the catch, they must be
thrown away.
▲ Fishing in the Solomon Islands
The market for fish on the island is limited by the size of the population.
Fortunately for the fishermen, the islanders enjoy fish, and regard it as an
important part of their diet, although they also grow vegetables and raise goats
and chickens. Fruit and coconuts are also abundant.
Follow-up questions
a What would you expect to be the nature of the price elasticity of supply in the
short run (that is, on any given day)?
b Suppose that, on one particular day, fishing conditions are so good that all
fishermen return with record catches. How would this affect the price of fish?
c How might the situation in (b) affect the supply of fish on the following day?
d How would you expect the supply of fish to be affected by the invention of a
new style of canoe that makes it easier to catch fish?
e How would the market be affected if this new-style canoe also enabled fish to
be traded with a neighbouring island?
Go online at hoddereducation.com/cambridgeextras for more case studies for
Chapter 3.
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AS LEVEL PART 2 The price system and the microeconomy
What this chapter covers
★ equilibrium and disequilibrium in a market
★ shifts in demand and supply
★ relationships between markets
★ the role of prices in allocating resources
★ consumer and producer surplus
The previous chapters introduced the notions of demand and supply, and it is now
time to bring the demand and supply curves together in order to meet the key concept
of market equilibrium. The model can then be further developed to see how it provides
insights into how markets operate. You will encounter demand and supply in a variety
of contexts, and begin to glimpse some of the ways in which the model can help to
explain how the economic world works.
4.1 Market equilibrium
The previous chapters have described the components of the demand and supply
model. It only remains to bring them together, for this is how the power of the model
can be appreciated. Figure 4.1 shows the demand for and supply of rice.
Suppose that the price were to be set at a relatively high price (above P*). At such a
price, firms wish to supply lots of rice to the market. However, consumers are not very
keen on rice at such a high price, so demand is not strong. Firms now have a problem:
they find that their stocks of rice are building up. What has happened is that the price
has been set at a level that exceeds the value that most consumers place on rice, so
they will not buy it. There is excess supply. Given this surplus of supply over demand,
firms need to reduce price in order to clear their stocks.
Price
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
4
Market equilibrium and the
price system
Excess supply
when price is high
Supply
P*
Excess demand
when price is low
Demand
0
Q*
Quantity of rice per period
▲ Figure 4.1 Bringing demand and supply together
Suppose they now set their price relatively low (below P*). Now it is the consumers
who have a problem, because they would like to buy more rice at the low price than
firms are willing and able to supply. There is excess demand. Some consumers may
offer to pay more than the going price in order to obtain their rice supplies, and firms
realise that because of the shortage, they can raise the price.
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EXERCISE 4.1
Identify the equilibrium market price if demand and supply are as in Figure 4.2.
Pa
Supply
Pb
Pc
Test yourself 4.1
How would you
expect price to adjust
when there is excess
demand for a good in a
competitive market?
4
Pd
Pe
Demand
0
Quantity per period
▲ Figure 4.2 What is the equilibrium price?
4 Market equilibrium and the price system
If a market is away
from equilibrium (i.e.
if it is in disequilibrium),
it is important to
understand how
the price adjusts to
return the market to
equilibrium. When
there is a surplus,
price will tend to fall
towards equilibrium.
If there is a shortage,
price will tend to rise.
How will it all end? When the price settles at P* in Figure 4.1, there is a balance in the
market between the quantity that consumers wish to demand and the quantity that
firms wish to supply, namely Q*. This is the market equilibrium. In a free market, the
price can be expected to converge on this equilibrium price, through movements
along both demand and supply curves. When the price reaches equilibrium, there is no
further reason for it to change, unless something disturbs that equilibrium.
Price
STUDY TIP
KEY TERMS
market equilibrium: a
situation that occurs in
a market when the price
is such that the quantity
that consumers wish to
buy is exactly balanced
by the quantity that
firms wish to supply
equilibrium price: the
unique price at which
the quantity demanded
by consumers in a
market is just balanced
by the quantity that
firms wish to supply
QUANTITATIVE SKILLS 4.1
Identifying and interpreting an intersection on a diagram
You will meet many diagrams in economics where there are upward- and
downward-sloping lines that intersect at some point. Such intersection points
are almost always significant. In the case of demand and supply, the downwardsloping line represents demand, and the upward-sloping curve shows supply.
Only at the point where the two lines meet are the decisions of consumers and
firms mutually consistent. In other words, consumers are choosing to demand
exactly the quantity that firms are willing and able to supply. The important
question to explore is the mechanism that will lead to this equilibrium point.
This in turn depends on the incentives facing economic agents if the starting
point is away from the intersection point.
STUDY TIP
In this section, we have discussed the market for a product. You will also meet other
types of market – for example, there are markets for factors of production and for
foreign exchange.
SUMMARY: MARKET EQUILIBRIUM
» Bringing demand and supply together, you can identify the market equilibrium.
» The equilibrium price is the unique point at which the quantity demanded by
consumers is just balanced by the quantity that firms wish to supply.
» In a free market, natural forces can be expected to encourage prices to adjust
to the equilibrium level.
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In the previous section, we explored the way in which a market moves towards
equilibrium between demand and supply through price adjustments and movements
along the demand and supply curves. This is static analysis, in the sense that
a ceteris paribus assumption is imposed by holding constant the factors that
influence demand and supply, in order to focus on the way in which the market
reaches equilibrium.
In the next stage, we explore the effect on market equilibrium if one of these
background factors is changed. In other words, beginning with a market in
equilibrium, one of the factors affecting either demand or supply is altered, and the
new market equilibrium is then studied.
A market for dried noodles
Begin with a simple market for dried noodles, a basic staple foodstuff that is widely
obtainable. Figure 4.3 shows the market in equilibrium.
Price per kilo
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
4
4.2 The effects of shifts in demand and supply
curves
S0
P0
D0
0
Q0
Quantity of noodles per week
▲ Figure 4.3 A market for noodles
D0 represents the demand curve in this initial situation, and S0 is the supply curve.
The market is in equilibrium with the price at P0, and the quantity being traded
is Q0. It is equilibrium in the sense that noodles producers are supplying just the
amount of noodles that consumers wish to buy at that price. This is the ‘before’
position. Some experiments will now be carried out with this market by disturbing
the equilibrium.
A change in consumer preferences
Suppose that a study is published highlighting the health benefits of eating
noodles, backed up with an advertising campaign. The effect of this is likely to
be an increase in the demand for noodles at any given price. In other words, this
change in consumer preferences will shift the demand curve to the right, as shown
in Figure 4.4.
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Price per kilo
S0
4
P1
P0
0
Q0
Q1
Quantity of noodles per week
▲ Figure 4.4 A change in consumer preferences for noodles
The market now adjusts to a new equilibrium, with a new price P1, and a new quantity
traded at Q1. In this case, both price and quantity have increased as a result of the
change in preferences.
A change in the price of a substitute
Price per kilo
A second possibility is that there is a fall in the price of fresh noodles. This is likely
to be a close substitute for dried noodles, so the probable result is that some former
consumers of dried noodles will switch to the fresh variety. This time the demand
curve for dried noodles moves in the opposite direction, as can be seen in Figure 4.5.
4 Market equilibrium and the price system
D1
D0
S0
P0
P2
D2
0
D0
Q2 Q0
Quantity of noodles per week
▲ Figure 4.5 A change in the price of a substitute for dried noodles
Here the starting point is the original position, with market equilibrium at price P0
and a quantity traded of Q0. After the shift in the demand curve from D0 to D2, the
market settles again with a price of P2 and a quantity traded of Q2. Both price and
quantity traded are now lower than in the original position.
An improvement in noodles technology
Next, suppose that a new noodle-making machine is produced, enabling dried noodle
makers to produce at a lower cost than before. This advance reduces firms’ costs, and
consequently they are prepared to supply more dried noodles at any given price. The
starting point is the same initial position, but now it is the supply curve that moves –
to the right. This is shown in Figure 4.6.
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Price per kilo
4
S0
S3
P0
D0
0
Q0 Q3
Quantity of noodles per week
▲ Figure 4.6 New noodles-making technology
Again, we can see how the market equilibrium changes. The new market equilibrium
is at price P3, which is lower than the original equilibrium, but the quantity traded is
higher at Q3.
An increase in labour costs
Finally, suppose that noodles producers face an increase in their labour costs. Perhaps
the Noodle Workers’ Union has negotiated higher wages, or the noodles producers have
become subject to stricter health and safety legislation, which raises their production
costs. Figure 4.7 starts as usual with equilibrium at price P0 and quantity Q0.
Price per kilo
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
P3
S4
S0
P4
P0
D0
0
Q4
Q0
Quantity of noodles per week
▲ Figure 4.7 An increase in labour costs
The increase in production costs means that noodles producers are prepared to supply
fewer dried noodles at any given price, so the supply curve shifts to the left – to S4.
This takes the market to a new equilibrium at a higher price than before (P4), but with
a lower quantity traded (Q4).
Shifts in both demand and supply
In the real world, it is quite possible for there to be shifts in both demand and supply
curves at the same time. The outcome for the market equilibrium will then depend on
the relative strength and direction of the shifts. Figure 4.8 shows one example. In
this case, the market begins in equilibrium with demand D0 and supply S0 in balance
at price P0 and quantity traded Q0. Suppose that there is an increase in supply to S1
combined with a decrease in demand to D1. The new equilibrium is at price P1 and
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What factors could
affect the position of the
supply curve?
Test yourself 4.3
Test yourself 4.4
In the summer of 2018
the UK experienced a
heatwave and the media
highlighted a shortage
of carbon dioxide
(CO2), which is used in
manufacturing fizzy
drinks and in storing
food products. What
effect would you expect
this to have on the
market for fizzy drinks?
S1
S0
P0
P1
D1
0
Q0 Q1
4
D0
Quantity
▲ Figure 4.8 Shifts in both demand and supply curves
4 Market equilibrium and the price system
In a competitive market,
suppose that the
equilibrium price and
the equilibrium quantity
traded are both seen to
increase. What shifts in
the demand and supply
curves could have taken
place?
quantity traded Q1. So, in this case, there has been a fall in the price and a rise in the
quantity traded. Notice that the extent of the increase in supply was large compared
with the magnitude of the decrease in demand. If the supply curve had shifted by less
and the demand curve by more, the result would have been different – indeed, the
quantity traded might have stayed the same or fallen in this alternative situation.
(You could sketch some diagrams to try for yourself what would happen with different
combinations of demand and supply shifts.)
Price
Test yourself 4.2
STUDY TIP
Economists use diagrams a lot to analyse how equilibrium is affected by external
changes – in this case, a change in market conditions that induces a shift in the
demand curve. Remember that practice makes perfect, so watch in the news for
examples of events that are likely to affect a market, and draw demand and supply
curves to analyse what is expected to happen next.
SUMMARY: THE EFFECTS OF SHIFTS IN DEMAND AND
SUPPLY CURVES
» A change in the market environment can cause a shift in demand or supply.
» The market then moves to a new equilibrium position as price adjusts to the
change.
4.3 Relationships between different markets
KEY TERM
alternative demand:
a situation in which
demand for a good is
affected by a change
in the price of an
alternative (substitute)
good
There are situations in which markets are interrelated, such that changes that affect
one market have knock-on effects elsewhere.
Alternative demand
We have already seen one example of interrelated markets in the previous section.
Figure 4.5 showed the effect of a change in the price of fresh noodles on the demand
for dried noodles. This effect arose because the two goods were seen as substitutes
for each other, as fresh noodles are viewed as being an alternative to dried noodles.
This is known as alternative demand.
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4
Test yourself 4.5
Joint demand
Give examples of
products that illustrate
situations of alternative
and joint demand.
Where two goods are seen as complements in their use, there will also be an
interrelationship between the markets, known as joint demand, because the goods
are consumed together. For example, many people like to take some sugar with their
coffee, so sugar and coffee are consumed together. If there is a surge in the popularity
of coffee, this will also bring an increase in the demand for sugar.
KEY
Test TERMS
yourself 4.5
joint
demand: aof
Give examples
situation
which
goods
products in
that
illustrate
are
consumed
together
situations of alternative
–
in other
words, where
and
joint demand.
they are complements
derived demand: where
the demand for a good
or a factor of production
derives not from the
good or factor itself,
but from the good or
service that it provides
There are situations in which the demand for a good or service is indirect. This is best
seen through some examples.
The labour market
Within the economy, firms demand labour and employees supply labour – so can we
use demand and supply to analyse the market for a factor of production?
From the firms’ point of view, the demand for labour is a derived demand. In other
words, firms want labour not for its own sake, but for the output that it produces.
When the price of labour is low, firms will tend to demand more of it than when
the price of labour is high. The wage rate can be regarded as this price of labour.
On the employee side, it is argued that more people tend to offer themselves for
work when the wage is relatively high. On this basis, the demand for labour curve is
expected to be downward sloping and the supply of labour curve upward sloping, as
in Figure 4.9.
Wage rate
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
Derived demand
Labour supply
W*
Labour demand
0
L*
Quantity of labour per period
▲ Figure 4.9 A labour market
LEARNING
LINKS
The working of labour
markets is discussed
in more detail in
Chapter 23.
The significance of
the exchange rate is
examined in Chapters
13 and 29.
As usual, the equilibrium in a free market will be at the intersection of demand and
supply, so firms will hire L* labour at a wage rate of W*.
The foreign exchange market
If you were to take a holiday in the USA, you would need to buy dollars. Equally, when
American tourists travel to visit Malaysia or Mauritius, they need to buy ringgits
or rupees. If there is buying going on, then there must be a market. So here is
another sort of market to be considered. The exchange rate is the price at which two
currencies exchange, and it can be analysed using demand and supply.
Consider the market for ringgits, and focus on the exchange rate between ringgits and
dollars, as shown in Figure 4.10.
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4
e*
Demand
0
Quantity of ringgits per period
▲ Figure 4.10 The market for ringgits
Think first about what gives rise to a demand for ringgits. It is not just Americans
visiting Malaysia who need dollars to spend on holiday: anyone holding dollars who
wants to buy Malaysian goods needs ringgits in order to pay for them. So the demand
for ringgits comes from people outside Malaysia who want to buy Malaysian goods or
services – or, indeed, assets. When the exchange rate for ringgits in terms of dollars
is high, potential buyers of American goods get relatively few ringgits per dollar, so
the demand will be relatively low, whereas if the dollar per ringgit rate is relatively
low, they get more for their money. Hence the demand curve is expected to be
downward sloping.
4 Market equilibrium and the price system
Exchange rate (price of ringgits in dollars)
Supply
Foreign exchange is a derived demand, in the sense that people want ringgits not
for their own sake, but for the goods or services that they can buy. One way of
viewing the exchange rate is as a means by which to learn about the international
competitiveness of exports from the USA. When the exchange rate (dollars per ringgit)
is high, Malaysian goods are less competitive in the USA, ceteris paribus. Notice the
ceteris paribus assumption here. This is important because the exchange rate is not
the only determinant of the competitiveness of Malaysian goods: this also depends on
the relative price levels in Malaysia and the USA.
How about the supply of ringgits? Ringgits are supplied by Malaysians wanting dollars
to buy goods or services from the USA. From this point of view, when the dollar/
ringgit rate is high, Malaysian residents get more dollars for their ringgits and
therefore will tend to supply more ringgits.
If the exchange market is in equilibrium, the exchange rate will be at e*, where the
demand for ringgits is matched by the supply.
Joint supply
KEY TERM
joint supply: where a
firm produces more
than one product
together
There are circumstances in which a firm may produce a range of goods jointly. Perhaps
one good is a by-product of the production process of another. For example, a sheep
farmer can produce both wool and meat from the sheep. An increase in the price of
one of the goods may mean that the firm will produce more of both goods. This notion
of joint supply is similar to the situation on the demand side where consumers regard
two goods as complements.
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AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
4
▲ Sheep provide wool and meat
EXERCISE 4.2
For each of the following market situations, sketch a
demand and supply diagram, and see what happens
to the equilibrium price and quantity. Explain your
answers.
a An increase in consumer incomes affects the
market for bus travel.
b New regulations on environmental pollution force
a firm making paint to reduce its emission of toxic
fumes.
c A firm of accountants brings in new, faster
computers to improve efficiency.
d An outbreak of bird flu causes consumers of
chicken to buy pizza instead. (What is the effect
on both markets?)
EXERCISE 4.3
Discuss how changes in the demand and supply of oil-based fuels could affect a
related market.
SUMMARY: RELATIONSHIPS BETWEEN DIFFERENT MARKETS
» There are situations in which markets are
interrelated, so that a change in one market
affects others.
» One way this happens is where two goods are
substitutes for each other, which gives rise to
alternative demand.
» When two goods are complements, there is a
situation of joint demand.
» Derived demand is where something is demanded
not for its own sake, but for the goods or services
that it provides.
» Joint supply occurs when a firm produces more
than one good together.
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4.4 The functions of prices in allocating resources
The coordination problem
Prices and preferences
Price
How can consumers signal their preferences to producers? Demand and supply analysis
provides the clue. Figure 4.11 shows the demand and supply for smartphones. Over
time there has been a rightward shift in the demand curve – in the figure, from D0 to
D1. This simply means that consumers are placing a higher value on these goods; they
are prepared to demand more at any given price. The result is that the market will
move to a new equilibrium, with price rising from P0 to P1 and quantity traded from Q0
to Q1: there is an extension of supply.
Supply
4
4 Market equilibrium and the price system
As Chapter 1 indicated, all societies face the fundamental economic problem of
scarcity. Because there are unlimited wants but finite resources, it is necessary to
take decisions on which goods and services should be produced, how they should be
produced and for whom they should be produced. For an economy the size of the USA
or India, there is an immense coordination problem. Another way of looking at this is
to ask how consumers can express their preferences between alternative goods so that
producers can produce the best mix of goods and services.
P1
P0
D0
0
D1
Q1
Q0
Quantity of smartphones per period
▲ Figure 4.11 The market for smartphones
The shift in the demand curve is an expression of consumers’ preferences; it embodies
the fact that they value smartphones more highly now than before. The price that
consumers are willing to pay represents their valuation of smartphones.
▲ Smartphones are highly
valued
Notice also that price is effectively acting as a rationing device as part of coping with
scarcity. Given limited resources, it is inevitable that not everyone who might want to
consume a good or service will be able to do so. The price of the good limits access to
those consumers who are willing and able to pay the price set by the market.
Prices as signals and incentives
From the producers’ perspective, the question is how they receive signals from
consumers about their changing preferences. Price is the key. Figure 4.11 showed how
an increase in demand for smartphones leads to an increase in the equilibrium price,
which encourages producers to supply more smartphones – there is an extension of
supply. This is really saying that producers find it profitable to expand their output of
smartphones at that higher price. The price level is working as a signal to producers
about consumer preferences.
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Notice that the price signal works equally well when there is a decrease in the demand
for a good or service. In Figure 4.12 there has been a large fall in the demand for a
good – for example, because a campaign has encouraged a switch away from junk
food. The demand curve shifts to the left from D0 to D1. Producers of junk food begin
to find that they cannot sell as much at the original price as before, so they have
to reduce their price to avoid an increase in unsold stocks. They have less incentive
to supply junk food, and will supply less. There is a contraction of supply and a
movement along the supply curve to a lower equilibrium price at P1, and a lower
quantity traded at Q1.
LEARNING
LINK
Supply
Price
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
4
P0
P1
This may also affect
the demand for
factors of production
(e.g. labour), as
explained in Chapter 1.
D1
D0
Q1 Q0
Quantity
▲ Figure 4.12 A decrease in demand
This shows how existing producers in a market receive signals from consumers in the
form of changes in the equilibrium price, and respond to these signals by adjusting
their output levels. In this way, prices act to guide resource allocation in the
economy.
Test yourself 4.6
What would happen to
the equilibrium price
if there was a good
harvest, creating excess
supply?
STUDY TIP
Prices fulfil a range of functions in a market economy, including:
» transmitting consumer preferences through signals to producers
» providing incentives to producers
» addressing shortages through rationing
» guiding the allocation of resources
SUMMARY: THE FUNCTIONS OF PRICES IN ALLOCATING
RESOURCES
» All societies face the fundamental problem of scarcity.
» Prices can provide signals and incentives to guide the allocation of resources
and can act as a rationing device.
» Consumers can signal their preferences through the price mechanism.
» Firms have incentives to respond to price signals.
4.5 Consumer and producer surplus
Consumer surplus
Think a little more carefully about what the demand curve represents. Figure 4.13
again shows the demand curve for smartphones. Suppose that the price is set at P*
and quantity demanded is thus Q*. P* can be seen as the value that the last customer
places on a smartphone. In other words, if the price were even slightly above P*, there
would be one consumer who would choose not to buy: this individual will be referred
to as the marginal consumer.
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Price
4
Consumer A’s valuation
Consumer B’s valuation
P*
0 AB
Q*
Quantity of smartphones per period
▲ Figure 4.13 Price as marginal benefit
KEY TERM
marginal social benefit
(MSB): the additional
benefit that society
gains from consuming
an extra unit of a good
KEY TERM
In most markets, all consumers face the same prices for goods and services. This leads
to an important concept in economic analysis. P* may represent the value of
smartphones to the marginal consumer, but what about all the other consumers who
are also buying smartphones at P*? They would all be willing to pay a higher price for
a smartphone. Indeed, consumer A in Figure 4.13 would pay a very high price indeed,
and values a smartphone much more highly than P*. When consumer A pays P* for a
smartphone, he gets a great deal, as he values the good so much more highly – as
represented by the vertical green line on Figure 4.13. Consumer B also gains a surplus
above her willingness to pay (the purple line).
If all these surplus values are added up, they sum to the total surplus that society
gains from consuming smartphones. This is known as the consumer surplus,
represented by the shaded triangle in Figure 4.14. It can be interpreted as the welfare
that society gains from consuming the good, over and above the price that has to be
paid for it.
Price
consumer surplus: the
value that consumers
gain from consuming
a good or service over
and above the price paid
for all but the last unit
that is bought
To that marginal consumer, P* represents the marginal benefit derived from
consuming this good – it is the price that just reflects the consumer’s benefit
from a smartphone, as it is the price that just induces her to buy. Thinking of the
society as a whole (which is made up of all the consumers within it), P* can be
regarded as the marginal social benefit (MSB) derived from consuming this good.
The same argument could be made about any point along the demand curve, so
the demand curve can be interpreted as the marginal benefit to be derived from
consuming smartphones.
4 Market equilibrium and the price system
Demand (MSB)
A
Test yourself 4.7
Explain why
consumer surplus
can be interpreted
as representing the
welfare that society
gains from consuming
a good.
P*
O
B
Demand (MSB)
Q*
Quantity of smartphones per period
▲ Figure 4.14 Consumer surplus
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4
EXERCISE 4.4
Table 4.1 shows the price at which each of six consumers would be prepared to
buy a good.
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
▼ Table 4.1 The price at which consumers A–F would buy a good
Consumer A
$20
Consumer B
$18
Consumer C
$16
Consumer D
$14
Consumer E
$12
Consumer F
$10
Suppose the market price is at $14.
a Which of the consumers would choose to buy the good?
b What would be consumer A’s consumer surplus at this price?
c What would be the total consumer surplus enjoyed by the consumers
purchasing the good?
d What would be the total consumer surplus if the price were to increase to
$16?
QUANTITATIVE SKILLS 4.2
Interpreting areas on a diagram
In using diagrams like Figure 4.14, it is often important to be able to interpret
areas on the graph as well as lines and positions. In this case, the area of
interest is the total amount of consumer surplus.
Notice that letters are used to identify points on the diagram (in this case,
the points are labelled P*, Q*, A, B and O); a combination of these letters then
identifies the area enclosed by the points.
The area under the demand curve up to the quantity sold (Q*) represents the
total value of the good that is sold. In total, consumers spend an amount on this
which is the price multiplied by the quantity sold, namely P* multiplied by Q*. In
Figure 4.14 total expenditure on the good is the area of the rectangle OP*BQ*.
The consumer surplus is then the shaded triangle P*AB.
LEARNING LINK
The notion of the marginal principle was introduced in Chapter 1. Economists rely
heavily on the idea that firms, consumers and other economic agents can make
good decisions by thinking in terms of the margin, weighing up the effect of small
changes.
Consumer surplus and price
There is a relationship between the size of consumer surplus and the price charged for
a good. If the price of a good increases, this will reduce the overall size of consumer
surplus, and affect the welfare that society receives from consuming the good. You
can see this in Figure 4.15.
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Price
4
A
C
B
Demand
O
G
H
Quantity
▲ Figure 4.15 Consumer surplus and price
When the price of the good is relatively low at OE, quantity demanded is OH,
consumers spend the area OEFH, and receive consumer surplus of AEF. However, if the
price were to increase to OB, quantity demanded would fall to OG, spending would be
the area OBCG, and consumer surplus would be lower than before, at ABC.
KEY TERM
Suppose there is an increase in the price of cinema tickets. What Figure 4.15 indicates
is that there will be some people who will not go to the cinema as frequently as before,
and that those who do go at the higher price will receive less in the way of consumer
surplus than if the price had remained at its original lower level. Welfare has fallen. A
key question is the extent to which the quantity demanded will fall, which depends on
the elasticity of demand. When demand is elastic, the impact will be greater, because
consumers will react more strongly than if demand is highly inelastic.
Producer surplus
Parallel to the notion of consumer surplus is the concept of producer surplus. Think about
the nature of the supply curve: it reveals how much output firms are prepared to supply at
any given price in a competitive market. Figure 4.16 depicts a supply curve. Assume the
price is at P*, and that all units are sold at that price. P* represents the value to firms of
the marginal unit sold. In other words, if the price had been set slightly below P*, the last
unit would not have been supplied, as firms would not have found this profitable.
Price
producer surplus: the
difference between the
price received by firms
for a good or service
and the price at which
they would have been
prepared to supply that
good or service
4 Market equilibrium and the price system
F
E
Supply
P*
A
0
Q*
Quantity supplied per period
▲ Figure 4.16 A supply curve
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marginal cost: the
cost of producing an
additional unit of output
Notice that the threshold at which a firm will decide it is not profitable to supply is
the point at which the price received by the firm reaches the cost to the firm of
producing the last unit of the good. Thus, in a competitive market the supply curve
reflects marginal cost.
The supply curve shows that, in the range of prices between point A and P*, firms
would have been willing to supply positive amounts of this good or service. So at P*,
they would gain a surplus value on all units of the good supplied below Q*. The total
area is shown in Figure 4.17: it is the area above the supply curve and below P*, shown
as the shaded triangle.
Price
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
4
KEY TERM
Supply
P*
A
Test yourself 4.8
Explain why producer
surplus may be
considered as a
motivation for firms.
0
Q* Quantity supplied per period
▲ Figure 4.17 Producer surplus
One way of defining this producer surplus is as the surplus earned by firms over and
above the minimum that would have kept them in the market. It is the reason for
which firms exist.
Notice that the extent to which suppliers can respond to a change in demand in the
short run will depend on the elasticity of supply. If supply is inelastic, so that firms
are unable to be flexible in varying their output level, then the short-run impact of a
change in demand may be limited.
Entry and exit of firms
The discussion so far has focused on the reactions of existing firms in a market
to changes in consumer preferences. However, this is only part of the picture.
Think back to Figure 4.11, where there was an increase in demand for smartphones
following a change in consumer preferences. The equilibrium price rose, and existing
firms expanded the quantity supplied in response. Those firms are now earning a
higher producer surplus than before. Other firms not currently in the market will
be attracted by these surpluses, perceiving this to be a profitable market in which
to operate.
If there are no barriers to entry, more firms will join the market. This in turn will tend
to shift the supply curve to the right, as there will then be more firms prepared to
supply. As a result, the equilibrium market price will tend to drift down again, until
the market reaches a position in which there is no further incentive for new firms to
enter the market. This will occur when the rate of return for firms in the smartphone
market is no better than in other markets.
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micro
Price
Figure 4.18 illustrates this situation. The original increase in demand leads, as before,
to a new equilibrium with a higher price P1. As new firms join the market in quest of
producer surplus, the supply curve shifts to the right to S2, pushing the price back
down to P0, but with the quantity traded now up at Q2.
4
S0
S2
P0
D1
D0
0
Q0
Q1
Q2
Quantity of smartphones per period
▲ Figure 4.18 The market for smartphones revisited
Price
If the original movement in demand is in the opposite direction, as it was for junk
food in Figure 4.12, a similar long-run adjustment takes place. As the market price
falls, some firms in the market may decide that they no longer wish to remain in
production, and will exit from the market altogether. This will shift the supply curve
to the left in Figure 4.19 (to S2) until only firms that continue to find it profitable will
remain in the market. In the final position, price is back to P0, and quantity traded
has fallen to Q2.
S2
4 Market equilibrium and the price system
P1
S0
P0
P1
D1
0
Q2
D0
Q0
Q1
Quantity of junk food per period
▲ Figure 4.19 The market for junk food
STUDY TIP
These concepts of consumer and producer surplus will be important in later
discussions of efficiency and inefficiency in resource allocation.
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AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
Figure 4.20 shows the effect on consumer and
producer surplus before and after a decrease in
supply, caused by an increase in production costs.
aIdentify the areas representing consumer surplus
before and after the change.
bIdentify the areas representing producer surplus
before and after the change.
c Comment on the relative size of the surpluses
before and after the change.
Price
4
EXERCISE 4.5
S1
S0
A
P1
P0
B
C
E
D
F
Q1 Q0
Quantity per period
▲ Figure 4.20 Consumer and producer surplus with a
decrease in supply
SUMMARY: CONSUMER AND PRODUCER SURPLUS
» The demand curve shows the valuation that
consumers place on a good, reflecting the
satisfaction they gain from consuming it.
» Consumer surplus represents the benefit that
consumers gain from consuming a product, over
and above the price they pay for that product.
» Producer surplus represents the benefit gained by
firms over and above the price at which they would
have been prepared to supply a product.
» Producers have an incentive to respond to changes
in prices. In the short run this occurs through
output adjustments of existing firms (movements
along the supply curve), but in the long run firms
will enter the market (or exit from it) until there
are no further incentives for entry or exit.
END OF CHAPTER QUESTIONS
Multiple choice
1 The demand for ice cream increases. Other things being equal, what could explain
a situation in which the price of ice cream stays unchanged?
A a simultaneous increase in the demand for milk
B a simultaneous decrease in the price of sugar
C a simultaneous increase in the tax on ice cream
D a simultaneous decrease in the price of frozen fruit
2 Fish is considered a staple food in some countries. In order to convert consumer
surplus into producer surplus, sellers of fish should:
A increase the quantity of fish caught
B provide discounts for large quantities of fish bought
C diversify the types of fish sold
D increase the price of fish
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Data response
4
1 Read the following extract and then answer the questions that follow.
Car production in the European Union
5
The supply of EVs is increasing
more quickly than demand, so their
price is falling. At the same time,
10 the price of lithium is increasing
▲ The price of electric cars is falling
due to the increasing demand for
its use in EV battery manufacture.
By contrast, the demand for petrol and diesel fuel is set to fall up to 2040,
reflecting the trend illustrated in Figure 4.21.
15 From 2020, new European Union rules will heavily penalise car makers if
average carbon dioxide emissions from the cars they produce rise above 95g
per kilometre.
Number of vehicles demanded (million)
Car makers’ excess emissions bill would have been £28.6 billion, based on
2018 sales figures. This illustrates the extent of the change required to their
20 production processes and the cost of compliance to suppliers.
4 Market equilibrium and the price system
It is estimated that the number
of electric vehicle (EV) models
available to European consumers
will increase from around 175 at the
end of 2020 to more than 330 by the
end of 2025.
100
Petrol/diesel vehicles
Electric vehicles
80
48.8m
60
40
42.2m
20
0
2015
2020
2025
2030
2035
2040
*2020–40 estimated
Source: adapted from Bloomberg New Energy Finance
▲ Figure 4.21 Demand for electric vehicles and petrol/diesel vehicles, 2015–40
a With reference to Figure 4.21, give one reason for the trend in demand for
electric vehicles after 2020.
b With the use of an example from the extract, define the term ‘joint demand’.
c With the use of an example from the extract, define the term ‘derived
demand’.
d The information provided states ‘From 2020, new European Union rules
will heavily penalise car makers if average carbon dioxide emissions from
the cars they produce rise above 95g per kilometre’ (lines 15–17). Explain
how compliance with new European Union emissions rules will affect the
firms’ equilibrium price and quantity.
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4
e Explain, with reference to the extract, what is likely to happen to consumer
surplus in the market for electric vehicles.
f Assess, with reference to the extract, the likely impact of the increase in the
supply of electric vehicles on the market for petrol and diesel vehicles.
AS LEVEL PART 2 THE PRICE SYSTEM AND THE MICROECONOMY
Essay style
2 a W
ith the help of a diagram explain the impact on the housing market in Ghana
of a time-limited government scheme involving financial support to benefit
house buyers and consider whether this benefit is likely to continue in the
long run.
b The consumption of chocolate will grow at an annual rate of 4.7% between 2019
and 2025, driven by increasing demand in East Asia.Cocoa is a key ingredient
of chocolate. In early 2020 Ghana, the world’s second largest producer of
cocoa, estimated a shortfall in production of 75,000 tonnes compared with the
previous year. This was caused in part by hot dry winds, which also damaged
the crop in neighbouring Ivory Coast, the world’s largest cocoa producer.
Discuss the likely effects of this information on the market for cocoa and
whether this situation is likely to persist in the long run.
CASE STUDY
A healthy diet?
Hardly a week seems to go by without scientists or nutritionists coming up
with some new finding about the healthiness of our diets. Some blueberry
muffins contain more than the recommended daily intake of sugar for adults.
A study alleges that real butter is healthier than margarine. Smoked salmon
from farmed fish may contain more fat than a pizza. Dark chocolate is good
for you, but milk chocolate is damaging. In March 2018, a judge in Los Angeles
ruled that coffee sold in California must carry a cancer warning because the
chemical acrylamide (created as part of the roasting process) is regarded as
carcinogenic.
A growing obsession has focused on the health and environmental benefits of
organic foods. The overuse of chemical fertilisers and pesticides is seen as
damaging for the environment, and potentially damaging to our health. This
has resulted in a premium price for certified organic foods, notably vegetables.
However, converting to organic production and gaining authentication is a longwinded and costly process.
Follow-up questions
Suppose people become convinced of the benefits of consuming organic foods.
a Sketch a demand and supply diagram to analyse how this would affect the
market for non-organic foodstuffs in the short run.
b Now use a demand and supply diagram to show how the market for certified
organic foods would be affected in the short run.
c With the help of more diagrams, explain how these interdependent markets
will adjust in the longer term, remembering that achieving certified organic
status is slow and costly.
Go online at hoddereducation.com/cambridgeextras for another case study for
Chapter 4.
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AS LEVEL PART 3 Government microeconomic intervention
5
The government in the
microeconomy
★
★
★
★
★
★
reasons for government intervention in markets
public goods and the free-rider problem
merit and demerit goods
specific indirect taxes
subsidies
direct government provision of goods and
services
★
★
★
★
★
★
maximum and minimum prices
buffer stock schemes
wealth and income inequality
the Gini coefficient
reasons for inequality of income and wealth
policies to redistribute income and wealth
If markets are to be effective in guiding the allocation of resources in society, a
precondition is that market prices are able to reflect the full costs and benefits
associated with market transactions. However, there are situations in which the
government may see that there is a need to intervene to influence markets. This
chapter looks at ways in which governments intervene, either to improve the workings
of markets or to affect the way in which resources are allocated – for example, by
influencing the distribution of income in society.
5 The government in the microeconomy
What this chapter covers
5.1 Reasons for government interventions in markets
LEARNING
LINK
The meaning and
significance of
property rights is
discussed in
Chapter 21.
Some roles are critical for a government to perform if a mixed economy is to function
effectively. One important role is the provision by the government of an environment
in which markets can operate effectively. There must be stability in the political
system if firms and consumers are to take decisions with confidence about the future.
And there must be a secure system of property rights, without which markets could
not be expected to work.
In addition, there are situations in which a free market will not produce good outcomes
for society. This does not necessarily mean that governments need to substitute markets
with direct action. However, it does mean that they need to be more active in markets
that cannot operate effectively, while at the same time performing an enabling role to
encourage markets to work well whenever this is feasible.
Public goods
STUDY TIP
Remember that the
key characteristics of
a public good are that
it is:
» non-exclusive
» non-rival
» non-rejectable
Chapter 1 explained the characteristics of a public good. The key feature of the market
for a public good is that, once the good has been provided, there is no incentive for
anyone to pay for it – so the market will fail, as no firm can make a profit, so will
not have an incentive to supply the good in the first place. This market failure arises
because of the free-rider problem, as individual consumers can free-ride and avoid
having to pay for the good once it has been provided. Given the importance of goods
such as street lighting, the government needs to find some way of addressing the
issue of how such goods can be provided.
LEARNING LINK
The meaning of market failure is explained in Chapter 15.
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EXTENSION MATERIAL
The problem of public goods
Think about the supply and demand curves for a public good such as street
lighting. To simplify matters, suppose there are just two potential demanders of
the good, a and b. Consider Figure 5.1. If it is assumed that the supply is provided
in a competitive market, S represents the supply curve, reflecting the marginal
cost of providing street lighting. The curves da and db represent the demand
curves of the two potential demanders. For a given quantity Q1, a would be
prepared to pay Pa and b would pay P b.
Price
AS LEVEL PART 3 GOVERNMENT MICROECONOMIC INTERVENTION
5
Test yourself 5.1
Explain why a
lighthouse might be
regarded as having the
characteristics of a
public good.
S (=MSC)
PT
Pa
MSB
Pb
da
db
Q1
Q*
Quantity
▲ Figure 5.1 Demand and supply of a public good
Test yourself 5.2
Explain the free-rider
problem in the context
of the provision of
national defence.
LEARNING
LINK
The problem of how
to provide public
goods and services
is not necessarily
addressed through
direct provision by the
government. This is
discussed in the next
section of this chapter.
Test yourself 5.3
Give an example of
a merit good and a
demerit good.
If these prices are taken to be the value that each individual places on this
amount of the good, then Pa + P b = P T represents the social benefit derived from
consuming Q1 units of street lighting. Similarly, for any given quantity of street
lighting, the marginal social benefit derived from consumption can be calculated
as the vertical sum of the two demand curves. This is shown by the curve MSB.
So the optimal provision of street lighting is given by Q*, at which point the
marginal social benefit is equated with the marginal cost of supplying the good.
However, if person a were to agree to pay Pa for the good, person b could then
consume Q1 of the good free of charge, but would not be prepared to pay in order
for the supply to be expanded beyond this point – as person b’s willingness to pay
is below the marginal cost of provision beyond this point. So, when there are many
potential consumers, the likely outcome is that none of this good will be produced:
why should any individual agree to pay if he or she can free-ride on others?
Merit and demerit goods
Chapter 1 also explained that there may be goods or services known as merit and
demerit goods where consumers face information failure because they do not clearly
perceive their potential advantages or disadvantages. What this means is that
consumers will demand less of a good or service that is a merit good, because they
undervalue it, but will demand more of a demerit good because they fail to appreciate
the potential disadvantages of the good. The government may see a need to address
these problems in order to achieve a good allocation of resources in society. From
society’s point of view, too few resources will be devoted to producing merit goods,
and too many to the production of demerit goods. This misallocation of resources
leaves society worse off than it could be.
The next section of the chapter will discuss ways in which this problem can be tackled.
Prices
There may be markets in which the free-market equilibrium price may be seen to be
inappropriate. For example, it might be that house rentals are seen to be too high,
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thus pricing poorer households out of the housing market, and causing homelessness.
Alternatively, it might be that food prices are seen to be too low, creating inadequate
incomes for farmers. In these circumstance, it may be tempting for the government to
intervene in order to control prices directly. This will be discussed in the next section.
5
SUMMARY: REASONS FOR GOVERNMENT INTERVENTIONS IN MARKETS
» There are several reasons why governments may
» It may be seen to be important to address the
problems of over-consumption of demerit goods
and the under-consumption of merit goods.
» In some situations, the government may wish to
control prices in a market.
5.2 Methods and effects of government intervention
in markets
In this chapter so far, we have seen a number of reasons for governments to want
to intervene in particular markets. We now turn our attention to the methods at the
government’s disposal to address these issues, and their effectiveness.
The impact and incidence of specific indirect taxes
KEY TERMS
indirect tax: a tax levied
on expenditure on
goods or services (as
opposed to a direct tax,
which is a tax charged
directly to an individual
based on a component
of income)
The effects of a sales tax can be seen in a demand and supply diagram. An indirect
tax is levied on expenditure, and paid by the seller, so it affects the supply curve for a
product. Figure 5.2 illustrates the case of a fixed rate or specific tax – a tax that is set
at a constant amount per pack of cigarettes. Without the tax, the market equilibrium
is at the intersection of demand and supply with a price of P0 and a quantity traded of
Q0. The effect of the tax is to reduce the quantity that firms are prepared to supply at
any given price – or, to put it another way, for any given quantity of cigarettes, firms
need to receive the amount of the tax over and above the price at which they would
have been prepared to supply that quantity. The effect is thus to move the supply curve
upwards by the amount of the tax, as shown in the figure. We get a new equilibrium with
a higher price at P1 and a lower quantity traded at Q1.
Price
specific tax: a tax of a
fixed amount imposed
on purchases of a
commodity
One of the issues that has been raised is that of demerit goods or services. These are goods
where the government sees that a free market will result in overconsumption of a good or
service. An example is tobacco. The medical evidence shows that smoking tobacco is
harmful to health, and imposes costs on society. However, the addictive nature of tobacco
means that individuals continue to smoke even in the face of the evidence. One way of
trying to tackle this problem is to impose a tax on sales on tobacco.
5 The government in the microeconomy
wish to intervene in individual markets.
» The free market may not enable the adequate
provision of public goods because of the free rider
problem.
Supply plus tax
Supply
Tax
P1
Buyer pays
P0
P1 – tax
Seller pays
Test yourself 5.4
If the government
removes a tax on a
good, will quantity
demanded of the good
decrease or increase?
Demand
0
Q1 Q0
Packets of cigarettes per period
▲ Figure 5.2 The effects of an indirect tax on cigarettes
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AS LEVEL PART 3 GOVERNMENT MICROECONOMIC INTERVENTION
5
KEY TERMS
incidence of a tax: the
way in which the burden
of paying a sales tax is
divided between buyers
and sellers
subsidy: a grant given
by the government to
producers to encourage
production of a good or
service
An important question is: who bears the burden of the tax? If you look at Figure 5.2,
you will see that the price difference between the with-tax and without-tax situations
(i.e. P1 − P0) is less than the amount of the tax, which is the vertical distance between
the with-tax and without-tax supply curves. Although the seller may be responsible for
the mechanics of paying the tax, part of the tax is effectively passed on to the buyer
in the form of the higher price. In Figure 5.2, the incidence of the tax falls partly on
the seller, but most of the tax is borne by the buyers, who pay (P1 − P0) per unit. The
sellers pay the rest.
The price elasticity of demand determines the incidence of the tax. If demand were
perfectly inelastic, then the sellers would be able to pass the whole burden of the tax
on to the buyers through an increase in price equal to the value of the tax, knowing
that this would not affect demand. However, if demand were perfectly elastic, then
the sellers would not be able to raise the price at all, so they would have to bear the
entire burden of the tax.
EXERCISE 5.1
Sketch demand and supply diagrams to confirm that the statements in the
previous paragraph are correct – that is, that if demand is perfectly inelastic,
then the tax falls entirely on the buyers, whereas if demand is perfectly elastic,
it is the sellers who have to bear the burden of the tax.
LEARNING
LINK
Indirect taxes are
explored in more
depth in Chapter 21.
The impact and incidence of subsidies
In some situations, the government may wish to encourage production of a particular
good or service, perhaps because it views a good as having strategic significance to
the country, or because it is seen as a merit good. One way it can do this is by giving
subsidies.
Subsidies are used to encourage producers to increase their output of particular goods.
Subsidies have been especially common in agriculture, which is often seen as being
of strategic significance. A museum may be regarded by government as being a merit
good, so a subsidy may be used to encourage more people to visit a museum.
Price
We can regard a subsidy as a sort of negative indirect tax that shifts the supply curve
down – as shown in Figure 5.3. Without the subsidy, market equilibrium is at a price P0
and the quantity traded is Q0. With the subsidy in place, the equilibrium price falls to
P1 and quantity traded increases to Q1.
Supply
Supply with subsidy
P0
P1
Subsidy
Demand
0
Q0 Q1
Quantity per period
▲ Figure 5.3 The effect of a subsidy
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Test yourself 5.5
If demand for a good
was relatively more
elastic, would a subsidy
have a lesser or greater
effect on quantity
traded?
Again, notice that because the price falls by less than the amount of the subsidy, the
incidence of the subsidy means that the benefits of the subsidy are shared between
the buyers and sellers – depending on the elasticity of demand. If the aim of the
subsidy is to increase production, it is only partially successful; the degree of success
also depends on the elasticities of demand and of supply. If demand is inelastic, then
the impact will be limited, as the fall in price will not induce many additional people
to consume the good or service. If producers are not able to expand production (i.e. if
supply is inelastic), then again the impact will be limited.
The notion of public goods was introduced in Chapter 1. It was noted that a free
market for public goods (or services) will not operate effectively because of the
free-rider problem. An important question is whether the government needs to
intervene in such circumstances by producing the good or service directly.
Test yourself 5.6
Is it necessarily the
case that a public
good can only be
provided directly by the
government?
For some public goods, the failure of the free market to ensure provision may be
regarded as a serious problem – for example, in such cases as street lighting or law
and order. Some government intervention may thus be needed to make sure that
a sufficient quantity of the good or service is provided. Notice that this does not
necessarily mean that the government has to provide the good itself, although it may
choose to do so. It may be that the government will raise funds through taxation in
order to ensure that street lighting is provided, but could still make use of private
firms to supply the good through some sort of subcontracting arrangement. In some
countries, it may be that the government delegates the responsibility for provision of
public goods to local authorities, which in turn may subcontract to private firms.
5 The government in the microeconomy
Direct provision of goods and services by government
5
Such intervention entails costs. There are costs of administering, and costs of
monitoring the policy to ensure that it is working as intended. This includes the need
to look out for the unintended effects that some policies can have on resource
allocation in a society. It is therefore important to check that the marginal costs of
implementing and monitoring policies do not exceed their marginal benefits.
LEARNING LINK
There may be situations in which the state may decide to take an industry or
firm into public ownership. In some countries, utilities such as the provision of
water, gas or electricity are run as nationalised industries, owned by the state.
The issues surrounding nationalisation (and privatisation) are discussed in
Chapter 21.
Minimum and maximum prices
Most governments see it as their responsibility to ensure that markets allocate
resources efficiently. One way in which governments may intervene is through direct
control of prices in some markets, because the market price of a good or service is
seen as being either too low for some reason, or too high.
KEY TERM
minimum wage:
legislation under which
firms are not allowed to
pay a wage below some
threshold level set by
the government
A minimum wage
One way in which governments have often intervened in markets by setting a
minimum price is by the introduction of a minimum wage. To illustrate how this
works, Figure 5.4 represents the labour market for office cleaners. Employers demand
labour according to the wage rate – the lower the wage, the higher the demand for the
labour of office cleaners. On the supply side, more workers will offer themselves for
work when the wage rate is relatively high. If the market is unregulated, it will reach
equilibrium with a wage rate W* and quantity of labour L*.
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Wage rate
5
Supply
Wmin
AS LEVEL PART 3 GOVERNMENT MICROECONOMIC INTERVENTION
W*
Demand
0
Ld
L*
Ls
Quantity of labour
▲ Figure 5.4 A minimum wage
Suppose that the government comes to the view that W* is not sufficiently high
to provide a reasonable wage for cleaners. One response is to impose a minimum
wage, below which employers are not permitted to offer employment – say, Wmin
on the figure. This will have two effects on the market situation. First, employers
will demand less labour at this higher wage, so employment will fall to Ld. Second,
more workers will be prepared to offer themselves for employment at the higher
wage, so labour supply will rise to Ls. However, the net effect of this is that there is
disequilibrium in the market, with an excess supply of labour at this wage and hence
unemployment, with more workers offering themselves for work than there are jobs
available in the market.
Test yourself 5.7
What would be the
effect of setting a
minimum price that was
below the equilibrium
level?
Notice that this analysis rests on some assumptions that have not been made explicit. In
particular, it rests on the assumption that the labour market is competitive. Where there
are labour markets in which the employers have some market power, and are able to offer
lower wages to workers than would be obtained in a free-market equilibrium situation, it is
possible that the imposition of a minimum wage will increase employment.
A maximum price: rent controls
Rent
Another market in which governments have been tempted to intervene is the housing
market. Figure 5.5 represents the market for rented accommodation. The free-market
equilibrium would be where demand and supply intersect, with the equilibrium rent
being R* and the quantity of accommodation traded being Q*.
Supply
R*
Rmax
Demand
0
Qs
Q*
Qd
Quantity of rented accommodation
▲ Figure 5.5 Rent controls
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If the government regards the level of rent as excessive, to the point where
households on low incomes may be unable to afford rented accommodation, then,
given that housing is one of life’s necessities, it may regard this as unacceptable.
It can be seen that the well-meaning rent control policy, intended to protect low-income
households from being exploited by landlords, merely has the effect of reducing the
amount of accommodation available. This is not what was supposed to happen.
Problems may arise whenever price controls are implemented, because holding a market
away from equilibrium means that some buyers or sellers are affected. In some markets,
this could mean that some buyers are rationed in their purchases and may turn to an
unofficial market. Suppliers of perishable goods who cannot sell their goods will lose
out. In addition, the administrative costs of operating the controls may be high.
Buffer stock schemes
5
5 The government in the microeconomy
The temptation for the government is to move this market away from its equilibrium by
imposing a maximum level of rent that landlords are allowed to charge their tenants.
Suppose that this level of rent is denoted by Rmax in Figure 5.5. The market is now in
equilibrium. There is excess demand for rented accommodation resulting from two
effects. First, landlords will no longer find it profitable to supply as much rental
accommodation, and so will reduce supply to Qs. Second, at this lower rent there will
be more people looking for accommodation, so that demand for rented accommodation
will move to Qd. The upshot of the rent controls, therefore, is that there is less
accommodation available, and more homeless people.
In some commodity markets, prices can exhibit volatility over time. This could arise,
for example, when the supply of a good varies from period to period because of the
varying state of the harvest. In such a market, the supply curve will shift to the right
when the harvest is good, but shift to the left in a period when the weather is poor
or where crops are affected by some disease or blight. It may also be that the demand
curve tends to shift around through time, with demand for some goods reflecting
fluctuations in the performance of economies. In other words, demand may shift to
the left when recession bites, but to the right in times of boom and prosperity.
Price
Suppose that Figure 5.6 represents a market in which demand is relatively stable between
periods, but in which supply varies between Spoor when the harvest is poor and Sgood
when the harvest is good. The price varies between Pp and Pg. This creates a high level of
uncertainty for producers, who find it difficult to form accurate expectations about the
future prospects for the commodity. This means that they are less likely to invest in ways
of improving productivity because of uncertain future returns. If a way could be found of
stabilising the price of the good, then this could encourage producers.
Sgood
Spoor
Pp
P*
A
B
C
Pg
D
KEY TERM
buffer stock: a scheme
intended to stabilise the
price of a commodity by
buying excess supply in
periods when supply is
high, and selling when
supply is low
308275_C05_CAM_IASAL ECO_073_087.indd 79
Qp Q*
Qg
Quantity
▲ Figure 5.6 A buffer stock
A buffer stock is a way of attempting to do this. A scheme is set up whereby excess
supply is bought up by the buffer stock in good years to prevent the price from falling
too low. In periods when the harvest is poor, stocks of the commodity are released on
to the market in order to maintain the price at the agreed level. In terms of Figure 5.6,
suppose that it is agreed to maintain the price at P*. When there is a good year, with
the supply curve located at Sgood, there is excess supply at the agreed price of the
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amount BC, so this amount is bought up by the buffer stock and stored. If the supply
is at Spoor because of a poor harvest, there is excess demand, so the buffer stock
releases the quantity AB on to the market, maintaining the price.
AS LEVEL PART 3 GOVERNMENT MICROECONOMIC INTERVENTION
5
Although this does have the effect of stabilising the price at P*, there is a downside.
If the members of the buffer stock scheme agree to maintain the price at too high a
level, relative to the actual average equilibrium price over time, then it will run into
difficulties. Notice in Figure 5.6 that to maintain price at P*, the buffer stock buys
up more in the ‘good’ year than it has to sell in the poor harvest year. If this pattern
is repeated, then the size of stocks to be stored will rise over time. This is costly and
will eventually become unsustainable.
EXERCISE 5.2
Discuss why prices in some markets may be
unstable from year to year and evaluate ways
in which more stability might be achieved. How
effective would you expect such measures to be?
What would be the benefits to economic agents of
having greater stability in prices?
Provision of information
In the case of merit and demerit goods, it was suggested that the underlying problem was
a failure of information. In other words, consumers make bad decisions about these types
of goods and services because they do not have sufficient information about the costs or
benefits of consuming the goods, or they do not take them enough into account.
Test yourself 5.8
Explain why the demand
for tobacco should be so
inelastic.
LEARNING
LINK
Information failure is
discussed further in
Chapter 21.
For example, take the example of smoking tobacco. This is classed as a demerit good
because consumers do not fully take on board the detrimental effects of smoking in
the long run, and become habituated to the use of tobacco. This means that the
demand for tobacco is relatively price inelastic, so taxes proved ineffective in
discouraging smoking. In such a situation, a public information campaign to broadcast
the ill effects of smoking might have an impact on behaviour, although people
addicted to tobacco might not be affected by campaigns.
Vaccination is an example of a merit good. During the Covid-19 pandemic, it was vital
that as many people as possible should be vaccinated to control the spread of the
virus. False stories about the dangers of vaccination circulated on social media, and
there was growing resistance to vaccination, especially in some sections of the public.
In response, many governments launched public information campaigns to make sure
that people understood the importance and safety of vaccines and their importance in
protecting healthcare systems and society as a whole. The extent to which people are
affected by such campaigns may vary between societies and may depend partly on the
degree of trust that people have in their governments.
SUMMARY: METHODS AND EFFECTS OF GOVERNMENT INTERVENTION
IN MARKETS
» A range of methods are available to a government
»
»
»
»
that wishes to influence a particular market.
Specific indirect taxes can be used to affect the
consumption of demerit goods and services.
The price elasticity of demand affects whether it is
producers or consumers who bear the burden of
the tax.
Subsidies can be used to encourage the
consumption of merit goods.
In some markets, the government may consider
direct provision of goods or services such as
public goods, or it may ensure provision by other
means.
» In some markets, government may intervene to
set minimum or maximum prices – for example,
through introducing a minimum wage or rent
controls.
» Where the government wishes to stabilise the
price of a good over time, it may establish a buffer
stock scheme.
» Governments may launch an information campaign
in order to combat an information failure.
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5.3 Addressing income and wealth inequality
Income and wealth
Test yourself 5.9
Give an example
of wealth held by a
household.
income: the flow of
wages, salaries and
earnings from other
sources in a period
wealth: the stock of
accumulated assets
income distribution: the
way in which national
income is distributed
among the population of
a country
wealth distribution:
the way in which the
nation’s wealth is
distributed among the
population of a country
LEARNING
LINK
International
comparisons of
income and the
standard of living
are discussed in
Chapter 30.
The distribution of income and wealth and inequality
The income distribution describes how income is distributed amongst the
population. You will be aware that not everyone receives the same income, so
there is some inequality in the income distribution. The same applies to the wealth
distribution; indeed, wealth tends to be more unequally distributed than income.
There are differences between countries in the extent of such inequality in income
and wealth.
Measuring income and wealth inequality
Inequality is present in all societies, and always will be. However, the degree of
inequality varies from one country to another; and before exploring the causes of
inequality, and the policies that might be used to influence how income and wealth
are distributed within society, it is necessary to be able to characterise and measure
inequality. This is important in order to be able to judge relative standards of living in
different countries or different periods.
5
5 The government in the microeconomy
KEY TERMS
It is important to be aware of the distinction between income and wealth. Income is
the flow of wages and earnings from other sources in a period, whereas wealth is the
stock of accumulated assets. An example of such assets would be where an individual
owns property. If an individual saves part of his or her income, this accumulates as
wealth. However, wealth may also come from other sources – in particular, from
legacies. Ownership of wealth can also generate a flow of income in the form of
interest and dividend payments.
One way of presenting data on this topic is to rank households in order of their
incomes, and then calculate the share of total household income that goes to the
poorest 10%, the poorest 20% and so on.
QUANTITATIVE SKILLS 5.1
Deciles, quintiles and quartiles
When the groups are divided into tenths in this way, they are referred to as
deciles; thus, the poorest 10% is the first decile, the next 10% is the second
decile and so on. Similarly, the poorest 20% is the first quintile, and the poorest
25% is the first quartile. This is useful in trying to explore the pattern of the
distribution of income because it quantifies the difference between income going
to low-income and high-income households.
According to the World Bank, the top decile (richest 10%) of households in Brazil
receives 41.9 times higher income than the lowest decile (poorest 10%). In Belarus,
on the other hand, the ratio is only 5.1. These are extreme examples of the degree of
inequality in the distribution of income within countries.
Table 5.1 presents some data for three countries. Notice that the unit of measurement
is normally the household rather than the individual, on the presumption that
members of a household tend to share their resources – a millionaire’s life-partner may
not earn any income, but he or she is not usually poor.
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AS LEVEL PART 3 GOVERNMENT MICROECONOMIC INTERVENTION
5
▲ Inequality in Brazil
Test yourself 5.10
Calculate the decile
ratio for each of the
countries in Table 5.1.
Do these give the same
ranking as for the
quintile ratios in the
table?
▼ Table 5.1 Distribution of income in Pakistan, the USA and China, by quintiles (%)
First decile
First quintile
Pakistan
USA
China
3.9
1.7
2.6
8.9
5.0
6.4
Second quintile
12.2
10.2
10.6
Third quintile
15.6
15.3
15.3
Fourth quintile
20.5
22.6
22.3
Top quintile
42.8
46.9
45.4
Top decile
28.9
30.6
29.4
4.8
9.4
7.1
Ratio top quintile: first quintile
Note: the data are the most recent available at the time of writing.
Source: World Development Indicators
EXERCISE 5.3
Use the data provided in Table 5.2 to calculate the ratios of top decile income to
bottom decile income, and of top quintile income to bottom quintile income. Then
compare the inequalities shown for Belarus and South Africa with each other
and with the countries already discussed.
▼ Table 5.2 Income distribution in Belarus and South Africa
Percentage share of income or consumption
South Africa
Belarus
Lowest decile
0.9
4.2
Lowest quintile
2.4
9.9
Second quintile
4.8
14.2
Third quintile
8.2
17.9
Fourth quintile
16.5
22.5
Highest quintile
68.2
35.5
Highest decile
50.5
21.3
Note: the data are the most recent available at the time of writing.
Source: World Development Indicators
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In data published by
the World Bank and
United Nations (and
sometimes the
UK’s ONS), the Gini
coefficient is known as
the Gini index.
The Gini coefficient is a way of expressing the degree of inequality in a country in
quantitative terms, making it possible to compare inequality across countries.
5
In published data, the Gini coefficient is usually expressed as a percentage (i.e.
multiplied by 100). The closer the Gini coefficient is to 100, the more unequal is
the income distribution. Table 5.3 shows some values for the Gini coefficient for a
selection of countries.
▼ Table 5.3 The Gini coefficient
Country
Gini coefficient (%)
USA
41.5
Pakistan
33.5
China
38.6
Brazil
53.3
Belarus
25.4
South Africa
63.0
Source: World Development Indicators
The Gini coefficient can be used to see how the overall income distribution has
changed over time. This is shown in Figure 5.7 for selected countries.
5 The government in the microeconomy
If every individual in a
country received the
same income, the Gini
coefficient would be 0,
but of course this never
happens. In the 2019
Human Development
Report (published by
the United Nations
Development
Programme), the
lowest value recorded
was for Ukraine at
25.0%; the highest was
South Africa at 63%,
so when you come
to interpret a Gini
value, remember that
countries fall within
this sort of range.
The Gini coefficient
Gini coefficient
STUDY TIP
70
60
50
40
30
20
10
0
1990
Brazil
China
Belarus
1995
USA
Pakistan
2000
2005
2010
2015
2020
Source: based on data from World Development Indicators
▲ Figure 5.7 The Gini coefficient, selected countries
Notice that these data are not collected for each country in each year, and that inequality
does not vary greatly over time for any country. The figure confirms earlier findings that
inequality in Brazil has been relatively high, whereas it has been lower in Belarus, and
this pattern was true throughout the period for which we have data. Indeed we can see
that inequality improved slowly but slightly in Brazil during most of the period. In China,
inequality showed a slight upward trend, but all these changes were relatively small in scale.
Economic reasons for inequality of income and wealth
There are reasons based in microeconomic analysis for expecting there to be
differences in income and wealth between individuals and groups in society.
Labour market explanations
There are various ways in which the labour market may be expected to give rise to
inequalities in earnings. This arises from demand and supply conditions in labour
markets, which respond to changes in the pattern of consumer demand for goods and
services, and changes in international comparative advantage between countries.
Furthermore, differences between different occupations and economic sectors reinforce
income inequalities.
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5
LEARNING
LINK
AS LEVEL PART 3 GOVERNMENT MICROECONOMIC INTERVENTION
The way in which
labour markets
operate is discussed
in Chapter 23.
A by-product of changes in the structure of the economy may be rising inequality between
certain groups in society. For example, if there is a change in the structure of employment
away from unskilled jobs towards occupations that require a higher level of skills and
qualifications, then this could lead to an increase in inequality, with those workers who
lack the skills to adapt to changing labour market conditions being disadvantaged by the
changes taking place. In other words, if the premium that employers are prepared to pay
in order to hire skilled or well-qualified workers rises as a result of changing technology in
the workplace, then people without those skills are likely to suffer.
A decline in the power of trade unions may contribute to the situation, as low-paid
workers may find that their unions are less likely to be able to offer employment
protection. It has been argued that this is a good thing if it increases the flexibility of
the labour market. However, again a balance is needed between worker protection and
having free and flexible markets.
Inequality in wealth
Perhaps the most obvious way in which inequality in wealth arises and changes through
time is through the pattern of the ownership of assets. This in turn may reflect the way
in which assets are passed through the generations, which depends on the inheritance
laws of a country. When wealth accumulates in a family over time and is then passed
down to succeeding generations, this generates a source of inequality that does not
arise from the current state of the economy or the operations of markets.
Notice, however, that although wealth and income are not the same thing, inequality
in wealth can also lead to inequality in income, as wealth (the ownership of assets)
leads to an income flow, from rents and profits.
Demographic change
A feature of many countries in recent years has been a change in the age structure
of the population. Improved medical drugs and treatments have meant that people
are living longer, and this has combined with low fertility rates in many economically
developed countries to bring about an increase in the proportion of the population
who are in the older age groups. This has put pressure on the provision of pensions,
and increased the vulnerability of this group in society. State pensions in some
countries have been funded primarily by the contributions of those in work, but if the
number of people of working age falls as a proportion of the whole population, then
this funding stream comes under pressure.
These differences in income and wealth mean that there will always be some inequality
in any society, in the sense that some individuals and groups will have greater
command over resources than others. In other words, resources will not be equally
distributed across society.
Policies to redistribute income and wealth
Governments have a range of measures that can be introduced to affect the
distribution of income and wealth.
A minimum wage
The idea of a minimum wage was introduced earlier in the chapter. This can be seen as
one way of influencing the distribution of income, by ensuring that low-paid workers
are not exploited by employers paying low wages. It is not clear to what extent this
will have a significant impact on the overall income distribution. With a minimum
wage in effect, workers (those who manage to remain in employment) are better off,
and now receive a better wage. However, those who are now unemployed are worse
off. It is not then clear whether the effect of the minimum wage is to make society as
a whole better off – some people will be better off, but others will be worse off.
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KEY TERM
LEARNING
LINKS
The impact of transfer
payments and other
policies to influence
inequality and poverty
are discussed in
Chapter 22.
The effects of
imposing taxes
are discussed in
Chapter 21.
KEY TERMS
direct tax: a tax levied
directly on income
progressive tax: a tax
in which the marginal
rate rises with income
marginal tax rate: tax
on additional income,
defined as the change
in tax payments divided
by the change in taxable
income
regressive tax: a tax
bearing more heavily
on the relatively poorer
members of society
5
Transfer payments
Governments in many countries make transfer payments to poor households. These may
be in the form of cash benefits, such as income support, child benefit, incapacity benefit
and working families tax credit. These benefits are designed to protect families in certain
circumstances whose income would otherwise be very low. Second, there are benefits in
kind, such as health and education. These benefits accrue to individual households
depending on the number of members of the household and their age and gender.
Taxation
There are two main forms of taxation – direct taxes levied on various forms of
income, and indirect taxes that are levied on expenditure.
Direct taxes (taxes on incomes) tend to be progressive: in other words, higher income
groups pay tax at a higher rate. Direct taxes include income tax, corporation tax
(paid by firms on profits) and capital gains tax (paid by individuals who sell assets
at a profit). There may also be taxes levied by local authorities on property, such as
the UK’s council tax. Some countries impose inheritance taxes, which are designed to
affect the distribution of wealth.
5 The government in the microeconomy
transfer payment:
occurs where the
government provides
benefits (in cash
or in kind) to poor
households; hence
there is a transfer
from taxpayers to the
recipients of the benefits
It is not clear how many workers would benefit from the imposition of a minimum
wage, even if they remain in employment. Partly this may depend on the level at
which the minimum wage is set – there may be workers who are unaffected by the
policy because they earn marginally more than the minimum, or because they are paid
on piecework rather than by time. In countries where there is significant informal
working, the policy may not reach those in most need.
With a tax such as income tax, its progressive nature is reflected in the way that the
percentage rates payable increase as an individual moves into higher income ranges.
In other words, the marginal tax rate increases as income increases. The progressive
nature of the tax ensures that it does indeed contribute to reducing inequality in the
income distribution.
The effect of indirect taxes can sometimes be regressive: in other words, indirect
taxes may fall more heavily on lower-income households. Indirect taxes are taxes that
are paid on items of expenditure, rather than on income.
State provision of essential goods and services
In the case of public or merit goods, the state may choose to intervene directly to
ensure that essential goods and services are made accessible to the population. This
was discussed earlier in the chapter, where it was pointed out that the authorities
may subcontract this provision to the private sector. In the case of goods and services
like health and education, the government may indeed intervene directly, but practice
does vary between countries. In times of war or civil conflict, it may be that markets
break down, so that the state (or other organisations) have to supply essential goods
and services to the population.
SUMMARY: ADDRESSING INCOME AND WEALTH INEQUALITY
» There is an important distinction between income
(a flow) and wealth (a stock).
» Income and wealth distribution in a country can be
measured by the Gini coefficient.
» Inequality of income and wealth arises because of
a variety of factors.
» The government can use various policies to
influence the distribution of income and
wealth.
» A minimum wage can help people or households at
the low end of the income distribution.
» Transfer payments can enable resources to be
transferred from the rich to the poor.
» Taxes can also be used to influence the distribution
of income and wealth.
» In some countries, the state makes provision of
essential goods and services to the poor, or takes
steps to ensure that provision takes place.
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END OF CHAPTER QUESTIONS
AS LEVEL PART 3 GOVERNMENT MICROECONOMIC INTERVENTION
5
Multiple choice
1 Which set of policies is classified correctly?
Price control
Direct provision
Transfer payment
A
Rent controls
Free provision of face masks
Minimum wage
B
Free admission to
Nationalisation of railway
museums for children and links
pensioners
Price ceiling on bread
C
Minimum wage
Emergency treatment in a
hospital
Child benefits
D
Subsidised schooling
Price floor on bread
Pensions
2 Other things being equal, what is a common disadvantage of the state provision of
essential goods and services available to all individuals?
A Those who have sufficient income to afford paid provision would also benefit.
B State provision would result in reduced quality of the essential good or service.
C The government cannot accurately judge the level of demand for essential
goods and services.
D State provision could lead to worse resource allocation than the competitive
market outcome.
Data response
1 Read the following extract and then answer the questions that follow.
The rising price of maize meal in Zimbabwe
Maize meal is a basic food consumed across much of southern Africa. In Zimbabwe
throughout most of 2019 the price of maize meal increased beyond the budget of many
consumers (see Figure 5.8). In November 2019, to keep its most consumed food affordable
the government of Zimbabwe introduced a subsidy on the production of maize meal. The
subsidy was regarded as the most effective way to protect vulnerable citizens from rising
food prices. This intervention was chosen over the imposition of a maximum price or the
introduction of a buffer stock scheme.
80
60
40
20
19
cDe
9
Ju
n19
Se
p19
ar
-1
M
c18
De
Ju
n18
Se
p18
ar
-1
8
De
M
17
0
c-
Price of maize
(Zimbabwe dollars per 10kg)
During 2019, the price of bread in Zimbabwe increased by as much as 60% overnight in some
cases. Local bakers said they were forced to increase their prices due to rising production
costs. Electricity prices increased significantly, as did the price of fuel and the cost of
importing wheat. While businesses, farmers and the government searched for solutions,
many Zimbabweans said they would no longer be able to buy dinner if they bought bread.
Source: ZIMSTAT
▲ Figure 5.8 Retail price of maize meal in Zimbabwe, December 2017–December 2019
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Essay style
ompare the direct provision of goods and services with provision of
2 a C
information as a means to encourage consumption in a particular market
and consider the likely effectiveness of each.
b Discuss whether the introduction of a minimum wage or progressive taxation
is more likely to lead to a successful redistribution of income towards the
relatively poor.
CASE STUDY
A bitter-sweet tax?
In the UK Budget Statement in 2016, the then
chancellor of the exchequer announced a new tax
intended to tackle the growing problem of childhood
obesity. This soon became popularly known as the
‘sugar tax’, although the levy targets the producers
and importers of sugary soft drinks, not all products
that contain sugar. The ‘Soft Drinks Industry Levy’
came into effect on 6 April 2018.
The consultation document on the gov.uk website
stated that: ‘This is not a tax on consumers. The
government is not increasing the price of products;
companies don’t have to pass the charge on to their
customers. If companies take the right steps to make
their drinks healthier they will pay less tax, or even
nothing at all.’
The levy is charged at different rates according to
the total sugar content, with companies having to pay
18p per litre of drink if the product contains more
than 5 grams of sugar per 100 millilitres and 24p per
litre if it contains more than 8 grams per millilitre.
Pure fruit juices and drinks with a high milk content
are exempt.
When the levy was originally announced, it was
thought that revenue from the levy would be in the
region of £520 million, which was intended to be
used to encourage children to participate in sport.
However, on the day the levy came into effect, this
estimate was reduced to £240 million.
5
5 The government in the microeconomy
a With reference to Figure 5.8, compare the change in the retail price of
maize meal between June–December 2018 and June–December 2019.
b Explain, with reference to the extract, how a buffer stock scheme could be
an alternative way to protect vulnerable citizens from rising food prices.
c Discuss the impact of one indirect tax that the government of Zimbabwe
could alter in order to reduce the price of bread in Zimbabwe.
d Analyse, with the aid of a diagram, the impact of the introduction of the
maize meal production subsidy in Zimbabwe on the market for maize meal.
e The government of Zimbabwe chose to protect its vulnerable consumers
from rising food prices by introducing a production subsidy. Discuss the
extent to which imposing a maximum price for maize meal below the
market price could protect vulnerable consumers in Zimbabwe.
Some firms had taken action before the introduction
of the levy, by cutting the sugar content of drinks
– in some cases attracting complaints from their
consumers.
Several other countries have introduced similar
levies. For example, in Mexico it was found that a
10% tax led to a 6% reduction in sales of sugarsweetened drinks in 2014 (the figure for lower-income
households was a reduction of 9%). The Danish
experience of a so-called ‘fat tax’ was less successful,
and it was repealed after just a year of operation.
Similar taxes have been introduced in Brunei, Sri
Lanka and the UAE, amongst others.
Follow-up questions
a Would you expect the manufacturers of sugary
drinks to absorb all of the levy, or would they pass
some of the cost on to consumers? Explain your
answer.
b Discuss the sort of market failure that the
government was trying to tackle through the levy.
c The estimated revenue from the levy was seen
as being much lower at the time of its launch
than had been originally envisaged. Discuss
whether this is an indication that the levy was
not working.
Go online at hoddereducation.com/cambridgeextras
for another case study for Chapter 5.
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AS LEVEL PART 4 The macroeconomy
AS LEVEL PART 4 THE MACROECONOMY
6
National income
What this chapter covers
★ what is meant by national income
★ the concepts of gross domestic product (GDP),
gross national income (GNI) and net national
income (NNI)
★ the difference between market prices and basic
prices
★ the adjustment needed between gross and net
values
★ the circular flow of income in a closed economy
and an open economy, recognising the flow of
income between households, firms, government
and the international economy
★ injections into and leakages from the circular flow
★ equilibrium and disequilibrium in the context of
the circular flow
This part of the book switches attention to macroeconomics. Macroeconomics has
much in common with microeconomics, but focuses on the whole economy, rather
than on individual markets and how they operate. Although the way of thinking about
issues is similar, and although similar tools are used, now it is interactions between
economic variables at the level of the whole economy that are studied. The starting
point is to consider what is meant by national income, which is a key measure of
economic activity in an economy.
6.1 National income statistics
The standard of living that can be achieved by the residents of a country will be
strongly influenced by the quantity of resources available – although, of course, the
way in which those resources are divided among the country’s residents will also be
important.
What is national income?
In terms of measurement, it would be helpful to be able to count up the total
quantity of resources in an economy, and to explore how they are divided between the
country’s residents. Such a total is known as national income.
KEY TERM
gross domestic product
(GDP): the total amount
of goods and services
produced in an economy
during a given period
This is easier said than done. A typical economy produces a wide range of different
goods and services during a given time period. This might include rice, onions, cars,
electronic goods, curry, banking services and so on. The quantities of these are all
likely to be counted in different units of measurement, so adding them together is
problematic. What can be done is to measure the value of these various commodities
in money terms – and this is the approach that governments use.
The total amount of goods and services produced in an economy during a time period
is known as the gross domestic product (GDP). This is one of the most important
economic indicators used in judging the performance of an economy. The United
Nations System of National Accounts (SNA) is the internationally recognised framework
used for compiling estimates of GDP.
Measurement of national income
When it comes to undertaking the measurement of GDP, three alternative approaches
can be taken.
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Test yourself 6.1
What is measured by
GDP?
The pattern of
expenditure in the
economy is discussed
in Chapter 7.
In principle, these three measures should produce the same result.
Each of these measures provides information about different aspects of a society’s
total resources.
6
6 National income
LEARNING
LINK
» Expenditure: add up all expenditure undertaken in the economy during a period,
including the various items purchased by households, the expenditure by firms on
capital equipment, spending by government and net export spending. Notice that
although foreigners may purchase domestic goods, domestic residents also spend
money on imported goods – which is why it is net export spending that is included
when calculating total expenditure.
» Income: measure the total amount of income received by people in the country in
the form of wages, salaries, profits, rent, etc.
» Output: add up the total amount of output produced by firms in the economy.
This needs to be calculated in terms of the value added by each firm to avoid
double counting.
The expenditure estimate describes how those resources are being used, so that it can
be seen what proportion of society’s resources is being used for consumption and what
for investment, etc.
LEARNING
LINK
These factors of
production and
their rewards were
introduced in
Chapter 1.
The income estimate reports on the way in which households earn their income.
In other words, it tells something about the balance between rewards to labour
(e.g. wages and salaries), capital (interest), land (rents), enterprise (profits)
and so on.
The output estimate focuses on the structure of the economy. One way in which
countries differ is in the balance between primary production such as agriculture,
secondary activity such as manufacturing, and tertiary activity such as services.
Service activity has increased in importance in many economies in recent years.
Real and nominal measurements
The measurement of economic variables poses many dilemmas for statisticians. Not least
is the fundamental problem of what to use as units of measurement. Suppose we want to
measure GDP in successive years. We cannot use volume measures. It may be possible to
count how many computers, passenger cars, tins of paint and cauliflowers the economy
produces – but how can these different items be combined to produce a total?
KEY TERMS
nominal value: the
value of an economic
variable based on
current prices, taking
no account of changing
prices through time
real value: the value of
an economic variable,
taking account of
changing prices through
time
An obvious solution is to use the money values. Given prices for all the items, it
is possible to calculate the money values of all these goods and thus produce a
measurement of the total output produced in an economy during a year in terms of their
monetary value. However, this is just the beginning of the problem because in order to
monitor changes in total output between two years, it is important to be aware that not
only do the volumes of goods produced change, but so too do their prices. In effect, this
means that if dollars or local currencies are used as the unit of measurement, that unit
of measurement will change in value from one year to the next as prices change.
This is a problem that is not faced by most of the physical sciences. After all, the
length of a metre does not alter from one year to the next, so if the length of
something is being measured, the unit is fixed. Economists, however, have to make
allowance for changing prices when measuring in money terms.
Measurements made using prices that are current at the time a transaction takes place
are known as measurements of nominal values. When prices are rising, these nominal
measurements will always overstate the extent to which an economic variable is
growing through time. Clearly, to analyse performance economists will be more
interested in real values – that is, the quantities produced after having removed the
effects of price changes. One way in which these real measures can be obtained is by
taking the volumes produced in each year and valuing these quantities at the prices
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that prevailed in some base year. This then enables allowance to be made for the
changes in prices that take place, permitting a focus on the real values. These can be
thought of as being measured at constant prices.
6
AS LEVEL PART 4 THE MACROECONOMY
LEARNING LINK
The way in which we measure the extent to which prices are changing through
time is by calculating a price index. This takes an average of prices across the
economy, and compares the value in any particular year to that in a chosen base
year. This will be explained more carefully in Chapter 10.
KEY TERMS
nominal GDP: GDP at
current prices, taking
no account of changing
prices through time
real GDP: GDP at
constant prices, taking
account of changing
prices through time
Test yourself 6.2
The same principle applies to other economic variables that change through time. For
example, we need to distinguish between real GDP and nominal GDP.
Figure 6.1 traces both real and nominal GDP in Pakistan since 1990, measured in
US$ billions. It is quite difficult to interpret the time path of real GDP, as the trend
component of the series is so strong. In other words, real GDP has been increasing
steadily throughout the period. There are one or two periods in which there was a
movement away from the trend, but these are relatively rare and not easy to analyse.
This reflects the nature of economic variables such as GDP, where the fluctuations
around trend are small relative to the trend, but can seem substantial when the
economy is experiencing them.
GDP (US$bn)
Would GDP it current
prices be known as
real GDP or as nominal
GDP?
For example, suppose that last year you bought a tub of ice cream for $2, but
that inflation has been 10%, so that this year you had to pay $2.20 for the same
tub. Your real consumption of the item has not changed, but your spending has
increased. If you were to use the value of your spending to measure changes in
consumption through time, it would be misleading, as you know that your real
consumption has not changed at all (so it is still $2), although its nominal value
has increased to $2.20.
400
Real GDP
Nominal GDP
300
200
Test yourself 6.3
Why would it be
misleading to consider
changes in GDP through
time without adjusting
for changing prices?
100
0
1990
1994
1998
2002
2006
2010
2014
2018
Source: based on data from World Development Indicators
▲ Figure 6.1 Real and nominal GDP in Pakistan since 1990
Comparing the path of real GDP with that of the nominal version, you can see how failing
to take changing prices into account could give a misleading impression of how GDP has
grown over time. The time-path shown by the nominal GDP series is much steeper than for
real GDP, so creates an impression of stronger increase through the period.
LEARNING LINK
The rate at which GDP changes through time is important for the economy,
as it gives an indication about economic growth. This is discussed further in
Chapter 8. The debate about whether GDP can be a good indicator of living
standards is discussed in Chapter 30.
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QUANTITATIVE SKILLS 6.1
Converting nominal measurements to real
6
The relationship between nominal and real values is captured by using a price
index. The ratio of the current (nominal) value of a variable to its constant price
(real) value (multiplied by 100) is a price index. For example,
nominal GDP
real GDP
is a price index. So, if we know GDP at current prices and we know the relevant
price index, we can calculate the real value of GDP.
100 ×
If a country’s real GDP
was $120 billion and the
underlying price index
was 105, what would
be the value of nominal
GDP?
Test yourself 6.5
What is the difference
between GNI and GDP?
6 National income
Test yourself 6.4
For example, in 2018, GDP for Pakistan in current prices was estimated to be
$315 billion, and the underlying price index was 123.9 (based on 2010 = 100). The
real value of GDP can thus be calculated as 100 × 315/123.9 = $254.2 billion.
GDP can be interpreted as the amount of output produced in an economy during a
period of time. It is tempting to think of this as being the resources that residents of
the economy have at their disposal. However, it is also important to recognise that
there are income flows that take place between countries. For example, there may be
foreign workers in a country who remit part of their earnings back to their families –
or there may be nationals of the country who work abroad and send income back to
the domestic economy. Gross national income (GNI) is GDP plus net income from
abroad. For some economies the difference is significant. For example, in 2018/19 net
factor income from abroad amounted to about 6% of GNI in Pakistan, partly reflecting
the number of Pakistani nationals who were working abroad.
Market prices and basic prices
KEY TERMS
gross national income
(GNI): GDP plus net
income from abroad
basic prices: the prices
used for valuing gross
value added, being
exclusive of taxes but
including subsidies
market prices: the
prices used for valuing
GDP, including taxes net
of subsidies
When compiling a measure of national income by adding up the value of output
produced in the various sectors that make up the economy, it is important to avoid
double counting, so total output is measured as the sum of value added across the
sectors. Value added here is naturally measured at what is known as basic prices.
These prices exclude indirect taxes, as these are not part of the value added in
production. However, they include subsidies.
When using a measure based on expenditures, it is natural to value transactions using
the prices actually being paid in the market. This is inclusive of indirect taxes on
expenditure, net of subsidies. So, the expenditure measure of GDP is GDP at market
prices. In other words, GDP at market prices is equal to gross value added plus taxes
on products minus subsidies on products.
EXERCISE 6.1
Table 6.1 shows values of some key items in the national accounts for a country
in 2019.
▼ Table 6.1 Items in the national accounts ($m)
Gross value added at basic prices
1,275
Taxes on products
91
Net income from abroad
86
Subsidies on products
9
Calculate GDP at market prices and GNI.
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6
KEY TERMS
depreciation (of capital
equipment): the fall
in the value of capital
goods due to wear and
tear
AS LEVEL PART 4 THE MACROECONOMY
net domestic product:
GDP – depreciation
net national
income (NNI): GNI –
depreciation
Test yourself 6.6
What is the difference
between GNI and NNI?
Gross and net values
As time goes by, physical capital is used up – in other words, machinery and other
equipment is subject to wear and tear. This process is known as depreciation, which
also affects the calculation of total output. Depreciation cannot be directly observed,
so national statistical offices make an estimate of it. Net domestic product and net
national income (NNI) are calculated by deducting depreciation from GDP and GNI
respectively.
SUMMARY: NATIONAL INCOME STATISTICS
» There are three ways in which the total level of economic activity in an
economy during a period of time can be measured: by total income, by total
expenditure, and by total output produced.
» In principle, the three ways of measuring GDP should give the same answers,
but in practice data measurements are not so accurate.
» Real GDP is a measure of the total economic activity carried out in an economy
during a period by residents living on its territory, adjusted for price changes.
» Real GNI also takes into account net income from abroad.
6.2 Introduction to the circular flow of income
A closed economy
Assume for the moment that there are just two types of economic agent in an
economy: households and firms. In other words, ignore the government and assume
there is no international trade. (These will be brought back into the picture soon.)
We also assume that all factors of production are owned and supplied to firms by
households.
In this simple world, firms produce goods and spend on investment goods.
Households supply labour and other factor inputs, in return for which they
receive income, which they spend on consumer goods. Figure 6.2 shows how all
this works.
Households
Factor
incomes
Factors of
production
Output of goods
and services
Expenditure
Firms
▲ Figure 6.2 The circular flow of income
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KEY TERMS
leakages: where money
flows out of the circular
flow in the form of
savings, taxation and
imports
injections: where
money flows into the
circular flow in the
form of investment,
government spending
and exports
Test yourself 6.7
What is meant by a
‘closed economy’ in this
context?
» There is a flow of income from firms to households, including wages, salaries, rents,
interest and profits. This flow is represented by the blue arrow in Figure 6.2.
» The output of goods and services produced by firms flows from firms to households
in the form of consumer goods. This is the orange arrow in Figure 6.2.
» Balancing the flow of output is a flow of expenditure, as households (and firms)
pay for the goods they obtain from firms. This is the green arrow in Figure 6.2.
» Households also supply factor services to firms, in the form of labour, land, capital
and enterprise. This is represented by the red arrow in Figure 6.2.
This model is known as the circular flow model.
As this is a closed system, these flows must balance. This means that there are three ways
in which the total amount of economic activity in this economy can be measured: by factor
incomes that firms pay out, by the total amount of goods and services that is produced, or
by total expenditure. Whichever method is chosen, it should give the same result.
6
6 National income
circular flow model: a
model of the economy
which shows the
movement of goods
and services between
households and firms
and their corresponding
payments in money
terms, together with
the supply of factors of
production
The main flows in this model are as follows:
An open economy
A real-world economy is more complicated than this, so it is also necessary to take
into account the economic activities of government and the fact that economies
engage in international trade, so that some of the output produced is sold abroad
and some of the expenditure goes on foreign goods and services. In other words, a
real-world economy is not a closed system, as there are leakages from the system
and injections into it. These arise because of the economic activities of government
and through an economy’s international trade with the rest of the world.
Injections into the circular flow
There are three key injections into the circular flow:
» government expenditure (G)
» exports (X)
» investment by firms (I)
The government spends money on goods and services. For example, it may spend
on the provision of public goods, and has to spend in order to carry out its other
governmental obligations.
STUDY TIP
Notice that in
economics ‘investment’
is used in this specific
way. In everyday
language the term
is sometimes used
to refer to investing
in shares or putting
money into a deposit
account at the bank.
Be careful not to
confuse these different
concepts. In economics
‘investment’ relates to a
firm buying new capital,
such as machinery or
factory buildings. If you
put money into a bank
account, that is an act of
saving, not investment.
Foreign residents buy goods and services produced in the home economy. From the
home economy’s point of view, these are exports of goods and services. Associated
with exports is an inflow of expenditure from the rest of the world.
Firms also undertake expenditure when they buy capital goods, such as machinery,
factory buildings or transport equipment. This is termed ‘investment’, as it involves
obtaining goods that will be used in future production.
Leakages from the circular flow
On the other side of the coin, there are leakages from the circular flow, comprising:
» taxes raised by the government from households (T)
» spending on imports from the rest of the world (M)
» household savings (S)
The government raises taxes in order to finance its spending. This includes direct
taxes such as income tax and corporation tax, but also indirect taxes such as VAT and
customs duties.
Residents in the domestic economy buy goods and services from abroad, in the form
of imports. This is a leakage from the system simply because it is expenditure that is
not going on home-produced goods and services.
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Households save part of their income, so these savings are also a leakage from the
circular flow.
6
Figure 6.3 adds all of these effects on to the circular flow diagram. The flow of
expenditure is no longer just made up of household consumption expenditure on
consumer goods, but is augmented by investment expenditure by firms (I), export
expenditure from overseas (X) and government expenditure (G). These can be regarded
as injections into the circular flow.
AS LEVEL PART 4 THE MACROECONOMY
S
Households
T
Factor
incomes
Factors of
production
M
Output of goods
and services
Expenditure
Firms
G
I
X
▲ Figure 6.3 Injections and leakages in the circular flow of income
Notice that there are connections between the injections and leakages – for example,
household savings may enter financial markets, and firms borrow from financial
markets in order to finance their investment expenditure.
Test yourself 6.8
Suppose that there
were to be a fall in
investment expenditure
by firms. How would
this affect the circular
flow?
International trade also affects the circular flow. Part of the expenditure on goods
and services in the economy comes from abroad in the form of exports. In addition,
part of the expenditure undertaken by households is on imported goods and services.
The saving activity of households also affects the circular flow, as there is a part of
household income that is saved instead of being spent on goods and services. It is
also important to realise that firms contribute to expenditure when they buy
investment goods to add to their productive capacity.
EXERCISE 6.2
For each of the following, state whether it is an
injection or a leakage, and whether it increases or
decreases the circular flow (ceteris paribus).
a The government cancels a road improvement
scheme.
b People become more thrifty because the future
seems more uncertain.
c Domestically produced goods become more
popular with foreigners.
d The government reduces the rate of income tax.
e People choose to take more holidays abroad.
f Firms reduce their spending on plant and
machinery.
Equilibrium in the overall economy
The overall economy will be in equilibrium when planned injections are equal to
planned leakages. In other words, when plans of economic agents are fulfilled, there
is no incentive to change behaviour.
Suppose that planned injections are higher than planned leakages, perhaps because
the government decides to spend more on the road network. This will cause an
increase in national income, but as household income rises, individuals will be likely
to save more, and will need to pay more of their income in tax, or spend part of their
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This phenomenon
is known as the
‘multiplier’ process,
and will be examined
in Chapter 24.
additional income on imported goods. Leakages will rise, and eventually the economy
will return to equilibrium, where planned injections equal planned leakages.
Notice that investment in the form of expenditure by firms on machinery, buildings
and other productive resources plays an important role within the macroeconomy. By
undertaking investment expenditure, firms add to the productive capacity of the economy,
and thus enable economic growth to take place. A change in the balance between
investment and consumption activity therefore affects the long-run path of the economy.
SUMMARY: INTRODUCTION TO THE CIRCULAR FLOW
» The circular flow of income describes the
relationship between income, expenditure and
output.
» The circular flow diagram needs to accommodate
injections and leakages.
» The government affects the circular flow through
expenditure (an injection) and taxation (a leakage).
» International trade is important because of
exports (an injection) and imports (a leakage).
6 National income
An increase in expenditure on investment by firms may have other effects as well.
In order to meet the additional demand for machinery, other firms need to expand
production. This means that they need to hire extra workers – and pay them, of
course. The additional workers will then spend part of their income on consumer
goods, thus unleashing a second round of expenditure.
6
» The circular flow is also affected by household
savings (a leakage) and by firms’ investment
expenditure (an injection).
» Investment is also important because it affects the
productive capacity of the economy in the long run,
and is thus important for economic growth.
» Equilibrium is achieved when total injections equal
total leakages.
END OF CHAPTER QUESTIONS
Multiple choice
1 A government official stated that the total money value resulting from all economic
activities in a country over a year increased. What term underpins their statement?
A real economic growth
C income per head
B circular flow of income
D national income
2 What is a likely reason why, in a given year, a country’s GDP would be higher than
its GNI?
A The country has received net inflows of foreign investment in the past.
B The country has encouraged local companies to invest abroad.
C The country’s net income from abroad has increased.
D The value of capital accumulation exceeds depreciation.
Data response
1 Read the following extract and then answer the questions that follow.
HS2: A circular argument
In the UK in early 2020, the prime minister gave the go-ahead to continue with
the planned new 400 km per hour railway line known as HS2.
The first phase of the project will be the line between London and
Birmingham, England’s second city. This is projected to be operational by
5 2031. Later phases are planned to extend the route further north to the cities
of Manchester and Leeds, for which the estimated completion date is 2040;
later still there are plans to extend the line into Scotland.
Government expenditure on the HS2 project is estimated to be US$135bn,
which equates to US$380m per mile.
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AS LEVEL PART 4 THE MACROECONOMY
6
10 The approval of the plans is a big deal because the HS2 project is controversial.
With the UK tax burden already near a 50-year high, the money for HS2 must
come from somewhere, so taxation is thought likely to increase further.
Those who support the project say it will reduce transport times, create
jobs and help the country’s economy. The government’s aim, spelled out in
15 its 2013 strategic case, was to ‘build a stronger, more balanced economy
capable of delivering lasting growth and widely shared prosperity’.
Transport links are critical for economic success, particularly high-quality
infrastructure that would join up cities around the country.
Locally, the leaders of the cities along the HS2 route believe beneficial
20 investment by firms will accompany the new line. HSBC, TalkTalk and Deutsche
Bank are among the companies that have already relocated some operations
out of the London area. It is hoped that HS2 will encourage more to follow.
Meanwhile, according to the HS2 company, the construction of the line itself
will employ about 30,000 people at its peak. In addition, research shows how
25 HS2 can help to better connect the region’s exporters by cutting journey times
from Newcastle in the far northeast of England to London’s Heathrow airport
in the southeast by 1 hour and 20 minutes. In these ways, HS2 will boost not
only the GDP of the UK but potentially the GNI of many other countries as well.
2020
US$135bn
2015
2011
US$71bn
US$41bn
Data from the BBC
▲ Figure 6.4 How the projected cost of HS2 has changed (current prices)
a Explain, with reference to the data in Figure 6.4, the importance of using real
rather than nominal values if a meaningful comparison of the volume
of resources used in the HS2 project is to be made.
b ‘HS2 will boost not only the GDP of the UK but potentially the GNI of many
other countries as well’ (lines 27–28). Distinguish between GDP and GNI and
explain why HS2 might potentially boost the GNI of other countries.
c Explain the difference between injections and leakages in the circular flow
of income model and identify one example of each in the extract.
d ‘Locally, the leaders of the cities along the HS2 route believe beneficial
investment by firms will accompany the new line’ (lines 19–20). Explain
some of the potential benefits of the investment by firms that the city
leaders anticipate.
e The following has been asserted. ‘The government decision to inject a large
sum of money in the HS2 project will lead to a temporary disequilibrium in
the overall UK economy. However, there will follow a return to a general
equilibrium.’ Discuss the validity of this statement.
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AS LEVEL PART 4 The macroeconomy
7
Aggregate demand and aggregate
supply analysis
★ the definition of aggregate demand (AD)
★ the components of AD, their meanings and
determinants
★ the shape of the AD curve and what influences its
position
★ aggregate supply (AS) and its determinants
★ the shape of the AS curve in the short run (SRAS)
and the long run (LRAS) and what causes them to
shift
★ the distinction between a movement along and a
shift in AD and AS
★ equilibrium in the AD/AS model and the
determination of the level of real output, the price
level and employment
★ the effects of shifts in the AD curve and the AS
curve on the level of real output, the price level
and employment
This chapter introduces a model that brings together concepts of aggregate demand
and aggregate supply – in other words, the total level of demand and supply in an
economy. The starting point is to consider the components of aggregate demand.
The way in which the levels of these components are determined in practice is
important for the operation of the economy when considered at the aggregate level.
It is also important to examine aggregate supply and the factors that influence it.
Macroeconomic equilibrium is seen to occur when aggregate demand equals aggregate
supply. There are some important differences between this model and the model of
demand and supply seen in microeconomics.
7 Aggregate demand and aggregate supply analysis
What this chapter covers
7.1 Aggregate demand
KEY TERM
aggregate demand: the
total amount of effective
demand in the economy
Macroeconomics deals with relationships between economic variables at the
aggregate level – that is, in the economy viewed as a whole. In building a theory to
explain those relationships, the starting point is to consider aggregate demand.
This represents the total amount of effective demand in the economy as a whole.
From the discussion of the circular flow, this includes households, firms, the
government and overseas residents who buy home-produced goods and services.
The main components of aggregate demand are:
»
»
»
»
consumption (which we will denote by C)
investment by firms (I)
government expenditure (G)
net exports – that is, exports minus imports (X – M)
We can write this as:
AD = C + I + G + (X – M)
The components of aggregate demand
Consumption
The largest component of aggregate demand is household spending on goods and
services produced in the domestic economy, often known as consumption (C). The
main factor that will influence the size of consumption expenditure is likely to be
the level of real income that households have at their disposal. When real incomes
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are relatively high, households will tend to spend more than when real incomes are
low. Consumption may also be influenced by interest rates, wealth and expectations
about the future. Notice that people may not choose to spend all of their income on
domestically produced goods: some expenditure may be on imported goods, and they
may choose to save part of their income against future needs.
7
Investment
AS LEVEL PART 4 THE MACROECONOMY
A second key part of aggregate demand is spending by firms – in particular, spending
on investment goods (I). For example, firms may choose to invest in new machinery
or transport equipment. This is important not only because it contributes to
aggregate demand in the current period, but because investment in new machinery
enables higher production of goods in the future. The amount of investment that
firms will wish to undertake depends on a number of factors. For example, it may be
influenced by whether firms are optimistic or pessimistic about future demand for
their products. If their expectations are high, they are more likely to invest in order
to meet future demand. However, investment expenditure needs to be financed, so
the level of investment may also depend on the availability of finance. If firms have
made good profits, then this may provide a fund for investment. However, if firms
need to borrow, then the cost of borrowing will also be important, and so the rate of
interest will be important.
Government expenditure
The government plays an important role in the macroeconomy. It spends on goods and
services, both to allow it to carry on its normal operations and to provide improved
facilities that will allow the economy to develop in the future or to protect vulnerable
members of society. In other words, government expenditure (G) may be partly
consumption and partly investment. Government expenditure may be considered to be
autonomous: in other words, it is determined by government decisions rather than by
other economic items.
International trade
KEY TERM
trade balance: the
balance between
expenditure on exports
and on imports (net
exports)
LEARNING
LINK
The determinants of
the components of
aggregate demand
are explained in
Chapter 24.
Most economies are open to international trade, and transactions between the
domestic economy and the rest of the world will affect aggregate demand. Domestic
residents and firms may spend on imports (M), bringing in goods and services that
are produced elsewhere in the world. At the same time, foreign consumers and firms
may purchase goods and services in the domestic economy in the form of exports
(X). The contribution of these transactions to domestic aggregate demand will
depend on the balance between exports and imports, known as the trade balance,
or net exports.
Trade in goods and services (exports and imports) is determined by the
competitiveness of domestic goods and services compared with the rest of the world,
which in turn is determined by relative inflation rates and the exchange rate. Imports
are also affected by domestic income, and exports are affected by incomes in the rest
of the world.
Figure 7.1 shows the shares of the components of aggregate expenditure in
selected countries in 2018. In all countries except China, consumption is by
far the largest component, which is the typical pattern. China is unusual in
devoting such a high proportion of expenditure to investment. Also of interest
is the relatively high proportion of GDP in Malaysia that is trade (exports and
imports). This reflects the fact that Malaysia’s economy is very oriented towards
international trade.
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% of GDP
170
C
I
G
X
M
7
120
70
20
–30
–80
India
Malaysia
USA
Note: C includes spending by non-profit institutions serving households;
I includes changes in inventory holdings; the statistical discrepancy is not shown.
Source: based on data from World Development Indicators
▲ Figure 7.1 GDP expenditure shares, 2018
Test yourself 7.1
In thinking about
the components of
aggregate demand,
which economic
agent or agents
undertake investment
expenditure?
7 Aggregate demand and aggregate supply analysis
China
▲ A container terminal in Johor in Malaysia
EXERCISE 7.1
Suppose there is an economy in which the following values apply.
▼ Table 7.1 Values for an economy
Values
$m
Consumption
75
Profits
60
Investment
30
Government expenditure
25
Exports
50
Private saving
50
Imports
55
a Calculate the level of aggregate demand.
b Calculate the trade balance.
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» Aggregate demand is the total amount of effective
demand in the economy.
» The components of aggregate demand are
consumption, investment, government expenditure
and net exports.
» Consumption is the largest of these components
and is determined by income and other influences,
such as interest rates, wealth and expectations
about the future.
» Investment leads to increases in the capital stock
and is influenced by interest rates, past profits and
expectations about future demand.
» Government expenditure may be regarded as
largely autonomous.
» Trade in goods and services (exports and
imports) is determined by the competitiveness
of domestic goods and services compared with
the rest of the world, which in turn is determined
by relative inflation rates and the exchange rate.
Imports are also affected by domestic income,
and exports are affected by incomes in the rest
of the world.
7.2 The aggregate demand curve
KEY TERM
aggregate demand
curve (AD): a
curve showing the
relationship between
the level of aggregate
demand in an economy
and the overall price
level; it shows planned
expenditure at any given
overall price level
A key relationship to help in explaining the macroeconomy is the aggregate demand
curve (AD), which shows the relationship between aggregate demand and the overall
price level. This curve shows the total amount of goods and services demanded in an
economy at any given overall level of prices.
It is important to realise that this is a very different sort of demand curve from the
microeconomic demand curves that were introduced in Chapter 2, where the focus was
on an individual product and its relationship with its own price. Here the relationship is
between the total demand for goods and services and the overall price level. Aggregate
demand is made up of all the components discussed above, and the price is an average of all
prices of goods and services in the economy. Figure 7.2 shows an aggregate demand curve.
Price level
AS LEVEL PART 4 THE MACROECONOMY
7
SUMMARY: AGGREGATE DEMAND
AD
STUDY TIP
It is important to
remember this
difference between
the aggregate
demand curve and
the microeconomic
demand curve for
a product. In the
macroeconomic
context, always label
the vertical axis as
‘Price level’ and the
horizontal axis as ‘Real
output’ or ‘Real GDP’
as a reminder. Do not
just use ‘P’ and ‘Q’.
0
Real output
▲ Figure 7.2 An aggregate demand curve
The shape of the AD curve
An important question is why the AD curve slopes downwards. To answer this, it is
necessary to determine the likely influence of the price level on the various components
of aggregate demand that have been discussed in this chapter, as prices have not been
mentioned explicitly. First, the discussion needs to be cast in terms of the price level.
When the overall level of prices is relatively low, the purchasing power of income is
relatively high. In other words, low overall prices can be thought of as indicating
relatively high real income. Furthermore, when prices are low, this raises the real value
of households’ wealth. For example, suppose a household holds a financial asset such
as a bond with a fixed money value of $100. The relative (real) value of that asset
is higher when the overall price level is relatively low. This suggests that, ceteris
paribus, a low overall price level means relatively high consumption.
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A third argument concerns exports and imports. It can be argued that, ceteris paribus,
when prices at home are relatively low compared with the rest of the world, this will
increase the competitiveness of domestically produced goods, leading to an increase
in foreign demand for exports, and a fall in the demand for imports into the economy
as people switch to buying home goods and services.
All of these arguments support the idea that the aggregate demand curve should
be downward sloping. In other words, when the overall price level is relatively
low, aggregate demand will be relatively high, and when prices are relatively high,
aggregate demand will be relatively low.
The position of the AD curve
What will cause the AD curve to shift its position? Any change in the components of
aggregate demand will affect the position of AD. For example, an increase in firms’
expenditure on investment goods will cause the AD curve to shift to the right. A fall
in government expenditure would cause the AD to shift to the left.
Test yourself 7.2
What factors would
induce a shift of the
aggregate demand
curve and what would
induce a movement
along it?
SUMMARY: THE AGGREGATE DEMAND CURVE
» The aggregate demand curve (AD) shows the relationship between the level of
aggregate demand in an economy and the overall price level.
» The AD curve is downward sloping with respect to the overall price level.
» Changes in the components of aggregate demand affect the position of the AD
curve.
7
7 Aggregate demand and aggregate supply analysis
The way in which
shifts in AD affect
the economy will
be discussed after
we have explored
the other key
relationship – the
aggregate supply
curve.
A second argument relates to interest rates. When prices are relatively low, interest
rates also tend to be relatively low, which would encourage both investment and
consumption expenditure, as interest rates can be seen as representing the cost of
borrowing to households and firms.
7.3 Aggregate supply
The previous section discussed the notion of aggregate demand and introduced the
aggregate demand curve. In order to analyse the overall macroeconomic equilibrium, it is
necessary to derive a second relationship: that between aggregate supply and the price
level. It is important to remember that the level of aggregate supply covers the output
of all sorts of goods and services that are produced within an economy during a period
of time. However, it is not simply a question of adding up all the individual supply
curves from individual markets. Within an individual market, an increase in price may
induce higher supply of a good because firms will switch from other markets in search of
higher profits. What you now need to be looking for is a relationship between the overall
price level and the total amount supplied, which is a completely different thing.
The total quantity of output supplied in an economy over a period of time depends on
the quantities of factors of production employed: that is, the total amounts of labour,
capital and other factors used. The ability of firms to vary output in the short run will be
influenced by the degree of flexibility that the firms have in varying inputs. This suggests
that it is important to distinguish between short-run and long-run aggregate supply.
Short-run aggregate supply
In the short run, firms may have relatively little flexibility to vary their inputs. Money
wages are likely to be fixed, and firms will not be able to expand the amount of
capital needed in the production process. Furthermore, raw materials may be in short
supply, and firms may find that hiring additional workers brings less additional output
than is obtained from existing workers because of the lack of additional machinery.
However, at a higher price level firms will want to produce more in order to increase
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short-run aggregate
supply curve (SRAS):
a curve showing how
much output firms
would be prepared to
supply in the short run
at any given overall
price level
their profits. This suggests that in the short run, aggregate supply may be upward
sloping, as shown in Figure 7.3, where SRAS represents short-run aggregate supply.
Price level
7
KEY TERM
SRAS
0
Real GDP
▲ Figure 7.3 The short-run supply curve (SRAS)
Test yourself 7.3
What would induce a
movement up along the
SRAS?
Underlying the aggregate supply curve are the decisions taken by firms about
production levels at any given price. Firms are assumed to choose how much output to
produce in order to maximise profits. In the short run, firms must take as given:
» the state of technology and the effectiveness with which factors are used
» the total supply of factors of production
The state of technology and the total supply of factors of production change
only gradually through time, which is why the short-run aggregate supply curve is
important: it shows how firms act in the short run.
On the other hand, input prices can change more rapidly – for example, wage rates can
change, as can the prices of some inputs such as oil or other raw materials. These changes
in input prices affect the costs faced by firms, and can affect the position of the SRAS.
The cost of inputs
There are several factors that could influence costs in the short run. For example, suppose
there is a change in the cost of raw materials. If a key raw material becomes more limited
in supply, perhaps because reserves are exhausted, then the prices of inputs will tend to
rise, thus raising firms’ costs of production. They may then choose to supply less output
at any given product price – and the aggregate supply curve would shift to the left.
The price of oil has been subject to significant variations over time. Oil is a key input for
many firms, and an increase in the price of oil affects the cost of energy and transport.
It also affects the economy in many other ways – for example, oil is a key input in
the production of many fertilisers used in the agricultural sector. The price of oil may
therefore have a significant impact on the position of aggregate supply in the short run
by affecting the costs faced by firms.
Another key input for firms is labour, so an increase in labour costs
will also affect the position of the short-run aggregate supply curve.
The exchange rate
▲ Oil is a key input for many firms
Where firms rely on imported inputs of raw materials, energy or
component parts used in production, then a change in the exchange
rate could affect aggregate supply, by affecting the domestic price of
imported inputs, and in turn affecting the costs faced by firms. This
could be favourable, of course, depending on the direction in which
the exchange rate changes. It could be that the exchange rate rises
(appreciates), thus reducing the domestic price of imports. Firms may
then be prepared to supply more output at any given price.
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Government intervention
There are some forms of government intervention that can affect firms’ costs in the
short run. An increase in regulation that forced firms to spend more on health and
safety measures would raise costs. An increase in the rate of corporation tax would
have similar effects.
Shifts in the short-run aggregate supply curve
Test yourself 7.4
How would a fall in
labour costs affect the
SRAS?
7
If any of the factors assumed to influence aggregate supply in the short run change,
then the aggregate supply curve will shift. The costs faced by firms are the main cause
of shifts in SRAS.
For example, given that aggregate supply arises from the use of inputs of factors of
production, one important influence is the price of factor inputs. Other factors that
influence the costs faced by firms will also be important, as mentioned above.
Price level
Figure 7.4 shows how the short-run aggregate supply curve would respond if the
government introduced measures that require firms to spend more on health and
safety. The increase in costs means that firms will be prepared to supply less output at
any given price, so the SRAS curve shifts to the left, from SRAS0 to SRAS1.
SRAS1
7 Aggregate demand and aggregate supply analysis
The significance of
the exchange rate
and the way in which
it is determined is
explained in Chapters
13, 28 and 29.
The exchange rate can change in the short run for a variety of different reasons, so firms
may face some quite sudden changes in their costs. One way that firms can guard against
this is through the nature of the contracts drawn up with their foreign suppliers, if future
prices can be specified in a way that hedges against possible exchange rate fluctuations.
SRAS0
0
Real GDP
▲ Figure 7.4 A shift in the SRAS curve
EXERCISE 7.2
For each of the following, state whether the short-run aggregate supply curve
would shift to the left or to the right.
a The discovery of a new source of a raw material, reducing its price
b An increase in the exchange rate
c An increase in wage rates
d A fall in the price of oil
Short-run aggregate supply: an alternative view
There are different views about the shape of the SRAS. Some economists have argued
that the SRAS will have a gentler slope when there is some ‘slack’ in the economy – in
other words, if the economy is operating at a relatively low level of real GDP, an increase
in aggregate supply will have a relatively weak effect on the overall price level. However,
as resources become more scarce, the pressure on the price level increases as real GDP
increases, and the SRAS becomes steeper. Figure 7.5 shows an example of such a curve.
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Price level
0
Real GDP
▲ Figure 7.5 An alternative view of the SRAS
Long-run aggregate supply
KEY TERMS
full-employment level
of output: the level of
output at which the
economy is operating at
full potential capacity
long-run aggregate
supply curve (LRAS): a
curve showing the level
of real output when
the economy is at full
capacity
Test yourself 7.5
Why would firms not
want to pay overtime to
their staff in the long
run?
LEARNING
LINK
Notice that
although this level
of employment is
regarded as being
‘full’ employment,
this does not mean
that that there is no
unemployment in
the economy. This
is explained in
Chapter 9.
At a given point in time, the state of technology and the availability of factors of
production determine the total capacity of the economy to produce. In the short run,
firms may be able to produce above this level, but only by increasing the intensity of
use of factors of production – for example, by paying their workers overtime. However,
firms will not want to do this on a long-term basis, so producing beyond the natural
full capacity of the economy will not be sustainable. There may also be periods in
which total output falls below the potential capacity to produce – for example, if
there is a recession in which unemployment increases.
So, in the long run, there is a potential capacity level of output, often referred to as
the full-employment level of output. If the economy always adjusts to this level,
then the long-run aggregate supply curve (LRAS) will be vertical at this fullemployment level. This is shown in Figure 7.6, where YFE represents the potential full
capacity output of the economy. In other words, this level of output corresponds to a
level of employment that is regarded as being ‘full’ employment.
Price level
AS LEVEL PART 4 THE MACROECONOMY
7
SRAS
0
LRAS
YFE
Real GDP
▲ Figure 7.6 The long-run aggregate supply curve
Shifts in the LRAS
The position of the long-run supply curve depends on:
» the quantity of factor inputs available
» the effectiveness with which factor inputs are used
The quantity of factor inputs
As far as labour input is concerned, an increase in the size of the workforce will affect
the position of aggregate supply. In practice, the size of the labour force tends to
change relatively slowly unless substantial international migration is taking place:
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for example, the expansion of membership of the EU in May 2004 led to significant
migration into the UK.
An increase in the quantity of capital will also have this effect, by increasing the capacity
of the economy to produce. However, such an increase requires firms to have undertaken
investment activity. In other words, the balance of spending between consumption and
investment may affect the position of the aggregate supply curve in future periods.
Price level
The effectiveness with which factor inputs are used
The effectiveness with which inputs are utilised is another important influence on the
position of LRAS. Advances in technology are one route through which inputs can be
more effectively utilised. New machinery can improve the efficiency with which other
inputs are used, and the development of new materials can also have an impact. Such
developments can reduce firms’ costs and increase the amount of aggregate output
that can be produced, leading to a shift in the long-run aggregate supply curve. This
is shown in Figure 7.7, where aggregate supply was originally at LRAS0. Technological
change that improves efficiency in the use of capital and other inputs means that
firms are prepared to supply more output at any given overall price level, so the
aggregate supply curve shifts to LRAS1, with real GDP increasing from YFE0 to YFE1.
0
LRAS0
YFE0
LRAS1
7 Aggregate demand and aggregate supply analysis
Demographic changes and migration can also affect the size of the workforce in the
long run. The UK and many other advanced economies have been characterised by an
ageing population in recent years. As more people live longer into retirement, the
working population falls as a proportion of the total, and the LRAS may shift to the
left. In many developing countries in sub-Saharan Africa, the HIV/AIDS epidemic was
especially devastating to people of working age, so reduced the size and effectiveness
of the labour force. In-migration can also affect the size of the workforce.
7
YFE1
Real GDP
▲ Figure 7.7 A shift in LRAS
Labour as a factor of production can also become more effective and productive, and
can be seen as a form of human capital. Improvements to education and the provision of
skills training can improve the productivity of labour, again leading to a rightward shift
of long-run aggregate supply. Training and education may be especially important for
an economy that is undergoing structural change, so that workers need to be prepared
to move between occupations. Government encouragement or provision of such training
can improve the flexibility of the labour market and affect aggregate supply.
EXERCISE 7.3
For each of the following, identify whether the
change described will affect short-run or longrun aggregate supply, and whether the result is a
leftward or rightward shift.
a A fall in the exchange rate that affects the price of
imported inputs
b
c
d
e
An increase in the rate of immigration
An increase in the price of oil
A reduction in corporation tax
The introduction of new super-computers
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Long-run aggregate supply: an alternative view
The assumption that LRAS is vertical depends on the assumption that prices and wages
adjust rapidly to take the economy to equilibrium. This assumption reflects a classical or
neoclassical view of the economy. A group of economists (sometimes known as ‘Keynesians’)
held that the macroeconomy was not sufficiently flexible to enable continuous full
employment, and that the adjustment to full-employment equilibrium would not be as
smooth as had been suggested. They argued that the economy could settle at an equilibrium
position below full employment, at least in the medium term. In particular, inflexibilities in
labour markets would prevent or slow the adjustment. For example, if firms had pessimistic
expectations about aggregate demand, and thus reduced their supply of output, this would
lead to lower incomes because of the workers being laid off. This would then mean that
aggregate demand was indeed deficient, so firms’ pessimism was self-fulfilling.
AS LEVEL PART 4 THE MACROECONOMY
7
Price level
These sorts of argument led to a belief that there would be a range of output over
which aggregate supply would be upward sloping. Figure 7.8 illustrates such an
aggregate supply curve, in which YFE represents full employment. When the economy
is operating below this level of output, aggregate supply is somewhat sensitive to the
price level, becoming steeper as full employment is approached.
LRAS
YFE
Real GDP
▲ Figure 7.8 Aggregate supply in the long run (the ‘Keynesian’ view)
Table 7.2 summarises the different views of long-run aggregate supply.
▼ Table 7.2 Summary of classical and Keynesian views
Classical view
Keynesian view
LRAS is vertical at the full-employment
level
LRAS is upward-sloping for a range of output
below full employment
The economy converges rapidly to full
employment
The economy could settle at a level of output
below full employment
Policy intervention is not needed
because the economy adjusts rapidly
Policy intervention may be needed to move
towards full employment
Aggregate supply is not sensitive to
the price level
Aggregate supply is sensitive to the price level
when the economy is below full employment
SUMMARY: AGGREGATE SUPPLY
» In the short run, firms aiming to maximise profits
will be prepared to supply more output at higher
prices.
» There is an upward-sloping relationship between
real output and the price level.
» Changes in factor prices may lead to a shift in the
position of the short-run aggregate supply curve.
» The level of output produced when the economy is
operating at full capacity (given technology and the
availability of factors of production) is known as
the full-employment level of output.
» In the long run, aggregate supply is vertical at this
full-employment level of real output, although
some economists have argued that it could slope
upwards over some range of output.
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7.4 Macroeconomic equilibrium
As with demand and supply in microeconomics, it is important to understand how equilibrium
is achieved at the macroeconomic level, both in the short run and in the long run.
7
Macroeconomic equilibrium in the short run
Price level
SRAS
P
AD
0
Y
Real GDP
▲ Figure 7.9 Short-run macroeconomic equilibrium
This is an equilibrium, in the sense that if nothing changes then firms and households
will have no reason to alter their behaviour in the next period. At the price P,
aggregate supply is matched by aggregate demand.
7 Aggregate demand and aggregate supply analysis
Bringing aggregate demand and short-run aggregate supply together, the overall
equilibrium position for the macroeconomy can be identified. In Figure 7.9, with
aggregate supply given by SRAS and aggregate demand by AD, equilibrium is reached at
the real GDP level Y, with the price level at P.
Can it be guaranteed that the equilibrium will occur at the full-employment level of real
GDP? For example, suppose that in Figure 7.10 the output level YFE corresponds to the
full-employment level of output – that is, the level of output that represents productive
capacity when all factors of production are fully employed. If aggregate demand is at
AD*, the macroeconomic equilibrium is at this full-employment output YFE. However, if
the aggregate demand curve is located at AD1 the equilibrium will occur at Y1, which is
below the full-employment level, so there is surplus capacity in the economy.
Price level
It may be possible to produce more than YFE in the short run, but only on a temporary
basis, perhaps by the use of overtime. In other words, in the short run it is possible
that the SRAS could move to a position with equilibrium to the right of YFE, but this
would be unsustainable in the long run, so the SRAS would move back to the left.
SRAS
P*
P1
AD*
AD1
0
Y1 YFE
Real GDP
▲ Figure 7.10 Will macroeconomic equilibrium
be at full employment in the short run?
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In the long run, the equilibrium level of real GDP cannot be higher than YFE, and
may only be below YFE temporarily when the LRAS is vertical. Figure 7.11 shows the
long-run equilibrium position with a ‘classical’, vertical, LRAS curve. In this long-run
equilibrium position, the overall price level in the economy is P*.
Price level
AS LEVEL PART 4 THE MACROECONOMY
7
Macroeconomic equilibrium in the long run
LRAS
P*
AD
0
YFE
Real GDP
▲ Figure 7.11 Long-run macroeconomic equilibrium
Two important questions need to be explored. One is how the economy adjusts to
equilibrium if there is a change in the market environment. The second question is
how long it takes to reach a new equilibrium. We will explore these questions by
considering how the equilibrium changes in response to a change in aggregate demand
or aggregate supply.
The effect of an increase in aggregate demand
The position of the aggregate demand curve depends on the components of aggregate
demand: consumption, investment, government spending and net exports. Factors that
affect these components will affect the position of aggregate demand.
Price level
Consider Figure 7.12, which shows the short-run position. Suppose that the economy
begins in equilibrium with aggregate demand at AD0. The equilibrium level of real GDP
is Y0, and the price level is at P0. An increase in government expenditure will affect
the position of the aggregate demand curve, shifting it to AD1. The economy will move
to a new equilibrium position, with a higher output level Y1 and a higher price level P1.
SRAS
P1
P0
AD1
AD0
0
Y 0 Y1
Real GDP
▲ Figure 7.12 A shift in aggregate demand in the short run
The shift in the AD curve from AD0 to AD1 results in a new equilibrium with higher real
GDP at Y1 and a higher overall price level at P1. Notice that the change brings about
a relatively large increase in the price level with a relatively modest increase in real
GDP. This reflects the shape of the SRAS.
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Price level
Figure 7.13 illustrates the effect of an increase in aggregate demand with a short-run
aggregate supply curve shaped as a sweeping upward curve. The key difference is that
with this shape of SRAS, the effect of the shift in AD is seen more in its impact on real
GDP than on the price level. In other words, the resulting increase in price in the new
equilibrium is relatively small compared to the increase in real GDP.
7
SRAS
AD1
0
AD0
Y0 Y1
Real GDP
▲ Figure 7.13 An increase in aggregate demand in the short run with a curved SRAS
In the long run, the economy will move to its long-run equilibrium at the full capacity
level of real output. But how does this adjustment work?
Price level
Figure 7.14 demonstrates, using a linear SRAS. The economy begins with real output
at its full-employment level YFE and the price level at P0. If there is an increase in
aggregate demand from AD0 to AD1 firms respond by increasing output, and there
is a movement along the short-run aggregate supply curve SRAS0. Real output has
increased to Y1 and the price level has risen to P1. As the economy begins to adjust,
firms find that their costs rise because of rising raw material prices and wage costs.
This means that there is a shift of the short-run aggregate supply curve from SRAS0 to
SRAS1. Real output has returned to the full-employment level, but the economy is left
with a higher equilibrium price level at P2.
LRAS
7 Aggregate demand and aggregate supply analysis
P1
P0
SRAS1
SRAS0
P2
P1
P0
AD1
AD0
Test yourself 7.6
Explain why the effect
of an increase in
aggregate demand
cannot be sustained if
the economy begins at
the full-employment
level of real GDP.
0
YFE Y1
Real GDP
▲ Figure 7.14 Adjustment following an increase in aggregate demand
This adjustment process would work in reverse if there is an initial fall in aggregate
demand. There would be an initial movement along the SRAS, with equilibrium real
output and price level falling. In the longer run, the economy would move back
towards the long-run equilibrium as firms’ costs adjust downwards with less upward
pressure on prices.
An important question in this situation is how long it takes for the economy to return to
long-run equilibrium. Economists who subscribe to the classical view of the world would
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argue that adjustment will be rapid. However, those in the Keynesian camp would tend
to argue that the adjustment could be slow, or that the economy could settle below full
employment in the medium or even long run. Figure 7.15 illustrates how this could occur.
If the AD curve comes to intersect the LRAS at a level of real GDP below full employment,
then the adjustment back to full employment may not take place, or it may take a long
time for the adjustment to work through the economy. This is an equilibrium position for
the economy, given that aggregate demand is equal to long-run aggregate supply.
AS LEVEL PART 4 THE MACROECONOMY
Price level
7
LRASK
PFE
PK
AD
0
YK YFE
Real GDP
▲ Figure 7.15 Long-run macroeconomic equilibrium below full employment
The effect of a short-run supply shock
The AD/AS model can also be used to analyse the effects of an external shock that
affects aggregate supply. For example, suppose there is an increase in oil prices arising
from a disruption to supplies in the Middle East. This raises firms’ costs, and leads to a
reduction in aggregate supply. Again, we can examine the likely effects on equilibrium.
Figure 7.16 analyses the short-run situation. The economy begins in equilibrium with
output at Y0 and the overall level of prices at P0. The increase in oil prices causes a
movement of the aggregate supply curve from SRAS0 to SRAS1, with aggregate demand
unchanged at AD. After the economy returns to equilibrium, the new output level has
fallen to Y1 and the overall price level has increased to P1.
STUDY TIP
In trying to analyse
the effects of a shock,
the first step is to
think about whether
the shock affects AD
or AS, and the second
is to analyse whether
the shock is positive
or negative: that is,
which way the relevant
curve will shift. The
move towards a new
equilibrium can then
be investigated.
Price level
At the time of the first oil price crisis back in 1973–74, the UK government of the day
tried to maintain the previous level of real output by stimulating aggregate demand.
This had the effect of pushing up the price level, but did not have any noticeable
effect on real output. In the long run, the impact of a supply shock will depend on
whether the shock was a temporary or a permanent change. If oil prices revert to their
original level, then the economy would self-adjust back to the full-employment level of
real GDP. However, if the change is permanent, the LRAS would also shift to the left.
SRAS1
SRAS0
P1
P0
AD
0
Y 1 Y0
Real GDP
▲ Figure 7.16 A supply shock
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Shifts of and movements along AD and AS
As in many other circumstances, it is important to be aware of the distinction
between shifts of the AD and AS curves, and movements along them. Typically, if a
shock affects the position of one of the curves, it will lead to a movement along the
other. For example, if the AS curve shifts as a result of a supply shock, the response is
a movement along the AD curve, and vice versa.
EXERCISE 7.4
For each of the following, decide whether the change
affects aggregate demand or long-run aggregate
supply, and draw a diagram to illustrate the effects
on equilibrium real output and overall price level.
a A technological advance that improves the
efficiency of capital
b A financial crisis in Asia that reduces the demand
for UK exports
c An improvement in firms’ expectations about
future demand, such that investment expenditure
increases
d An increase in firms’ transport costs
For each of these changes, indicate whether the
result is a shift of or a movement along the AD and
LRAS curves.
SUMMARY: MACROECONOMIC EQUILIBRIUM
» Macroeconomic equilibrium is achieved in the
»
»
»
»
short run at the intersection of the AD and SRAS
curves.
It is possible to produce more than the theoretical
capacity output, but only in the short run.
In the long run the economy converges on the fullemployment level of output where AD equals LRAS.
An increase in AD results in a higher price level
and higher real GDP.
With a classical SRAS the main impact is on price
rather than real GDP.
» If the SRAS has a shallower slope when output is
below full employment, then an increase in AD
affects real GDP more strongly than the price level.
» There has been some debate about how long
it takes for an economy to return to long-run
equilibrium.
» A shock to aggregate demand leads to a movement
along the aggregate supply curve, whereas a
shock to aggregate supply leads to a movement
along the aggregate demand curve.
7 Aggregate demand and aggregate supply analysis
The onset of the coronavirus (Covid-19) pandemic in 2020 caused substantial shifts in
both aggregate demand and aggregate supply curves in countries around the world.
This is discussed in the case study on page 113.
7
END OF CHAPTER QUESTIONS
Multiple choice
1 When constructing a market supply curve, economists sum horizontally the supply
curves of all firms in the market. Why is it not possible to construct the aggregate
supply curve of an economy by simply summing horizontally all firms’ supply
curves from all individual markets?
A The aggregate supply curve measures the relationship between the general
price level and total output.
B The short-run aggregate supply curve is constrained by the availability of
resources in the economy.
C As prices rise, each level of output brings higher profits.
D At higher output produced, firms will experience rising costs of production.
2 Why is the AS curve not perfectly elastic throughout the whole range of output?
A As firms increase output, they bid up the prices of factors of production.
B Firms become less willing to increase supply at higher levels of output.
C Aggregate demand increases faster over higher levels of output.
D Firms are more likely to increase investment as their scale of operation increases.
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Data response
AS LEVEL PART 4 THE MACROECONOMY
7
1 Read the following extract and then answer the questions that follow.
Aggregate demand and supply in France
5
In the years prior to 2020, the French economy had showed consistent
economic growth fuelled by higher consumption, a surge in investment by
firms and increased global trade. The inflation rate in France had also been
consistently below the average of its trade partners. Table 7.3 summarises
some key economic data from this period.
▼ Table 7.3 France’s exchange rate (euro) against the US$ and trade balance in goods
and services, January 2018–January 2020
Date
Exchange rate: €1 to US$
France trade balance in goods
and services (exports minus
imports) (€bn)
Jan 2018
1.200
−6,344
April 2018
1.230
−5,212
July 2018
1.165
−4,472
Oct 2018
1.153
−4,342
Jan 2019
1.147
−4,321
April 2019
1.122
−5,383
July 2019
1.129
−5,060
Oct 2019
1.010
−4,710
Jan 2020
1.160
−5,894
Source: tradingeconomics.com
However, in the first quarter of 2020, household consumption fell by 5.6%, a
record amount, government spending dropped by 2.0%, investment by firms
plunged by 10.5% and net exports of goods and services fell by 0.4%. On an
annual basis, economic activity dropped by 5.0% in quarter 1, in contrast to the
10 growth of 0.9% in quarter 1 of 2019.
The French economy is forecast to shrink throughout 2020, ravaged by
Covid-19. Increases in unemployment and social distancing measures will
dampen household consumption, while heightened uncertainties over the
length of the pandemic are likely further to reduce investment by firms.
15 Like other countries, in 2020 the French government put in place a fiscal
rescue package. Even before the difficulties the French government had
pledged in its 2019 budget to increase spending on tertiary education and had
introduced the income tax reforms summarised in Table 7.4.
▼ Table 7.4 French income tax rates, 2019 and 2020
Income tax rates 2019
Income
Income tax rates 2020
Tax rate
Income
Tax rate
Up to €10,064
Nil
Up to €10,064
Nil
€10,065 to €27,794
14%
€10,065 to €25,659
11%
€27,795 to €74,517
30%
€25,660 to €73,369
30%
€74,518 to €157,806
41%
€73,370 to €157,806
41%
Over €157,806
45%
Over €157,806
45%
Source: Blevinsfranks.com
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Essay style
xplain what is meant by inward migration and consider whether a high rate
2 a E
of inward migration will always lead to an increase in an economy’s long run
aggregate supply.
b When government expenditure increases, in the short run the price level is
more strongly affected than real GDP.’ Assess the validity of this statement.
CASE STUDY
The Covid-19 pandemic
The Covid-19 pandemic that swept across the world
in 2020 affected people in almost every country.
Healthcare systems came under enormous and
unanticipated pressure; many people were unable
to work; in many countries there were strong
restrictions on movement, with many people
confined to their homes. International travel was
restricted, with many airlines facing financial
difficulties. In terms of macroeconomics, countries
faced major disruption that will have repercussions
for many years beyond the end of the pandemic. The
AD/AS model explained in Chapter 7 cannot capture
all of these effects, but it may help to begin to
understand how economies have been affected.
The pandemic brought sudden changes to both the
demand and supply sides of the macroeconomy.
Aggregate demand was quickly affected as illness
spread and many individuals were unable to work,
reducing consumption. Firms were discouraged from
undertaking new investment. There was also severe
disruption to the supply chain. Firms faced loss of
workers, or had to find ways of enabling workers
to work from home. As the pandemic progressed,
further restrictions were introduced, with firms
producing products that were considered to be
non-essential being forced to cease production. This
effectively meant that there was a forced reduction
in the potential full capacity of the economy.
7
7 Aggregate demand and aggregate supply analysis
a ‘The inflation rate in France had also been consistently below the
average of its trade partners’ (lines 3–4). Use this information to
explain one possible reason why the aggregate demand curve slopes
downwards from left to right.
b Explain, using the trade balance data in Table 7.3, what would have
happened to the position of the aggregate demand curve of France
between January 2018 and January 2019, ceteris paribus.
c Discuss, using the exchange rate data in Table 7.3, the impact on
the position of the short-run aggregate supply curve of France between
April 2018 and April 2019.
d Explain, with reference to the extract, which action taken by the French
government is likely to affect its long-run aggregate supply.
e Explain, with reference to Table 7.4, whether the changes in income
tax would cause a movement along or a shift of the French aggregate
demand curve.
▲ Travel was restricted during the Covid-19 pandemic
Some governments launched massive spending
programmes to offset the impact of the pandemic.
These were targeted partly at building capacity in
healthcare systems and searching for treatments
and vaccines. However, they were also intended to
try to protect small and medium-sized enterprises,
by providing support for employees who had been
prevented from working.
Follow-up questions
a Use an AD/AS diagram to identify the impact of
the pandemic in the short run.
b Discuss problems that need to be faced as an
economy emerges from the pandemic.
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AS LEVEL PART 4 The macroeconomy
AS LEVEL PART 4 THE MACROECONOMY
8
Economic growth
What this chapter covers
★ the meaning of economic growth and how it can
be measured
★ the distinction between growth in nominal GDP
and real GDP
★ the causes of economic growth
★ the consequences of economic growth
One of society’s prime responsibilities is to provide a reasonable standard of living for its
citizens and to promote their wellbeing. Hence one of the major objectives for economic
policy in the long run is to enable improvements in wellbeing, and in order to do this it
is first necessary to expand the resources available within society. A key element in this
process is to achieve economic growth, which is the subject of this chapter.
8.1 What is economic growth?
KEY TERMS
potential economic
growth: an increase in
the productive capacity
of the economy
actual economic
growth: an increase
in measured real GDP
over a period of time
LEARNING
LINK
The concept of GDP
as a measurement
of the total amount
of economic activity
taking place in
a period of time
is introduced in
Chapter 6.
Economic growth is one of the most carefully monitored indicators of the performance
of an economy. It is important in looking at an economy’s performance because it
is through economic growth that a country expands the resources available to its
citizens. But what do we mean by ‘economic growth’?
From a theoretical point of view, potential economic growth can be thought of as
an expansion of the productive capacity of an economy. It is an expansion of the
potential output of the economy.
Actual economic growth is where aggregate output increases in the short run in
response to an increase in aggregate demand or an improvement in utilisation of the
factors of production – for example, when unemployment falls. This is measured in
terms of the rate of change of real gross domestic product (GDP) over a period of time
(normally a year).
STUDY TIP
Notice the important distinction between the level of real GDP and the rate of
economic growth. The actual rate of growth is calculated as the percentage change in
the level of real GDP. Notice that in comparing economic growth across countries it is
important to adjust for the size of countries in terms of population, by calculating GDP
per head (GDP per capita).
Chapter 1 discussed economic growth in terms of the production possibility curve (PPC).
In Figure 1.4 on page 19, economic growth was characterised as an outward movement
of the production possibility frontier from PPC0 to PPC1. In other words, economic
growth enables a society to produce more goods and services in any given period as
a result of an expansion in its resources. This is long-run economic growth. Shortrun economic growth takes place when an economy moves towards the production
possibility curve from a point within it. Remember that if the economy is operating
inside its PPC, it is failing to use all of its factors of production effectively, so a move
towards the PPC is possible when employment rises and output increases as a result.
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EXERCISE 8.1
Capital goods per period
8
D
C
B
A
PPC0
PPC1
Consumer goods per period
▲ Figure 8.1 Economic growth?
Price level
A second way of thinking about economic growth is to use the AD/AS model. In
Figure 8.2, an increase in the skills of the workforce will enable firms to produce more
output at any given price, so that the aggregate supply curve will shift outwards
from LRASFE0 to LRASFE1. This entails an increase in full-employment output (capacity
output) from YFE0 to YFE1. This again can be characterised as economic growth.
LRASFE0
8 Economic growth
In Figure 8.1, which of the following
represent(s) potential economic growth?
a A shift from A to B
b A shift from B to C
c A shift from C to A
d A shift from C to D
e None of the above
LRASFE1
P0
P1
AD
0
YFE0
YFE1
Real GDP
▲ Figure 8.2 An increase in long-run aggregate supply
Test yourself 8.1
STUDY TIP
If there is an increase
in the full-employment
level of real GDP, would
this be classified as
actual or potential
economic growth?
Notice that you can show long-run economic growth using either a PPC diagram or an
AD/AS diagram, depending on the context in which you need to demonstrate long-run
economic growth. A shift in the PPC shows that the potential production opportunities
have expanded, but does not show exactly what would happen. The AD/AS approach
shows the effect on real GDP and the price level.
EXERCISE 8.2
Which of the following represent(s) potential economic growth, and which may
just involve a move to the PPC (i.e. actual economic growth)?
a An increase in the rate of change of potential output
b A fall in the unemployment rate
c Improved work practices that increase labour productivity
d An increase in the proportion of the population joining the workforce
e An increase in the utilisation of capital
f A rightward shift in the LRAS curve
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» Economic growth is an important indicator of the
» Potential economic growth can be shown as
performance of an economy.
» Potential economic growth is an expansion of the
productive capacity of an economy.
» If aggregate output increases in the short run in
response to an increase in aggregate demand or a
recovery from recession, this is actual economic
growth.
an outward shift of an economy’s production
possibility curve.
» In the AD/AS model, potential economic growth
is shown as a rightward shift of the long-run
aggregate supply curve.
8.2 Measuring economic growth
Real GDP is a way of measuring the total output of an economy over a period of
time, and its rate of change is used as a measure of economic growth. However, if
economists try to measure potential economic growth using the rate of change of
real GDP as an indicator, they are not necessarily measuring what they want to. GDP
growth measures the actual rate of change of output rather than the growth in the
potential output capacity of the economy.
In Figure 8.3, a movement from A to B represents a move to the frontier. This is an
increase in actual output resulting from using up surplus capacity in the economy, but
it is not potential economic growth in our theoretical sense, as moving from A to B
does not entail an increase in productive capacity. On the other hand, a movement of
the frontier itself, enabling the move from B to C, does represent potential economic
growth. However, when economists observe a change in GDP they cannot easily
distinguish between the two sorts of effect, especially if the economy is not always
operating at full capacity. It is therefore better to think of economic growth in terms
of the underlying trend rate of growth of real GDP.
STUDY TIP
Be careful to avoid
confusing the level of
GDP with economic
growth, which is the
rate of change of
GDP. For example, a
reduction in the rate
of economic growth
from 3% to 2% does
not mean that GDP
itself is falling – it just
means that the rate of
growth is slowing.
Test yourself 8.2
Would GDP at constant
prices be known as
real GDP or as nominal
GDP?
Capital goods per period
AS LEVEL PART 4 THE MACROECONOMY
8
SUMMARY: WHAT IS ECONOMIC GROWTH?
C
B
A
PPC0
0
PPC1
Consumer goods per period
▲ Figure 8.3 Economic growth?
Actual economic growth can be calculated as the annual percentage rate of change of
real GDP, normally on an annual basis. The rate of change of GNI, which also includes
net income from abroad, is an alternative measure. This may be seen as a more helpful
LEARNING LINK
Notice that when calculating economic growth it is important to use data for
real GDP. The distinction between real and nominal values of a variable was
explained in Chapter 6. You may recall that the reason for this is that real GDP
has been adjusted to remove the effect of changing prices over time.
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indicator for countries where citizens of a country work abroad and send income back to
their families. This is significant for countries such as Pakistan and the Philippines.
QUANTITATIVE SKILLS 8.1
8
Calculating a percentage change
Test yourself 8.3
Test yourself 8.4
GDP in New Zealand
grew by 3.1% between
2016 and 2017 and by
2.8% between 2017 and
2018. What happened
to the level of GDP in
2018?
As an example, consider the growth rate of real GDP in Malaysia between 2017
and 2018. GDP in 2017 was 1.23 trillion ringgits. This increased to
1.36 trillion ringgits in 2018. To calculate the percentage change in real GDP, we
need to calculate the change in real GDP (1.36 – 1.23 = 0.13), then express that as
a percentage of the original value. In other words, the percentage change is:
1.36 – 1.23
= 10.6%
100 ×
1.23
Notice that the change in the variable is always expressed as a percentage of the
initial value, not the final value.
8 Economic growth
Explain why it is difficult
to identify potential
economic growth.
In macroeconomics it is often important to be able to calculate the percentage
change in a variable. For example, it may be that there is interest in calculating
the rate of economic growth or in knowing how rapidly prices are changing.
EXERCISE 8.3
Table 8.1 provides data on real GDP in the USA for the period 2005–18. Calculate
the growth rate of GDP for each year from 2005/06 to 2017/18. Calculate your
answers to 2 decimal places. In which year was growth at its highest and in
which year was it at its lowest?
▼ Table 8.1 Real GDP in the USA, 2005–18 ($ trillion)
2005
14.333
2006
14.742
2007
15.018
2008
14.998
2009
14.617
2010
14.992
2011
15.225
2012
15.567
2013
15.854
2014
16.243
2015
16.710
2016
16.972
2017
17.349
2018
17.856
SUMMARY: MEASURING ECONOMIC GROWTH
» Actual economic growth is measured as the percentage rate of change of real
GDP or real GNI over time.
» Potential economic growth is more difficult to measure, as economies are not
always operating at full capacity.
» It is important to use data for real GDP as this takes into account the effect of
changing prices. Looking at the rate of change of nominal GDP or GNI would be
misleading.
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8
8.3 Causes of economic growth
KEY TERMS
AS LEVEL PART 4 THE MACROECONOMY
productivity: a measure
of the efficiency of a
factor of production
labour productivity: a
measure of output per
worker, or output per
hour worked
capital productivity: a
measure of output per
unit of capital
total factor productivity:
the average productivity
of all factors, measured
as the total output
divided by the total
amount of inputs used
investment:
expenditure undertaken
by firms on capital
goods
depreciation (of capital
equipment): the fall
in the value of capital
goods due to wear and
tear
gross investment:
net investment plus
depreciation
net investment:
investment net of the
replacement of existing
capital (depreciation)
STUDY TIP
Always be careful not
to confuse these two
different meanings of
‘investment’.
Test yourself 8.5
Name the two key ways
in which productive
capacity can increase.
Test yourself 8.6
What is the difference
between gross and net
investment?
At a basic level, production arises from the use of factors of production –
capital, labour, enterprise and so on. Capacity output is reached when all factors
of production are fully and efficiently utilised. From this perspective, an
increase in capacity output can come either from an increase in the quantity
of the factors of production, or from an improvement in their efficiency or
productivity.
Productivity is a measure of the efficiency of a factor of production. For example,
labour productivity measures output per worker, or output per hour worked. The
latter is the more helpful measure, as clearly total output is affected by the number
of hours worked, which varies somewhat across countries. Capital productivity
measures output per unit of capital. Total factor productivity refers to the average
productivity of all factors, measured as the total output divided by the total amount
of inputs used.
An increase in productivity raises long-run aggregate supply and the potential
capacity output of an economy, and contributes to economic growth.
Capital
Capital is a critical factor in the production process. An increase in capital
input is therefore one source of economic growth. In order for capital to
accumulate and increase the capacity of the economy to produce, investment
needs to take place.
Notice that in economics ‘investment’ is used in this specific way. In everyday
language, the term is sometimes used to refer to investing in shares or putting money
into a deposit account at the bank. Do not confuse these different concepts. In
economics, ‘investment’ relates to a firm buying new capital, such as machinery or
factory buildings. If you put money into a bank account, that is an act of saving, not
investment.
In the national income accounts, the closest measurement that economists have to
investment is ‘gross fixed capital formation’. This covers net additions to the capital
stock, but it also includes depreciation. Some of the machinery and other capital
purchased by firms is to replace old, worn-out capital: that is, to offset depreciation.
It does not therefore represent an addition to capital stock. As depreciation cannot
be observed easily, the convention in the accounts is to measure gross investment
(i.e. including depreciation) and then make an adjustment for depreciation to arrive
at net investment.
Society has to decide between using resources for current consumption and using
resources for investment. Investment entails sacrificing present consumption in order
to have more resources available in the future.
Different countries give investment very different priorities. Something of this
can be seen in Figure 8.4, which shows gross fixed capital formation in a selection
of countries around the world in 2018. The diversity is substantial, ranging from
just 12.5% in Zimbabwe to 42.3% in China. Given this high rate of investment,
it is perhaps not surprising to discover that China is among the fastest-growing
economies in the world in the early twenty-first century – but it must also
be remembered that there is a cost to this, as it means sacrificing present
consumption in China.
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Nepal
Pakistan
Kenya
Bangladesh
Zimbabwe
India
Sri Lanka
South Africa
China
Brazil
Malaysia
Korea
New Zealand
UAE
UK
Japan
USA
8
10
20
30
40
50
% of GDP
8 Economic growth
0
Note: countries are in ascending order of GDP per capita.
Source: based on data from World Development Indicators
▲ Figure 8.4 Gross fixed capital formation, 2018
QUANTITATIVE SKILLS 8.2
Calculating a percentage share
As with this discussion of the share of investment in GDP, it is often useful
to calculate how important a component of a total is within the whole by
calculating the percentage share. For example, in China in 2018, gross fixed
capital formation was $5,755.4 billion, and GDP was $13,608.2 billion. The
percentage share is calculated as 100 × 5,755.4/13,608.2 = 42.3%.
LEARNING
LINK
Ways in which we
can compare living
standards across
countries (including
the use of GDP or
GNI per capita)
are discussed in
Chapter 30.
QUANTITATIVE SKILLS 8.3
Interpreting bar graphs when the data have been ranked
Notice that the data in Figure 8.4 have been ordered in ascending order of
GDP per capita (i.e. with the lowest income countries at the top). GDP per
capita is simply GDP divided by the size of population, so it is an estimate
of the average GDP per person. This can be used to compare average
incomes between countries. The rather jagged pattern shown in the figure
is informative. If there had been a clear and smooth pattern, we might have
concluded that there is a close correlation between average incomes and
the proportion of GDP devoted to investment. However, this is clearly not the
case for this selection of countries.
The contribution of capital to growth is reinforced by technological progress, as the
productivity of new capital is greater than that of old capital that is being phased
out. For example, the speed and power of computers has increased enormously over
recent years, which has had a great impact on productivity. Effectively, this means
that technology is increasing the contribution that investment can make towards
enlarging capacity output in an economy.
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AS LEVEL PART 4 THE MACROECONOMY
8
▲ Improvements in the speed and power of computers have helped to increase productivity
Innovation can also contribute, through the invention of new forms of capital and new
ways of using existing capital, both of which can aid economic growth.
Labour
Capital has sometimes been seen as the main driver of growth, but labour too has a
key contribution to make. There is little point in installing a lot of hi-tech equipment
unless there is the skilled labour to operate it.
KEY TERM
human capital:
the stock of skills
and expertise that
contribute to a worker’s
productivity; it can
be increased through
education and training
LEARNING
LINK
Merit goods are
discussed in
Chapters 1 and 5.
There is relatively little scope for increasing the size of the labour force in a country,
except through international migration. (Encouraging population growth is a rather
long-term policy!) Nonetheless, the size of the workforce does contribute to the
size of capacity output. A number of sub-Saharan African countries experienced this
effect in reverse during the HIV/AIDS epidemic. The spread of this epidemic had a
devastating impact in a number of countries in the region; at the peak of the epidemic
the percentage of adults affected in some countries rose to over 30% – nearly 40% in
Botswana. It is estimated that by 2018 the disease had caused the deaths of some 32
million people worldwide. This had a serious impact on capacity output in the affected
countries because the disease affects people of working age disproportionately,
diminishing the size of the workforce and the productivity of workers.
The quality of labour input is more amenable to policy action. Education and training
can improve the productivity of workers, and can be regarded as a form of investment
in human capital.
If individuals do not perceive the full social benefits associated with education,
training and certain kinds of healthcare, they may choose to invest less in these forms
of human capital than is desirable from the perspective of society as a whole. This can
be seen as a justification for viewing education and healthcare as merit goods.
For many developing countries, the provision of healthcare and improved nutrition can
be seen as additional forms of investment in human capital, since such investment can
lead to future improvements in productivity.
SUMMARY: CAUSES OF ECONOMIC GROWTH
» Economic growth can stem from an increase in
the inputs of factors of production, or from an
improvement in their productivity: that is, the
efficiency with which factors of production are
utilised.
» Investment contributes to growth by increasing
the capital stock of an economy, although some
investment is to compensate for depreciation.
» The contribution of capital is reinforced by the
effects of technological progress.
» Labour is another critical factor of production
that can contribute to economic growth: for
instance, education and training can improve
labour productivity. This is a form of human capital
formation.
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8.4 Consequences of economic growth
For many people, economic growth is viewed as the most important indicator of an
economy’s performance. Expanding the availability of resources in an economy enables
the standard of living of a country’s citizens to increase. For low-income countries
this may facilitate the easing of poverty, and may allow investment in human capital
that will improve standards of living further in the future. In the industrial economies,
populations have come to expect steady improvements in incomes and resources.
8 Economic growth
Many economies enjoyed a period of steady economic growth during the 2000s, but
the onset of financial crisis in the late 2000s brought a significant slowdown in the
growth of GDP. The concerns raised by this period highlight the negative consequences
when economic growth does not occur, and the importance of this key variable. If the
negative impact of the financial crisis was bad, the onset of the Covid-19 pandemic
in 2020 brought economic growth to a complete standstill in countries all round the
world. It will take time to assess the long-run effects of this pandemic.
8
% per annum
Figure 8.5 shows the annual growth rates of real GDP since 2005 for a selection of
countries. This shows that not all countries were equally affected by the financial
crisis of the late 2000s. The UK, USA and Malaysia all experienced negative growth in
2008/09, but the other countries shown escaped the effects. The figure also shows
the strong performance of China and India throughout this period.
15
10
5
China
India
Malaysia
Pakistan
UK
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
–5
2005
0
USA
Source: calculated using data from World Development Indicators
▲ Figure 8.5 Annual percentage growth rate of real GDP in selected countries since 2005
The benefits and costs of economic growth
Even in periods of steady economic growth, there may be costs as well as benefits
arising from economic growth.
Economic growth in the long run entails an expansion of productive capacity, which in
turn expands the resources available within the country. This means that standards of
living can improve, together with healthcare provision and educational opportunities.
This is the fundamental benefit of economic growth, allowing the country’s population
to enjoy better living conditions and hopefully improving people’s morale.
Growth can also mean higher employment – or improved employment opportunities and
working conditions. People may also benefit from an improved environment and from
advancing technology. From the government’s perspective, tax revenues may increase,
allowing higher expenditure that further adds to the improvements in living standards.
Economic growth also brings costs, perhaps most obviously in terms of pollution
and degradation of the environment. In designing long-term policy for economic
growth, governments need to be aware of the need to maintain a good balance
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AS LEVEL PART 4 THE MACROECONOMY
8
LEARNING
LINK
The impact of
economic growth on
the environment, and
questions of whether
economic growth
can be sustainable
in the long run, are
explained in
Chapter 25, which
also explores
inclusive growth
and the effect
growth may have on
inequality.
between enabling resources to increase and safeguarding the environment. Pollution
reduces the quality of life, so pursuing economic growth without regard to this may
be damaging. This means that it is important to consider the long-term effects of
economic growth – it may even be important to consider the effects not only for
today’s generation of citizens, but also for future generations.
Although economic growth may expand the resources available, there is no guarantee
that these will be evenly distributed among the population. If growth leads to higher
concentration of income and wealth in a relatively small proportion of people, then
inequality may increase. This may lead to increasing tension and even to civil conflict.
EXTENSION MATERIAL
Growth versus basic needs
In some less developed countries the perspective may be different, and there
has been a long-running debate about whether a society in its early stages of
development should devote its resources to achieving the growth objective or to
catering for basic needs. By making economic growth the prime target of policy,
it may be necessary in the short run to allow inequality of incomes to continue,
in order to provide the incentives for entrepreneurs to pursue growth. With such
a ‘growth-first’ approach, it is argued that eventually, as growth takes place, the
benefits will trickle down: in other words, growth is necessary in order to tackle
poverty and provide for basic needs. However, others have argued that the first
priority should be to deal with basic needs, so that people gain in human capital
and become better able to contribute to the growth process. It is also important to
realise that economic growth does not necessarily translate into improvements in
living standards: for example, where the benefits from growth are concentrated in
certain groups within a society, rather than being spread widely.
SUMMARY: CONSEQUENCES OF ECONOMIC GROWTH
» Economic growth is seen as one of the
most important indicators of an economy’s
performance.
» Economic growth expands the availability of
resources within a country, and enables an
increase in the standard of living for the country’s
citizens.
» Periods of slowdown and recession highlight the
importance that is attached to economic growth.
» Economic growth can bring benefits to workers,
firms and governments.
» Economic growth may also impose costs on
society by harming the environment or by
increasing inequality in the distribution of income.
END OF CHAPTER QUESTIONS
Multiple choice
1 Potential growth can be illustrated on both a PPC diagram and an AS/AD diagram.
Which of the following changes would represent potential growth on each diagram?
A a rightward shift of the PPC and a rightward shift of the AD
B a rightward shift of the PPC and an outward shift of the LRAS
C a movement along the PPC and a rightward shift of the SRAS
D a movement towards the PPC from a point within and an outward shift of the
LRAS
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2 Which consequence of economic growth could have undesirable side-effects if the
economy is approaching full employment?
A higher average incomes
B more efficient use of national resources
C higher utilisation of the economy’s productive capacity
D better quality of life
17/02/21 10:42 AM
Data response
8
1 Read the following extract and then answer the questions that follow.
Nepal: economic growth
Earlier, the World Bank had projected Nepal’s economy to grow at 7.1%,
primarily driven by private investment and consumption. The Asian
Development Bank, on the other hand, had forecast Nepal’s economy to grow
at 6.3%, stating that the country’s economy can only expand further if gross
10 fixed capital formation improves substantially.
There are, however, two sides to any increase in economic growth that Nepal
might enjoy. These include issues around benefits and costs at a national and
individual level for the Nepalese people.
8 Economic growth
5
In early 2020 (before the Covid-19 pandemic), the Nepalese government
revised the economic growth target for 2019/20 down by 1.49 percentage
points to a 7.01% increase in GDP. The revised economic growth projection
was primarily backed by anticipation of low agricultural growth in 2019/20 and
government expenditure failing to gather pace.
Table 8.2 shows GDP in Nepal between 2012 and 2018, and Figure 8.6 gives its
15 gross fixed capital formation between the same dates.
▼ Table 8.2 Nepal GDP (constant prices), 2012–18
Year
GDP at constant prices
(Nepalese rupees)
2012
699,727
2013
740,010
2014
770,055
2015
771,081
2016
837,241
2017
887,455
2018
950,033
350,000
300,000
250,000
200,000
150,000
2012
2013
2014
2015
2016
2017
2018
100,000
Sources: tradingeconomics.com; Central Bureau of Statistics, Nepal
▲ Figure 8.6 Nepal real gross fixed capital formation, 2012–18
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a ‘…the Nepalese government revised the economic growth target for 2019/20
down by 1.49 percentage points to a 7.01% increase in GDP’ (lines 1–3).
Distinguish between ‘actual’ and ‘potential’ economic growth and, using the
information provided, suggest which is being referred to in lines 1–2.
b Calculate the annual rate of change of GDP (constant prices) in Nepal
between 2017 and 2018.
c Table 8.2 presents GDP at ‘constant prices’. Explain the importance of using
‘real’ GDP data if the figures are to allow a meaningful discussion of
economic growth in terms of the improved wellbeing of the people of Nepal.
d i Explain the relationship you would expect between gross fixed capital
formation and the level of real GDP.
ii Consider the extent to which this relationship is evident in the data in
Table 8.2 and Figure 8.6.
e Discuss the view that the benefits of economic growth in Nepal will
outweigh the costs.
AS LEVEL PART 4 THE MACROECONOMY
8
CASE STUDY
China’s economic growth
Since China adopted market reforms in the late
1970s, its economy has enjoyed a period of rapid
economic growth that is unprecedented by historical
standards. One of the characteristics of this period
of rapid growth has been the gradual move towards
allowing market forces to operate after a long period
of central planning. This would be expected to have
benefits for the economy in terms of the efficiency of
resource allocation.
Although China’s success in achieving such rapid
economic progress has been much admired, it has
also been much criticised, for a number of reasons.
One source of criticism centres on the environmental
damage that results from a rapid rate of economic
growth. A key ingredient of the growth process –
especially in terms of industrialisation – is an
expansion in energy supplies. Factories cannot
operate without reliable electricity and other energy
sources. Proposals to double China’s production
of hydroelectric power caused concerns about the
effects of new dams on river levels in downstream
countries in Southeast Asia and in India.
Air pollution has become a severe problem, with heavy
smog levels in Beijing and other cities. The problem is
not confined within China’s boundaries, and neighbours
Japan and South Korea have suffered from pollution
spreading from China into their territories.
Booming car ownership raises further concerns:
one estimate is that the number of cars in China had
reached an estimated 240 million by 2018 (from just
4 million in 2000). This number continues to rise
rapidly, and China is the largest car producer in the
world. The effect of this on the demand for oil has
already been reflected in higher world prices – China
is already the world’s second biggest oil importer
▲ Hydroelectric power production in China
(behind the USA). China is also the world’s biggest
producer of coal, which accounts for some 80% of
China’s energy use.
All of this means that China has now overtaken the
USA as the largest emitter of carbon dioxide. It seems
unlikely that environmental damage on this sort of
scale is sustainable from a global perspective.
During the Covid-19 pandemic, large reductions in
air pollution in China were reported as traffic fell and
industries scaled back their production.
Follow-up questions
a Explain why a move towards a market-based
system would be expected to ‘have benefits for
the economy in terms of the efficiency of resource
allocation’.
b How can the problems caused when pollution
crosses international borders be tackled?
c Discuss whether China should seek to restrain
the growing car ownership that is a by-product
of rapid economic growth, which has led to rising
real incomes.
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AS LEVEL PART 4 The macroeconomy
9
Unemployment
★ the meaning of unemployment
★ how unemployment is measured, and some of the
difficulties in so doing
★ the causes and types of unemployment
★ the consequences of unemployment
9 Unemployment
What this chapter covers
Full employment is a key macroeconomic objective. The existence of high
unemployment suggests that the economy is not operating at full capacity, but
some kinds of unemployment will always be present in a dynamic economy. This
chapter explores the nature of employment and unemployment, and examines some
of the problems in measuring unemployment as well as setting out the causes and
consequences of this important indicator.
9.1 The meaning and measurement of unemployment
From society’s point of view, surplus capacity in the economy represents
waste. In the macroeconomic policy arena, attention in this context focuses
on unemployment, although there may also be situations in which capital is
underutilised. There are two ways in which we can view underutilisation of
resources in an economy.
The production possibility curve (PPC) shows the maximum combinations of goods
that can be produced in an economy. If an economy is producing within the PPC, it
is not fully employing all of its resources (labour, capital or other factor inputs).
LEARNING
LINK
Chapter 26 discusses
this situation at more
length and defines
what is meant by full
employment.
KEY TERM
working population:
all people between the
ages of 16 and 64
In the AD/AS model, a leftward shift in aggregate demand leads to a movement
along the short-run aggregate supply curve, so that real GDP falls below what we
have referred to as the full-employment level. This means that there will be some
unemployment in the short run, which will last until the economy returns to its
equilibrium. Under Keynesian assumptions, the adjustment process could be slow, and
the impact on real GDP relatively large.
It is also important to be aware that there will always be some unemployment in
labour markets, even when the economy is at ‘full employment’.
The way in which people earn a living is an important aspect of any economy. One
measure on which governments are judged is whether people who want to work can
find jobs – and find jobs that are appropriate to their talents and training. In order
to evaluate this, it is necessary to explore the composition of the population, and the
way in which unemployment is measured.
The first step is to define the working population. In any society, there are
individuals who are either too young or too old to work. The working population is
defined as the number of people of working age – normally taken to be those aged
between 16 and 64. Notice that the minimum and maximum ages at which people
may work vary between countries. Indeed, in a number of high-income countries, the
retirement age is being increased.
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AS LEVEL PART 4 THE MACROECONOMY
9
KEY TERMS
workforce: people who
are economically active
– either in employment
or unemployed
employed (in
employment): people
who are either working
for firms or other
organisations, or selfemployed
economically inactive:
those people of working
age who are not looking
for work, for a variety of
reasons
discouraged workers:
people who have
been unable to find
employment and who
are no longer looking
for work
unemployed: people
who are economically
active but not in
employment
Among those people of working age, there may be some who choose not to participate
in work. The participation rate measures the percentage of the working population
who choose to join the labour force or workforce, by becoming economically active.
The participation rate varies significantly between countries, and between males
and females. Female participation rates tend to be lower than for males, partly
because of childcare responsibilities, but also because of cultural differences
between societies.
Those people who are in the workforce fall into three economic categories: the
employed, the unemployed and the economically inactive. Those in employment in
this context include both those who are employed by firms or other organisations
(such as government) and also the self-employed. The economically inactive
include students, and those who have retired, are sick or are looking after family
members. Also included are discouraged workers – people who have failed to find
work and have given up looking. In other words, the economically inactive category
includes all those people in the age range who are not considered to be active in
the workforce. The unemployed are those who are in the workforce, but who are
without jobs.
Figure 9.1 shows how the people in the 16–64 age group in the UK were distributed
between the three key economic categories in 2019.
Economically inactive, including
students, retired, sick, carers,
discouraged workers, 8.566 m, 21%
Unemployed,1.284 m, 3%
Employed, 31.486 m, 76%
Source: based on data from ONS (UK)
Test yourself 9.1
▲ Figure 9.1 The structure of the UK population aged 16–64 years, 2019
Would the unemployed
be classified as being
economically active or
inactive?
In this context, the unemployment rate is defined as the percentage of the labour
force that is unemployed. In order to be able to measure the unemployment rate, it is
necessary to count the number of people who are in the labour force and the number
of people who are unemployed.
The International Labour Organization (ILO) has recommended a definition of
unemployment to be used for measurement across countries. The ILO measure captures
three key characteristics. A person is defined as unemployed if they are:
» without work
» available for work
» seeking work
Historically in the UK, unemployment was measured by the so-called claimant count of
unemployment, which simply counted the number of people registered as unemployed
and claiming unemployment benefit (the Jobseeker’s Allowance (JSA)).
One of the problems with the claimant count is that although people claiming the JSA
must declare that they are available for work, it nonetheless includes some people
who are claiming benefit, but are not actually available or prepared to work. It also
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KEY TERM
ILO unemployment
rate: measure of the
percentage of the
workforce who are
without jobs, but are
available for work,
willing to work and
looking for work
excludes some people who would like to work, and who are looking for work, but who
are not eligible for unemployment benefit, such as women returning to the labour
force after childbirth.
It defines as being unemployed those people who are: ‘without a job, want a job, have
actively sought work in the last four weeks and are available to start work in the next
two weeks; or out of work, have found a job and are waiting to start it in the next two
weeks’ (Labour Market Statistics).
Notice that in order to measure the percentage unemployment rate, data on the
number of people employed is also required, as the unemployment rate is defined as
the percentage of the workforce who are unemployed.
9 Unemployment
Because of these problems, the claimant count does not meet the ILO definition,
so it has been replaced for official purposes by the ILO unemployment rate, a
measure based on the Labour Force Survey. This identifies the number of people
available for work, and seeking work, but without a job. This definition corresponds
to that used by the ILO, and is closer to what economists would like unemployment
to measure.
9
QUANTITATIVE SKILLS 9.1
Calculating the percentage rate of unemployment
When calculating the percentage rate of unemployment, the key question
concerns the portion of the active workforce who are unemployed at any
point in time. This is calculated by expressing the number of unemployed as a
percentage of the active workforce (i.e. employed plus unemployed). In the UK in
the last quarter of 2019 it was estimated that there were 31.637 million people in
employment and 1.257 people unemployed. The percentage rate was thus:
100 × 1.257 ÷ (31.637 + 1.257) = 3.82%.
STUDY TIP
The relevant formulae used in this context are as follows:
Working population = economically active + economically inactive (aged between
16 and 64)
Workforce = economically active = employed + unemployed
Employed = those working for firms + self-employed
Participation rate = 100 × economically active/working population
Unemployment rate = 100 × unemployed/workforce
EXERCISE 9.1
In Greece in 2019, there were 6,935,000 people aged between 15 and 64. Of
these, 3,945,000 were employed and 2,205,000 were economically inactive.
Calculate the number of people in this age bracket who were unemployed and
the percentage unemployment rate.
Figure 9.2 shows the percentage unemployment rate for selected countries since
2005. Notice that unemployment in the high-income countries (the UK, USA and New
Zealand) increased appreciably during the financial crisis of the late 2000s, but the
other countries were relatively unaffected.
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% of workforce
9
12
China
India
New Zealand
Pakistan
Sri Lanka
UK
USA
10
8
4
2
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
0
2005
AS LEVEL PART 4 THE MACROECONOMY
6
Source: based on data from World Development Indicators
▲ Figure 9.2 Unemployment rate, selected countries
Comparing unemployment across countries can be problematic, even when a standard
definition is adopted. Recall that two key things need to be counted in order to
measure the unemployment rate – the number of people in the workforce and the
number of people who are unemployed.
It may not always be straightforward to count either of these things. In particular,
if there is no provision for unemployment benefit in a country, then there is no
possibility of counting those who register as unemployed – because they have no
incentive to do so. It is then necessary to rely on a survey in order to be able to
count the number of unemployed – and the number of people in the workforce. Such
surveys are expensive, and more difficult to undertake in a country that covers a large
geographic area, and in which there may be remote rural areas to be covered.
Furthermore, there are some countries in which there remains substantial subsistence
agriculture and a large informal sector. The informal economy covers largely
unregulated economic activity, which is widespread in many less developed countries.
In this context, the number of people classified as economically inactive would be
potentially much higher and the reliability of data may be expected to vary between
countries.
A further cause of difficulty in interpreting unemployment as an indicator of
underutilisation of labour is that the data may conceal the extent to which labour is
underused, even when some individual workers are employed. In some cases, there
may be workers who would like to work for longer hours, but can only find parttime jobs. In other cases, there may be workers who cannot find employment in
the occupation for which their skills have prepared them. For example, a university
graduate may find him or herself driving a taxi or sweeping the streets.
The notion of a full-employment level of real GDP was introduced in Chapter 7 in the
context of the AD/AS model. The full-employment level of real GDP corresponds to
a situation in which the economy is operating at its full capacity level, utilising its
resources (including workers) effectively.
However, does this mean that everyone should have a job or be self-employed? Setting
aside those who are economically inactive, there will always be some unemployment
in a society, if only because there will be some people between jobs, or engaging
in job searching. Furthermore, if the economy were to be operating very close to
full capacity, this would be likely to put upward pressure on wages and thus prices.
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LEARNING
LINK
9
So full employment does not mean that unemployment will be zero. But it is difficult
to specify a particular percentage that would constitute full employment. This may
vary in different periods, and in different countries, partly reflecting the degree of
flexibility in the labour market.
SUMMARY: THE MEANING AND MEASUREMENT OF
UNEMPLOYMENT
9 Unemployment
The possibility
of there being
trade-offs or
conflicts between
macroeconomic
variables and
policy objectives is
discussed in Chapter
28.
In other words, there may be a conflict between achieving full employment and
maintaining the stability of prices.
» Underutilisation of resources in an economy can be seen when production
Test yourself 9.2
»
Why will unemployment
not be zero if there is
full employment?
»
»
»
»
»
»
takes place within the PPC or when real GDP is below the full-employment
level in the AD/AS model.
The working population in a country is the number of people between the ages
of 16 and 64.
At any time, only a proportion of these are economically active, and these make
up the workforce.
The ILO defines unemployment as those people who are without work, are
available for work and are seeking work.
The unemployment rate is measured by the percentage of the workforce who
meet these conditions.
A number of difficulties may arise in comparing unemployment rates across
countries.
Measurement depends on surveys, and countries may differ in the extent to
which individuals are classified as being economically inactive.
There may also be disguised unemployment where people are employed for
fewer hours than they would like, or are employed in occupations for which
they are overqualified.
9.2 Causes of unemployment
Frictional unemployment
KEY TERM
frictional
unemployment:
unemployment
associated with job
search: that is, people
who are between jobs
There will always be some unemployment in a dynamic economy. At any point in time,
there will be workers transferring between jobs. This may occur simply because an
individual wishes to improve their job prospects, and needs to spend time searching
for a new job. Accordingly, there will be some unemployment while this transfer takes
place, and this is known as frictional unemployment. Searching may take some time
if information about the availability of jobs is not good.
Structural unemployment
In a typical period of time there will be some sectors of an economy that are
expanding and others that are in decline. This happens when the pattern of production
changes in order to keep up with changing patterns of consumer demand and relative
opportunity cost. In this case, it is important that workers are able to transfer from
those activities that are in decline to those that are booming. For example, coal
mining may be on the decline in an economy, but international banking may be
booming. It is clearly unreasonable to expect coal miners to turn themselves into
international bankers overnight. In this sort of situation there may be some longerterm unemployment while workers retrain for new occupations and new sectors of
activity. Indeed, there may be workers who find themselves redundant at a relatively
late stage in their career and for whom the retraining is not worthwhile, or who
cannot find firms that will be prepared to train them for a relatively short payback
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AS LEVEL PART 4 THE MACROECONOMY
9
KEY TERMS
structural
unemployment:
unemployment arising
because of changes in
the pattern of economic
activity within an
economy
technological
unemployment:
unemployment that
arises when workers
do not have the skills
needed to work with
newly developed
technology
cyclical unemployment:
unemployment that
arises during the
downturn of the
economic cycle, such as
a recession
seasonal
unemployment:
unemployment that
arises in seasons of the
year when demand is
relatively low
time. Such unemployment is known as structural unemployment. It arises because of
the mismatch between the skills of workers leaving contracting sectors and the skills
required by expanding sectors in the economy.
Technological unemployment
Technological unemployment is a type of structural unemployment that arises from
the introduction of technology, when existing workers do not have the skills to
operate the new technology.
Cyclical unemployment
Economies can be subject to fluctuations in real GDP around an underlying trend. In
the AD/AS model, this would be reflected in movements along the short-run aggregate
supply curve, with the economy sometimes rising above the full-employment level
of real GDP, and at other times falling below it. If real GDP does fall below the fullemployment level, then unemployment is likely to be present during the period when
the economy is adjusting back to its long-run equilibrium. This is known as cyclical
unemployment. Under Keynesian assumptions, this adjustment period may not be
rapid.
Seasonal unemployment
There may also be times of the year when the demand for labour varies because of
seasonal effects: for example, the tourist sector experiences quiet periods during the
winter. This may give rise to seasonal unemployment.
LEARNING LINK
More discussion of the types and causes of unemployment can be found in
Chapters 23 and 26.
Test yourself 9.3
Migration and unemployment
In Figure 9.2 you can
see how unemployment
in the UK, USA and New
Zealand was affected
in the recession that
followed the financial
crisis of 2008/09. What
sort of unemployment
was this?
In some countries, a contentious issue in recent years has been the question of
migration, and the effect of an inflow of migrants on a domestic labour market. From
the point of view of economic analysis, this issue turns on the characteristics of
immigrant workers, especially in relation to skills. If immigrant workers have skills
that are complementary to those of native workers, then an inflow of migrants can
have beneficial effects on the domestic economy, by raising national income, resulting
in an increase in the demand for workers. The situation is different where migrants are
substitutes for domestic workers, such that the result may be a decrease in the
equilibrium wage, and an increase in unemployment among native workers.
EXERCISE 9.2
Classify each of the following types of unemployment as arising from frictional,
structural or other causes.
a Unemployment arising from a decline of the manufacturing sector and the
expansion of financial services
b A worker leaving one job to search for a better one
c Unemployment that occurs when real GDP falls below the full-employment
level as part of the regular fluctuations that occur in the level of economic
activity
d Unemployment of workers in the tourist sector during the winter months
e Unemployment arising because workers do not have the appropriate skills to
service new and unfamiliar machinery
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SUMMARY: CAUSES OF UNEMPLOYMENT
» Unemployment can arise for a number of reasons, in some cases when the
9
economy is at full employment.
» Structural unemployment arises because of changes in the pattern of
9.3 Consequences of unemployment
9 Unemployment
economic activity within an economy.
» Technological unemployment arises when workers do not have the skills
needed to work with newly developed technology.
» Cyclical unemployment arises during the downturn of the economic cycle,
such as a recession.
» Seasonal unemployment arises in seasons of the year when demand is
relatively low.
Perhaps the most obvious consequence of unemployment is the costs it imposes on
prospective workers, in terms of forgone earnings and the need to rely on social
security support (if it is available). At the same time, the inability to find work and
to contribute to the family budget may impose a cost in terms of personal worth and
dignity.
From society’s perspective, if the economy is operating below full capacity, then it
is operating within the PPC, and therefore is not making the best possible use of
society’s resources. In other words, if those unemployed workers were in employment,
society would be producing more aggregate output; the economy would be operating
more efficiently overall.
Test yourself 9.4
Why might structural
unemployment be
more persistent than
some other types of
unemployment?
When unemployment is high, the government will raise less tax revenue in the form of
income tax, but will face higher expenditure in the form of social security payments.
Firms will be unable to sell as much output as previously, so will make lower profits.
In addition, when unemployment is rising and aggregate demand is falling, there
will be negative knock-on effects, so other workers will suffer, either by becoming
unemployed, or by having to work fewer hours.
Long-term unemployment has potentially important social effects. Workers who are
unemployed for a long period will become dispirited and deskilled, and thus find it
increasingly difficult to get back into the workforce. A by-product of this may be an
increase in crime and vandalism or social unrest, imposing costs on other members of
society.
Frictional unemployment, on the other hand, may have beneficial effects. When
workers are able to find better jobs, this leads to an improvement in the overall
efficiency of production, and could potentially improve allocative efficiency.
SUMMARY: CONSEQUENCES OF UNEMPLOYMENT
» Unemployment imposes costs on those workers who are unable to find work.
» From society’s perspective, unemployment may be seen as a loss of potential
output if the economy is operating below its full capacity.
» Governments will raise less tax revenue when there is unemployment, and
may face higher expenditure in the form of social security payments.
» Long-term unemployment imposes higher costs, as workers may become
deskilled, and may find it difficult to get back into work.
» Frictional unemployment may have beneficial effects by allowing workers to
transfer between jobs.
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END OF CHAPTER QUESTIONS
AS LEVEL PART 4 THE MACROECONOMY
9
Multiple choice
1 An economy is going through a process of industrialisation. Which type of
unemployment is present?
A frictional
B structural
C cyclical
D regional
2 Which consequences of unemployment can be considered as benefits to the
employers and to the unemployed individuals?
Benefit to employers
Benefit to unemployed individuals
A
Larger pool of job applicants
Abundant job opportunities
B
Lower recruitment costs
The opportunity to find a better-paid job
C
Lower training costs
Lower stress levels
D
Acquisition of new skills
More free time
Data response
1 Read the following extract and then answer the questions that follow.
Unemployment in selected countries
5
In the three decades to 2020, Bangladesh experienced a steady
transformation. The economy moved from traditional primary-based activities
to modern secondary and tertiary sector-related production. In 1991,
agriculture contributed approximately 70% of GDP, which had slumped to
around 40% of GDP by 2019. The shares of secondary and tertiary sectors of
total employment increased to 20% and 40% respectively from 13% and 17%
during the period 1991–2019.
In April 2020, Spain had an unemployment rate of 14.8% calculated by the
International Labour Organization method. The youth unemployment rate in
10 Spain (15- to 24-year-olds) was far higher at 33.2% and looking forward it
was expected to increase further to 34.7% by April 2021. This rate is relatively
high by international standards – the forecast for the average G20* youth
unemployment rate in 2021 was 13.94%.
Long-term unemployment refers to people who have been unemployed for
15 12 months or more. Italy, South Africa and Greece suffer some of the worst
long-term unemployment rates with 59%, 62% and 70% respectively of those
unemployed having been out of work for more than 1 year.
*A group of finance ministers and central bank governors from
19 of the world’s largest economies along with the European Union.
▼ Table 9.1 Labour force status in Norway (April 2020)
Employed persons
Absolute numbers
Unemployed persons
Absolute numbers
Males
1,445,000
Males
57,000
Females
1,283,000
Females
46,000
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CASE STUDY
The cost of unemployment
By setting full employment as a key objective of
macroeconomic policy, there is an underlying
presumption that unemployment is a bad thing. But
what are the costs associated with unemployment?
From society’s point of view there are some
obvious costs. If people are unemployed, they
are not contributing to society’s output, so there
is an opportunity cost in relation to the work that
unemployed individuals could have been providing.
High unemployment may create low morale, and
therefore affect firms’ expectations of future demand
for their products. If this is so, they may decide to
invest less in expanding capacity, which would then
affect the rate of economic growth.
There may also be a social impact arising from a
high rate of unemployment, as some commentators
have pointed to the effect of unemployment on crime
or social disorder.
On the other hand, if unemployment is low, this
could put pressure on prices, potentially resulting in
inflation.
It should also be remembered that it is important
that the economy responds to changes in the
economic environment. At any point in time, there
are likely to be some activities that are in decline,
and others that are expanding. This is the nature
of a dynamic economy. The labour market thus
needs to be sufficiently flexible to allow workers
to transfer from declining to expanding sectors –
even if this requires retraining and a period of
unemployment.
9
9 Unemployment
a Explain how the information contained in the extract (lines 1–7) could
lead to structural unemployment.
b Calculate, using the information in Table 9.1, the female unemployment
rates in Norway in April 2020.
c Explain one difficulty in calculating the International Labour Organization
figure for unemployment.
d Explain why longer-term unemployment in Italy, South Africa and Greece
imposes higher costs on individuals than short-term unemployment.
e Discuss, with reference to the information provided, the consequences of
youth unemployment in Spain for the Spanish economy.
There is also the issue of the costs that are incurred
by the individuals who are unemployed. They may
face not only loss of income and descent into relative
poverty, but also a loss of dignity and the ability to
contribute to society.
In considering this, it is important to distinguish
between different types of unemployment.
Individuals may choose to be unemployed for various
reasons. It could be that they simply want to find
a better job than the one they have, or to join an
expanding sector where they can be better paid.
Of course, there may also be those who view the
available social security benefits as being adequate
for their needs, enabling them to enjoy more leisure.
Unemployment may be of more concern when it
involves people who would like to work but cannot
find suitable employment. Even this may not be
of major concern if the period for which they are
unemployed is relatively short. Of most concern
are those in this category who are unemployed for
extended periods of time.
Follow-up questions
a Evaluate the consequences of unemployment
from the point of view of society as a whole.
b Discuss the extent to which society should be
concerned about the situation facing individuals
who are unemployed.
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AS LEVEL PART 4 The macroeconomy
AS LEVEL PART 4 THE MACROECONOMY
10
Price stability
What this chapter covers
★ reasons why price stability is important for an
economy
★ inflation, deflation and disinflation
★ the interpretation of index numbers and how they
are constructed
KEY TERMS
inflation: a sustained
rise in the general price
level, measured by the
rate of change of the
average price level in an
economy over a period
of time
index number: a way of
comparing the value of
a variable with a base
observation such as a
location or past period
(e.g. the consumer price
index measures the
average level of prices
relative to a past year,
known as a base period)
★ changes in the price level as estimated using a
consumer price index
★ possible difficulties in measuring price changes
★ the causes of inflation through cost-push and
demand-pull pressures
★ the consequences of inflation
Inflation is one of the key indicators of macroeconomic performance, and its control
has been a primary objective of governments. This chapter explores what is meant by
inflation, how it is calculated and why price stability is so important.
10.1 Price stability and the measurement of inflation
Economic growth is often seen as the most fundamental objective of economic policy.
However, successive governments in many parts of the world have made stability of
prices a fundamental objective of macroeconomic policy.
Inflation occurs when there is a sustained increase in the average price level in an
economy. When looking to monitor whether the government of a country is achieving
stability of prices, the question is therefore whether inflation is being kept under
control. Deflation occurs when there is a fall in the general price level.
The main reason why inflation is seen as a key indicator of the performance of an
economy is the fear that if inflation is high and volatile, firms will be deterred from
undertaking investment, which would hinder economic growth. This is because firms
base their investment plans on their expectations of the future. If inflation is high
and volatile, it becomes more difficult to form reliable expectations about the future,
or to be sure of the likely return on investment expenditure. To put this another way,
it is believed that a stable macroeconomic environment is crucial if there is to be
economic growth.
10.2 Measuring the price level and inflation
If the control of inflation is to be a policy objective, some way of monitoring it is
needed. The first step is therefore to measure the average level of prices in the economy.
Inflation can then be calculated as the percentage rate of increase of prices over time.
STUDY TIP
If you are writing an
essay, be careful not
to claim that inflation
is a policy objective of
the government – it is
low and stable inflation
that is the objective!
Index numbers
In setting out to measure the general level of prices in an economy, there is no
obvious way of producing a meaningful ‘average’ price. The solution is to use index
numbers, a form of ratio that compares the value of a variable with some base point.
For example, suppose the price of a kilo of oranges last year was $0.80, and this year
it is $0.84. How can the price between the two periods be compared? One way of
doing it is to calculate the percentage change:
100 × (84 – 80) ÷ 80 = 5%
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LEARNING
LINK
The calculation of a
percentage change
is discussed in
Quantitative skills 8.1
on page 117.
(Note that this is the formula for calculating any growth rate in percentage terms. The
change in the variable is always expressed as a percentage of the initial value, not the
final value.)
QUANTITATIVE SKILLS 10.1
Creating an index number
If a bundle of goods
costs 4% higher in
year 2 than in year 1,
what would be the value
of an index for year 2
based on year 1 = 100?
10 Price stability
A way of showing how prices have changed is to calculate an index number. In
the above example, the current value of the index could be calculated as the
current value divided by the base value, multiplied by 100. In other words, this
would be 100 × 84 ÷ 80 = 105. The resulting number gives the current value
relative to the base value.
This turns out to be a useful way of expressing a range of economic variables
where you want to show the value relative to a base period. Index numbers can
also be used to compare between regions or to compare variables measured in
different units – anything where you want to compare with some base level.
Test yourself 10.1
10
This technique is used to show the average level of prices at different points in
time. If the aim is to see how changing prices are affecting consumers, the first
step is to select a representative bundle of goods and services that the average
consumer purchases in a period. Of course, some goods and services will be
more important in a household’s budget than others, so when calculating the
average, some products must have a higher weight than others. For example, in
January 2020 in the UK, ‘Food’ counted for 71 per 1,000 of household spending,
compared with 9 per 1,000 for footwear. These weights reflect the relative
importance of different goods and services when calculating the average cost of
the bundle of goods and services, which is intended to capture the pattern of
spending by a representative household in the UK. The cost of that bundle can
be calculated in a base year, and then in subsequent years. The cost in the base
year is set to equal 100, and in subsequent years the index is measured relative
to that base date, thereby reflecting the change in prices since then. For
example, if in the second year the average increase in prices were 2.5%, then
the index in year 2 would take on the value 102.5 (based on year 1 = 100). Such a
general index of prices would give the level of prices faced by the average
household relative to the base year.
Notice that there is a crucial distinction between such measurements of the general
price level and the notion of inflation, which is a key economic indicator frequently
discussed in the media. A price index such as those described above measures the
average level of prices at a particular moment in time. Inflation, on the other hand,
is the rate of increase of the price index – it measures the rate at which prices are
increasing through time. These two different things should not be confused with each
other, although clearly they are related.
In any economy, prices of different goods and services change at different rates
through time. This is partly in response to changes in demand and supply – if a good
becomes popular, excess demand will tend to push up the price of the good as the
market moves to a new equilibrium, while some other goods may face the opposite
effect so that prices rise less steeply. A price index designed to represent the general
level of prices in an economy is based on taking a weighted average of individual
prices, as described above. With prices changing at different rates, the choice of
which goods and services to include in the index – and with what weights – is an
important step. For example, it is likely that different groups in a society choose to
consume different combinations of goods and services, so may experience inflation
at different rates. Furthermore, the content of the representative bundle is likely to
change over time, so the weights must be regularly updated.
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The consumer price index
10
A consumer price index is therefore designed to capture the changes in the general
level of prices of goods and services that households buy (or use) for consumption
purposes. The International Monetary Fund (IMF) publishes a manual for National
Statistical Offices explaining good practice in the compilation of an index, and
collates data from member countries.
AS LEVEL PART 4 THE MACROECONOMY
KEY TERM
consumer price index
(CPI): a measure of
the general level of
prices; in the UK, this
was adopted as the
government’s inflation
target in December 2003
LEARNING
LINK
Another use of a
price index is to
adjust a data series
from nominal into
real terms. This is
explained in Chapter
6, where it was
noted that real GDP
is calculated as
nominal GDP divided
by an appropriate
price index.
STUDY TIP
As noted in the
previous section,
it is important to
remember that
the CPI provides a
measurement of the
level of prices in the
economy. This is not
inflation: inflation
is the rate of change
of prices, and the
percentage change
in the CPI provides
an estimate of the
inflation rate.
In the UK the consumer price index (CPI), which has been used by the government in
setting its inflation target since the beginning of 2004, is compiled in line with the
IMF recommendation. This index is based on the prices of a bundle of goods and
services measured at different points in time. A total of 180,000 individual price
quotes on more than 700 different products are collected by the Office for National
Statistics (ONS) each month, by visits to shops, and using the telephone and internet.
Data on spending from Household Final Monetary Consumption Expenditure is used to
compile the weights for the items included in the index. These weights are updated
each year, as changes in the consumption patterns of households need to be
accommodated if the index is to remain representative.
EXERCISE 10.1
Table 10.1 provides data on consumer prices for Malaysia, Pakistan and Sri Lanka.
▼ Table 10.1 Consumer prices
Consumer price index (2011=100)
Malaysia
Pakistan
Sri Lanka
2006
90.9
59.7
64.1
2007
92.8
64.2
74.2
2008
97.8
77.3
91.0
2009
98.4
87.8
94.1
2010
100.0
100.0
100.0
2011
103.2
111.9
106.7
2012
104.9
122.8
114.8
2013
107.1
132.2
122.7
2014
110.5
141.7
126.6
2015
112.8
145.3
131.4
2016
115.1
150.8
136.6
2017
119.6
156.9
147.1
2018
120.7
164.9
150.2
Source: MyOECD
a Calculate the annual inflation rates for each of the countries from 2007 to 2018.
b Plot these three inflation series on a graph against time.
c By what percentage did prices increase in each country over the whole
period – that is, between 2006 and 2018?
d Which economy do you judge to have experienced most stability in the
inflation rate?
Alternative measurements of inflation
The traditional measure of inflation in the UK for many years was the retail price index
(RPI), which was first calculated (under another name) in the early twentieth century
to evaluate the extent to which workers were affected by price changes during the
First World War. This was later replaced by RPIX, which is the RPI excluding mortgage
interest payments.
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The CPI replaced RPIX partly because it is believed to be a more appropriate indicator
for evaluating policy effectiveness. In addition, it has the advantage of being
calculated using the methodology recommended by the IMF, so that it is more useful
than the RPIX for making international comparisons of inflation.
The indexes share a common failing, arising from the fixed weights used in calculating
the overall index. Suppose the price of a particular item rises more rapidly than other
prices during the year. One response by consumers is to substitute an alternative, cheaper,
product. As the indices are based on fixed weights, they do not pick up this substitution
effect, and therefore tend to overstate the price level in terms of the cost of living. Some
attempt is made to overcome this problem by changing the weights on an annual basis in
order to limit the impact of major changes. This includes incorporating new items when
appropriate in order to reflect changes in consumer spending patterns.
10 Price stability
The CPI and RPI are based on a similar approach, although there are some significant
differences in the detail of the calculation. Both measures set out to calculate the overall
price level at different points in time. Each is based on calculating the overall cost of a
representative basket of goods and services at different points in time relative to a base
period. Both are produced from the same raw data, but use different formulae to produce
the index. The result of these calculations is an index that shows how the general level of
prices has changed relative to the base year. The rate of inflation is then calculated as the
percentage rate of change of the price index, whether it be the CPI or the RPI.
10
The CPI and RPI differ for a number of reasons, partly because of differences in the
content of the basket of goods and services that are included, and partly in terms of
the population of people who are covered by the index. For example, in calculating
the weights, the RPI excludes pensioner households and the highest-income
households, whereas the CPI does not. There are also some other differences in the
ways that the calculations are carried out.
Figure 10.1 shows data for the rates of change of the CPI and RPI since January 2008.
These rates have been calculated on a monthly basis, computing the percentage rate
of change of each index relative to the value 12 months previously. Calculating the
inflation rate in this way smooths out the effect of seasonal variations.
Test yourself 10.2
% change over 12 months
Give reasons why
pensioner households
might display a different
pattern of consumption
than other households.
A noticeable characteristic of Figure 10.1 is that for much of the period the CPI has
shown a lower rate of change than the RPI. In part this reflects the way in which the
prices are combined, but it also reflects the fact that different items and households
are covered. The large drop in the RPI in 2009 reflects the substantial fall in interest
rates at this time, which affected mortgage interest rates, which are not included in
the CPI. In early 2020 you can see the early effects of the Covid-19 pandemic.
6.0
CPI
5.0
RPI
Target rate
4.0
3.0
2.0
1.0
0.0
2020 Jan
2019 Jul
2019 Jan
2018 Jul
2018 Jan
2017 Jul
2017 Jan
2016 Jul
2016 Jan
2015 Jul
2015 Jan
2014 Jul
2014 Jan
2013 Jul
2013 Jan
2012 Jul
2012 Jan
2011 Jul
2011 Jan
2010 Jul
2010 Jan
2009 Jul
2009 Jan
2008 Jul
–2.0
2008 Jan
–1.0
Source: based on data from ONS (UK)
▲ Figure 10.1 Alternative inflation measures in the UK since 2008
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10
Deflation and disinflation
KEY TERMS
deflation: a fall in the
average level of prices
AS LEVEL PART 4 THE MACROECONOMY
disinflation: a fall in the
rate of inflation
Test yourself 10.3
If the rate of change of
prices decelerates but
remains positive, would
this be described as
deflation or disinflation?
STUDY TIP
Be careful not to
confuse falling prices
(deflation) with falling
inflation (disinflation).
Falling inflation just
means that prices are
rising less quickly than
before.
The recession that began to affect many advanced economies in the late 2000s raised
the possibility that the overall level of prices in an economy might fall. This situation
of negative inflation is known as deflation. This can occur when there is a substantial
fall in aggregate demand, leading to recession. Figure 10.1 showed that the UK
experienced falling prices according to the RPI for a period. This is not to be confused
with disinflation, which refers to a period in which inflation falls relative to the
previous period: in other words, a period in which inflation decelerates. Japan
experienced periods of deflation between 1999 and 2005, and again in 2009–12.
Figure 10.1 shows UK inflation falling at the beginning of the Covid-19 pandemic in
early 2020, but up to August 2020 this was disinflation rather than deflation, as prices
were not actually falling; the rate of price increases was just decelerating.
Deflation is perceived to be bad for the economy on the grounds that economic agents
will see this as a sign that the economy is in terminal decline. If people expect prices
to continue to fall, they may postpone purchases in the expectation of being able to
buy at a lower price in the future. Deflation may also affect the confidence of firms
when forming expectations about the future, so they may reduce their expenditure on
investment. This would then mean a fall in aggregate demand in the economy, and a
movement down along the short-run aggregate supply curve. Firms that receive lower
prices for their goods may reduce the size of their workforce, so unemployment may
rise. If expectations remain low, this could delay the adjustment back to full
employment.
EXERCISE 10.2
Table 10.2 shows annual inflation in the UK between
2007 and 2011, as measured by changes in the RPI.
Identify years in which there was inflation, deflation
and disinflation.
▼ Table 10.2 RPI inflation
in the UK, 2007–11
RPI inflation
2007
4.3
2008
4.0
2009
–0.5
2010
4.6
2011
5.2
Hyperinflation
KEY TERM
hyperinflation: a
situation in which
inflation reaches
extreme or excessive
rates
When inflation gets completely out of control, a situation of hyperinflation may
arise. When inflation is running at an extreme or excessive rate, the associated costs
can also be extreme.
Hyperinflation has been rare in high-income countries in recent years, although many
Latin American economies were prone to hyperinflation for a period in the 1980s, and
some of the transition economies also went through periods of very high inflation
as they began to introduce market reforms; one example of this was Ukraine, where
inflation reached 10,000% per year in the early 1990s. Another example is the African
country of Zimbabwe, where The Economist in April 2013 claimed that inflation had
reached 230,000,000% in 2008.
Inflation around the world
Economies have experienced inflation to varying degrees in the past. Figure 10.2
shows how inflation has affected the world in the period since 1972, and how
advanced and developing economies were affected in different ways.
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% change in prices (p.a.)
120
Advanced economies
Emerging and developing economies
World
10
100
80
60
40
20
2018
2016
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1982
1984
1980
1978
1976
1972
1974
Source: based on data from IMF
▲ Figure 10.2 World inflation since 1972 (% change in consumer prices)
10 Price stability
0
For the world as a whole, inflation had been steady (below 10% per year) through
most of the 1960s until the mid-1970s, when there was an acceleration following
the first oil-price crisis in 1973–74. Average inflation then remained relatively high
until the period of relative stability in the late 1990s and early 2000s. The figure
also shows that in the advanced economies, inflation decelerated relatively quickly
from about 1980 onwards, with those countries showing inflation rates that were
consistently lower than the world average.
% change in prices (p.a.)
In part, this was a regional phenomenon, with Latin America being especially prone
to very high inflation during this period, even hyperinflation in some countries.
This can be seen in Figure 10.3, which contrasts inflation in Latin America (‘Western
hemisphere’) with that in developing Asian economies and the world as a whole.
Notice the scale of the vertical axis – in order to show average inflation across
the Western hemisphere, the other series on the graph get compressed to the axis.
Average inflation in the Western hemisphere peaked at 515% in 1990, but this
conceals the wide variation in inflation between countries. In 1990, Argentina was
experiencing inflation of 2,314% (down from 3,079% in 1989), Brazil was suffering
2,947% and Peru 7,482%. Bolivia had experienced inflation at 11,750% in 1985.
600
Emerging and developing Asia
Western hemisphere
World
500
400
300
200
100
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
0
Source: based on data from IMF
▲ Figure 10.3 Inflation in Latin America and developing Asia
In contrast, Figure 10.4 shows inflation in developing countries in Asia and in subSaharan Africa over the same period. Again, notice that the vertical scale of the graph
has changed radically. The figure reveals that these countries in Asia experienced
inflation below the world average for much of the period, although the spike at the
time of the 1973–74 oil-price hike is more marked. Notice that countries in subSaharan Africa suffered from higher inflation from the 1990s onwards.
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% change in prices (p.a.)
10
45
Developing Asia
40
World
sub-Saharan Africa
35
30
25
20
15
5
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
0
1972
AS LEVEL PART 4 THE MACROECONOMY
10
Source: based on data from IMF
▲ Figure 10.4 Inflation in developing Asia and sub-Saharan Africa
SUMMARY: MEASURING THE PRICE LEVEL AND INFLATION
» Inflation is the rate of change of the general level
measure of the price level, and inflation
is monitored through the rate of change
of CPI.
» Deflation is a situation in which prices fall, so
there is a negative change in the price level.
» Disinflation is where inflation decelerates.
» When inflation reaches such high levels that it is
out of control, there is hyperinflation.
of prices in an economy.
» Index numbers are helpful in comparing the value
of a variable with a base date or unit, and are
used to arrive at a measure of the average level of
prices in an economy.
» In December 2003 the UK government adopted
the consumer price index (CPI) as its preferred
10.3 Causes of inflation
Inflation occurs when there is a rise in the general price level. However, it is
important to distinguish between a one-off increase in the price level and a sustained
rise over a long period of time.
Cost-push inflation
Price level
Suppose there is a one-off permanent rise in the price of oil. Such an increase means
that firms face higher production costs, because oil is a key input. Therefore, this is
one reason why prices may begin to increase. In the AD/AS model, this permanent
change would be seen as a decrease in long-run aggregate supply. In Figure 10.5,
aggregate supply moves from LRASFE0 to LRASFE1 and the price level rises from P0 to P1.
Notice that real GDP falls from YFE0 to YFE1.
LRASFE0
LRASFE1
P1
P0
AD
0
YFE1
YFE0
Real GDP
t Figure 10.5 A decrease in long-run
aggregate supply
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KEY TERMS
cost-push inflation:
inflation initiated by an
increase in the costs
faced by firms, arising
on the supply side of the
economy
money stock: the
quantity of money in the
economy
Test yourself 10.4
Demand-pull inflation
An alternative explanation for a rise in the general price level could come from the
demand side, where an increase in aggregate demand leads to a rise in prices,
especially if the economy is close to its full capacity. An increase in the price level
arising from the demand side of the macroeconomy is referred to as demand-pull
inflation.
An increase in aggregate demand can arise from an increase in any of the components
of aggregate demand, or from a cut in taxes. In terms of the AD/AS model, an increase
in expenditure by consumers, firms or government would cause a rightward shift in
the AD curve, as would an increase in exports or a decrease in taxes. This is shown in
Figure 10.6, with a shift from AD0 to AD1 and an increase in the price level from P0,
first to P1 and finally to P2. In this case, real GDP returns to YFE. However, the AD/AS
diagram again shows that there would be a one-off increase in the price level, which is
not the same as saying there would be persistent inflation.
Price level
Name two examples
(other than the price of
oil) of how firms’ costs
may rise and trigger
cost-push inflation.
10
LRAS
10 Price stability
demand-pull inflation:
inflation initiated by an
increase in aggregate
demand
In this way, inflation may be initiated by an increase in the costs faced by firms. This
is referred to as cost-push inflation, as the increase in the overall level of prices is
cost-driven. However, the AD/AS diagram only shows that there would be a one-off
increase in the price level, which is not the same as saying there would be persistent
inflation. Indeed, if the increase in the price of oil is only temporary, the economy
would be expected to adjust back to equilibrium.
SRAS1
SRAS0
P2
P1
P0
AD1
AD0
0
YFE Y1
Real GDP
STUDY TIP
Notice that if
an increase in
aggregate demand
is accompanied by
a corresponding
increase in long-run
aggregate supply,
there would not be
demand-pull inflation.
Test yourself 10.5
Would cost-push
inflation be initiated by
demand- or supply-side
factors?
▲ Figure 10.6 Adjustment following an increase in aggregate demand
Why should there be persistent inflation?
Why should there be persistent increases in prices over time? The AD/AS model shows
that there may be one-off movements in either aggregate demand or aggregate supply
that may lead to one-off changes in the overall price level, but unless the movements
continue in subsequent periods there is no reason to suppose that inflation will
continue. One explanation is provided by changes in the supply of money circulating
in an economy.
Persistent inflation can take place only when the money stock grows more rapidly
than real output. This can be shown in terms of aggregate demand and aggregate
supply. If the money supply increases, firms and households in the economy find they
have excess cash balances: that is, for a given price level they have more purchasing
power than they expected to have. Their impulse will thus be to increase their
spending, which will cause the aggregate demand (AD) curve to move to the right.
They will probably also save some of the excess, which will tend to result in lower
interest rates – which will then reinforce the increase in aggregate demand. However,
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10
LEARNING
LINK
AS LEVEL PART 4 THE MACROECONOMY
The role of money
and its relationship
with inflation is
discussed more fully
in Chapter 27.
as the AD curve moves to the right, the equilibrium price level will rise, returning the
economy to the full-employment equilibrium.
If the money supply continues to increase, the process repeats itself, with prices then
rising persistently. One danger of this is that people will get so accustomed to the
process that they speed up their spending decisions, which simply accelerates the
whole process.
To summarise, the analysis suggests that although a price rise can be triggered on
either the supply side or the demand side of the macroeconomy, persistent inflation
can arise only through persistent excessive growth in the money stock.
SUMMARY: CAUSES OF INFLATION
» Cost-push inflation is initiated by an increase in
the costs faced by firms, arising on the supply side
of the economy.
» Demand-pull inflation is initiated by an increase in
aggregate demand.
» Inflation will only persist if there is an increase in
the money supply.
10.4 Consequences of inflation
It is worth noting that when governments have set targets for inflation, they do
not choose to set the target at 0%. For example, the UK has set a target of 2% per
annum, as is the case in the USA. New Zealand aims to keep average inflation between
1 and 3% per annum in the medium term. India has a target of 4% per annum. This
suggests that inflation is not always bad. The main argument here is that a stable
and modest rate of inflation allows prices to work effectively as signals. In particular,
it is important that prices can signal to producers where sectors are expanding or
declining, and this is more easily achieved when prices are rising at different rates,
rather than allowing some prices to fall.
However, there are also a number of costs that can arise if an economy experiences
inflation.
Uncertainty and investment
If the rate of change of prices cannot be confidently predicted by firms, the increase
in uncertainty may be damaging, and firms may become reluctant to undertake the
investment that would expand the economy’s productive capacity.
Resource allocation
Chapter 4 emphasised that prices are very important in allocating resources in a
market economy. Inflation may consequently inhibit the ability of prices to act as
reliable signals in this process, leading to a wastage of resources and lost business
opportunities.
Effects on income distribution
Test yourself 10.6
If workers are awarded
a 3% increase in
wages when inflation
is running at 5%, what
would be the effect on
their real wages?
As inflation accelerates, there could be an increase in inequality in the distribution
of income, because some groups in society are less able to protect themselves against
rising prices. In particular, pensioners and others on fixed incomes find the value of
their incomes (and savings) are diluted by rising prices.
Effect on wages
Another consequence of high inflation is that workers negotiate for higher wages to
compensate for the increase in prices. This further increases the costs faced by firms,
which may reinforce the inflationary process.
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Menu and shoe-leather costs
Test yourself 10.7
This reluctance to use money for transactions may inhibit the effectiveness of
markets. For example, there was a period in the early 1980s when inflation in
Argentina was so high that some city parking fines had to be paid in litres of petrol
rather than in cash. Markets will not work effectively when people do not use money
and the economy begins to slip back towards a barter economy. The situation may be
worsened if taxes or pensions are not properly indexed so that they do not keep up
with inflation.
10
10 Price stability
What is meant by the
menu costs of inflation?
When inflation is very high and volatile, firms have to keep amending their price
lists, which raises the costs of undertaking transactions. These costs are often
known as the menu costs of inflation; however, these should not be expected to
be significant unless inflation really is very high. A second cost of very high
inflation is that it discourages people from holding money because, at the very
high nominal interest rates that occur when inflation is high, the opportunity
cost of holding money becomes great. People therefore try to keep their money
in interest-bearing accounts for as long as possible, even if it means making
frequent trips to the bank – for which reason these are known as the shoe-leather
costs of inflation.
Inflation as a policy objective
STUDY TIP
The key costs of
inflation are:
» uncertainty
reduces incentives
for investment
» prices fail to be
reliable signals for
resource allocation
» redistribution of
income away from
those on fixed
incomes
» menu costs
» shoe-leather costs
» reluctance to
use money for
transactions
Although the menu costs and shoe-leather costs become important only at quite high
rates of inflation, the potential negative consequences of inflation have caused the
governments of many countries to focus on maintaining stability of prices as a key
part of macroeconomic policy.
The reasoning here is twofold. One argument is that measured inflation will
overstate actual inflation, partly because it is so difficult to take account of
quality changes in products such as smartphones, where it is impossible to
distinguish accurately between a price change and a quality change. Second,
wages and prices tend to be sticky in a downward direction: in other words, firms
may be reluctant to lower prices and wages. A modest rate of inflation (e.g. 2%)
thus allows relative prices to change more readily, with prices rising by more in
some sectors than in others. This may help price signals to be more effective in
guiding resource allocation.
EXERCISE 10.3
Suppose that next year inflation in the economy in which you live suddenly takes
off, reaching 15% per annum – in other words, prices rise by 15% – but so do
incomes. Discuss how this would affect your daily life.Why would it be damaging
for the economy in the future?
SUMMARY: CONSEQUENCES OF INFLATION
» High and volatile inflation causes uncertainty,
which may discourage investment by firms.
» Inflation may disguise price signals and cause a
misallocation of resources.
» Inflation can cause a worsening of income
inequality.
» Workers may negotiate for higher wages when
inflation is high, which could fuel further inflation.
» High inflation inflicts menu and shoe-leather costs
on society.
» Inflation may cause an increase in transaction
costs if people become reluctant to use money for
transactions.
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END OF CHAPTER QUESTIONS
AS LEVEL PART 4 THE MACROECONOMY
10
Multiple choice
1 The consumer price index in a country changes from 110 to 115. For the same
period the nominal interest rate on an individual’s savings account changes by
+5%. What can be concluded with certainty?
A The individual is on fixed income.
B The individual is now 5% better off.
C The real value of the individual’s savings stayed unchanged.
D The real value of the individual’s savings increased.
2 A desirable consequence of domestic inflation could be:
A more competitive exports
B reduced burden of real debt
C reduced real interest on savings
D reduced international value of the country’s currency
Data response
1 Read the following extract and then answer the questions that follow.
Inflation and deflation
The consumer price index (CPI) is a measure designed to record the general
price level of household goods and services. The CPI is produced as a weighted
average index for which the International Monetary Fund provides construction
guidelines.
5
The potential negative consequences of price instability cause the
governments of many countries to focus on maintaining a target rate of
inflation. This is monitored through their CPI and forms a key part of their
macroeconomic strategy.
In early 2020, this was brought into sharp focus when a sinking global economy
10 was suffering through disinflation that briefly pushed some economies into
dangerous deflation territory for the first time in decades.
In 2008 and again in 2011, increased oil prices caused temporary spikes in UK
inflation to over 5%. However, in 2020, with many national economies all but
shutting down in an effort to contain Covid-19, prices of everything from oil and
15 copper to hotel rooms and takeaway food were tumbling.
While falling prices may seem like good news for consumers, widespread
deflation is likely to be harmful for the macroeconomy.
The concern was that even after the Covid-19 crisis eased, the scars from
the shutdown, elevated unemployment, shattered consumer and company
20 confidence, and staggered returns to work may have prolonged the
disinflation.
However, some economists thought that it was inflation, not deflation, that
would be the problem. As the lockdown lifted and recovery ensued, following
a period of massive fiscal and monetary expansion, there were concerns there
25 would be a surge in inflation, quite likely more than 5% and even in the order of
10% in 2021.
One commentator said, ‘If we get inflation that would be good. That would be a
good sign that we have adequate demand.’
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CASE STUDY
Inflation and the economy
Since the mid-1970s inflation has been regarded by
the governments of many countries around the world
as economic public enemy number one. How did it
gain this reputation?
The view that inflation is dangerous for the economy
was initially fuelled by the experience of many
countries after the sudden and unexpected rise in
oil prices in 1973–74 and 1979–80. In addition, some
countries, especially in South America, went through
periods of hyperinflation, partly caused by excessive
spending.
What harm does inflation do?
Many arguments have been advanced to show that
inflation causes damage. Many pensioners rely on
incomes that are fixed in money terms, so they lose
out when prices rise rapidly – at a time when other
groups in society gain. This means that inequality
worsens. At high levels of inflation, transaction costs
rise: firms need to keep changing their prices, and
people try to avoid using cash, and keep as much as
possible of their money in interest-bearing accounts
that they access less frequently. Rapid changes in
relative prices make it difficult for firms to interpret
prices. This makes it hard to make plans for
future contracts, so firms tend to form pessimistic
expectations about the future course of the economy.
Inflation in the twenty-first century
In the early years of this century, prices were
relatively stable in many countries and people
began to become accustomed to low inflation rates.
Some countries successfully introduced inflation
targeting to maintain stability. Everything then went
horribly wrong. A sudden rise in commodity prices
led to an acceleration of inflation, but this trend was
interrupted by a financial crisis, with many banks in
the USA, UK and elsewhere needing to be bailed out.
As the global economy began to recover from this,
tariff wars broke out between the USA and China,
the UK decided to exit from the EU, and uncertainty
spread through the global community. As if this were
not enough, the Covid-19 pandemic hit. Inflation no
longer seemed to be the major concern.
10
10 Price stability
a ‘The CPI is produced as a weighted average index’ (lines 2–3). Explain one
difficulty arising from the use of weights when attempting to provide a
meaningful measure of inflation in an economy.
b Distinguish between ‘inflation’ (line 7) and ‘disinflation’ (line 10).
c Use the information provided and an AD/AS diagram to show how a
temporary spike in inflation can be caused.
d Explain why ‘widespread deflation is likely to be harmful for the
macroeconomy’ (lines 16–17).
e Discuss whether the disinflation predicted in the extract is likely to persist
over the longer term.
Follow-up questions
a Identify examples of demand-pull and cost-push
inflationary pressures in the passage.
b What are the potential benefits that come from
having low and stable inflation?
c What are the main costs of inflation?
d Which of the costs do you regard as the most
important?
e How has inflation changed since the onset of the
pandemic in the country in which you live?
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AS LEVEL PART 5 Government macroeconomic intervention
AS LEVEL PART 5 GOVERNMENT MACROECONOMIC INTERVENTION
11
Macroeconomic policy
What this chapter covers
★ the main objectives of macroeconomic policy
★ what is meant by the government budget and the
meaning and significance of the national debt
★ the working of fiscal policy
★ monetary policy and how the tools of monetary
policy can affect the path of the economy
★ the meaning and significance of supply-side
policy
The previous chapters have identified some of the key indicators used to judge a country’s
macroeconomic performance. In looking to improve the performance of the macroeconomy,
a government can call on a range of policy options. These are the subjects of this chapter.
11.1 Government macroeconomic policy objectives
and instruments
LEARNING
LINK
Although these are
arguably the most
important objectives
that a government
can pursue at the
macroeconomic
level, they are not the
only ones. Avoiding
an imbalance on the
balance of payments
and ensuring that
the exchange rate
is at an appropriate
level are also
important objectives,
and are discussed
in Chapters 13
and 29. Policies to
promote sustainable
economic growth
are discussed in
Chapter 25; economic
development is the
topic of Chapter 30.
Chapter 8 explored the topic of economic growth. Chapter 9 looked at unemployment.
Chapter 10 examined price stability. Together, these are the main objectives of
government macroeconomic policy that we will discuss in this chapter:
» price stability
» low unemployment
» economic growth
Price stability
Low inflation has been seen as a key part of macroeconomic policy design for many
countries since the mid-1970s. There have nonetheless been periods when inflation
has risen appreciably – notably in some Latin American economies in the 1980s and
more recently in some transition and African countries. When inflation is high and
unpredictable, firms do not have confidence to undertake productive investment,
which is a key component of economic growth.
Low unemployment
Chapter 9 has argued that high unemployment is wasteful for a society as it means
that the economy is operating below its full potential capacity. It also imposes costs
on those individuals who are unemployed.
Economic growth
If the ultimate aim of a society is to improve the wellbeing of its citizens, then in
economic terms this means that the resources available within the economy need to
expand through time in order to widen people’s choices.
Economic growth may be regarded as the most fundamental of all macroeconomic policy
objectives, with other policy objectives being subsidiary to it. For example, one of the key
reasons for maintaining stability of prices is to encourage firms to undertake investment
– because this enables economic growth. Maintaining full employment ensures the best
possible use of a society’s resources, enabling it to reach the production possibility curve –
and failure to do this may have consequences for economic growth.
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Test yourself 11.1
Explain why economic
growth may be
regarded as the most
fundamental of all
macroeconomic policy
objectives.
Macroeconomic policy instruments
11
11 Macroeconomic policy
The government has three main types of policy instrument with which to attempt to
meet its macroeconomic objectives:
1 Fiscal policy: the term ‘fiscal policy’ covers a range of policy measures that affect
government expenditures and revenues through the decisions made by the
government on its expenditure, taxation and borrowing. Fiscal policy is used to
influence the level and structure of aggregate demand in an economy. As this
chapter unfolds, you will see that the effectiveness of fiscal policy depends
crucially on the whole policy environment in which it is utilised, and on the
interrelationship between the three types of policy.
2 Monetary policy: this entails the use of monetary variables such as money
supply, interest rates and credit regulations to influence aggregate demand.
The effectiveness of monetary policy will depend on the policy environment in
which it is used. In particular, the exchange rate has an important impact on how
effective monetary policy can be. The importance of exchange rates and how they
are determined is discussed in Chapters 13, 28 and 29. The financial crisis of the
late 2000s highlighted the need for adequate regulation of financial markets to
influence the flow of credit in the economy.
3 Supply-side policies: such policies comprise a range of measures intended to have a
direct impact on aggregate supply – specifically, on the potential capacity output
of the economy. These measures are often microeconomic in character and are
designed to increase output and hence economic growth.
11.2 Fiscal policy
KEY TERMS
fiscal policy:
decisions made by
the government on its
expenditure, taxation
and borrowing
government budget:
the balance between
government receipts
and outlays
government budget
deficit: a situation in
which government
expenditure exceeds
government revenue
government budget
surplus: a situation
in which government
expenditure is less than
government revenue
government balanced
budget: a situation
in which government
expenditure equals
government revenue
Fiscal policy covers a range of policy measures involving government expenditures
and revenues. As the government has discretion over the amount of expenditure that
it undertakes and the amount of revenue that it chooses to raise from taxation, these
can be manipulated in order to influence its policy objectives. An important question
concerns the extent to which a government can use fiscal policy to influence the level
of aggregate demand in the economy.
The government budget
Fiscal policy can be used to affect the level of aggregate demand in the economy. The
overall balance between government receipts and outlays comprises the government
budget. Receipts come mainly from taxation; outlays cover the range of expenditures
undertaken by government.
The overall government budget position
An important issue in considering fiscal policy is the balance between government
expenditure and government revenue, as it is this balance that affects the position of
the aggregate demand curve.
When total government expenditure exceeds revenues, there is a government budget
deficit, whereas if revenues exceed expenditure, there is a government budget
surplus. In the event that revenues were to equal expenditure, there would be a
balanced budget. This is rarely achieved in any single year, but for sustainability,
having a balanced budget may be seen as a long-term objective for the government.
An increase in the government budget deficit (or a decrease in the government budget
surplus) increases aggregate demand. A budget deficit may arise either from an
increase in expenditure or from a decrease in taxation, although the two have some
differential effects.
The overall size of the budget deficit may limit the government’s actions in terms
of fiscal policy. In addition, the overall pattern of revenue and expenditure has a
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strong effect on the overall balance of activity in the economy. A neutral
government budget can be attained either with high expenditure and high
revenues, or with relatively low expenditure and low revenues. Such decisions
affect the overall size of the public sector relative to the private sector. Over the
years and in different countries, different governments have taken different
decisions on this issue.
11
AS LEVEL PART 5 GOVERNMENT MACROECONOMIC INTERVENTION
The national debt and government borrowing
KEY TERM
national debt: the total
amount of government
debt, based on
accumulated previous
deficits and surpluses
Test yourself 11.2
If a government spends
more than it receives
from taxation, will there
be a budget deficit or
budget surplus?
If the government spends more than it raises in revenue, the resulting deficit has to
be financed in some way. The government budget deficit is known as the public sector
net cash requirement (PSNCR). Part of the PSNCR is covered by borrowing, and the
government closely monitors its net borrowing. Over time, such borrowing leads to net
debt, which is the accumulation of past borrowing, known as the national debt.
A major argument in favour of controlling the level of public sector net debt arises
from the long-run effects of policy on spending and borrowing. It has been argued
that sustainable economic growth has to take into account the needs of future
generations. It can be argued that future generations should not have to meet the
cost of the consumption of the present population.
In the UK, public sector debt was stable for some time at less than 40% of GDP, and it
was not seen as being of major concern. However, the financial crisis of the late 2000s
led to a refocusing of macroeconomic policy. In the UK, the government provided a
bailout for failing banks, as this was seen to be needed to safeguard the financial
system. Public sector net debt rose to more than 140% of GDP by the end of 2009.
This began to fall as the government gradually reduced its stake in bailed-out banks.
However, when the Covid-19 pandemic started in early 2020, the net debt was already
above 90% of GDP, and the measures taken to try to conserve the economy in the face
of the virus increased debt by even more. Debt continued to rise well into 2021.
Figure 11.1 shows the national debt as a percentage of GDP for a range of countries.
(These data predate the Covid-19 pandemic.) This highlights the varied nature of
experience in different countries around the world. Japan has the highest national
debt of any country in the world, at almost 240% of GDP. In the UAE national debt is
less than 20% of GDP. A problem of having a high level of national debt is the interest
payments that need to be made, and the difficulty that may be faced in repaying the
debt in the longer term may restrict the ability of the government to carry out its
expenditure plans. The low level of interest rates in the 2010s eased the position in
the short run.
Nepal
Pakistan
Bangladesh
Zimbabwe
India
Sri Lanka
China
Malaysia
New Zealand
UAE
UK
Japan
USA
0
50
100
150
200
250
% of GDP
Source: based on data from World Population Review
▲ Figure 11.1 National debt (% of GDP)
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LEARNING
LINK
Reasons for taxation
Governments impose taxes for a variety of purposes. In particular, there is a need to
raise revenue to finance government expenditures, but taxes are also used to address
some forms of market failure and to influence the macroeconomy.
11
Revenue is needed to:
» provide services to people, such as healthcare and education
» finance infrastructure projects that will increase future productive capacity, such
as roads and communication networks
Taxes can address market failures, such as:
» the provision of public goods, which would not otherwise be provided by the market
» the need to deal with externalities, such as pollution
At the macroeconomic level, taxes can be used to:
» influence the level of aggregate demand
» influence the distribution of income and wealth
11 Macroeconomic policy
The use of indirect
taxes to address
issues of market
failure is discussed
in Chapter 5 with
some further
coverage in
Chapter 21.
Externalities are
explained in
Chapter 16.
Taxation
Tax collection
Tax collection presents a challenge to many less developed countries. In many cases,
the institutions needed to collect taxes are absent, or are ineffective. To some
extent this is reflected in the data shown in Figure 11.2, which shows tax revenue in
a range of countries as a percentage of GDP. Notice how the UK and New Zealand in
this group are able to raise a significantly higher proportion of GDP in the form of tax
revenue. Of course, there may also be countries (such as UAE, where tax revenue is
only 0.06% of GDP) that could raise a higher level of taxes, but which choose not to
do so. However, there are also countries that are not able to collect taxes efficiently
and effectively.
KEY TERMS
direct tax: a tax levied
directly on income
progressive tax: a tax
in which the marginal
tax rate rises with
income, i.e. a tax
bearing most heavily on
the relatively well-off
members of society
Nepal
Kenya
Bangladesh
Zimbabwe
India
Sri Lanka
South Africa
China
Brazil
Malaysia
Korea
New Zealand
UAE
UK
Japan
USA
0
5
10
15
20
25
30
% of GDP
Source: based on data from World Development Indicators
▲ Figure 11.2 Tax revenue (% of GDP)
Direct taxes
Direct taxes are taxes levied on income of various kinds, such as personal income tax.
Such taxes are designed to be progressive and so can be effective in redistributing
income. The progressive nature of income tax is reflected in the way the tax rate
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marginal tax rate: the
rate of tax on additional
income, defined as the
change in tax payments
divided by the change in
taxable income
average tax rate: the
ratio of tax payments to
the level of income
increases as an individual moves into a higher income range. In other words, the
marginal tax rate increases as income increases. The average tax rate also increases
as income rises. The progressive nature of the tax ensures that it does indeed help to
reduce inequality in income distribution.
STUDY TIP
In contrast, indirect taxes – taxes on expenditure, such as VAT and excise duties – tend to
be regressive. As poorer households tend to spend a higher proportion of their income
on items that are subject to excise duties, a greater share of their income is taken up by
indirect taxes. Even VAT can be regressive if higher-income households save a greater
proportion of their incomes. This is explained in Chapter 5 and in a later section of this
chapter.
Figure 11.3 shows average direct tax rates for UK households by quintile group in
2015/16. Notice that the figure shows average rather than marginal tax rates. When
average rates are rising, marginal tax rates are higher than the average. Exercise 11.1
illustrates this.
% of gross income
25
20
Income tax
Employees’ NIC
Council tax and rates
15
10
All households
Top quintile
4th quintile
3rd quintile
0
2nd quintile
5
Bottom
quintile
AS LEVEL PART 5 GOVERNMENT MACROECONOMIC INTERVENTION
11
KEY TERMS
Note: NIC = National Insurance contributions
Source: ONS (UK)
▲ Figure 11.3 Average direct taxes by quintile households, 2015/16
Test yourself 11.3
Looking at Figure 11.3,
would you say that
employees’ National
Insurance contribution*
payments are
progressive or
regressive?
*National Insurance is a
tax on earnings and
self-employment profits.
Figure 11.3 shows how income tax is progressive in the UK, as the average tax rate
increases from 3.8% in the bottom quintile to 16.5% in the top quintile. However, it
also shows that council tax (a tax on property) is certainly not progressive, as it takes
a higher percentage from the bottom quintile than from the top.
EXERCISE 11.1
Table 11.1 shows the amount of tax paid by an individual as income increases.
Calculate the average and marginal tax rates at each of the income levels.
(Remember the definition of the marginal tax rate provided above.)
▼ Table 11.1 Amount of tax at various income levels
Income ($)
1,000
Tax paid ($)
100
2,000
300
3,000
600
4,000
1,000
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Test yourself 11.4
Explain why producers
are more able to
pass on an increase
in indirect taxes to
consumers when
demand is relatively
price inelastic.
Indirect taxes
Indirect taxes are taxes paid on items of expenditure, rather than on income.
Examples of indirect taxes are value added tax (VAT), which is charged on most
goods and services sold in the UK, tobacco taxes, excise duties on alcohol and
oil duties. These taxes are levied per unit sold. When demand is price inelastic,
producers are able to pass much of an increase in the tax rate on to consumers,
whereas if demand is price elastic they have to absorb most of the increase as part
of their costs.
KEY TERMS
regressive tax: a tax in
which the marginal tax
rate falls with income,
i.e. a tax bearing most
heavily on the relatively
less-well-off members
of society
proportional tax: a tax
that is proportional
to income, being
neither regressive nor
progressive
government current
expenditure: spending
by the government on
goods and services
transfer payments:
occur when the
government provides
benefits (in cash
or in kind) to poor
households
government capital
expenditure: spending
by government on
investment projects for
the future benefit of the
economy
STUDY TIP
Notice that what
is important for
aggregate demand is
not only government
expenditure, but also
the level of taxation. In
other words, it is the
size of the government
deficit or surplus that
influences aggregate
demand.
Why should some of these taxes be regressive? Take the tobacco tax. In the
first place, the number of smokers is higher among lower-income groups than
among the relatively rich – research has shown that only about 10% of people in
professional groups now smoke compared with nearly 40% of those in unskilled
manual groups. Second, expenditure on tobacco tends to take a lower proportion
of income of the rich compared with that of the poor, even for those in the former
group who do smoke. Thus, the tobacco tax falls more heavily on lower-income
groups than on the better-off. It is estimated that for UK households in the
bottom quintile of the income distribution in 2015/16, indirect taxes accounted
for 27.0% of their disposable income, compared with 14.4% for households in the
top quintile. The largest share of indirect tax was VAT, which accounted for 11.4%
of disposable income of households in the bottom quintile, compared with 7.1%
for the top quintile.
11 Macroeconomic policy
The effect of indirect taxes can sometimes be regressive: in other words, indirect
taxes may fall more heavily on lower-income households.
11
Notice that a tax that is simply proportional to income would be neither
regressive nor progressive, but would be charged at the same percentage rate
to all taxpayers.
STUDY TIP
Make sure you are clear about the distinction between the different effects of taxes:
» a progressive tax (such as income tax) bears most heavily on relatively highincome households
» a regressive tax (such as an expenditure tax) tends to fall more heavily on relatively
low-income households
» a proportional tax falls equally on households at all income levels
Government expenditure
Government undertakes spending on a wide range of goods and services.
Government current expenditure is spending on goods and services for
immediate use. This includes transfer payments such as social security payments,
but also covers expenditure on the wages of civil servants and on health and
education, which takes a significant portion of the budget in many countries.
Government capital expenditure is spending that is investment for the future
benefit of the economy. This covers expenditure on infrastructure projects such as
improving transport and communications. Such projects are intended to facilitate
economic growth.
Expansionary and contractionary fiscal policy
Government expenditure is a component of aggregate demand, so changes in
expenditure can affect aggregate demand. There may be situations in which the
government wants to influence the level of aggregate demand in the economy, so
fiscal policy can be a part of macroeconomic policy.
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contractionary fiscal
policy: where the
government reduces its
expenditure or raises
taxes in times when real
GDP is above its fullemployment level
expansionary fiscal
policy: where the
government increases
its spending or reduces
taxes when real GDP
is below its fullemployment level
LEARNING
LINK
The AD/AS model was
introduced in
Chapter 7.
For example, there may be periods in which real GDP rises above the full-employment
level so that there is a danger that the economy will overheat, and inflation begin
to rise. If the government is not certain that the economy will adjust rapidly to its
long-run equilibrium position, it may wish to dampen aggregate demand by reducing
government expenditure or raising taxes. This would be a contractionary fiscal
policy.
Conversely, if the economy is operating below its full capacity, an increase in
aggregate demand fuelled by government spending (or by reducing taxes) could speed
the process of adjustment back to equilibrium. This could be particularly important
if the short-run aggregate supply curve is a sweeping curve. This would be an
expansionary fiscal policy.
Fiscal policy and the AD/AS model
The effects of contractionary and expansionary fiscal policy changes can be seen
using the AD/AS model.
First consider an expansionary policy, which is shown in Figure 11.4. Suppose that for
some reason there has been a fall in aggregate demand, so that the economy begins in
short-run equilibrium with real GDP at Y0 and price level at P0.
Price level
AS LEVEL PART 5 GOVERNMENT MACROECONOMIC INTERVENTION
11
KEY TERMS
SRASK
Test yourself 11.5
How would spending on
building a new power
station be classified?
P1
P0
AD1
AD0
0
Y0
Y1
YFE
Real GDP
▲ Figure 11.4 An expansionary fiscal policy
The figure has been drawn with short-run aggregate supply as a sweeping curve, so
real GDP has fallen a relatively long way below full employment. The government
may perceive that the adjustment back to full employment will be long-lived, so may
wish to speed up the return to equilibrium. An expansionary fiscal policy may enable
this. The government could increase its expenditure, raising aggregate demand so
that there is a shift to AD1, taking the economy back towards long-run equilibrium
more quickly.
Figure 11.5 shows an economy that starts in long-run equilibrium with real GDP at YFE
and overall price level at P0. Suppose that there is an increase in aggregate demand
because of an increase in exports. The aggregate demand curve shifts from AD0 to AD1.
In the short run there is a movement along the short-run aggregate supply curve, with
real GDP rising to Y1 and the price rising to P1. The new equilibrium in the long run
would be with real GDP back at YFE, but with a higher price P2. In other words, SRAS
would adjust until it intersects AD at the point at which AD1 cuts LRAS.
The government could use fiscal policy to moderate the increase in price, by reducing
government expenditure so that the aggregate demand curve shifted to AD3, with
the price level only rising to P3. This contractionary fiscal policy has the effect of
moderating the increase in price that would otherwise have occurred. Real GDP returns
to its full-employment level.
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Price level
LRAS
SRAS1 SRAS3
SRAS0
11
P2
P1
P3
P0
AD1
AD0
0
YFE Y1
Real GDP
▲ Figure 11.5 Adjustment to an increase in aggregate demand
Test yourself 11.6
The use of fiscal policy to influence aggregate demand might be seen differently if
the long-run aggregate supply curve has a Keynesian shape, being upward-sloping for
some range below full employment. Figure 11.6 shows this situation. Suppose that
the initial equilibrium is with aggregate demand AD0, with price PK and real GDP at YK.
Because this is a long-run equilibrium, there is no immediate reason why this position
should not remain, although it may be that eventually the economy will find its way
back to full employment.
Price level
Give an example of
a fiscal measure
that would increase
aggregate demand.
A danger of both of these policy moves is that the government might misjudge the
size of stimulus that was needed, so the economy could overshoot.
11 Macroeconomic policy
AD3
LRASK
PFE
P1
PK
AD1
AD0
0
YK Y1 YFE
Real GDP
▲ Figure 11.6 An expansionary fiscal policy with a Keynesian LRAS
An expansionary fiscal policy could shift the aggregate demand curve to AD1, so that the
economy moves back towards full employment, with real GDP rising to Y1 and the price
level increasing to P1. The relative size of movements in real GDP and the overall price
level will depend on the slope of the LRAS in this range. If the natural adjustment is
very slow, this intervention might be helpful, but there is still a danger that the timing
of the adjustment will be misjudged, so that the economy overshoots its equilibrium.
EXERCISE 11.2
Use a diagram to analyse the effect of an expansionary fiscal policy when the
economy begins with real GDP at its full-employment level.
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11
SUMMARY: FISCAL POLICY
» Fiscal policy covers decisions made by the
»
AS LEVEL PART 5 GOVERNMENT MACROECONOMIC INTERVENTION
»
»
»
»
»
»
government on its expenditure, taxation and
borrowing.
The government budget shows the balance
between government receipts and outlays.
When government expenditure exceeds revenues,
there is a government budget deficit.
When government expenditure is less than
revenues, there is a government budget surplus.
A balanced budget, where revenues equal
expenditures, may be seen as a desirable
long-term objective.
The national debt is the accumulation of past
borrowing.
Changes in the government budget can affect the
overall level of aggregate demand.
Indirect taxes may often be regressive, and can
be used for addressing market failure and for
»
»
»
»
»
affecting the distribution of income, but may also
affect aggregate demand.
Direct taxes tend to be progressive, and may
influence the distribution of income.
Governments undertake expenditure on goods and
services for immediate use (current expenditure),
but also spend on investment projects to benefit
the economy in the long run (capital expenditure).
An increase in the government budget deficit
is expansionary, as it leads to an increase in
aggregate demand.
A decrease in the government budget deficit is
contractionary, as it leads to a fall in aggregate
demand.
The AD/AS model can be used to show the effects
of a change in aggregate demand on the economy
in the short and long run.
11.3 Monetary policy
KEY TERM
monetary policy:
decisions made by the
government regarding
monetary variables
such as money supply
and interest rates
LEARNING
LINK
The significance of
the exchange rate is
discussed in Chapters
13, 28 and 29.
LEARNING
LINK
The roles of money
supply and interest
rates are discussed
more fully in Chapter
27, where there is
also an explanation of
quantitative easing.
Monetary policy entails the use of monetary variables to influence aggregate demand
in the economy, with the intention of meeting the government’s macroeconomic
objectives. The key tools are the money supply, the interest rate and credit
regulations, although the exchange rate also has an important impact, and may in
some circumstances be manipulated in support of the other tools of monetary policy.
In many less developed countries, monetary policy may also aim to encourage the
development of the financial sector and to promote confidence in it.
Monetary policy has become the prime instrument of government macroeconomic
policy in many developed countries. Monetary policy involves the manipulation of
monetary variables in order to influence aggregate demand in the economy, with the
intention of meeting the government’s inflation target.
The tools of monetary policy
Until the financial crisis of the late 2000s, the interest rate was viewed as the
main instrument of monetary policy in the UK and elsewhere. However, as interest
rates fell to record low levels during and after the crisis, it became necessary to
make more use of changes in money supply to influence the economy, through
a process that became known as ‘quantitative easing’. The financial crisis also
highlighted the key importance of financial regulation to ensure an appropriate
flow of credit in the economy.
Although reference has been made to ‘the interest rate’, this is a simplification. In the
real-world economy, there are many different interest rates. For example, if you borrow
from a bank, you will pay a higher interest rate than would be paid to you on your
savings. Indeed, it is this difference between the rates for savers and borrowers that
enables the banks to make a profit.
Similarly, interest rates on financial assets differ depending on the nature of the
asset. In part, these differences reflect different degrees of risk associated with the
assets. A risky asset pays a higher interest rate than a relatively safe asset.
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How does monetary policy work?
In evaluating the tools of monetary policy, it is important to understand the route
by which a change in a monetary variable can have an effect on the real economy. In
other words, how can a change in money supply, or the interest rate, affect the level
of equilibrium output in the economy?
11
The monetary transmission mechanism
transmission
mechanism of monetary
policy: the channel by
which monetary policy
affects aggregate
demand
LEARNING
LINK
A contractionary monetary policy
Suppose that the monetary authorities need to dampen aggregate demand to
reduce inflationary pressure. At a higher interest rate, firms undertake less
investment expenditure because fewer projects are worthwhile. In addition,
a higher interest rate may encourage higher saving, which also means that
households undertake less consumption expenditure. This may then reinforce the
impact on investment because if firms perceive consumption to be falling, this will
affect their expectations about future demand, and further dampen their desire to
undertake investment. These factors lower the level of aggregate demand, shifting
the AD curve to the left.
This can be seen by looking at Figure 11.7. Suppose that there has been an increase
in aggregate demand to AD0 that has taken the economy to Y0, which is beyond its
full-employment level of real GDP. The authorities realise that there is a danger
that the economy will move to a new long-run equilibrium with the overall price
level rising to P*. To prevent price from rising beyond its current level (at P0) they
can raise the interest rate so that aggregate demand shifts to the left at AD1. The
economy settles back in equilibrium with the price at P0 and real GDP back to full
employment at YFE.
Price level
The transmission
mechanism of
monetary policy is
explained in more
detail in Chapter 28.
In drawing this analysis together, an important issue concerns the relationship between
the rate of interest and the level of aggregate demand. This is critical for the conduct
of monetary policy. Indeed, the interest rate has been seen as the prime instrument of
monetary policy in recent years – and monetary policy is seen as the prime instrument
of macroeconomic policy. By setting the interest rate, monetary policy is intended to
affect aggregate demand through the so-called monetary transmission mechanism.
11 Macroeconomic policy
KEY TERM
LRAS
SRAS1
SRAS0
P*
P0
AD0
AD1
0
YFE Y0
Real GDP
▲ Figure 11.7 A contractionary monetary policy
Test yourself 11.7
Explain why investment
may be sensitive to the
rate of interest.
Notice that this may not be the end of the story. If one of the effects of the higher
interest rate is to discourage investment that might otherwise have occurred, this
will also have long-term consequences. Investment allows the productive capacity
of the economy to increase, leading to a rightward drift in the AS curve. With lower
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investment, this process will slow down, leaving the economy with lower productive
capacity than it otherwise could have had.
11
The AD/AS graph is drawn in terms of the overall price level. However, in a dynamic
context, such a policy stance may be needed in order to maintain control of inflation.
An expansionary monetary policy?
AS LEVEL PART 5 GOVERNMENT MACROECONOMIC INTERVENTION
A reduction in interest rates would, of course, have the reverse effect. If the
economy were to be in a position where real GDP was below its full-employment
level, the monetary authorities could consider an expansionary monetary policy.
Reducing interest rates would shift aggregate demand to the right. If the economy
faced a curved SRAS curve, the result would be to stimulate real GDP with only a
modest increase in the price level. The effect would be similar to the impact of an
expansionary fiscal policy, as shown in Figure 11.4 on page 152 and Figure 11.6 on
page 153.
In creating a stable macroeconomic environment, the ultimate aim of monetary policy
is not simply to keep inflation low, but to improve the confidence of decision-makers,
and thereby encourage firms to invest in order to generate an increase in production
capacity. This will stimulate economic growth and create an opportunity to improve
living standards.
Monetary policy in practice
The monetary transmission mechanism explains the way in which a change in the
interest rate affects aggregate demand in the economy. In summary, suppose there
is a reduction in the interest rate. From firms’ point of view, this lowers the cost
of borrowing, and would be expected to encourage higher investment spending.
Furthermore, consumers may also respond to a fall in the interest rate by increasing
their expenditure, both because this lowers the cost of borrowing – so there may be
an increase in the demand for consumer durable goods – and because households may
perceive that saving now pays a lower return, so may decide to spend more.
An expansionary monetary policy intended to stimulate aggregate demand would
be damaging if the economy were close to (or at) full employment, as the main
impact would be on the overall price level rather than real output. This suggests that
monetary policy should only be used to stimulate aggregate demand with careful
consideration of where the economy is in relation to full employment. However,
monetary policy can still play an important role in managing the economy. This arises
through its influence on the price level and hence the rate of change of prices – that
is, inflation.
Inflation targeting
KEY TERM
inflation targeting: an
approach to monetary
policy in which the
central bank is given
independence to set
interest rates in order
to meet an inflation
target
An increasing number of countries (both developed and less developed) have
introduced inflation targeting. This approach to monetary policy gives independence
to the central bank to set interest rates at such a level as to meet an inflation target
set by the government.
The idea of this was to boost the credibility of government policy, by establishing a
firm commitment to controlling inflation, as the control of money supply would now
be out of the government’s control. It cannot expand money supply to boost aggregate
demand in order to create a temporary boom that might bolster its popularity in the
lead-up to an election.
Monetary policy in the UK has been the responsibility of the Bank of England since
1997. The Bank’s responsibility is to meet the government’s target for inflation. The
Bank’s Monetary Policy Committee (MPC) meets each month to decide whether or not
the interest rate needs to be altered. The objective of this exercise is to ensure that
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Test yourself 11.8
Would a rise in interest
rates lead to a leftward
or rightward shift of the
AD curve?
KEY TERM
Operationally, the MPC sets the interest rate which it pays on commercial bank
reserves. This is known as the bank rate. The commercial banks tend to use this rate
as their own base rate, from which they calculate the rates of interest that they
charge to their borrowers. If the MPC changes the bank rate, the commercial banks
soon adjust the rates they charge to borrowers. These will vary according to the
riskiness of the loans – for example, credit cards are charged at a higher rate than
mortgages – but all the rates are geared to the base rate set by the commercial banks,
and hence indirectly to the bank rate set by the Bank of England.
However, decisions to change the rate
of interest are not taken solely in
the light of expected inflation. In its
deliberations about the interest rate, the
MPC takes a wide variety of factors into
account, including developments in:
»
»
»
»
»
»
LEARNING
LINK
The way in which
changes in interest
rates are transmitted
to affect aggregate
demand is discussed
in Chapter 28
together with a
discussion of the
effectiveness of
monetary policy.
financial markets
the international economy
money and credit
demand and output
the labour market
costs and prices (e.g. changes in oil
prices)
11
11 Macroeconomic policy
bank rate the interest
rate that is set by
the Monetary Policy
Committee of the Bank
of England in order to
influence inflation; it
is the rate of interest
charged by the Bank of
England on short-term
loans to other banks
the government’s inflation target is met. If the rate of inflation threatens to
accelerate beyond the target rate, the Bank of England can intervene by raising
interest rates, thereby having a dampening effect on aggregate demand and reducing
the inflationary pressure. In reaching its decisions, the MPC takes a long-term view,
projecting inflation ahead over the next 2 years.
▲ Credit cards are charged at higher rates
than mortgages
A good example was in 2008, when the UK and other countries were struggling to
cope with the financial crisis. At this time, inflation was accelerating, and had
reached a rate that was more than 1 percentage point above the target. This being
so, it might have been expected that the Bank of England would raise interest
rates in order to stem aggregate demand and bring inflation back into line with
the target. However, this would have been damaging in other ways, pushing the
economy further into recession. With house prices falling, an increase in interest
rates could have damaged this sector too. It was also thought that there were
other pressures affecting the world economy that would in any case mean that the
rate of inflation was likely to slow down of its own accord. In the event, inflation
accelerated way beyond its target range, but the MPC refrained from raising the
bank rate because of fears that the recession would become even deeper, or that the
economy would recover more slowly.
The financial crisis arose in part because of inadequate credit regulation. Banks had
found ways of extending credit in ways that seemed to be secure, but which in the
event carried high risk, leading to bank failures in the USA, the UK and elsewhere.
The response during the post-crisis period was to put in place more stringent
financial regulation to ensure there was no repeat of the crisis and that credit could
be supplied to meet the needs of the economy in a more secure way.
STUDY TIP
Fiscal policy is used to influence real GDP through aggregate demand via the
government budget, using expenditure and taxation as its tools.
Monetary policy is used to maintain price stability by influencing aggregate demand,
using interest rates and money supply (through quantitative easing) as its tools.
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11
SUMMARY: MONETARY POLICY
» Monetary policy entails the manipulation of
»
AS LEVEL PART 5 GOVERNMENT MACROECONOMIC INTERVENTION
»
»
»
monetary variables in order to influence aggregate
demand in the economy.
The prime instruments of monetary policy are the
interest rate, money supply and credit regulation.
There is not a single interest rate in the economy,
but a variety of rates associated with the wide
range of financial assets available.
The monetary authorities can control either the
money supply or interest rates, but not both
independently.
The transmission mechanism from the interest
rate to aggregate demand works through
»
»
»
»
investment and consumption, and indirectly via the
exchange rate.
A number of countries around the world have
adopted inflation targeting, under which the
central bank is given independence to meet the
government’s inflation target.
Monetary policy cannot focus solely on meeting
the inflation target, but must also operate with
an awareness of other developments in the
macroeconomy.
With the financial crisis of the late 2000s a new
approach was needed.
Quantitative easing was introduced to help manage
an economy in recession.
11.4 Supply-side policies
KEY TERM
supply-side policies:
a range of measures
intended to have a
direct impact on longrun aggregate supply
LEARNING
LINK
These are also the
two factors identified
in Chapter 8 as
being the underlying
causes of economic
growth.
Test yourself 11.9
Explain what is meant
by human capital.
The fiscal and monetary policy instruments that we have discussed in this chapter
so far have been aimed at affecting aggregate demand and at stabilising the
macroeconomy in the relatively short run. Supply-side policies are measures intended
to have a direct impact on long-run aggregate supply – specifically, on the potential
capacity output of the economy. These measures are often microeconomic in character
and are designed to increase output and hence economic growth.
Supply-side policies are directed at affecting long-run aggregate supply, and are
therefore important for the macroeconomic objective of economic growth. These
policies are much less concerned with other macroeconomic objectives of the
government. Supply-side policies focus on affecting the determinants of aggregate
supply in order to shift the LRAS curve to the right.
The factors that influence the position of long-run aggregate supply were discussed in
Chapter 7. Recall that the position of the long-run supply curve depends on:
» the quantity of factor inputs available
» the effectiveness with which factor inputs are used.
Supply-side policies include encouraging education and training, improving the
flexibility with which markets operate and encouraging firms to invest in new
technology. Notice that it is quite difficult to quantify the effects of these supplyside policies. In the case of education and training, the idea is that by increasing
education and training, the human capital of the labour force is increased, thus
resulting in improvements in productivity, which enable an increase in the overall
productive capacity of the economy – in other words, this will lead to a rightward
shift of the aggregate supply curve. However, some of the effects of increased
spending become evident only after very long time lags.
Education and training
An important interventionist supply-side policy takes the form of encouraging workers
(and potential workers) to undertake education and training to improve their
productivity. This takes place partly through education in schools and colleges in
preparation for work. It is important, therefore, that the curriculum is designed
to provide key skills that will be useful in the workplace. However, this does not
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LEARNING
LINK
The meaning and
significance of human
capital was discussed
in Chapter 8.
Why might the
government need to
intervene to encourage
firms to train their
workers?
LEARNING
LINK
The need to ensure
adequate provision
of public goods is
discussed in
Chapter 5.
Test yourself 11.11
How would you decide
whether an item of
government spending
is a demand-side fiscal
policy or a supply-side
policy?
Adult education is also important. When the structure of the economy is changing,
retraining must be made available to enable workers to move easily between sectors
and occupations. This is crucial if structural unemployment is not to become a major
problem. For any society, education and skills are necessary to enable workers to
switch into new activities in response to structural changes in the economy. For
example, workers displaced from manufacturing industry are likely to need retraining
if they are to find jobs in the service sector. Workers released from agriculture in a
less developed country will need training before they can become productive members
of the industrial workforce.
The market may not deliver the training that is necessary, as firms will not invest in
training workers unless they can be sure that they will not be poached by competitors once
they have completed their training. The government may thus need to provide incentives.
Such intervention by government can improve the flexibility of the labour market, by
enabling workers to move more readily between jobs – or even occupations. Education
and training also have a direct impact on the productivity of workers, which can
improve productive efficiency.
11
11 Macroeconomic policy
Test yourself 11.10
mean that all education has to be geared directly to providing skills. For example,
problem-solving and analytical skills can be developed through the study of a wide
range of disciplines.
Infrastructure
An important area of government expenditure relates to the provision of infrastructure.
Firms need efficient transport and communication networks, and other types of
infrastructure that enable markets to operate effectively. The public goods aspects of
infrastructure means that they will not be adequately provided by the free-market
mechanism, so government intervention is needed.
The objective of investing in infrastructure is to improve future productive efficiency,
which again should have the effect of shifting long-run aggregate supply to the right.
However, a word of caution is needed. Government undertakes expenditure for a wide
variety of reasons. This means that it is important to set priorities in the allocation
of funds.
EXERCISE 11.3
Discuss the relative merits of government spending on improving the
country’s road network as compared to increasing spending on the provision of
healthcare.
Subsidies
One of the hindrances to structural change in the economy has been that declining
sectors of activity have not always been located in the same regions as the
expanding sectors, making it difficult for displaced workers to gain employment in
the newly growing industries. In England, this led to a north–south divide, with
industries in the north in decline, and the growth areas being in the south.
This phenomenon is not unique to the UK economy, and across Europe there are
substantial differences in unemployment rates. One way in which this can be tackled is
through the use of subsidies. For example, firms that agree to set up their operations in
disadvantaged regions could be offered incentives in the form of investment subsidies.
The UK has operated such subsidies in the past, and the European Commission has also
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provided assistance to regions with high unemployment rates. Indeed, regions such as
Wales in the UK benefited from such subsidies.
11
By giving subsidies in this way, the hope is to influence aggregate supply. However, it
must be remembered that subsidies need to be financed somehow, and the danger is
that by providing subsidies to encourage investment in some areas, there will be less
investment elsewhere.
AS LEVEL PART 5 GOVERNMENT MACROECONOMIC INTERVENTION
Information gaps are a form of market failure. One area in which this may be a
problem is in the labour market, where workers may not have adequate information
about job opportunities – especially in other regions of the economy. By providing
information about job vacancies, the authorities may be able to encourage
mobility of workers, thus improving the way in which the labour market operates.
Subsidies for key workers in regions where housing and transport costs are high
may also be a useful interventionist strategy to encourage labour mobility.
Research and development
One of the most important influences on economic growth is technological change. As
technology improves over time, production becomes potentially more efficient. One way
of achieving technological progress is through research and development (R&D). In spite
of its universities and research institutes, the UK has not devoted as much funding to
R&D as some other advanced countries. You can see something of this in Figure 11.8,
which shows the percentage of GDP devoted to R&D in a range of countries.
Korea
Sweden
Japan
Germany
USA
Belgium
France
China
Norway
EU
UK
Italy
Poland
Greece
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
% of GDP
Source: based on data from OECD
▲ Figure 11.8 R&D expenditure, 2018 (% of GDP)
This may be an area in which the UK could do more if it could find a way of encouraging
more R&D. This could be achieved through direct government funding, or by tax relief on
R&D expenditure. However, again it may be important to bear in mind the opportunity
cost of supporting R&D relative to other areas of government spending.
LEARNING
LINK
Labour markets and
their operation are
discussed in
Chapter 23.
Improved labour market flexibility
An important supply-side approach is to find ways of improving the flexibility of the
labour market. Where labour markets are flexible, the structure of economic activity
can more readily be adjusted to changing patterns of global demand. If declining lowproductivity sectors can give way to more dynamic activities where productivity is
higher, then productive efficiency improves, and this will lead to a rightward shift in
the long-run aggregate supply curve.
One possibility is to limit the power of the trade unions, whose actions can sometimes
lead to inflexibility, either through resistance to new working practices that could
improve productivity or by pushing up wages so that the level of employment is reduced.
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It has also been argued that abolishing the minimum wage would improve flexibility.
However, this must be balanced against the need to protect low-paid workers.
Maintaining the flexibility of markets is one way in which the macroeconomic stability
promoted by disciplined fiscal and monetary policy can improve aggregate supply.
Macroeconomic stability enables price signals to work more effectively, as producers are
better able to observe changes in relative prices. This can promote allocative efficiency.
11
Reforms of the tax and benefit system
There are dangers in having a taxation system that is too progressive. Most people
accept that income tax should be progressive, as a way of redistributing income within
society and preventing inequality from becoming extreme. However, there may come
a point at which marginal tax rates are so high that a large proportion of additional
income is taxed away, reducing incentives for individuals to supply additional effort
or labour. This could also have an effect on aggregate supply. Again, however, it is
important to balance these incentive effects against the distortion caused by having
too much inequality in society.
11 Macroeconomic policy
Incentive effects are important in economic analysis. In this context, questions have
been raised about the extent to which the tax system provides appropriate incentives
to supply work effort.
An important influence on labour supply, particularly for low-income workers, is the
level of unemployment benefit. If unemployment benefit is provided at too high a
level, it may inhibit labour force participation, in that some workers may opt to live
on unemployment benefit rather than take up low-skilled (and low-paid) employment.
In such a situation, a reduction in unemployment benefit may induce an increase in
labour supply, which again will move the aggregate supply curve to the right.
Such a policy needs to be balanced against the need to provide protection for those
who are unable to find employment. It is also important that unemployment benefit is
not reduced to such a level that workers are unwilling to leave their jobs to search for
better ones, as this may inhibit the flexibility of the labour market.
Supply-side policies and the AD/AS model
If you look back at Figure 8.2 on page 115, you can see how an increase in long-run
aggregate supply can be viewed in the AD/AS model. An increase in the productivity of
factor inputs leads to a higher potential capacity level of real GDP. In the figure, the
LRAS curve shifts to the right from YFE0 to YFE1. There is a movement down along the
aggregate demand curve as the economy moves to a new equilibrium, with a lower
overall price level and higher real GDP. Associated with this higher level of real GDP,
there is higher employment.
SUMMARY: SUPPLY-SIDE POLICIES
» Supply-side policies are measures intended to
have a direct impact on long-run aggregate supply.
» The position of the LRAS curve depends on
the quantity of factor inputs available and the
effectiveness with which inputs are used.
» Education and training can enable workers to
become more productive.
» Improving the social infrastructure (such as
efficient transport and communication networks)
can improve firms’ efficiency.
» Subsidies can be used to influence aggregate
supply by reducing regional variations in
unemployment and capital availability.
» Research and development helps firms to become
more efficient through the development of new
technologies.
» Improving the flexibility of labour markets can
influence long-run aggregate supply.
» The structure of taxes and benefits needs to be
carefully defined to offer protection to low-income
households without damaging their incentives to
accept jobs.
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END OF CHAPTER QUESTIONS
AS LEVEL PART 5 GOVERNMENT MACROECONOMIC INTERVENTION
11
Multiple choice
1 The marginal rate of taxation under a progressive tax system:
A is higher for the first tax bracket than for the last one
B increases as income increases
C is considered less equitable than a flat tax rate
D only applies to income earned within the highest tax bracket applicable
2 Which supply-side policy is correctly matched with the objective it aims to achieve?
Supply-side policy
Objective
A
Privatisation
Lower the general price level
B
Deregulation
Attain economies of scale
C
Vocational training
Protect declining industries
D
Reduce the power of trade unions
Increase labour market flexibility
Data response
1 Read the following extract and then answer the questions that follow.
Macroeconomic policy in New Zealand
5
The fiscal strategy of the government of New Zealand is to ensure a progressive
taxation system that is fair, balanced, and promotes the long-term sustainability
and productivity of the economy. Through this strategy in 2019, the government
of New Zealand delivered a budget surplus of NZ$7.5bn, up NZ$2bn on the
previous year and very different from the NZ$1.2bn deficit recorded in 2014.
‘This allows the government to spend more on infrastructure and make
record investments in health and education,’ the finance minister said. He
claimed this was already under way following a NZ$10bn infrastructure spend
in the 2018 budget. The national debt was also better than expected at 19.2%
10 of GDP, below the government’s self-imposed target.
In New Zealand, monetary policy is comprised of the actions taken by the Reserve
Bank of New Zealand (RBNZ) to influence the Official Cash Rate (OCR), which
is the interest rate for overnight transactions between banks. Through that
mechanism, the RBNZ changes monetary policy to meet its goals of price stability
15 while avoiding undue volatility in the economy and the exchange rate. This
process is illustrated in Figure 11.9.
1 OCR
2 Interest rates
Exchange rate
3 Economic
activity
Inflation
expectations
4 CPI
inflation
Trading partner
inflation
Source: RBNZ
▲ Figure 11.9 Monetary policy process in New Zealand
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In 2019, the RBNZ cut the OCR to a record low of 1% to give the economy a
boost. It has also said that it would like increased spending by the government
to raise aggregate demand.
11
20 In practice the linkages in Figure 11.9 take varying lengths of time to influence
The World Bank’s ‘Doing Business’ project looks at domestic firms and measures
the local regulations applied to them. By analysing data to compare business
regulation across economies, the relative ‘ease of doing business’ can be
30 calculated. Supplier-friendly regulations implemented over a number of years
in New Zealand have led to increasing productivity and increasing productive
capacity. The outcome was that in 2018 and again in 2019, New Zealand was placed
first out of 190 economies in the World Bank’s ‘ease of doing business’ rankings.
11 Macroeconomic policy
behaviour. Interest rate changes typically take 1 to 2 years to achieve their
full impact on economic activity and inflation. So, the RBNZ has to look ahead
in formulating monetary policy, often based on forecasts and judgement.
Moreover, recent historically low interest rates have meant the RBNZ and
25 many other central banks have turned to ‘alternative’ monetary policies to
expand their economies.
a Explain what is meant by ‘progressive taxation’ (line 1).
b Explain the likely effect of the change in the fiscal balance between 2014
and 2019 on the national debt of New Zealand.
c ‘…recent historically low interest rates have meant the RBNZ and many
other central banks have turned to “alternative” monetary policies to
expand their economies’ (lines 24–26). Explain the need for and the
operation of one ‘alternative’ monetary policy.
d Explain, using the information provided, one supply-side reason why
New Zealand has experienced ‘increasing productivity and increasing
productive capacity’ (lines 31–32).
e Explain, with reference to Figure 11.9, how an increase in interest rates can
lead to a decrease in the consumer price index (CPI).
Essay style
2 a C
ompare the causes of an increase in a government’s budget surplus with the
cause of an increase in the country’s national debt and consider whether an
increase in the budget surplus will always lead to a reduction in the national debt.
b Evaluate the extent to which fiscal policy focused on reduced taxation will
move an economy toward its full-employment output level.
CASE STUDY
Macroeconomic policy instruments
Governments in a modern economy have three main types of policy instrument
for affecting the macroeconomy – monetary policy, fiscal policy and supply-side
policy. Monetary policy is dedicated to ensuring the stability of the economy
by influencing aggregate demand. Fiscal policy is used to influence aggregate
demand and to maintain balance in the economy between public and private
sectors and between present and future generations of citizens. Supply-side
policies are dedicated to affecting the productive capacity of the economy,
operating primarily through microeconomic incentives.
Follow-up question
Explain these distinctions between the types of policy instrument. Discuss the roles
of each type of policy in meeting the government’s macroeconomic objectives.
Go online at hoddereducation.com/cambridgeextras for another case study for
Chapter 11.
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AS LEVEL PART 6 International economic issues
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
12
International trade and
protectionism
What this chapter covers
★ the distinction between absolute and comparative
advantage
★ the economic arguments in favour of
specialisation and free trade
★ the significance of the terms of trade
★ the limitations of the theories of absolute and
comparative advantage
★ the meaning of protectionism in international
trade
★ the tools of protectionism
★ evaluation of protectionism as a trade strategy
International trade between countries is a well-established feature of the global
economy. Economics can help to explain why international trade can be beneficial
to the countries that engage in it. However, individual countries sometimes try
to intervene to restrict trade in order to protect their domestic markets. These
arguments are explained and evaluated in this chapter.
12.1 The reasons for international trade
Trade between countries has become part of the global landscape, and enables
consumers in a country to have an expanded range of choice of products. Consumers
in the UK may like to buy mangoes, but these can only be obtained from abroad, as
they cannot be grown in the UK. On the other hand, the UK may have expertise in
professional services or infrastructure design and planning that a country such as
Pakistan might be less fitted to produce.
The central importance of international trade for growth and development has
been recognised since the days of Adam Smith and David Ricardo. For example,
during the Industrial Revolution a key factor was that Britain could bring in raw
materials from its colonies for use in manufacturing activity. Today, consumers in
the UK are able to buy and consume many goods that simply could not be produced
within the domestic economy. In the twenty-first century most, if not all, countries
engage in international trade to some extent. From the point of view of economic
analysis, Ricardo showed that countries could gain from trade through a process of
specialisation.
Absolute and comparative advantage
The notion of specialisation was briefly introduced in Chapter 1, where it was pointed
out that the division of labour could enable efficiency gains. This analysis can now be
extended to demonstrate the potential gains to be made from specialisation and trade.
Consider a simple example. Ali and Ayesha supplement their incomes by making pots
and bracelets to sell at a local market. Depending on how they divide their time, they
can make differing combinations of these goods; some of the possibilities are shown
in Table 12.1.
Notice that Ayesha is much better at both activities than Ali. If they each devote all
their time to producing pots, Ali produces only 12 to Ayesha’s 18. If they each produce
only bracelets, Ali produces 12 and Ayesha 36.
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▼ Table 12.1 Ali and Ayesha’s production
Ali
comparative advantage:
the ability to produce
a good relatively more
efficiently (i.e. at lower
opportunity cost)
law of comparative
advantage: a theory
arguing that there
may be gains from
trade arising when
countries (or individuals)
specialise in the
production of goods or
services in which they
have a comparative
advantage
Test yourself 12.1
Is the presence of
absolute advantage
sufficient to ensure that
there are potential gains
from specialisation and
trade?
Bracelets
Pots
Bracelets
12
0
18
0
9
3
12
12
6
6
6
24
3
9
3
30
0
12
0
36
This illustrates absolute advantage. Ayesha is simply better than Ali at both
activities. Another way of looking at this is that, in order to produce a given quantity
of a good, Ayesha needs less labour time than Ali.
There is another significant feature of this table. Although Ayesha is better at producing
both goods, the difference is much more marked in the case of bracelet production than
for pot production. So Ayesha is relatively more proficient in bracelet production: in
other words, she has a comparative advantage in making bracelets. This is reflected in
differences in opportunity cost. If Ayesha switches from producing pots to producing
bracelets, she gives up 6 pots for every 12 additional bracelets that she makes. The
opportunity cost of an additional bracelet is thus 6/12 = 0.5 pots. For Ali, there is a oneto-one trade-off between the two, so his opportunity cost of a bracelet is 1 pot.
12
More interesting is what happens if the same calculation is made for Ali and pot
making. Although Ayesha is absolutely better at making pots, if Ali increases his
production of pots, his opportunity cost in terms of bracelets is still 1. But for Ayesha
the opportunity cost of making pots in terms of bracelets is 12/6 = 2, so Ali has the
lower opportunity cost. Although Ayesha has an absolute advantage in pot making, Ali
has a comparative advantage. It is this difference in comparative advantage that gives
rise to the gains from specialisation.
The law of comparative advantage states that overall output can be increased if all
individuals specialise in producing the goods in which they have a comparative advantage.
Gains from international trade
This same principle can be applied in the context of international trade. Suppose there are
two countries – call them Overthere and Elsewhere. Each country can produce combinations
of agricultural goods and manufactures. However, Overthere has a comparative advantage
in producing manufactured goods, and Elsewhere has a comparative advantage in
agricultural goods. Their respective PPCs are shown in Figure 12.1.
Manufactures
absolute advantage: the
ability to produce a good
more efficiently (e.g.
with less labour)
Pots
12 International trade and protectionism
KEY TERMS
Ayesha
70
60
50
Trading
possibilities
curve
40
30
PPC for
Elsewhere
20
10
PPC for
Overthere
0
0
20
40
60
80
Agricultural goods
▲ Figure 12.1 Trading possibilities for Overthere and Elsewhere
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The pattern of comparative advantage held by the two countries is reflected in the
different slopes of the countries’ PPCs. In the absence of trade, each country is
constrained to consume along its PPC. For example, if Elsewhere wants to consume 20
units of manufactures, it can consume a maximum of 20 units of agricultural goods.
12
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
KEY TERM
trading possibilities
curve: shows
the consumption
possibilities under
conditions of free trade
However, suppose that each country were to specialise in producing the product
in which it has a comparative advantage. Overthere could produce 60 units of
manufactures and Elsewhere could produce 60 units of agricultural goods. If each
country were to specialise completely in this way, and if trade were to take place
on a one-to-one basis (i.e. if one unit of manufactures is exchanged for one unit
of agricultural goods), then it can be seen that this expands the consumption
possibilities for both countries. The trading possibilities curve in Figure 12.1 shows
the potential consumption points for each country in this situation.
QUANTITATIVE SKILLS 12.1
Calculating opportunity cost ratios
The key to comparative advantage is the difference in the opportunity costs
faced by each country in the production of these goods. This can be calculated
using Figure 12.1. First, notice that if Overthere chooses to increase output of
agricultural goods by 10 units, it must sacrifice 20 units of manufactures, so
the opportunity cost ratio is 2:1, meaning that for every unit of extra agricultural
goods it must sacrifice 2 units of manufactures. However, for Elsewhere 10 units
of manufactures are sacrificed if 10 more units of agricultural goods are to be
produced, so the opportunity cost ratio is 1:1. Similarly, the opportunity cost ratios
for manufactured goods are 0.5 for Overthere and 1 for Elsewhere.
For example, if Elsewhere still wishes to consume 20 units of manufactures, with
specialisation it could produce 60 units of agricultural goods, and exchange 20 units
of them for 20 units of manufactures. It would then have its 20 units of manufactures,
but have more agricultural goods than without trade. In this particular exchange,
Overthere would now have 40 units of manufactures and 20 units of agricultural
goods, and would also be better off than without trade.
Test yourself 12.2
Country A’s opportunity
cost ratio for good X
relative to good Y is 3:1,
compared with a ratio
of 2:1 for country B.
Which country should
specialise in producing
good X?
It can be seen that in this situation trade may be mutually beneficial. Notice that this
particular result of trading has assumed that the countries exchange the goods on a
one-to-one basis. Although this makes both better off, it is not the only possibility. It
is possible that exchange will take place at different prices for the goods, although it
will only be mutually beneficial if the rate of exchange lies between the opportunity
cost ratios of the two countries. The prices at which exchange takes place will
determine which of the countries gains more from the trade that occurs.
In the above example, specialisation and trade are seen to lead to higher overall
production of goods. Although the examples have related to goods, you should be
equally aware that services too may be a source of specialisation and trade.
Who gains from international trade?
KEY TERM
trade liberalisation:
a process of moving
towards freer trade by
removing restrictions
on trade
Specialisation can result in an overall increase in total production. However, one of
the fundamental questions of economics introduced in Chapter 1 is ‘for whom?’ So far
nothing has been said about which of the countries will gain from trade. It is possible
that exchange can take place between countries in such a way that both countries are
better off. But whether this will actually happen in practice depends on the prices at
which exchange takes place.
There have been many advocates of free trade, or at least of reducing restrictions on
trade (a process known as trade liberalisation), but equally there have been many
people who have resisted freeing up trade between countries. The World Bank has
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Figure 12.2 shows production possibility curves for two countries, each of which
produces both coats and scooters. The countries are called ‘Here’ and ‘There’.
450
400
350
300
250
200
150
100
50
Here’s PPC
There’s PPC
0
0
200
400
600
800
1,000
Coats
▲ Figure 12.2 Coats and scooters
LEARNING
LINK
The role of the
World Bank (and the
International Monetary
Fund) is discussed in
Chapter 31.
12
a Suppose that Here produces 200 scooters and There produces 100: how
many coats are produced in each country?
b Now suppose that 300 scooters and 200 coats are produced by Here, and
that There produces only coats. What has happened to the total production of
coats and scooters?
12 International trade and protectionism
Don’t forget the
three fundamental
questions of
economics that
were introduced in
Chapter 1: what, how
and for whom. They
underpin economic
analysis.
EXERCISE 12.1
Scooters
LEARNING
LINK
been among those who have been in favour of liberalising trade, and have
recommended this strategy to less developed countries as a way of achieving
economic growth and development.
However, specialisation may bring dangers and risks, as well as benefits. One obvious
way in which this may be relevant is that, by specialising, a country allows some
sectors to run down. For example, suppose a country came to rely on imported food,
and allowed its agricultural sector to waste away. If the country then became involved
in a war, or for some other reason was unable to import its food, there would clearly
be serious consequences if it could no longer grow its own foodstuffs. For this reason,
many countries have in place measures designed to protect their agricultural sectors –
or other sectors that are seen to be strategic in nature. This argument was key in the
establishment of the Common Agricultural Policy in Europe.
Overreliance on some commodities may also be risky. For example, the development
of artificial substitutes for rubber had an enormous impact on the demand for natural
rubber; this was reflected in falls in its price and caused difficulties for countries such
as Malaysia that had specialised in producing rubber.
▲ Rubber tapping in
Malaysia – a fall in prices
caused problems for
countries that specialise
in producing rubber
KEY TERM
terms of trade: the
ratio of export prices to
import prices
Exports, imports and the terms of trade
When a country engages in international trade, it sells goods and services to buyers
abroad and buys goods and services from overseas. In other words, the country
exports goods and services in order to purchase imports of goods and services. The
question of who gains from such trading depends not only on the volume of goods
and services exported and imported, but also on the prices of these goods and
services.
A key factor that determines which of the countries will gain from trade – and whether
trade will take place at all – is the relative prices at which trade takes place, known as
the terms of trade. In practice, the relative prices are set in world markets, although
it is possible that for some commodities there are countries large enough to influence
prices. The terms of trade are defined as the ratio of export prices to import prices.
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QUANTITATIVE SKILLS 12.2
12
Calculating and interpreting the terms of trade
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
Export and import prices are expressed as index numbers, based on a
particular year. Suppose we want to know how the terms of trade for a country
have changed in October 2019 relative to 2000. This can be done using the data
in Table 12.2, which shows price indexes for exports and imports based on 2011
= 100.
▼ Table 12.2 The terms of trade
STUDY TIP
When interpreting the
terms of trade index,
be aware that an
increase in the index
means that the terms
of trade have become
more favourable, and
if they fall, the terms of
trade have worsened.
STUDY TIP
Price index of exports
Price index of imports
2000
72.1
74.4
October 2019
94.8
95.7
First calculate the price index number for October 2019 based on 2000 = 100.
The rebased price index for exports is 100 × 94.8/72.1 = 131.5. For the price of
imports, the index is 128.6 (check this calculation to make sure you understand
how to do it). These calculations show that prices of both exported and imported
goods have risen over the period.
The terms of trade represent the relative price change over the period, so for
October 2019 we calculate the ratio of the price of exports to the price of
imports. This is normally expressed as a percentage (i.e. as an index number),
so the calculation is 100 × 131.5/128.6 = 102.3. The terms of trade increased by
2.3% between 2000 and October 2019. This indicates that the same volume of
exports will purchase a greater volume of imports than in 2000.
Notice that when the prices of both exports and imports are changing, it is their
relative movement that determines what happens to the terms of trade. For example,
if both export and import prices rise, but export prices rise proportionately more, the
terms of trade will improve.
A fall in the terms of trade indicates that the same volume of exports will purchase a
smaller volume of imports than before. A downward movement in the terms of trade is thus
unfavourable for an economy. Figure 12.3 shows the terms of trade for selected countries
since 2000. You can see from this that different countries can experience changes in the
terms of trade in very different ways in the same period of time. This depends strongly on
the pattern of a country’s exports and imports. For the countries shown, Zambia’s exports
are dominated by copper, so copper prices have a strong influence on the terms of trade.
You can see that for Pakistan and Nepal, the terms of trade fell through much of the
period. Sri Lanka showed relatively little variation.
Index
Be careful to avoid
confusing the terms of
trade (relative export
and import prices) with
the balance of trade (the
difference between the
volume of exports and
imports).
Date
250
New Zealand
Zambia
Pakistan
Sri Lanka
Nepal
200
150
100
50
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
0
Source: based on data from World Development Indicators
▲ Figure 12.3 The terms of trade in selected countries, 2000–18 (2000 = 100)
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Test yourself 12.3
If the export prices for
a country increase by
15% over a given period,
but import prices rise
by 20%, have the terms
of trade improved or
deteriorated?
income terms of
trade: the value of
a country’s exports
divided by the price of
its imports: measures
the purchasing power
of a country’s exports
in terms of the price of
its imports
LEARNING
LINK
The identity and
characteristics of less
developed countries
(LDCs) are explored
in Chapter 30.
The terms of trade described above are known as the net barter terms of trade. As
noted, the net barter terms of trade relate only to the relative prices of exports and
imports, so do not take into account changes in the volume of exports and imports.
The income terms of trade take the volume of trade into account, being defined as
the value of a country’s exports divided by the price of imports. In other words, this
measures the purchasing power of a country’s exports in terms of the price of its
imports: a rise in the value of exports can more than offset an increase in the price of
imports. It is possible for all countries to experience an increase in the income terms
of trade simultaneously.
Suppose that both export and import prices are rising through time, but import prices
are rising more rapidly than export prices. This means that the ratio of export to
import prices will fall – which in turn means that a country must export a greater
volume of its goods in order to acquire the same volume of imports. In other words, a
fall in the terms of trade makes a country worse off.
Concerns have been raised about the effect of changes in the terms of trade for less
developed countries (LDCs). One problem faced by LDCs that export primary products
is that they are each too small as individual exporters to be able to influence the
world price of their products. In other words, the problem for LDCs is that they have
little market power in world markets, so they cannot influence the terms of trade that
they face in their international transactions. They must accept the prices that are set
in world commodity markets.
12
12 International trade and protectionism
KEY TERM
The terms of trade are calculated purely with respect to prices, and take no account of
changing volumes of trade. In other words, a deterioration in the terms of trade does
not necessarily mean that an economy is worse off, so long as the volume of trade is
increasing sufficiently rapidly.
The terms of trade change over time as the prices of exports and imports change.
Economic analysis suggests that there are reasons to expect the terms of trade to be
volatile in the short run, and to follow trends in the longer run. Neither of these may
prove favourable for many LDCs.
EXERCISE 12.2
In 2018, the terms of trade index for United Arab
Emirates was 165.6 (based on 2000 = 100). For
Bangladesh it was 62.2, and for the USA it was 99.8.
Explain what is implied by these statistics.
Limitations of the theory of absolute and comparative
advantage
The theory of absolute and comparative advantage seems to provide clear messages
to countries that there are potential gains to be made from specialising in products
in which a country has a comparative advantage, and engaging in international trade.
But can a country be sure that these potential gains can be realised in practice? And
how does a country identify the goods or services in which it should specialise?
Two Swedish economists, Eli Heckscher and Bertil Ohlin, argued that a country’s
comparative advantage would depend crucially on its relative endowments of factors
of production. They argued that the optimal techniques for producing different
commodities varied. Some commodities are most efficiently produced using labourintensive techniques, whereas others could be more efficiently produced using
relatively capital-intensive methods. This suggests that if a country has abundant
labour but scarce capital, then its natural comparative advantage would lie in the
production of goods that require little capital but lots of labour. In contrast, a
country with access to capital but facing a labour shortage would tend to have a
comparative advantage in capital-intensive goods or services.
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Under these arguments, it would seem to make sense for LDCs to specialise in labouror land-intensive activities such as agriculture or other primary production. More
economically developed countries could specialise in more capital-intensive activities
such as manufacturing activity or financial services. By and large, this describes the
way in which the pattern of world trade developed. However, some limitations of this
approach have become apparent over time. In particular, the strategy that LDCs should
specialise in primary production has come under criticism because of problems that
arose in the short run and in the long run.
12
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
Short-run volatility
Price
In the case of agricultural goods, demand tends to be relatively stable over time,
but supply can be volatile, varying with weather and climatic conditions from season
to season. Figure 12.4 shows a typical market in two periods. In period 1 the global
harvest of this commodity is poor, with supply given by S1: equilibrium is achieved
with price at P1 and quantity traded at Q1. In period 2 the global harvest is high at S2,
so that prices plummet to P2 and quantity traded rises to Q2.
S1
S2
P1
P2
Demand
0
Q1
Q2
Quantity
▲ Figure 12.4 Volatility in supply
Notice that in this case the movement of prices is relatively strong compared with the
variation in quantity. This reflects the price elasticity of demand, which is expected
to be relatively inelastic for many primary products. From the consumers’ point of
view, the demand for foodstuffs and other agricultural goods will tend to be inelastic,
as demand will not be expected to respond strongly to changes in prices.
For many minerals and raw materials, however, the picture is different. For such
commodities, supply tends to be stable over time, but demand fluctuates with the
economic cycle in economically developed countries, which are the importers of raw
materials. Figure 12.5 illustrates this. At the trough of the economic cycle, demand
is low, at D1, and so the equilibrium price will also be low, at P1. At the peak of the
cycle, demand is more buoyant, at D2, and price is relatively high, at P2.
STUDY TIP
Notice that export
earnings in the
face of volatility in
prices depend on the
elasticity of demand
for exports as well as
their price.
From an individual country’s point of view, the result is the same: the country faces
volatility in the prices of its exports. From this perspective it does not matter whether
the instability arises from the supply side of the market or from the demand side. The
problem is that prices can rise and fall quite independently of conditions within the
domestic economy.
Instability of prices also means instability of export revenues, so if the country is
relying on export earnings to fund its development path, to import capital equipment
or to meet its debt repayments, such volatility in earnings can constitute a severe
problem: for example, if export earnings fall such that a country is unable to meet its
commitments to repaying debt.
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Price
Supply
12
P2
D1
0
D2
Q2
Q1
Quantity
▲ Figure 12.5 Volatility in demand
Long-run deterioration
The nature of the demand for primary products may be expected to influence the
long-run path of relative prices. In particular, the income elasticity of demand
is an important consideration. As real incomes rise in the high-income countries,
the demand for agricultural goods can be expected to rise relatively slowly.
Ernst Engel pointed out that at relatively high income levels, the proportion of
expenditure devoted to foodstuffs tends to fall and the demand for luxury goods
rises. This suggests that the demand for agricultural goods shifts relatively slowly
through time.
12 International trade and protectionism
P1
In the case of raw materials, there have been advances in the development of artificial
substitutes for many commodities used in manufacturing. Furthermore, technology has
changed over time, improving the efficiency with which inputs can be converted into
outputs. This has weakened the demand for raw materials produced by LDCs.
Price
Furthermore, if some LDCs are successful in boosting output of these goods, there
will be an increase in supply over time. Figure 12.6 shows the result of such an
increase. Suppose that the market begins with demand at D0 and supply at S0. Market
equilibrium results in a price of P0 and quantity of Q0. As time goes by, demand moves
to the right a little to D1, and supply shifts to S1. The result is a fall in the price of the
commodity to P1.
S0
S1
P0
P1
D0
0
Q0
Q1
D1
Quantity
▲ Figure 12.6 Long-term movements of demand and supply
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It is clear that, not only may LDCs experience short-run volatility in prices, but the
terms of trade may also deteriorate in the long run.
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
12
In the light of these twin problems, it is perhaps no surprise that many LDCs see
themselves as trapped by their pattern of comparative advantage, rather than being in
a position to exploit it. They are therefore reluctant to continue in such a state of
dependency on (non-fuel) primary products, but the process of diversification into a
wide range of products has been difficult to achieve.
Test yourself 12.4
Explain why a long-run
deterioration in the
terms of trade for
primary products is a
problem for many less
developed countries.
A potential change in this pattern was seen in 2007 and 2008, with food prices
rising rapidly. This included the prices of some staple commodities such as maize
and rice. The net effect of this on LDCs was not clear. Countries in a position
to export these commodities would benefit from the rise in prices – that is, an
increase in their terms of trade. However, there are many LDCs that need to import
these staple commodities and for them the terms of trade deteriorated. These
trends were interrupted by the onset of recession in many high-income countries
in 2008.
The balance of market power
LEARNING
LINK
The relationships
between countries
at different levels of
development are
explored in Chapter 31.
Further problems faced by LDCs looking to increase their involvement in international
trade are that they lack experience of trading in global markets, and are likely to find
themselves having to compete with producers in high-income economies that are able
to exert significant market power. This may mean that the gains from trade are more
likely to go to the high-income economies, rather than to the LDCs.
Taking these arguments together, it would seem that countries may not always be well
advised to follow their natural pattern of comparative advantage too closely. This in
turn suggests that there may be potential for countries to seek to alter the pattern
of their comparative advantage by diversifying their economies and developing new
specialisms in the face of changing patterns of global consumer demand. This is not an
easy path for an economy to travel, and it may be tempting to turn instead to a more
inward-looking protectionist strategy.
The Covid-19 pandemic affected countries all around the world, and interrupted the
flow of international trade, with consequences that have yet to be fully understood.
SUMMARY: THE REASONS FOR INTERNATIONAL TRADE
» The theory of absolute and comparative advantage
»
»
»
»
suggests that a country can potentially gain
from specialising in production and engaging in
international trade.
Absolute advantage reflects the ability to produce
a good more efficiently than another individual,
firm or country.
Comparative advantage is the ability to produce a
good relatively more efficiently (that is, at a lower
opportunity cost).
The trading possibilities curve shows the
consumption possibilities under conditions of free
trade.
The potential gains from trade depend on the
terms of trade, which influence how the gains
from trade are distributed between the trading
partners.
» The terms of trade can be defined in terms of the
ratio of export prices to import prices.
» The nature of comparative advantage varies
between countries according to the relative
availability of factors of production.
» This could be taken to suggest that a less
developed country (LDC) should specialise in
primary production, given the relative abundance
of labour and land compared to capital.
» However, prices of primary goods tend to be
volatile in the short run, and may experience a fall
relative to manufactured products over the long
term.
» In addition, LDCs may be at a disadvantage in
entering global markets because of the greater
experience and market power of high-income
countries.
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12.2 Protectionism
KEY TERMS
protectionism:
measures taken by
a country to restrict
international trade
tariff: a tax imposed on
imported goods
In spite of these potential gains from trade, countries have often seemed reluctant
to open their economies fully to international trade, and have tended to intervene
in various ways to protect their domestic producers: a process known as
protectionism.
Forms of protectionism
When recession began to threaten in 2008, there was strong lobbying in several
countries, including the USA, in favour of introducing protectionist measures.
Indeed, in the lead-up to the G20 Summit in April 2009, the World Bank reported
that the 17 members of that group had taken a total of 47 trade-restricting steps
in the previous months. However, the drive towards globalisation has created a
more integrated global economy, in which many firms rely on a global supply chain.
With the production process fragmented between different parts of the world,
the dangers of protectionism become more severe, and the possibilities of rapid
contagion from a crisis become acute.
12
12 International trade and protectionism
Comparative advantage is just one of many reasons for countries to engage in
international trade. Trade enables consumers in a country to have access to products
that could not be produced at home, and enables producers to have access to new
markets and resources. In some cases it allows producers to take advantage of
economies of scale that would not be possible if they had to rely only on selling
to the domestic market. From the country’s perspective, export-led growth may be
possible, and there are countries such as China and other countries in Southeast
Asia that have benefited from this. It is also possible that exposure to competition
from foreign firms provides a good incentive for domestic firms to become more
efficient, raising the quality of their goods or the efficiency with which they
are produced. Consumers may then gain from wider variety of available products,
improved quality and lower prices.
Tariffs
A policy instrument commonly used in the past to give protection to domestic
producers is the imposition of a tariff. Tariff rates have been considerably reduced in
the period since the Second World War, but nonetheless are still in place.
Figure 12.7 shows how a tariff is expected to operate. D represents the domestic
demand for a commodity, and Sdom shows how much domestic producers are
prepared to supply at any given price. The price at which the good can be
imported from world markets is given by Pw. If dealing with a global market, it is
reasonable to assume that the supply at the world price is perfectly elastic. So,
in the absence of a tariff, domestic demand is given by D0, of which S0 is supplied
within the domestic economy and the remainder (D0 − S0) is imported. If the
government wishes to protect this industry within the domestic economy, it needs
to find a way of restricting imports and encouraging home producers to expand
their capacity.
By imposing a tariff, the domestic price rises to Pw + T, where T is the amount of the
tariff. This has two key effects. One is to reduce the demand for the good from D0 to
D1; the second is to encourage domestic producers to expand their output of this good
from S0 to S1. As a consequence, imports fall substantially to (D1 − S1). On the face of
it, the policy has achieved its objective. Furthermore, the government has been able
to raise some tax revenue (given by the green rectangle).
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Price
12
Sdom
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
Pw + T
Pw
D
0
S0
S1
D1
D0
Quantity
▲ Figure 12.7 The effects of a tariff
Test yourself 12.5
Identify the ways
in which consumer
surplus is reduced
following the imposition
of a tariff.
LEARNING
LINK
Notice that the notions
of consumer and
producer surplus turn
up again here. These
were explained in
Chapter 4.
Test yourself 12.6
However, not all the effects of the tariff are favourable for the economy. Consumers
are certainly worse off, as they have to pay a higher price for the good; they therefore
consume less, and there is a loss of consumer surplus. Some of what was formerly
consumer surplus has been redistributed to others in society. The government has
gained the tariff revenue, as mentioned. In addition, producers gain some additional
producer surplus, shown by the dark-blue area. There is also a welfare loss to society,
represented by the red and pale-blue triangles. In other words, overall society is worse
off as a result of the imposition of the tariff.
Effectively, the government is subsidising inefficient local producers, and forcing domestic
consumers to pay a price that is above that of similar goods imported from abroad.
Some would defend this policy on the grounds that it allows the country to protect an
industry, thus saving jobs that would otherwise be lost. However, this involves sacrificing
the benefits of specialisation. In the longer term it may delay structural change. For an
economy to develop new specialisations there needs to be a transitional process in which
old industries contract and new ones emerge. Although this process may be painful, it
is necessary in the long run if the economy is to remain competitive. Furthermore, the
protection that firms enjoy that allows them to reap extra producer surplus from the
tariff may foster complacency and an inward-looking attitude. This complacency is likely
to lead to inefficiency, and an inability to compete in the global market.
Even worse is the situation that develops where nations respond to tariffs raised by
competitors by putting up tariffs of their own. This has the effect of further reducing
the trade between countries, and everyone ends up worse off, as the gains from trade
and specialisation are sacrificed.
How would the
effectiveness of a tariff
be affected if domestic
supply were highly
inelastic?
President Trump’s decision to extend the tariffs on steel to Canada, the EU and Mexico
in 2018 brought an immediate response from those countries, threatening a trade war
that would leave all involved worse off as a result. When tariffs against China were
raised further, China responded with tariffs of its own. Although the World Trade
Organization (WTO) is committed to reducing tariffs over time, retaliation in the form
of ‘countervailing duties’ is permitted.
KEY TERM
Quotas
quota: an agreement
by a country to limit
its exports to another
country to a given
quantity
An alternative policy that a country may adopt is to limit the imports of a commodity
to a given volume. For example, a country may come to an agreement with another
country that only a certain quantity of imports will be accepted by the importing
country. Such arrangements are sometimes known as quotas or voluntary export
restraints (VERs).
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Price
Figure 12.8 illustrates the effects of a quota. D represents the domestic demand
for this commodity, and Sdom is the quantity that domestic producers are prepared
to supply at any given price. Suppose that, without any agreement, producers from
country A would be prepared to supply any amount of the product at a price PA. If the
product is sold at this price, D0 represents domestic demand, of which S0 is supplied
by domestic producers and the remainder (D0 − S0) is imported from country A.
Sdom
Quota
P1
PA
D
S0
S1
D1
D0
Quantity
▲ Figure 12.8 The effects of a quota
STUDY TIP
Notice that the
diagram for a quota is
very like the diagram
for a tariff. Make sure
you do not confuse the
two, as they differ in
terms of who gains and
who loses from the
measure.
12 International trade and protectionism
Stotal
0
12
By imposing a quota, total supply is now given by Stotal, which is domestic supply plus
the quota of imports allowed into the economy from country A. The market equilibrium
price rises to P1 and demand falls to D1, of which S1 is supplied by domestic producers
and the remainder is the agreed quota of imports.
Figure 12.8 shows who gains and who loses by this policy. Domestic producers gain by
being able to sell at the higher price, so (as in the case of the tariff) they receive
additional surplus given by the dark-blue area. Furthermore, the producers exporting
from country A also gain, receiving the green rectangle (which, in the case of the
tariff, was tax revenue received by the government). As in the case of the tariff, the
two triangles (red and pale blue) represent the loss of welfare suffered by the
importing country.
Such an arrangement effectively subsidises the foreign producers by allowing them
to charge a higher price than they would have been prepared to accept. Furthermore,
although domestic producers are encouraged to produce more, the protection offered
to them is likely to lead to inefficiency and weak attitudes towards competition.
Embargoes
Countries have sometimes used embargoes to prohibit imports of particular goods
or imports from particular countries. Imports of certain goods may be embargoed
because the products themselves are seen as being undesirable. For example, Australia
prohibits the imports of chemical weapons and plant materials. The embargoing of
imports from a country may be introduced as part of a political policy of sanctions
against a country. In other cases, there may be an embargo on exporting to a country.
For example, in 2006 the UN Security Council imposed sanctions on North Korea
following North Korea’s first nuclear test. One downside of such a policy is that it may
encourage smuggling activity.
An export subsidy
Another way in which a country may attempt to restrict trade is by subsidising
domestic producers to enable them to compete more effectively with imports.
Figure 12.9 illustrates a possible scenario.
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Price
12
Sdom
A
Pw + Sub
Pw
B
C
D
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
S0
S1
D0
Quantity
▲ Figure 12.9 The effects of an export subsidy
This shows domestic demand and supply for a product that can be imported at
the world price Pw. Without intervention, demand is D0, of which S0 is supplied by
domestic producers, with the remainder being imported.
Assume that the country is too small a producer to affect the world price. If the
government decides to pay a subsidy of an amount Sub to domestic producers,
this affects the supply curve such that it is horizontal up to S1 in Figure 12.9. This
encourages domestic firms to increase production up to S1, but unlike the case of the
tariff, domestic consumers are still able to buy the good at the world price, so there
is not the same impact on consumer surplus. Imports are D0 – S1, so this measure has
reduced the country’s dependence on imported goods.
Producers gain from this, receiving the additional producer surplus given by the
dark-blue shaded area. However, this needs to be covered by the government, as does
the area ABC in the figure, which represents the production inefficiency that was a
welfare loss in the case of the tariff.
The total cost to the government of providing the subsidy is thus the sum of the
dark- and light-blue areas. The downside of this approach is that these funds need to
be raised from elsewhere in the economy, thus distorting the allocation of resources
in other markets. Although consumers are better off in respect of this product with
the subsidy than with a tariff, as taxpayers they may pay the price in other ways.
Furthermore, it is not clear that subsidising domestic production in this way provides
any better incentives for efficiency than the tariff approach. If governments wish
to encourage firms to become more efficient in order to compete, a better approach
might be to subsidise education and training or research and development to improve
production techniques, and thus tackle the problem more directly. Of course, this
would depend on what was causing the inefficiency in the first place.
At the WTO ministerial summit in Nairobi in 2015, it was agreed that developed
economy members would eliminate all export subsidies immediately, and that
developing country members would eliminate them by the end of 2018.
Non-tariff barriers
KEY TERM
non-tariff barrier: an
obstacle to free trade
other than a tariff
(e.g. quality standards
imposed on imported
products)
There are other ways in which trade can be hampered, one example being the use of
what are known as non-tariff barriers. These often comprise rules and regulations
that control the standard of products that can be sold in a country.
This is a grey area, as some of the rules and regulations may seem entirely sensible
and apply equally to domestic and foreign producers. For example, laws that prohibit
the sale of refrigerators that contain CFCs are designed to protect the ozone layer,
and may be seen to be wholly appropriate. In this case, the regulation is for purposes
other than trade restriction.
However, there may be other situations in which a regulation is more clearly designed
to limit trade. For example, the USA specifies a larger minimum size for vine-ripened
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tomatoes than for green tomatoes, thereby raising costs for the former. This has to do
with trade because vine-ripened tomatoes are mainly imported from Mexico, but green
tomatoes are mainly grown in Florida. Thus, the regulation gives Florida producers an
advantage.
Test yourself 12.7
EXERCISE 12.3
Figure 12.7 showed the effects of a tariff.
If a country decides to remove the tariff, identify the effects on:
a consumers of the good
b producers of the good
c the government
Advantages and disadvantages of protectionism
The debate about whether countries should engage in protectionism or allow free
trade has a long history, and still does not seem to have been resolved, given the
USA’s decision to raise tariffs in 2018 – and the impulse of other countries to respond
in kind. Some of the arguments that have been advanced by politicians in favour of
protectionism have little grounding in economic analysis.
12 International trade and protectionism
Explain how trade
would be affected if
a country insisted
that all imports of a
particular product had
to be imported through
a single understaffed
office.
Such rules and regulations may operate against producers in less developed countries,
who may find it especially difficult to meet demanding standards of production or to
cope with excessive administrative burdens (‘red tape’). This applies in particular
where such countries are trying to develop new skills and specialisations to enable
them to diversify their exports and engage more actively in international trade.
12
There may be political reasons for wanting to protect domestic industries. For
example, there may be strategic arguments that a country should always maintain
an agricultural sector so as not to be overdependent on imported foodstuffs, as this
could be disastrous in the event of war. Such arguments were used in setting up the
Common Agricultural Policy in Europe. President Trump’s arguments for imposing a levy
on steel imports in 2018 similarly claimed that the USA’s steel industry was suffering
from unfair competition, which was a threat to national security.
KEY TERMS
dumping: where
domestic producers
face competition
from imported goods
that are priced below
marginal cost, perhaps
as a result of export
subsidies
sunset industry: an
industry in decline that
needs protection for its
displaced workers
infant industry:
an industry that
needs protection
from international
competition in the short
run so that it can learn
to become competitive
A country may find that it faces competition from foreign producers which have had
the benefit of export subsidies from their government. This means that they have
been shielded from facing the full costs of production, so have been given an unfair
advantage in international trade. This might be seen as dumping, by which the
foreign producers are able to undercut domestic producers, rather than facing the full
cost of their production activities. The imposition of a tariff may then be justified in
allowing domestic producers to compete on fairer terms. This may also guard against
the possibility that competition will force domestic firms out of business, leaving the
importing producers with a monopoly.
Some have also argued that domestic industries should be protected because of the impact
of high unemployment among workers displaced from declining sectors – so-called sunset
industries. This is really an argument about the period of transition to more open trade,
as it could also be noted that workers released from those declining sectors could, in
time, be redeployed in sectors that are more efficient in comparative advantage terms.
A common line of argument is about the need to protect so-called infant industries. This
may be especially important in the context of less developed countries wanting to develop
their manufacturing sectors. The argument is that protecting a domestic industry from
international competition will allow the new firms to become familiar with the market
so that in the longer term they will be able to compete. A problem with both infant
and sunset industries is that once protection is put in place, it is difficult to remove.
The infants may never grow up and declining sectors may never expire completely.
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The impact of protectionism
Why might
overprotection of an
infant industry be
ineffective in allowing
the industry to compete
in global markets?
Consumers
Protectionist policies have a number of effects on economic agents in a country.
These effects differ according to which policy is in operation, but are most clearly
illustrated with reference to the imposition of a tariff, which is the most common
form of protectionist policy.
In general, consumers are likely to be worse off as a result of protectionist measures.
Consumer surplus is lower after a tariff is imposed, as consumers must pay a higher
price for the good, and will consume less.
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
12
Test yourself 12.8
Producers
Producers in the domestic economy will gain from protection, as they will receive
higher producer surplus (at the expense of consumers). However, their incentives to
produce efficiently will be low, so in the long run they may never become able to
compete effectively in world markets. The infant industry benefits are rarely delivered.
Governments
When a government imposes a tariff, it gains by the revenue that it raises. This
may be valuable for the government of a less developed country that faces
problems with raising revenue through other forms of taxation because of the lack
of an adequate administrative structure. The balance of payments will be affected,
as imports will fall after the imposition of a tariff. Whether domestic production
will actually rise to compensate will depend on the elasticity of supply. If home
producers are unable to respond by increasing production, then the benefits from
the tariff will be lower.
Living standards
For society as a whole, the imposition of a tariff imposes costs on society, so overall
wellbeing is lower with a tariff in place.
Equality
Protectionist measures entail a redistribution of resources, from consumers to
producers, so there may be an increase in inequality in the society. For example, as
explained above, the imposition of a tariff means that the domestic price of a good
will rise, which leads to a fall in consumer surplus, some of which becomes an
increase in producer surplus. This represents a redistribution of income away from
consumers.
SUMMARY: PROTECTIONISM
» Although comparative advantage suggests that
countries can potentially gain from engaging in
international trade, there is often a temptation to
interfere with free trade.
» Countries may wish to protect their domestic
industries from international competition.
» A common protectionist tool is a tariff – a tax
placed on imports of a good.
» A tariff has the effect of reducing imports of a
good, but there is a welfare loss associated with it.
» A quota has a similar effect to a tariff, but benefits
foreign producers without providing revenue to the
home government.
» An export subsidy can be used to encourage home
producers to export more, but this is costly from
the perspective of the home government.
» Non-tariff barriers are administrative rules and
regulations that make it more difficult for foreign
producers to meet local requirements.
» Protectionist policies have a number of effects on
economic agents in a country.
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END OF CHAPTER QUESTIONS
2 Infant industries are often criticised for becoming complacent and inefficient due
to government protection, so they fail to grow and develop economies of scale.
What can the government do to prevent this?
A expose infant industries to more competition
B only choose to protect manufacturing industries
C combine tariffs on imports with import quotas
D encourage the formation of monopolies through mergers and acquisitions
Data response
1 Read the following extract and then answer the questions that follow.
Comparative advantage, trade and protectionism
12
12 International trade and protectionism
Multiple choice
1 In a world with two countries and two products only, if Country A has greater
factor endowment, it would have the absolute advantage in both products. What
explains why Country B can also participate in international trade?
A Country A is more abundant in resources than Country B.
B Country B negotiates more favourable conditions of international trade.
C Country B’s domestic opportunity cost in one of the products is lower than
Country A’s.
D Country B’s PPC lies further to the left of Country A’s PPC.
In countries such as Indonesia and the Philippines where labour is abundant,
but capital relatively scarce, the law of comparative advantage would suggest
the country should specialise in labour- or land-intensive activities such as
agriculture or other primary production. Indeed, Indonesia and the Philippines
5 account for most of the world’s production of coconuts.
More recently, the palm oil industry has expanded in these countries. Unlike
coconut production, which is dominated by smallholders, about 60% of palm oil
is grown on large plantations. The palm oil corporations get ample government
support in the form of export subsidies, scientific research and even lobbying to
10 keep export markets open. Some coconut farmers say they need the same kind
of support from the government if they are to continue exporting.
▲ A large palm oil plantation in Indonesia
Palm oil is not a common edible oil in China because the oil palm grows only
in the extreme southern part of the country. The production of the oil has been
small, and its consumption was originally limited to local areas. However,
15 changes in consumer tastes have meant the demand for the foods that use
palm oil in their processing has increased dramatically, such that in 2020 China
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removed palm oil from its import quota management list. This will increase
Chinese imports of palm oil from Indonesia and the Philippines, expanding this
key market at a time when environmental concerns elsewhere fuel opposition to
20 the product.
12
International trade is assumed to benefit both the exporter and the importer.
However, the question of who gains from such trading depends largely on the
prices of the goods.
25 Table 12.3 provides data on the average indexed prices of imports and exports
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
to and from the Philippines.
▼ Table 12.3 Index of export and import prices for the Philippines,
January 2018–January 2020 (2000 = 100)
Index of export prices
Index of import prices
January 2018
109.15
116.94
January 2019
107.55
119.32
January 2020
105.82
119.91
Source: tradingeconomics.com
a Explain, with the use of an example, why export subsidies (line 9) can be
viewed as a form of protectionism.
b With reference to Table 12.3, calculate the change in the terms of trade
between January 2019 and January 2020, and explain one reason why this
could be unfavourable for the Philippines.
c Explain the operational impact of one non-tariff barrier to trade referred to
in the extract (other than an export subsidy).
d Explain, with reference to the extract, the advantage to China of engaging in
greater palm oil trade with Indonesia and the Philippines.
e Discuss the benefit in the short run to the Philippines of specialising in
agricultural production as suggested by the law of comparative advantage.
Essay style
2 a With the use of a numerical example explain what is meant by a country having a
comparative advantage in the production of a good and consider whether trade will
always be beneficial between two countries when a comparative advantage exists.
b A ssess the impact on domestic economic welfare when a protectionist tariff is
imposed on imports to a country.
CASE STUDY
International trade and the Covid-19
pandemic
The Covid-19 pandemic had an unprecedented
impact on economies throughout the world, not least
in its impact on international trade. The impact on
trade was most significant in the trade for medical
supplies, especially in relation to products for
prevention, testing and treatment.
According to the World Trade Organization (WTO),
medical products in normal times have comprised
about 5% of total world trade. The USA, Germany
and China account for 34% of world imports of
medical goods; Germany, the USA and Switzerland
supply 35% of medical products to the world. The top
ten exporters supply almost three-quarters of world
exports of these goods.
As the pandemic took off in early 2020, it soon
became apparent that some countries (such as
Germany) were better prepared for dealing with a
pandemic than others, and there was a widespread
global shortage of protective equipment necessary
for medical staff treating Covid-19 patients.
Members of the WTO face rules about the imposition
of quantitative restrictions on exports of particular
goods, but temporary prohibitions are permitted ‘to
prevent or relieve critical shortages of foodstuffs or
other products essential to the exporting member’.
Some countries faced with serious domestic
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shortages of protective equipment took advantage
of this and restricted exports to secure supplies for
their own citizens. By April 2020, some 80 countries
were thought to have imposed such prohibitions,
although this only includes the countries that had
formally notified the WTO that they were in place.
One response to this may be that countries will begin
to develop local capacity to produce. In the long run,
this may have the effect of reducing global trade
interdependencies. It may also be that in order to
allow these new activities to survive and grow, some
countries will raise tariffs to protect these infant
industries. Other countries may react by imposing
export restrictions of their own.
As the pandemic grew, there was a search for
treatments and vaccines. This also produced
temptation for countries to adopt protectionist
attitudes. For example, a US company produced a
treatment that was effective in shortening hospital
stays for Covid-19 patients. The USA promptly
Follow-up questions
a If a country that is a significant global supplier of
a good prohibits exports, how will the domestic
price of the good be affected?
b What would be the effect on world prices of the
good?
c How will export prohibition affect the incentives
faced by domestic producers?
d Who benefits and who loses from the prohibition
of exports?
e Discuss the relative merits of protectionism and
openness in the context of the pandemic.
12
12 International trade and protectionism
Such measures are likely to have economic effects.
In particular, relative domestic and world prices
may be affected, and protectionism may reduce
the extent to which countries are prepared to work
collaboratively.
secured the entire supply for a 3-month period. In
July 2020, the New York Times reported that there
were 155 teams of researchers worldwide working
on producing a vaccine. Further evidence of the lack
of international collaboration were the rumours
circulating of attempts to hack vaccine research
progress. As vaccines became available, there were
squabbles between countries over their distribution.
The losers from this protectionism are likely to be
many less developed countries that find themselves
struggling to contain the virus.
Go online at hoddereducation.com/cambridgeextras
for another case study for Chapter 12.
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AS LEVEL PART 6 International economic issues
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
13
The balance of payments and
exchange rates
What this chapter covers
★ components of the balance of payments accounts,
★
★
★
★
with a particular focus on the current account
how to calculate the current account balance (CAB)
causes and consequences of imbalances in the
current account
the definition of the exchange rate
how the exchange rate is determined in a floating
exchange regime
★ causes of changes in a floating exchange rate
★ the impact of exchange rate changes on
macroeconomic equilibrium in the
AD/AS model
★ the relationship between macroeconomic
policy and the current account of the balance of
payments
Most economies in the world are open economies – they engage in international trade,
exporting and importing goods and services, albeit to varying degrees. This chapter
analyses these transactions, and explores ways in which the domestic economy can be
influenced by the international environment. This requires discussion of the balance of
payments and the foreign exchange (Forex) market.
13.1 The balance of payments
KEY TERM
balance of payments: a
set of accounts showing
the transactions
conducted between
residents of a country
and the rest of the world
STUDY TIP
Don’t forget that it is the
direction of currency
flows that distinguishes
between exports and
imports. Exports cause
an inflow of currency,
whereas imports cause
a currency outflow.
Test yourself 13.1
Explain why the balance
of payments must
always balance overall.
When a country engages in international trade, it is important to be able to keep track
of the various transactions that take place between the residents of a country and the
rest of the world. The balance of payments is the set of accounts that monitors these
transactions. For an individual household it is important to monitor incomings and
outgoings, as items purchased must be paid for in some way – either by using income
or savings, or by borrowing. In a similar way, a country has to pay for goods, services
or assets that are bought from, or sold to, other countries. The balance of payments
accounts enable the analysis of such international transactions.
As with the household, transactions can be categorised as either incoming or outgoing
items. For example, if a car made in Malaysia is exported (i.e. purchased by a non-resident
of Malaysia), this is an ‘incoming’ item, as the payment for the car is a credit item for
Malaysia. On the other hand, the purchase of Thai pineapples (an import) is a debit item.
Similarly, all other transactions entered into the balance of payments accounts can be
identified as credit or debit items, depending on the direction of the payment. In
other words, when money flows into the country as the result of a transaction, that is
a credit; if money flows out, it is a debit. As all items have to be paid for in some way,
the overall balance of payments when everything is added together must be zero.
However, individual components can be positive or negative.
It is important to be able to monitor these transactions because of the increasing
interconnectedness of economies through the process of international trade – a process
known as globalisation. This is the way in which economies have become more and more
linked as a result of rapid changes in the technology of communications and transport,
and with increasing deregulation of markets. The onset of the Covid-19 pandemic in
2020 caused enormous disruption to international trade, hopefully temporarily. The
UK’s decision to reduce its dependence on the EU through Brexit goes against the trend
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KEY TERMS
financial account of the
balance of payments:
account identifying
transactions in financial
assets between the
residents of a country
and the rest of the
world
capital account of the
balance of payments:
account identifying
transactions in
(physical) capital
between the residents
of a country and the rest
of the world
reserve assets: stocks
of foreign assets (e.g.
foreign currency or
gold) owned by the
central bank of a
country to enable it to
meet any mismatch
between the demand
and supply of a
country’s currency
LEARNING
LINK
The significance of
the financial and
capital accounts is
discussed in Chapter
29, but for now we
focus on the current
account.
LEARNING LINK
13
This process of globalisation, by which economies have become increasingly
interconnected, is discussed in Chapter 32.
In line with international standards (as set out by the International Monetary Fund
(IMF)), the balance of payments accounts are divided into three categories: the
current account, the capital account and the financial account. In addition, it is
important to identify transactions in reserve assets. Taken together, these items
should all sum to zero, as the overall balance of payments must always be in
balance. However, because it is not possible to record everything accurately, a final
item called ‘errors and omissions’ or the ‘balancing item’ ensures overall balance.
The current account
The current account identifies transactions in goods and services, together with
income payments and international transfers. Income payments here include
compensation of employees, which is where an employee and employer are located in
different countries. Also important are payments of investment income. Transfers are
mainly transactions between governments and workers’ remittances. Flows of bilateral
aid and social security payments abroad are also included here.
Commentators in the media often focus on the current account. Three main items
appear on this account:
13 The balance of payments and exchange rates
current account of the
balance of payments:
account identifying
transactions in goods
and services between
the residents of a
country and the rest of
the world, together with
income payments and
international transfers
towards globalisation, and the success of this decision will depend on whether the UK is
able to develop new links with economies elsewhere in the world.
» Trade in goods and services
» Primary income
» Secondary income (transfers)
Trade in goods and services
The balance of trade in goods and services is simply the balance between exports and
imports of goods and services. Notice that not all of the trade carried on involves
physical goods; the trade in services is also important. The trade in goods is known as
visible trade, and the trade in services is known as invisible trade.
In looking at the components of the current account of the balance of payments, it is
the balance between positive and negative elements that is important. For example,
the balance between exports of goods and services (i.e. exports minus imports) is a
component of aggregate demand.
QUANTITATIVE SKILLS 13.1
Calculate the balance of an item in the balance of
payments accounts
In 2018, exports of goods from China were estimated as $2,417.4 billion and
imports were $2,022.3 billion. The balance of trade in goods was therefore total
exports of goods minus imports of goods: that is, $2,417.4bn – $2,022.3bn =
+$395.1bn. In other words, there was a net surplus in trade in goods.
In a similar way, we can calculate balances for the trade in services, and in
goods and services combined. The overall balance taking into account all of the
items that are part of the current account (including primary and secondary
income) is known as the current account balance (CAB), and is an important
indicator of the performance of an economy.
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AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
13
LEARNING
LINK
Net exports comprise
an important part of
aggregate demand,
as is discussed
in Chapter 7.
Trade policies and
negotiations are
discussed in Chapter
32.
EXERCISE 13.1
In Pakistan in 2018, exports of goods were estimated at $24.8 billion and exports
of services were $5.3 billion. Imports of goods were $57.4 billion and imports
of services $10.4 billion. The balance in secondary income was +$24.1 billion.
Calculate the overall balance for trade in goods and services.
The process of trading with other countries creates important connections across
national borders. After all, exports from one country become the imports of its
trading partners. In principle, this suggests that overall the sum of all countries’ trade
balances should be zero. In practice, this will not be the case – if only because of data
inaccuracies and mis-recordings. However, it is important to realise that the demand
for a country’s exports depends in part on economic conditions in its trading partners.
Primary income
Primary income is the second important item in the current account. This comprises
compensation to employees and earnings accruing to domestic citizens on past
investment abroad (less income earned by overseas residents who own assets in
the domestic economy). The primary income balance for Pakistan in 2018 showed a
relatively small deficit of $5.5 billion.
Secondary income
Test yourself 13.2
Would an inflow
of foreign direct
investment be included
as part of the current
account of the balance
of payments?
Secondary income is made up of current transfers. These include taxes and social
contributions received from non-resident workers and businesses, bilateral aid
flows and military grants. For Pakistan in 2018, this part of the current account
showed a surplus of $24.1 billion, part of which was transfers in the form of aid
from abroad. Secondary income also includes remittances, where an individual
works abroad but remits part of their income back to a family in the home country.
For Pakistan, such remittances made up about 60% of the secondary income
balance in 2018.
It is important to realise that the overall balance on the current account arises from
combining the balances on all of these items. An overall current account deficit arises
when the deficit items outweigh the surplus items in the accounts.
It is also important to realise that a deficit on the current account must be balanced
by a surplus on the financial and capital accounts if the overall balance of payments
is to be in balance. In the short run, it may be possible to finance a trade deficit
by selling domestic financial assets to foreigners, or by borrowing from overseas.
However, this might not be regarded as being desirable in the longer term if it
affects the overall ownership pattern of assets. For this reason, the current account
cannot be viewed in isolation from the rest of the balance of payments.
Causes and consequences of imbalances in the current account
As already mentioned, the overall balance of payments (combining the credit and
debit items from all three accounts) must always be zero because outgoings must be
equal to incomings – in other words, everything must be paid for. However, this does
not mean that each of the three accounts will always balance, and imbalances can
arise for a number of reasons.
In the UK economy, the current account has been in deficit every year since 1984. China has
shown a surplus on the current account in every year since 1990 (except in 1993). There are
several possible causes of an imbalance on the current account of the balance of payments.
» Changes in the structure of economic activity affect the pattern of trade in goods
and services.
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» The competitiveness of domestic production relative to other countries is
important. If productivity at home is weak, or if domestic firms are producing
poor-quality products, then the demand for exports will be relatively low.
» If inflation in the home country is high relative to elsewhere, this will again
discourage exports and encourage imports. With high inflation, rising labour costs
can fuel this process.
» Rapid economic growth can draw in imports and contribute to a current account deficit.
% of GDP
STUDY TIP
The data here show
the balances on the
component items of
the current account as
a percentage of GDP.
This helps to put the
data into perspective,
but also is a way of
removing the effect of
changing prices over
time.
10
Trade in goods
Trade in services
Primary income
Secondary income
CAB
5
0
–5
–10
–15
2010
2011
2012
2013
2014
2015
2016
2017
13 The balance of payments and exchange rates
Figure 13.1 shows the components of the current account in India since 2010 together with
the overall balance. You can see that overall, it is the trade in goods that has the strongest
impact on the overall current account balance, with the overall balance on the current
account (CAB) tracking the trade in goods quite closely. The deficit in the trade in goods has
been partially offset by surpluses in the trade in services and secondary income (transfers).
For India, trade in services has been strong given its strength in professional services.
13
2018
Source: calculated using data from World Development Indicators
▲ Figure 13.1 The composition of the current account of the balance of payments in India
since 2010 (balances, % of GDP)
QUANTITATIVE SKILLS 13.2
Reading a composite graph
Test yourself 13.3
Looking at Figure 13.1,
which items contributed
to the smaller current
account deficit in 2016?
You may not have met a composite graph like Figure 13.1 before. Effectively,
there are two graphs here superimposed on each other. The bars on the graph
show the component items of the current account and the way they change
through time. Credit items are shown above the line. In this case, these are
trade in services and secondary income. Debit items (trade in goods and primary
income) are shown below the line. These are stacked for each year, and show
you their relative size as well as whether they are positive or negative balances.
The line that is superimposed on the bars is the overall current account balance.
This, of course, is the sum of the individual components. The fact that it is
negative throughout this period indicates that the combined debit items exceed
the combined credit items.
Notice that the data here have been expressed as a percentage of GDP. As the
data are measured in current prices, steps have to be taken to remove the effect
of changing prices through time.
This pattern is not unique. For example, trade in goods has traditionally shown
a deficit for the UK – it has shown a surplus in only 6 years since 1950. On the
other hand, trade in services has recorded a surplus in every year since 1966. This
imbalance partly reflects changes in the pattern of economic activity in the UK, with
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manufacturing in decline and services expanding. Exports of cars and consumer goods
have typically shown a significant deficit, whereas services such as insurance and
financial services have been in surplus.
13
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
This and the other causes outlined above are all concerned with the relative
competitiveness of goods produced domestically compared with those produced
abroad. If a country loses international competitiveness, then net exports are likely
to fall, thus reducing aggregate demand and potentially resulting in an increase in
unemployment. To some extent, these effects can be mitigated through exchange rate
movements, as is discussed in the next section of this chapter.
There is an important consequence that arises if persistent deficits are being sustained
over long periods of time. A deficit on the current account must be balanced by a
surplus on the financial and capital accounts if the overall balance of payments is to
be zero. For an economy like the UK, it may be possible to finance the trade deficit in
the short run by selling UK financial assets to foreigners or by borrowing from overseas.
However, this might not be regarded as being desirable in the longer term if this affects
the overall ownership pattern of British assets. For this reason, the current account
cannot be viewed in isolation from the rest of the balance of payments.
% of GDP
Figure 13.2 shows that the situation for the current account of the balance of payments
in China is very different. Trade in goods again dominates the pattern, but this item has
shown a consistent and strong surplus throughout the period, partly offset by a deficit
in the trade in services. Notice that in the late 2010s the surplus on trade in goods
declined somewhat while the deficit on trade in services remained fairly constant.
6
Trade in goods
Trade in services
Primary income
Secondary income
CAB
5
4
3
2
1
0
–1
–2
–3
2010
2011
2012
2013
2014
2015
2016
2017
2018
Source: calculated using data from World Development Indicators
▲ Figure 13.2 The composition of the current account of the balance of payments in China
since 2010 (balances, % of GDP)
SUMMARY: THE BALANCE OF PAYMENTS
» The balance of payments is a set of accounts
showing the transactions conducted between the
residents of a country and the rest of the world.
» The accounts are made of separate components:
the current account, capital account and financial
accounts, together with an ‘errors and omissions’
item. Changes in the holdings of reserve assets
may also feature in some countries.
» The current account of the balance of payments
identifies transactions in goods and services together
with flows of primary and secondary income.
» The balances on each component of the current
account contribute to the overall current account
balance (CAB).
» Any imbalance on the current account must be
countered by an opposite balance on the financial
and capital account to ensure that the overall
balance of payments is zero.
» Imbalances on the current account reflect
changes in the structure of economic activity in a
country and its relative competitiveness compared
with its trading partners.
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13.2 Exchange rates
exchange rate: the
price of one currency in
terms of another
Test yourself 13.4
LEARNING
LINK
The notion of a derived
demand is explained
in Chapter 4.
Chapter 4 introduced the notion of the demand and supply of foreign currency in the
diagram reproduced here as Figure 13.3. This uses ringgits as an example, with the
vertical axis representing the price of Malaysian ringgits in terms of US dollars. The
demand for ringgits arises from people holding US dollars wanting to purchase Malaysian
goods, services or assets, whereas the supply comes from holders of ringgits wanting to
purchase US goods, services or assets. The balance of payments accounts itemise these
transactions, which entail the demand for and supply of ringgits. Notice that the demand
for currency is a derived demand – thus ringgits are demanded when people holding
dollars or other currencies want to buy Malaysian goods, services or assets. Similarly,
ringgits are supplied when Malaysians want to buy foreign goods, services or assets.
Supply
13
13 The balance of payments and exchange rates
Suppose that the
exchange rate between
US dollars and euros is
0.8 (€ per $). If you have
60 euros, what would be
the value in dollars?
Closely associated with the balance of payments is the exchange rate – the price of
one currency in terms of another. The exchange rate is important because it influences
the prices that domestic consumers must pay for imported goods, services and assets,
and also the price that foreigners pay for domestically produced goods, services and
assets. A foreign exchange transaction is needed whenever trade takes place. If you
buy goods from abroad, you need to purchase foreign exchange – say, dollars – and
you have to supply some of your own currency in order to buy dollars. For example, if a
French tourist in the UK buys UK goods or services, the transaction needs to be
carried out in pounds, so there is a demand for pounds.
Exchange rate
(price of ringgits in dollars)
KEY TERM
e*
Demand
0
Quantity of ringgits per period
▲ Figure 13.3 The market for ringgits
The demand curve in Figure 13.3 is downward sloping because when the $/RM rate is
low, Malaysian goods, services and assets are relatively cheap in terms of dollars, so
demand is relatively high. On the other hand, when the $/RM rate is relatively high,
Americans receive fewer ringgits for their dollars, so the demand for ringgits will be
relatively low.
Test yourself 13.5
How would the market
for sterling be affected
if Europeans find British
goods less attractive
after Brexit?
The supply curve of ringgits is upward sloping. When the $/RM rate is relatively high,
the supply of ringgits will be relatively strong, as Malaysian residents will get plenty
of dollars for their ringgits and thus will demand American goods, services and assets,
supplying ringgits in order to buy the foreign exchange needed for the transactions.
When the $/RM rate is low, US goods, services and assets will be relatively expensive
for Malaysian residents, so fewer ringgits will be supplied.
The market is in equilibrium at e*, where the demand for ringgits is just matched
by the supply of ringgits. This position has a direct connection with the balance of
payments. If the demand for ringgits exactly matches the supply of ringgits, this
implies that there is a balance between the demand from Malaysians for US goods,
services and assets and the demand by US residents for Malaysian goods, services and
assets. In other words, the balance of payments is in overall balance.
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In analysing the balance of payments, the relative competitiveness of domestically
produced goods and services is an important issue. The exchange rate plays a key role
in this process. If a country persistently shows a deficit on the current account, does
that imply that the goods that it produces are uncompetitive in international markets?
Consider the situation from the perspective of the Malaysian economy. The demand
for Malaysian exports in world markets depends on a number of factors. In some ways,
it is similar to the demand for a good. In general, the demand for a good depends on
its price, on the prices of other goods, and on consumer incomes and preferences.
In a similar way, you can think of the demand for Malaysian exports as depending
on the price of Malaysian goods, the price of other countries’ goods, incomes in the
rest of the world and foreigners’ preferences for Malaysian goods over those produced
elsewhere. However, in the case of international transactions the exchange rate is also
relevant, as this determines the purchasing power of Malaysian incomes in the rest
of the world. Similarly, the demand for imports into Malaysia depends on the relative
prices of domestic and foreign goods, incomes in Malaysia, preferences for foreign
and domestically produced goods and the exchange rate. These factors will all come
together to determine the balance of demand for exports and imports.
The exchange rate plays a key role in influencing the levels of both imports and
exports, and thus affects the balance of payments, so the way it changes over time
and the way in which it is determined is important.
Figure 13.4 shows the $/Pakistan rupee exchange rate since 2000. This seems to suggest
that the exchange rate remained fairly stable until about 2007, after which it declined
steadily. This decline between 2007 and 2018 suggests that, other things being equal,
there was a gradual decline in the international competitiveness of Pakistan’s goods.
There is discussion
of international
competitiveness in
Chapter 29, which
also considers the
effects of fixing a
currency in terms of
the dollar or some
other currency. For
now, we focus on how
exchange rates are
determined when
allowed to adjust
to the free-market
equilibrium.
KEY TERM
floating exchange rate
system: a system in
which the exchange rate
is permitted to find its
own level in the market
0.02
0.018
0.016
0.014
0.012
0.01
0.008
0.006
0.004
0.002
0
20
0
20 0
0
20 1
02
20
0
20 3
04
20
0
20 5
06
20
0
20 7
0
20 8
09
20
1
20 0
1
20 1
12
20
1
20 3
1
20 4
1
20 5
16
20
1
20 7
18
LEARNING
LINK
Exchange rate (US$/rupee)
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
13
Source: calculated using data from World Development Indicators
▲ Figure 13.4 The US$/Pakistan rupee exchange rate
However, some care is needed because other things do not remain equal. In particular,
remember that the competitiveness of domestic goods in overseas markets depends
not only on the exchange rate, but also on movements in the prices of goods over
time, so this needs to be taken into account. In other words, if the prices of Pakistan’s
goods have risen more rapidly than prices in the USA in this period, this will have
partly offset the downward movement in the exchange rate.
The determination of the exchange rate in a floating exchange
rate regime
The way in which a country’s exchange rate is determined has important implications for
the balance of payments, and for macroeconomic policy. Viewing the foreign exchange
market as a variant of the demand and supply model seems to suggest that the exchange
rate will be determined by the interaction of demand and supply. If the market were to
be left to find its way to equilibrium, this is exactly what would happen, and where this
is permitted to happen, it is known as a floating exchange rate system.
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Under a floating exchange rate system, the value of the currency is allowed to find its
own way to equilibrium. This means that the overall balance of payments is
automatically assured, and the monetary authorities do not need to intervene to make
sure it happens. In practice, however, governments have tended to be wary of leaving
the exchange rate entirely to market forces, and there have been occasional periods in
which intervention has been used to affect the market rate.
KEY TERMS
appreciation: a rise in
the exchange rate in a
floating exchange rate
system
Causes of changes in the exchange rate
If the foreign exchange market is left free to find its own way to equilibrium, there
are several reasons for the exchange rate to change.
The key factors that determine the exchange rate in a floating rate system are:
»
»
»
»
»
relative inflation rates
the trade balance
net investment in the domestic economy
speculation
relative interest rates and monetary policy
13 The balance of payments and exchange rates
depreciation (of a
currency): a fall in
the exchange rate in a
floating exchange rate
system
If the foreign exchange market is left free to find its own way to equilibrium,
it becomes important to consider what factors will influence the level of the
exchange rate. Notice that under a floating exchange rate system, a fall in the
value of a currency is known as a depreciation, whereas an increase is known as
an appreciation. For example, between 2001 and 2003, the exchange rate between
the Pakistan rupee and the US dollar rose from 0.0161 to 0.0173 (rupees per dollar),
which was an appreciation. Between 2007 and 2009, it fell from 0.0165 to 0.0122 (a
depreciation).
13
STUDY TIP
When answering a question or writing an essay, remember to explain that these
factors influence the exchange rate through the effect they have on either the demand
for or the supply of the currency.
Relative inflation rates
Exchange rate equilibrium also implies a zero overall balance of payments. If the
exchange rate always adjusts to the level that ensures this, it might be argued that
the long-run state of the economy is one in which the competitiveness of domestic
firms remains constant over time. In other words, you would expect the exchange rate
to adjust through time to offset any differences in inflation rates between countries.
EXTENSION MATERIAL
The purchasing power parity theory
The purchasing power parity theory of exchange rates argues that this is exactly
what should be expected in the long run if there are differences in inflation rates
between countries. The nominal exchange rate should adjust in such a way as to
offset changes in relative prices between countries.
The trade balance
The exchange rate in a free market is determined by the demand for and supply of the
currency. This means that changes in the balance between exports and imports can
affect the exchange rate. An increase in the demand for exports implies an increase
in the demand for domestic currency, so would lead to an appreciation of the currency
(ceteris paribus).
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13
LEARNING
LINK
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
The interaction
between the current
and financial
accounts is discussed
in Chapter 29.
Net foreign investment in the economy
An increase in foreign direct investment would have similar effects. If the economy
becomes an attractive prospect for foreign investors, this could also lead to an
appreciation of the exchange rate (or at least some upward pressure).
Speculation
In the short run the exchange rate may diverge from its long-run equilibrium. An
important influence on the exchange rate in the short run is speculation. So far, the
discussion of the exchange rate has focused on the current account of the balance of
payments. The financial account is also important, as large-scale movements of financial
capital can affect the exchange rate. These effects are discussed in Chapter 29. Changes
in the domestic real interest rate can have a significant effect on these flows.
Interest rates and monetary policy
Test yourself 13.6
Give an example of
how the exchange rate
for the currency of the
country in which you
live has been affected
by a news item.
Financial flows between countries may be induced by the relative level of interest
rates. If interest rates in a country are high relative to elsewhere, this may attract an
inflow of financial capital, thus putting upward pressure on the exchange rate and
leading to an appreciation. The significance of this is that changes in the stance of
monetary policy will have an effect on the exchange rate under a floating exchange
rate system. These become an important part of the operation of monetary policy.
Indeed, the decision of the monetary authorities in setting interest rates may be
partly influenced by movements in the exchange rate.
EXERCISE 13.2
A British firm wants to purchase a machine tool
which is obtainable in the UK for a price of £125,000,
or from a US supplier for $300,000. Suppose that the
exchange rate is fixed at £1 = $3.
a What is the sterling price of the machine tool if
the firm chooses to buy in the USA?
b From which supplier would the firm be likely to
purchase?
c Suppose that, between ordering the machine
tool and its delivery, the pound depreciates, so
that when the time comes for the firm to pay up
the exchange rate is £1 = $2. What is the sterling
price of the machine tool bought from the USA?
d Comment on how the competitiveness of British
goods has been affected.
e Discuss the effects that the depreciation is likely
to have on the economy as a whole.
Exchange rate changes and the AD/AS model
Price level
Given the factors that can lead to a change in the exchange rate, how would such
changes be seen in the AD/AS model? Suppose that for some reason there is an
increase in demand for a country’s exports. This can be shown in Figure 13.5.
LRAS
SRAS0
P1
P0
AD1
AD0
0
YFE Y1
Real GDP
▲ Figure 13.5 An increase in exports with a floating exchange rate
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The economy begins at full employment with real GDP at YFE and the overall price level
at P0. The increase in demand for exports is reflected in a rightward shift of aggregate
demand from AD0 to AD1, with the price level increasing to P1. Associated with the
increase in the demand for exports is an increase in demand for domestic currency, so
the demand curve shifts to the right, leading to an appreciation of the exchange rate.
A change in the opposite direction would have similar effects, but in reverse. For
example, suppose that after Brexit, the UK experiences a fall in the demand for exports,
causing the AD curve to shift to the left. There would be a fall in the demand for
pounds, so the exchange rate would depreciate. Remember that with a depreciation,
imports would become more expensive, and exports would become cheaper. (The reverse
would happen with an appreciation.) Aggregate demand would tend to increase because
of these changes. However, with a curved short-run aggregate supply curve, the new
short-run equilibrium would be at a relatively lower real GDP, with only a relatively minor
impact of the price level. The adjustment back to full employment could be relatively
slow, especially if the lower real GDP led firms to form low expectations about future
demand, and reduce their investment expenditure as a result.
SUMMARY: EXCHANGE RATES
» The exchange rate is the price of one currency in
terms of another.
» It is important because it influences the prices of
international transactions in goods and services.
» Under a floating exchange rate regime, the
exchange rate is determined by the interaction of
demand and supply.
13 The balance of payments and exchange rates
The appreciation of the exchange rate means that imports become cheaper and
exports become more expensive. In response, there will be an increase in demand for
imports (with a fall in the demand for domestically produced goods that compete with
imports) and a fall in the demand for exports. In other words, the rise in the exchange
rate will at least partially offset the original increase in aggregate demand, so AD will
tend to move back to the left, perhaps even returning to its original position.
13
» The fall in the value of a currency is known as a
depreciation; a rise is known as an appreciation.
» The exchange rate of a currency can change in
response to changes in relative inflation rates,
the trade balance, net investment in the domestic
economy, speculation or changes in relative interest
rates.
» The AD/AS model can be used to examine the
effects of a change in the exchange rate.
13.3 Macroeconomic policy and the current account
of the balance of payments
LEARNING
LINK
The business (trade)
cycle is explained in
Chapter 25. When
writing an essay, it
is worth drawing
attention to the
distinction between a
cyclical deficit and a
structural one.
Under floating exchange rates, problems arise not with the overall balance of
payments, but with an imbalance between components of the balance of payments.
However, this does not mean that an imbalance on the current account can be ignored,
and the state of the current account is carefully monitored by the government and
economic commentators. Stability on the current account is one of the objectives of
macroeconomic policy.
A deficit on the current account of the balance of payments may be a temporary
situation, perhaps associated with the business cycle. When the economy enters into
an expansionary boom period, there will tend to be a move towards deficit on the
current account, as imports tend to rise. Such a cyclical deficit will be of less concern
than if the deficit arises from long-term structural factors.
If the current account is in deficit, domestic residents are purchasing more in imports
of goods and services than the economy is exporting. In other words, earnings from
exports are not sufficient to pay for imports. This is a bit like a household spending
beyond its income, which can be sustained only by selling assets or by borrowing.
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AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
13
Test yourself 13.7
What will be the
effect on the current
account of the
balance of payments
in the long run if the
economy experiences
a persistent inflow
of foreign direct
investment?
LEARNING
LINK
The influence of the
exchange rate in the
context of monetary
policy is discussed in
Chapter 29.
The concern for the economy is that a large and sustained deficit on the current
account implies that the financial account must be in a large and sustained surplus.
This in turn means that the country is effectively exporting assets. And this means
that overseas residents are buying up domestic assets, which in turn may mean a
leakage of investment income in the future. Alternatively, overall balance could be
achieved through the sale of foreign exchange reserves. This soaks up the excess
supply of domestic currency that arises because residents are supplying more currency
in order to buy imports than overseas residents are demanding in order to buy exports
from the home economy.
However the current account deficit is financed, a large deficit cannot be
sustained indefinitely. Equally, running a persistent surplus on the current account
can create difficulties. China showed a persistent surplus on current account
during its period of rapid economic growth, when exports were expanding rapidly.
Domestically, this was only possible because the economy was able to expand
so quickly in order to supply exports, but this was probably at the expense of
domestic consumption. It also meant political pressure from the USA, which
perceived that China’s undervalued currency was creating an unfair competitive
advantage.
A critical issue for a deficit country is whether home assets will remain attractive
to foreign buyers. Running a sustained deficit on current account requires
running a surplus on financial account. If foreign buyers of domestic assets
become reluctant to buy, interest rates in the home economy might have to rise
in order to make assets more attractive. A by-product of this would be a curb
in spending by domestic firms and consumers. Given that part of this reduction
in spending would have an impact on imports, this would begin to reduce the
current account deficit.
The quantity of exports of goods and services from an economy depends partly
on income levels in the rest of the world and partly on the competitiveness of
domestically produced goods and services, which in turn depends partly on the
exchange rate and partly on relative price levels at home and abroad. Similarly, the
level of imports depends partly on domestic income and partly on the international
competitiveness of domestic and foreign goods and services.
This suggests that a fundamental cause of a deficit on the current account is a lack of
competitiveness of domestic goods and services, arising from an overvalued exchange
rate or from high relative prices of home-produced goods and services. There may
thus be a need to improve the efficiency of production in order to compete more
effectively with foreign producers. Alternatively, domestic incomes may be rising more
rapidly than those in the rest of the world.
How is the current account of the balance of payments
affected by macroeconomic policy?
The current account of the balance of payments is monitored by the authorities
because an imbalance is indicative of underlying problems and because of its longterm effects. However, the situation is complicated because macroeconomic policy
changes also affect the current account.
Fiscal policy
Suppose that the government increases expenditure in order to stimulate aggregate
demand. As we saw earlier in the chapter, an increase in aggregate demand puts
upward pressure on the overall price level. This reduces the competitiveness of the
country’s goods. Exports become more expensive to foreigners, and imports become
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less expensive to domestic residents. There will be a deterioration in the current
account of the balance of payments as exports fall and imports rise, and aggregate
demand will fall because of the reduction in net exports. In other words, the original
increase in government expenditure as part of fiscal policy will be partly offset by the
impact on net exports.
13
Monetary policy
The way in which
the exchange
rate affects the
transmission
mechanism of
monetary policy
is explained in
Chapter 28.
Supply-side policy
Successful supply-side policies result in a rightward shift in the long-run aggregate
supply curve. This reflects improvements in productivity and efficiency in domestic
production. In other words, this improves the competitiveness of domestic products
both at home and abroad. This would be expected to result in an increase in net
exports, thus improving the balance on the current account of the balance of
payments.
13 The balance of payments and exchange rates
LEARNING
LINK
Suppose now that the monetary authorities raise interest rates in order to combat
an increase in inflation. The widening of the differential between domestic and
foreign interest rates would attract an inflow of financial capital, which will result
in an appreciation of the currency. The appreciation of the currency reduces the
competitiveness of domestic goods in both home and overseas markets, so net exports
(and aggregate demand) fall. The current account deficit increases. Indeed, in this
case the exchange rate is part of the transmission mechanism by which monetary
policy affects aggregate demand. The increase in the interest rate is also likely to
affect investment and consumption directly. If firms become reluctant to invest, this
then affects long-run economic growth.
Protectionist policies
LEARNING
LINK
The effects of a tariff
are explained in
Chapter 12.
The use of protectionist policies is designed to improve the current account of the
balance of payments by reducing dependence on imported goods and encouraging
increased domestic production. But how will this work out? For example, suppose that
tariffs are imposed across a range of products. This is indeed likely to reduce imports,
but there are other effects that will also come into play.
The immediate impact of the imposition of tariffs is that the prices of the goods that
are subject to the tariff will increase. This affects both consumers and producers.
From the consumers’ point of view, they face an increase in the price of imports, so
will switch demand from imports to domestically produced goods. There will be an
improvement in the balance on the current account of the balance of payments and
(ceteris paribus) an increase in net exports and aggregate demand. However, there will
also be a fall in demand for the goods subject to the tariff.
From the point of view of domestic producers, they receive a higher price for their
goods and are encouraged to expand output. What happens next depends partly
on whether they are able (and willing) to respond to the increase in demand,
especially if they also face higher prices for imports of material inputs. Even if
they do expand production, they will be producing less efficiently than foreign
producers. This is because they are only prepared to expand their production
because of the higher prices that they receive with the tariffs in place. This
reduction in relative productivity could mean a decrease in long-run aggregate
supply.
In other words, the use of protectionist policies may improve the current account of
the balance of payments in the short run, but the sacrifice of the gains from trade
may leave the country worse off in the long run.
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13
SUMMARY: MACROECONOMIC POLICY AND THE CURRENT ACCOUNT OF THE
BALANCE OF PAYMENTS
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
» Stability of the current account of the balance
of payments is seen as one of the objectives of
macroeconomic policy.
» A large and sustained deficit on the current
account must be offset by a large and sustained
surplus on the financial account, which affects the
long-term ownership of assets in the economy.
» Neither a persistent deficit nor a persistent
surplus is sustainable in the long run.
» A fundamental cause of a deficit on the current
account is a lack of competitiveness of domestic
goods both at home and abroad.
» Macroeconomic policy changes, whether in fiscal,
monetary or supply-side policies, have effects on
the current account of the balance of payments.
END OF CHAPTER QUESTIONS
Multiple choice
1 Other things being equal, which of the following sets of events is most likely to
cause an overall appreciation of a country’s exchange rate?
A An increase in the quality of the country’s exports and higher domestic interest
rates.
B Domestic inflation greater than that of trading partners and an increase in the
substitutes available to the country’s exports.
C Higher interest rates abroad and greater demand for foreign holidays by the
country’s residents.
D An increase in foreign investment opportunities and more favourable local
business climate.
2 Why is stability of the current account of the balance of payments an important
policy objective for the government?
A Cyclical current account deficits can signal a loss in comparative advantage.
B A current account disequilibrium reduces national income.
C Growing current account imbalances unmatched by other components of the
balance of payments can put undesired pressure on the exchange rate.
D A financial account disequilibrium is corrected more easily than a current
account disequilibrium.
Data response
1 Read the following extract and then answer the questions that follow.
The balance of payments and exchange rates
A floating exchange rate is determined by market forces. In relation to the
Covid-19 pandemic in early 2020, the key changes to these market forces
operating on currencies were demand shocks caused by quarantines and
travel restrictions, and supply shocks caused when global supply chains
were interrupted and destabilised.
Amidst this, the Australian dollar, having fallen 9% in value against the US dollar
(US$) in early 2020, had the largest gain among major currencies, appreciating
4.9% versus the US$ in May 2020. This trend was forecast to continue.
The emerging market currencies of Mexico, Brazil and Russia were among the
hardest hit in 2020. The Russian rouble fell around 20% against the Chinese
yuan between January and March 2020. In 2019, China was the destination for
US$56.8 billion of Russian exports, making it Russia’s largest trade partner,
purchasing 13.4% of Russian exports. Moreover, China’s recovery from the
Covid-19 downturn was quicker than other nations, and more sustained.
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The balance of payments is a set of accounts showing the transactions
conducted between residents of one country and the rest of the world. They
include, among other items, the trade in goods and services. These data are
summarised in Table 13.1 for the USA for April 2020.
13
▼
Table 13.1 USA: value of goods and services imported and exported,
April 2020 (US$bn)
Imports
Trade in goods
95.5
167.4
Trade in services
55.8
33.3
In early 2020, final quarter forecasts for 2021 of the current account balance
as a percentage of GDP placed the UK, at −3.5%, as one of the largest deficit
countries among the 37-member Organization for Economic Cooperation
and Development. Other members with similarly large deficit figures were
Colombia at −3.7% and Canada at −3.4%. All three nations operate a floating
exchange rate. The inflation rate of 0.6% in Canada was also problematic at
that time, being significantly below the Canadian government’s 2% target rate.
Figure 13.6 shows the current account position of Norway up to early 2020. Norway
is a country where work–life balance is highly valued, and family is a huge priority.
Norway has the third lowest average working week in the world, 38 hours, and for
the 3 years 2017–20 achieved the highest productivity rate in the world.
100,000
83,893
13 The balance of payments and exchange rates
Exports
80,000
69,758
66,411
66,078
58,799
60,000
47,127
39,820
27,654
40,000
27,022 26,913 25,059
20,000
12,440
Jul 2017
Jan 2018
Jul 2018
Jan 2019
Jul 2019
Jan 2020
0
Source: tradingeconomics.com
▲ Figure 13.6 Current account balance of Norway (NOK million), July 2017–April 2020
a i
b
c
d
e
Explain the relationship you would expect between the productivity
rate and the current account position of a country.
ii Consider whether this relationship is evident in the extract.
Calculate the balance of trade in goods for the USA in April 2020.
Explain, using AD/AS analysis, how the change in the value of the Australian
currency in May 2020 would cause a change in the equilibrium price level
in the short run.
Describe, using the information provided, the likely impact on the trade
balance of Russia of the change in its exchange rate and the strengthening
Chinese economy.
Assess the impact on the current account of the balance of payments of
Canada of a fiscal policy measure that the government may take in light
of the country’s inflation rate.
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Essay style
2 aWith the help of a diagram, explain how an increase in the rate of interest will
affect a floating exchange rate in the short run and consider how expectations of
the future exchange rate could impact on the outcome.
bDiscuss whether a deficit on the current account of the balance of payments
will always cause problems for the domestic economy.
CASE STUDY
The UK balance of trade
Figure 13.7 shows the UK’s balance of trade in goods
since 1990, measured in current prices. The picture
is startling, showing a steady increase in the deficit
since 1997, following a period of relative stability.
There are several possible causes underpinning this
picture. One relates to the production of North Sea
£bn at current prices
AS LEVEL PART 6 INTERNATIONAL ECONOMIC ISSUES
13
0
–20
–40
–60
oil and gas, which peaked in the late 1990s and has
declined steadily since then. Secondly, the structure
of economic activity has been changing, such that
the trade balance in services has increased steadily,
which partly offsets the decline in the goods trade
balance.
Overall, the negative trade balance has contributed
to the overall deficit on the current account of
the balance of payments, which has meant that
the overall balance of payments has only been
maintained by surpluses on the financial account.
–80
Follow-up questions
a What is the significance of the fact that the trade
–120
balance as shown in Figure 13.7 is measured in
–140
current prices?
–160
b
Why is the changing structure of the economy
1990
1995
2000
2005
2010
2015
relevant in trying to understand why the trade
deficit has declined so rapidly?
Source: based on data from ONS (UK) c To what extent does the increasing deficit in the
▲ Figure 13.7 The UK balance of trade in goods since 1990
trade balance raise concerns for the authorities?
–100
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A LEVEL PART 7 The price system and the microeconomy
14
Marginal utility and consumer
choice
★
★
★
★
★
marginal and total utility
the law of diminishing marginal utility
marginal utility and demand
the equi-marginal principle
limitations of marginal utility theory
KEY TERMS
utility: the satisfaction
received from
consuming a good or
service
marginal utility: the
additional utility gained
from consuming an
additional unit of a good
or service
★
★
★
★
★
the assumption of rational behaviour
the budget line and indifference curves
consumer equilibrium
income and substitution effects
limitations of the indifference curve model
Chapter 2 explained the nature of demand as part of the basis for the demand
and supply model. This chapter extends that analysis by introducing the notion of
marginal utility and using this to add to your understanding of the demand curve.
The consumer’s budget line is introduced, and there is discussion of how a consumer’s
reaction to a change in the price of a good or service can be broken down into two
separate effects – the income effect and the substitution effect.
14 Marginal utility and consumer choice
What this chapter covers
14.1 Utility
Suppose you could measure the satisfaction that you derive from consuming a good?
For example, consider the case of chocolate bars. Consuming a chocolate bar gives
you a certain amount of satisfaction – which economists often refer to as utility in
this context. Imagine that it is possible to put a numerical value on this utility, and
for the sake of argument that the utility you get from consuming a chocolate bar is
30 ‘utils’, this being the unit in which utility is measured.
Marginal and total utility
Having consumed the chocolate bar, you are now offered a second, which you also
consume, this time receiving 26 utils of utility. You probably get less utility from the
second bar simply because you have already had some chocolate – and the more chocolate
bars you eat, the less utility you are likely to get from the additional bar. Notice here that
the valuation of the utility refers to the additional satisfaction that is gained from the
second bar. This is therefore known as the marginal utility from consuming an additional
chocolate bar. Indeed, there will come a time when you have eaten so much chocolate
that you cannot face eating any more, as you know you would be ill. Table 14.1 shows the
marginal utility that Majida gains from consuming chocolate bars.
▼ Table 14.1 Utility from chocolate
Number of bars
Marginal utility (utils)
1
30
2
26
3
21
4
15
5
8
6
0
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law of diminishing
marginal utility: the
more units of a good
that are consumed,
the lower the utility
from consuming those
additional (marginal)
units
total utility: the total
satisfaction received
from consuming all
chosen units of a good
or service
In this example, the sixth chocolate bar gives no satisfaction to Majida, who has
already had enough chocolate for the day.
This idea that the more of a good you consume, the less additional pleasure you get
from the extra unit of it is known as the law of diminishing marginal utility. It is a
‘law’ because it has been found to be universally true. If you keep consuming more of
something, you get less additional satisfaction from extra units. Figure 14.1 plots the
marginal utility values on a graph. The law of diminishing marginal utility ensures that
the MU curve is downward sloping.
Marginal utility (in utils)
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
14
KEY TERMS
35
30
25
20
15
10
5
MU
0
0
1
2
3
4
5
6
7
Number of chocolate bars
▲ Figure 14.1 A marginal utility curve
If it were really possible to measure satisfaction in this way, it would also be possible
to calculate the total utility that Majida receives from consuming chocolate bars. For
instance, if she consumes two bars, she gets 30 + 26 = 56 utils. If she has a third bar,
her total utility would be 77 utils.
Test yourself 14.1
What would be Majida’s
total utility if she were
to consume four bars of
chocolate?
Equally, if we know the total utility that Majida obtains from consuming different
quantities of a good, we can calculate the marginal utility. For example if Majida gets
total utility of 60 utils from consuming two ice creams but 65 utils from consuming
three, her marginal (additional) utility from consuming the third ice cream is the total
utility from consuming three ice creams minus the total utility from consuming two
ice creams, i.e. 65 – 60 = 5 utils.
Notice that maximum total utility is achieved when marginal utility is zero, because if
marginal utility is zero, this adds nothing to total utility.
STUDY TIP
The relationship
between ‘total’ and
‘marginal’ appears
in many areas of
economic analysis, and
it is good to be clear
about it. The ‘marginal’
value is calculated
as the change in the
‘total’.
EXERCISE 14.1
Table 14.2 shows the total utility that Nazim obtains from consuming a good.
▼ Table 14.2 Nazim’s total utility from good X
Units of X
Total utility (utils)
1
10
2
19
3
27
4
34
5
40
6
45
7
49
a Calculate the marginal utility at each level.
b Draw the MU curve on a diagram.
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Marginal utility and demand
Price, MU
MU*
D (MU )
0
14
14 Marginal utility and consumer choice
If marginal utility were measured in terms of money, then the MU curve would become
a person’s demand curve. Consider Figure 14.2. The quantity of the good Q* provides
this individual with marginal utility of MU*. If the price of the good were higher
than MU*, then the individual would not buy Q* of the good, as the price exceeds
his valuation. On the other hand, if price were to be set lower than MU*, then the
individual would be prepared to buy more than Q*, as the marginal utility would be
higher than the asking price. Another way of putting this is to say that the consumer
will purchase the good up to the point where the price is equal to the marginal utility
gained from consuming the good. Of course, a similar argument applies at each point
along the MU curve, so this is indeed the individual’s demand curve when utility is
measured in money terms.
Q*
Quantity
▲ Figure 14.2 An individual’s demand curve
Test yourself 14.2
How quickly would the
marginal utility curve
drop away if the product
concerned were
haircuts?
LEARNING
LINK
We will see another
way of looking at this
principle later in the
chapter.
The previous discussion of the demand curve emphasised that the curve shows the
relationship between the quantity demanded of a good and its price, ceteris paribus.
In other words, it focused on the relationship between demand and price, holding
other influences on demand constant. This argument also applies in this case. Changes
in the price of other goods, in consumer incomes or in preferences would all affect the
position of the demand (MU) curve.
This highlights the fact that decisions about the consumption of one good are
interconnected with decisions being made about other goods. If a consumer chooses
to consume more of one good, that means there is less income available to be spent
on other goods. Furthermore, a decision to consume more of one good will affect
the consumption of complementary and substitute goods. So rather than focusing
on a consumer’s decisions about the demand for a single good, it is also necessary
to consider the demand for a bundle of goods and services, and how a consumer can
arrive at a joint decision.
The equi-marginal principle
To keep things simple, consider an individual choosing a combination of two goods,
X and Y. The individual gains utility from each good, and sets out to maximise the
utility received from consumption of both. The quantity chosen of one good affects
the demand for the other, given a limited budget to spend on the items. Therefore, it
is not a simple question of setting marginal utility equal to price, as the decision on
one good affects the position of the MU curve for the other good because of the
linkage through the budget constraint.
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A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
14
KEY TERM
equi-marginal
principle: a consumer
maximises utility by
consuming at the point
where the marginal
utilities per dollar from
each of the two goods
are equal
It turns out that the best a consumer can do is to consume the two goods at the point
where the ratio of the marginal utilities per dollar from each of the two goods is
equal. In other words, this is where:
MUX
MUY
=
PX
PY
This is known as the equi-marginal principle. It describes the conditions under which
a consumer will maximise his or her utility. In principle, this can be extended to the
case where consumers are choosing between many goods and services.
Let’s look at an example. Suppose that Abdul is choosing a combination of apples
(priced 20c each) and cans of cola (priced at 40c). Table 14.3 shows the marginal utility
that he receives from each of the goods and the ratio of his marginal utility to price.
▼ Table 14.3 Abdul’s MU and MU/P for apples and cola
Number consumed
Marginal utility from
apples
Marginal utility from
apples divided by price
Marginal utility from
cola
Marginal utility from
cola divided by price
1
160
8
440
11
2
140
7
280
7
3
80
4
200
5
4
60
3
60
1.5
5
40
2
40
1
The point at which the marginal utility from apples is equal to that from cola occurs when
Abdul chooses to consume two apples and two cans of cola. Of course, the quantities
consumed need not always be the same. In this case, this happens by coincidence.
Limitations of marginal utility theory
The marginal utility approach provides insights into consumer behaviour, but it has
its limitations. First, utility is not something that can be measured; there is no
objective way of valuing utility because this will vary from individual to individual.
In other words, because each consumer is different and has different preferences, it
is impossible to compare utility between individuals. One person may gain different
utility from $1 than another, and there is no way of comparing their utility values.
This does not mean that the analysis is unhelpful – but it must be recognised that
there are limitations when it comes to putting the theory into practice. For example,
it may be difficult to think of aggregating across individual consumers in order to
build a market demand curve for a good. However, it will be shown that there are some
important insights to be gained from pushing this analysis a bit further.
It is also difficult to imagine how the marginal utility approach would work when
the analysis needs to be extended to multiple goods and services, so that the many
interactions between the demand for one good and the demand for another need to
be taken into account. One way of making some sense of this would be to consider the
consumer’s choice as being between the utility gained from one good and the utility
gained from all other goods considered together.
KEY TERM
behavioural economics:
a branch of economics
that builds on the
psychology of human
behaviour in decision
making
Do consumers always act rationally?
Marginal utility theory rests on the crucial assumption that consumers act rationally
in taking decisions about their spending and consumption by setting out to maximise
their utility. Recent advances in behavioural economics suggest that this is not
always the case.
This branch of economic analysis recognises that the psychology of human decision making
is more complex than the simple desire to maximise utility. People do not always focus on
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Test yourself 14.3
Other than the example
of charitable donations,
identify another way in
which consumers may
take decisions that may
not maximise their utility.
purely economic influences, but may act on impulse, or in response to their feelings. This
can lead them to take decisions about their spending that cannot be explained only by
utility maximisation. For example, they may make charitable donations or may purchase
more of some goods than would be dictated by rational economic behaviour.
SUMMARY: UTILITY
» Marginal utility represents the additional
» The equi-marginal principle shows that an
satisfaction that a consumer receives from
consuming an additional unit of a good.
» Marginal utility diminishes as more of a good is
consumed.
» Diminishing marginal utility helps to explain why
demand curves are downward sloping.
individual’s utility is maximised where the ratio of
the marginal utilities per dollar is equal for the two
goods.
» Although it offers some insights into consumer
choice, marginal utility analysis has some
limitations.
» There is some evidence that consumers do not
always act rationally.
14 Marginal utility and consumer choice
Increasingly, behavioural economists are using experimental situations to discover
more about how people react in situations of risk and how their spending behaviour is
influenced by impulse and in response to stimuli. This analysis is potentially valuable
to firms: if they can understand what induces people to behave in certain ways, they
may be able to influence their spending. Governments are also using findings from
behavioural economics when designing and publicising policies where they want to
influence behaviour.
14
14.2 Indifference curves and budget lines
Suppose that a consumer is choosing between two goods. How can we analyse the decision
process under the assumption that the aim is to maximise utility from the two goods?
The budget line
KEY TERMS
Bottles of cola
budget line: shows
the boundary of
an individual’s
consumption set, given
the amount available to
spend and the prices of
the goods
Suppose that Abdul has $1.20 to spend, and wants to split his purchases between
apples (which are 20c each) and cola (which is 40c per bottle). He can choose to spend
the whole amount on apples, or on cola – or can buy some of each. Given these prices,
he could buy six apples or three bottles of cola. The possibilities are shown as the
budget line in Figure 14.3. This connects the combinations of apples and cola that
Abdul could purchase. For example, he could buy four apples and one bottle of cola,
as marked on the figure. One way of interpreting the budget line is as the boundary
showing the combinations of apples and cola that Abdul can afford – he could not
choose to consume beyond the budget line. The slope of the budget line is given by
the relative prices of the two goods.
4
3
2
1
BL
0
0
2
4
6
8
10
Apples
▲ Figure 14.3 Abdul’s budget line
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indifference curve:
a curve showing
the combinations of
two goods that give
equal total utility to a
consumer
marginal rate of
substitution: the slope
of an indifference curve,
showing the amount
of one good that a
consumer must give up
in exchange for another
while keeping total
utility constant
Test yourself 14.4
How would the budget
line differ if Abdul had
$2 to spend, with the
prices of these goods
having remained the
same?
The indifference curve
In order to analyse Abdul’s choice between apples and cola, some way is needed to
show his preferences on the diagram. This can be done using indifference curves. An
indifference curve shows the various combinations of apples and cola that give Abdul
equal satisfaction – that is, equal utility. These are downward sloping because Abdul
can trade off the satisfaction received from one of the goods against that from the
other. In other words, if he consumes fewer apples, he needs to consume more cola
in order to maintain equal utility. The slope of an indifference curve is known as the
marginal rate of substitution between the goods, and is equal to the ratio of the
marginal utilities that Abdul receives from the two goods.
Figure 14.4 shows three such curves. Consider the curve IC2. This shows that Abdul
would receive equal utility from consuming two bottles of cola and two apples as he
would from three bottles of cola and one apple. Similarly, any point along this curve
would be equally satisfactory to Abdul (if he could consume fractions of bottles or
apples). The same argument applies to the other curves shown in the diagram, but
because we assume that Abdul would prefer more to less, he would maximise utility by
reaching the highest possible curve that he can reach. In other words, he would prefer
to be on IC2 than on IC1, but IC3 would be better than both.
Bottles of cola
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
14
KEY TERMS
4
3
2
IC3
IC2
IC1
1
0
0
2
4
6
8
10
Apples
▲ Figure 14.4 Abdul’s indifference curves
Abdul’s choice
KEY TERM
Bottles of cola
consumer equilibrium:
the point at which a
consumer maximises
utility at the tangency
between an indifference
curve and the budget
line
Abdul cannot choose to be on just any of the curves, as he is constrained by his budget
line. If the budget line is superimposed on the map of indifference curves, his choice can
be identified. This can be seen in Figure 14.5. The highest indifference curve that Abdul
can reach given his budget line (BL) is IC2. The budget line just touches the indifference
curve at one point, where Abdul consumes two bottles of cola and two apples. At any
other point along the budget line or below it, he would receive lower utility than this.
The tangency point at A is his choice point, and represents consumer equilibrium. It
is the point at which the ratio of the marginal utilities (the slope of the indifference
curve) is equal to relative prices (the slope of the budget line).
STUDY TIP
Notice that this
consumer equilibrium
at the tangency point
echoes the earlier
discussion of the equimarginal principle.
4
3
A
2
IC3
IC2
IC1
BL
1
0
0
2
4
6
8
10
Apples
▲ Figure 14.5 Abdul’s choice
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A shift in Abdul’s budget
Bottles of cola
6
5
4
B
3
A
2
Test yourself 14.5
1
Explain why Abdul is
better off at point B than
at point A.
0
IC3
IC2
BL IC1
BL1
0
0
2
4
6
8
10
12
Apples
14
14 Marginal utility and consumer choice
Suppose that Abdul receives an increase in his income, so that his budget for
spending on these goods increases: for example, suppose he found an extra 80c in his
pocket so he now has $2 to spend on these goods. Given that the prices of the goods
remain as before, his budget line moves out, but keeps the same slope as before. This
is shown in Figure 14.6, where the budget line moves from BL0 to BL1. As a result,
Abdul can now reach a higher indifference curve by moving from point A to point
B. He now consumes three bottles of cola and four apples. In this example, Abdul
increases his consumption of both goods as income rises, indicating that they are
both normal goods.
▲ Figure 14.6 A change in Abdul’s budget
Bottles of cola
This need not be the case. The indifference curves could be such that the change in
income causes Abdul to consume less of one of the goods. In other words, one of the
goods could be an inferior good. Figure 14.7 illustrates this on the assumption that
Abdul can consume fractions of bottles of cola and apples. In this example, Abdul
responds to the change in income by consuming more apples, but less cola.
6
5
4
3
A
2
B
IC2
BL0
1
0
0
2
4
6
IC1
BL1
8
IC3
10
12
Apples
▲ Figure 14.7 A change in Abdul’s budget when cola is an inferior good
LEARNING
LINK
The concepts of
normal and inferior
goods were introduced
in Chapter 2.
A change in relative prices
If there is a fall in the price of apples, Abdul’s budget line is again affected.
Figure 14.8 shows what happens to his budget line if the price of apples halves.
He can now consume either three bottles of cola (if he spends his entire budget
on cola), or 12 apples. With this set of indifference curves, his choice changes
from point A to point B, and he continues to consume two bottles of cola, but now
chooses four apples.
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Bottles of cola
14
4
3
A
2
B
IC3
IC2
0
BL0
0
2
4
IC1
6
BL1
8
10
12
Apples
▲ Figure 14.8 A fall in the price of apples
KEY TERMS
substitution effect of a
price change: reflects
the way that a change
in the price of a good
affects relative prices
income effect of a price
change: reflects the
way that a change in the
price of a good affects
purchasing power
(income)
Notice that a fall in the price of apples has two separate effects on Abdul. On the one
hand, there has been a change in the relative price of apples and cola, so Abdul will
tend to substitute his consumption from the more expensive to the cheaper item (i.e.
he will tend to switch from consuming cola to consuming apples). However, there is
also a second effect, which is that the fall in the price of apples means that Abdul has
higher real income, in the sense that his budget line has shifted out, and his choice
set has expanded.
It is possible to identify these two effects. Consider Figure 14.9. This time,
suppose that there is an increase in the price of apples, shifting the budget
line from BL0 to BL1. Abdul’s initial choice point is at A, and the increase in the
price of apples means that he can no longer reach this point, and thus ends up
at B. Given the new relative prices, the shadow budget line BL* shows the level
of income that would have left Abdul at his original utility level – that is, this
would have allowed him to reach IC2. The impact of the price change is partly
a substitution effect along the indifference curve from A to C, and partly an
income effect from C to B.
Bottles of cola
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
1
IC2
IC1
C
A
LEARNING
LINK
These effects were
introduced briefly
in an extension box
in Chapter 2 (see
page 27).
B
BL1
BL*
BL0
Apples
▲ Figure 14.9 Income and substitution effects of a price change
Notice that in this example, both apples and cola are normal goods, and the
substitution and income effects work in the same direction. In other words, when
the price of apples increases, both income and substitution effects reduce the
consumption of apples.
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C
A
B
IC2
BL1
LEARNING
LINK
The notion of the Giffen
good was introduced
in an extension box
in Chapter 2 (see
page 30), where it
was noted that such
goods exist in theory,
but rarely (if ever) in
practice.
STUDY TIP
Remember that three
key limitations of the
indifference curve
model are:
» indifference curves
cannot be identified
» consumers’
expectations may
not be realised
» consumers may not
act rationally
BL0
Apples
KEY TERM
Giffen good: a good
for which the income
effect is so strong that
it more than offsets
the substitution effect,
so that the demand
curve becomes upward
sloping
BL* IC1
▲ Figure 14.10 Income and substitution effects of a price change when apples are
an inferior good
14
14 Marginal utility and consumer choice
Bottles of cola
Figure 14.10 shows that when apples are an inferior good, the substitution and income
effects work in opposite directions. Abdul’s tendency to substitute cola for apples
(from A to C) is partly offset by the income effect from C to B: as income falls, Abdul
tends to consume more apples.
Notice that in this case, the demand (MU) curve would still be downward sloping,
because the income effect only partially offsets the substitution effect. The demand
curve would only become upward sloping if the income effect were so strong that
it more than offset the substitution effect. If this did happen, the good would be
classed as a Giffen good.
EXERCISE 14.2
Suppose that Jennifer is allocating her available budget between two goods.
Using a diagram, explain the impact of an increase in the price of one of the
goods, distinguishing between the income and substitution effects.
Limitations of the indifference curve model
The indifference curve model allows us to analyse consumer choice and to identify how
individuals may respond to a price change in terms of income and substitution effects.
However, there are some limitations of the model.
For an individual consumer, the budget line can be identified, but it is not possible to
plot out the indifference curves, so these are effectively just a theoretical construct
that cannot be observed in practice.
Even if it were possible to persuade consumers to reveal the satisfaction that they
expect to receive from consuming a set of goods and services, those expectations
may not be fulfilled in reality. For example, it could be that the experience of
actually consuming a product may exceed those expectations – or provide less
satisfaction than had been anticipated. Advertising or recommendations from
friends and relatives may not paint an accurate picture of what it will be like to
consume a product.
It was noted earlier that consumers may not always act rationally to maximise their
utility. If this is the case, then a model that rests on the assumption that consumers
are rational would not help us to explain actual behaviour.
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» The budget line shows the combination of goods
» The effects of a price change can be divided into an
that an individual can consume given the amount
available to spend and the prices of the goods.
» An indifference curve maps the preferences of a
consumer between two goods.
» Utility from consuming two goods is maximised
where an indifference curve is at a tangent to the
budget line.
income effect and a substitution effect.
» The indifference curve model is a tool that aids our
understanding of consumer choice, but it has its
limitations in practice.
END OF CHAPTER QUESTIONS
Multiple choice
1 Figure 14.11 illustrates the effect of a rise in the price of a Giffen good B.
Good A
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
14
SUMMARY: INDIFFERENCE CURVES AND BUDGET LINES
b
a
c
I1
B2
0
I2
B1’
B1
Qb2 Qb1 Qb3
Good B
▲ Figure 14.11 The effect of a rise in the price of a Giffen good
Which option correctly describes the effects taking place on the diagram following
the rise in price?
Qb1 to Qb2
Qb2 to Qb3
Qb1 to Qb3
A
Price effect
Income effect
Substitution effect
B
Income effect
Substitution effect
Price effect
C
Price effect
Substitution effect
Income effect
D
Substitution effect
Income effect
Price effect
2 What is a valid limitation of indifference analysis applying when an individual
purchases a washing machine versus most other goods?
A The individual can be misled by advertising, thus distorting their rational choice.
B The individual might have derived more utility from purchasing other goods.
C Indifference analysis considers consumer choice at a point in time, but
consumer durables are only purchased infrequently but consumed over an
extended period.
D The individual cannot plot the indifference curves to determine the point of
tangency to their highest attainable budget line.
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Data response
1 Read the following extract and then answer the questions that follow.
14
Mei’s iced latte and chocolate muffin utility
Mei lives in Hong Kong close to the Causeway Bay railway station. She
sometimes buys an iced latte coffee or a chocolate muffin from a coffee shop
at the station.
Mei has calculated the utility derived from her consumption of a chocolate
muffin and an iced latte coffee, the results of which are summarised in
Table 14.4.
▼ Table 14.4 Utility derived from the consumption of a chocolate muffin and iced latte
Number of (large)
iced latte coffee
drinks
Total utility
Number of
chocolate muffins
Marginal utility
1
80
1
44
2
144
2
40
3
192
3
36
4
224
4
32
5
240
5
28
14 Marginal utility and consumer choice
The price of a chocolate muffin is 20 HKD (Hong Kong dollars) while her
favourite (large) iced latte coffee is priced at 40 HKD.
a Explain how the law of diminishing marginal utility can justify Mei’s downwardsloping (left to right) demand curve for large iced latte drinks.
b Use the equi-marginal principle to explain Mei’s utility-maximising
consumption of chocolate muffins and iced latte drinks and comment on
the validity of the outcome.
c Suppose Mei had 160 HKD. Draw her budget line with respect to chocolate
muffins and iced latte and the indifference curve on which she will consume.
Mark on your diagram a point X, where Mei spends all her income but does
not attain maximum utility, and a point Y, Mei’s utility-maximising level of
consumption.
d Distinguish between the income and substitution effects following an
increase in the price of a chocolate muffin compared to those effects
when the price of an inferior good increases.
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A LEVEL PART 7 The price system and the microeconomy
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
15
Efficiency and market failure
What this chapter covers
★ productive efficiency and allocative efficiency
★ Pareto optimality
★ dynamic efficiency
★ the meaning and sources of market failure
In the early stage of your study of economics, you became familiar with the demand
and supply model and the way in which prices act as signals to guide resource
allocation. It is now time to take this discussion further and adopt a wider view of
how resources are allocated within a society. We will explore how economists view the
important concept of efficiency, and whether markets can be relied on to guide this
process, or whether there are times when markets will fail.
15.1 Productive efficiency and allocative efficiency
Prices and resource allocation
The notions of consumer surplus and producer surplus are important because they
can be used to evaluate the total benefit that consumers and producers receive from
consuming and producing a good. When consumers all pay the same price for a good
in a market, then the area of consumer surplus can be interpreted as the total welfare
that consumers receive from consuming that good. Similarly, the producer surplus is
interpreted as the surplus earned by firms over and above the minimum return that
would have kept them in the market. In a market system, prices are the signals that
carry information between consumers and producers, and which ultimately guide the
decisions that influence the way in which resources are allocated.
LEARNING
LINK
The concepts of
consumer and
producer surplus
were introduced in
Chapter 4.
Test yourself 15.1
Why is it difficult to
judge whether society is
better off at B than C in
Figure 15.1?
The underlying assumption that is made in this context is that consumers aim to maximise
their surplus, and firms aim to maximise profits. In other words, both consumers and firms
are assumed to be motivated by self-interest, and the key question is whether this will
lead to a good outcome for society as a whole in the way that resources are allocated.
Will resources be allocated in an efficient way? And what do we mean by efficiency?
Efficiency
In tackling the fundamental economic problem of scarcity, a society needs to find a way
of using its limited resources as effectively as possible. In everyday language it might be
natural to refer to this as a quest for efficiency. From an economist’s point of view there are
two key aspects of efficiency, both of which are important in evaluating whether markets in
an economy are working effectively to deliver efficiency.
Chapter 1 introduced one of these aspects in relation to the production possibility
curve (PPC). Figure 15.1 shows a country’s production possibility curve. One of the
choices to be made in allocating resources in this country is between producing
agricultural or manufactured goods.
In Chapter 1 it was seen that at a production point such as A, the economy would not
be using its resources fully, since by moving to a point on the PPC it would be possible
to produce more of both types of good. For example, if production took place at point
B, then more of both agricultural and manufactured goods could be produced, so that
society would be better off than at A.
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Quantity of manufactured goods per period
C
B
A
PPC
Quantity of agricultural goods per period
▲ Figure 15.1 Productive efficiency and the PPC
▲ Vilfredo Pareto
KEY TERMS
Pareto optimum:
an allocation of
resources is said to be
a Pareto optimum if no
reallocation of resources
can make an individual
better off without making
some other individual
worse off
productive efficiency:
attained when a firm
operates at minimum
average total cost,
choosing an appropriate
combination of inputs
(cost efficiency) and
producing the maximum
output possible from
these inputs (technical
efficiency)
average total cost:
total cost of production
divided by the quantity
produced
economies of scale:
occur for a firm when
an increase in the scale
of production leads to
production at lower
long-run average cost
A similar claim could be made for any point along the PPC: it is more efficient to
be at a point on the frontier than at some point within it. However, if you compare
point B with point C, you will notice that the economy produces more manufactured
goods at C than at B – but only at the expense of producing fewer agricultural
goods.
15 Efficiency and market failure
0
15
This draws attention to the trade-off between the production of the two sorts of
goods. It is difficult to judge whether society is better off at B or at C without
knowing more about the preferences of consumers.
This discussion highlights the two aspects of efficiency. On the one hand, there is
the question of whether society is operating on the PPC, and thus using its resources
effectively. On the other hand, there is the question of whether society is producing
the balance of goods that consumers wish to consume. These two aspects of efficiency
are known as productive efficiency and allocative efficiency, and are discussed in more
detail below.
An efficient point for a society would be one in which no redistribution of resources
could make any individual better off without making some other individual worse off.
This is known as the Pareto criterion, after the nineteenth-century economist Vilfredo
Pareto, who first introduced the concept.
Notice, however, that any point along the PPC is a Pareto optimum: with a different
distribution of income among individuals in a society, a different overall equilibrium
will be reached.
Aspects of efficiency can be explored further by considering an individual market.
First, however, it is necessary to identify the conditions under which productive and
allocative efficiency can be attained.
Productive efficiency
The production process entails combining a range of inputs of factors of production
in order to produce output. Firms may find that there are benefits from large-scale
production, so that efficiency may improve as firms expand production.
One way of measuring productive efficiency is in terms of the average total cost
of production. This is simply the total cost of production divided by the quantity of
output produced. Productive efficiency can then be defined in terms of the minimum
average cost at which output can be produced, noting that average cost is likely to
vary at different scales of output. Economies of scale occur when an increase in the
scale of production leads to production at lower long-run average cost.
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The nature of the
costs faced by firms
is examined in
Chapter 17, where
there is also an
explanation of
economies of scale.
There are two aspects to productive efficiency. One entails making the best possible
use of the inputs of factors of production: in other words, it is about producing as
much output as possible from a given set of inputs. This is sometimes known as
technical efficiency. However, there is also the question of whether the best set of
inputs has been chosen. For example, there may be techniques of production that use
mainly capital and not much labour, and alternative techniques that are more labour
intensive. The firm’s choice between these techniques will depend crucially on the
relative prices of capital and labour. This is sometimes known as cost efficiency.
To attain productive efficiency, both technical efficiency and cost efficiency need to
be achieved. In other words, productive efficiency is attained when a firm chooses the
appropriate combination of inputs (cost efficiency) and produces the maximum output
possible from those inputs (technical efficiency).
It is worth noting that the choice of technique of production may depend crucially on
the level of output that the firm wishes to produce. The balance of factors of
production may well change according to the scale of activity. If the firm is producing
very small amounts of output, it may well choose a different combination of capital
and labour than if it were planning mass production on a large scale.
Thus, the firm’s decision process is a three-stage procedure. First, the firm needs to
decide how much output it wants to produce. Second, it has to choose an appropriate
combination of factors of production, given that intended scale of production. Third,
it needs to produce as much output as possible, given those inputs. Once the intended
scale of output has been decided, the firm has to minimise its costs of production.
These decisions are part of the response to the question of how output should be
produced. Remember also the concept of marginal cost, which refers to the cost faced
by a firm in changing the output level by a small amount. This becomes an important
part of the discussion.
Allocative efficiency
KEY TERM
allocative efficiency:
achieved when society
is producing an
appropriate bundle
of goods relative to
consumer preferences –
this occurs when price
equals marginal cost
Allocative efficiency is about whether an economy allocates its resources in such a
way as to produce a balance of goods and services that matches consumer preferences.
In a complex modern economy, it is clearly difficult to identify such an ideal result.
How can an appropriate balance of goods and services be identified?
Take the market for an individual product, such as the market for smartphones that
was considered in Chapter 4. It was then argued that in the long run, the market
could be expected to arrive at an equilibrium price and quantity at which there was
no incentive for firms either to enter the market or to exit from it. Figure 15.2 will
remind you of the market situation.
Price
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
15
LEARNING
LINK
S0
S2
P1
P0
D0
0
Q0
D1
Q1 Q2
Quantity of smartphones per period
▲ Figure 15.2 The market for smartphones revisited
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The sequence of events in the diagram shows that, from an initial equilibrium with
price at P0 and quantity traded at Q0, there was an increase in demand, with the
demand curve shifting to D1. In response, existing firms expanded their supply,
moving up the supply curve. However, the lure of the producer surplus (abnormal
profits) that was being made by these firms then attracted more firms into the
market, such that the supply curve shifted to S2, a process that brought the price back
down to the original level of P0.
However, it was also argued that from the consumers’ point of view any point along
the demand curve could be regarded as the marginal benefit received from consuming
a good or service.
Where is all this leading? Putting together the arguments, it would seem that market
forces can carry a market to a position in which, from the firms’ point of view, the
price is equal to marginal cost, and from the consumers’ point of view, the price is
equal to marginal benefit.
15 Efficiency and market failure
Now think about that price from the point of view of a firm. P0 is at a level where
there is no further incentive to attract new firms, but no firm wishes to leave the
market. In other words, no surplus is being made on that marginal unit, and the
marginal firm is just breaking even on it. The price in this context would seem to be
just covering the marginal cost of production.
15
This is an important result. Suppose that the marginal benefit from consuming a
good were higher than the marginal cost to society of producing it. It could then
be argued that society would be better off producing more of the good because, by
increasing production, more could be added to benefits than to costs. Equally, if the
marginal cost were above the marginal benefit from consuming a good, society would
be producing too much of the good and would benefit from producing less. The best
possible position is thus where marginal benefit is equal to marginal cost – in other
words, where price is set equal to marginal cost.
One way of viewing this system is through the notion of opportunity cost, introduced
in Chapter 1. For example, in choosing to produce onions, a farmer faces an opportunity
cost. If resources are indeed used to produce onions, those resources are not being
EXERCISE 15.1
Quantity of investment goods per period
Consider Figure 15.3, which shows a production
possibility curve (PPC) for an economy that produces
consumer goods and investment goods.
A
Identify each of the following (hint: in some cases
more than one answer is possible):
a a point of productive inefficiency
b a point that is Pareto-superior to B
c a point of productive efficiency
d a point of allocative efficiency
e an unreachable point (hint: think about what
would need to happen for society to reach such a
point)
C
B
D
PPC
0
Quantity of consumer goods per period
▲ Figure 15.3 A production possibility curve
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A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
15
Test yourself 15.2
What are the two key
aspects of efficiency?
used to grow sweet potatoes. There may come a point at which the cost of producing
onions becomes too high if the profitability of sweet potatoes is so much higher than
that for onions, because of changes in the pattern of consumer demand. When the firm
finds that it is not covering its opportunity costs, it will transfer production from the
market for onions to the market for sweet potatoes. Notice that this discussion is built
on the assumption that firms are free to enter a market, or to exit from it.
If all markets in an economy operated in this way, resources would be used so
effectively that no reallocation of resources could generate an overall improvement.
Allocative efficiency would be attained. The key question is whether the market
mechanism will work sufficiently well to ensure that this happens – or whether it will
fail. In other words, are there conditions that could arise in a market, in which price
would not be set at marginal cost? We will return to this issue shortly.
Dynamic efficiency
KEY TERM
dynamic efficiency: a
view of efficiency that
takes into account the
effects of innovation
and technological
progress on productive
and allocative efficiency
in the long run
The discussion of efficiency so far has been conducted in terms of how to make the best
use of existing resources, producing an appropriate mix of goods and services and using
factor inputs as efficiently as possible given existing knowledge and technology. This is
good as far as it goes, but it does represent a relatively static view of efficiency.
Dynamic efficiency goes one step further, recognising that the state of knowledge
and technology changes over time. For example, investment in research and
development today means that production can be carried out more efficiently at some
future date. Furthermore, the development of new products may also mean that a
different mix of goods and services may serve consumers better in the long term.
The notion of dynamic efficiency stemmed from the work of Joseph Schumpeter,
who argued that a preoccupation with static efficiency (efficiency in the short
run) may sacrifice opportunities for greater efficiency in the long run. In other
words, there may be a trade-off between achieving efficiency today and improving
efficiency tomorrow.
SUMMARY: PRODUCTIVE EFFICIENCY AND ALLOCATIVE EFFICIENCY
» A society needs to find a way of using its limited
resources as efficiently as possible.
» Productive efficiency occurs when firms have
chosen appropriate combinations of factors of
production and produce the maximum output
possible from those inputs.
» Allocative efficiency occurs when firms produce
an appropriate bundle of goods and services, given
consumer preferences.
» An allocation of resources is said to be a Pareto
optimum if no reallocation of resources can make
KEY TERM
market failure: a
situation in which the
free-market equilibrium
does not lead to a socially
optimal allocation of
resources, such that too
much or too little of a
good is being produced
and/or consumed
an individual better off without making some other
individual worse off.
» An individual market exhibits aspects of allocative
efficiency when the marginal benefit received by
society from consuming a good or service matches
the marginal cost of producing it – that is, when
price is equal to marginal cost.
» Dynamic efficiency recognises that there may be a
trade-off between efficiency in the short run and
in the long run.
15.2 Market failure
What is market failure?
A key question in microeconomics is whether markets will work in such a way as to
produce a good outcome for society as a whole. Market failure occurs when this is not
the case. When we look at how markets do work, it turns out that there are significant
situations in which markets do not produce the best for society.
An ideal outcome for society would be where, for each good or service, the marginal
benefit that society receives from consuming the good matches the marginal cost of
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KEY TERMS
marginal social cost
(MSC): the cost to
society of producing an
extra unit of a good
asymmetric
information: a
situation in which some
participants in a market
have better information
about market conditions
than others
Test yourself 15.3
In the case of a merit
good, will too much or
too little of the good be
consumed?
LEARNING
LINK
Externalities are
discussed in more
detail in the next
chapter, which
shows how they
lead to allocative
inefficiency.
15
Reasons for market failure
Externalities
If the costs that firms and consumers face and the prices to which they respond
do not reflect the actual costs and benefits associated with the production and
consumption of goods, then the market equilibrium will not represent the best
outcome for society, even if demand seems to equal supply.
Suppose your elder sister is on a gap year before going to uni. She owns a car and is
still living at home. You persuade her to give you a lift to college, although this takes
her out of her way. What would she charge you for this? The journey will obviously
cost her fuel, but is that the only cost? What about the wear and tear on her car? Her
time? The loss of value of her car because of the increase in mileage? If she only
charges you for the fuel, you will think that the journey is cheaper than it actually is
and might ask her to drive you every day.
An externality exists where the economic agents do not pay all of the costs, or are
unaware of all the benefits. These extra costs or benefits are often to society, rather
than specifically to the agents.
15 Efficiency and market failure
marginal social benefit
(MSB): the additional
benefit that society
gains from consuming
an extra unit of a good
producing it. If the actual amount is larger or smaller than this then the society could
be better off. Notice that when we talk about marginal benefit and marginal cost here,
it is the marginal benefit and cost to society that is relevant. We will refer to these as
marginal social benefit and marginal social cost.
Information failures
If markets are to be effective in guiding resource allocation, it is important that
economic decision-makers receive full and accurate information about market
conditions. Consumers need information about the prices at which they can buy
and the quality of the products for sale. Producers need to be able to observe how
consumers react to prices. Information is thus of crucial significance if markets are to
work. However, there are some markets in which not all traders have access to good
information, or in which some traders have more or better access to it than others.
This is known as a situation of asymmetric information, and can be a source of
market failure.
EXERCISE 15.2
Mary, who has retired, is sitting quietly at home when there is a knock on the
door. At the door is a stranger who tells her that he has noticed that her roof is
in desperate need of repair, and if she does not get something done about it very
soon, there will be problems in the next rainstorm. Fortunately, he can help – for
a price. Discuss whether there is a market failure in this situation, and what Mary
(or others) could do about it.
Healthcare
One example of asymmetric information is in healthcare. Suppose you go to
your dentist for a check-up. He tells you that you have a filling that needs to be
replaced, although you have had no pain or problems with it. In this situation the
seller in a market has much better information about the product than the buyer.
You as the buyer have no idea whether or not the recommended treatment is needed,
and without going to another dentist for a second opinion you have no way of
finding out. You might think this is an unsatisfactory situation, as it seems to give
a lot of power to the seller relative to the consumer. The situation is even worse
where the dentist does not even publish the prices for treatment until after it has
been carried out!
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The same argument applies in the case of other areas of healthcare, where doctors have
better information than their patients about the sort of treatment that is needed.
15
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
Test yourself 15.4
Eighteen-year-olds
whose parents or
relatives have attended
university are much
more likely to take up
a university place than
those from families
where nobody has
ever attended. To what
extent could this be a
result of an information
failure?
Education
The market for education is similar. Teachers or government inspectors may know
more about the subjects and topics that students need to study than the students do
themselves. This is partly because teachers are able to take a longer view and can see
education provision in a broader perspective. Students taking economics at university
may have to take a course in mathematics and statistics in their first year, and some
will always complain that they have come to study economics, not maths. It is only
later that they come to realise that competence in maths is crucial these days for the
economics that they will study later in their course.
How could this problem be tackled? The answer would seem to be obvious – if the
problem arises from an information failure, then the answer should be to improve the
information flow, in this case to students. This might be achieved by providing a
convincing explanation of why the curriculum has been designed in a particular way.
It may also be necessary to provide incentives for students to study particular
unpopular subjects, perhaps by making success a requirement for progression to the
next stage of the course. By understanding the economic cause of a problem, it is
possible to devise a strategy that should go some way towards removing the
market failure.
Second-hand cars
One of the most famous examples of asymmetric information relates to the secondhand (or ‘pre-owned’, by the latest terminology) car market. This is because the
first paper that drew attention to the problem of asymmetric information, by Nobel
laureate George Akerlof, focused on this market.
▲ Second-hand cars
Akerlof argued that there are two types of car. Some cars are good runners and are
totally reliable, whereas some are continually breaking down and needing parts and
servicing; the latter are known as ‘lemons’ in the USA (allegedly from fruit machines,
where lemons offer the lowest prize). The problem in the second-hand car market arises
because the owners of cars (potential sellers) have better information about their cars
than the potential buyers. In other words, when a car owner decides to sell a car, he or
she knows whether it is a lemon or a good-quality car – but a buyer cannot tell.
In this sort of market, car dealers can adopt one of two possible strategies. One is to
offer a high price and buy up all the cars in the market, knowing that the lemons will
be sold on at a loss. The problem is that, if the lemons make up a large proportion
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STUDY TIP
You may recall that the
key characteristics of
public goods are that
they are non-exclusive,
non-rivalrous and nonrejectable.
The concepts of merit
and demerit goods
and public goods
were introduced
in Chapter 1 and
discussed further in
Chapter 5.
STUDY TIP
Don’t forget that having
price equal to marginal
cost is the key indicator
of allocative efficiency.
You will see in
Chapters 18 and 19 that
there are some market
structures in which
price is likely to be set
above marginal cost.
Test yourself 15.5
Name three possible
causes of market
failure.
15
Again, the solution may be to tackle the problem at its root, by finding a way to provide
information. In the case of second-hand cars, some dealers may offer warranties as a
way of improving the flow of information about the quality of cars for sale.
Merit and demerit goods
Information failure is at the heart of the examples of merit and demerit goods.
In this case, the nature of the information failure is that the government sees that
consumers of a good misperceive the benefits and/or costs of consuming a good or
service. This may then cause merit goods to be underconsumed and demerit goods to
be overconsumed. This in turn means that there will be a divergence between marginal
social benefits and marginal social costs.
Public goods
Another form of market failure involves the provision of public goods, where the problem
arises from the characteristics of the goods. The root of the market failure here is the
free-rider problem, which removes the incentive for firms to supply public goods.
15 Efficiency and market failure
LEARNING
LINK
of the cars in the market, this could generate overall losses for the dealers. The
alternative is to offer a low price, and just buy up all the lemons to sell for scrap.
In this situation, the market for good-quality used cars is effectively destroyed – an
extreme form of market failure!
Firm dominance in a market
Another form of market failure may occur when a firm or firms hold such a strong
position in a market that they can take advantage of the situation at the expense of
others – either their consumers or their suppliers. For example, a firm may be able to
charge a higher price for its product because of the lack of effective competition in
the market. This will be discussed further in Chapters 18 and 19.
EXERCISE 15.3
Identify the form of market failure associated with each of the following:
a the use of tobacco
b the provision of a police officer
c vaccination against measles
d a situation in which a firm cannot easily monitor how hard an employee is
working
e a firm with such a dominant position in a market that it is able to raise the
price of its product
SUMMARY: MARKET FAILURE
» Free markets do not always lead to the best
possible allocation of resources: there may be
market failure, causing the market equilibrium to
diverge from the socially optimum position.
» When there are costs or benefits that are external
to the price mechanism, the economy will not
reach allocative efficiency.
» Markets can operate effectively only when
participants in the market have full information
about market conditions.
» Goods that the government believes will be
underconsumed (overconsumed) in a free market
are known as merit goods (demerit goods).
» Public goods have characteristics that prevent
markets from supplying the appropriate quantity.
» Markets may fail when firms are able to utilise
market power to disadvantage consumers.
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END OF CHAPTER QUESTIONS
Multiple choice
1 A student has written the following three statements about economic efficiency:
i Productive efficiency is attained at lowest long-run average cost (LRAC).
ii Allocative efficiency is achieved where P = MU.
iii Allocative efficiency is achieved where MSB = MSC.
Which of the statements are true?
A i and ii
B i and iii
C ii and iii
D only i
2 The diagram represents the relationship between R&D costs and LRAC. Which
economic concept is being illustrated?
R&D costs
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
15
0
LRAC
A productive efficiency
C dynamic efficiency
B allocative efficiency
D economic efficiency
Data response
1 Read the following extract and then answer the questions that follow.
The problems of Kenyan flower production
Kenya is one of the largest exporters of cut flowers in the world. Indeed, in
2020 Kenya’s main export was horticultural products, closely followed by tea.
Europeans often turn to surprisingly cheap supermarket blooms at
celebration times, but many may not realise that up to 38% of those bouquets
were grown in Kenya.
Cheap labour helps Kenyan flower farmers to minimise costs with over
2 million workers employed locally in the labour-intensive industry. However,
with increasing competition, notably from the technology-rich Netherlands,
Kenyan flower producers must be very aware of getting the right cost
combination of labour and capital inputs.
Despite clear success in this multi-billion-dollar industry, Kenya will not
necessarily achieve Pareto optimality in its resource allocation. Moreover, its
success will almost certainly have come at a price. An initial lack of regulation
over the use of chemical fertilisers has resulted in the significant pollution
of freshwater sources such as Kenya’s Lake Naivasha. More recently,
interventions have been put in place reflecting dynamic efficiency. However,
fish farmers face smaller catches as experts warn it could take 40 years for
lakes such as Naivasha to recover.
Those bathing in contaminated water can also suffer health problems; eye
infections have been reported. Therein lies a further set of problems. Those
suffering with such conditions will be unsure if they require relatively expensive
local healthcare. If they decide they do, they may be similarly unsure whether any
medication they receive is necessary or ultimately the best value for money.
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a Explain why a point on a production possibility curve diagram using Kenya’s
two main exports could be productively but not allocatively efficient.
b Assume that a Kenyan flower farm is producing its desired output level from
a given set of inputs at the minimum average cost from those inputs. With
reference to the extract, explain why this flower farm may not be productively
efficient.
15
c Define the term ‘dynamic efficiency’.
e Discuss, using the extract, the extent to which market failure in the
healthcare sector could be caused by asymmetric information.
15 Efficiency and market failure
d Explain what is meant by Pareto optimality in resource allocation and state where
on a production possibility curve diagram Pareto optimality is achieved.
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A LEVEL PART 7 The price system and the microeconomy
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
16
Private costs and benefits, externalities
and social costs and benefits
KEY TERMS
What this chapter covers
private cost: a cost
incurred by an individual
(firm or consumer) as
part of its production
or other economic
activities
★ private and social benefits and costs
★ externalities: negative and positive externalities in production and
external cost: a cost
associated with an
individual’s (a firm or
household’s) production
or other economic
activities, which is
borne by a third party
and is not reflected in
market prices
social costs: the sum
of private and external
costs
private benefit: the
benefit received by an
individual (a firm or
consumer) as part of its
economic activity
external benefit:
the benefit received
by society (a firm or
household) that accrues
to a third party (firm or
household) not engaged
in that economic
activity, but which is
not reflected in market
prices
social benefits: the sum
of private benefits and
external benefits
Test yourself 16.1
What is the difference
between marginal
private cost and
marginal social cost?
★
★
★
★
★
consumption
deadweight loss associated with externalities
examples of markets with externalities
asymmetric information and moral hazard
costs and benefits in decision making
social cost–benefit analysis
If markets are to be effective in guiding the allocation of resources in society, a
precondition is that market prices are able to reflect the full costs and benefits
associated with market transactions. However, there are many situations in which
this is not so, and there are costs or benefits that are external to the workings of
the market mechanism. This chapter examines the circumstances in which this may
happen, and provides a justification for government intervention to improve the
workings of the market.
16.1 Private and social benefits and costs
In the next chapter, we will be considering the costs faced by producers in the
production process. Such costs are private costs, in the sense that firms must meet
these costs, which they do by factoring them into the prices that they charge for
their products. However, in the case of some products there are costs associated with
production that are not borne directly by the producers, but by third parties. These
are known as external costs. From the viewpoint of society as a whole, the costs of
production should include both private and external costs. So, the social costs of
production are equal to private costs plus external costs.
Similarly, we should realise that the private benefits received by an individual
(consumer or firm) from the production of a good or service may be augmented by
external benefits that are received by third parties to a transaction. So, the social
benefits are equal to private benefits that accrue to individuals plus the external
benefits received by third parties.
When considering whether a market is achieving allocative efficiency, it is important
that these external costs and benefits are taken into account to avoid inflicting costs
on society.
EXERCISE 16.1
In the production of a product, the costs faced by firms amount to $75 and the
consumers of the product receive benefits of $90. However, there are also costs
that are not borne directly by the firms, which amount to $20. In addition, there
are spin-off benefits of $15.
Is the overall balance of social benefits and social costs positive or negative?
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SUMMARY: PRIVATE AND SOCIAL BENEFITS AND COSTS
» A cost borne by an individual (firm or consumer) as
consumer) as part of its economic activity is a
private benefit.
» The benefit received by society (a firm or
household) that accrues to a third party (firm or
household) not engaged in that economic activity,
but which is not reflected in market prices, is an
external benefit.
» The social benefit associated with an economic
activity is the sum of private and external benefits.
16.2 Externalities
KEY TERMS
externality: a cost or a
benefit that is external
to a market transaction,
and is thus not reflected
in market prices
consumption
externality: an
externality that impacts
on the consumption
side of a market, which
may be either positive
or negative
production externality:
an externality that
impacts on the
production side of a
market, which may
be either positive or
negative
Externality is one of those ugly words invented by economists, which says exactly
what it means. It simply describes a cost or a benefit that is external to the market
mechanism.
An externality will lead to a form of market failure because if the cost or benefit is
not reflected in market prices, it cannot be taken into consideration by all parties
to a transaction. In other words, there may be costs or benefits resulting from a
transaction that are borne (or enjoyed) by some third party not directly involved in
that transaction. This in turn implies that decisions will not be aligned with the best
interests of society.
For example, if there is an element of costs that is not borne by producers, it is likely that
‘too much’ of the good will be produced. Where there are benefits that are not included,
it is likely that too little will be produced. Later in the chapter, it will be shown that
this is exactly what does happen. Externalities can affect either demand or supply in a
market: that is to say, they may arise either in consumption or in production.
In approaching this topic, begin by tackling Exercise 16.2, which offers an example of
each type of externality.
16
16 Private costs and benefits, externalities and social costs and benefits
part of its production or other economic activities
is a private cost.
» A cost that is associated with an individual’s (a
firm or household’s) production or other economic
activities that is borne by a third party and is not
reflected in market prices is an external cost.
» The social cost of an economic activity is the sum
of private and external costs.
» The benefit received by an individual (a firm or
EXERCISE 16.2
Each of the following situations describes a type of externality. Does it affect
production or consumption?
a A factory situated in the centre of a town, and close to a residential district,
emits toxic fumes through a chimney during its production process. As a
result, residents living nearby have to wash their clothes more frequently,
and incur higher medical bills as a result of breathing in the fumes.
b Residents living along a main road cover their houses with lavish lights and
decorations during major festivals, helping passers-by to capture the festive
spirit.
c A factory that produces chemicals, which is located on the banks of a river,
installs a new water purification plant that improves the quality of water
discharged into the river. A fish farm located downstream finds that its
productivity increases, and that it has to spend less on filtering the water.
d Fatima enjoys playing her music at high volume late at night, in spite of the
fact that she lives in a flat with inadequate sound insulation. The neighbours
prefer peace and quiet, but cannot escape the noise of Fatima’s music.
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Toxic fumes
Example a in Exercise 16.2 is a negative production externality. The factory emits
toxic fumes that impose costs on the residents (third parties) living nearby, who
incur high washing and medical bills. The households face costs as a result of the
production activities of the firm, so the firm does not face the full costs of its
activity.
Thus, the private costs faced by the producer are lower than the social costs: that
is, the costs faced by society as a whole. The producer will take decisions based only
on its private costs, ignoring the external costs it imposes on society. From society’s
point of view, social costs are the sum of private and external costs.
Figure 16.1 illustrates this situation under the assumption that firms operate in
a competitive market (i.e. there is not a monopoly). Here, D (MSB) represents the
demand curve, which was characterised in Chapter 4 as representing the marginal
social benefit derived from consuming a good. In other words, the demand curve
represents consumers’ willingness to pay for the good, and thus reflects their marginal
valuation of the product.
Costs, benefits
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
16
S (MSC )
Y
P*
P1
MPC
X
Z
D (MSB)
Q* Q1
Quantity per period
▲ Figure 16.1 A negative production externality
LEARNING
LINK
The way that
decisions are taken
‘at the margin’ was
explained in
Chapter 1.
Producers face marginal private costs given by the line MPC, but in fact impose
higher costs than this on society. S represents the supply curve that includes these
additional costs imposed on society, and therefore represents the true cost to society
of producing the good. This may be regarded as being the marginal social cost (MSC)
of the firms’ production.
If the market is unregulated by the government, firms will choose how much to supply
on the basis of the marginal (private) cost they face, shown by MPC in Figure 16.1. The
market equilibrium will thus be at quantity traded Q1, where firms just break even on
the marginal unit sold; price will be set at P1.
This is not a good outcome for society, as it is clear that there is a divergence
between the price in the market and the ‘true’ marginal cost – in other words, a
divergence between marginal social benefit and marginal social cost. It is this
divergence that is at the heart of the market failure. The last unit of this good sold
imposes higher costs on society than the marginal benefit derived from consuming it.
Too much is being produced at the free-market equilibrium.
In fact, the socially optimum position is at Q*, where marginal social benefit is
equal to marginal social cost. This will be reached if the price is set equal to (social)
marginal cost at P*. Less of the good will be consumed, but also less pollution will be
created, and society will be better off than at Q1.
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QUANTITATIVE SKILLS 16.1
KEY TERM
The extent of the welfare loss that society suffers can be identified: it is shown by
the shaded triangle (XYZ) in Figure 16.1. Each unit of output that is produced above
Q* imposes a cost equal to the vertical distance between MSC and MPC. The shaded
area represents the difference between marginal social cost and marginal benefit
over the range of output between the optimum output and the free-market level of
output. This is known as the deadweight welfare loss of the externality.
STUDY TIP
Test yourself 16.2
Does the presence of
a negative production
externality cause
overproduction or
underconsumption?
Make sure that you are clear about these key ideas:
» Demand represents consumers’ willingness and ability to purchase a good or
service – this is consumers’ marginal private benefit (MPB).
» Where society receives more or less benefit from the consumption of a good or
service, this is the marginal social benefit (MSB). It includes the external benefits.
» Supply represents firms’ willingness and ability to supply a good or service – this
is firms’ marginal private cost (MPC).
» Where society incurs more or less cost from the production of a good or service,
this is the marginal social cost (MSC). It includes the external costs.
Festive lights and decorations
Example b in Exercise 16.2 is an example of a positive consumption externality. Residents
of this street decorate their homes in order to share the festival spirit with passers-by. The
benefit they gain from the decorations (the private benefit) spills over and adds to the
enjoyment of others (providing external benefit). In other words, the social benefits from
the residents’ decision to provide festive decorations go beyond the private enjoyment
that they receive. The social benefit is equal to the sum of private and external benefits.
Test yourself 16.3
Costs, benefits
Does the presence of a
positive consumption
externality cause
overproduction or
underconsumption?
Figure 16.2 illustrates this situation. MPB represents the marginal private benefits
gained by residents from the festive decorations; but MSB represents the full marginal
social benefit that the community gains, which is higher than the MPB. Residents will
provide decorations up to the point Q2, where their marginal private benefit is just
balanced by the marginal cost of the decorations. However, if the full social benefits
received are taken into account, Q* would be the optimum point: the residents do not
provide enough décor for the community to reach the optimum. The shaded triangle
in Figure 16.2 shows the deadweight welfare loss: that is, the amount of social benefit
forgone if the outcome is at Q2 instead of Q*. Again, there is a divergence between the
free-market equilibrium and the socially preferred position.
16
16 Private costs and benefits, externalities and social costs and benefits
deadweight welfare
loss (of an externality):
the loss in social welfare
that arises when an
externality moves a
market away from its
optimum position
Identifying welfare loss in a diagram
MC
MSB
MPB
Figure 16.2 A positive
consumption externality
0
Q2
Q*
Quantity of festive decorations
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It is important to
realise that both
negative and positive
externalities are
situations of market
failure. Positive
externalities carry
a market away from
the social optimum
just as negative
externalities do.
LEARNING
LINK
The distinction
between positive
and normative
statements was
introduced in
Chapter 1.
Example b may be seen as a reminder of the distinction between positive and
normative analysis. Economists would agree that Figure 16.2 shows the effects of a
beneficial consumption externality. However, probably not everyone would agree that
the lavish festive decorations are providing such benefits. This is where a normative
judgement comes into play. It could equally be argued that the lavish decorations are
unsightly and inappropriate, or that they constitute a distraction for drivers and are
therefore likely to cause accidents. After all, not everyone appreciates over-the-top
decorations.
Water purification
Example c in Exercise 16.2 is a production externality that has positive effects. The
action taken by the chemical firm to purify its waste water has beneficial effects on
the fish farm, which finds that its costs have been reduced without it having taken any
action whatsoever. Indeed, it finds that it has to spend less on filtering the water.
Figure 16.3 shows the position facing the chemicals firm. It faces relatively high
marginal private costs given by MPC. However, its actions have reduced the costs
faced by the fish farm, so the ‘social’ cost of the firm’s production activities is lower
than its private cost. Thus, in this case marginal social cost, shown by MSC in the
figure, is lower than marginal private cost. The firm will produce up to the point where
MPC equals marginal social benefit: that is, at Q3.
Costs, benefits
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
16
STUDY TIP
MPC
MSC
D (MSB)
0
Q3
Q*
Quantity of chemicals per period
▲ Figure 16.3 A positive production externality
In this market position, notice that the marginal benefit that society receives from
consuming the product is higher than the marginal social cost of producing it, so too
little of the product is being consumed for society’s good. Society would be better off
at Q*, where marginal social benefit is equal to marginal social cost.
Again, the shaded triangle in Figure 16.3 represents the extent of the inefficiency: it
is given by the excess of marginal social benefit over marginal social cost, over the
range of output between the market outcome and society’s optimum position. This is
the deadweight welfare loss in this situation.
Loud music
Example d in Exercise 16.2 is a negative consumption externality. Fatima gains benefit
from listening to her music at high volume, but the neighbours also hear her music
and suffer as a result. Their private benefit is reduced by having to hear the music
when all they want is peace and quiet.
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Costs, benefits
Figure 16.4 illustrates this. The situation can be interpreted in terms of the benefits that
accrue as a result of Fatima’s consumption of loud music. She gains benefit as shown by
the line MPB, which represents marginal private benefit. However, the social benefit is
lower than this if the annoyance suffered by the neighbours is taken into account, so MSB
in Figure 16.4 represents the marginal social benefits from Fatima’s loud music.
MSC
MSB
Q*
Q4
Quantity of music
▲ Figure 16.4 A negative consumption externality
Fatima will listen to music up to the point where her marginal private benefit is just
equal to the marginal cost of playing it, at Q4. However, the optimal position that
takes the neighbours into consideration is where marginal social benefit is equal to
marginal cost – at Q*. Thus, Fatima plays too much music for the good of society.
Externalities occur in a wide variety of market situations, and constitute an important
source of market failure. This means that externalities may hinder the achievement of
good resource allocation from society’s perspective. The final section of this chapter
explores some ways in which attempts have been made to measure the social costs
imposed by externalities. First, however, a number of other externalities that appear
in various parts of the economy will be examined.
Test yourself 16.4
STUDY TIP
Explain how to identify
the area of welfare loss
in a diagram showing
the effect of a positive
production externality.
Externalities are a common topic, so be ready to respond if questioned. Be very
careful when drawing the diagram, especially in identifying the area representing
welfare loss. If you understand why this area represents welfare loss, you should be
able to check whether you have identified it correctly. If you are uncertain about this,
look back at Quantitative skills 16.1 on page 221.
16 Private costs and benefits, externalities and social costs and benefits
MPB
0
16
Examples of markets with externalities
Externalities and the environment
Concern for the environment has been growing in recent years, with ‘green’ lobbyist
groups demanding attention, sometimes through demonstrations and protests. There
are so many different facets to this question that it is sometimes difficult to isolate
the core issues. Externalities are central to much of the debate.
Some of the issues are international in nature, such as the debate over global warming. At
the heart of this concern is the way in which emissions of greenhouse gases are said to be
warming up the planet. Sea levels are rising and major climate change seems imminent.
One reason why this question is especially difficult to tackle is that actions taken by
one country can have effects on other countries. Scientists argue that the problem is
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caused mainly by pollution created by transport and industry, especially in the richer
countries of the world. However, poorer countries suffer the consequences as well,
especially countries such as Bangladesh, where much of the land is low lying and
prone to severe flooding.
16
In principle, this is very similar to example a in Exercise 16.2: it is an example of a
negative production externality, in which the nations causing most of the damage
face only part of the costs caused by their lifestyles and production processes. The
inevitable result in an unregulated market is that too much pollution is produced.
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
When externalities cross international borders in this way, the problem can be tackled
only through international cooperation. For example, as part of the United Nations
Framework Convention on Climate Change (UNFCCC) the Paris Agreement was launched in
2016. This covers greenhouse gas emissions mitigation, adaptation and finance, and by
2020, 189 countries had become parties to the agreement. President Trump’s decision to
withdraw from the agreement in 2020 threatened the effectiveness of the measures,
but Joe Biden reversed this as one of his first acts as President.
Global warming is not the only example of international externality effects.
Scandinavian countries have suffered from acid rain caused by pollution in other
European countries, including the UK. Forest fires left to burn in Indonesia have caused
air pollution in neighbouring Singapore.
▲ Forest fire in Indonesia
Another environmental issue concerns rivers. Some of the big rivers of the world,
such as the Nile in Africa, pass through several countries on their way to the sea. For
Egypt, through which the river runs at the end of its journey, the Nile is crucial for the
livelihood of the economy. If countries further upstream were to increase their usage of
the river, perhaps through new irrigation projects, this could have disastrous effects on
Egypt. Again, the actions of one set of economic agents would have damaging effects
on others, and these effects would not be reflected in market prices, in the sense that
the upstream countries would not have to face the full cost of their actions.
LEARNING
LINK
The importance of
property rights is
discussed in Chapter
21, together with
measures that could
be taken to tackle
externalities.
Part of the problem here can be traced back to the difficulty of enforcing property
rights. If the countries imposing the costs could be forced to make appropriate
payment for their actions, this would help to bring the costs back within the market
mechanism. Such a process is known in economics as ‘internalising the externality’.
Concern has also been expressed about the loss of biodiversity, a word that is shorthand for
‘biological diversity’. The issue here is that when a section of rainforest is cleared to plant
soya, or for timber, it is possible that species of plants, insects or animals whose existence
is not even known at present may be wiped out. Many modern medicines are based on
chemicals that occur naturally in the wild. By eradicating species before they have been
discovered, possible scientific advances will be forgone. Notice that when it comes to
measuring the value of what is being destroyed, biodiversity offers particular challenges –
namely, the problem of putting a value on something that might not even be there.
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Externalities and transport
Costs, benefits
Cities in many parts of the world, such as Singapore and London, have been attempting
to tackle traffic congestion. When traffic on the roads reaches a certain volume,
congestion imposes heavy costs on road users. This is another example of an externality.
MSC
MPC
Q*
Q1
Number of journeys per period
▲ Figure 16.5 Traffic congestion
Figure 16.5 illustrates the situation. Suppose that D (MSB) represents the demand
curve for car journeys along a particular stretch of road. When deciding whether or not
to undertake a journey, drivers will balance the marginal benefit gained from making
the journey against the marginal cost that they face. This is given by MPC – the
marginal private cost of undertaking journeys. When the road is congested, a motorist
who decides to undertake the journey adds to the congestion, and slows the traffic.
The MPC curve incorporates the cost to the motorist of joining a congested road, and
the chosen number of journeys will be at Q1.
However, in adding to the congestion the motorist not only suffers the costs of
congestion, but also imposes some marginal increase in costs on all other users of the
road, as everyone suffers from the slower journeys resulting from the extra congestion.
Thus, the marginal social costs (MSC) of undertaking journeys are higher than the cost
faced by any individual motorist. MSC is therefore higher than MPC. Society would be
better off with lower congestion: that is, with the number of journeys undertaken
being limited to Q*, where marginal social benefit equals marginal social cost.
16 Private costs and benefits, externalities and social costs and benefits
D (MSB)
0
16
Externalities and health
Healthcare is a sector in which there is often public provision, or at least some state
intervention in support of the health services. However, in many countries public
provision of healthcare is augmented with private healthcare, and the use of private
health insurance schemes is on the increase. Again, externalities can help to explain
why there should be a need for government to intervene.
Consider the case of vaccination against a disease such as measles. Suppose an
individual is considering whether or not to be vaccinated. Being vaccinated reduces the
probability of that individual contracting the disease, so there are palpable potential
benefits. However, these benefits must be balanced against the costs. There may be a
direct charge for the vaccine; some individuals may have a phobia of needles; or they
may be concerned about possible side-effects. Individuals will opt to be vaccinated only
if the marginal expected benefit to them is at least as large as the marginal cost.
From society’s point of view, however, there are potential benefits that individuals
will not take into account. After all, if they do contract measles, there is a chance of
their passing it on to others. Indeed, if lots of people decide not to be vaccinated,
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there is the possibility of a widespread epidemic, which would be costly and damaging
to many. Figure 16.6 illustrates this point.
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
Costs, benefits
16
MSC
MSB
MPB
0
Q1
Q*
Quantity of vaccinations
▲ Figure 16.6 Vaccination
Test yourself 16.5
Why might there be
externality effects
associated with
smoking tobacco?
The previous paragraph argues that the social benefits to society of having people
vaccinated against measles exceed the private benefits that will be perceived by
individuals, so that marginal social benefits exceed marginal private benefits. Private
individuals will choose to balance marginal private benefit against marginal private
cost at Q1, whereas society would prefer more people to be vaccinated at Q*. This
parallels the discussion of a positive consumption externality.
EXTENSION MATERIAL
The Covid-19 pandemic and externalities
During the Covid-19 pandemic, externalities became
vitally important. With no vaccine available, and little
knowledge about how to treat the virus, containing
the spread of the disease relied on individuals being
prepared to act in a socially desirable manner.
Lockdowns and the use of face coverings were
central to the strategy for preventing the spread of
the virus. This was all about controlling the negative
externalities that arose from people who were
infected with the disease (perhaps without realising
it) passing it on to others. Those countries that
were slow to recognise the importance of this, or
which refused to believe it, suffered huge pressure
on healthcare services and massive loss of life.
Individuals who broke the rules on social distancing
imposed heavy costs on others. And there were some
cases where social isolation was simply not possible.
In this case, there was the added complication
that the costs of dealing with the externalities had
an enormous cost in economic terms, with many
industries and activities being closed down altogether
for the period of the lockdown. This then created
difficult decisions for political leaders in trying to
balance the economic costs of lockdown against the
human costs of allowing the virus to take hold.
Externalities and education
As you are reading this textbook, it is reasonably safe to assume that you are
following a course in economics. You have decided to demand education. This is yet
another area in which externalities may be important.
When you decided to take A levels (including economics), there were probably a
number of factors that influenced your decision. Perhaps you intend to demand even
more education in the future, by proceeding to study at university. Part of your
decision process probably takes into account the fact that education improves your
future earnings potential. Your expected lifetime earnings depend in part on the level
of educational qualifications that you attain. Research has shown that, on average,
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graduates earn more during their lifetimes than non-graduates. This is partly because
there is a productivity effect: by becoming educated, you cultivate a range of skills
that in later life will make you more productive, and this helps to explain why you can
expect higher lifetime earnings than someone who chooses not to demand education.
Test yourself 16.6
In other words, when you decide to undertake education, you do so on the basis of
the expected private benefits that you hope to gain from education. However, you do
not take into account the additional benefits through cooperation that society will
reap. So here is another example of a positive consumption externality.
Externalities and tourism
As international transport has become easier and cheaper, more people are wanting to
travel to new and different destinations. For less developed countries, this offers an
opportunity to earn much-needed foreign exchange.
There has been some criticism of this. The building of luxury hotels in the midst of
the poverty that characterises many less developed countries is said to have damaging
effects on the local population by emphasising differences in living standards.
However, constructing the infrastructure that tourists need may have beneficial effects
on the domestic economy. Improved roads and communication systems can benefit local
businesses. This effect can be interpreted as an externality, in the sense that the local
firms will face lower costs as a result of the facilities provided for the tourist sector.
EXERCISE 16.3
Discuss examples of some externalities that you meet in everyday situations,
and classify them as affecting either production or consumption.
16 Private costs and benefits, externalities and social costs and benefits
School drop-out rates
tend to be high in
some less developed
countries. What sort of
externality effect might
be at work here?
What does society get out of this? Evidence suggests that, not only does education
improve productivity, but a group of educated workers cooperating with each other
becomes even more productive. This is an externality effect, as it depends on
interaction between educated workers – but each individual perceives only the
individual benefit, and not the benefits of cooperation.
16
Asymmetric information and moral hazard
One of the reasons advanced for possible market failure in the previous chapter was
the presence of asymmetric information. When some parties to a transaction have
better information than others, they may be able to benefit at the others’ expense.
This is another situation in which there may be costs entailed in an economic
transaction which take place outside of market prices and which affect a third party.
A good example of this is in the market for insurance.
The insurance market
KEY TERMS
adverse selection:
a situation in which
a person at risk is
more likely to take out
insurance
moral hazard: a
situation in which a
person who has taken
out insurance is prone
to taking more risk
People take out insurance to cover themselves against the risk of uncertain future
events. Asymmetric information can cause problems with this market in two
different ways. Suppose an individual approaches an insurance company wanting
health insurance. The individual knows more about his or her current health and
health history than the insurance company. After all, the individual knows whether
they are prone to illness or if they are accident-prone. This could mean that the
people most likely to take out health insurance are the ones most likely to fall ill
or be involved in accidents. This is known as adverse selection. A second form of
information failure in terms of insurance is known as moral hazard. An individual
who has taken out insurance may be more likely to take risks, knowing that he or
she is covered by insurance. For example, if someone has taken out insurance against
the loss of their mobile phone, they may be less careful about leaving it around.
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Test yourself 16.7
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
16
A bank makes risky
loans believing that it
will be bailed out if it
gets into trouble. Is this
an example of adverse
selection or moral
hazard?
EXERCISE 16.4
Table 16.1 shows the situation in a market where pollution is generated by the
production process.
a At what level of output would marginal social benefit be equal to marginal
private cost? (Note: this would be the quantity of output that would be
produced by firms in an unregulated competitive market.)
b By how much would marginal social cost exceed marginal private cost at this
level of output?
c At what level of output would marginal social benefit be equal to marginal
social cost?
d What amount of tax would induce firms to supply this quantity of output?
▼ Table 16.1 A market with pollution
Quantity produced
(thousands per week)
Marginal social
benefit
Marginal private
cost
Marginal social
cost
10
80
5
10
20
75
10
20
30
70
20
35
40
60
32
60
50
48
48
90
60
30
75
125
70
8
110
175
SUMMARY: EXTERNALITIES
» Markets can operate effectively only if all relevant
»
»
»
»
costs and benefits are taken into account in
decision making.
Some costs and benefits are external to the
market mechanism, and are thus neglected,
causing a distortion in resource allocation.
Such external costs and benefits are known as
‘externalities’.
Externalities may occur in either production or
consumption, thereby affecting either demand or
supply.
Externalities may be either positive or negative,
but either way resources will not be optimally
allocated if they are present.
» Externalities arise in many aspects of economic life.
» Environmental issues are especially prone to
externality effects, as market prices do not always
incorporate environmental issues, especially
where property rights are not assigned.
» Congestion on the roads can be seen as a form of
externality.
» Externalities also arise in the areas of healthcare
provision and education, where individuals do not
always perceive the full social benefits that arise.
» Asymmetric information can also result in
problems of adverse selection and moral hazard.
16.3 Costs and benefits in decision making
The importance of externalities in regard to environmental and other issues means
that it is especially important to be aware of externalities when taking decisions
that are likely to affect the environment. This is especially important for large-scale
projects that can have far-reaching effects on the economy, such as the construction
of a new dam or a major road-building project. If good decisions are to be taken, it is
crucial to be able to measure the external costs and benefits that are associated with
those decisions, and not focus only on the private costs and benefits.
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This suggests that in taking such decisions, it is important to be able to weigh up the
costs and benefits of a scheme. If it turns out that the benefits exceed the costs, it might
be thought appropriate to go ahead. However, in valuing the costs and the benefits, it
is clearly important to include some estimate for the externalities involved in order that
the decision can be based on all relevant factors. In other words, it is important to take a
‘long and wide view’ and not to focus too narrowly on purely financial costs and benefits.
Social cost–benefit analysis
KEY TERM
social cost–benefit
analysis: a process of
evaluating the worth of
a project by comparing
its costs and benefits,
including both direct
and social costs and
benefits – including
externality effects
Social cost–benefit analysis is a procedure for bringing together the information
needed to make appropriate decisions on such large-scale schemes. This entails a
sequence of key steps.
1 Identify relevant costs and benefits
The first step is to identify all relevant costs and benefits. This needs to cover all of
the direct costs of the project. These can probably be identified relatively easily, and
include the production costs, labour costs and so on.
The indirect costs also need to be identified, and this is where externality effects
need to be considered. For example, in constructing a dam across a river, there are the
visible direct costs that are inevitably entailed in such a large engineering project.
But there are also the indirect costs, i.e. the opportunity costs. How many people and
businesses will be uprooted by the project, and how much land that could have been
used for agriculture will be flooded as a result of the new dam? Similarly, in a roadbuilding scheme, it is important to think in terms not only of the costs of construction,
but also of the opportunity cost – how else could the land being used for the road have
been used? How will the increase in traffic affect the quality of life enjoyed by local
residents? For example, they may suffer from noise from the traffic using the road, or
from the traffic fumes. Similarly, direct and indirect benefits need to be identified. The
dam may bring benefits in terms of hydroelectric power, or irrigation for crops. A new
road may increase the efficiency of transportation, and reduce costs for firms.
16 Private costs and benefits, externalities and social costs and benefits
A further complication is that with many such schemes the costs and benefits will
be spread out over a long period of time, and it is important to come to a reasonable
balance between the interests of present and future generations.
16
2 Valuation
If the costs and benefits are to be compared, they all need to be given a monetary
valuation. It is likely that some of them will be items that have a market price attached
to them. For these, valuation is not a problem. However, for externalities, or for other
indirect costs and benefits without a market valuation, it is necessary to establish a
shadow price – an estimate of the monetary value of each item. Notice that this can be
quite difficult, as some of the external costs may be elusive, especially if the impact is
on the quality of life, rather than on measurable production loss.
3 Discounting the future
It is also important to recognise that costs and benefits that will flow from the project
at some point in the future need to be expressed in terms of their value in the present.
From today’s perspective, a benefit that is immediate is more valuable than one that
will only become relevant in 20 years’ time. In order to incorporate this notion into
the calculations, we need to discount the future at an appropriate rate, and estimate
the future stream of costs and benefits associated with the project under consideration.
Notice that a government taking decisions on behalf of future generations may choose
take a longer perspective than consumers who prefer to enjoy benefits in the present.
Equally, a government that is feeling vulnerable may prefer to provide benefits in the
present to persuade the electorate, rather than taking decisions that will not bear fruit until
the distant future. In other words, there may be a political backdrop to take into account.
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The decision-making process
If it is possible to identify all the private and external costs of a project, to place a
monetary valuation on each of them and to choose an appropriate discount rate, then
there is a framework for taking decisions about a project. The bottom line is whether
the total social benefits expected to arise from a project outweigh the social costs.
This may sound straightforward, but it is important to remember all the assumptions on
which such decisions would be based. In particular, the valuations made of the various
elements of benefits and costs may be considered to be at least partially subjective, and
different members of society may take different views of what is an appropriate discount
rate. However, this does not mean that social cost–benefit analysis is unhelpful. For
example, a government may be choosing between a range of different development
projects. By using consistent assumptions in valuation and discount rates across the
projects, it may be possible to produce a coherent ranking of alternative projects, and
thus identify the project that would produce the highest benefit–cost ratio.
EXERCISE 16.5
You discover that your local authority has chosen to locate a new landfill site for
waste disposal close to your home. What costs and benefits for society would
result? Would these differ from your private costs and benefits? Would you object?
EXERCISE 16.6
Each of the Figures 16.7–16.10 shows a particular type of externality.
Costs, benefits
For each figure, identify the sort of externality, and state whether the result is
too much or too little output being traded in a free market.
Costs, benefits
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
16
MSC
MPC
MSC
MPB
MSB
MSB
Quantity
Quantity
▲ Figure 16.8 Externality B
MSC
Costs, benefits
Costs, benefits
▲ Figure 16.7 Externality A
MSC
MPC
MSB
MSB
MPB
Quantity
▲ Figure 16.9 Externality C
Quantity
▲ Figure 16.10 Externality D
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SUMMARY: COSTS AND BENEFITS IN DECISION MAKING
» A number of approaches have been proposed to
» Each component must then be valued.
» An appropriate discount rate needs to be applied
to those benefits and costs that will arise in the
future.
» The project with the highest ratio of benefits to
costs is likely to be the one that is most beneficial
for society.
END OF CHAPTER QUESTIONS
Multiple choice
1 During the Covid-19 pandemic, mathematical models of exponential growth were
used to predict the number of new infections that an infected individual would
cause. Which economic concept can be used to explain the cost this individual
inflicts on others?
A private cost
B social cost
C external cost
D marginal cost
2 Which of the following is not an example of moral hazard?
A The managers of a public limited company choose a project that will not
maximise shareholder value because they do not bear the risk of losing
investment in the company if the project is unsuccessful.
B The owner of a car insured against theft leaves the engine running while they
are getting a coffee.
C An employee leaves their company mobile phone unattended.
D A borrower takes out a loan at a higher interest rate because they do not have
full information about the bank’s products.
Data response
16 Private costs and benefits, externalities and social costs and benefits
measure externalities. Measurement may enable a
social cost–benefit analysis to be made of projects
involving a substantial externality element.
» The first step is to identify all direct and indirect
(private and external) benefits and costs of a
project.
16
Billion metric tonnes
1 Study Figure 16.11, read the following extract and then answer the questions that
follow.
2019
3.0
History
Projections
2.5
Petroleum
2.0
Natural gas
1.5
1.0
Coal
0.5
0
1990
2000
2010
2020
2030
2040
2050
Source: Energy Policy Update
▲ Figure 16.11 US energy-related carbon dioxide emissions by fuel, 1990–2050
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New bike share scheme launched in Norwich
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
16
Norwich is the largest city in the east of England. In 2020, Transport for
Norwich announced a new bike-sharing scheme aimed at reducing road
traffic and carbon dioxide emissions through the government’s Transforming
Cities Fund.
The idea is to convert commuters away from using their own cars and
even from using buses, and to encourage them instead to share the readily
available environmentally more friendly cycles. This would both reduce
emissions and increase the health and wellbeing of local people.
However, this will spell double trouble for struggling local bus firms, which
spend a large amount each year training their new bus drivers. Each year
many of the existing bus drivers leave to work as coach drivers for local coach
firms. The costs of the coach company are reduced as they receive the benefit
of the previously trained and qualified drivers at no cost.
As the cycle share scheme expands, driving schools are likely to see a
reduction in demand for their services. The owner of one local driving school
has been told to take the positives from this outcome because there will be
a reduction in the deadweight welfare loss that results from driving their
vehicles. The owner opined that it is existing heavily insured drivers who
need additional lessons due to the excessive risks they take while driving,
regardless of the damage they may cause.
Source: Norfolk County Council
a Compare the trends in energy-related carbon dioxide emissions
illustrated in Figure 16.11 between 1990 and 2050.
b State what is meant by private cost and identify one example from
the extract.
c Explain why the externality received by local coach firms in Norwich will
lead to a social benefit greater than the corresponding private benefit.
d Explain the positive externality in consumption created by the people
of Norwich who take part in the cycle share scheme.
e Assess, with the use of a diagram, the impact on the deadweight welfare
loss created by the reduced demand from student drivers attending
driving schools in Norwich.
f State what is meant by moral hazard and provide one possible
example from the extract.
Essay style
2 Xiaoshan international airport serves Hangzhou, a major city in the Yangtze
River Delta region of China. A proposed expansion to the airport is part of
a wider push to strengthen Hangzhou’s infrastructure as the city prepares
to host the 2022 Asian Games.
Assess the contribution of social cost–benefit analysis in decision making
with respect to undertaking a proposed airport expansion such as that of
Xiaoshan.
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CASE STUDY
Healthcare: public or market?
The pandemic brought a new perspective. Suddenly the healthcare system was
under enormous pressure, and there was a rush to try to protect the health service.
The pandemic highlighted a particular problem with care homes, which were mainly
provided by the private sector, and were strongly affected by the virus.
Meanwhile, in the USA, the president was keen to dismantle the care funding
system that had been put in place by his predecessor, which had provided
affordable health insurance for poorer members of society.
So, how should healthcare be funded?
What does economic analysis have to say about the matter? The justification for
public provision of healthcare rests on the existence of market failure. There
are a number of reasons why there might be some form of market failure in the
provision of healthcare, whether we consider the provision of preventative or
curative measures.
In the case of preventative healthcare, there may be other factors at work.
Take the case of vaccination against disease. If vaccinations are provided
by a private competitive market, an individual faces costs of the treatment,
both financial and perhaps in the unpleasantness and possible risks of being
vaccinated. The benefits of having been vaccinated may be perceived to be
relatively low, if the individual sees a low probability of being infected. However,
the benefits of vaccination from the point of view of society may be greater,
because a widespread vaccination programme not only reduces the risk of
infection for each individual, but also reduces the likelihood of an epidemic.
Here again, the Covid-19 pandemic highlighted the controversy over vaccination
programmes.
16 Private costs and benefits, externalities and social costs and benefits
The UK’s National Health Service
(NHS) was founded in 1948. Seventy
years on, it faced crisis, with much
talk in the media about failures in
providing care and long waiting lists.
This revitalised the debate about
whether healthcare should be stateprovided, or whether market forces
should be given a greater role. In
the UK, market forces have played
▲ Protective medical equipment
an increasing part in allocating
resources within the public health
sector through the operation of internal markets, but the debate over public
versus private provision continues. Until the Covid-19 pandemic, the proportion
of health expenditure undertaken by the public sector changed little.
16
Follow-up questions
a Explain what is meant by market failure.
b Draw a diagram to help to explain the possible market failure outlined in
relation to a vaccination programme.
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A LEVEL PART 7 The price system and the microeconomy
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
17
Types of cost, revenue and profit,
short-run and long-run production
What this chapter covers
★ types of firm
★ production in the short run and the short-run
production function
★ the law of diminishing returns
★ the relationship between total, average and
marginal product
★ how short-run costs vary with output
★ fixed, variable and sunk costs
★ production and costs in the long run
★
★
★
★
★
★
★
★
economies and diseconomies of scale
the minimum efficient scale
X-inefficiency
a firm’s revenue
total, average and marginal revenue
normal, supernormal and subnormal profit
the shutdown price in the short run and long run
profit maximisation
Firms play a central role in the operation of markets. This chapter introduces the
theory of the firm by examining some of the key concepts that are needed for this
important part of economic analysis. The discussion will explore the relationship
between costs and production in the short run and the long run, and explain how
firms may act to maximise profit.
17.1 Types of firm
KEY TERM
firm (business): an
organisation that
produces output (a good
or service)
The economic agents concerned with providing the supply of goods and services are
firms (businesses). Firms exist in order to organise production by bringing together
factors of production in order to supply output to market.
Internally, firms may be organised in various ways, from small businesses such as
a corner shop to mega-sized multinational corporations (such as Google). A key
decision that all firms face concerns the scale of their operations. This decision
turns partly on the nature of the market that they are serving, but it also depends
on the technology of the sector in which they operate and the structure of costs
that they face.
Some firms may need to grow in order to compete with other large-scale competitors
in global markets. There may be many reasons why firms wish to expand their
operations. In some sectors, there are examples of both large and small firms.
For example, in the leisure sector, your local gymnasium may be a relatively small
enterprise, but there are also some big players in the sports market, such as Chelsea
FC and Sky. In the transport sector, there may be small local taxi firms, but there are
also large firms such as global airlines.
EXERCISE 17.1
Identify firms that operate in the town or city where
you live. Classify them into three categories:
1 Small local firms that only operate in your area
2 National firms that sell throughout the country
3 International and multinational corporations that
sell goods and services in global markets
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SUMMARY: TYPES OF FIRM
» A firm is an organisation that exists to bring
together factors of production in order to produce
goods or services.
» Firms range in the complexity of their organisation
from sole traders to large companies.
» Firms vary in size, from local concerns to large
multinational corporations operating in global
markets.
In thinking about production in the short run, we consider a single firm and assume
that it produces a single product. Of course, in reality this does not apply to all firms.
There are many large conglomerate firms that produce a range of different products.
However, this complicates the analysis unnecessarily, so the focus here is on a firm
that produces a single product.
In order to undertake production, the firm uses inputs of factors of production. These
include human resources (labour, enterprise and management), natural resources (land,
raw materials, energy) and produced resources (physical capital).
The factors of
production were
explained in
Chapter 1.
The factors of production are organised by the firm in order to produce output. For
example, in the leisure sector, your local gym uses capital in the form of exercise
equipment, and labour in the form of the training staff and receptionist. In
transport, a taxi firm uses capital in the form of the cars, and labour – the drivers
and phone operators.
KEY TERMS
Notice that these factors have some differing characteristics that affect the analysis
of firms’ behaviour. In the short run, the firm faces limited flexibility. Varying the
quantity of labour input that the firm uses may be relatively straightforward – it can
increase the use of overtime, or hire more workers, fairly quickly. However, varying the
amount of capital the firm has at its disposal may take longer. For example, it takes
time to commission a new piece of machinery, or to build a new sports centre or power
station. Hence labour is regarded as a flexible factor and capital as a fixed factor. The
short run is defined by this characteristic as the period in which the input of at least
one factor of production is fixed.
short run: the period
in which at least one
factor of production is in
fixed supply
production function:
a relationship that
embodies information
about technically
efficient ways of
combining labour
and other factors of
production to produce
output
law of diminishing
returns: a law stating
that if a firm increases
its inputs of one factor
of production while
holding inputs of other
factors fixed, eventually
the firm will get
diminishing marginal
returns from the
variable factor
17 Types of cost, revenue and profit, short-run and long-run production
17.2 Production in the short run
LEARNING
LINK
17
The short-run production function
As the firm changes its volume of production, it needs to vary the inputs of its factors
of production. So, the total amount of output produced in a given period depends on
the labour, capital and other inputs used in the production process. Of course, there are
many different ways of combining these inputs, some combinations being more efficient
than others. The production function summarises the technically most efficient
combinations for any given output level. It specifies how the level of output produced
by a firm depends on the quantities of the factors of production that are utilised.
The nature of technology in an industry will determine the way in which output varies
with the quantity of inputs. However, one thing is certain. If the firm increases the
amount of inputs of the variable factor (labour) while holding constant the inputs of
the other factors, it will gradually derive less additional output per unit of labour for
each further increase. This is known as the law of diminishing returns (or the law
of variable proportions), and is one of the few ‘laws’ in economics. It is a short-run
concept, as it relies on the assumption that capital and other factor inputs are fixed.
It can readily be seen why this should be the case. Suppose a firm has ten computer
operators working in a travel agency, using ten computers. The 11th worker may add
some extra output, as the workers may be able to ‘hot-desk’ and take their coffee
breaks at different times. The 12th worker may also add some extra output, perhaps
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by keeping the printers stocked with paper. However, if the firm keeps adding staff
without increasing the number of computers, each extra worker will be adding less
additional output to the office. Indeed, the 20th worker may add nothing at all, being
unable to get access to a computer.
17
Why is the law of
diminishing returns
regarded as a short-run
concept?
Figure 17.1 illustrates the short-run relationship between labour input and total
physical product (TPPL), with capital held constant. The shape of the TPPL curve
reflects the law of diminishing returns: as labour input increases, the amount of
additional output produced gets smaller. An increase in the amount of capital
available will raise the amount of output produced for any given labour input, so the
TPPL will shift upwards, as shown in Figure 17.2.
TPPL
Output
The production function carries information about the physical relationship between
the inputs of the factors of production and the physical quantity of output.
Output
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
Test yourself 17.1
TPPL1
TPPL0
0
Labour input
▲ Figure 17.1 A short-run production function
0
Labour input
▲ Figure 17.2 The effect of an increase in capital input
QUANTITATIVE SKILLS 17.1
Total, average and marginal
There is a very important relationship between the
total, average and marginal values of a variable. This
can be illustrated by looking at how production of
a good varies in the short run. In other words, how
does production change as a firm increases labour
input with other factor inputs remaining constant?
Table 17.1 provides a simple arithmetic example.
Reading down column (2), you can see how output
(total physical product) increases as the firm takes on
more workers. So, the first worker produces 10 units
of output; with two workers, 26 units are produced
– and so on down the column. Column (3) shows the
average output per worker. This is calculated as the
value in column (2) divided by the number of workers,
shown in column (1). The marginal product is shown
in column (4). This shows the change in output as
more workers are added. So, the marginal change
in output as the firm moves from one worker to two
is calculated as the output produced by two workers
minus the output produced by one worker, divided by
the number of workers added (in this case this is 1, as
the table shows increments of 1; this will not always
be the case). The figure for the marginal product
is shown between the entries in the other columns
because it is the change between successive entries.
▼ Table 17.1 Total, average and marginal
product (short run)
(1)
Number of
workers
(2)
Total
product
0
0
(3)
Average
product
(4)
Marginal
product
10
1
10
10
16
2
26
13
16
3
42
14
12
4
54
13.5
4
5
58
11.6
−4
6
54
9
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at a point where the marginal product is positive,
then total output increases. If the marginal product
is higher than the average product, then the average
product must also rise. If the marginal product is
lower than the average, the average will fall. You can
see this by comparing columns (3) and (4) in the table.
17
20
15
Average physical product
10
5
Marginal physical product
0
–5
0
1
2
3
4
5
6
7
Number of workers
▲ Figure 17.3 Average and marginal product
SUMMARY: PRODUCTION IN THE SHORT RUN
» A firm may face inflexibility in the short run, with
some factors being fixed in quantity and only some
being variable.
» The short run is defined in this context as the period
over which a firm is free to vary some factors, but not
others.
» The production function shows how output can be
efficiently produced through the input of factors of
production.
» The law of diminishing returns states that, if
a firm increases the input of a variable factor
while holding input of the fixed factors constant,
eventually the firm will get diminishing marginal
returns from the variable factor.
» It is important to distinguish between total,
average and marginal product.
17 Types of cost, revenue and profit, short-run and long-run production
Average and
marginal product
Figure 17.3 plots the values for average and marginal
(physical) product. Notice that the marginal product
curve passes through the maximum point of the
average product curve. This is a mathematical
property of the relationship between average and
marginal values. If a firm increases its production
17.3 The short-run cost function
Given the short-run production function and the prices of factor inputs, it is possible
to identify the way in which costs will vary with output in the short run. This is
important in analysing the way in which firms will take decisions in the short run.
KEY TERMS
total cost: the sum of all
costs that are incurred
in producing a given
level of output (including
opportunity cost)
average total cost:
total cost divided by
the quantity produced;
sometimes known as
unit cost
marginal cost: the
cost of producing an
additional unit of output
As with the earlier discussion of total, average and marginal product, economists
distinguish between total, marginal and average costs. Total cost is the sum of all
costs that are incurred in order to produce a given level of output. Total cost will
always increase as the firm increases its level of production, as this will require
more inputs of factors of production, materials and so on. Average total cost is
simply the cost per unit of output – it is total cost divided by the level of output
produced.
Equally important as these measures is the concept of marginal cost. Economists rely
heavily on the idea that firms, consumers and other economic actors can make good
decisions by thinking in terms of the margin. As was pointed out in Chapter 1, this
is known as the marginal principle. For example, a firm may examine whether a small
change in its behaviour makes matters better or worse. In this context, marginal cost
is important. It is defined as the change in total cost associated with a small change
in output. In other words, it is the additional cost incurred by the firm if it increases
output by one unit.
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fixed costs: costs that
do not vary with the
level of output in the
short run
variable costs: costs
that do vary with the
level of output
STUDY TIP
Notice that by
definition fixed costs
do not vary with output,
so all marginal costs
are variable costs.
total costs = total fixed costs (TFC) + total variable costs (TVC)
Total costs will increase as the firm increases the volume of production because more
of the variable input is needed to increase output. The way in which the costs will
vary depends on the nature of the production function, and on whether the prices of
labour or other factor inputs alter as output increases.
A common assumption made by economists is that in the short run, at very low levels
of output, total costs will rise more slowly than output, but that as diminishing
returns set in, total costs will accelerate, as shown in Figure 17.4.
Costs
sunk costs: costs
incurred by a firm that
cannot be recovered if
the firm ceases trading
Because the firm cannot vary some of its inputs in the short run, some costs may be
regarded as fixed, and some as variable. In this short run, some fixed costs are sunk
costs: that is, they are costs that the firm cannot avoid paying even if it chooses
to produce no output at all. Short-run total costs (STC) are the sum of fixed and
variable costs:
STC
TVC
Test yourself 17.2
For an ice cream
factory, would business
rates be a fixed or a
variable cost? How
about overtime pay? Or
interest on a loan taken
out on variable terms?
TFC
0
Output
▲ Figure 17.4 Total costs in the short run
Short-run average and marginal curves are plotted in Figure 17.5, which shows how
they relate to each other. First, notice that short-run average total costs (SATC) are
shown as a U-shaped curve. This is the form often assumed in economic analysis. SATC
is the sum of average fixed and variable costs (SAFC and SAVC, respectively). Average
fixed costs slope downwards throughout – this is because fixed costs do not vary with
the level of output, so as output increases, SAFC must always get smaller, as the fixed
costs are spread over more and more units of output. However, SAVC is also a U-shape,
and it is this that gives the U-shape to SATC.
Costs ($)
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
17
KEY TERMS
SMC
SATC
SAVC
Test yourself 17.3
A firm produces 50
units of a good. What
is the firm’s average
(total) cost if it faces
fixed costs of $4,000
and total variable costs
of $2,500?
SAFC
0
Output per period
▲ Figure 17.5 The firm’s short-run average and marginal cost curves
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QUANTITATIVE SKILLS 17.2
The relationship between output
and costs
▼ Table 17.2 The short-run relationship between output and costs ($)
(1)
Output
(000 units
per week)
(2)
Fixed
costs
(STFC)
(3)
Total
variable
costs
(STVC)
(4)
Total
costs
(2) + (3)
(STC)
(5)
Average
total cost
(4)/(1)
(SATC)
1
225
85
310
310
2
225
150
375
187.5
3
225
210
435
145
4
225
300
525
131.25
5
225
475
700
140
6
225
870
1,095
Average total cost (SATC, column (5)) is calculated
as total cost divided by output. To calculate marginal
cost, you need to work out the additional cost of
producing an extra unit of output at each output
level. This is calculated as the change in costs
divided by the change in output (Δ column (4) divided
by Δ column (1), where Δ means ‘change in’).
Finally, average variable costs (SAVC, column (3)/
column (1)) and average fixed costs (SAFC, column
(2)/column (1)) can be calculated.
182.5
(6)
Marginal
cost
∆(4)/∆(1)
(SMC)
65
60
90
175
395
(7)
Average
variable cost
(3)/(1)
(SAVC)
(8)
Average
fixed cost
(2)/(1)
(SAFC)
85
225
75
112.5
70
75
75
56.25
95
45
145
37.5
Notice that SATC initially falls as output increases,
but after 4,000 units of output it begins to increase.
SATC is composed of average variable and
average fixed costs (SAVC and SAFC). SAFC falls
continuously as output increases, because the
fixed costs are being spread out across more units
of output. This helps to explain why SATC initially
falls. However, as diminishing marginal returns set
in, average variable costs begin to increase, and
this helps to explain the way that SATC varies with
output.
17
17 Types of cost, revenue and profit, short-run and long-run production
Table 17.2 provides an arithmetic example to
illustrate the relationship between these different
aspects of costs. The firm represented here faces
fixed costs of $225 per week. The table shows the
costs of production for up to 6,000 units of the firm’s
product per week. Column (3) shows total variable
costs of production: you can see that these rise
quite steeply as the volume of production increases.
Adding fixed and variable costs gives the total costs
at each output level. This is shown in column 4,
which is the sum of columns (2) and (3).
QUANTITATIVE SKILLS 17.3
Graphing short-run costs
Quantitative skills 17.2 showed the arithmetic
relationship between the components of short-run
costs. The short-run average and marginal curves
based on these data are plotted in Figure 17.6. First,
notice that short-run average total costs (SATC)
takes on the typical U-shape. SATC is the sum of
average fixed and variable costs (SAFC and SAVC,
respectively). Average fixed costs slope downwards
throughout – this is because fixed costs do not vary
with the level of output, so as output increases, SAFC
must always get smaller, as the fixed costs are spread
over more and more units of output. However, SAVC
also shows a U-shape, and it is this that gives the
U-shape to SATC.
A very important aspect of Figure 17.6 is that the
short-run marginal cost curve (SMC) cuts both SAVC
and SATC at their minimum points. This is always the
case. If you think about this for a moment, you will
realise that it makes good sense. If you are adding
on something that is greater than the average, the
average must always increase. For a firm, when the
marginal cost of producing an additional unit of a
good is higher than the average cost of doing so, the
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A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
An example can show how general this rule is.
Suppose that a team newly promoted to the country’s
top league brings in a new striker, whose wage far
exceeds that of existing players. What happens to
the average wage? Of course it must increase, as
the marginal wage of the new player is higher than
the previous average wage. This is quite simply an
arithmetic property of the average and the marginal,
and always holds true.
Costs (£)
17
average cost must rise. If the marginal cost is the
same as the average cost, then average cost will not
change.
450
400
350
300
250
200
150
100
50
0
SMC
SATC
SAVC
SAFC
0
1
2
3
4
5
6
7
Output (thousands)
▲ Figure 17.6 Short-run cost curves
Test yourself 17.4
STUDY TIP
When drawing average
and marginal cost
curves, what is the key
relationship between
them?
Remember that when you draw the average and marginal cost curves for a firm, the
marginal cost curve will always cut average cost at the minimum point of average
cost. Another way of viewing marginal cost is as the slope or gradient of the total cost
curve.
Remember that the short-run cost curves show the relationship between the volume of
production and costs under the assumption that the quantity of capital and other inputs
are fixed, so that in order to change output the firm has to vary the amount of labour.
The position of the cost curves thus depends on the quantity of capital. In other words,
there is a short-run average total cost curve for each given level of other inputs.
EXERCISE 17.2
In producing a good, a firm incurs fixed costs of
300. If it produces 40 units of the good, it finds that
variable costs (STVC) amount to 140.
a Calculate STC, SATC, SAVC and SAFC.
If the firm increases output to 50 units, it now faces
variable costs (STVC) of 200.
LEARNING
LINK
The distinction
between the short
run, the long run and
the very long run was
discussed in Chapter 1.
b Calculate STC, SATC, SAVC, SAFC and SMC.
When production is 60, short-run total costs (STC)
are 660.
c Calculate short-run variable costs (STVC).
SUMMARY: THE SHORT-RUN COST FUNCTION
» Short-run costs can be separated into fixed, sunk and variable costs.
» There is a clear and fixed relationship between total, average and marginal costs.
» For a U-shaped average cost curve, marginal cost always cuts the minimum
point of average cost.
17.4 Production and costs in the long run
KEY TERM
long run: the period over
which the firm is able to
vary the inputs of all its
factors of production
The short-run production and cost functions show the relationship between the
volume of production and costs under the assumption that the quantities of capital
and other inputs are fixed, so that in order to change output the firm can only vary
the amount of labour. This assumption does not apply in the long run, so we define
the long run as the period over which the firm can vary all its inputs of factors of
production.
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increasing returns
to scale: when a
percentage increase
in inputs results in
a larger percentage
increase in output
constant returns
to scale: when a
percentage increase
in inputs results in
the same percentage
increase in output
STUDY TIP
Remember that there
are no fixed costs in
the long run.
Test yourself 17.5
A firm finds that when
it increases its use
of inputs by 10%, its
output increases by 2%.
What type of returns
to scale is the firm
experiencing?
STUDY TIP
It is important not to confuse the notion of returns to scale with the idea introduced
earlier of diminishing marginal returns to a factor. The two concepts arise in different
circumstances. The law of diminishing returns to a factor applies in the short run,
when a firm increases its inputs of one factor of production while facing fixed amounts
of other factors. It is thus solely a short-run phenomenon. However, a firm facing
decreasing returns to scale is confronting a long-run phenomenon.
Costs in the long run
In the long run, a firm is able to vary capital and labour (and other factor inputs). It
is thus likely to choose the level of capital that is appropriate for the level of output
that it expects to produce. Figure 17.7 shows a selection of short-run average total
cost curves corresponding to different expected output levels, and thus different
levels of capital. With the set of SATC curves in Figure 17.7, the long-run average cost
curve also takes on a U-shape.
SATC1
C2
SATC2
SATC3
SATC4
LAC
C1
C3
q1
q2
17
17 Types of cost, revenue and profit, short-run and long-run production
decreasing returns
to scale: when a
percentage increase
in inputs results in a
smaller percentage
increase in output
What will happen if a firm increases inputs of its factors of production? In some
cases, it could be that the resulting percentage increase in output is greater than the
percentage increase in inputs. This is known as a position of increasing returns to
scale, and suggests that the firm gains efficiency in production as it expands (although
this will also depend on the prices of its factor inputs). On the other hand, it could be
that as the firm expands its factor inputs, it finds that the resulting increase in output
is less in percentage terms than the increase in inputs. This is known as decreasing
returns to scale. Constant returns to scale describes a situation where an increase in
inputs results in the same percentage increase in output.
Costs
KEY TERMS
q3
Output
▲ Figure 17.7 Short-run cost curves with different levels of capital input
STUDY TIP
Notice in Figure 17.7
the LAC just touches
each of the SATCs, but
not at the minimum
point of each SATC,
except at the minimum
point of the LAC at q3.
For the firm in Figure 17.7, the choice of capital is important. Suppose the firm wants
to produce the quantity of output q1. It would choose to install the amount of capital
corresponding to the short-run total cost curve SATC1, and could then produce q1 at
an average cost of C1 in the short run. However, if the firm finds that demand is more
buoyant than expected, and so wants to increase output to q2, in the short run it has
no option but to increase labour input and expand output along SATC1, taking cost per
unit to C2.
In the longer term, the firm will be able to adjust its capital stock and move on to
SATC2, reducing average cost to C3. Thus, as soon as the firm moves away from the
output level for which capital stock is designed, it incurs higher average cost in the
short run than is possible in the long run.
In this way a long-run average cost curve can be derived to illustrate how the firm
chooses to vary its capital stock for any given level of output. The dashed line in
Figure 17.7 shows what such a curve would look like for the firm. The long-run average
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cost curve (LAC) just touches each of the short-run average cost curves, and is known
as the ‘envelope’ of the SATC curves.
17
Economies of scale
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
KEY TERM
economies of scale:
occur for a firm when
an increase in the scale
of production leads to
production at lower
long-run average cost
Test yourself 17.6
Will firms always
benefit from economies
of scale if they increase
production?
LEARNING
LINK
The idea of the
division of labour
was introduced in
Chapter 1.
One of the reasons why some firms find it beneficial to be large is the existence of
economies of scale. These occur when a firm finds that it is more efficient in cost
terms to produce on a larger scale.
It is not difficult to imagine industries in which economies of scale are likely to
arise. For example, recall the notion of the division of labour. When a firm expands,
it reaches a certain scale of production at which it becomes worthwhile to take
advantage of division of labour. Workers begin to specialise in certain stages of the
production process, and their productivity increases. Because this is only possible
for relatively large-scale production, this is an example of economies of scale. It is
the size of the firm (in terms of its output level) that enables it to produce more
efficiently – that is, at lower average cost.
Although the division of labour is one source of economies of scale, it is by no
means the only source, and there are several explanations of cost benefits from
producing on a large scale. Some of these are industry-specific, and thus some
sectors of the economy exhibit more significant economies of scale than others –
it is in these activities that the larger firms tend to be found. There are no
hairdressing salons that come into the top ten largest firms, but there are plenty of
oil companies.
Technology
One source of economies of scale is in the technology of production. There are
many activities in which the technology is such that large-scale production is more
efficient.
One source of technical economies of scale arises from the physical properties of the
universe. There is a physical relationship between the surface area of an object and
the volume of material that it can enclose. In other words, a large ship can transport
proportionally more than a small ship, and large storage tanks hold more liquid
relative to the surface area of the tank than small tanks. Hence there may be benefits
in operating on a large scale.
Furthermore, some capital equipment is designed for
large-scale production, and would only be viable for a firm
operating at a high volume of production. Agricultural
machinery designed for large plantations cannot be used in
small fields; a production line for car production would not
be viable for small levels of output. In other words, there
may be indivisibilities in the production process.
There are many economic activities in which there are
high overhead expenditures. Such components of a firm’s
costs do not vary directly with the scale of production. For
example, having built a factory, the cost of that factory
is the same regardless of the amount of output that is
produced in it. Expenditure on research and development
could be seen as such an overhead, which may be viable
only when a firm reaches a certain size.
▲ Constructing the Channel Tunnel
Notice that there are some economic activities in which
these overhead costs are highly significant. For example,
think about the Channel Tunnel that links England with
France. The construction (overhead) costs were enormous
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compared to the costs of running trains through the tunnel. Thus the overhead cost
element is substantial – and the economies of scale will also be significant for such an
industry.
17
Marketing
Firms need to reach their intended customers. This means that they need to devote
resources to advertising in order to attract buyers. But this is not all – they also need
to find out what characteristics those potential buyers are looking for in the product.
This requires firms to devote part of their resources to a marketing budget.
Management
A further source of economies of scale pertains to the management of firms. One
of the key factors of production is managerial input. A certain number of managers
are required to oversee the production process. As the firm expands, there is a
range of volumes of output over which the management team does not need to
grow as rapidly as the overall volume of the firm, as a large firm can be managed
more efficiently. Notice that there are likely to be limits to this process. At some
point, the organisation begins to get so large and complex that management finds
it more difficult to manage. At this point diseconomies of scale are likely to cut in –
in other words, average costs may begin to rise with an increase in output at some
volume of production.
All firms need to conduct certain functions such as accounting or human resource
management. As a firm expands, it may be able to employ specialist staff to handle
these functions, and may not need to expand those sections of the company
proportionately with the growth of the business. Again, this may lead to economies
of scale. A firm operating on a small scale may need to buy in the expertise that it
needs – for example, to audit its accounts or advise on employment law. However, if
its market is limited in size, or confined to a local area, this may be unavoidable, and
the firm may not be looking to expand.
17 Types of cost, revenue and profit, short-run and long-run production
There may be scale economies involved here, as the average spend on marketing for
a large firm is likely to be less per unit sold than for a small firm. In other words, the
average cost per unit of marketing may be lower for a larger firm. A large firm such
as Cadbury’s incurs high marketing expenditure, but because of its large volume of
sales, its per unit spend is lower than some smaller-scale chocolatiers with lower sales
volume. Although expenditure may increase as output increases, it will do so less than
proportionately.
Finance
A large firm with a strong reputation may be able to raise finance for further
expansion on more favourable terms than a small firm. In other words, a large firm
may be able to persuade a bank to advance the firm loans at lower rates of interest
than a small firm, where the risks may be seen to be greater. This, of course, reinforces
the market position of the largest firms in a sector and makes it more difficult for
relative newcomers to become established.
Test yourself 17.7
List factors that may
result in economies of
scale for a firm when
it expands its scale of
production.
Purchasing
Once a firm has grown to the point where it is operating on a relatively large scale, it
will also be purchasing its inputs in relatively large volumes. In particular, this relates
to raw materials, energy and transport services. When buying in bulk in this way,
firms may be able to negotiate good deals with their suppliers, and thus again reduce
average cost as output increases.
It may even be the case that some of the firm’s suppliers will find it beneficial to
locate in proximity to the firm’s factory, which would reduce costs even more.
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Internal and external economies of scale
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
17
KEY TERMS
internal economies of
scale: economies of
scale that arise from
the expansion of a firm
external economies
of scale: economies of
scale that arise from
the expansion of the
industry in which a firm
is operating
The factors listed so far that may lead to economies of scale arise from the internal
expansion of a firm. These are therefore known as internal economies of scale. For
example, as a firm grows it may find that the firm can be managed more efficiently.
However, if the firm is in an industry that is itself expanding, there may also be
external economies of scale. Firms may benefit from the fact that they operate in an
industry that is expanding.
Concentration
One example of an external economy of scale is where a firm is located close to other
firms in the same industry or related activities. Such geographical concentration
can mean that transport and communication links will be developed, so all firms will
benefit. For example, if several mining companies set up in a region, the government
could decide that it is important to provide a railway link, which would then reduce
transport costs for all of the companies.
Technology and skills
Some of the most successful firms of recent years have been in activities that require
high levels of technology and skills. Web design is one example of an economic
activity that has expanded rapidly. As the sector expands, a pool of skilled labour
is built up that all the firms can draw on. The very success of the sector encourages
people to acquire the skills needed to enter it, colleges may begin to find it viable to
provide courses, and so on. Each individual firm benefits in this way from the overall
expansion of the sector. The greater availability of skilled workers reduces the amount
that individual firms need to spend on training.
Web design is by no means the only example of this. Formula 1 development teams,
pharmaceutical companies and others similarly enjoy external economies of scale.
EXTENSION MATERIAL
Economies of scope
There are various ways in which firms expand their
scale of operations. Some do so within a relatively
focused market, but others are multi-product
firms that produce a range of different products,
sometimes in quite different markets.
For example, look at Nestlé. You may immediately
think of instant coffee, and indeed Nestlé produces
200 different brands of instant coffee worldwide.
However, Nestlé also produces baby milk powder,
mineral water, ice cream and pet food, and has
diversified into hotels and restaurants.
Such conglomerate companies can benefit
from economies of scope, whereby there may
be benefits of size across a range of different
products. These economies may arise because
there are activities that can be shared across
the product range. For example, a company may
not need a finance or accounting section for each
different product, or human resource or marketing
departments. There is thus scope for economies to
be made as the firm expands.
EXERCISE 17.3
Which of the following reflects a movement along a
long-run average cost curve, and which would cause
a shift of a long-run average cost curve?
a A firm becomes established in a market, learning
the best ways of utilising its factors of production.
b A firm observes that average cost falls as it
expands its scale of production.
c The larger a firm becomes, the more difficult it
becomes to manage, causing average cost to rise.
d A firm operating in the financial sector installs
new, faster computers, enabling its average
cost to fall for any given level of service that it
provides.
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Diseconomies of scale
KEY TERM
diseconomies of scale:
occur for a firm when
an increase in the scale
of production leads
to higher long-run
average costs
The problems
caused when the
owners of a firm are
separated from the
managers who take
everyday decisions
are discussed in
Chapter 20.
17
Internal diseconomies of scale
Communication
One issue that arises as a firm expands is that it becomes more difficult to
communicate across the organisation. This is especially the case if the firm has to
operate across a range of different locations. This makes the organisation more
difficult to manage, if the central managers cannot readily communicate their needs
and intentions to the workforce.
Coordination
Similarly, coordinating activity across a large firm becomes more costly and less
efficient. For example, suppose that a manufacturing firm has separate factories
producing components of a good, which then need to be assembled somewhere
else. Coordinating in order to establish an efficient supply chain becomes more and
more difficult as the firm expands. Indeed, it is possible that some multinational
corporations have divided their production activities across a number of countries in
order to take advantage of local conditions or resources in different locations. This
adds to the problems of coordinating the production process.
Motivation
When a firm becomes large, it comes to rely on managers to oversee everyday
production activities and take day-to-day decisions. The firm’s owners may find it
difficult to motivate these managers to run the firm in the way that they want.
External diseconomies of scale
Pollution
If several firms choose to locate in a region, the result may be an increase in pollution
in the area. Firms may then face higher pollution taxes or higher costs to reduce
pollution levels.
17 Types of cost, revenue and profit, short-run and long-run production
LEARNING
LINK
Notice that there are likely to be limits to the extent of economies of scale. At some
point, diseconomies of scale are likely to cut in – in other words, average costs may
begin to rise with an increase in output at some volume of production. There may be a
variety of reasons why such diseconomies may arise.
Infrastructure
If a number of firms choose to locate in an area, this can cause congestion on transport
and communication links, which can raise costs. For example, if there is growing
pressure on road and rail links that the government does not tackle, firms either face
higher costs or find that they need to invest in upgrading the transport network.
Over-extraction of minerals
In the case of mining companies that operate in a region, there may be pressure
arising from over-extraction of minerals. With many firms operating, it is likely that
the costs of mining will rise because the most accessible reserves are exhausted, and
the difficulty of reaching the remaining stocks increases.
Input prices
The growth of firms in an area may put pressure on wages. Firms may find that in
order to recruit the workers that they need, they need to pay higher wages or offer
non-pecuniary benefits or assistance with housing costs.
EXERCISE 17.4
Discuss for what sort of firm each of the causes of economies and diseconomies
of scale may be important.
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The minimum efficient scale
KEY TERM
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
minimum efficient
scale: the level of
output at which longrun average cost
stops falling as output
increases
When considering long-run costs it is important to note that the point at which longrun average cost stops falling is known as the minimum efficient scale. This is the
smallest level of output that a firm can produce at the minimum level of long-run
average cost.
The long-run average cost curve (LAC) is often drawn as a U-shape because of the
assumptions that were made about the technology of production. The underlying
assumption here is that the firm faces economies of scale at relatively low levels of
output, so that LAC slopes downwards. However, at some point diseconomies set in,
and LAC then begins to slope upwards.
Possible shapes of the LAC curve
Costs
Costs
Will the LAC curve always take this shape? It turns out to be a convenient representation,
but in practice the LAC curve can take on a variety of shapes. Figure 17.8 shows some
of these. LAC1 is the typical U-shape, which has been discussed. LAC2 shows an example
of a situation in which there are economies of scale up to a point, after which longrun average cost levels out and there is a long flat range over which the firm faces
constant returns to scale, with costs increasing at the same rate as output. LAC3 is a bit
similar, except that the constant returns to scale (flat) segment eventually runs out and
diseconomies of scale set in. In LAC4 the economies of scale continue over the whole
range of output shown. This could occur in a market where the fixed costs are substantial,
dominating the influence of variable costs.
LAC1
LAC2
Costs
Output
Output
Costs
17
LAC3
LAC4
LEARNING
LINK
The extent of
economies of scale
influences the
number of firms
that can operate
effectively in a
market, and thus
affects the intensity
of competition. This
will be discussed in
Chapters 18–20.
Output
Output
▲ Figure 17.8 Possible shapes of the LAC curve
It turns out that the size of the minimum efficient scale relative to market demand
has an important influence on the way in which a market will develop, and this has
implications for the market power held by firms. This will be explored in the following
chapters.
The significance of economies and diseconomies of scale
The extent of economies of scale in an industry and the level of output at which
diseconomies set in is significant because it affects the operation of markets.
In particular, the existence of economies of scale affects the ability of a firm to
compete with other firms – and ultimately the extent of economies (or diseconomies)
of scale has a major impact on the structure of the market and the number of firms
that will be viable.
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As we will see later, when diseconomies of scale set in at a low level of output
relative to the size of market demand, there is likely to be scope for firms to enter
the market quite readily (ceteris paribus). However, if there are substantial economies
of scale, it becomes more likely that the market will be dominated by a relatively
small number of firms.
17
EXERCISE 17.5
▼ Table 17.3 Output and long-run costs
Output (000 units per week)
Total cost ($000)
0
0
1
32
2
48
3
82
4
140
5
228
6
352
a Calculate long-run average cost and long-run
marginal cost for each level of output.
b Plot long-run average cost (LAC) and long-run
marginal cost (LMC) curves on a graph (hint:
don’t forget to plot LMC at points that are halfway
between the corresponding output levels).
c Identify the output level at which long-run
average cost is at a minimum.
d Identify the output level at which LAC = LMC.
e Within what range of output does this firm enjoy
economies of scale?
f Within what range of output does the firm
experience diseconomies of scale?
X-inefficiency
KEY TERM
Costs
X-inefficiency:
situation arising when
a firm is not operating
at minimum cost,
perhaps because of
organisational slack
Will a firm always operate as efficiently as it can? Consider a monopolist
operating behind secure barriers to entry, so it knows that it does not face
effective competition from other firms. One possibility is that the firm becomes
complacent, and fails to keep looking to be as efficient as possible. This can
result in what is called X-inefficiency. For example, in Figure 17.9 LAC* represents
the long-run average cost curve showing the most efficient cost positions for
the firm at any output level. With X-inefficiency, a firm could end up producing
on a long-run average cost curve such as LAC1 that is above the most efficient
that could be achieved. For example, at output q1, the firm would produce at an
average cost of AC1, although it could have produced at AC* if it were not for the
X-inefficiency. Thus, in the presence of X-inefficiency the firm will be operating
above its lowest-possible long-run average cost curve. It is also possible that
some X-inefficiency will exist for some firms in the short run, with a similar
impact on costs.
LAC1
LAC*
AC1
LEARNING
LINK
Productive efficiency
is explained in
Chapter 15.
17 Types of cost, revenue and profit, short-run and long-run production
A firm faces long-run total cost conditions as shown
in Table 17.3.
AC*
q1
Output
▲ Figure 17.9 X-inefficiency
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A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
17
SUMMARY: PRODUCTION AND COSTS IN THE LONG RUN
» The long run is defined as the period over which
the firm is able to vary the input of all of its factors
of production.
» Increasing returns to scale occur when an
increase in a firm’s inputs results in a higher
percentage increase in output.
» The firm may also experience decreasing or
constant returns to scale.
» Economies of scale occur for a firm when an
increase in the scale of production leads to
production at lower long-run average cost.
» There are several reasons why such economies of
»
»
»
»
scale may arise, either from reasons internal to
the firm or from external effects.
However, the firm may experience diseconomies of
scale when long-run average cost rises as output
expands.
The minimum efficient scale is the level of output
at which long-run average cost stops falling.
The long-run average cost curve can take a variety
of shapes.
X-inefficiency occurs when a firm is not operating
at as low a cost as is possible.
17.5 A firm’s revenue
KEY TERMS
total revenue: the
revenue received by a
firm from its sales of a
good or service; it is the
quantity sold, multiplied
by the price
average revenue:
the average revenue
received by the firm per
unit of output; it is total
revenue divided by the
quantity sold
marginal revenue:
the additional revenue
received by the firm if it
sells an additional unit
of output
In Chapter 3, you saw how the total revenue received by a firm varies along the
demand curve, according to the price elasticity of demand. In the same way that
there is a relationship between total, average and marginal cost, there is also a
relationship between total revenue, average revenue and marginal revenue.
Chapter 3 introduced the relationship between the demand curve and the revenues
received by a firm from selling different levels of output. The relationship between
total revenue and the price elasticity of demand was also explained. Ignoring indirect
taxes, the price of a good is the average revenue received by the firm, and the total
revenue is the price multiplied by the quantity sold.
LEARNING LINK
You may find it useful to remind yourself of the discussion in Chapter 3, which
explored the relationship between average and total revenue and the price
elasticity of demand.
Moving down along the demand curve, the average revenue per unit (i.e. the
price) of a good falls but the quantity demanded increases. What happens to total
revenue depends on the balance between the fall in price and the increase
in quantity.
You saw earlier in this chapter that there is a fixed mathematical relationship between
total, average and marginal costs. The same applies to total, average and marginal
revenue. Marginal revenue is the additional revenue received by the firm when it sells
an additional unit of output.
When average revenue (price) falls, marginal revenue also falls, as the revenue
received on the last unit is now lower. However, because all customers also
experience a fall in the price, marginal revenue must fall more rapidly than
average revenue. Indeed mathematically, when the demand curve is a straight
line marginal revenue always falls at twice the rate of the fall in average
revenue (price).
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What is the relationship
between average
revenue and price? How
would total revenue be
affected if there is an
increase in price when
demand is elastic?
The formulae for these are:
total revenue = price × quantity sold
17
average revenue = total revenue/quantity sold
marginal revenue = change in revenue/change in quantity sold
Price
Test yourself 17.8
A
Elastic
Inelastic
MR
B
C
Demand (AR)
D
Price
Quantity
Total revenue
0
qr
Quantity
▲ Figure 17.10 Elasticity and total revenue
17 Types of cost, revenue and profit, short-run and long-run production
Unit elastic
Figure 17.10 reminds you of the relationship between total revenue and the price
elasticity of demand (PED). The marginal revenue (MR) curve has also been added to
the figure, and has a fixed relationship with the average revenue (AR) curve.
MR shares the intercept point on the vertical axis (at point A on Figure 17.10), and has
exactly twice the slope of AR.
STUDY TIP
Whenever you have to draw this figure, remember that MR and AR have this
relationship, meeting at A, and with the distance BC being the same as the distance
CD. MR is zero (meets the horizontal axis) at the maximum point of the total revenue
curve. Remember also that the AR curve is the demand curve, as AR is the same as
price when all units of a good are sold at the same price.
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The relationship between sales and
revenue
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
Table 17.4 provides an arithmetic example to illustrate
the relationship between these different aspects of
revenue.
▼ Table 17.4 The relationship between sales and revenue
(1)
Quantity
sold
0
(2)
Average
revenue
(price, $)
12
(3)
Total
revenue
(TR, $)
0
20
10
200
40
8
320
60
6
360
(4)
Marginal
revenue
(MR, $)
10
6
2
4
320
2
0
12
10
6
200
2
–2
0
Columns (1) and (2) describe the demand curve for
this product, showing the quantities sold at each price.
Column (3) calculates total revenue (TR) as column (1)
multiplied by column (2). Marginal revenue is shown
in column (4). This is calculated by taking the change
Demand (AR)
MR
0
−10
120
14
4
−6
100
Figure 17.11 plots these values (but not all of the
negative values of MR have been plotted). This
shows the relationship between AR and MR. The
two lines (curves) share the same intercept with the
y-axis, and the MR curve is exactly twice as steep as
the AR line (curve). This relationship always holds.
8
−2
80
in revenue between the points on the demand curve,
expressed per unit. For example, if price goes from
$10 to $8, the quantity sold increases from 20 to 40,
and total revenue goes from $200 to $320, so revenue
increases by $320 − $200 = $120, which is $6 per unit
sold. In the table, the values for marginal revenue
are shown halfway between the values in the other
columns, as we are looking at the change between the
successive points.
Price
17
QUANTITATIVE SKILLS 17.4
20
40
60
80
100
120
140
Quantity
▲ Figure 17.11 Average and marginal revenue
Notice that the MR line cuts the x-axis at the
quantity 60, which is the point at which TR is at a
maximum. This is also a mathematical feature of the
relationship.
SUMMARY: A FIRM’S REVENUE
» Total revenue (TR) is the revenue received by a
firm from selling the goods and services that it
produces: it is the quantity sold multiplied by the
price.
» Average revenue (AR) is the revenue per unit of
output: TR/Q.
» Marginal revenue (MR) is the revenue received
from selling an additional unit of output.
» There is a fixed (mathematical) relationship
between AR and MR.
» There is a relationship between total revenue and
the price elasticity of demand.
17.6 Profit and loss
Economists define profit as the difference between the total revenue received by a
firm and the total costs that it incurs in production:
profits = total revenue − total cost
Total revenue here is seen in terms of the quantity of the product that is sold
multiplied by the price. Total cost includes the fixed and variable costs that have
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KEY TERMS
normal profit: the
return needed for a firm
to stay in a market in
the long run
subnormal profits:
profits less than
normal profits
accounting profits:
the profits made by
a business based
on explicit costs
incurred but excluding
opportunity cost
shutdown price (short
run): the price below
which a firm will choose
to exit the market in the
short run because it
is not able to cover its
fixed costs
shutdown price
(long run): the price
below which a firm
will choose to exit the
market in the long run
because it is not able
to cover its long-run
average total costs
Consider the case of a sole trader – a small local business such as a gym or a taxi firm.
It seems reasonable to assume that such a firm will set out to maximise its profits.
However, from the entrepreneur’s perspective there is an opportunity cost of being in
business, which may be seen in terms of the earnings that the proprietor could make
in an alternative occupation. This required rate of return is regarded as a fixed cost,
and is included in the total cost of production.
The same procedure applies to cost curves for other sorts of firm. In other words, when
economists refer to costs, they include the rate of return that a firm needs to make if it
is to stay in a particular market in the long run. This is known as normal profit. Profits
made by a firm above that level are known as supernormal profits. If a firm makes
profits that are lower than normal profit, this is known as subnormal profit.
As ‘opportunity cost’ cannot be identified as an explicit item in the accounts,
accounting profit differs from the economist’s view of profit because of this
component of costs. In other words, accounting profits are defined in terms of the
explicit (observable) costs of doing business.
Notice that when total revenue is smaller than total cost, the firm makes a loss. If the
total revenue equals total cost, the economist sees the firm as making normal profit,
as it is covering the opportunity cost of production.
The shutdown price
In the short run, a firm may choose to remain in a market even if it is not covering
its opportunity costs, provided its revenues are covering its variable costs. Since the
firm has already incurred fixed costs, if it can cover its variable costs in the short run,
it will be better off remaining in business and paying off part of the fixed costs than
exiting the market and losing all of its fixed costs. Thus, the level of average variable
costs represents the shutdown price (short run), below which the firm will exit
from the market in the short run. In situations where firms in a market are making
supernormal profits, it is likely that other firms will be attracted to enter the market.
The absence or existence of supernormal profits will thus be important in influencing
the way in which a market may evolve over time.
17
17 Types of cost, revenue and profit, short-run and long-run production
supernormal, abnormal
or economic profits:
profits above normal
profits
already been discussed. However, one important item of costs should be highlighted
before going any further.
In the long run, there are no fixed costs, so the long-run shutdown price is where
the price does not cover average total cost for a firm, so that it is not able to make
normal profits.
Test yourself 17.9
Explain why it would
be rational for a firm to
leave a market in the
short run if price were
to be below its variable
costs.
EXERCISE 17.6
Table 17.5 shows how a firm’s output sold and average cost vary with price.
▼ Table 17.5 A firm’s price, output and average (total) cost
a
b
c
d
Price ($)
Quantity of output sold
Average cost ($)
35
200
24
30
300
18
25
400
18
20
500
20
15
600
25
Calculate the amount of profit made at each price.
At what level(s) of output does the firm make supernormal profit?
At what level(s) of output does the firm make normal profit?
At what level(s) of output does the firm make subnormal profit?
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Profit maximisation
Traditional economic analysis has tended to start from the premise that firms set out with
the objective of maximising profits. How does a firm choose its output level if it wishes
to maximise profits? An application of the marginal principle shows how. Suppose a firm
realises that its marginal revenue is higher than its marginal cost of production. What
does this mean for profits? If it were to sell an additional unit of its output, it would
gain more in revenue than it would incur additional cost, so its profits would increase.
Similarly, if it found that its marginal revenue was less than marginal cost, it would be
making a loss on the marginal unit of output, and profits would increase if the firm sold
less. This leads to the conclusion that profits will be maximised at the level of output at
which marginal revenue (MR) is equal to marginal cost (MC). Indeed, this MR = MC rule is a
general rule that tells a firm how to maximise profits in any market situation.
STUDY TIP
The MR = MC rule for
profit maximisation is
an important one, as it
applies in any market
situation where a firm
sets out to maximise
profits, so make sure
you understand and
remember it.
Test yourself 17.10
If a firm were to find
that it was producing at
an output level at which
marginal cost exceeded
marginal revenue,
would it be likely to
increase or decrease
output if it wants to
maximise profits?
EXERCISE 17.7
Figure 17.12 shows a firm operating in a market in which it has no influence
over price, so it gains the same marginal revenue from the sale of each unit of
output. Marginal revenue and average revenue are thus the same. P1, P2 and P 3
represent three possible prices that could prevail in the market.
a For each price level, identify the output level that the firm would choose in
order to maximise profits.
b For each of these output levels, compare the level of average revenue with
that of average cost, and consider what this means for the firm’s profits.
Revenue, cost
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
17
SMC
SATC
AVC
P1
MR1
MR2
P2
P3
MR3
A
BC D E
Output
▲ Figure 17.12 Profit maximisation in the short run
SUMMARY: PROFIT AND LOSS
» Normal profit is where total revenue equals total cost, where total cost
includes the rate of return needed to keep the firm in the market.
» Profits above normal profit are known as supernormal profits; profits below
normal profits are known as subnormal profits.
» Profits are maximised at the level of output at which marginal revenue equals
marginal cost.
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END OF CHAPTER QUESTIONS
Multiple choice
1 The table gives information on the number of workers in a firm and the total
product they produce.
No. of workers
17
Total product (units)
0
1
5
2
10
3
40
4
55
5
65
6
70
7
70
8
68
TPP
The manager of the firm changes their objective from producing maximum output
to maximising productivity. What is the change in the number of workers?
A They should employ 3 workers rather than 7.
B They should employ 4 workers rather than 6.
C They should employ 5 workers rather than 6.
D They should employ 6 workers rather than 8.
2 The diagram shows the production function of a firm, where TPP is total physical
product.
TPP
17 Types of cost, revenue and profit, short-run and long-run production
0
b
0
Number of workers
What is observed at point b and beyond?
A increasing productivity
B diminishing marginal returns
C increasing marginal physical product
D increasing returns to scale
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Data response
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
17
1 a Table 17.6 shows the output and short-run costs of a manufacturing firm.
▼ Table 17.6 Output and short-run costs (US$)
Output
Fixed cost
Variable cost
1
400
200
2
400
320
3
400
400
4
400
480
5
400
600
6
400
880
Define marginal cost and calculate the marginal cost of the 4th unit
produced.
b Define average total cost and calculate the average total cost when
5 units of output are produced.
c Explain the relationship between average fixed cost and the quantity
of output.
d Table 17.7 shows how the long-run total costs of a firm making dining
tables change as the scale of its output increases. The firm is currently
operating at its minimum efficient scale (MES).
▼ Table 17.7 Output and total cost of production
Output
Total cost of production (US$)
200
800
300
900
400
1,000
500
1,050
600
1,320
The total cost of production then decreases by 10% at all levels of output.
Calculate the decrease in total costs if the firm continues to operate at
its MES after the decrease in total cost.
e In 2010, nickel-cadmium batteries powered many of our phones and
computers. By 2020, more efficient lithium-ion batteries had taken over
and were powering our cars and houses too.
Over that 10-year period Panasonic Sanyo grew to be one of the world’s
leading lithium-ion battery manufacturers.
Explain one internal economy of scale and one external economy of scale
that Panasonic Sanyo might enjoy as it increases its output of lithium-ion
batteries. Assess the likelihood of these economies of scale occurring.
f Table 17.8 shows how the total product of a firm changes when the
number of workers employed increases while holding all other factor
inputs constant.
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▼ Table 17.8 Number of workers and total product
Total product
(units produced)
0
0
1
8
2
20
3
32
4
42
5
47
6
42
17
Use the data in the table to illustrate the law of diminishing returns.
Essay style
2 Table 17.9 shows how a profit-maximising firm’s output sold and average
total cost vary with price.
▼ Table 17.9 Price, output sold and average total cost
Price (US$)
Quantity of output sold
Average total cost (US$)
9
1
2.00
8
2
1.50
7
3
1.67
6
4
2.00
5
5
2.40
4
6
2.80
Explain why this firm will make supernormal profit in the short run and
assess the reliability of such conclusions.
17 Types of cost, revenue and profit, short-run and long-run production
No. of workers
CASE STUDY
The costs of a hypothetical firm
In producing 100 units of output, a firm incurs average fixed costs per unit (AFC)
of $15 and total variable costs (TVC) of $1,700.
a Calculate total fixed cost (TFC), total cost (TC) and average (total) cost (ATC).
The firm sees that the marginal cost per unit (MC) of producing 100 more units
of output is $14.
b Calculate total cost (TC), total variable cost (TVC), average fixed cost (AFC)
and average total cost (ATC).
The firm knows that the total cost of producing 300 units is $5,700.
c Calculate the marginal cost (MC) of producing the last 100 units. Also
calculate average fixed cost (AFC) and average (total) cost (ATC).
d Is the firm experiencing economies of scale at this level of output? Explain
your answer and comment on the pattern shown by the way that AFC varies
with output.
e What additional information would you need in order to identify the profitmaximising level of output?
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A LEVEL PART 7 The price system and the microeconomy
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
18
Different market structures:
perfect competition and monopoly
What this chapter covers
★ the characteristics of different market structures
★ the model of perfect competition
★ profit maximisation for a firm in the short run
under perfect competition
★ industry equilibrium under perfect competition in
the short run and the long run
★ efficiency under perfect competition
★
★
★
★
★
★
the model of monopoly
barriers to entry
profit maximisation under monopoly
natural monopoly
efficiency under monopoly
monopoly and perfect competition compared
The previous chapter discussed the way in which firms may be expected to operate.
Further analysis shows that the behaviour of firms is strongly influenced by the market
environment in which they find themselves. It is now time to look at market structure
more closely in order to evaluate the way that markets work, and the significance of
this for resource allocation. The fact that firms try to maximise profits is not in itself
bad for society. However, the structure of a market has a strong influence on how well
the market performs. ‘Structure’ here is seen in relation to a number of dimensions,
but in particular to the number of firms operating in a market and the way in which
they interact. This chapter considers two extreme forms of market structure: perfect
competition and monopoly.
18.1 Different market structures
Firms cannot take decisions without some awareness of the market in which they are
operating. In some markets, a firm finds itself to be such a small player that it cannot
influence the price at which it sells. In others, a firm may find itself to be the only firm,
which clearly gives it much more discretion in devising a price and output strategy.
There may also be many intermediate situations where the firm has some control over
price, but needs to be aware of rival firms in the market.
KEY TERM
market structure: the
market environment
within which firms
operate
Economists have devised a range of models that allow such different market
structures to be analysed. Before looking carefully at the most important types of
market structure, the key characteristics of alternative market structures will be
introduced. The main models are summarised in Table 18.1. In many ways, we can
regard these as a spectrum of markets with different characteristics. Each form of
market structure will be discussed more carefully in this chapter and the next.
▼ Table 18.1 Types of market structure
Perfect competition Monopolistic competition Oligopoly
Monopoly
Number of firms
Many
Many
Few
One
Freedom of entry
Not restricted
Not restricted
Some barriers
High barriers to entry
Firm’s influence
over price
None
Some
Some
Price maker, subject to the
demand curve
Nature of product Homogeneous
Differentiated
Varied
No close substitutes
Examples
Fast-food outlets, travel
agents
Cars, mobile phones PC operating systems, local
water supply
Cauliflowers, onions
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LEARNING
LINK
LEARNING
LINK
We will return to
analyse the monopoly
model and barriers
to entry later in
this chapter, after
we have discussed
perfect competition.
18
At one extreme of the spectrum of market structures is perfect competition. This
is a market in which each individual firm is a price taker. This means that there
is no individual firm that is large enough to be able to influence the price, which
is set by the market as a whole. This situation would arise where there are many
firms operating in a market, producing a product that is much the same whichever
firm produces it. You might think of a market for a particular sort of vegetable, for
example. One cauliflower is very much like another, and it would not be possible for a
particular cauliflower-grower to set a premium price for its product.
Such markets are also typified by freedom of entry and exit. In other words, it is
relatively easy for new firms to enter the market, or for existing firms to leave it to
produce something else. The market price in such a market will be driven down to that
at which the typical firm in the market just makes enough profit to stay in business. If
firms make more than this, other firms will be attracted in, and thus any supernormal
profits will be competed away. If some firms in the market do not make sufficient
profit to want to remain in the market, they will exit, allowing price to drift up until
again the typical firm just makes enough to stay in business.
Monopoly
At the other extreme of the spectrum of market structures is monopoly. This is a
market where there is only one firm in operation. Such a firm has some influence over
price, and can choose a combination of price and output in order to maximise its
profits. The monopolist is not entirely free to set any price that it wants, as it must
remain aware of the demand curve for its product. Nonetheless, it has the freedom to
choose a point along its demand curve.
Monopolistic competition
Between the two extreme forms of market structure are many intermediate situations
in which firms may have some influence over their selling price, but still have to
take account of the fact that there are other firms in the market. One such market is
known as monopolistic competition. This is a market in which there are many firms
operating, each producing similar but not identical products, so that there is some
scope for influencing price, perhaps because of brand loyalty. However, firms in such a
market are likely to be relatively small. Such firms may find it profitable to make sure
that their own product is differentiated from other goods, and may advertise in order
to convince potential customers that this is the case. For example, small-scale local
restaurants may offer different styles of cooking.
18 Different market structures: perfect competition and monopoly
The model of perfect
competition is fully
analysed later in
this chapter. The
concepts of normal
and supernormal
profits are explained
in Chapter 17,
and are crucial
in understanding
and evaluating the
alternative models of
market structure.
Perfect competition
▲ A small local restaurant
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A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
18
Test yourself 18.1
What form of market
structure could be
regarded as being at
the opposite extreme
of the market structure
spectrum to monopoly?
LEARNING
LINK
The market structures
of monopolistic
competition and
oligopoly are
examined in
Chapter 19.
KEY TERM
barrier to entry: a
characteristic of a
market that prevents
new firms from readily
joining the market
Test yourself 18.2
Give an example of a
barrier to entry that
might make it difficult
for new firms to enter a
market.
Oligopoly
Another intermediate form of market structure is oligopoly, which literally means ‘few
sellers’. This is a market in which there are just a few firms that supply the market.
Each firm will take decisions in close awareness of how other firms in the market may
react to its actions. In some cases, the firms may try to collude – to work together
in order to behave as if they were a monopolist – thus making higher profits. In
other cases, they may be intense rivals, which will tend to result in supernormal
profits being competed away. The question of whether firms in an oligopoly collude
or compete has a substantial impact on how the overall market performs in terms of
resource allocation, and whether consumers will be disadvantaged as a result of the
actions of the firms in the market.
Barriers to entry and exit
It has been argued that if firms in a market are able to make supernormal profits,
this will act as an inducement for new firms to try to gain entry into that market
in order to share in those profits. A barrier to entry is a characteristic of a
market that prevents new firms from joining the market. The existence of such
barriers is thus of great importance in influencing the market structure that will
evolve.
For example, if a firm holds a patent on a particular good, this means that no
other firm is permitted by law to produce the product, and the patent-holding firm
thus has a monopoly. The firm may then be able to set a price such as to make
supernormal profits without fear of rival firms competing away those profits. On
the other hand, if there are no barriers to entry in a market, then if the existing
firms set price to make supernormal profits, new firms will join the market, and
the increase in market supply will push price down until no supernormal profits are
being made.
Firms may also face barriers to exit – a situation in which leaving a market may cause
the firm to incur high costs. For example, there may be significant sunk costs that
cannot be recovered if a firm leaves its market. Such costs may arise because a firm
has invested in specific capital goods that cannot be used for alternative reasons, or
it may have contracts with suppliers that cannot be broken.
SUMMARY: DIFFERENT MARKET STRUCTURES
LEARNING
LINK
Barriers to entry are
explained in more
detail later in this
chapter in the context
of monopoly, where
the existence of
barriers to entry is a
key assumption.
» The decisions taken by firms must be taken in the context of the market
»
»
»
»
»
environment in which they operate.
Under conditions of perfect competition, each firm must accept the market
price as given, but can choose how much output to produce in order to
maximise profits.
In a monopoly market, where there is only one producer, the firm can choose
output and price (subject to the demand curve).
Monopolistic competition combines some features of perfect competition and
some characteristics of monopoly. Firms have some influence over price, and
will produce a differentiated product in order to maintain this influence.
Oligopoly exists where a market is occupied by just a few firms. In some cases,
these few firms may work together to maximise their joint profits; in other
cases, they may seek to outmanoeuvre each other.
An important characteristic of a market is the existence (or absence) of
barriers to entry and exit.
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EXERCISE 18.1
Market situations:
a A fairly large number of fast-food outlets in a city
centre, offering various different styles of cooking
(Indian, Chinese, fish and chips, burgers, etc.) at
broadly similar prices
b An island’s only airport
c A large number of farmers selling onions at the
same price
d A small number of large firms that between them
supply most of the market for commercial vans
18.2 The model of perfect competition
KEY TERM
perfect competition:
a form of market
structure that
produces allocative and
productive efficiency in
long-run equilibrium
At one end of the spectrum of market structures is perfect competition. This model
has a special place in economic analysis because if all its assumptions were fulfilled,
and if all markets operated according to its precepts, the best allocation of resources
would be ensured for society as a whole. Although it may be argued that this ideal is
not often achieved, perfect competition nonetheless provides a yardstick by which all
other forms of market structure can be evaluated.
The assumptions of the model
The model of perfect competition rests on some important assumptions:
1 Firms aim to maximise profits.
2 There are many participants (both buyers and sellers), none of whom is large
enough to influence price.
3 The product is homogeneous.
4 There are no barriers to entry or exit from the market.
5 There is perfect knowledge of market conditions.
LEARNING
LINK
The conditions
necessary for a firm
to maximise profits
are explained in
Chapter 17.
LEARNING
LINK
The concept of
the minimum
efficient scale and
its relevance were
discussed in
Chapter 17.
18
18 Different market structures: perfect competition and monopoly
For each of the market situations listed below, select
the form of market structure that is most likely to
apply. In each case, comment on the way in which
the firm’s actions may be influenced by the market
structure.
Forms of market structure:
A perfect competition
B monopoly
C monopolistic competition
D oligopoly
Profit maximisation
The first assumption is that firms act to maximise their profits. You might think that firms
acting in their own self-interest are unlikely to do consumers any favours. However, it turns
out that this does not interfere with the operation of the market. Indeed, it is the pursuit
of self-interest by firms and consumers that ensures that the market works effectively.
Many participants
This is an important assumption of the model: that there are so many buyers and so
many sellers that no individual trader is able to influence the market price. The market
price is thus determined by the operation of the market.
On the sellers’ side of the market, this assumption is reinforced where there are
limited economies of scale in the industry. If the minimum efficient scale (that is, the
level of output at which a firm’s long-run average costs reach their minimum) is small
relative to market demand, then no firm is likely to become so large that it will gain
influence in the market.
A homogeneous product
This assumption means that buyers of the good see all products in the market as being
identical, and will not favour one firm’s product over another. If there were brand loyalty,
such that one firm was more popular than others, then that firm would be able to
charge a premium on its price. By ruling out this possibility the previous assumption is
reinforced, and no individual seller is able to influence the selling price of the product.
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No barriers to entry or exit
18
By this assumption, firms are able to join the market if they perceive it to be a profitable
step, and they can exit from the market without hindrance. This assumption is important
when it comes to considering the long-run equilibrium towards which the market will tend.
Why is the assumption
of perfect knowledge
important in perfect
competition?
Perfect knowledge
It is assumed that all participants in the market have perfect information about
trading conditions in the market. In particular, buyers always know the prices that
firms are charging, and thus can buy the good at the cheapest possible price. Firms
that try to charge a price above the market price will get no takers. At the same time,
traders are aware of the product quality.
Perfect competition in the short run
The firm under perfect competition
KEY TERM
price taker: a firm that
must accept whatever
price is set in the
market as a whole
With the above assumptions, it is possible to analyse how a firm will operate in the
market. An important implication of these assumptions is that no individual trader
can influence the price of the product. In particular, this means that the firm is a
price taker, and has to accept whatever price is set in the market as a whole.
As a price taker, the firm faces a perfectly elastic demand curve for its product, as
is shown in Figure 18.1. In this figure P1 is the price set in the market, and the firm
cannot sell at any other price. If it tries to set a price above P1 it will sell nothing, as
buyers are fully aware of the market price and will not buy at a higher price, especially
as they know that there is no quality difference between the products produced by
different firms in the market. What this also implies is that the firm can sell as much
output as it likes at that going price – which means there is no incentive for any firm
to set a price below P1. Thus, all firms charge the same price, P1.
Price
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
Test yourself 18.3
P1
Demand
(AR = MR)
0
Output per period
▲ Figure 18.1 The firm’s demand curve
EXTENSION MATERIAL
Competition and the internet
The assumption of perfect knowledge of market
conditions can seem unrealistic in some situations,
but it is necessary for the model of perfect
competition to work. This is because if some
traders have better information than others, they
may be able to exploit the situation, and firms may
not all face the same price. Chapter 16 explored
some of the implications of asymmetric information
for a market.
The internet has had an enormous impact on the
information available to buyers – and to sellers in
relation to their competitors. The proliferation of
price comparison sites makes it easy to look for
good deals when buying goods and services. In this
context, the assumption of perfect knowledge begins
to appear rather less unrealistic. So, we might argue
that the arrival of the internet has made it more
likely that firms in some markets will indeed be
price takers, less able to charge high prices because
consumers are better informed.
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The firm’s short-run supply decision
If the firm can sell as much as it likes at the market price, how does it decide how
much to produce?
Price, costs
SMC
SATC
SAVC
P1
KEY TERM
short-run supply
curve: for a firm
operating under perfect
competition, the curve
given by its short-run
marginal cost curve
above the price at which
MC = SAVC; for the
industry, the horizontal
sum of the supply
curves of the individual
firms
Test yourself 18.4
What shape will the
demand curve take if a
firm is a price taker?
Demand
(AR = MR)
0
q1
Output per period
▲ Figure 18.2 The firm’s short-run supply decision
If the market price were to change, the firm would react by changing output, but
always choosing to supply output at the level at which MR = SMC. This suggests
that the short-run marginal cost curve represents the firm’s short-run supply curve:
in other words, it shows the quantity of output that the firm would supply at any
given price.
18 Different market structures: perfect competition and monopoly
The previous chapter explained that to maximise profits a firm needs to set output
at such a level that marginal revenue is equal to marginal cost. Figure 18.2 illustrates
this rule by adding the short-run cost curves to the demand curve. (Remember that
SMC cuts SAVC and SATC at their minimum points.) As the demand curve is horizontal,
the firm faces constant average and marginal revenue and will choose output at q1,
where MR = SMC.
18
However, there is one important proviso to this statement. If the price falls below
short-run average variable cost, the firm’s best decision will be to exit from the
market, as it will be better off just incurring its fixed costs. This is the shutdown price
in the short run. So the firm’s short-run supply curve is the SMC curve above the
point where it cuts SAVC (at its minimum point).
EXERCISE 18.2
Table 18.2 shows the costs (SATC and SMC) facing a firm
under perfect competition at different levels of output.
▼ Table 18.2 A firm’s costs
Output
Short-run average
cost (SATC)
Short-run marginal
cost (SMC)
100
60
25
200
40
20
300
30
18
400
25
25
500
30
40
600
40
60
Notice that under perfect competition, the firm is a
price taker, which means that it faces a horizontal
demand curve such that price = AR = MR. Assume
that the firm maximises profit.
a If the firm faces a price of 40, how much output
will the firm supply, and what will be the level of
supernormal profit or loss per unit?
b If the firm faces a price of 25, how much output
will the firm supply, and what will be the level of
supernormal profit or loss per unit?
c If the firm faces a price of 20, how much output
will the firm supply, and what will be the level of
supernormal profit or loss per unit?
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Industry equilibrium in the short run
18
Supply
= SMC
P1
Demand
0
Q1
Quantity per period
▲ Figure 18.3 A perfectly competitive industry in short-run equilibrium
Test yourself 18.5
Which curve represents
the individual firm’s
short-run supply
curve under perfect
competition?
On the supply side, it has been shown that the individual firm’s supply curve is
its marginal cost curve above SAVC. If you add up the supply curves of each firm
operating in the market, the result is the industry supply curve, shown in Figure 18.3
as Supply = ∑SMC (where ‘∑’ means ‘sum of’). The price will then adjust to P1
at the intersection of demand and supply. The firms in the industry between them
will supply Q1 output, and the market will be in equilibrium.
As this seems to be a well-balanced situation, with price adjusting to equate market
demand and supply, the only question is why it is described as just a short-run
equilibrium. The clue to this is to be found back with the individual firm.
Figure 18.4 illustrates the position facing an individual firm in the market. As
before, the firm maximises profits by accepting the price P1 as set in the market and
producing up to the point where MR = SMC, which is at q1. However, now the firm’s
average revenue (which is equal to price) is greater than its average cost (which is
given by AC1 at this level of output). The firm is thus making supernormal profits at
this price. (Remember that ‘normal profits’ are included in average cost.) The total
amount of supernormal profits being made is shown as the shaded area on the graph.
Notice that average revenue minus average costs equals profit per unit, so multiplying
this by the quantity sold determines total profit.
Price, costs
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
Price
One crucial question that we have not yet examined is how the market price comes
to be determined. To answer this, it is necessary to consider the industry as a whole.
In this case there is a conventional downward-sloping demand curve. This is formed
according to preferences of consumers in the market and is shown in Figure 18.3.
SMC
SATC
P1
Demand
(AR = MR)
AC1
0
q1
Output per period
▲ Figure 18.4 The firm in short-run supply equilibrium
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This is where the assumption about freedom of entry becomes important. If firms in
this market are making profits above opportunity cost, the market is generating more
profits than other markets in the economy. This will prove attractive to other firms,
which will try to enter the market – and the assumption is that there are no barriers
to prevent them from doing so.
If the price were to fall even further, some firms would choose to exit from the
market, and the process would go into reverse. Therefore price can be expected to
stabilise such that the typical firm in the industry is just making normal profits.
Price, costs
Figure 18.5 shows a different situation. This firm also tries to maximise profits by
setting MC = MR, but finds that its average cost exceeds the price. It makes losses
shown by the shaded area, and in the long run will choose to leave the market. As this
and other firms exit from the market, the market supply curve shifts to the left, and
the equilibrium price will drift upwards until firms are again making normal profits.
SMC
SATC
AC1
P1
Demand
(AR = MR)
q1
Output per period
18 Different market structures: perfect competition and monopoly
This process of entry will continue for as long as firms are making supernormal profits.
However, as more firms join the market, the position of the industry supply curve,
which is the sum of the supply curves of an ever-larger number of individual firms,
will be affected. As the industry supply curve shifts to the right, the market price will
fall. At some point the price will have fallen to such an extent that firms are no longer
making supernormal profits, and the market will then stabilise.
18
▲ Figure 18.5 The firm in short-run equilibrium again
Perfect competition in the long run
Long-run equilibrium under perfect competition
Figure 18.6 shows the situation for a typical firm and for the industry as a whole once
long-run equilibrium has been reached and firms no longer have any incentive to enter
or exit the market. The market is in equilibrium, with demand equal to supply at the
going price. The typical firm sets marginal revenue equal to marginal cost to maximise
profits, and just makes normal profits.
Test yourself 18.6
What is the long-run
shutdown price for
a firm under perfect
competition?
LMC
LAC
S = SMC
AR = MR
P*
0
Price, costs
Industry
Price, costs
Typical firm
0
q*
Output
Demand
Q*
Output
▲ Figure 18.6 Long-run equilibrium under perfect competition
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The long-run supply curve
Suppose there is an increase in the demand for a product. Perhaps, for some reason,
everyone becomes convinced that the product is really health promoting, so demand
increases at any given price. This disturbs the market equilibrium, and the question
then is whether (and how) equilibrium can be restored.
Figure 18.7 reproduces the long-run equilibrium that was shown in Figure 18.6. In
the initial position market price is at P*, the typical firm is in long-run equilibrium,
producing q*, and the industry is producing Q*. Demand was initially at D0, but with
the increased popularity of the product it has shifted to D1. In the short run this
pushes the market price up to P1 for the industry because, as market price increases,
existing firms have the incentive to supply more output: that is, they move along their
short-run supply curves. So in the short run a typical firm starts to produce q1 output.
The combined supply of the firms then increases to Q1.
Typical firm
Industry
LMC
S = SMC0
Price, costs
Price, costs
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
18
S = SMC1
LAC
P1
AR = MR
P*
P1
P*
KEY TERM
industry longrun supply curve
(LRS): under perfect
competition, the curve
that, for the typical
firm in the industry,
is horizontal at the
minimum point of the
long-run average cost
curve
Test yourself 18.7
What level of profit
is made by a firm
operating under perfect
competition in long-run
equilibrium?
LRS
D0
0
q*
0
q1
Output
D1
Q* Q1 Q**
Output
▲ Figure 18.7 Adjusting to an increase in demand under perfect competition
However, at the higher price the firms start making supernormal profits (shown by the
shaded area in Figure 18.7), so in time more firms will be attracted into the market,
pushing the short-run industry supply curve to the right. This process will continue
until there is no further incentive for new firms to enter the market – which occurs
when the price has returned to P*, but with increased industry output at Q**. In other
words, the adjustment in the short run is borne by existing firms, but the long-run
equilibrium is reached through the entry of new firms. This suggests that the industry
long-run supply curve (LRS) is horizontal at price P*, which is the minimum point of
the long-run average cost curve for the typical firm in the industry.
Strictly speaking, the LRS is perfectly flat only if all firms face equal cost conditions,
and if factor prices remain constant as the industry expands. For example, if there is
a labour shortage, then industrial expansion may drive up labour costs, causing firms
to face higher costs at any output level. In these sorts of circumstances, the LRS is
slightly upward sloping.
EXTENSION MATERIAL
Different cost conditions
If firms are not identical, but face different cost conditions, then the LRS may
slope upwards. This could happen because some firms face a more favourable
environment than others. Perhaps their location confers some advantage
because they are closer to the market, or to some raw material. This would
then allow some firms to survive for longer if the market price falls. In this
case, as price falls, the least efficient firms would exit from the market until
the marginal firm just makes normal profits. Notice that this also suggests
that the most efficient firms in the market are able to make some supernormal
profits even in long-run equilibrium, and it is only the marginal firm that just
breaks even.
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QUANTITATIVE SKILLS 18.1
Points and areas on a diagram
Price, costs
SMC SATC
SAVC
A
E
I
L
O
B
C
F
J
G
D
H
K
M
N
P
Q
Output per period
▲ Figure 18.8 A firm operating under short-run perfect
competition
A first question is to consider at what price the firm
would just make ‘normal’ profits. This point would
be where the price (average revenue) is just equal to
average total costs, which would be at a price OA in
the figure.
Now consider the conditions under which a firm
would choose to exit the market. In the short run, if
the firm is getting a sufficiently high price to cover
its variable cost then it will stay in business, as it is
at least covering a part of its fixed costs. However,
if the price falls below average variable cost, this
no longer applies. So the firm would exit if the price
were to fall below OI (which is the minimum point of
the SAVC curve). In other words, when the price is
between OI and OE the firm makes a loss in the short
run but continues in the market.
Notice that as the price varies, the firm effectively
moves along its SMC curve, so we can interpret
the SMC curve (above OI) as showing the short-run
supply curve of the firm.
Notice also that if the price is above OA, the firm
makes supernormal profits.
EXERCISE 18.3
18
18 Different market structures: perfect competition and monopoly
Figure 18.8 shows the short-run cost curves for
a firm that is operating in a perfectly competitive
market. We can use a diagram like this to analyse
some key aspects of the firm’s situation. Think
carefully about what follows, and make sure you
understand the points and areas mentioned.
If the price were indeed at OA, then we could find
areas of the figure to represent fixed and variable
costs. With the price at OA the firm would produce
OQ output (where MC = MR), so, average variable
costs would be given by OE, and total variable costs
would be the area OEHQ. We can then infer that total
fixed costs are the area EADH.
Starting from a diagram like Figure 18.6, track the response of a perfectly
competitive market to a decrease in market demand for a good – in other words,
explain how the market adjusts to a leftward shift of the industry demand curve.
Efficiency under perfect competition
STUDY TIP
These diagrams can
be quite confusing until
you get used to them,
and you would be well
advised to practise
both interpreting and
drawing them, so you
can be confident in
using them when you
need to do so.
Having reviewed the characteristics of long-run equilibrium in a perfectly competitive
market, you may wonder what is so good about such a market in terms of productive
and allocative efficiency.
Productive efficiency
For an individual market, productive efficiency is reached when a firm operates at the
minimum point of its long-run average cost curve. Under perfect competition, this
is indeed a feature of the long-run equilibrium position. So, productive efficiency is
achieved in the long run – but not in the short run, when a firm is not necessarily
operating at minimum average cost.
Allocative efficiency
For an individual market, allocative efficiency is achieved when price is set equal to
marginal cost. In perfect competition, the process by which supernormal profits are
competed away through the entry of new firms into the market ensures that price
is equal to marginal cost when the market is in long-run equilibrium. So allocative
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LEARNING
LINK
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
18
The idea of allocative
efficiency was
introduced in Chapter
15, along with the
notion that it will be
achieved when price
is equal to marginal
cost.
efficiency is achieved. Indeed, price is equal to marginal cost even in the short run, so
allocative efficiency is a feature of perfect competition in both the short run and the
long run.
Evaluation of perfect competition
A criticism sometimes levelled at the model of perfect competition is that it is merely
a theoretical ideal, based on a sequence of assumptions that rarely holds in the real
world. Perhaps you have some sympathy with that view.
It could be argued that the model does hold for some agricultural markets. One study
in the USA estimated that the price elasticity of demand for an individual farmer
producing sweetcorn was –31,353, which is pretty close to being perfectly elastic.
However, to argue that the model is useless because it is unrealistic is to miss a very
important point. By allowing a glimpse of what the ideal market would look like, at least
in terms of resource allocation, the model provides a benchmark against which alternative
market structures can be compared. Furthermore, economic analysis can be used to
investigate the effects of relaxing the assumptions of the model, which can be another
valuable exercise. For example, it is possible to examine how the market is affected if firms
can differentiate their products, or if traders in the market are acting with incomplete
information. The impact of the internet on how markets work is also significant in this
respect, as information is becoming much more accessible than ever before.
So, although there may be relatively few markets that display all the characteristics of
perfect competition, that does not destroy the usefulness of the model in economic
theory. It will continue to be a reference point when examining alternative models of
market structure.
SUMMARY: THE MODEL OF PERFECT COMPETITION
» The model of perfect competition describes an
» The industry’s short-run supply curve is the
»
»
»
»
»
extreme form of market structure. It rests on a
sequence of assumptions.
Its key characteristics include the assumption that
no individual trader can influence the market price
of the good or service being traded, and that there
is freedom of entry and exit.
In such circumstances each firm faces a perfectly
elastic demand curve for its product, and can sell
as much as it likes at the going market price: it is a
price taker.
A profit-maximising firm chooses to produce the
level of output at which marginal revenue (MR)
equals marginal cost (MC).
The firm’s short-run marginal cost curve, above its
short-run average variable cost curve, represents
its short-run supply curve.
KEY TERM
monopoly: a form of
market structure in
which there is only
one seller of a good or
service
»
»
»
horizontal summation of the supply curves of all
firms in the market.
Firms may make supernormal profits in the short
run, but because there is freedom of entry these
profits will be competed away in the long run by
new firms joining the market.
The long-run industry supply curve is horizontal,
with price adjusting to the minimum level of the
typical firm’s long-run average cost curve.
Allocative efficiency is achieved under perfect
competition because price is equal to marginal
cost.
Under perfect competition in long-run equilibrium,
both productive efficiency and allocative efficiency
are achieved.
18.3 The model of monopoly
At the opposite end of the spectrum of market structures is monopoly, which strictly
speaking is a market with a single seller of a good. However, there is a bit more to it
than that, and economic analysis of monopoly rests on some important assumptions.
In the real world, the Competition and Markets Authority, the official body in the UK
with responsibility for monitoring monopoly markets, is empowered to investigate
mergers which could restrict competition. Similar bodies operate in other countries
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around the world: for example, the Competition Commission of Pakistan, the Federal
Trade Commission in the USA or the Malaysian Competition Commission. In a situation
where a single firm dominates a market, it may be able to act as if it were the only
firm – a dominant monopoly. Some discussion of the theory of how monopoly markets
operate is necessary in order to understand why such monitoring is required.
18
The assumptions of the model
Test yourself 18.8
What is the significance
of the assumption that
there are no substitutes
for the product of a
monopolist for the
market position of the
firm?
LEARNING
LINK
Chapter 19 will
explore how the
market would be
affected if there
were potential
substitutes for the
good produced by a
monopolist.
These assumptions all have their counterparts in the assumptions of perfect
competition, and this is why the model can be described as being at the opposite end
of the market structure spectrum.
If there is a single seller of a good, and if there are no substitutes for the good, the
monopoly firm is thereby insulated from competition. Furthermore, any barriers to
entry into the market will ensure that the firm can sustain its market position into the
future. The assumption that there are no potential substitutes for the good reinforces
the situation.
Barriers to entry
The existence of barriers to the entry of firms into a market is especially important
in a monopoly market because these barriers enable the firm to maintain its position.
Without barriers to entry, the market would soon cease to be a monopoly. Some key
factors that create barriers to entry are:
»
»
»
»
»
»
»
economies of scale
high fixed costs
cost advantages
government regulation
switching costs
strategic action
network effects
18 Different market structures: perfect competition and monopoly
The assumptions of the monopoly model are as follows:
1 The firm aims to maximise profits.
2 There is a single seller of a good.
3 There are no substitutes for the good, either actual or potential.
4 There are barriers to entry into the market.
Some of these barriers arise from government regulation (legal barriers). Others may
arise because of the set-up of the market or from cost considerations, and there
may also be physical barriers. It is important to note that some of these barriers are
natural, reflecting the nature of the product or the market conditions. However, there
may be situations in which the existing firm or firms take strategic action in order to
maintain their position in the market.
Economies of scale
Economies of scale can act as a barrier to the entry of new firms into an industry. If
a monopoly firm faces significant economies of scale – for example, if the minimum
efficient scale is close to the extent of market demand, then it will always be able to
produce at lower cost than any potential entrant, so this will make it difficult for new
firms to join the market.
High fixed costs
One situation in which a firm may face substantial economies of scale is where fixed
costs are high relative to marginal costs. For example, if a potential entrant knows
that it needs to invest heavily in set-up costs before being able to produce, this may
deter entry.
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There may be circumstances where the existing monopoly firm is able to consolidate
its position by taking strategic action to affect its fixed costs to deter entry from
new firms. For example, heavy investment in research and development can make it
difficult for potential entrants to become established in a market, because they need
to undertake high expenditure before being able to compete with the existing firm.
18
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
Cost advantages
A monopoly firm may hold some absolute cost advantage over potential entrants.
For example, the firm may have control over a key input needed for the production
process. This could be control over a raw material or a supply chain. Or it might be
that the firm has a locational advantage, being sited close to suppliers of a key
input – or, indeed, to the market for the good.
Government regulation
In some cases, a firm may have some form of legal protection against competition.
A common example of this is the patent system, whereby a firm may be protected
from competition for a period following the introduction of a new innovative product.
The aim of such government action is to encourage research and development and
innovation in product development.
Switching costs
In some cases, the barrier to entry may arise because a firm’s customers face high
costs in switching to a new substitute product. Such costs may occur because a
consumer has signed a contract for a fixed term, or simply because of brand loyalty.
A person who is familiar with using Microsoft products, for example, may be reluctant
to invest time in learning to use new systems and software.
LEARNING
LINK
Strategic action is
discussed in
Chapter 19.
Strategic action
An incumbent firm may undertake actions that create barriers to the entry of new
firms. This action could be in taking out patents that the firm does not intend to use,
thus preventing new firms from setting up in a market, or it might be that the firm
adopts a pricing policy that deters entry.
Network effects
Some goods or services have significant network effects. This is where people use
a product because they know that there are many others who also use it. Adobe
Acrobat’s .pdf format is so widely used that it would be difficult for a new firm to
come along with a different format for files.
How the monopoly model works
KEY TERM
price maker: a firm that
is able to choose the
selling price for its good
or service, as it faces
a downward-sloping
demand curve
The first point to note is that a monopoly firm faces the market demand curve
directly. Thus, unlike in perfect competition, the demand curve slopes downwards.
For the monopolist, the demand curve may be regarded as showing average revenue
(notice that for a firm charging the same price for all units sold, price is the same as
average revenue). Unlike a firm under perfect competition, therefore, the monopolist
has some influence over price, and can make decisions regarding price as well as
output. This is not to say that the monopolist has complete freedom to set the price,
as the firm is still constrained by market demand. However, the firm is a price maker
and can choose a location along the demand curve.
As with the firm under perfect competition, a monopolist aiming to maximise
profits will choose to produce at the level of output at which marginal revenue (MR)
equals marginal cost (MC). This is at Qm in Figure 18.9. Having selected output, the
monopolist will then set the price at the highest level at which all output will be
sold – in Figure 18.9 this is Pm.
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This choice allows the monopolist to make supernormal profits, which can be
identified as the shaded area in the figure. As before, this area is average revenue
minus average cost, which gives supernormal profit per unit, multiplied by the
quantity.
Price, costs
MC
AC
Pm
AR (= D)
MR
0
Qm
Output
▲ Figure 18.9 Profit maximisation and monopoly
It is important to notice that the monopolist cannot be guaranteed always to make
such substantial profits as are shown in Figure 18.9. The size of the profits depends
on the relative position of the market demand curve and the cost curves. If the cost
curves in the diagram were higher, the monopoly profits would be much smaller, as the
distance between average revenue and average costs would be less. It is even possible
that the cost curves will be so high as to force the firm to incur losses, in which case
it would be expected to shut down.
Test yourself 18.9
Will a profit-maximising
monopoly firm always
make supernormal
profits? Briefly explain
your answer.
18 Different market structures: perfect competition and monopoly
It is at this point that barriers to entry become important. Other firms may see that
the monopoly firm is making healthy supernormal profits, but the existence of barriers
to entry will prevent those profits from being competed away, as would happen in
a perfectly competitive market. With secure barriers to entry, the monopolist can
continue to make supernormal profits in the long run.
18
EXERCISE 18.4
Table 18.3 shows the demand situation faced by a
monopolist.
▼ Table 18.3 Demand situation for a monopolist
Demand
(000s per week)
Price
($)
0
80
1
70
2
60
3
50
4
40
5
30
6
20
7
10
a Calculate total revenue and marginal revenue for
each level of demand.
b Plot the demand curve (AR) and marginal revenue
on a graph.
c Plot total revenue on a separate graph.
d Identify the level of demand at which total
revenue is at a maximum.
e At what level of demand is marginal revenue
equal to zero?
f At what level of demand is the price elasticity of
demand unitary?
g If the monopolist maximises profits, will the
chosen level of output be higher or lower than the
revenue-maximising level?
h What does this imply for the price elasticity of
demand when the monopolist maximises profits?
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If a monopoly experiences (or can induce) an increase in the demand for its product,
it will benefit. In Figure 18.10, suppose that initially the monopoly faces the demand
curve D0. It maximises profits by setting MR = MC, producing Q0 output and charging
a price P0. If the demand curve shifts to the right, notice that the MR curve will also
shift, as this has a fixed relationship with the demand curve. After the increase in
demand, the monopoly chooses to produce Q1 output, where MR = MC, and now sets a
higher price at P1, making higher profits.
Price, costs
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
18
A monopoly and an increase in demand
MC
AC
P1
P0
MR0
Q0 Q1
MR1
D0
D1
Output
▲ Figure 18.10 A monopoly and an increase in demand
How do monopolies arise?
Monopolies may arise in a market for a number of reasons. In a few instances, a
monopoly is created by the authorities. For example, for 150 years the UK Post
Office held a licence giving it a monopoly on delivering letters. From the beginning
of 2006, the service was fully liberalised. The Post Office monopoly covered a wide
range of services, but its coverage was gradually eroded over the years, and it was
finally privatised in 2013. Nonetheless, it remains an example of one way in which a
monopoly can be created. Another example of a monopoly is Tenaga Nasional Berhad
in Malaysia, which holds a monopoly as an electric utility in Peninsular Malaysia.
▲ Tenaga Nasional Berhad, Malaysia
The patent system offers a rather different form of protection for a firm. The patent
system was designed to provide an incentive for firms to innovate through the
development of new techniques and products. By prohibiting other firms from copying
the product for a period of time, a firm is given a temporary monopoly.
There are markets in which firms have risen to become monopolies by their actions
in the market. Such a market structure is sometimes known as a competitive
monopoly. Firms may get into a monopoly position through effective marketing, or by
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establishing a new product as a widely accepted standard. For example, by the mid2010s, Google had come to control some 90% of the search engine market in Europe.
Monopolies may also be created through mergers and acquisitions, if one firm is able
to buy out its competitors or combine with them to exploit economies of scale.
18
A natural monopoly
natural monopoly: a
monopoly that arises
in an industry in
which there are such
substantial economies
of scale that only one
firm is viable
Figure 18.11 illustrates this point. The firm in this market enjoys economies of scale
right up to the limit of market demand. The largest firm operating in the market can
always produce at a lower cost than any potential entrant, so will always be able to price
such firms out of the market. Here the economies of scale act as an effective barrier
to the entry of new firms and the market is a natural monopoly. A profit-maximising
monopoly would set MR = MC, produce at quantity Qm and charge a price Pm.
Price, costs
KEY TERM
Pm
AR (= D)
18 Different market structures: perfect competition and monopoly
In some cases the technology of the industry may create a monopoly situation. In a
market characterised by substantial economies of scale, there may not be room for
more than one firm in the market. This could happen where there are substantial
fixed costs of production but low marginal costs. For example, in establishing an
underground railway in a city, a firm faces very high fixed costs in building the
network of track and stations and buying the rolling stock. However, once it is in
operation, the marginal cost of carrying an additional passenger is very low.
LAC
LMC
MR
0
Qm
Output
Test yourself 18.10
Explain why the rail
network (that is,
the track) might be
regarded as a natural
monopoly.
▲ Figure 18.11 A natural monopoly
Such a market poses particular problems regarding allocative efficiency. Notice in the
figure that marginal cost is below average cost over the entire range of output. If the
firm were to charge a price equal to marginal cost, it would inevitably make a loss, so
such a pricing rule would not be viable.
EXERCISE 18.5
A rail company is awarded a franchise to operate trains on a route joining two
neighbouring cities. Discuss the extent to which the company would be able to
operate as a profit-maximising monopoly.
Monopoly and efficiency
The characteristics of the monopoly market can be evaluated in relation to productive
and allocative efficiency (see Figure 18.9).
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Productive efficiency
A firm is said to be productively efficient if it produces at the minimum point of
long-run average cost. It is clear from the figure that this is extremely unlikely for a
monopoly. A monopoly firm will produce at the minimum point of long-run average
cost only if it so happens that the marginal revenue curve passes through this exact
point – and this would happen only by coincidence. More likely is that it will produce
in a position of excess capacity at an output below the minimum point of long-run
average cost. The intensity of competition in this market structure makes it unlikely
that firms will be able to operate with X-inefficiency.
Allocative efficiency
For an individual firm, allocative efficiency is achieved when price is set equal to
marginal cost. It is clear from Figure 18.9 that this will not be the case for a profitmaximising monopoly firm. The firm chooses output where MR equals MC; however,
given that MR is below AR (i.e. price), price will always be set above marginal cost.
Monopoly and perfect competition
How does monopoly compare with perfect competition in terms of efficiency? The
two models have different implications for resource allocation. By its behaviour, a
monopoly distorts resource allocation, and by comparing a monopoly market with a
perfectly competitive market, we can identify the extent of the distortion. To do this,
the situation can be simplified by setting aside the possibility of economies of scale.
This is perhaps an artificial assumption to make, but it could be relaxed.
Suppose that there is an industry with no economies of scale, which can be operated
either as a perfectly competitive market with many small firms, or as a monopoly firm
running a large number of small plants.
Figure 18.12 shows the market demand curve (D = AR) and the long-run supply curve
under perfect competition (LRS). If the market is operating under perfect competition,
the long-run equilibrium will produce a price of Ppc and the firms in the industry will
together supply Qpc output. Consumer surplus (the surplus that consumers gain from
consuming this product) is given by the area APpcE. This is a measure of the welfare
that society receives from consuming the good, as was explained in Chapter 4.
Price, costs
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
18
A
B
Pm
Ppc
The deadweight loss caused by monopoly
E
C
MR
0
LRS (= LMCm)
Qm
D = AR
Qpc
Output
▲ Figure 18.12 Comparing perfect competition and monopoly
Now suppose that the industry is taken over by a profit-maximising monopolist. The
firm can close down some of the plants to vary its output over the long run, and
the LRS can be regarded as the monopolist’s long-run marginal cost curve. As the
monopoly firm faces the market demand curve directly, it will also face the MR curve
shown, so will maximise profits at quantity Qm and charge a price Pm.
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Thus, the effect of this change in market structure is that the profit-maximising
monopolist produces less output than a perfectly competitive industry and charges a
higher price.
LEARNING
LINK
X-inefficiency is
explained in
Chapter 17.
This deadweight loss is a measure of the welfare loss imposed on society in a
monopoly situation. However, there are two key aspects of efficiency, as was shown
in Chapter 15. The loss in allocative efficiency shown in Figure 18.12 may be partly
offset by improved productive efficiency: for example, because a monopoly is able to
take advantage of economies of scale that would be sacrificed if it were to be split
into many small firms, none of which would be able to reach the minimum average
cost level of output.
It is also worth noting that when a monopoly faces no competition from other firms,
it is possible that it will become complacent, and allow some X-inefficiency to occur.
In other words, a monopolist may not always operate on its lowest average cost curve.
SUMMARY: THE MODEL OF MONOPOLY
» A monopoly market is one in which there is a
single seller of a good.
» The model of monopoly used in economic analysis
also assumes that there are no substitutes for the
goods or services produced by the monopolist, and
that there are barriers to the entry of new firms.
» The monopoly firm faces the market demand
curve, and is able to choose a point along that
demand curve in order to maximise profits.
» Such a firm may be able to make supernormal
profits, and sustain them in the long run because
of barriers to entry and the lack of substitutes.
» A monopoly may arise because of patent
protection or from the nature of economies of
scale in the industry (a ‘natural monopoly’).
» A profit-maximising monopolist does not achieve
allocative efficiency, and is unlikely to achieve
productive efficiency in the sense of producing at
the minimum point of the long-run average cost
curve.
» Comparing monopoly with perfect competition, a
monopoly will produce less output and charge a
higher price, thus imposing a deadweight loss on
society.
18 Different market structures: perfect competition and monopoly
It is also apparent that consumer surplus is now very different, as in the new situation
it is limited to the area APmB. Looking more carefully at Figure 18.12, you can see that
the loss of consumer surplus has occurred for two reasons. First, the monopoly firm is
now making profits shown by the blue shaded area PmBCPpc. This is a redistribution of
welfare from consumers to the firm, but as the monopolist is also a member of society,
this does not affect overall welfare. However, there is also a loss, which represents
a loss to society resulting from the monopolisation of the industry. This is measured
by the area of the red triangle BCE. This is known as the deadweight loss that society
incurs as a result of the restriction of competition. Notice that a small number of
firms in collusion with each other may have similar effects to a monopoly.
18
END OF CHAPTER QUESTIONS
Multiple choice
1 The marginal costs of a perfectly competitive firm and a monopolist both exceed
the respective firms’ average revenue. Both firms aim to maximise profits. What
should each of the firms do to maximise profits?
Perfectly competitive firm
Monopoly
A
Increase output
Increase output
B
Decrease output
Increase output
C
Increase output
Decrease output
D
Decrease output
Decrease output
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A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
18
2 Firms in perfect competition are often claimed to lead to a more efficient outcome,
lower prices and higher output than monopolies. On the other hand, arguments in
favour of monopolies suggest a single seller can yield more efficiency. What is a
necessary condition to ensure the monopolist would operate at a lower price and
higher output?
A Consumers must place more value per unit on the product sold by the
monopolist.
B The marginal cost curves of the perfectly competitive firm and the monopolist
must be different.
C The monopolist must be protected by sufficiently high barriers to entry.
D The perfectly competitive firm must operate at excess capacity.
Data response
1 Read the following extract and then answer the questions that follow.
Inefficiency in the Australian water market
In 2020, Australian Water was estimated to have an annual revenue of
AUS$22.71 billion.
Commercial water firms such as Australian Water occur in markets
characterised by extremely high set-up costs and extensive sunk costs. This
can often lead to a natural monopoly emerging because only one firm is viable.
This in turn can impact on the efficiency of the market.
In Australia the efficiency of the centralised water industry has been declining
rapidly. On a microeconomic level, the operating costs for water companies
in many parts of Australia have soared and the economic efficiency of water
supply has plunged by up to 2,300% while consumers appear to be paying for it
through higher prices.
a Define the terms ‘sunk cost’ and ‘fixed cost’ and explain with the use of
an example one fixed cost that Australian Water might incur that is not a
sunk cost.
b Other than sunk costs identify one barrier to entry in the extract and
explain the importance of barriers to entry for Australian Water in
maintaining long-run supernormal profit.
c i Explain what is meant by X-inefficiency and why Australian Water is
unlikely to achieve X-efficiency.
ii State the condition under which a firm will achieve allocative efficiency
and explain why Australian Water is unlikely to achieve allocative
efficiency.
d Discuss, with the aid of a diagram, whether a profit-maximising monopolist
such as Australian Water will always make supernormal profit.
Essay style
2 ‘The market structure of perfect competition will deliver both allocative and
productive efficiency in the long run.’ Analyse the validity of this statement
and assess the view that the model and its outcomes are meaningless
because it does not reflect reality.
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CASE STUDY
Of cabbages and rings
Edward de Vere owns a diamond mine – the only
such mine in the country. His company cuts the
stones and uses them to produce diamond rings.
In selling the rings, Edward takes into account the
strength of demand, choosing a price that will clear
the market. He finds that by restricting the number
of rings that he produces, he is able to charge a
higher price. By doing so he is able to increase the
Follow-up questions
a Which of the two producers appears to operate
under conditions of perfect competition, and
which is a monopoly?
b Explain your answer to part (a), referring to the
assumptions that underlie the two theories of
market structure.
c Under what conditions would Ted Greens decide
to give up growing cabbages?
d Can you think of steps that Ted Greens might take
in order to improve his profits on cabbages?
e Draw a diagram to explain how Edward de Vere
would react to an increase in the demand for
diamond rings.
f Suppose that a foreign firm starts to import
diamond rings into the country in competition
with Edward de Vere. How would you expect him
to react?
Go online at hoddereducation.com/cambridgeextras
for another case study for Chapter 18.
18
18 Different market structures: perfect competition and monopoly
Ted Greens has a farm on which he grows a variety
of crops, including cabbages that grow well on his
south field, which seems especially suited to the
crop. When Ted takes his cabbage crop to market,
hoping to make as much profit as possible, he finds
that the price he can charge for cabbages depends
on market conditions – after all, one cabbage is very
much like any other. He thus has to accept the price
that he can get, which is the same as that charged by
his many rival producers. If he tries to set a higher
price, he sells nothing as all traders in the market
have good awareness of market conditions. But as
he can sell as much as he likes at the going price,
there is no need to drop price below that prevailing
in the market. Price tends to fluctuate from one
harvest season to the next, and in some years when
cabbages are plentiful, Ted finds that he barely
covers his costs.
profits that he makes. As he controls the only source
of diamonds, Edward does not have to worry about
other producers entering the market, and there
are no substitutes for diamonds that people are
prepared to accept.
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A LEVEL PART 7 The price system and the microeconomy
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
19
Different market structures:
monopolistic competition and
oligopoly
What this chapter covers
★ the model of monopolistic competition
★ product differentiation
★ the importance of freedom of entry in
monopolistic competition
★ short- and long-run equilibrium under
monopolistic competition
★ efficiency in monopolistic competition
★ characteristics of oligopoly
★
★
★
★
★
★
★
★
non-price competition
game theory and the Prisoners’ Dilemma
a two-player pay-off matrix
contestable markets
efficiency in a contestable market
market concentration
calculating a concentration ratio
market dominance
The previous chapter introduced the models of perfect competition and monopoly,
and described them as being at the extreme ends of a spectrum of forms of market
structure. In between those two extremes are other forms of market structure,
which have some but not all of the characteristics of either perfect competition or
monopoly. It is in this sense that there is a spectrum of structures. Attention in
this chapter is focused on some of these intermediate forms of market structure,
including a discussion of the sorts of pricing strategy that firms may adopt, and
ways in which firms may try to prevent new firms from joining a market, in terms
of both pricing and non-price strategies. The theory of contestable markets is
outlined, and the chapter concludes by explaining how to measure concentration
in a market.
19.1 Monopolistic competition
KEY TERMS
monopolistic
competition: a market
that shares some
characteristics of
monopoly and some of
perfect competition
product differentiation:
a strategy adopted
by firms that marks
their product as being
different from their
competitors’
If you consider the characteristics of the markets that you frequent on a regular
basis, you will find that few of them display all of the characteristics associated
with perfect competition. However, there may be some that show a few of these
features. In particular, you will find some markets in which there appears to
be intense competition but in which the products for sale are not identical.
For example, think about restaurants. In many cities, you will find a wide
range of restaurants, cafés and coffee bars that compete with each other for
business, but do so by offering slightly different products: this is called product
differentiation.
The theory of monopolistic competition was devised by Edward Chamberlin, writing
in the USA in the 1930s, and his name is often attached to the model, although Joan
Robinson published her book on imperfect competition in the UK at the same time.
The motivation for the analysis was to explain how markets worked when they were
operating neither as monopolies nor under perfect competition.
The model describes a market in which there are many firms producing similar, but not
identical products: for example, package holidays, hairdressers and fast-food outlets.
In the case of fast-food outlets, the high streets of many cities are characterised by
large numbers of different types of takeaway – burgers, curries, noodles, fried chicken
and so on.
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Characteristics of monopolistic competition
The model of monopolistic competition shares some characteristics with perfect
competition and some with monopoly. Its features are:
»
»
»
»
»
a downward-sloping demand curve
product differentiation
no (or low) barriers to entry
many firms
no dominant firm
As with a monopoly, a firm in monopolistic competition has some control over price.
In other words, it can choose the price at which it sells, rather than having to accept
the market price as it would in perfect competition. A fall in price would increase
the quantity demanded, so the demand curve slopes downwards. In this respect it
resembles monopoly rather than perfect competition.
When a firm engages
in advertising
or product
development in
order to differentiate
its product, it is
known as non-price
competition. This is
also important in the
context of oligopoly,
and is discussed in
more detail later in
this chapter.
Test yourself 19.1
Why is product
differentiation
an important
characteristic of the
model of monopolistic
competition?
Product differentiation
Monopolistic competition differs from monopoly because the firm faces competition from
other firms. This means that the firm needs to find ways to distinguish itself from the
other firms. It does this by making its product slightly different. This allows the firms to
build up brand loyalty among their regular customers, which gives them some influence
over price. It is likely that firms will engage in advertising or in product design in order
to maintain such brand loyalty, and heavy advertising is a common characteristic of a
market operating under monopolistic competition. This strategy is known as product
differentiation. Notice that by spending on advertising or on improving product quality
and design, the firm is adding to its costs, so that the average cost curve will shift
upwards. However, competition between firms may discourage X-inefficiency.
Because other firms are producing similar goods, there are substitutes for each
firm’s product, which means that demand is relatively price elastic (although this
does not mean that it is never inelastic). However, it is certainly not perfectly price
elastic, as was the case with perfect competition. These features – that the product
is not homogeneous and demand is not perfectly price elastic – represent significant
differences from the model of perfect competition.
19 Different market structures: monopolistic competition and oligopoly
A downward-sloping demand curve
LEARNING
LINK
19
Freedom of entry
In the model, there are no (or low) barriers to entry into the market. Firms are able
to join the market if they observe that existing firms are making supernormal profits.
New entrants will be looking for some way to differentiate their product slightly from
the others – perhaps the next fast-food restaurant will be Nepalese or Peruvian.
This characteristic distinguishes the market from the monopoly model, as does the
existence of fairly close substitutes.
Many firms
STUDY TIP
One way of gauging
whether a firm or
some firms have
some dominance
in the market is to
look at whether it is
concentrated. This is
explained later in the
chapter.
A further assumption of the model is that there are many firms operating in the
market. For this reason, a price change by one of the firms will have negligible effects
on the demand for its rivals’ products.
This characteristic means that the market is also different from an oligopoly market,
where there are a few firms that interact strategically with each other.
STUDY TIP
Remember these characteristics, and why they are important in making the model of
monopolistic competition distinct from both perfect competition and monopoly.
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19
LEARNING
LINK
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
Oligopoly models are
discussed later in
this chapter.
No dominant firm
Although there are many firms in the market, no individual firm is dominant. If one
firm had significantly more power than others, so was able to dictate how the market
operated, perhaps by setting price, then the market would work differently.
Overview
Taking these characteristics together, it can be seen that a market of monopolistic
competition has some of the characteristics of perfect competition and some features
of monopoly; hence its name.
Short-run equilibrium in monopolistic competition
Price
Figure 19.1 represents short-run equilibrium under monopolistic competition. Ds is the
demand curve and MRs is the corresponding marginal revenue curve. AC and MC are the
average and marginal cost curves for a representative firm in the industry. If the firm is
aiming to maximise profits, it will choose the level of output such that MRs = MC. This
occurs at output qs, and the firm will then choose the price that clears the market at ps.
MC
AC
ps
MRs
0
Ds(= AR)
qs
Output
▲ Figure 19.1 Short-run equilibrium under monopolistic competition
This closely resembles the standard monopoly diagram that was introduced in Chapter 18. As
with monopoly, a firm under monopolistic competition faces a downward-sloping demand
curve, as already noted. The difference is that now it is assumed that there is some freedom
of entry into the market under monopolistic competition, so that Figure 19.1 represents
equilibrium only in the short run. This is because the firm shown in the figure is making
supernormal profits, shown by the shaded area (which is AR − AC multiplied by output).
Test yourself 19.2
If a firm operating
under monopolistic
competition is making
supernormal profits,
what would you expect
to happen to its demand
curve?
The importance of no (or low) barriers to entry
This is where the assumption of freedom of entry into (and exit from) the market
becomes important. In Figure 19.1 the supernormal profits being made by the
representative firm will attract new firms into the market. The new firms will produce
differentiated products, and this will affect the demand curve for the representative
firm’s product. In particular, the new firms will attract some customers away from this
firm, so that its demand curve will tend to shift to the left. Its shape may also change
as there are now more substitutes for the original product.
Long-run equilibrium in monopolistic competition
This process of entry of firms will continue as long as firms in the market continue
to make supernormal profits that attract new firms into the activity (or make losses,
causing some firms to leave). It may be accelerated if firms are persuaded to spend
money on advertising in an attempt to defend their market shares. The advertising
may help to keep the demand curve downward sloping, but it will also affect the
position of the average cost curve, by pushing up average cost at all levels of output.
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MC
AC
pl
MRl
0
Dl
ql
Output
▲ Figure 19.2 Long-run equilibrium under monopolistic competition
Efficiency under monopolistic competition
One way of evaluating the market outcome under this model is to examine the
consequences for productive and allocative efficiency. It is clear from Figure 19.2 that
neither of these conditions will be met. For productive efficiency to be achieved, the
firm would need to be operating at minimum average cost, but Figure 19.2 shows that
the firm will not be at this point. Allocative efficiency requires price to be set equal
to marginal cost, but a firm maximising profit under monopolistic competition will set
a price higher than this, as is also shown in Figure 19.2.
Evaluation of monopolistic competition
Test yourself 19.3
Why are firms
under monopolistic
competition more
keen to sell a higher
output than firms under
perfect competition?
LEARNING
LINK
X-inefficiency is
explained in
Chapter 17.
19
19 Different market structures: monopolistic competition and oligopoly
The conditions under
which a firm will
exit from a market
depend crucially on
whether the price
falls below the
shutdown price in
the short or long
run. The notion of the
shutdown price
is explained in
Chapter 17.
Figure 19.2 shows the final position for the market. The typical firm is now operating
in such a way that it maximises profits (by setting output such that MR = MC); at the
same time, the average cost curve (AC) at this level of output is at a tangent to the
demand curve. This means that AC = AR, and the firm is just making normal profit (i.e.
is just covering opportunity cost). There is thus no further incentive for more firms to
join the market. In Figure 19.2 this occurs when output is at ql and price is set at pl.
Price
LEARNING
LINK
If the typical firm in the market is not fully exploiting the possible economies of
scale that exist, it could be argued that product differentiation is a disadvantage that
damages society’s total welfare, in the sense that product differentiation allows firms
to keep their demand curves downward sloping. In other words, too many different
products are being produced. However, this argument could be countered by pointing
out that consumers may enjoy having more freedom of choice, which could be seen as an
advantage of this type of market structure. The very fact that they are prepared to pay a
premium price for their chosen brand indicates that they have some preference for it.
Another crucial difference between monopolistic competition and perfect competition
is that under monopolistic competition firms would like to sell more of their product
at the going price, whereas under perfect competition they can sell as much as they
like at the going price. This is because price under monopolistic competition is set
above marginal cost.
The use of advertising to attract more customers and to maintain consumer perception
of product differences may be considered a disadvantage of this market. It could
be argued that excessive use of advertising to maintain product differentiation is
wasteful, as it leads to higher average cost curves than needed. Given the higher
costs, firms may need to charge higher prices. On the other hand, the need to
compete in this way may result in less X-inefficiency than under a complacent
monopolist. In addition, it might be argued that with plenty of advertising, customers
are better informed about the products available.
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a Identify the profit-maximising level of output.
b At what price would the firm sell its product?
c What supernormal profits (if any) would be made
by the firm?
d Is this a short-run or a long-run equilibrium?
Explain your answer.
e Describe the subsequent adjustment that might
take place in the market (if any).
f At what level of output would productive
efficiency be achieved? (Assume that AC
represents long-run average cost for this part
of the question.)
Figure 19.3 shows a firm under monopolistic
competition.
Price
19
EXERCISE 19.1
MC
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
AC
B
A
C
F
J
E
H
G
K
M
L
Demand
MR
0
N
R
S
Output
▲ Figure 19.3 A firm under monopolistic competition
SUMMARY: MONOPOLISTIC COMPETITION
» The theory of monopolistic competition has its
»
»
»
»
origins in the 1930s, when economists such as
Edward Chamberlin and Joan Robinson were
writing about markets that did not conform to the
models of perfect competition and monopoly.
The model describes a market where there are
many firms producing similar, but not identical,
products.
By differentiating their product from those of other
firms, it is possible for firms to maintain some
influence over price.
To do this, firms engage in advertising to build
brand loyalty.
There are no barriers to entry into (or exit from)
the market, and concentration is low.
» Firms may be able to make supernormal profits in
»
»
»
»
the short run.
In response, new entrants join the market, shifting
the demand curves of existing firms and affecting
their shape.
The process continues until supernormal profits
have been competed away, and the typical firm has
its average cost curve at a tangent to its demand
curve.
Neither productive nor allocative efficiency is
achieved in long-run equilibrium.
Consumers may benefit from the increased range
of choice on offer in the market.
19.2 Oligopoly
KEY TERM
oligopoly: a market
with a few sellers, in
which each firm must
take account of the
behaviour and likely
behaviour of rival firms
in the industry
A number of markets seem to be dominated by relatively few firms – think of
commercial banking, cinemas or the newspaper industry. A market with just a few
sellers is known as an oligopoly market. An important characteristic of such markets
is that when making economic decisions each firm must take account of its rivals’
behaviour and reactions. The firms are therefore interdependent.
An important characteristic of oligopoly is that each firm has to act strategically, both
in reacting to rival firms’ decisions and in trying to anticipate their future actions and
reactions. This interdependence of firms is a strong influence on their behaviour in
the market, as we shall see.
Unlike monopolistic competition, an oligopoly market is likely to be protected by
barriers to entry, although the strength of those barriers may vary from industry to
industry.
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The key characteristics of an oligopoly are therefore:
» a few firms dominate the market
» there is strategic interdependence between the firms
» there are barriers to entry
19
There are many different ways in which a firm may take such strategic decisions, and
this means that there are many ways in which an oligopoly market can be modelled,
depending on how the firms behave in relation to each other. This chapter reviews just
a few examples.
KEY TERMS
non-price competition:
a strategy whereby
firms compete
by advertising to
encourage brand loyalty
or by quality or design,
rather than on price
game theory: a method
of modelling the
strategic interaction
of firms within an
oligopoly market
Prisoners’ Dilemma:
an example of game
theory with a range of
applications in oligopoly
theory
Test yourself 19.4
Give two examples of
ways in which firms
may indulge in nonprice competition.
LEARNING
LINK
One interesting
application of this
theory is in the
analysis of cartels
(a form of collusion
between firms):
this is explained in
Chapter 20.
Within an oligopoly market, firms may adopt rivalrous behaviour or they may choose
to cooperate with each other. The two attitudes have implications for how markets
operate. Cooperation will tend to take the market towards the monopoly end of the
spectrum, whereas non-cooperation will take it towards the competitive end. In either
scenario, it is likely that the market outcome will be somewhere between the two
extremes.
Non-price competition
One feature of oligopoly is that firms may engage in non-price competition. Nonprice competition is exactly what it says: firms do not use price to compete with
rival firms, but find other ways, such as product differentiation (as used by firms
in monopolistic competition). For example, they may use advertising to set their
own products out from the crowd, and encourage customers to be loyal to a brand.
Alternatively, they may compete on the quality or design of their goods or services.
Launching a loyalty card system can also encourage customers to stick with a
particular brand. The use of clever packaging, or the offering of discounts to return
customers, can also be effective.
Non-price competition may be favoured by firms in an oligopoly market, because there
are relatively few firms in the market, so the way in which products are differentiated
can be more targeted to counter the actions of rival firms. Furthermore, there may
be situations in oligopoly in which firms may be reluctant to compete on price, or to
become involved in a price war.
19 Different market structures: monopolistic competition and oligopoly
Oligopolies may come about for many reasons, but perhaps the most convincing
concerns economies of scale. An oligopoly is likely to develop in a market where there
are some economies of scale – economies that are not substantial enough to require a
natural monopoly, but which are large enough to make it difficult for too many firms
to operate at minimum efficient scale.
Game theory and the Prisoners’ Dilemma
An important development in the economic theory of the firm has been in the
application of game theory. This began as a branch of mathematics, but it became
apparent that it had wide applications in explaining the behaviour of firms in an
oligopoly.
Game theory itself has a long history, with some writers tracing it back to
correspondence between Pascal and Fermat in the mid-seventeenth century. Early
applications in economics were by Antoine Augustin Cournot in 1838, Francis
Edgeworth in 1881 and J. Bertrand in 1883, but the key publication was the book by
John von Neumann and Oskar Morgenstern, Theory of Games and Economic Behaviour, in
1944. Other famous names in game theory include John Nash (played by Russell Crowe
in the film A Beautiful Mind), John Harsanyi and Reinhard Selten, who shared the 1994
Nobel prize for their work in this area.
Almost certainly, the most famous game is the Prisoners’ Dilemma, introduced in a
lecture by Albert Tucker (who taught John Nash at Princeton) in 1950. This simple example
of game theory turns out to have a multitude of helpful applications in economics.
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Two prisoners, Al Fresco and Des Jardins, are being interrogated about a major crime,
and the police know that at least one of the prisoners is guilty. The two are kept
in separate cells and cannot communicate with each other. The police have enough
evidence to convict them of a minor offence, but not enough to convict them of the
major one.
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
19
Each prisoner is offered a deal. If he turns state’s evidence and provides evidence to
convict the other prisoner, he will get off – unless the other prisoner also confesses.
If both refuse to deal, they will just be charged with the minor offence. Table 19.1
summarises the sentences that each will receive in the various circumstances.
▼ Table 19.1 The prisoners’ dilemma: possible outcomes (years in jail)
Des
Confess
Al
Refuse
Confess
10
10
0
15
Refuse
15
0
5
5
QUANTITATIVE SKILLS 19.1
Reading and using a matrix of
numerical data
depends on what Des chooses to do. If Des also
confesses, then Al gets a sentence of 10 years, but if
Des refuses to deal, then Al gets away scot-free.
In each case, Al’s sentence (in years) is shown in red
and Des’s in blue. How do we read the matrix? Think
about this from Al’s perspective. If Al confesses, we
look at the red entries in the first row of the table.
This shows that the sentence that Al will receive
Suppose Al instead refuses to confess. We then read
across the second row, and see that Al gets a heavy
sentence if he refuses to confess but Des confesses
(i.e. testifies against Al), but if they both refuse to
confess they both get off relatively lightly.
If both Al and Des refuse to deal, they will be convicted of the minor offence, and
each will go down for 5 years. However, if Al confesses and Des refuses to deal, Al will
get off completely free, and Des will take the full rap of 15 years. If Des confesses and
Al refuses, the reverse happens. However, if both confess, they will each get 10 years.
KEY TERMS
dominant strategy: a
situation in game theory
where a player’s best
strategy is independent
of those chosen by
others
duopoly: a market with
two firms
Test yourself 19.5
Why does Des face a
dominant strategy to
confess?
Think about this situation from Al’s point of view, remembering that the prisoners
cannot communicate, so Al does not know what Des will choose to do and vice versa.
You can see from Table 19.1 that, whatever Des chooses to do, Al will be better off
confessing. John Nash referred to such a situation as a dominant strategy.
The dilemma is, of course, symmetric, so for Des too the dominant strategy is to
confess. The inevitable result is that, if both prisoners are selfish, they will both
confess – and both will then get 10 years in jail. If they had both refused to deal,
they would both have been better off; but this is too risky a strategy for either of
them to adopt. A refusal to deal might have led to 15 years in jail.
What has this to do with economics? Think about the market for DIY products. Suppose
there are two firms (Diamond Tools and Better Spades) operating in a duopoly market
(i.e. a market with only two firms). Each firm has a choice of producing ‘high’ output
or ‘low’ output. The profit made by one firm depends on two things: its own output
and the output of the other firm.
Table 19.2 shows the range of possible outcomes for a particular time period. Consider
Diamond Tools: if it chooses ‘low’ when Better Spades also chooses ‘low’, it will make
$2 million profit (and so will Better Spades); but if Diamond Tools chooses ‘low’ when
Better Spades chooses ‘high’, Diamond Tools will make zero profits and Better Spades
will make $3 million.
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▼ Table 19.2 Diamond Tools and Better Spades: possible outcomes (profits in $m)
19
Better Spades
High
Diamond
Tools
Low
High
1
1
3
0
Low
0
3
2
2
KEY TERM
Nash equilibrium: a
situation occurring
within a game when
each player’s chosen
strategy maximises
payoffs given the other
players’ choices, so
no other player has
an incentive to alter
behaviour
If Better Spades produces ‘low’, you will maximise profits by producing ‘high’, whereas
if Better Spades produces ‘high’, you will still maximise profits by producing high! So
Diamond Tools has a dominant strategy to produce high – it is the profit-maximising
action whatever Better Spades does, even though it means that joint profits will be lower.
Given that the table is symmetric, Better Spades faces the same decision process, and
also has a dominant strategy to choose high, so they always end up in the northwest
corner of the table, even though southeast would be better for each of them.
Furthermore, after they have made their choices and seen what the other has chosen,
each firm feels justified by its actions, and thinks that it took the right decision, given
the rival’s move. This is known as a Nash equilibrium, which has the characteristic that
neither firm needs to amend its behaviour in any future period. This model can be used
to investigate a wide range of decisions that firms need to take strategically.
EXERCISE 19.2
Suppose there are two cinemas in a market, X and
Y; you are taking decisions for firm X. You cannot
communicate with the other firm; both firms are
considering only the next period. Each firm is
choosing whether to set price ‘high’ or ‘low’. Your
expectation is that the payoffs (in terms of profits)
to the two firms are as shown in Table 19.3 (firm X in
red, firm Y in blue).
a If firm Y sets price high, what strategy maximises
profits for firm X?
b If firm Y sets price low, what strategy maximises
profits for firm X?
c So what strategy will firm X adopt?
d What is the market outcome?
LEARNING
LINK
In Chapter 18 it
was shown that a
monopoly firm would
impose a deadweight
loss on society by
restricting output and
raising price. Firms
that collude under
oligopoly can have a
similar impact.
▼ Table 19.3 Cinemas X and Y: possible outcomes
Firm Y chooses:
High price
Firm X
chooses: Low price
High price
Low price
10
10
1
15
15
1
4
4
19 Different market structures: monopolistic competition and oligopoly
The situation that maximises joint profits is for both firms to produce low; but
suppose you were taking decisions for Diamond Tools – what would you choose?
e What outcome would maximise the firms’ joint
profit?
f How might this outcome be achieved?
g Would the outcome be different if the game were
played over repeated periods?
Advantages and disadvantages of an oligopoly market
When evaluating an oligopoly market in terms of the possible advantages and
disadvantages, a key question is whether firms in the market collude with each
other, or whether they look for ways of competing with each other. The very fact that
legislation has been introduced to protect consumers from market abuse by cartels
and other forms of collusion between firms in an oligopoly market suggests that there
is a downside to a collusive oligopoly: at least potentially. This argument is based on
the way in which colluding firms may act to maximise their joint profits.
On the other hand, if firms in an oligopoly do compete intensively with each other,
then consumers may benefit from seeing the price being set at a competitive level.
They may also gain through having wider consumer choice. Notice that where firms in
an oligopoly are acting competitively, there may be little X-inefficiency present, but
where there is collusion, this may be different.
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A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
Figure 19.4 shows a market in which there are only
two firms operating.
a The two firms competing in the market produce
at constant marginal cost 0D, which means
that average cost is also constant and equal to
marginal cost. Competing intensively, the price is
driven down to a level at which no surplus above
marginal cost is made. Identify the price charged,
the quantity traded and consumer surplus.
b Suppose the two firms decide to collude to raise
price to a level 0B. Identify the quantity traded and
the consumer surplus.
c You should have found that consumer surplus is
much smaller in the second situation than in the
first. What has happened to the areas that were
formerly part of consumer surplus?
Price
19
EXERCISE 19.3
A
C
B
D
E
F
MC = AC
Demand
0
G
H
Output
▲
Figure 19.4 Anti-competitive behaviour
EXTENSION MATERIAL
Monopsony
The discussion of market structure so far has
focused on the number of sellers in a market, and
the interrelationships between them. However, it is
also important to consider the number of traders
who are potential buyers in a market. An extreme
situation would be where there is a single buyer of a
good or service. Such a market structure is known
as a monopsony.
A single buyer may be able to exert substantial
influence over the suppliers of the good when
drawing up contracts on the price and quality of
goods. Suppose that a firm is producing computer
chips in competition with other similar firms, but
enters into a contract to sell all of its output to a
particular computer manufacturer. This may have
advantages for the firm, which is assured of a secure
market for its output. However, in return for this it
may have to agree a competitive price and production
schedule with the buyer, which is effectively acting
as a monopsonist. The monopsonist gains by keeping
its costs down and by being assured of regular
supply of components. The consumer gains indirectly
because of the monopsonist’s low cost base.
Another example might occur in some labour markets.
There may be towns in which there is a single large
employer that employs a significant proportion of the
local labour force. Again, such an employer might be
seen to have market power within that local labour
market. This is discussed in Chapter 23.
EXERCISE 19.4
For each of the following markets, identify the model
that would most closely describe it (e.g. perfect
competition, monopoly, monopolistic competition or
oligopoly).
a A large number of firms selling branded varieties
of toothpaste
b A sole supplier of postal services
c A large number of farmers producing
cauliflowers, sold at a common price
d A situation in which a few large banks supply
most of the market for retail banking services
e A sole supplier of rail transport
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SUMMARY: OLIGOPOLY
» An oligopoly is a market with a few sellers, each
of which takes strategic decisions based on likely
rival actions and reactions.
» As there are many ways in which firms may
interact, there is no single way of modelling an
oligopoly market.
» Game theory (such as the Prisoners’ Dilemma) can
be used to analyse strategic interaction between
firms.
It has been argued that in some markets, in order to prevent the entry of new firms,
the existing firm would have to charge such a low price that it would be unable to
reap any supernormal profits at all.
hit-and-run entry:
where a firm enters a
market to take shortrun supernormal
profits, knowing it can
exit without incurring
costs
LEARNING
LINK
Sunk costs were
first defined in
Chapter 17, and now
become critical as an
essential ingredient
of contestability.
Test yourself 19.6
Why is the absence of
exit costs important
for a market to be
contestable?
A contestable market is one in which new firms:
»
»
»
»
»
face no barriers to entry or exit
incur no sunk costs in entering the market
have no competitive disadvantage compared with the incumbent firm or firms
have access to the same technology as the incumbent(s)
are able to enter and exit rapidly
Under these conditions, the incumbent firm cannot set a price that is higher than average
cost because, as soon as it does, it will open up the possibility of hit-and-run entry
by new firms, which can enter the market and compete away the supernormal profits.
Consider Figure 19.5, which shows a monopoly firm in a market. The argument is that, if
the monopolist charges the profit-maximising price at P1, then in a contestable market
the firm will be vulnerable to hit-and-run entry — a firm could come into the market,
take some of the supernormal profits, then exit again. The only way the monopolist
can avoid this happening is to set price equal to average cost (for example, at P2 in
Figure 19.5), so that there are no supernormal profits to act as an incentive for entry.
However, if the monopolist adopted this tactic, it would still be possible for new firms
to enter the market and make at least normal profit, given that by assumption there are
no barriers to entry and new firms face the same technology as the incumbent firm. Of
course, as soon as new firms enter the market, it ceases to be a monopoly.
The best chance a monopoly would have to prevent entry would be to make sure that
the long-run average cost curve is as low as possible (no X-inefficiency), and that it
does not set a price above the minimum point of the AC curve – for example, at P3 in
Figure 19.5. Even this may not deter firms from entering the market to make normal
profit, as there is unmet demand if the firm only sells Q3 of the good.
Price
contestable market:
a market in which the
existing firm makes
only normal profit, as
it cannot set a price
higher than average
cost without attracting
entry, owing to the
absence of barriers to
entry and sunk costs
This theory was developed by William Baumol and is known as the theory of
contestable markets. It was in recognition of this theory that the monopoly model in
Chapter 18 included the assumption that there must be no substitutes for the good,
either actual or potential.
19 Different market structures: monopolistic competition and oligopoly
19.3 Contestable markets
KEY TERMS
19
MC
P1
AC
P2
P3
MR
AR (= D)
Q1 Q3 Q2
Output
 Figure 19.5 Contestability
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On the face of it, the conditions for contestability sound pretty stringent. However,
suppose a firm has a monopoly on a domestic air route between two destinations. An
airline with surplus capacity (i.e. a spare aircraft sitting in a hangar) could enter this
route and exit again without incurring sunk costs in response to profits being made by
the incumbent firm. This is an example of how contestability may limit the ability of
the incumbent firm to use its market power.
19
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
Notice in this example that although the firm only makes normal profits when
setting price equal to average cost, neither productive nor allocative efficiency is
achieved. The firm does not produce at minimum average cost (needed for productive
efficiency), nor is price set at marginal cost (needed for allocative efficiency).
A moot point is whether the threat of entry will in fact persuade firms that they
cannot set a price above average cost. Perhaps the firms can risk making some profit
above normal profits and then respond to entry very aggressively if and when it
happens. After all, it is difficult to think of an example in which there are absolutely
no sunk costs. Almost any business is going to have to advertise in order to find
customers, and such advertising expenditure cannot be recovered.
The impact of the internet on contestability
The growth of the internet has had a significant impact on the contestability of
markets and hence on competitiveness. By making information more freely available,
the internet has given consumers improved knowledge of market conditions and
enabled them to make more informed choices. Furthermore, the growth of online sales
has made it much easier for new firms to enter markets.
One good example of this is the travel industry. In 2016 UK residents made more than
70 million trips abroad, so this is a significant sector. In the past, many overseas trips,
especially holidays, were arranged by the high street travel agents. Although there were
many retail outlets, the largest chains of travel agents were responsible for a significant
market share. The internet has revolutionised this sector, with online firms competing
effectively with the established firms, and individual consumers able to make their own
travel arrangements much more effectively. This is an example of where increased
contestability of a market has resulted in an increase in competitiveness.
EXERCISE 19.5
Discuss the extent to which the following markets
may be considered to be contestable – or to have
become more so in recent years.
a Opticians
b
c
d
e
Travel agents
Financial services
The postal service
Aircraft manufacture
SUMMARY: CONTESTABLE MARKETS
» In contestable markets, the incumbent firm or
firms may be able to make only normal profit.
» Contestability requires that there are no barriers
to entry or exit and no sunk costs – and that the
incumbent firm(s) have no cost advantage over hitand-run entrants.
19.4 Market concentration
As firms grow, markets may become more concentrated, especially if the growth takes
place through mergers and acquisitions. With fewer firms in a market, the market may
move closer to being an oligopoly, so an important question is whether such markets
behave more like a competitive market or more like a monopoly.
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It is helpful to have some way of gauging how close a particular market is to being a
monopoly. One way of doing this is to examine the degree of concentration in the market.
KEY TERM
n-firm concentration
ratio: a measure of the
market share of the
largest n firms in an
industry
Concentration is normally measured by reference to the concentration ratio, which
measures the market share of the largest firms in an industry. For example, the threefirm concentration ratio measures the market share of the largest three firms in the
market; the five-firm concentration ratio calculates the share of the top five firms,
and so on. Concentration can also be viewed in terms of employment, reflected in the
proportion of workers in any industry who are employed in the largest firms.
Calculating a concentration ratio
Consider the following example. Table 19.4 gives average circulation figures
for firms that publish national newspapers in the UK (with a circulation of more
than 100,000 per day). In the final column these are converted into market
shares. Where one firm produces more than one newspaper, their circulations
have been combined (e.g. News UK publishes both The Sun and The Times).
▼ Table 19.4 Concentration in the UK newspaper industry, January 2018
Firm
Newspapers
Average
circulation
Market
share (%)
dmg media
Daily Mail, Metro
2,818,514
34.6
News UK
The Sun, The Times
1,986,152
24.4
London Evening Standard
London Evening Standard
888,017
10.9
Northern & Shell
Daily Star, Daily Express
756,719
9.3
Trinity Mirror
Daily Mirror, Daily Record
717,279
8.8
Telegraph Group
Daily Telegraph
385,346
4.7
Johnston Press
I
257,223
3.2
Pearson
Financial Times
189,579
2.3
Guardian Media Group
The Guardian
Total
152,714
1.9
8,151,543
100.0
19 Different market structures: monopolistic competition and oligopoly
QUANTITATIVE SKILLS 19.2
19
Source: based on data from Audit Bureau of Circulations
The market shares are calculated by expressing the average circulation for a
firm as a percentage of the total. For example, the market share of the Financial
Times is 100 × 189,579/8,151,543 = 2.3%.
The three-firm concentration ratio is calculated as the sum of the market
shares of the biggest three firms: that is, 34.6 + 24.4 + 10.9 = 69.9%.
Test yourself 19.7
How would you
calculate the four-firm
concentration ratio for
an industry in terms of
sales?
Concentration ratios may be calculated on the basis of either shares in output or
shares in employment. In the above example, the calculation was on the basis of
output (daily circulation). The two measures may give different results because
the largest firms in an industry may be more capital-intensive in their production
methods, which means that their share of employment in an industry will be smaller
than their share of output. For the purposes of examining market structure, however,
it is more helpful to base the analysis of market share on output.
This might seem an intuitively simple measure, but it is too simple to enable an
evaluation of a market. For a start, it is important to define the market appropriately:
for instance, in the above example are the Financial Times and The Sun really part of
the same market? They cater for a very different readership.
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There may be other difficulties too. Table 19.5 gives some hypothetical market shares
for two markets. The 5-firm concentration ratio is calculated as the sum of the market
shares of the largest five firms. For markets A and B, the result is the same. In both
cases the market is perceived to be highly concentrated, at 75%. However, the nature
of likely interactions between the firms in these two markets is very different because
the large relative size of firm 1 in market A is likely to give it substantially more market
power than any of the largest five firms in market B. Nonetheless, the concentration
ratio is useful for giving a first impression of how the market is likely to function.
19
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
▼ Table 19.5 Market shares (% of output)
Largest firms in rank order
Market A
Market B
Firm 1
68
15
Firm 2
3
15
Firm 3
2
15
Firm 4
1
15
Firm 5
1
15
Scale and market concentration
Average cost
An important issue that arises as firms become larger concerns the number of firms
that a market can support. Suppose that economies of scale are available almost
to the limit of market demand, as in Figure 19.6. If more than one firm were to try
to supply this market, each producing at minimum average cost, there would be
substantial excess supply, and the situation would not be viable.
LAC
Demand
0
Qmes
Output
▲ Figure 19.6 How many firms can a market support?
LEARNING
LINK
The situation of a
natural monopoly was
explained in
Chapter 18.
Test yourself 19.8
Explain why competition
in a market is more
likely if the minimum
efficient scale is small
relative to market
demand.
In this situation, the largest firm in the market will come to dominate, as it will be able
to produce at lower average costs than any potential competitor. This will be reinforced if
there are significant learning-by-doing effects, which will further entrench the largest firm
as the market leader. Such a market is likely to become a natural monopoly.
Such substantial economies of scale are not available in all sectors. It will depend on the
nature of technology and all the other factors that can give rise to economies of scale. In
some activities there may be little scope at all for economies of scale. For example, there are
no great fixed costs in setting up a restaurant or a hairdressing salon – at least, compared
with those involved in setting up a steel plant or an underground railway. The level of output
at which minimum average cost is reached for such activities may thus be relatively small
compared with market demand, so there may be room for many firms in the market. This
helps to explain the proliferation of bars, takeaway restaurants and hairdressing salons.
There may also be an intermediate position, where the economies of scale are not
sufficient to bring about a monopoly situation, but only relatively few firms can
operate efficiently.
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How does this affect the way in which a market works? Is there any reason to believe
that a monopoly or oligopoly will work against society’s best interests? If market
share is concentrated among a small number of firms, does this inevitably mean that
consumers will suffer?
If there is an incentive for a single firm to act in this way, there is a similar incentive
for firms in an oligopoly to do the same, as they can increase their joint profits – with
the same effects on consumers. However, the oligopoly case is more complicated, as
there is always the possibility that individual firms will try to increase their own share
of the market at the expense of others in the oligopoly.
SUMMARY: MARKET CONCENTRATION
» It is important to be able to evaluate the degree of
» The size of the minimum efficient scale relative to
concentration in a market.
» While not a perfect measure, the concentration
ratio is one way of doing this, by calculating the
market share of the largest firms.
market demand influences the number of firms
that the market can support.
END OF CHAPTER QUESTIONS
Multiple choice
1 The following market structures are presented in ranked order:
i monopoly
ii oligopoly
iii monopolistic competition
iv perfect competition
19 Different market structures: monopolistic competition and oligopoly
The answer to these questions depends on the behaviour of firms within the market.
There may be an incentive for a monopoly firm to use its market power to increase
its profits. It can do this by restricting the amount of output that it releases on to
the market, and by raising the price to consumers. In Chapter 18 it was shown that a
monopoly has the incentive to act in this way, since by lowering output and raising
price it can increase its overall profits. From the consumer’s point of view, the result is
a loss of consumer surplus.
19
The market structures are ranked from (i) to (iv) in order of:
A increasing barriers to entry
B increasing contestability
C increasing product differentiation
D increasing abnormal profits
2 The table gives the 3-firm concentration ratio in four industries. Which industry is
most fragmented?
3-firm concentration ratio
A
68.7%
B
54.3%
C
45.2%
D
32.4%
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Data response
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
19
1 Read the following extract and then answer the questions that follow.
Markets and market concentration in Bangladesh and the UK
In Bangladesh, ‘kitchen markets’ are where most customers purchase their daily
vegetables. It is relatively easy to become a small-scale kitchen market vegetable
trader. These entrepreneurs know their market well and set their own prices to
gain the custom of well-informed buyers. Vendors sell similar but not identical
produce; this is because the quality varies between the many sellers spread
between the various kitchen markets in each city.
Mobile Financial Services (MFS), popularly known as ‘Mobile Banking Bangladesh’,
is a service provided by a bank allowing customers to conduct financial
transactions remotely. Table 19.6 shows this market to be highly concentrated.
▼ Table 19.6 Total market share of Bangladesh MFS providers
MFS provider
Market share (%)
BRAC
55.11
DBBL
38.26
FSIBL
0.60
OBL
0.65
Other
0.67
SEBL
0.52
TBL
3.16
UCB
1.03
The prices charged by the MFS providers in Bangladesh are remarkably similar. In
fact, there is no charge for opening a mobile account with any of the main providers,
which also offer the facility of paying cash in for free. Many of the providers are also
trying to attract new customers by being the first to link their mobile accounts to
other banking services such as paying utility bills and receiving salary payments.
The banking sector in the UK is also highly concentrated. In the past, the
European Commission (which upholds EU legislation) has fined eight UK banks
a total of €1.7 billion ($1.9 billion) for forming illegal cartels to fix interest
rates. The cartels operated in markets used to manage the risk of interest rate
movements. Two of the eight were excused their financial penalties for revealing
the cartels’ existence. The Commission said it was shocking that competing
banks had operated such collusion.
Sources: FinTech
a Explain, with reference to the extract, the view that the vegetable sellers in the
kitchen markets of Bangladesh are operating under conditions of monopolistic
competition.
b Discuss, with the use of a diagram, the conditions under which a profitmaximising vegetable seller in the kitchen markets of Bangladesh
might continue trading if they were making less than normal profit.
c Calculate the 3-firm concentration ratio in the MFS market in Bangladesh.
d Explain the importance of the non-price competition between firms
in the oligopolistic MFS market in Bangladesh.
e Suggest why the eight UK banks referred to in the extract may have
engaged in the collusive activity identified.
Essay style
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2 Discuss the likely impact on profits when new firms, attracted by
supernormal profits, enter a monopolistically competitive market.
17/02/21 5:50 PM
Competition in oligopolistic markets
19
v
x
w
y
MC = AC
z
D
MR
O
a
b
Quantity
▲ Figure 19.7 Maximising joint profits?
If the firms were producing different products (as is
usually the case) then the analysis would be more
complex, but again we could take the monopoly price
or prices to be the upper limit on possible choices.
An alternative option for each of our two firms would be
to set a price below the monopoly level. If one firm were
to choose the monopoly price and the other a lower
price, then the latter would gain a larger market share
and, provided the price was not too low, a larger profit.
But if both chose the low price, each would earn less
profit than if they had both chosen the monopoly price.
The situation facing the firms is illustrated in Table 19.7.
▼ Table 19.7 Profits of two firms
Firm B chooses:
▲ The oil industry is an example of an oligopoly
Modelling oligopoly
The defining characteristic of oligopoly is that the
actions of one firm have an appreciable effect on its
rival(s), and thus when modelling such a market it is
natural to begin by assuming that each firm recognises
this interdependence and takes it into account when
formulating its strategy. To keep things simple, let’s
suppose there are just two firms in the market and
each of them is thinking about what price to charge for
its product. Again, just for simplicity, we will focus on
two possibilities.
What is the highest price that they might
conceivably choose? To answer this, consider the
maximum aggregate profit that the two firms could
theoretically generate. Figure 19.7 depicts the two
firms as producing identical products with identical
horizontal marginal cost (average cost) curves.
The market demand curve is D, and MR shows the
(joint) marginal revenue accruing to the firms if they
set the same price. This is the same marginal revenue
curve that would have existed had the market been a
monopoly.
Firm A
High price
chooses: Low price
High price
Low price
2
2
0
3
3
0
1
1
19 Different market structures: monopolistic competition and oligopoly
An oligopolistic market is one in which firms engage
in strategic competition. Strategic competition exists
when the actions of one firm have an appreciable
effect on its rival or rivals. Common textbook
examples of oligopoly include the oil industry, motor
manufacturing, soft drinks and airlines operating
between particular city pairs. But oligopolists are
not necessarily large firms. Close to the university
campus in Southampton, in the UK, there is a road
containing several small restaurants and takeaways.
They are engaged in strategic competition locally
because if one firm were to change its prices, this
would have an appreciable effect on the sales and
thus profits of the others. So you can see that many
firms will find themselves competing in oligopolistic
markets and thus it is important that, as economists,
we try to understand how such markets operate.
Price
CASE STUDY
The two firms, A and B, must choose either a high
price or a low price and the decisions are assumed to
be made simultaneously, in the sense that each firm
makes its decision without knowledge of the other
firm’s choice. The figures represent the profits of the
two firms, with the red numbers denoting the profit of
firm A and the blue numbers the profit of firm B. Thus,
for example, if both opt for high (the monopoly price)
then each will earn a profit of 2 (half the monopoly
profit), but if, say, A chooses high and B chooses low,
A will make a profit of 0 and B will make 3.
Follow-up questions
a What is the maximum joint profit that the firms could
theoretically generate? Explain how this could be
achieved.
b What prices will the two firms choose?
c The passage describes the situation close to the
campus at the University of Southampton in the UK,
in which there are several restaurants operating in
close proximity. Discuss whether they would be able
to maximise their joint profits through collaboration.
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A LEVEL PART 7 The price system and the microeconomy
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
20
The growth and objectives of firms
What this chapter covers
★
★
★
★
★
★
★
★
★
the growth and survival of firms
organic growth of firms and diversification
mergers and takeovers
horizontal, vertical and backward integration
conglomerate mergers
cartels
the principal–agent problem
objectives of firms
behavioural theories and satisficing
★
★
★
★
★
★
★
★
revenue maximisation
sales volume maximisation
utility maximisation
first-, second- and third-degree price
discrimination
limit pricing
predatory pricing
price leadership
the kinked demand curve model
Firms range in size, from small local enterprises to giant global firms. Firms undergo
growth in different ways, through internal and external expansion. So far, we have
assumed that firms act rationally, and set out to maximise their profits. This is one
possible motivation for firms, and one that is readily analysed, but it is not the only
possible objective. This chapter explores profit maximisation as well as alternative
theories that have been put forward to explain how firms take decisions. In particular,
it begins to explore how firms take decisions about the level of output to produce and
the price at which it is to be sold.
20.1 The growth and survival of firms
A key decision that all firms face concerns the scale of their operations. This decision
turns partly on the nature of the market that they are serving, but it also depends on
the technology of the sector in which they operate and the structure of costs that
they face.
Some firms may need to grow in order to compete with other large-scale competitors
in global markets. There may be many reasons why firms wish to expand their
operations.
LEARNING
LINK
The way that costs
vary with the scale
of production is
important; Chapter
19 explains how the
minimum efficient
scale relative to
market demand
influences the size of
firms.
The nature of the activity being undertaken by the firm and its scale of operation
will help to determine its most efficient form of organisation. For firms to operate
successfully, they must minimise the transaction costs of undertaking business.
Some firms may not wish to grow into large organisations – nor may it be profitable
for them to do so.
A feature of the economic environment in recent years has been the increasing size of
firms. Some, such as Microsoft, Wal-Mart and Google, have become giants. Why is this
happening?
Of course, not all firms become giants, and many small firms operate profitably and
effectively. In part, this may reflect the nature of the markets in which small firms
thrive. The service sector in particular provides opportunities for small firms to
operate effectively, perhaps because of the absence of economies of scale, or because
there are niche products where small firms have a competitive advantage over larger
enterprises. After all, small firms may be more flexible and responsive to customer
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needs, and able to provide a high-quality personal service. Small firms tend to emerge
in times of high unemployment, when jobs are scarce and self-employment becomes an
attractive option for some individuals, as it can offer high job satisfaction.
20
There are drawbacks with being small as a firm. Obtaining finance for investment may
be more difficult, and a small firm may find it more difficult to survive when times are
hard. In some markets, competing with larger firms may pose problems.
Organic growth
Some firms grow simply by being successful. For example, a successful marketing
campaign may increase a firm’s market share, and provide it with a flow of profits that
can be reinvested to expand the firm even more. Some firms may choose to borrow in
order to finance their growth, perhaps by issuing shares (equity).
KEY TERM
organic growth: when
a firm grows internally
by reinvesting profits or
borrowing from banks
Such organic growth may encounter limits. A firm may find that its product market is
saturated, so that it can grow further only at the expense of other firms in the market.
If its competitors are able to maintain their own market shares, the firm may need to
diversify its production activities by finding new markets for its existing product, or
perhaps offering new products.
20 The growth and objectives of firms
Firms may wish to increase their size in order to gain market power within the industry
in which they are operating. A firm that can gain market share, and perhaps become
dominant in the market, may be able to exercise some control over the price of its
product, and thereby influence the market. However, firms may wish to grow for other
reasons, which will be explained later in the chapter.
There are many examples of growth through diversification. Tesco, a leading UK
supermarket, has launched itself into new markets by opening branches overseas,
and has also introduced a range of new products, including financial services, to its
existing customers. Microsoft has famously used this strategy, by selling first its
internet browser and later its media player as part of its Windows operating system,
in an attempt to persuade existing customers to buy its new products. This aggressive
approach attracted the attention of the regulatory authorities in the USA and Europe.
Test yourself 20.1
If a firm expands its
market share by using
funds from past profits,
is this classified as
‘organic growth’?
▲ Tesco supermarket in China
Test yourself 20.2
Explain what is meant
by ‘diversification’ in
this context.
Diversification may be a dangerous strategy: moving into a market in which the firm is
inexperienced and where existing rival firms already know the business may pose quite
a challenge. In such circumstances, much may depend on the quality of the
management team. However, diversification may reduce risk if the products do not
follow the same cycle of activity through time.
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Mergers and takeovers
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
20
Instead of growing organically – that is, based on the firm’s own resources – many
firms choose to grow by merging with, or taking over, other firms. The distinction
here is that a takeover (or acquisition) may be hostile, whereas a merger may be the
coming together of equals, with each firm committed to forming a single entity.
Growth in this way has a number of advantages: for example, it may overcome the
management problem and allow some rationalisation to take place. On the other hand,
firms tend to develop their own culture, or way of doing things, and some mergers
have failed because of an incompatibility of corporate cultures.
Horizontal mergers
LEARNING
LINK
Market concentration
is discussed in
Chapter 19.
KEY TERMS
horizontal merger: a
merger between two
firms at the same stage
of production in the
same industry
Mergers (or takeovers) can be of three different types. A horizontal merger is a
merger between firms operating in the same industry and at the same stage of the
production process: for example, the merger of two car assembly firms. The car
industry has been characterised by such mergers, including the takeover of Rover
by BMW and the merger of Daimler-Benz with Chrysler in the 1990s. The merger of
Hewlett-Packard with Compaq is another example of a horizontal merger. A more
recent example was the takeover of Instagram by Facebook in the early 2010s.
This sort of merger leads to horizontal integration, which can affect the degree
of market concentration because after the merger takes place there are fewer
independent firms operating in the market. This may increase the market power held
by the new firm.
Vertical mergers
horizontal integration:
the result of a
horizontal merger
A car assembly plant merging with a tyre producer, on the other hand, is an example
of a vertical merger. A real-life example of this was the merger in 2000 of AOL with
Time Warner.
vertical merger: a
merger between two
firms in the same
industry, but at different
stages of the production
process
Vertical mergers may be either upstream or downstream. If a car company merges with
a component supplier, that is known as backward integration, as it involves merging
with a firm that is involved in an earlier part of the production process. Forward
integration entails merging in the other direction, as for example if the car assembly
plant decided to merge with a large distributor.
backward integration:
a process under which
a firm merges with a
firm that is involved in
an earlier part of the
production chain
forward integration: a
process under which a
firm merges with a firm
that is involved in a later
part of the production
chain
conglomerate merger:
a merger between
two firms operating in
different markets
Test yourself 20.3
Give another example of
forward integration.
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Vertical integration may allow rationalisation of the process of production. Car producers
often work on a just-in-time basis, ordering components for the production line only as they
are required. This creates a potential vulnerability because if the supply of components fails
then production has to stop. If a firm’s component supplier is part of the firm rather than
an independent operator, this may improve the reliability of, and confidence in, the justin-time process, and in consequence may make life more difficult for rival firms. However,
vertical mergers have different implications for concentration and market power.
Conglomerate mergers
The third type of merger, conglomerate merger, involves the merging of two firms
that are operating in quite different markets or industries. For example, companies like
Unilever, Tata and Nestlé operate in a wide range of different markets, partly as a result
of takeovers. The UK supermarket Sainsbury’s acquired Argos in 2016, thus expanding its
non-food business. In 2018, Nestlé announced a global coffee alliance, whereby it would
pay Starbucks $7.1 billion to sell its coffee, thus extending its supply chain downwards.
One argument in favour of conglomerates is that they reduce the risks faced by firms. Many
markets follow fluctuations that are in line with the business cycle but are not always
fully synchronised. By operating in a number of markets that are on different cycles, the
firm can even out its activity overall. However, it is not necessarily an efficient way of
doing business, as the different activities undertaken may require different skills and
specialisms. In recent years, conglomerate mergers seem to have become less popular.
17/02/21 5:46 PM
Test yourself 20.4
Give another example of
a conglomerate firm.
Not all mergers turn out to be successful, and there may be circumstances in which
merged firms choose to ‘demerge’ and split. A common factor that can lead to this
happening is where firms from different countries merge, only to find that their
corporate cultures are incompatible. This can even happen with firms from the
same country, where management styles in the individual companies do not fit
well together. In other situations, it may be that synergies achieved between the
production activities of the firms are not as strong as expected. Demergers can turn
out to be costly and bitterly disputed.
Categorise each of the following as a horizontal,
vertical or conglomerate merger:
a the merger of a firm operating an instant coffee
factory with a coffee plantation
b the merger of a soft drinks manufacturer with a
bakery
c the merger of a soft drinks manufacturer with a
crisp manufacturer
STUDY TIP
d the merger of a soft drinks manufacturer with a
chain of fast-food outlets
e the merger of an internet service provider with a
film studio
f a merger between two firms producing tyres for
cars
Evaluation of mergers and takeovers
Make sure that you
are familiar with the
three types of merger
(horizontal, vertical
and conglomerate)
and be ready with
examples of each
to illustrate your
answers.
Mergers and takeovers seem at first glance to be an attractive option for a firm wishing
to expand. Organic growth may offer a more controlled environment for growth, as it
builds on the known existing strengths of the growing firm. However, it may be a slower
process, as the rate of growth may be constrained by the availability of finance, whereas
a merger offers an instant expansion of market share and of the expertise available
within the merged firm. It also seems to offer the potential for cost savings through
rationalisation of key functions within the internal organisation of a firm.
Test yourself 20.5
A vertical merger, whether forward or backward, offers greater control over the supply
chain. If the firm after the merger now has its own suppliers of components, or its
own distribution chain, it is clearly less subject to interruptions in supply, and has
more control over the margins at each stage of the production process.
Why is it an advantage
for a firm to have
greater control over
its supply chain after a
vertical merger?
20 The growth and objectives of firms
EXERCISE 20.1
20
In the case of a horizontal merger, the advantages may be seen as providing instant access
to increased economies of scale, and an increase in market share, perhaps leading to
increased market power. In practice, this may also be a disadvantage, because such gains in
market share may attract the attention of the regulator, as will be discussed in Chapter 21.
A conglomerate merger may also offer advantages because a diversified portfolio
of production activities may leave the firm less vulnerable to recession, if different
activities are affected to different degrees by fluctuations in the general level of
economic activity. There may also be possibilities for cost savings, if the merged firms
can find synergies in core business functions such as financial accounting or marketing.
It is thus likely to consolidate these functions, shedding staff and perhaps relocating
some functions. On the other hand, there may be managerial diseconomies if the
management team do not understand all aspects of the new diversified business.
SUMMARY: THE GROWTH AND SURVIVAL OF FIRMS
» Firms range, in the size and complexity of their
» If limited by the size of their markets, firms may
organisation, from sole proprietors to public
limited companies.
» Firms may undergo organic growth, building on
their own resources and past profits.
diversify into new markets or products.
» Firms may also undergo external growth through
horizontal, vertical or conglomerate mergers and
takeovers.
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20.2 Cartels
20
Look back at the prisoners’ dilemma game in Table 19.2 on page 283. It is clear that
the requirement that the firms are unable to communicate with each other is a serious
impediment from the firms’ point of view. If both firms could agree to produce ‘low’,
they would maximise their joint profits, but they will not risk this strategy if they
cannot communicate.
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
KEY TERM
cartel: an agreement
between firms on price
and output with the
intention of maximising
their joint profits
If they could join together in a cartel, the two firms could come to an agreement to
adopt the low–low strategy. However, if they were to agree to this, each firm would
have a strong incentive to cheat because, if each now knew that the other firm was
going to produce low, they would also know that they could produce high and
dominate the market – at least, given the payoffs in the table.
This is a common feature of cartels. Collusion can bring high joint profits, but there
is always the temptation for each of the member firms to cheat and try to sneak some
additional market share at the expense of the other firms in the cartel.
EXTENSION MATERIAL
The operation of a cartel
You can see how a cartel might operate in Figure 20.1, which shows the situation
facing a two-firm cartel (a duopoly). Panels (a) and (b) show the cost conditions
for each of the firms, and panel (c) shows the whole market.
(a) Firm 1
(b) Firm 2
£
MC1
£
(c) Cartel
MC2
£
MC
P*
SAC2
Dm
MR*
SAC1
MRm
Q2 Q2*
Q1
Output
(Q1 + Q2)
Output
Output
▲ Figure 20.1 Market allocation in a two-firm cartel
If the firms aim to maximise their joint profits, then they set MR = MC at the level
of the market (shown in panel (c)). This occurs at the joint level of output Q1 + Q2,
with the price set at P*. Notice that the joint marginal cost curve is the sum of
the two firms’ marginal cost curves.
The critical decision is how to divide the market up between the two firms. In
the figure, the two firms have different cost conditions, with firm 1 operating
at lower short-run average cost than firm 2. If the firms agree to set price at
P*, and each produces up to the point where marginal cost equals the level of
(market) marginal revenue at MR*, then the market should work well. Firm 1
produces Q1 and firm 2 produces Q2. Joint profits are maximised, and there is a
clear rule enabling the division of the market between the firms.
However, notice that firm 2 is very much the junior partner in this alliance, as it
gets a much smaller market share. The temptation to cheat is obvious. If firm 2
accepts price P*, it sees that its profits will be maximised at Q2*, so there is a
temptation to try to steal an extra bit of market share.
Of course, the temptation is also there for firm 1, but as soon as either one of
the firms begins to increase output, the market price will have to fall to maintain
equilibrium, and the cartel will be broken: the market will move away from the
joint profit-maximising position.
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Test yourself 20.6
Why should cartels be
illegal?
There is another downside to the formation of a cartel. In the vast majority of
countries around the world they are illegal. For example, in the UK the operation of
a cartel is illegal under the UK Competition Act, under which the Competition and
Markets Authority (CMA) is empowered to fine firms up to 10% of their turnover for
each year the cartel is found to have been in operation.
Some conditions may favour the formation of cartels – or at least, some form of
collusion between firms. The most important of these is the ability of each of the
firms involved to monitor the actions of the other firms, and so ensure that they are
keeping to the agreement.
Test yourself 20.7
What factors might
hinder collusion
between firms?
In this context, it helps if there are a relatively small number of firms; otherwise it
will be difficult to monitor the market. It also helps if they are producing similar
goods; otherwise one firm could try to steal an advantage by varying the quality of
the product. When the economy is booming it may be more difficult to monitor market
shares, because all firms are likely to be expanding. If firms have excess capacity, this
may increase the temptation to cheat by increasing output and stealing market share;
on the other hand, it also makes it possible for the other firms to retaliate quickly.
The degree of secrecy about market shares and market conditions is also important.
20 The growth and objectives of firms
This means that overt collusion is rare. The most famous example is not between
firms but between nations, in the form of the Organisation of Petroleum Exporting
Countries (OPEC), which over a long period of time has operated a cartel to control the
price of oil.
20
SUMMARY: CARTELS
» A cartel is an agreement between firms on price and output with the intention of maximising their joint
profits.
» Collusion between the firms can increase profits, but there is a tendency for individual firms to cheat on the
agreement.
» Cartels are illegal in most countries.
20.3 The principal–agent problem
KEY TERM
principal–agent
problem: a problem
arising from conflict
between the objectives
of the principals and
those of the agents who
take decisions on their
behalf
LEARNING
LINK
The various
objectives that firms
(or their managers)
pursue are discussed
later in this chapter.
One issue for many larger firms – especially public limited companies – is that the
owners may not be directly involved in running the business. This gives rise to the
principal–agent problem. In a public limited company, the shareholders delegate the
day-to-day decisions concerning the operation of the firm to managers who act on
their behalf. In this case the shareholders are the principals, and the managers are the
agents who run things for them. The degree of accountability of managers to the
owners may be weak when the shareholders are a disparate group of individuals.
If the agents are fully in sympathy with the objectives of the owners, there is no
problem and the managers will take exactly the decisions that the owners would like.
Problems arise when there is conflict between the aims of the owners and those of
the managers. Shareholders (the owners) are likely to want the firm to maximise its
profits, but the managers may have other motivations.
One simple explanation of why this problem arises is that the managers like a quiet
life, and therefore do not push to make as much profit as possible, but do just enough
to keep the shareholders off their backs.
LEARNING LINK
The situation where managers aim to produce satisfactory profits rather than
maximum profits is discussed later in the chapter.
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A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
20
Test yourself 20.8
Why might there be
conflict between a
firm’s owners and its
managers?
LEARNING
LINK
X-inefficiency is
explained in Chapter
17; asymmetric
information is
discussed in
Chapter 15.
Another possibility is that managers become negligent because they are not fully
accountable. One manifestation of this may be organisational slack: costs will not be
minimised, as the firm is not operating as efficiently as it could. In other words, there
could be some degree of X-inefficiency.
The principal–agent problem arises primarily because there is asymmetric information.
This arises because the agents have better information about the effects of their
decisions than the owners (the principals), who are not involved in the day-to-day
running of the business. In order to overcome this, the owners need to overcome the
information problem by improving their monitoring of the managers’ actions, or to
provide the managers with an incentive to take decisions that align with the owners’
objectives. For example, if bonuses related to profit are offered, the managers will be
more likely to try to maximise profits.
EXERCISE 20.2
The principal–agent distinction is applicable in many different contexts. In each
of the following cases, identify which is the principal and which is the agent.
a The owners of a firm and the managers hired to run it
b A department store and its employees
c A department store and its customers
d An electricity supplier and consumers of electricity
e A dentist and his or her patients
SUMMARY: THE PRINCIPAL–AGENT PROBLEM
» For many larger firms, where day-to-day control is delegated to managers, a
principal–agent problem may arise if there is conflict between the objectives of
owners (principals) and those of the managers (agents).
» Where this occurs, the managers may be able to pursue their own interests,
rather than those of the owners of the firm.
LEARNING
LINK
Profit maximisation
as a motivation for
firms is discussed in
Chapter 17.
20.4 Differing objectives and policies of firms
Most of the discussion so far has rested on the assumption that firms set out to
maximise profits. When we consider a relatively small, owner-managed firm, this may
be a reasonable assumption – but it is clear that many firms do not fall into this
category. Firms may not always appear to be only concerned with profit. There may be
explanations for this.
Survival
Not all firms have ambitions to grow into large (or even medium-sized) companies.
Indeed, where there are limited economies of scale, it may not be feasible to grow
significantly. A small family business may be content for the family to remain in
control of their enterprise rather than striving to maximise profits. It may be that
they aim to serve their local community, perhaps in a small village where there are
close personal links with customers.
Some firms may actually gain advantage from being small, having low overheads
and being flexible in the face of changing demand. Or there may be firms that are
reluctant to take on debt in order to expand.
Without ambition to grow, a firm may be content with survival rather than maximum
profits.
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Behavioural theories and profit satisficing
KEY TERMS
corporate social
responsibility (CSR):
actions that a firm takes
in order to demonstrate
its commitment to
behaving in the public
interest
Although firms may set out to take rational decisions, they may not have all the
relevant information about market conditions that is needed, or might not have the
capacity to analyse the information that they have. It might be that the information
is costly to acquire, or costly to analyse fully. In such a situation, firms do the best
they can to take good decisions, but without full information they may not achieve a
fully rational outcome.
Firms may wish to develop a favourable reputation by demonstrating a commitment
to acting in ways that benefit society at large, or that improve the welfare of their
employees and the community in which they are located. This notion of corporate
social responsibility (CSR) has become widespread, with firms devoting resources to
promoting community programmes of various kinds and encouraging their employees
to engage in volunteering activities.
EXERCISE 20.3
Google ‘corporate social responsibility’ with the
name of some large firms with which you are
20
20 The growth and objectives of firms
satisficing behaviour:
managers of firms aim
to produce satisfactory
results for the firm,
e.g. in terms of profits,
rather than trying to
maximise them
Businesses may not set out to maximise anything, either consciously because they
have other motivations, or as a result of the principal–agent issue. For example, it
might be that managers simply prefer a quiet life, and therefore do not push for the
absolute profit-maximising position, but do just enough to keep the shareholders off
their backs. Herbert Simon referred to this as satisficing behaviour, where managers
aim to produce satisfactory profits rather than maximum profits.
familiar, and check out the range of activities in
which firms engage under this banner.
Has this now become a prerequisite for firms’ survival? If it is perceived that failure to
engage with CSR has a major impact on firms’ sales, then it becomes crucial for a firm to
be able to demonstrate its commitment in order to compete with its rivals. Devoting
resources to CSR then becomes part of a firm’s strategy to safeguard its market position.
Test yourself 20.9
Explain what is
meant by ‘satisficing’
behaviour.
Test yourself 20.10
The industrial economist William Baumol argued that managers may set out with the
objective of maximising sales revenue. One reason is that in some firms managerial
salaries are related to sales revenue rather than profits. The effects of this can be seen in
Figure 20.2, which shows how total revenue (TR) varies as output increases. (The TR curve
always takes this shape when the firm faces a downward-sloping straight-line demand
curve.) You can see that total revenue is maximised at the peak of the TR curve (which is
also the point at which MR = 0), at qr. A revenue-maximising firm will produce more output
than a profit-maximising one, and will need to charge a lower price in order to sell the
extra output. This should be apparent from the fact that profits are maximised where
MR = MC, which must be at a positive level of MR – and thus to the left of qr in Figure 20.2.
Revenue, cost
Give an example of
an action taken by a
firm to demonstrate
a commitment to
behaving responsibly.
Revenue maximisation
TC
TR
q qr
Output
▲ Figure 20.2 Sales revenue maximisation
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Baumol pointed out that the shareholders might not be too pleased about this. The
way the firm behaves then depends on the degree of accountability that the agents
(managers) have to the principals (shareholders). For example, the shareholders may
have sufficient power over their agents to be able to insist on some minimum level of
profits. The result may then be a compromise solution.
20
In some cases, managers may focus more on the volume of sales than on the resulting
revenues. For example, a newspaper publisher may be more concerned about
circulation figures than revenue. This could lead to output being set even higher, as
shown in Figure 20.3. The firm would now push for higher sales up to the point where
it just breaks even at qs. This is the point at which total revenue only just covers total
cost. Remember that total cost includes normal profit – the opportunity cost of the
resources tied up in the firm. The firm would have to close down if it did not cover
this opportunity cost.
Revenue, cost
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
Sales volume maximisation
TC
STUDY TIP
Remember that the
‘break-even’ point is
where the firm makes
just normal profits,
which is where AC = AR
(i.e. where TC = TR).
Test yourself 20.11
What is the difference
between sales volume
and sales revenue?
TR
q qr qs
Output
▲ Figure 20.3 Sales volume maximisation
Again, the extent to which the managers will be able to pursue this objective without
endangering their positions with the shareholders depends on how accountable the
managers are to the shareholders. Remember that the managers are likely to have
much better information about the market conditions and the internal functioning of
the firm than the shareholders, who view the firm only remotely. This may be to the
managers’ advantage.
Utility maximisation
Oliver Williamson argued that managers would set out to maximise their utility. Just
as consumers gain satisfaction from consuming goods, it is argued that managers
gain satisfaction in various ways. For example, they may enjoy the status of having
a large team of people working for them, or they may like to have discretion over
the way in which profits made by the firm are used, perhaps allowing them to have
a large and well-appointed office or a prestigious company car. Again, such activity
would take the firm away from its profit-maximising position, and may result in
X-inefficiency.
Long-run profit maximisation
Firms may be prepared to take a long-term view of their situation. There may be
times when the decision to maximise profits in the short run may damage their
long-run prospects. For example, firms may undertake costly investment now in
order to reap higher profits in the long term. Or firms may delay adjusting price
to an increase in costs so that they maintain customer loyalty. In other words,
short-run profit maximisation may not always be in the best long-run interests of
the firm.
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20.5 Price discrimination
A profit-maximising monopoly firm will set a price that is above marginal cost,
producing a level of output that is below the level required for allocative efficiency.
However, there is a special case in which a monopolist could produce the level of
output that is allocatively efficient.
$
A
Pm
LMC = AC
B
P*
Demand
MR
0
Qm
Q*
20 The growth and objectives of firms
Consider Figure 20.4. Suppose this market is operated by a monopolist that faces the
constant marginal cost curve LMC. (This is to simplify the analysis.) In Chapter 18,
we saw that under perfect competition the market outcome would be a price P* and
quantity Q*. What would induce the monopolist to produce at Q*?
20
Output
▲ Figure 20.4 First-degree price discrimination
STUDY TIP
There may be
circumstances in
which different firms
charge different prices
to their customers
for products that
may seem identical
or similar. This is not
price discrimination.
The difference here
is that a single firm is
able to charge different
prices to individual
customers. This is
price discrimination.
One of the assumptions made throughout the analysis so far is that all consumers
in a market get to pay the same price for the product. This leads to the notion of
consumer surplus, which was introduced in Chapter 4. In Figure 20.4, if the market
were operating under perfect competition and all consumers were paying the same
price, consumer surplus would be given by the area AP*B. If the market were operated
by a monopolist, also charging the same price to all buyers, then profits would be
maximised where MC = MR: that is, at quantity Qm and price Pm.
But suppose this assumption is now relaxed; suppose that the monopolist is able to
charge a different price to each individual consumer. The monopolist is then able to
charge each consumer a price that is equal to his or her willingness to pay for the
good. In other words, the demand curve effectively becomes the marginal revenue
curve, as it represents the amount that the monopolist will receive for each unit of the
good. It will then maximise profits at point B in Figure 20.4, where MR (i.e. AR) is
equal to LMC. The difference between this situation and that under perfect
competition is that the area AP*B is no longer consumer surplus, but producer surplus:
that is, the monopolist’s profits. The monopolist has hijacked the whole of the original
consumer surplus as its profits.
First-degree price discrimination
KEY TERM
first-degree price
discrimination:
situation arising in
a market whereby a
monopoly firm is able to
charge each consumer
a different price
From society’s point of view, total welfare is the same as it is under perfect
competition (but more than under monopoly without discrimination). However, now
there has been a redistribution, from consumers to the monopoly – and presumably to
the shareholders of the firm. This situation is known as perfect price discrimination or
first-degree price discrimination.
First-degree price discrimination is fairly rare in the real world, although it might
be said to exist in the world of art or fashion, where customers may commission
a painting, sculpture or item of designer jewellery and the price is a matter of
negotiation between the buyer and supplier.
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A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
20
Second-degree price discrimination
KEY TERMS
second-degree price
discrimination: situation
in which a firm is able
to charge consumers a
different price for the
same product, according
to the quantity that they
purchase
Another way in which firms can engage in price discrimination is by giving consumers
some choice in their buying pattern. For example, supermarkets may offer shoppers a
choice between buying a single unit of a good at one price, or buying two units at a
lower average price (a ‘2 for $x’ type of offer). In this situation, consumers are charged
a different unit price for a product depending on the quantity that they purchase. This
is known as second-degree price discrimination.
third-degree price
discrimination:
situation in which a firm
is able to charge groups
of consumers a different
price for the same
product
arbitrage: a process
by which prices in
two market segments
will be equalised by a
process of purchase
and resale by market
participants
▲ Shoppers may be charged a unit price dependent on how much they buy
Third-degree price discrimination
In some circumstances, firms are able to charge a different price to different groups
of consumers. This is known as third-degree price discrimination. For example,
students or older people may get discounted bus fares, the young and/or old may
get cheaper access to sporting events or theatres, etc. In these instances, individual
consumers are paying different prices for what is in fact the same product.
Conditions for price discrimination
There are three conditions under which a firm may be able to price discriminate:
» The firm must have market power.
» The firm must have information about consumers and their willingness to pay – and
there must be identifiable differences between consumers (or groups of consumers).
» The consumers must have limited ability to resell the product.
Market power
Clearly, price discrimination is not possible in a perfectly competitive market,
where no seller has the power to charge other than the going market price. So price
discrimination can take place only where firms have some ability to vary the price.
Information about different groups of consumers
From the firm’s point of view, it needs to be able to identify different groups of
consumers with different willingness to pay. What makes price discrimination
profitable for firms is that different consumers display different sensitivities to price:
that is, they have different price elasticities of demand.
Test yourself 20.12
Why would a firm not
be able to use price
discrimination if
consumers could resell
the product?
Ability to resell
If consumers could resell the product easily, then price discrimination would not
be possible, as consumers would engage in arbitrage. In other words, the group of
consumers who qualified for the low price could buy up the product and then turn a
profit by reselling to consumers in the other segment(s) of the market. This would
mean that the firm would no longer be able to sell at the high price, and would no
longer try to discriminate in pricing.
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Consequences of price discrimination
In the case of student discounts and concessions, the firm can identify particular
groups of consumers; and such ‘products’ as bus journeys and dental treatment cannot
be resold. But why should a firm undertake this practice?
20
The simple answer is that, by undertaking price discrimination, the firm is able to
increase its profits by switching sales from a market with relatively low marginal
revenue to a market where it is higher.
(a) Market A
£
(b) Market B
(c) Combined market
£
A
£
MC
PA
P*
PB
MRB
MR*
P*
Total
demand
MR
ARB
MRA
MRA
MRB
ARA
qA qA*
qB* qB
Output
20 The growth and objectives of firms
This is shown in Figure 20.5, which separates two distinct groups of consumers
with differing demand curves. Thus, panel (a) shows market A and panel (b) shows
market B, with the combined demand curve being shown in panel (c), which also shows
the firm’s marginal cost curve.
Q*
Output
Output
▲ Figure 20.5 A price-discriminating monopolist
STUDY TIP
Be ready with the three
conditions that are
necessary if a firm is
to be able to use price
discrimination:
» The firm must have
some market power.
» The firm must be
able to identify
different consumers
(or groups of
consumers) and
differences in
their elasticities of
demand.
» There must be
limited ability for
consumers to
resell the product.
Test yourself 20.13
What incentive would
a firm have to practise
price discrimination?
If a firm has to charge the same price to all consumers, it sets marginal revenue in the
combined market equal to marginal cost, and produces Q* output, to be sold at a price
of P*. This maximises profits when all consumers pay the same price. The firm sells qA*
in market A, and qB* in market B.
However, if you look at panels (a) and (b), you will see that marginal revenue in
market A is much lower (at MRA) than that in market B (at MRB). It is this difference in
marginal revenue that opens up a profit-increasing opportunity for the firm. By taking
sales away from market A and selling more in market B, the firm gains more extra
revenue in B than it loses in A. This increases its profit. The optimal position for the
firm is where marginal revenue is equalised in the two markets. In Figure 20.5 the firm
sells qA in market A at the higher price of PA. In market B sales increase to qB with
price falling to PB. Notice that in both situations the amounts sold in the two submarkets sum to Q*.
The consumers in market B seem to do quite well by this practice, as they can
now consume more of the good. Indeed, it is possible that with no discrimination
the price would be so high that they would not be able to consume the good
at all.
In 2016, the UK’s Competition and Market Authority reported on an investigation of
the UK energy market. One of its findings was that there was wide variation in the
prices paid by domestic customers for energy, although electricity and gas are
homogeneous products. Potentially, most customers could have made savings by
switching suppliers, tariffs or payment methods. Indeed, average potential gains
from switching were equivalent to more than 20% of customers’ bills. A number of
remedies were recommended to address this situation.
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In which of the following products might price
discrimination be possible? Explain your answers.
a Hairdressing
b Peak and off-peak rail travel
c
d
e
f
Apples
Air tickets
Newspapers
Plastic surgery
SUMMARY: PRICE DISCRIMINATION
» In some markets a monopolist may be able to
» Under first-degree price discrimination, the firm is
engage in price discrimination by selling its
product at different prices to different consumers
or groups of consumers.
» This enables the firm to increase its profits by
absorbing some or all of the consumer surplus.
able to charge a different price to each customer
and absorb all of the consumer surplus.
» The firm can practise price discrimination only
where it has market power, where consumers
have differing elasticities of demand for the
product, and where consumers have limited ability
to resell the product.
20.6 Other pricing policies
There are other pricing policies that a firm may adopt in markets where it has some
influence over price, as in oligopoly or monopoly. Some of these are designed to help
a firm to maintain its market position by making it more difficult for other firms to
enter the market.
Limit pricing
KEY TERM
limit price: the highest
price that an existing
firm can set without
enabling new firms to
enter the market and
make a profit
One such strategy is limit pricing. This assumes that the incumbent firm has some
sort of cost advantage over potential entrants – for example, economies of scale.
Figure 20.6 shows a firm facing a downward-sloping demand curve, and thus having
some influence over the price of its product. If the firm is maximising profits, it is
setting output at Q0 and price at P0. As average revenue is comfortably above average
cost at this price, the firm is making healthy supernormal profits.
Price
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
20
EXERCISE 20.4
MC
AC
P0
P2
MR
Q1
AR (= D)
Q0 Q0 + Q1
Output
▲ Figure 20.6 Limit pricing
Suppose that the natural barriers to entry in this industry are weak. The supernormal
profits will be attractive to potential entrants. Given the cost conditions, the
incumbent firm is enjoying the benefit of economies of scale, although producing
below the minimum efficient scale.
If a new firm joins the market, producing on a relatively small scale, say at Q1, the
impact on the market can be analysed as follows. The immediate effect is on price,
as now the amount Q0 + Q1 is being produced, pushing price down to P2. The new firm
(producing Q1) is just covering average cost, so is making normal profits and feeling
justified in having joined the market. The original firm is still making supernormal
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profits, but at a lower level than before. The entry of the new firm has competed away
part of the original firm’s supernormal profits.
Test yourself 20.14
Explain why setting a
price equal to average
cost could be a rational
strategy.
So, by setting a price below the profit-maximising level, the original firm is able to
maintain its market position in the longer run. This could be a reason for avoiding
making too high a level of supernormal profits in the short run, in order to make
profits in the longer term.
Notice that such a strategy need not be carried out by a monopolist, but could also
occur in an oligopoly, where existing firms may jointly seek to protect their market
against potential entry.
Predatory pricing
KEY TERM
predatory pricing:
an anti-competitive
strategy in which a
firm sets price below
average variable cost
in an attempt to force
a rival or rivals out of
the market and achieve
market dominance
STUDY TIP
Be careful to distinguish
between limit pricing
and predatory pricing.
Limit pricing is used
as a barrier to entry,
making it more difficult
for a new firm to join
an industry. However,
the limit price is set
at a level that still
allows the incumbent
firm(s) to make profits.
Predatory pricing is
a more aggressive
strategy by which a
firm is prepared to
set price below SAVC,
taking losses as a
result. The hope is to
force competitors out
of business, leaving the
predatory firm with a
dominant position in the
market.
There is an aggressive strategy that has sometimes been used by firms wishing to
deter entry into their market, known as predatory pricing. This is illegal in many
countries, including the UK and USA. It should be noted that, in order to declare an
action illegal, it is necessary to define that action very carefully – otherwise it will
not be possible to prove the case in the courts. In the case of predatory pricing, the
legal definition is based on economic analysis.
20
20 The growth and objectives of firms
One way in which the firm could have guarded against entry is by charging a lower price
than P0 to begin with. For example, if it had set output at Q0 + Q1 and price at P2, then a
new entrant joining the market would have pushed the price down to a level below P2, and
without the benefit of economies of scale would have made losses and exited the market.
In any case, if the existing firm has been in the market for some time, it will have gone
through a process of learning by doing, and therefore will have a lower average cost curve
than the potential entrant. This makes it more likely that limit pricing can be used.
Remember that if a firm fails to cover average variable costs, its strategy should be to
close down immediately, as it would be better off doing so. The courts have backed this
theory, and state that a pricing strategy should be interpreted as being predatory if the
price is set below average variable costs, as the only motive for remaining in business
while making such losses must be to drive competitors out of business and achieve
market dominance. This is known as the Areeda–Turner principle (after the case in which
it was first argued in the USA).
On the face of it, consumers have much to gain from such strategies through the
resulting lower prices. However, a predator that is successful in driving out the
opposition is likely to recoup its losses by putting prices back up to profit-maximising
levels thereafter, so the benefit to consumers is short lived.
In some cases, the very threat of predatory pricing may be sufficient to deter entry
by new firms, if the threat is a credible one. In other words, the existing firms need
to convince potential entrants that they, the existing firms, will find it in their best
interests to fight a price war, otherwise the entrants will not believe the threat. The
existing firms could do this by making it known that they have surplus capacity, so that
they would be able to increase output very quickly in order to drive down the price.
Whether entry will be deterred by such means may depend in part on the
characteristics of the potential entrant. After all, a new firm may reckon that if
the existing firm finds it worth sacrificing profits in the short run, the rewards of
dominating the market must be worth fighting for. It may therefore decide to sacrifice
short-term profit in order to enter the market – especially if it is diversifying from
other markets and has resources at its disposal. The winner will then be the firm that
can last the longest; but, clearly, this is potentially very damaging for all concerned.
EXERCISE 20.5
Discuss the extent to which consumers benefit from a price war.
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KEY TERM
A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
price leadership: a
form of tacit collusion
that allows firms in a
market to synchronise
their prices without
formally communicating
STUDY TIP
Notice the importance
of firms’ perceptions
in this analysis. Firms
take decisions based
on their perceptions
of their own position
in the market, and on
their expectations of
how rival firms will
react. This is a key
feature of oligopoly
markets – and of
economists’ models
that attempt to explain
firms’ behaviour.
LEARNING
LINK
The relationship
between a firm’s
revenues and the
price elasticity of
demand was first
explained in Chapter
3: see especially
Table 3.1 on page 44.
Firms in an oligopoly face the dilemma that although they could benefit from collusion
with other firms in the market, forming a cartel is illegal. One way in which tacit
collusion may happen is through some form of price leadership. If one firm is a dominant
producer in a market, then it may take the lead in setting the price, with the other firms
following its example. It has been suggested that the OPEC cartel operated according to
this model in some periods, with Saudi Arabia acting as the dominant country.
An alternative is barometric price leadership, in which one firm tries out a price increase
and then waits to see whether other firms follow. If they do, a new higher price has
been reached without the need for overt discussions between the firms. On the other
hand, if the other firms do not feel the time is right for the change, they will keep
their prices steady and the first firm will drop back into line or else lose market share.
The initiating firm need not be the same one in each round. It has been argued that
the domestic air travel market in the USA has operated in this way on some internal
routes. The practice is facilitated by the ease with which prices can be checked via
computerised ticketing systems, so that each firm knows what the other firms are doing.
The frequency of anti-cartel cases brought by regulators in recent years suggests that
firms continue to be tempted by the gains from collusion. The operation of a cartel is
now a criminal act in the UK, as it has been in the USA for some time.
The kinked demand curve model
One model of oligopoly revolves around how a firm perceives its demand curve. This is
called the kinked demand curve model, and was developed by Paul Sweezy in the USA
in the 1930s.
In this model, a firm’s pricing policy is influenced by its perceptions of how rival firms
will react to a change in price, given the relationship between a firm’s revenues and
its price elasticity of demand. The model relates to an oligopoly in which firms try to
anticipate the reactions of rivals to their actions. One problem that arises is that a
firm cannot readily observe its demand curve with any degree of certainty, so it must
form expectations about how consumers will react to a price change.
Figure 20.7 shows how this works. Suppose the price is currently set at P*; the firm is
selling Q* and is trying to decide whether to alter the price. The problem is that there
is only one point on the demand curve that can be observed: that is, when the price
is P*, the firm sells Q*.
Price
20
Price leadership
Dcop
MC1
P*
AC1
A
Dig
AC*
Supernormal
profits
B
0
dd
MR
Q*
Quantity
 Figure 20.7 The kinked demand curve
However, the firm is aware that the degree of sensitivity to its price change will
depend on whether or not the other firms in the market will follow its lead. In other
words, if its rivals ignore the firm’s price change, there will be more sensitivity to this
change than if they all follow suit.
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Figure 20.7 shows the two extreme possibilities for the demand curve which the firm
perceives that it faces. If other firms ignore its action, Dig will be the relevant demand
curve, which is relatively elastic. On the other hand, if the other firms copy the firm’s
moves, Dcop will be the relevant demand curve.
Test yourself 20.15
KEY TERM
price rigidity: a
situation that arises
in the kinked demand
curve model, where
firms in a market avoid
changing the price of
their product because of
the expected response
of rival firms, which will
lead to a fall in revenue
On the other hand, a price reduction takes the firm into the relatively inelastic part of
the demand curve, where it can expect to experience a fall in revenue. This is because
such a move is likely to be seen by the rivals as threatening, and they are likely to copy
in order to preserve their market positions. For a price decrease, then, Dcop is relevant.
Putting these together, the firm perceives that it faces a kinked demand curve (dd). If
the firm faces cost curves MC1 and AC1, the shaded area shows the supernormal profit
being made at the profit-maximising level of output. Notice that the marginal revenue
curve has a break in it at the kink. This means that even if the firm’s cost curves shift
up or down, as long as the marginal cost curve cuts marginal revenue between points A
and B, the firm will continue to maximise profit at Q* output.
The model predicts that if the firm perceives its demand curve to be of this shape,
it has a strong incentive to do nothing, even in the face of changes in costs.
However, it all depends on the firm’s perceptions. If all firms perceive things in
the same way, there will tend to be price rigidity. In other words, no single firm
will want to change its price because of the consequences of so doing. Price will
tend to remain constant.
20 The growth and objectives of firms
In the kinked demand
curve model, is the price
prevailing in the market
likely to be volatile?
The question then is: under what conditions will the other firms copy the price change,
and when will they not? The firm may imagine that if it raises its price, there is little
likelihood that its rivals will copy. By raising its price, the firm faces relatively elastic
demand for its product, so its total revenue will fall. This is a non-threatening move that
gives market share to the other firms. So for a price increase, Dig is the relevant section.
20
If there is a general increase in costs that affects all producers, this may affect the
firm’s perception of rival reaction, and thus encourage it to raise price. If other firms
are reading the market in the same way, they are likely to follow suit.
Notice that this model does not explain how the price reaches P* in the first place. If
firms are so keen to avoid competing on price, they may turn to non-price competition
as a way of maintaining or increasing their market share.
The kinked demand curve model is just one way of trying to explain how firms may behave
in an oligopoly, and goes some way towards explaining why firms may be keen to engage
in non-price competition. However, it is not the only model to explore how firms act
strategically, nor is it inevitable that firms in an oligopoly will always act competitively.
They may instead perceive that it is in their best interest to work together in the market.
SUMMARY: OTHER PRICING POLICIES
» There are many pricing rules that a firm may
» Firms cannot collude by setting up a cartel as
choose to adopt, depending on the objectives it
wishes to achieve.
» Limit pricing occurs when a firm or firms choose
to set price below the profit-maximising level
in order to prevent entry. The limit price is the
highest price that an existing firm can set without
allowing entry.
» Predatory pricing is an extreme strategy that
forces all firms to endure losses. It is normally
invoked in an attempt to eliminate a competitor,
and is illegal in many countries.
this is illegal in many countries. Firms may thus
look for covert ways of colluding in a market: for
example, through some form of price leadership.
» The kinked demand curve model argues that
firms’ perceptions of the demand curve for their
products are based on their views about whether
or not rival firms will react to their own pricesetting actions.
» The model suggests that price is likely to remain
stable over a wide range of market conditions.
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A LEVEL PART 7 THE PRICE SYSTEM AND THE MICROECONOMY
20
END OF CHAPTER QUESTIONS
Multiple choice
1 The managers of a company are considering merging with another company
in a period of boom because they are concerned the market is becoming less
fragmented and competition is reduced. Which of the following reasons for
integration are they pursuing?
A to prevent being taken over by a larger rival
B to achieve economies of scales
C to maximise growth
D to increase market share
2 The dominant firm price leadership model assumes all other firms in the industry:
A believe the price leader can best decide on the prices in the industry
B have the same cost structure as the price leader
C form a cartel
D are price takers
Data response
1 Read the following extract and then answer the questions that follow.
Company objectives and pricing: the PSA-FCA merger and pricing in coach travel
The French motor manufacturer PSA Group and Fiat Chrysler Automobiles
(FCA) have officially signed a deal for a full merger, creating the world’s fourth
largest car manufacturer with combined revenues of US$180 billion. The two
firms say the newly formed public limited company will create ‘leadership,
resources and scale to be at the forefront of a new era of sustainable mobility’.
PSA-FCA will focus on its core markets of Europe, North America and
Latin America – but says it will ‘reshape the strategy in other regions’. Both
firms have struggled to gain a foothold in the vital Chinese market in recent
years and view the merger as their chance to correct this while maximising
shareholder return as they move forward.
The PSA-FCA group aims to retain its commitment to the economic
development of the regions in which it operates. It selects suppliers that meet
strict social and environmental standards and supports the least privileged
members of society through its Corporate Foundation, which funds mobilitybased inclusion and access to education.
The merger will allow for increased investment efficiency. The group is in the
process of launching several electric vehicles including the Peugeot e-208 and
an electric Fiat 500.
For some an alternative to travel by car is travel by coach. In many countries,
coach travel is a competitive market, and typically the price of a ticket will depend
on age, when the journey is being made and how far in advance a booking is made.
A typical set of discounted fare types might include the following:
» Off-peak prices – lower rates than peak times.
» Senior citizen and student fare – 1/3 reduction on standard fare prices.
a Discuss the possible effects of a merger between PSA and FCA on
consumers who are planning the purchase of an electric car.
b Do you agree with the view that the principal–agent problem should not
be a source of concern for PSA-FCA at this time?
c Explain how the sense of corporate social responsibility demonstrated
in the extract might influence the objectives of firms such as PSA-FCA.
d Explain which form of price discrimination there is evidence of in
the extract.
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Essay style
2 Almost the whole of today’s standard theory of the firm is derived from
neoclassical models developed during the early part of the twentieth century
that assume the objective of profit maximisation. To what extent do you agree
that profit maximisation will always be the objective of a firm?
20
CASE STUDY
20 The growth and objectives of firms
Coke versus Pepsi in India
In the mid-2000s it was reported that Coca-Cola and
PepsiCo were fighting to increase their sales in India.
A pesticide scare in the previous year had caused
sales to plummet, and the two firms were anxious to
recover the situation.
The tactics they adopted were to reduce the size of
the bottles for sale in order to appeal to consumers
with low incomes, to cut prices, to increase the
availability of the products in rural areas, and to
encourage more at-home consumption in urban
areas.
It was seen that there was plenty of scope for growth
in the market, as India showed one of the lowest
average levels of consumption of fizzy drinks in
the world, and was substantially below the Asian
average. This may partly reflect the way that children
have been discouraged from drinking colas by their
teachers at school.
The prices being charged were rated as being the
world’s lowest prices for cola as the two firms
battled to increase their market shares. However,
in consequence the firms faced reductions in their
profit margins, and continued to face competition
from local producers. The logistics of supplying such
a geographically large and diverse region, given the
need to ensure refrigeration, added significantly
to costs. Attempts were made to counter this by
reducing the weight of the bottles and by making use
of cheap transport in the form of bullock carts and
cycle rickshaws in the rural areas.
Market analysts said that soft-drink companies
should be able to improve profits, but executives
remained bent on boosting volumes. The vicepresident of Coca-Cola marketing in India was
quoted as saying that ‘any affordability strategy will
put pressure on margins, but it is critical to build the
market’.
▲ Pepsi or Coca-Cola?
The pesticide issue proved to be a long-lasting
controversy, and the Kerala government filed
a criminal complaint against PepsiCo over its
environmental impact, although this was rejected by
the Supreme Court of India in 2010. Indeed, the US
Department of State named PepsiCo as one of the
12 multinationals that displayed ‘the most
impressive corporate social responsibility
credentials in emerging markets’.
Follow-up questions
a Given the statements in the passage, do you
think that Coca-Cola and PepsiCo were trying to
maximise short-run profits?
b Explain your answer to (a) and comment on
what the firms were trying to achieve by their
strategies.
c Identify ways in which the firms were seeking to
influence their costs.
d How do you think PepsiCo’s record on corporate
social responsibility will have affected its position
in the market?
e Discuss what you think the firms would want to
achieve in the long run.
Go online at hoddereducation.com/cambridgeextras
for another case study for Chapter 20.
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A LEVEL PART 8 Government microeconomic intervention
A LEVEL PART 8 GOVERNMENT MICROECONOMIC INTERVENTION
21
Government policies to achieve
efficient resource allocation and
correct market failure
What this chapter covers
★
★
★
★
★
★
taxes and subsidies
indirect taxes – and ad valorem tax
a tax on pollution
direct controls
production quotas, prohibitions and licences
nationalisation, privatisation, regulation and
deregulation
★
★
★
★
★
direct provision by government
pollution permits
property rights and information provision
behavioural insights and nudge theory
government failure
Markets do not always deliver the best outcome for society – for example, where
marginal social benefit is not equal to marginal social cost, or where price is not
set equal to marginal cost. This chapter discusses the effectiveness of policies
available to government to achieve efficient resource allocation and to correct
market failure.
21.1 Taxes and subsidies
Taxation
LEARNING
LINK
The effect of
direct taxes on the
distribution of income
is discussed in
Chapter 22; the role
of taxes in the context
of fiscal policy is
discussed in
Chapter 28.
Governments need to raise funds to finance the expenditure that they undertake,
and the imposition of taxes is a way of raising revenue. One way of doing this
is through expenditure taxes such as value added tax (VAT), which is levied on
a wide range of goods and services. Such taxes levied on goods are known as
indirect taxes, in contrast to direct taxes (such as income tax), which are charged
on the basis of income received by economic agents. In general, direct taxes
are applied at the economy-wide level, rather than being intended to influence
particular markets.
An indirect tax
Chapter 5 explained the effects of a specific indirect tax – a fixed rate tax that is
set at a constant rate for each unit of a good that is purchased. The way in which the
burden of such a tax is shared between buyers and sellers (the incidence of the tax)
was also discussed.
LEARNING LINK
KEY TERM
ad valorem tax: a tax on
expenditure imposed
as a percentage of the
selling price
You may find it helpful to revisit this discussion in Chapter 5, which you will find
on pages 75–76.
Not all indirect taxes work like this. An alternative way of imposing an indirect tax
is by setting the tax at a percentage of the selling price. This is known as an ad
valorem tax.
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An ad valorem tax
Supply plus tax
Supply
P1
P0
Demand
Q1 Q0
Packets of cigarettes per period
▲ Figure 21.1 The effects of an ad valorem tax on cigarettes
Without the tax, the equilibrium for the market occurs at quantity Q0 and price P0.
Imposing the tax causes the price to increase to P1.
STUDY TIP
Notice the difference between a specific tax, in which the supply curve shifts in
parallel to the original curve, and an ad valorem tax, where the slope of the supply
curve steepens with the imposition of the tax.
There are several reasons why the government might want to discourage smoking.
There is the demerit good argument, which suggests that individuals may take poor
decisions about smoking cigarettes. However, there are also externality effects.
Smoking imposes costs on others through passive smoking. Furthermore, smokers
require more medical and hospital treatment as their health declines, taking up scarce
resources in the health sector.
An important question is whether this is an effective approach to discouraging
smoking. The problem is that tobacco is addictive – once someone starts smoking,
they will continue, so their demand for cigarettes will tend to be highly inelastic.
The incidence of the tax will therefore fall primarily on the consumers. In addition, if
demand is highly inelastic, the tax will not have much impact on behaviour, so it will
not have the desired effect of reducing tobacco consumption.
21
21 Government policies to achieve efficient resource allocation and correct market failure
Price
The effect of an ad valorem tax is similar to the impact of a specific tax. It is
analysed in the same way – through shifting the position of the supply curve,
but now the supply curve steepens, as the monetary size of the tax is higher at
higher prices. Figure 21.1 shows the situation if an ad valorem tax is imposed
on the sale of cigarettes in an attempt to discourage the consumption of this
demerit good.
A tax on pollution
A tax can also be used to tackle a negative production externality such as pollution.
Figure 21.2 illustrates the situation. Suppose that firms in the market for chemicals
use a production process that emits toxic fumes, thereby imposing costs on society
that the firms themselves do not face. In other words, the marginal private costs
faced by these firms are less than the marginal social costs that are inflicted on
society. Firms in this market will choose to produce up to point Q1 and charge a price
of P1 to consumers. At this point, marginal social benefit is below the marginal cost of
producing the chemicals, so it can be claimed that ‘too much’ of the product is being
produced – that society would be better off if production were at Q*, with a price
charged at P*.
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Costs, benefits
21
MSC
MPC
P*
Pollution tax
D (MSB)
0
Q* Q1
Quantity of chemicals per period
▲ Figure 21.2 Pollution
Note that this optimum position is not characterised by zero pollution. In other words,
from society’s point of view it pays to abate pollution only up to the level where the
marginal benefit of reducing pollution is matched by the marginal cost of doing so.
Reducing pollution to zero would be too costly.
KEY TERM
polluter pays principle:
an argument that a
firm causing pollution
should be charged the
full external cost that
they inflict on society
How can society reach the optimum output of chemicals at Q*? The polluter pays
principle argues that polluters should face the full external costs caused by their
actions. One approach would be to impose a tax on firms in line with this principle. In
Figure 21.2, if firms were required to pay a tax equivalent to the vertical distance
between marginal private cost (MPC) and marginal social cost (MSC), they would
choose to produce at Q*, paying a tax equal to the green line on the figure.
An alternative way of looking at this question is via a diagram showing the marginal
benefit and marginal cost of emissions reduction. In Figure 21.3, MB represents the
marginal social benefits from reducing emissions of some pollutant and MC is the
marginal costs of reducing emissions. The optimum amount of reduction is found
where marginal benefit equals marginal cost, at e*. Up to this point, the marginal
benefit to society of reducing emissions exceeds the marginal cost of the reduction,
so it is in the interest of society to reduce pollution. However, beyond that point the
marginal cost of reducing the amount of pollution exceeds the benefits that accrue, so
society will be worse off. Setting a tax equal to t* in Figure 21.3 will induce firms to
undertake the appropriate amount of emission reduction.
Costs, benefits
A LEVEL PART 8 GOVERNMENT MICROECONOMIC INTERVENTION
P1
MC
t*
MB
0
e*
Emission reduction
▲ Figure 21.3 Reducing the emission of toxic fumes
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This is not the only way of reaching the objective, however. Figure 21.3 suggests
that there is another possibility – namely, to impose environmental standards, and
to prohibit emissions beyond e*. This amounts to controlling quantity rather than
price; and, if the government has full information about marginal costs and marginal
benefits, the two policies will produce the equivalent result.
The marginal social benefits of reducing pollution cannot be measured with great
precision, for many reasons. It may be argued that there are significant gains to be
made in terms of improved health and lower death rates if pollution can be reduced,
but quantifying this is not straightforward. Even if it were possible to evaluate the
saving in resources that would need to be devoted to future medical care resulting
from the pollution, there are other considerations: quantification of the direct
improvements to quality of life; whether or not to take international effects into
account when formulating domestic policy; and the appropriate discount rate for
evaluating benefits that will be received in the future. Moreover, the environmentalist
and the industrialist may well arrive at different evaluations of the benefits of
pollution control, reflecting their different viewpoints.
Test yourself 21.1
What will be the effect
if the government
overestimates the size
of the tax needed to
discourage pollution?
LEARNING
LINK
Subsidies were
discussed in Chapter
5: in particular, look
back at Figure 5.3 on
page 76.
21 Government policies to achieve efficient resource allocation and correct market failure
Either of the approaches outlined above will be effective – if the authorities have
full information about the marginal costs and benefits. But how likely is this? There
are many problems with this proviso. The measurement of both marginal benefits and
marginal costs is fraught with difficulties.
21
▲ How can we measure the benefits of controlling air pollution?
The measurement of costs may also be problematic. For example, it is likely that there
will be differences in efficiency between firms. Those using modern technology may
face lower costs than those using relatively old capital equipment. Do the authorities
try to set a tax that is specific to each firm to take such differences into account? If
they do not, but instead set a flat-rate tax, then the incentives may be inappropriate.
This would mean that a firm using modern technology would face the same tax as one
using old capital. The firm using new capital would then tend to produce too little
output relative to those using older, less efficient capital.
A subsidy
Subsidies are used to encourage producers to increase their output of particular goods.
A government may wish to do this if it regards certain products as being necessary
for strategic reasons, or because there is some form of market failure that results in a
product being undersupplied.
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How does a subsidy address market failure? A museum may be seen by government
as being a merit good, so a subsidy may be used to encourage more people to visit a
museum or art gallery. Figure 21.4 shows how such a subsidy might be used to affect
the quantity of museum services provided. Demand (MPB) again shows the demand
for museum services from the public, and supply is given by S. Marginal social benefit
(MSB) is what the authorities perceive to be the true value of museum services, but
we assume there is no production externality, so supply is equal to marginal social
cost. The free-market equilibrium position is at Q0, where MPB = S. However, the
government believes that Q* is the socially optimum position, where MSC = S. There is
a deadweight loss in this situation given by the area ABC.
LEARNING
LINK
This is an example
of a positive
consumption
externality, which is
explained in Chapter
16 (see page 221).
STUDY TIP
Remember that if you
are asked to discuss
an indirect tax or a
subsidy in the exam,
the effect is to shift the
supply curve to the left/
upwards (for a tax) or
to the right/downwards
(for a subsidy).
Test yourself 21.2
If demand for a good is
relatively inelastic, will
a subsidy have a lesser
or greater effect on
quantity traded?
If the government could intervene in such a way as to achieve the socially optimum
output of Q*, then this deadweight loss could be avoided. By providing a subsidy, the
supply curve is shifted to S with subsidy, and consumers will choose to demand the
optimum quantity at the subsidised price P1.
Price
A LEVEL PART 8 GOVERNMENT MICROECONOMIC INTERVENTION
21
S
S with
subsidy
A
B
D
P0
C
P1
E
Subsidy
per unit
0
MSB
MPB
Q0 Q*
Quantity per period
▲ Figure 21.4 Subsidising museums
Again, because the price falls by less than the amount of the subsidy, the benefits of
the subsidy are shared between buyers and sellers, depending on the elasticity of
demand. Consumers benefit from paying a lower price, whereas firms receive the
subsidy. The downside of this is that the government has to meet the cost of the
subsidy, which is represented by the area DBEP1. This means that it is not clear
whether there will be a net welfare gain as a result of the subsidy. The deadweight
loss has been avoided, but the government will need to raise the funds to pay the
subsidy, which may involve raising taxes or reducing expenditure elsewhere in the
economy.
If the aim of the subsidy is to increase production, it is only partially successful – the
degree of success also depends on the elasticity of demand.
STUDY TIP
Notice from this that a net welfare gain is not necessarily the exact opposite of a
deadweight loss, as markets in the economy are interrelated, so that intervention in
one market may have unintended effects on other markets.
SUMMARY: TAXES AND SUBSIDIES
»Taxes and subsidies may be used to correct some forms of market failure.
» Indirect taxes may be used in the case of demerit goods.
» Subsidies can help to encourage higher demand for merit goods.
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21.2 Direct controls
Although taxes and subsidies are one way in which a government may attempt to
correct market failure, there may be other situations in which intervention takes the
form of direct controls on prices, or the setting of production quotas or licences.
Indeed, a government may sometimes decide to prohibit the production of some
goods altogether.
21
Price controls
Chapter 5 discussed
the examples
of policies for a
minimum wage (see
page 77) and for rent
controls (see page 78);
the effect of a
minimum wage is
further discussed in
Chapter 23.
Test yourself 21.3
How would the market
for rice be affected if
the government set the
price at which it can be
sold below the market
equilibrium level?
Controlling prices may be introduced if firms are seen to be exploiting their market power.
Will such policies be effective in tackling market failure? If the authorities do
choose to impose direct control of prices, the inevitable result is that the market
concerned will be held in a disequilibrium position. In the case of a minimum
wage, the result could be to increase the level of unemployment; in the case of
rent controls, the result could be that the supply of rental accommodation will be
reduced. Neither of these outcomes is what is intended. A buffer stock scheme can
be used to ensure that agricultural producers receive a minimum price for their
products (see page 79).
In some less developed countries, governments have been tempted to control prices.
Most governments are based in urban areas, and a government may wish to keep the
urban population contented, especially if the government knows that its situation is
insecure. One way in which this may be achieved is by controlling food prices in the
urban areas, ensuring that people there can get food supplies. The problem with this
approach is that if farmers do not receive a fair price for their produce, they will not
have the incentive to supply it, or to improve their farming methods. This will then
have long-term damaging effects on the agricultural sector. Pakistan is one country
that has intervened to try to control prices of essential foodstuffs.
Production quotas and licences
Instead of controlling through price, another approach would be to control quantity.
The discussion of pollution earlier in this chapter noted the possibility of controlling
pollution by limiting emissions of toxic substances. This could be administratively costly,
because it is difficult to be sure about the appropriate level of emissions to be permitted,
not to mention the problem of monitoring whether firms are following the rules.
Price
Production quotas are one way of approaching quantity control. Figure 21.5 shows how
a production quota might work.
A
Quota
Supply
B
Pq
P*
21 Government policies to achieve efficient resource allocation and correct market failure
LEARNING
LINK
C
E
F
Demand
0
Qq
Q*
Quantity
▲ Figure 21.5 A production quota
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A LEVEL PART 8 GOVERNMENT MICROECONOMIC INTERVENTION
21
LEARNING
LINK
The operation of
import quotas was
explained in Chapter
12. Be careful not
to confuse the two
things, which are not
the same thing.
Assume this is a competitive market, and that in equilibrium the market would settle
with output Q* and price P*. If the government were to impose a quota of Qq, the
equilibrium price would rise to Pq. This would have several effects. Consumer surplus
would be reduced from ACP* to ABPq. Producer surplus would also change from 0P*C to
0PqBF. For producers, they gain the area PqBEP*, which was previously part of consumer
surplus. However, they lose the area ECF. Notice also that the area BCF is a deadweight
loss.
Another way in which it is possible to affect production by firms is through a licensing
arrangement. The authorities can choose to permit firms to operate in a particular
market only if they hold a licence. The licence can then specify the conditions under
which production can take place. For example, the government may impose quality
or environmental conditions, or insist that prices do not rise by more than inflation,
perhaps with some allowance being made for productivity improvements. In this way,
the market can operate, but within a controlled framework.
An example might be in water supply, where the authorities specify the standards to
which firms operate to ensure that the supply of water can be secured and its quality
assured. It may also be that the authorities wish to ensure that steps are taken to
conserve the environment.
Prohibition
KEY TERM
prohibition: an
attempt to prevent the
consumption of a good
by declaring it illegal
There may be some goods that a government wishes to prohibit entirely – in other
words, a form of extreme demerit good. Direct action to prohibit the sale of a good
may have some unintended effects. Consider the example of offensive items, such as
certain types of knives. It can be argued that such items represent a danger to the
public and have no legal uses. One response to this issue is to ban the sale of such
goods – a policy known as prohibition. One result of such prohibition may be an
increase in smuggling activity. It may also be likely that those individuals who would
want to own such offensive items will instead obtain knives that are designed for
legitimate purposes, such as chef’s knives. Prohibition may be effective in reducing
the supply of these offensive items but will not necessarily have a major impact on the
outcomes in terms of crime.
SUMMARY: DIRECT CONTROLS
» There are situations in which the government may decide to control prices.
» The downside of this is that price controls force a market to operate in
disequilibrium.
» Imposing a production quota also results in a market being out of equilibrium
and results in a deadweight welfare loss.
» Licensing allows the authorities to influence production in a market – for
example, by specifying quality standards or ensuring productivity improvements.
» For an extreme demerit good, a government may prohibit production or sale of
a good, but this may have unintended effects.
21.3 Nationalisation, privatisation, regulation and
deregulation
Natural monopolies pose particular problems with regard to allocative efficiency.
Figure 21.6 involves an industry with substantial economies of scale relative to market
demand – indeed, the minimum efficient scale is beyond the market demand curve.
(In other words, long-run average cost is still falling beyond market demand.)
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21
Pm
AR (= D)
LAC
AC*
P*
LMC
MR
Qm
Q*
Output
▲ Figure 21.6 A natural monopoly
This market is almost bound to end up as a monopoly because the largest firm is
always able to dominate the market and undercut smaller competitors, as it has a
natural cost advantage over possible rivals. If the monopoly chooses to maximise
profits, it will set marginal revenue equal to marginal cost, choose output Qm and set
price at Pm.
Such industries tend to have large fixed costs relative to marginal costs. Railway
systems, water or gas supply and electricity generation are all examples of natural
monopolies.
The key problem is that if such firms were forced to set a price equal to marginal cost,
they would make a loss. If the firm in Figure 21.6 were required to set price equal to
marginal cost (i.e. at P*) then it would not be viable: average cost would be AC*, with
losses represented by the shaded area on the diagram.
Nationalisation
KEY TERM
nationalisation: where
a privately owned firm
or industry is taken into
public ownership
Test yourself 21.4
Why would a
government not regard
it as appropriate for a
nationalised industry
to make supernormal
profits?
LEARNING
LINK
The principal–
agent problem was
explained in
Chapter 20.
One response to this situation is to nationalise the industry (i.e. take it into state
ownership), since no private sector firm would be prepared to operate at a loss, and
the government would not allow firms running such natural monopolies to act as
profit-maximising monopolists making supernormal profits.
In order to prevent the losses from becoming too substantial, many utilities such as
gas and electricity supply adopted a pricing system known as a two-part tariff system,
under which all consumers paid a monthly charge for being connected to the supply,
and on top of that a variable amount based on usage. In terms of Figure 21.6, the
connection charge would cover the difference between AC* and P*, spread across all
consumers, and the variable charge would reflect marginal cost.
However, this sort of system has been heavily criticised. In particular, it has
been argued that the managers of the nationalised industries were insufficiently
accountable. The situation could be regarded as an extreme form of the principal–
agent problem, in which the consumers (the principals) had very little control over
the actions of the managers (their agents), a situation leading to considerable
X-inefficiency and waste.
21 Government policies to achieve efficient resource allocation and correct market failure
The notion of a
natural monopoly
was first introduced
in Chapter 18 as part
of the discussion of
monopoly markets.
Price
LEARNING
LINK
Nationalisation has been much less used in the twenty-first century in high-income
countries, but there have been some high-profile examples. These have occurred
when a government has chosen to intervene to bail out failing firms. The bailout of a
number of banks in many countries during the financial crisis in the late 2000s is one
prominent example.
The existence of natural monopoly was a key reason for nationalisation in many
countries. However, for some countries such as India state-ownership was seen as a
way of directing resources in order to achieve economic growth.
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21
Privatisation
KEY TERM
privatisation: where
an enterprise in public
ownership is returned
to private ownership
Test yourself 21.5
Why would competition
flourish more readily
in telecommunications
than in some other
natural monopolies?
Privatisation is the transfer of nationalised industries into private ownership, and has
often been a response to the apparent inefficiency of many nationalised or state-owned
enterprises. This was especially the case where the sector being privatised was a natural
monopoly, where it was perceived that managers had faced low incentives to become
efficient. One central argument for privatisation was that this would force managers to
be accountable to their shareholders, which would encourage an increase in efficiency.
In the UK during the 1980s, there was widespread privatisation, as there was in other
Western European countries. This did not remove the original problem: that these
industries were natural monopolies. Therefore, wherever possible, privatisation was also
accompanied by measures to encourage competition, which was seen as an even better
way to ensure efficiency improvements. This proved to be more feasible in some industries
than in others because of the nature of economies of scale – there is little to be gained
by requiring that there be several firms in a market where the economies of scale can be
reaped only by one large firm. However, the changing technology in some of the industries
did allow some competition to be encouraged, especially in telecommunications.
The most recent example in the UK was that of Royal Mail, which was privatised in October
2013, becoming a quoted company on the London Stock Exchange. The company has a
‘Universal Service Obligation’, under which it must continue to provide 6-days a week, one
price goes anywhere postal service. It delivers to 30 million addresses in the UK and is also
subject to control on prices. These obligations are subject to regulation by Ofcom.
Privatisation has not been confined to Western Europe, but it has taken a different form
in transition economies, where there was a need to move away from central planning and
allow market forces to play a greater role in allocating resources. In developing countries
there has also been privatisation, again in a somewhat different form. The aims of
privatisation tend to be similar across different economies. There are three key motivations:
» to improve the performance of natural monopolies
» to encourage economic growth
» to raise revenue for the government
The first two of these reflect a belief that firms in the private sector would have stronger
incentives to look for higher efficiency, especially where there was competition in the
market. Raising revenue by selling off state-owned enterprises was often a secondary
motivation, but may have been an influence in some situations. The effectiveness of
privatisation depends on the feasibility of competition and may also reflect whether the
enterprise was sold to domestic or foreign firms. Where an enterprise is taken over by a
foreign firm with experience of operating in the relevant market, this may be beneficial,
especially in the context of a developing economy. Also significant is the extent to which
the market can be monitored or regulated after privatisation.
Regulation
Test yourself 21.6
Explain why regulation
is important after
privatisation of a stateowned enterprise.
In many markets, it was seen as crucial that the newly privatised enterprises should
be regulated to ensure that the desired efficiency improvements would be made. The
problems of using regulation differ between countries. In the UK and other Western
European economies, the institutional structure allowed close monitoring. In
transition and developing economies, there were challenges to be faced in ensuring
monitoring and regulation.
In Europe, regulation was seen as important in the case of natural monopoly,
especially in sectors where it was not possible or feasible, to encourage competition.
In the case of the UK, regulatory bodies focused on price, and the key control
method was only to allow price increases each year at a rate that was a set amount
below changes in the retail price index (RPI − X). The idea was that it would force
companies to look for productivity gains to eliminate the inefficiency that had built
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up. The X refers to the amount of productivity gain that the regulator believed could
be achieved, expressed in terms of the change in average costs. For example, if the
regulator believed that it was possible to achieve productivity gains of 5% per year,
and if the RPI was increasing at a rate of 10% per year, then the maximum price
increase that would be allowed in a year would be 10% − 5% = 5%.
An alternative method of regulation would be to place a limit on the rate of return
the firm is permitted to make, thereby preventing it from making supernormal profits.
This too may affect the incentive mechanism: the firm may not feel the need to be as
efficient as possible, or may fritter away some of the profits in managerial perks to
avoid declaring too high a rate of return.
Price regulation came under criticism as it was perceived that there was too strong
a focus on cost-saving rather than output delivery, and that companies were looking
for static rather than dynamic efficiency. There was also increasing concern about
environmental issues, and the quality of output that was being produced.
Some less developed countries have faced issues in trying to monitor and regulate
privatised industries because of a lack of rigorous institutions and underdeveloped
stock markets.
KEY TERM
regulatory capture: a
situation in which the
regulator of an industry
comes to represent
the industry’s interests
rather than regulating it
In some cases, regulatory capture is a problem. This occurs when the regulator
becomes so closely involved with the firm it is supposed to be regulating that it
begins to champion its cause rather than imposing tough rules where they are needed.
EXERCISE 21.1
How does the principal–agent argument help to explain why nationalised
industries may become inefficient? How does privatisation (with regulation)
attempt to remedy this situation?
Deregulation
Deregulation occurs where a government removes restrictions placed on producers in a
market in order to encourage competition. This reflects the belief that competition in
a market benefits consumers by encouraging innovation and efficiency improvements
and by limiting the market power of firms.
LEARNING
LINK
The concept of
X-inefficiency is
explained in
Chapter 17.
21 Government policies to achieve efficient resource allocation and correct market failure
There are problems inherent in this approach. For example, how does the regulator set
X? This is problematic in a situation where the company has better information about
costs than the regulator – another instance of the problems caused by the existence
of asymmetric information. There is also the possibility that the firm will achieve its
productivity gains by reducing the quality of the product, or by neglecting long-term
investment for the future and allowing maintenance standards to lapse.
21
The main argument here is that if firms are over-regulated, they may become complacent,
which may result in X-inefficiency. Over-regulation may stifle innovation and risk-taking
that could otherwise lead to new developments that could benefit consumers.
A danger of deregulation is that firms may take too much advantage of their newfound freedom from rules and restrictions. Widespread deregulation of financial
markets in the early 2000s allowed banks in many countries to become too inventive
in their search for new profit-making opportunities, laying the foundations for the
financial crisis that affected the global economy in the late 2000s.
Direct provision
Another way in which the government could intervene to correct a market failure,
or to improve resource allocation, is to undertake direct provision of a good. In the
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case of public goods, there has to be some sort of government involvement, as a free
market will not ensure the provision of these goods.
21
Test yourself 21.7
A LEVEL PART 8 GOVERNMENT MICROECONOMIC INTERVENTION
Why is government
intervention needed to
ensure the supply of a
public good?
Direct provision is closely akin to nationalisation, and many governments have been
reluctant to follow this route. It has been recognised that the same arguments that
apply to the impact of competition on private sector efficiency are also relevant for
public sector activity, so there is no guarantee that direct government provision will
produce a more efficient allocation of resources. Furthermore, governments may not
have the administrative or practical experience to be able to engage directly in the
production process.
However, direct provision is not the only way of ensuring that a good is supplied, and
there are several ways in which the public sector can ensure provision through some
sort of engagement with the private sector that have been developed.
KEY TERMS
contracting out: a
situation in which the
public sector places
activities in the hands of
a private firm and pays
for the provision
competitive tendering:
a process by which the
public sector calls for
private firms to bid for a
contract for provision of
a good or service
public–private
partnership (PPP): an
arrangement by which a
government service or
private business venture
is funded and operated
through a partnership
of government and the
private sector
The simplest form of this is contracting out. Under such an arrangement, the public
sector issues a contract to a private firm for the supply of some good or service. One
example is waste disposal, where a local authority may issue a contract for a firm
to provide the necessary waste disposal service. Competition between firms can be
encouraged by a competitive tendering process. In other words, the contract would
be announced and firms invited to put in bids specifying the quality of service they
are prepared to provide, and at what price. The local authority would then be in a
position to look for efficiency in choosing the most competitive bid.
More complex models of cooperation between public and private sectors have been
developed, involving various kinds of public–private partnership (PPP). A PPP is ‘an
arrangement by which a government service or private business venture is funded and
operated through a partnership of government and the private sector’ (UK National
Audit Office). Such arrangements have been set up in a number of countries. For
example, India has been developing a number of PPPs to help to enhance the country’s
infrastructure such as roads and port developments, which is seen as vital to allow
economic growth and poverty alleviation.
The Covid-19 pandemic that swept the world in 2020 brought unprecedented
reactions from governments around the world. This involved far-reaching
interventions in economies, closing ‘non-essential’ businesses, diverting production
to ensure medical supplies and taking over wages and salaries of workers forced to
remain in quarantine.
SUMMARY (NATIONALISATION, PRIVATISATION, REGULATION AND
DEREGULATION)
» Natural monopolies pose particular problems
»
»
»
»
for policy, as setting price equal to marginal cost
would force such firms to make a loss.
One response to this problem was
nationalisation.
However, this can lead to widespread
X-inefficiency.
Privatisation was expected to encourage
competition and provide better incentives for
managers.
Regulation was put into place to ensure that the
newly privatised firms did not abuse their market
positions, for example by inflating prices or
reducing quality.
» In some cases, regulatory capture was a
»
»
»
»
problem, whereby the regulators became too
close to their industries.
Deregulation of some markets was designed to
encourage competition, which was expected to
benefit consumers.
The danger with deregulation is that firms may
take too much advantage of their freedom.
Direct provision of goods by the government
is possible, but may not always be an effective
solution.
Establishing public-private partnerships is
one way in which the government can ensure
provision of public goods without direct
involvement in production.
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21.4 Pollution permits
Test yourself 21.8
Why might it be difficult
to quantify the size
of the tax needed to
reduce pollution to the
desired level?
pollution permit
system: a system for
controlling pollution
based on a market for
permits that allow firms
to pollute up to a limit
Another approach is to use a tradable pollution permit system, under which the
government issues or sells permits to firms, allowing them to pollute up to a certain
limit. These permits are then tradable, so that firms that are relatively ‘clean’ in their
production methods and do not need to use their full allocation of permits can sell
their polluting rights to other firms, whose production methods produce greater levels
of pollution.
Advantages
One important advantage of such a scheme lies in the incentives for firms. Firms that
pollute because of their relatively inefficient production methods will find they are
at a disadvantage because they face higher costs. Rather than continuing to purchase
permits, they will find that they have an incentive to produce less pollution – which,
of course, is what the policy is intended to achieve. In this way, the permit system
uses the market to address the externality problem – in contrast to direct regulation
of environmental standards, which tries to solve pollution by overriding the market.
A second advantage is that the overall level of pollution can be controlled by this
system, as the authorities control the total amount of permits that are issued. After
all, the objective of the policy is to control the overall level of pollution, and a
mixture of ‘clean’ and ‘dirty’ firms may produce the same amount of total emissions as
uniformly ‘slightly unclean’ firms.
Disadvantages
However, the permit system may not be without its problems. In particular, there is the
question of enforcement. For the system to be effective, sanctions must be in place for
firms that pollute beyond the permitted level, and there must be an operational and
cost-effective method for the authorities to check the level of emissions.
Furthermore, it may not be a straightforward exercise for the authorities to decide on
the appropriate number of permits to issue in order to produce the desired reduction
in emission levels. Some alternative regulatory systems share this problem, as it is not
easy to measure the extent to which marginal private and social costs diverge.
One possible criticism that is unique to a permit form of regulation is that the very
different levels of pollution produced by different firms may seem inequitable – as if
those firms that can afford to buy permits can pollute as much as they like. On the other
hand, it might be argued that those most likely to suffer from this are the polluting
firms, whose public image is likely to be tarnished if they acquire a reputation as heavy
polluters. This possibility might strengthen the incentives of such firms to clean up their
production. Taking the strengths and weaknesses of this approach together, it seems
that on balance such a system could be effective in regulating pollution.
21
21 Government policies to achieve efficient resource allocation and correct market failure
KEY TERM
Earlier in the chapter the possibility of using a tax to tackle pollution was discussed.
A problem with this approach is that it may be difficult to quantify the size of the tax
needed to reduce pollution to a desirable level, or to identify the main culprit firms
that are causing the problem. Furthermore, the cost of implementing and monitoring
such a scheme is high.
An example is the EU Emissions Trading System (EU ETS), which has been in operation
since 2005. It now operates in 31 countries, and limits carbon emissions from more
than 11,000 energy-using installations. The system works on a ‘cap and trade’
system. A cap is set on the total amount of greenhouse gases that can be emitted
by installations that are part of the scheme, with the cap being reduced over time.
Companies in the scheme receive or buy emission allowances that can then be traded
with other firms. The scheme is seen as having had success in reducing emissions. By
2020 they were expected to be 21% lower compared with 2015.
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21
SUMMARY: POLLUTION PERMITS
» Under a pollution permit scheme, the government
» This enables the market to allocate the permits to
issues (or sells) permits to firms that allow them
to emit pollution up to a certain level.
» These permits can then be traded.
where they are most needed, while controlling the
overall level of pollution.
» This reduces the cost and improves the
effectiveness of controlling pollution.
21.5 Property rights and information provision
KEY TERM
property rights: the
social framework that
gives individuals legal
control or ownership of
goods
Property rights
Nobel prize winner Ronald Coase argued that the existence of property rights and
transaction costs is key to understanding how markets work. In other words, the existence
of a system of secure property rights is essential as an underpinning for the economy. The
legal system exists in part to enforce property rights, and to provide the set of rules under
which markets operate. When property rights fail, there is a failure of markets.
In this view of the world, one of the reasons underlying the existence of some
externalities is that there is a failing in the system of property rights. For example,
think about the situation in which a factory is emitting toxic fumes into a residential
district. One way of viewing this is that the firm is interfering with local residents’ clean
air. If those residents could be given property rights over clean air, they could require
the firm to compensate them for the costs it was inflicting. However, the problem is
that with such a wide range of people being affected to varying degrees (according to
prevailing winds and how close they live to the factory), it is impossible in practical
terms to use the assignment of property rights to internalise the pollution externality.
This is because the problem of coordination requires high transaction costs in order for
property rights to be individually enforced. Therefore, the government effectively takes
over the property rights on behalf of the residents, and acts as a collective enforcer.
Ronald Coase thus argued that externality effects could be internalised in conditions
where property rights could be enforced, and where the transaction costs of doing so
were not too large.
Test yourself 21.9
What is meant by the
notion of asymmetric
information?
LEARNING
LINK
The notion of
asymmetric
information was
discussed in
Chapter 15.
Information provision
Market failure can arise from information failure, especially where there is asymmetric
information or where economic agents lack information or the capacity to process the
information available. In such circumstances, the solution would seem to be to find a
way of providing the information to remedy the situation.
One example discussed in Chapter 15 was that of second-hand cars, where car dealers
may find that they cannot find buyers for good-quality cars at a fair price if potential
buyers cannot distinguish quality. The solution here may be to tackle the problem at
its root, by finding a way to provide information about quality. In the case of secondhand cars, inspection schemes or the offering of warranties may be a way of improving
the flow of information about the quality of cars for sale. Buyers may then have
confidence that they are not buying a lemon.
Similarly, in the case of the insurance market, the asymmetric information problem
helps to explain why insurance companies try to cover themselves by insisting on
comprehensive health histories of those who take out health insurance, and include
exclusion clauses that entitle them to refuse to pay out if past illnesses have not been
disclosed. It also helps to explain why banks may insist on collateral to back up loans.
Information problems may also be present in respect of some demerit goods. Think back to
the tobacco example discussed earlier. Tobacco is seen by government as a demerit good
on the grounds that smokers underestimate the damaging effects of smoking. There may
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also be negative externalities caused by passive smoking. At first, taxes were used to try
to discourage smoking in the UK, but given the inelastic demand for tobacco, this proved
ineffective. The taxes were reinforced by extensive campaigns to spread information
about the damaging effects of smoking. When even this did not solve the problem, the
government had to introduce regulation by prohibiting smoking in public buildings.
21
SUMMARY: PROPERTY RIGHTS AND INFORMATION PROVISION
» Information failure can be tackled by ensuring that
important underpinning of the operation of markets.
» In the case of pollution and other issues, the
difficulty of coordinating action when property
rights are held by many different individuals may
dilute its effectiveness.
economic agents have access to the information
that they need.
» However, economic agents may not always
respond to being given information.
21.6 Behavioural insights and nudge theory
One of the key insights of economics concerns the importance of incentives in influencing
the behaviour of economic agents. This is crucial for the design of microeconomic policy,
and governments need to understand how people respond to different types of incentive.
The use of indirect taxes to correct market failure rests on the assumption that people
respond to prices, so that an increase in the price of a good will tend to lead to a
reduction in demand. Behavioural economics is a branch of economic analysis that
blends ideas from psychology with microeconomic analysis, and suggests that people do
not always act rationally as traditional economic analysis tends to assume. One aspect of
this is that people may not always react solely to price signals in their decision making.
They may make decisions based on habit or buy goods on impulse. Indeed, they may
take decisions based on humanitarian motives, or through a sense of loyalty.
KEY TERM
nudge theory: a notion
based on behavioural
theory suggesting
that people can be
encouraged to adopt
behaviour that is
beneficial for society
Test yourself 21.10
Give an example of
how a sense of social
responsibility may
influence behaviour.
From a government perspective, this analysis may offer new ways of inducing people
to take decisions that are beneficial for society. This is sometimes known as nudge
theory, under which governments may be able to nudge people towards taking
decisions and adopting behaviour that the authorities want to encourage.
One example of this is where shops are encouraged to display healthy foods in more
prominent positions to promote impulse buying. The idea has also been used to
develop campaigns that foster good social behaviour: for example, displaying signs
that say ‘Take your litter home – other people do’, or reminding people that there
are CCTV cameras overlooking them. This tries to persuade people that it is their
responsibility to behave in certain ways. During the Covid-19 pandemic the British
government persistently encouraged people to comply with official recommendations
about behaviour because it was socially responsible to do so.
21 Government policies to achieve efficient resource allocation and correct market failure
» The existence of secure property rights is an
Another example of nudge theory is where legislation is passed that allows people to
opt out, rather than opt in to some desirable action: for example, the rules under
which individuals are automatically enrolled in workplace pension schemes unless they
consciously opt out. Research has shown that people are more likely to remain opted
in than to take the trouble to opt out. Robert Thaler was awarded the Nobel Prize for
Economic Sciences in 2017 for his work in this area.
SUMMARY: BEHAVIOURAL INSIGHTS AND NUDGE THEORY
» Behavioural economics is a branch of economic
» It suggests that people do not always act rationally
analysis that blends ideas from psychology with
microeconomic analysis.
as traditional economic analysis tends to assume.
» Governments can use nudge theory to encourage
individuals to adopt behaviour that benefits society.
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A LEVEL PART 8 GOVERNMENT MICROECONOMIC INTERVENTION
21
21.7 Government failure in microeconomic intervention
KEY TERM
government failure:
a misallocation of
resources arising
from government
intervention to correct
a market failure that
causes a less efficient
allocation of resources
and imposes a welfare
loss on society
Most governments see it as their responsibility to try to correct some of the
failures of markets to allocate resources efficiently. This has led to a wide variety
of policies being devised to address issues of market failure, such as taxes on
polluting firms, levies to enable funding of public goods, and campaigns to combat
information gaps. However, some policies have effects that may not culminate in
successful elimination of market failure. Indeed, in some cases government
intervention may introduce new market distortions, leading to a phenomenon
known as government failure. The remainder of this chapter examines some
examples of such government failure.
Causes of government failure
Many of the situations in which government failure arises stem from the
interrelationships between markets in an economy. This means that taking action in
one area can have spillover effects elsewhere in an economy.
Some roles are critical for a government to perform if a mixed economy is to function
effectively. A vital role is the provision by the government of an environment in which
markets can operate effectively. There must be stability in the political system if firms and
consumers are to take decisions with confidence about the future. And there must be a
secure system of property rights, without which markets could not be expected to work.
However, there are sources of market failure that require intervention. This does not
necessarily mean that governments need to substitute markets with direct action.
However, it does mean that they need to be more active in markets that cannot
operate effectively, while at the same time performing an enabling role to encourage
markets to work well whenever this is feasible.
Interventions to address market failure can cause problems if they are not carefully
implemented, or if the government itself does not have sufficient information to take
good decisions. For example, in the case of externalities, the government may choose
to tackle pollution by a tax, or by regulation. However, if it is not possible to identify
the appropriate amount of the tax that is needed to correct the market failure, or if it
is not known how much pollution represents the optimum outcome for society, then it
will not be possible to get the policy exactly right. Similar implementation problems
may arise with other attempts to deal with market failure. The consequences can
impose costs on society, which may exceed the benefits gained from the intervention.
Consequences of government failure
This chapter has explored a range of government policies designed to achieve
improved resource allocation and to address market failure. In evaluating these
interventions, several issues have been highlighted that show areas in which
government failure could arise.
Sales taxes
Governments need to raise funds to finance the expenditure that they undertake.
One way of doing this is through expenditure taxes such as value added tax (VAT) or
excise duties on such items as alcohol or tobacco. You might think that raising money
in this way to provide goods and services such as healthcare that would otherwise be
underprovided would be a benefit to society. But there is a downside to this action,
even if all the funds raised by a sales tax are spent wisely.
The effects of a sales tax can be seen in a demand and supply diagram such as in
Figure 5.2 on page 75. Such a tax is paid by the seller, so it affects the supply curve
for a product, shifting it to the left and leading to a higher equilibrium price but
lower quantity traded.
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To what extent is this good for society? The government has raised revenue as a result
of the tax, so we might argue that the funds raised can be used in a way that benefits
society as a whole. However, the picture is not quite so straightforward. Recall from
Chapter 4 that an efficient allocation of resources is achieved when a market reaches
an equilibrium such that the price of a product is equal to the marginal cost of
producing it. This suggests that the imposition of a sales tax moves a market away
from this ideal state of affairs. It may arise that by imposing a tax to raise funds for
correcting market failure in one part of the economy, the government introduces a
misallocation of resources elsewhere.
Sales taxes
Is it possible to identify how a sales tax will affect
total welfare in society? Consider Figure 21.7, which
shows the market for games consoles. Suppose that
the government imposes a specific tax on games
consoles. This would have the effect of taking
market equilibrium from the free-market position at
P* with quantity traded at Q* to a new position, with
price now at Pt and quantity traded at Qt. Remember
that the price rises by less than the amount of the
tax, implying that the incidence of the tax falls
partly on buyers and partly on sellers. In Figure 21.7
consumers pay more of the tax (the area P*PtBE)
than the producers (who pay FP*EG). The effect on
society’s overall welfare will now be examined.
Remember that the total welfare that society receives
from consuming a product is the sum of consumer
and producer surplus. The situation before and after
the sales tax is as follows. Before the tax, consumer
surplus is given by the area AP*C and producer
surplus is given by the triangle P*CH. How about
afterwards? Consumer surplus is now the smaller
triangle APtB, and producer surplus is FGH. The area
PtBGF is the revenue raised by the government from
the tax, which should be included in total welfare on
Price
EXTENSION MATERIAL
A
Supply + tax
Supply
B
Pt
P*
F
E
C
G
H
Demand
Qt Q*
Quantity of games consoles
▲ Figure 21.7 A sales tax and economic welfare
the assumption that the government uses this wisely.
The total amount of welfare is now ABGH. If you
compare these total welfare areas before and after
the tax, you will realise that they differ by the area
BCG. This triangle represents a deadweight loss that
arises from the imposition of the tax. It is sometimes
referred to as the excess burden of the tax.
So, even where the government intervenes to raise
funding for its expenditure – and spends it wisely – a
distortion is introduced to resource allocation, and
society must bear a loss of welfare.
21 Government policies to achieve efficient resource allocation and correct market failure
Of course, it may be that in this particular market, the government has some other
reason for wanting to reduce the consumption of tobacco. However, if a sales tax is
levied on all goods and services in an economy, this argument cannot be applied.
21
Information failure
A tax on pollution
An issue arose in considering how a tax on pollution might tackle the negative
externality associated with a production process. It was pointed out that setting
the appropriate value for the tax required good information about the extent of the
externality, which would be costly to get. If the tax were to be set at the wrong
level, the consequence would be that resources would not be best allocated. The
administrative cost of setting the appropriate tax and of monitoring firms’ behaviour
might not justify imposing the tax.
A subsidy
A similar issue can arise when setting the level of a subsidy to encourage higher
production of a good. Setting the subsidy will again be costly to the government, and
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21
it may be difficult to find the appropriate level for the subsidy that will produce the
ideal outcome. In order to cover the cost of the subsidy, funds will need to be raised
elsewhere in the economy, which may affect taxpayers, or other markets.
A LEVEL PART 8 GOVERNMENT MICROECONOMIC INTERVENTION
Price controls
If the government intervenes to set prices in a market, whether it be a minimum wage or
rent controls, a distortion is introduced to resource allocation. A minimum wage may cause
an increase in unemployment in some markets, and rent controls may end up reducing the
amount of rental housing available and increasing homelessness. Any direct control of
prices may interrupt the role of prices as signals in allocating resources in society.
Prohibition
Regulating production of undesirable demerit goods through prohibition may
encourage smuggling activities.
Nationalisation and privatisation
The nationalisation of natural monopolies has been seen to be affected by the principal–
agent problem, leading to inefficiencies through limited accountability of management.
The regulation of privatised natural monopolies has also created some problems, and has
been costly to administer. One problem is that of regulatory capture, whereby a regulator
may champion the cause of the regulated enterprise, rather than ensuring compliance.
EXERCISE 21.2
The markets for rented and owner-occupied dwellings are likely to be
interrelated, at least to some extent. Use demand and supply diagrams to examine
how a rent control policy would affect the two markets in the short and long runs.
SUMMARY: GOVERNMENT FAILURE IN
MICROECONOMIC INTERVENTION
» Government failure can occur when often well-meaning interventions by
government have unintended effects.
» In tackling one problem, the government may introduce distortions in resource
allocation that affect another part of the economy.
» For example, imposing a sales tax across all goods and services can lead to
a deadweight welfare loss, even if all the revenues from the tax are used to
benefit society.
» Price controls can create disequilibrium in a market.
END OF CHAPTER QUESTIONS
Multiple choice
1 A government changed the indirect tax on a product from specific to ad valorem.
What can be concluded with certainty?
A The tax is now a fixed amount regardless of the value of the product.
B The tax is now a fixed percentage of the value of the product.
C Richer individuals now pay a higher tax rate.
D There would be more tax avoidance.
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2 What advantage do property rights have over indirect taxes as a method to deal
with negative externalities?
A The extension of private property rights cannot result in government failure.
B Unlike indirect taxes, effective property rights incentivise firms to reduce
pollution rather than penalising them for polluting.
C Property rights, if adequately managed, have the potential to generate more
government revenue.
D Property rights can be used at both central and local levels.
1 Read the following extract and then answer the questions that follow.
What pollutes the air in central Asia?
The government of Uzbekistan is planning to sell off state shares in over 1,000
enterprises. Among the plans is the radical privatisation and upgrading of
Uzbekistan’s energy industry to include renewables and nuclear sources.
This is partly to help improve the economic efficiency of the sector, which is
5 characterised by high costs and low productivity, and partly to address the issue
of air pollution.
In most cities, air quality decreases during November to March when
households increase the use of their heating systems. Air in Tashkent (the
capital of Uzbekistan) was harmful for 80% of the days in 2019.
10 Exhaust emissions from vehicles are a common cause of air pollution in central
Asian cities. For example, there are 420,000 cars registered in Bishkek (the
capital of Kyrgyzstan), while the city is designed for a maximum of 50,000 cars.
Dust storms present the main danger to the population of Dushanbe (the capital
of Tajikistan), where their number has increased in recent years. The main
15 reason for more frequent dust storms is desertification. This has resulted from
the destruction of 700,000 hectares of forest that were in common rather than
private ownership. Scientists argue that the trees had previously stood in the
way of the wind, filtering the dust from the air.
Emissions from heating systems that provide heat to apartment ­buildings also
20 reduce air quality. Authorities in Bishkek claim that powerful filters installed
in the heating systems of the Kyrgyzstan capital successfully purify p
­ articulate
emissions by 97%. In order to pay for these filters, the government of Kyrgyzstan
is considering raising revenue through the introduction of sales taxes.
Percentage of people who intend to make certain decisions based on
climate change in 2020
Buy fewer plastic products
Heat home less in winter
Boycott carbon negative companies
98
81
Fly less
Protest or march for climate change
91 94 95
93
79
75 69
66
78 75 76
56
52
USA
21 Government policies to achieve efficient resource allocation and correct market failure
Data response
21
China
Europe
Source: European Investment Bank
▲ Figure 21.8 Climate change: a key factor in decision making in 2020
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a Explain how the privatisation of the energy industry in Uzbekistan might
encourage an increase in efficiency.
b The extract states that ‘Authorities in Bishkek claim that powerful filters
installed in the heating systems of the Kyrgyzstan capital successfully purify
particulate emissions by 97%’ (lines 20–22). Despite increasing social welfare
through the installation of the air filters, government failure could be created if
the filters are paid for through the introduction of a sales tax.
To what extent do you agree with this statement?
c The extract refers to ‘700,000 hectares of forest that were in common rather
than private ownership’ (lines 16–17). Explain how the existence of private
property rights over the forest could have helped to prevent any
subsequent market failure.
d In order to alter behaviour that affects climate change, the governments
of all three areas represented in Figure 21.8 employ policies based on
nudge theory. Explain what is meant by nudge theory and, with reference
to Figure 21.8, comment on the relative effectiveness of such policies in the
regions identified.
A LEVEL PART 8 GOVERNMENT MICROECONOMIC INTERVENTION
21
Essay style
2 Assess the view that indirect taxation is the best solution to reducing
environmental pollution caused by production externalities.
CASE STUDY
Plastic oceans
The contamination of the natural marine environment by plastics has been increasing, causing a range of
negative effects. These include endangering marine life, damaging maritime industries and infrastructure,
and potentially having an impact
on human wellbeing. This has
received prominent coverage
in the media, with a succession
of studies seeking to analyse
the impact of plastics on the
environment. A prime source of
the contamination is litter – about
70% of litter in the oceans is made
of plastic. In particular, much of
this litter comprises single-use
packaging, as well as rope, netting
and sewage-related debris. A UK
government report published in
2017 noted that if plastic litter
continued to enter the marine
environment at the then-current
rates, this will far exceed the
possibility of its removal.
▲ Plastics pollution
Packaging goods has become part
of everyday life, as any visit to a supermarket will demonstrate. It is cheap and convenient, and firms under
pressure to keep their costs low in order to remain competitive are naturally reluctant to use more expensive
but more environment-friendly materials. This leads to a divergence between private and social costs.
Follow-up questions
a Draw a diagram to show the economic effect of plastic pollution on society.
b Discuss the difficulties in tackling this problem, given that plastic in the ocean is occurring on a global scale.
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A LEVEL PART 8 Government microeconomic intervention
22
Equity and redistribution of
income and wealth
★ the distinction between equity and equality
★ the difference between equity and efficiency
★ absolute poverty and relative poverty
★ policies that can be adopted towards equity and
inequality
★ the poverty trap
In all countries, there is inequality in the distribution of income and wealth. In this
chapter, we explore ways in which a government can attempt to influence the way
in which resources are allocated among different groups in society, particularly in
response to the presence of poverty.
22.1 Equity and inequality
KEY TERMS
inequality: where
different groups within
society receive differing
amounts of income
and/or wealth
equity: where people
in the same situation
receive equal treatment
Some degree of inequality in the distribution of income within a society is inevitable.
Individuals have different innate talents and abilities, and choose to undertake
different types and levels of education and training. This means that they acquire
different sets of skills, which open up different income-earning opportunities.
Inequality also arises because of the pattern of ownership of assets. In other words,
complete equality of income in a society (whereby everyone receives the same amount
of income and wealth) can never be achieved.
22 Equity and redistribution of income and wealth
What this chapter covers
LEARNING LINK
Chapter 5 introduced some key concepts related to inequality in the distribution
of income in a society, and ways in which the degree of inequality can be
measured. It also explained the distinction between income and wealth.
Test yourself 22.1
Provide another
example of how some
groups receive unequal
treatment compared
with others in your
country.
A separate issue is whether there can be equity in the way that people are treated.
One aspect of this is whether individuals face equal opportunities, and whether
identical people receive identical treatment in economic terms. Many people would
acknowledge that people in identical circumstances and with identical skills, abilities
and experience should receive identical income. There are situations in which such
equal treatment is not achieved. One example is that male and female workers receive
unequal treatment in many societies.
In looking at a society, the notion of equity is about whether or not the distribution
of income and wealth among the citizens of a country is fair. This idea of fairness
underlies the question of whether the government needs to intervene to influence the
way in which resources are distributed between individuals and groups.
SUMMARY: EQUITY AND EQUALITY
» Inequality in the distribution of income and wealth
» Equity is where people in the same situation
occurs in all societies.
» This results from differences in talents, abilities
and experience, and from differences in the
ownership of assets.
receive equal treatment.
» Inequity is also present in societies to some
degree.
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22.2 Equity and efficiency
22
A LEVEL PART 8 GOVERNMENT MICROECONOMIC INTERVENTION
STUDY TIP
It is important to
remember that
efficiency and equity
do not necessarily go
together. A resource
allocation may be
efficient, but this does
not mean that it will
always be equitable.
In discussing ways in which markets may fail to lead to an optimal allocation of
resources, the focus has been primarily on questions of efficiency. In particular, it has
been noted that allocative efficiency will not be reached when there is a divergence
between private and social costs or benefits. However, even if a society achieves
allocative efficiency, this does not guarantee that this is really the ideal outcome for
society. It was noted in Chapter 15 that there is no unique overall equilibrium for a
society, and that a different distribution of income between individuals will lead to a
different Pareto optimum position.
What this suggests is that an economy may settle into an equilibrium in which allocative
efficiency has been reached, but the distribution of resources is seen to be unfair.
In other words, there may be times when there is a trade-off between efficiency and
equity in policy design. A policy designed to promote allocative efficiency may not
offer sufficient protection to the poor. A tax on tobacco intended to correct a market
failure may fall disproportionately on low-income groups within society. Here again,
balance is needed to ensure that policy offers sufficient protection for the poor without
compromising the efficiency with which markets are able to work in allocating resources.
22.3 Poverty
All societies are characterised by some inequality – and some poverty. Although the
two are related, they are not the same. Indeed, poverty might be regarded as one
aspect of inequality.
KEY TERMS
absolute poverty:
situation of a household
whose income is
insufficient to purchase
the minimum bundle
of goods and services
needed for survival
relative poverty:
situation in which
household income
falls below a specified
percentage of median
adjusted household
income
headcount ratio:
a measure of the
percentage of a
country’s population
living below a poverty
line
International Poverty
Line: an agreed
measure that defines
the absolute poverty line
based on international
prices, set at PPP$1.90
from October 2015
If there is a wide gap between the richest and poorest households, it is important
to evaluate just how poor those poorest households are, and whether they should
be regarded as being officially ‘in poverty’ and in need of assistance. This requires a
definition of poverty.
One approach is to define a basket of goods and services that is regarded as being the
minimum required to support human life. Households that are seen to have income
that falls short of allowing them to purchase that basic bundle of goods would be
regarded as being in absolute poverty.
Poverty can also be defined in relative terms. If a household has insufficient income
for the members of the household to participate in the normal social life of the
country, then they are said to be in relative poverty. This is also defined in terms
of a poverty line. The line is defined relative to the median adjusted household
disposable income (the median is the income of the middle-ranked household). For
example, in European countries, the line is set at 60% of median income.
A common way of measuring the poverty rate in a country is to estimate the percentage
of the population living below a poverty line, known as a headcount ratio. The poverty
line in this context is an estimate of the income needed to ensure basic human survival.
People living below this level are perceived to be in absolute poverty. To enable
international comparisons of poverty levels, the World Bank has defined an International
Poverty Line. This is based on 2011 prices, and from October 2015 it was set at $1.90 (in
internatonal (PPP) dollars). The line has to be reset every few years in line with changing
prices over time. The World Bank estimated that around 736 million people worldwide
were living beneath this level in 2015 (down from 1.9 billion in 1990). Some individual
countries also set their own national poverty line to reflect local conditions.
Progress has been made to reduce the number of people living in absolute poverty
on this definition, except in sub-Saharan Africa, where the number continues to rise.
However, there was concern that poverty remained a problem, with people living on
incomes that were not significantly higher than the International Poverty Line.
In October 2018 the World Bank launched additional poverty lines to reflect typical
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national poverty lines in lower- and upper-middle-income countries. It was estimated
that in 2015, over a quarter of the world’s population was surviving on less than $2.20
per day, and almost a half on less than $5.50 per day.
22
Figure 22.1 shows estimates of the poverty headcount ratio for a range of countries
around the world. For most developed economies, the headcount ratio at this level is
zero or close to it. Italy is unusual in appearing on this graph, as relatively few highincome countries have poverty on this measure.
This distinction
between absolute
and relative poverty
is an important one.
Absolute poverty
is almost entirely
confined to the less
developed countries,
but relative poverty
can exist in any society,
even in the more
developed nations.
0
10
20
30
50
40
60
70
80
% of population
Source: based on data from World Development Indicators
▲ Figure 22.1 Poverty headcount ratio at $1.90 (% of population)
22 Equity and redistribution of income and wealth
STUDY TIP
China
Sri Lanka
Italy
Pakistan
Brazil
Indonesia
Bangladesh
Nepal
South Africa
India
Zimbabwe
Tanzania
Zambia
Uzbekistan
Madagascar
In Europe (including the UK), estimates of poverty are based on a regular survey
of households conducted in EU member states and some other selected countries.
In 2017, the UK’s threshold for poverty was set at £12,597 per year. This is based
on adjustments for household size and composition. Households with income below
this are described as being in relative income poverty (or being ‘at risk of poverty’);
households that experience this in the current year and at least 2 of the 3 preceding
years are said to be in persistent poverty.
Explain why it is
necessary to recalibrate
the poverty line on a
regular basis.
%
Test yourself 22.2
Figure 22.2 presents some data for a range of European countries in 2017. The
proportion of people below the relative poverty line varies substantially across these
countries, from 11.5% in Finland to 23.6% in Romania.
25
Relative income poverty
Persistent poverty
20
15
10
5
ia
m
an
n
Ro
ai
Sp
ly
Ita
ce
re
e
G
UK
y
an
G
er
m
en
ed
ce
Sw
la
er
th
Ne
Fr
an
s
nd
k
ar
nm
De
nd
0
la
Calculate the median
adjusted household
disposable income
level for the UK in 2017,
based on the fact that
the UK relative poverty
threshold is 60% of the
median.
Fin
Test yourself 22.3
Source: based on data from Eurostat as cited by ONS
▲ Figure 22.2 Relative and persistent poverty: selected countries, 2017
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The percentage falling below the poverty line is not a totally reliable measure, as it
is also important to know how far below the poverty line households are falling. The
income gap (the distance between household income and the poverty line) is useful to
measure the intensity of poverty as well as its incidence.
22
A LEVEL PART 8 GOVERNMENT MICROECONOMIC INTERVENTION
LEARNING
LINK
There is further
discussion of
poverty and how
it is measured in
Chapter 30.
EXERCISE 22.1
Imagine that you are the Minister for Poverty Alleviation in a country in which
the (absolute) poverty line is set at $500 per year. Of the people living below the
poverty line, you know that there are two distinct groups, each made up of 50
individuals. The people in group 1 have an income of $450, whereas those in group
2 have only $250. Suppose that your budget for poverty alleviation is $2,500.
a Your prime concern is with the most needy: how would you use your budget?
b Suppose instead that your prime minister instructs you to reduce the
percentage of people living below the poverty line: do you adopt the same
strategy for using the funds?
c How helpful is the poverty line as a strategic target of policy action?
SUMMARY: POVERTY
» Absolute poverty measures whether individuals or households have sufficient
resources to maintain a reasonable life.
» Relative poverty measures whether individuals or households are able to
participate in the life of the country in which they live: this is calculated as
having 60% of median adjusted household disposable income.
22.4 Policies towards equity and inequality
LEARNING
LINKS
You may find it
helpful to look
back at the earlier
discussion of policies
to address inequality
on pages 81–85.
Chapter 5 introduced some of the policy instruments that a government can use to
influence the distribution of income and wealth in a country.
Policies towards equity
Equity is about fairness, and is probably one of the most difficult areas for
governments to influence. It is one thing to state the principle that everyone should
be treated fairly and equally, but quite another thing to persuade all economic agents
to put that into practice.
In the UK, the Equality Act of 2010 attempts to provide a legal framework to
ensure equal treatment of individuals in employment. This is an attempt to
outlaw discrimination against individuals on the grounds of nine protected
characteristics, including age, gender, race and disability. This means that all
individuals should have:
» an equal chance to apply and be selected for posts pre-employment
» an equal chance to be trained and promoted while employed with the organisation
» an equal chance to have their employment terminated equally and fairly
(www.eoc.org.uk)
There has been some success in raising the profile of what is meant by equity and the
dimensions of diversity, but in the UK there remains a gender gap in pay between men
and women, and proving discrimination can be problematic in some cases.
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Policies to address inequality
A negative income tax
KEY TERMS
transfer payment:
occurs where the
government provides
benefits (in cash
or in kind) to poor
households; hence
there is a transfer
from taxpayers to
the recipients of the
benefits
means-tested benefit:
a benefit (in cash or
kind) paid to people
or households whose
income falls below a
certain level
universal benefit: a
benefit (in cash or kind)
paid without reference
to the income of the
receiving person or
household
Test yourself 22.4
Why would a UBI
scheme be less costly
to implement than a
means-tested benefit
system?
Benefits
Governments can make direct transfer payments from rich to poor households as
a way of redistributing income. Such transfers can be paid in monetary terms, or as
benefits in kind (such as free education or healthcare).
Some benefits may be means tested, that is paid only to those whose income falls
below a certain level. For example, in the UK, households whose income falls below a
certain level are entitled to housing benefit, that is, assistance in paying their rent.
Means testing is designed to make benefits fairer, but these benefits are costly to
administer and monitor.
Other benefits may be universal, that is paid to all, regardless of income. Some
of these benefits are funded through contributions. For example, in Pakistan a
pension is paid to those above the retirement age who have made at least 15 years of
contributions to the social insurance system. This is a universal benefit, in the sense
that anyone who has met the contribution level is entitled to the pension regardless
of their income or asset holdings. However, any shortfall must be covered by the
government, partly through tax revenues.
22
22 Equity and redistribution of income and wealth
negative income tax:
a combined system
of taxes and benefits
under which individuals
receive benefits through
the tax system when on
low incomes, but these
are phased out as their
incomes rise
One possible solution that has been proposed is to introduce a negative income
tax. Under such a system, people with a certain level of income would pay no tax,
and the tax rate would increase as their income grew above that level. People
with incomes below that level would receive payment through the tax system.
This would guarantee that low-income households would receive a minimum level
of subsistence income. Although such a system has been discussed by economists
in the UK and the USA, no such system has yet been implemented because of
logistical and political problems.
Universal basic income (UBI)
There have been proposals to establish a guaranteed safety net for all by paying a
universal basic income (UBI) to everyone, regardless of their economic circumstances.
It is argued that this would give people currently unemployed time to search and
apply for a job. Those at the higher end of the income distribution would receive the
UBI, but in practice would pay it back through higher tax rates. It has been suggested
that such a scheme would be less costly to implement than the rather complicated
welfare schemes operating in some countries. Others have argued that it would simply
discourage individuals from seeking employment.
Finland was the first country to put such a scheme into practice, albeit on a trial
basis. A pilot scheme was introduced in 2017. The income payment was made to 2,000
randomly selected people who were receiving unemployment benefits to see how they
would react. The scheme ran until the end of 2018, but the results were mixed. The
recipients claimed that as a result of the payments, they were happier – but there was
no evidence that they were more likely to find jobs than those who were not in the
scheme. Similar schemes are being piloted elsewhere – for example, in Kenya, Italy
and the Netherlands. During the Covid-19 pandemic, some commentators argued for
the introduction of a UBI in the USA and the UK.
The poverty trap
Problems can arise when a system of means-tested benefits co-exists with a
progressive income tax structure. Consider the incentives facing a person who is
receiving welfare benefits because of unemployment or low pay. Such an individual
may find that there is no incentive to take a job or to work more hours because the
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A LEVEL PART 8 GOVERNMENT MICROECONOMIC INTERVENTION
22
KEY TERM
poverty trap: a situation
in which an individual
has no incentive to
take a job or work
longer hours because
the loss of benefits
and/or increase in tax
payments outweighs
the gain from increased
earnings
gain in terms of earnings would be lower than the loss of benefit payments or the
increase in tax liability. This is known as the poverty trap.
This creates a dilemma for the authorities, who would like to provide protection
for the poor, but also want to offer incentives for people to work. Finding the right
balance between these two policies can be challenging. A negative income tax scheme
could offer a possible solution by guaranteeing a minimum subsistence level of
income. However, proposals to introduce a universal basic income scheme have been
criticised because of the existence of the poverty trap.
Taxation
It was noted in Chapter 5 that direct taxes such as income tax are designed to be
progressive, as tax rates rise as income rises. This means that they are progressive,
as richer households pay more in tax than those with low incomes. Income tax is
therefore one way in which the government can influence the distribution of income.
However, it was also pointed out that indirect taxes, such as taxes on expenditure,
tend to be regressive. This is because lower-income households spend a higher
proportion of their income, and may also be more likely to spend on products such as
tobacco on which the tax is often higher than on other goods.
This means that achieving a balance of taxation between direct and indirect taxes is
an important aspect of the government’s redistributive policy. A switch in the balance
from direct to indirect taxes will tend to increase inequality in a society.
It is also important to be aware that taxation may have intergenerational effects.
High taxation today in order to fund expenditure on today’s generation may leave
future generations struggling for resources. This is related to the notion of sustainable
economic growth and development. On the other hand, high taxation today in order
to provide improved living conditions for future generations may increase poverty
in the current generation. There is thus a need to maintain a careful balance across
the generations, which requires the government to be able to take a long-term view.
In this context, having a stable political environment is significant, as without such
stability, governments may be tempted to take a short-run view.
LEARNING LINKS
The concept of sustainable economic growth and development is explained in
Chapter 25 and there is more discussion of the macroeconomic impact of
taxation on the distribution of income in Chapter 28 in the context of the
effectiveness of fiscal policy.
SUMMARY: POLICIES TOWARDS EQUITY AND INEQUALITY
» Policy towards equity needs to promote fairness
» Proposals have been discussed whereby a
in the way that people are treated: for example,
through encouraging equal opportunities.
» One approach to tackling inequality is to
implement a negative income tax, but there are
problems in terms of logistical and political
problems.
» Transfers from rich to poor households in the form
of monetary benefits or benefits in kind are one of
the most important ways of tackling inequality.
» Such benefits can be universal (provided to all) or
means tested.
guaranteed safety net would be provided in the
form of a universal basic income (UBI) that would
be paid to everyone.
» Pilot schemes have been launched in a number of
countries around the world.
» Problems can arise if benefit levels are set so high
that individuals have little incentive to work – this
is known as the ‘poverty trap’.
» The balance between (progressive) direct taxation
and (regressive) indirect